There is growing global anticipation that central banks are likely to increase short-term rates. The spectre of inflationary pressure on longer-term rates looms large. What does this mean for value and growth stocks? Value might be expected to come up top and growth to lose out. But this is not the whole story. We examined stock returns during several historical periods of rate increases in the US and UK to see which factor would ultimately come out on top, and when. 

  • The tennis match between value and growth stocks is coming to a close

There is growing global anticipation that central banks are likely to increase short-term rates. The spectre of inflationary pressure on longer-term rates looms large. What does this mean for value and growth stocks? Value might be expected to come up top and growth to lose out. But this is not the whole story. We examined stock returns during several historical periods of rate increases in the US and UK to see which factor would ultimately come out on top, and when. 

Until this year, value stocks were suffering from chronic underperformance, leaving many asking whether the value factor was dead. Throughout the pandemic growth stocks consistently climbed, with investors piling into companies such as Amazon and Tesla. But as the global vaccination rollout began and economies started to open up, the performance of value stocks improved. Stocks including utilities and banks got a much-needed boost and investors questioned whether the much spoken about great rotation to value had begun. It had not. 

Since then, value and growth stocks have both flip-flopped from periods of strong outperformance to periods of strong underperformance. In July, it was growth stocks that did well. All growth sub-factors, including earnings growth and dividend growth, performed strongly. The only exception was forecast growth, which did see underperformance. 

On the other hand, value stocks underperformed across the board in the same month. All value sub–factors, including book to price and cash flow yield, saw a significant decline. Momentum stocks, which had previously taken on more value stocks, covered a combination of growth and value, in addition to quality. So far in 2021, there has been no clear winner. But with economic conditions shifting, this tennis match between value and growth stocks should come to a close.  

Change in US 10-year rate and active performance of value:growth stocks

On any given day over the past nine months, it would be possible to predict accurately whether value stocks or growth stocks would perform better by looking at the 10-year bond rate’s movements. On days when bond rates went up, value beat growth. On days when bond rates went down, growth stocks came up on top. This is because long-term interest rates force growth stocks, which tend to have longer-term cash flow horizons than value stocks, to be more heavily discounted. As a result, growth stocks appear less valuable. This means that rising rates should help value stocks and hurt growth stocks. 

Yes, rising rates will ultimately see value outperform but, crucially, only if they rise fast enough. Betting on value stocks before long rates rise more than 5% in a given month in the US or by more than 20% in the UK might not bring investors the returns they hope for. Historically, when interest rate increases were slower than those thresholds, there was no clear winner between value and growth. Only rapidly increasing rate hikes resulted in a clear outperformance by value.

We looked at the returns from stocks across several historical periods of rate increases to see how they might react this time around. In the US, we looked at March 1983 to June 1984 (10.7% to 13.56% rise in the 10-year rate), March 1987 to August 1987 (7.25% to 8.76%), February 1994 to November 1994 (5.75% to 7.96%), October 2010 to December 2010 (2.65% to 3.29%), and August 2020 to April 2021 (0.62% to 1.64%). In the UK, we looked at August 1989 to May 1990 (9.91% to 12.4%), June 1994 to November 1994 (8.71% to 8.64%), October 2012 to Apr 2014 (1.77% to 2.75%), and July 2020 to April 2021 (0.21% to 0.85%). 

Using our Style Analytics factor database, we measured the monthly returns during the periods of interest rate increases for portfolios. This was made up of the top quartile of stocks on value measures such as book-to-price, free-cash-flow yield and sales-to-price and on growth measures like earnings growth, sales growth and forecast growth. We then averaged those returns to determine the overall value and growth return in each month.

“Yes, rising rates will ultimately see value outperform but, crucially, only if they rise fast enough”

Recent long-term rates increased from a low of about 50bps in August 2020 to a high of about 160bps this May in the US and from 20bps to about 90bps in the UK. But what can we expect from stocks if inflationary pressure pushes those rates back to historically ‘normal’ values like 3% or 5%, or even higher? 

The US value-growth spread is about twice as sensitive to rising rates as the UK spread. Our research has found that in the US, value stocks outperform growth stocks by about 100bps for every 10% rise in rates. For example, if rates rise from 1.0% to 1.1% within a month, we can expect to see value stocks outperform by about 100bps over growth stocks (as shown in the figure). 

In the UK, the value-growth spread is about 100bps for every 20% rise in monthly rate. This means that for value stocks to see a 100bps outperformance on growth stocks, rates would need to increase from 1% to 1.2%. 

But value only consistently wins if rates rise fast enough. In the US, value only systematically beats growth once the 10-year rate rises more than 5% in a given month. In the UK, the minimum rate increase is closer to 20%. Below those amounts, there is no clear winner between growth and value.  

So, will value finally beat growth? Only if long-term rates rise above their local market thresholds. Monthly factor performance analysis has shown both value and growth winning over the year so far and, in the short term, this looks set to continue. Growth stocks can breathe a sigh of relief, for now. 

Damian Handzy is head of research and applied analytics and James Monroe senior client consultant at Investment Metrics