The first weeks of 2022 saw a rise in cyclical sectors and a fall in growth stocks. Several factors drove this move, starting with the rise in interest rates, linked to the prospect of monetary tightening by the Fed.
This is one of the highlights at the start of the year: in the United States, inflation is now at 7% over 12 months. By disrupting supply chains and creating unprecedented stimulus from governments and central banks, the Covid-19 pandemic has become the source of a powerful rise in global inflation.
Rising rates unfavourable for growth stocks
For the Fed, it is time to act. After supporting the recovery with its low interest rates and its asset purchase policy, the US central bank is about to make a strategic shift. Its asset purchases will end in March 2022, when a first key rate hike should also be implemented. Several key rate hikes are expected in 2022.
This outlook has significant consequences for bond markets. Since the beginning of the year, US rates have been rising, in line with a scenario of higher inflation and tighter monetary policy. As a result, the US 10-year borrowing rate has returned to its highest level for two years, close to 2%. The US 10-year real rate remains negative and below its pre-crisis level, but has also risen in recent weeks. However, there is a strong correlation between this real rate and the relative performance of cyclical stocks to growth stocks.
For all intents and purposes, remember that cyclical stocks are those whose activity depends on the economic situation: banks, insurance companies, real estate companies, industry, automotive and energy. We are also talking about value sectors, in reference to their moderate valuation multiples. Conversely, “growth” stocks refer to high-growth sectors, including technology and luxury goods.
The impact of rates on these two major categories of companies is, of course, not a coincidence. The phenomenon is based on two clearly identifiable pillars.
In traditional valuation models, companies’ future revenues are mathematically updated by taking long-term rates into account. Thus, the lower interest rates are, the higher future income is valued. We therefore understand that growth stocks, benefiting from high visibility of their future earnings, are benefiting in periods of low interest rates, as this was the case in 2020 and 2021. Conversely, if rates rise, models lead to lower valuations for these companies.
From a more operational point of view, the banking and insurance sector, based on credit margins and investment, is structurally more profi-table in a context of high rates. This effect can only be observed over the long term: – rate hikes observed since the beginning of the year do not allow the sector’s outlook to be revised right now. Nevertheless, the rise in rates is contributing to its revaluation by easing the prospect of persistently low interest rates.
Multiple drivers for cyclicals
Simultaneously with the rise in interest rates, which is particularly beneficial to financial stocks, other factors are supporting the “cyclical” universe.
First of all, the Covid-19 pandemic benefited the “stay at home” stocks, particularly tech stocks. On the other hand, the “go out” stocks, including transport, hotels and shopping center real estate companies, had been severely affected. This negative effect has spread to the whole of non-tech stocks, often from cyclical sectors.
This trend is now tending to reverse itself: the prevalence of a less dangerous Omicron variant, combined with less stringent health measures, suggests a return to normality. Cyclical companies are therefore regaining a more stable outlook.
At the same time, the economic upturn seen in 2021 was accompanied by various shortages, the most striking of which was that of semiconductors. The production of these components, penalised by disruptions in supply chains, was unable to meet demand. The automotive sector was one of the most affected: last year, most manufacturers were unable to meet their production targets because they did not receive the necessary components for vehicle assembly. These shortages are now being resolved and this is excellent news for the automotive sector, for which sales could finally increase after two difficult years.
Lastly, the return of inflation at the end of 2021 resulted in a sharp rise in commodity prices. Oil, returning to above $85/barrel, reached its highest level since 2014. Gas and electricity prices have reached all-time highs in Europe for reasons we have already mentioned.
The situation is therefore beneficial for some energy companies, but not all. The French case is the perfect illustration of this: while the increase in electricity prices seems first and foremost to be good news for EDF, in January the group published a significant profit warning relating to its 2022 forecasts. In question: the losses caused by the limitation of electricity sales prices in France, in addition to the shutdown of certain reactors due to maintenance. This proves that within the energy sector, situations can be very different from one company to another.
In short, sector rotation towards cyclical stocks is a market opportunity to exploit, but requires a high level of vigilance in the selection of stocks. It should also be noted that the recent outperformance of these stocks, which we had anticipated by signalling long-standing interest in the banking sector, does not limit the interest of certain growth stocks, especially when they have a solid capacity for innovation. The latter can therefore provide an additional driver of performance, but the current period leads us to favour cyclical, quality, often undervalued stocks.
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Article drawn up on 28 January 2022. This document is not pre-contractual or contractual in nature. It is provided to its recipient for information purposes. The analyses and/or descriptions contained in this document should not be interpreted as advice or recommendations from Lazard Frères Gestion SAS. This document does not constitute an offer or invitation to purchase or sell, nor an encouragement to invest. This document is the intellectual property of Lazard Frères Gestion SAS.
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