Great rotations: The value factor

In December, the ‘Value trade’ continued to do well as the US Federal Reserve made the environment for the style more conducive by signalling inflation concerns and that it expects to raise rates faster than expected.

Higher rates reduce the value of companies’ future earnings, which weighs more on growth companies with their profit expected in years ahead.

Value stocks are less sensitive to changes to macroeconomic conditions and have a history of emerging as the winning ‘factor’ following a recession.

The return of rising rates

US inflation exceeded five per cent, well above US Federal Reserve’s long-term target of two per cent. Prior to the end of the last quarter, markets and US Federal Reserve had shrugged off this concern, citing that the drivers were ‘transitory’ as opposed to persistent, expecting inflation to “cool off”.

That has changed. Chairman of the US Federal Reserve, Jerome Powell said of ‘transitory’, “I think it's probably a good time to retire that word and try to explain more clearly what we mean,” during a congressional hearing at the start of December, 2021.

The market reacted almost immediately, with rate rises expected as early as this year and inflationary pressures expected to persist.

Chart 1: US Fed fund rate, expectations and wages pressure

The impact of rising rates and high inflation on equity markets

Historically, Value companies have outperformed when inflation and interest rates increase, as they are less sensitive to changes in macro-economic conditions. High inflation and rising rates were characteristics of markets in the late 70s and 80s.

Given this, investors seeking to tap the current trends may wish to consider the VanEck MSCI International Value ETF (VLUE). It is worthwhile noting that the December month outperformance is not an historical aberration. Since the turn of the century the value factor has outperformed the MSCI World ex Australia Index, despite its ‘lost decade’ past the GFC.

Based on back testing, the index VLUE tracks (net of VLUE’s 0.40% p.a. management costs) displays strong long-term performance, as highlighted by the chart below.

Using Value in a portfolio

As evidenced above, the performance of factors can be cyclical. Value has been used by savvy investors to diversify their other exposures, by combining approaches.