Global equity markets were a bit herky-jerky on the quarter. A strong rally characterized the early part of the summer as the MSCI ACWI Index was up over 3% in the first two months of the quarter. What had already been an impressive 2021 run-up looked like it was going to continue. Headline GDP numbers (granted, off a low base) seemed to paint a rosy picture. And then September hit. A toxic brew of worries spoiled the mood as the world seemed to come to grips with the damage wrought by the Delta variant in all its forms – return-to-work hesitancy, further lockdowns, back-to-school worries and tensions, global supply-chain snafus, etc. Throw daily reminders of price hikes at the gas pump and the supermarket into the mix, and a dreaded term from the 1970s re-emerged: stagflation. The rally came to a halt globally and gave back all of the summer’s returns. MSCI ACWI lost over 4% in September, driving the quarterly return to -1.1%. To be fair, global markets did not move in sync. The U.S. was able to hold up a bit better, with the S&P 500 up +0.6%. MSCI EAFE was down -0.5% (in U.S. dollar terms). Japan, which often marches to its own drummer was up: the Tokyo Stock Price Index (TOPIX), for example, returned +4.6%. Ironically this was because of (not despite) a bit of political turmoil as Suga’s resignation led to a rally on the view that the Liberal Democratic Party (LDP) would continue its fiscal and monetary support. It was the emerging markets that got particularly pinched in Q3, with the MSCI Emerging Markets Index down -8.1% (in U.S. dollar terms). The main culprit was China, which lost -18%. Broadly, markets were spooked by the prospect of an Evergrande (the Chinese real estate conglomerate) bankruptcy and its contagion effect, but the big story in China was the central government’s crackdown on education and technology companies. Importantly, it was the growth stocks within China that suffered the most damage as the MSCI China Growth Index was down over -22%.
This herky-jerky nature of markets also applied to the path of Value vs. Growth stocks. In the early part of the quarter, Growth was experiencing a reversal of “the reversal;” that is, Value stocks around the globe had begun re-asserting themselves last fall after a decade-long hiatus. They had been posting some very impressive returns, both in absolute terms and relative to Growth, but this movement reversed (again) in July and August. Many point to today’s relationship between the change in interest rates and this Value/Growth interplay, which seemed to hold sway during the quarter. For example, as the yield on the U.S. 10-year Treasury shifted downward in July and August, Growth beat Value; come September, inflation fears stoked a rise in yields and Value beat Growth. We have written about this extensively on our website (www.gmo.com), but it bears repeating: While correlations are positive today, the longer-term relationship between rates and the Value/Growth dynamic is unstable, and over the very long term, it has actually been negative. Remember, the best performance of Value vs. Growth in U.S. history occurred in the 2000 to 2003 period – when interest rates were declining. Our contention, therefore, that Value deserves to win over Growth is not predicated on a call about future interest rates or inflation; instead, it is based on something much more fundamental and logical. Value deserves to win simply because it is the cheapest it’s been relative to Growth in over 20 years. The last time we saw Value this cheap relative to Growth was during the last few gasping months of 1999. When that Value reversal started, it too, was herky-jerky and non-linear; but for those of us that care about these things, it was the beginning of a multi-year dominance of Value.
Ten-year Treasury yields were falling through the early part of the quarter and then rebounded hastily in September, finally settling in a little bit higher than June 30 levels. Break-evens also ticked up, albeit modestly once all was said and done. The term “transitory” has become an internet meme in a mocking way, though many people on Main Street are suffering the very real effects of rising prices at the pump and in the food aisles. There’s nothing transitory about it. Yet longer term, break-evens, while higher, are still trading in a largely range-bound pattern. Mr. Market believes quite certainly that the current spike in CPI will be short-lived.
Credit spreads widened in the high yield space, but it was more pointed in the lower quality cohorts. In the end the asset class was still able to chunk out a positive return, with the ICE BofAML U.S. High Yield Index up 0.9%. Emerging debt also saw a general risk-off period, with spreads widening in higher-beta and lower-rated countries (Sri Lanka, Pakistan, and Egypt, for example). The JPM EMBIG Index was down -0.5%.
The end of the quarter still leaves us in a Growth bubble. The valuation spread between global Value and Growth remains historically wide. Valuation spreads across asset classes more broadly in rates, FX, and commodities also represent huge opportunities in the non-traditional long/short space. Different impairments from, and different government and Central Bank policy responses to Covid-19 and its economic devastation have left cross-sectional rate FX plays attractive. Merger activity is healthy, with a robust pipeline, wider-than-average spreads, and a variety of deals across structures and industries.
Our main message is still the following: 1) exploit the bubble with a long cheap-value/short expensive-growth equity strategy, 2) avoid the bubble by investing in liquid alternatives, and 3) concentrate assets away from the bubble by investing in EM value, Japan small value (which is benefitting from historically cheap valuations and improving fundamentals), quality cyclicals, and quality, and 4) for fixed income portfolios, keep duration shorter than normal and use active management in credit, where there remains pockets of dislocated pricing and a rich alpha opportunity set.
The end of the quarter is also a time to breathe and take stock more broadly of the “mood” of the markets and our clients. While we were encouraged by the outperformance of Value in the first six months of the year, this quarter’s reversal of the reversal, especially in July and August, was disappointing. We understand the frustration. We feel it too. It has been a long, hard road for all valuation-sensitive managers, and 2020 (the worst year in history for Value’s underperformance of Growth) added insult to injury; 2021, indeed, offered powerful glimmers of hope. Still, some fear it may be too little too late.
To be sure, frustration is even more poignant on the way up. It’s hard to be a valuation-based manager from a psychological perspective given our tendency to lag during up markets and lose less during down markets. In the long term, it is a wonderful way to compound wealth. But in the short-to-intermediate term, it can feel unsatisfying. Truth be told, the real pain is the lagging on the upside – particularly during higher-than-average market run-ups. And it is really hard to focus on valuation when entering the speculative phase of that run-up. Nothing is more frustrating, as Jeremy Grantham has pointed out, than watching your neighbor get rich. Again, we understand and appreciate this painful phenomenon.
It is worth noting that this multi-year U.S rally has been primarily about multiple expansion, not fundamentals. That is not a good thing. In fact, the last 7 years has seen mean-aversion, not mean re-version. In 2014, the cyclically adjusted price-to-earnings (CAPE) ratio stood at a heady 26 (close to the levels of the market top of October 2007), putting it in the 92nd percentile of expensiveness. It would have been reasonable back then to think that U.S. stocks were looking pricey. Since then, however, they have defied mean reversion’s gravitational pull by going up even further and blowing past 2007 and 1929 levels. Today, the CAPE ratio stands at 38, which is in the 99th percentile. During this same time frame, the U.S economy grew at a measly 1.9% real. Sales for the S&P 500 grew a miserly 1.9% real, and EPS for the S&P 500 grew at 4.5% real, which is nice, but hardly spectacular (and frankly driven more by stock buybacks than true earnings growth). We acknowledge the earnings growth from the depths of the Covid-induced lock-down beat expectations and has recovered to pre-pandemic levels. The problem is that overall long-term growth has been OK at best while price movement has been exuberant.
But we have seen this movie before. In fact, it is eerily reminiscent of the late 90s’ lead-up to the TMT Bubble. All through 1997, 1998, and 1999, clients and consultants were losing patience with our performance. This late 90s experience at GMO – that gnawing, pit-in-the-stomach fear that perhaps Value was dead – has even been memorialized at the Harvard Business School. GMO is literally a case study due to our ability to hang on to our forecasts and stay disciplined in the face of second-guessing. We mention this, of course, because ultimately mean reversion occurred. Maybe not on time, maybe a bit too late for some – but it nevertheless arrived. And it did so with a vengeance. The Russell 1000 Value Index went on to beat the Russell 1000 Growth by over 14% per year for the next 7 years. Again, there is no guarantee that Value’s dominance will repeat in the same time frame or by the same magnitude; but we believe with equal vigor that it deserves to.