Why Growth Stocks Are Looking Good Again

Summary

• In equity markets, the 2021 storylines have been large caps versus smaller caps and growth versus value.
• After enjoying mega-rallies, growth has been battered by rising rates, and smaller caps lost their post-election tailwind.
• The recent rally in large-cap growth stocks suggests investors are becoming more confident that the Fed will not mount any pre-emptive strike against inflation.

Market Implications

• We favour large-cap growth over value.
• We are neutral on large caps versus smaller caps, although that could change as President Biden’s infrastructure proposal evolves.

To say that equities in 2021 have been a battle royale between large- versus small-capitalization stocks and growth versus value would be an understatement.

For the record, over the past 20 years, smaller caps have tended to outperform large caps (Chart 1).^[1] There is no good reason to think that will stop being the case – at least for buy-and-hold investors over the medium term.

Growth Has Been About Tax Cuts and Low Rates

The growth versus value story is more nuanced. For much of the past 20 years, until the 2017 tax cut, relative returns for growth and value styles have seesawed (Chart 2). (Here we look at cumulative price returns for growth divided by value, or relative price performance of growth.)

During the 2000s, following the excesses of the dot-com era and the corporate accounting scandals at Enron and World-Com, value was the clear winner, especially for large caps. Among small caps, there was less differentiation. After the financial crisis, growth tended to be the stronger performer for about eight years, although there were periods when value did better. Then growth took off in late 2017 after Corporate America received a huge tax cut, especially for large caps.

The growth sector for all three cap sectors again leaped ahead of value by more than 20% in March 2020when the Fed slashed rates and the 10-year Treasury yield fell from 2% to 0.5%. When the 10-year Treasury yield started rising again, growth began relinquishing some of the earlier gains.

Markets Are Very Technical These Days

The growth versus value outlook is a rate-driven storyline – one readily apparent in recent weeks as the 10-year Treasury yield traded in a narrow 15-basis-point range. From the election to around 12 February, growth and value traded close together for both large- and mid-cap equities. Then as the 10-year Treasury yield crossed 1.3%, growth slumped and value jumped (Charts 3a and b). But once the yield peaked at 1.75% and started retreating, large-cap growth started rallying, taking the S&P 500 to record highs. In the mid-cap sector, value and growth have been moving roughly in line with each other lately. The recent performance of small caps is similar to mid caps.

We see the recent price action as indicating a growing conviction that even if inflation ticks up, it is unlikely to turn into an upward spiral. And that in turn means the Fed is unlikely to raise rates.

Markets Are Unconcerned About Inflation by Itself

We would hazard a guess that the markets are not really worried about inflation per se. It collectively knows upward-spiralling inflation is off the cards. Their worry has been that if inflation does approach or exceed the Fed’s 2% target, the Fed will take pre-emptive measures to control its rise.

In that light, the resumption of the rally in growth can be seen as a growing (if still tentative) confidence that the Fed is serious about keeping rates near zero indefinitely.

Equity markets being the manic-depressive beasts they are, we can reasonably expect further angst about the Fed, especially if the key 10-year Treasury yield starts pushing above 1.75%. Barring some major exogenous shock, we doubt that will lead to a significant selloff.

We Favour Growth Over Value

Our underlying macro view is that while inflation may perk up in coming months, it will struggle to stay near or above 2%. And we firmly doubt the Fed will make any pre-emptive move to raise rates.

Given this outlook and looking beyond near-term technicals, we favour growth over value, particularly in the large-cap sector. One potential risk for growth is whether and to what extent President Joe Biden can raise the corporate tax rate to pay for his infrastructure plan. It may be some months before we get a clear read on likely changes to tax policy. His capital gains tax proposal for the wealthy could be another near-term headwind but we doubt it will have any lasting impact.

We are neutral on large caps versus smaller caps. We noted back in January that the small-cap Russell 2000 had performed exceptionally well since the election and that, at this point in the cycle, large and smaller caps tend to trade roughly in line with each other. Nevertheless, the Russell 2000 kept sprinting ahead, outperforming the S&P 500 by a further 13% at one point. But between a selloff in the Russell 2000 and recent gains in large caps, these indices are close to even year-to-date (Chart 4). For now, we think small caps are unlikely to systematically outperform large caps, but that could change depending on how Biden’s infrastructure plan progresses. That said, ongoing technicals will likely favour one side over the other at various times, which may provide opportunities for trading-oriented investors.

Table 1 below summarises major ETFs for subsectors of the S&P 1500 and Russell 3000 indices.

1. In this note, we focus on the S&P 500 (large caps), S&P 400 (mid-caps) and S&P 600 (small caps). Major EFTs covering these sectors are SPY, IJH, and IJR, respectively. ↑