Discover why value and income-oriented stocks are set to outperform in today’s market dominated by rising interest rates and persistent inflation.
The Case for Value and Income-Oriented Stocks
The post-pandemic era has seen a significant divergence in the valuation of value and income-oriented stocks compared to growth stocks. This widening gap—now at almost 50%—could signal a multi-year period of outperformance for value stocks. The environment of near-zero interest rates over the past decade, which fueled growth stocks, is giving way to a period where the cost of capital is more significant, and inflation is likely to remain elevated. These factors could provide a tailwind for value stocks, which typically benefit from higher interest rates and inflationary pressures.
Interestingly, while the broader equity market has performed well in 2023, high-dividend-yielding stocks, as represented by the MSCI World High Dividend Yield Index, have lagged, returning only 3%. This underperformance, coupled with the attractive starting valuations, suggests that now could be an opportune time to consider value and income strategies. Looking ahead, the market-cap-weighted indices may deliver lower returns over the next decade compared to historical averages. For investors, focusing on high-dividend-paying companies could provide a valuable head start in outperforming these indices over time, particularly if broader equity returns settle into a 5% to 6% range.
The Fed’s Next Move: A Rate Hike that May Not Matter
As for the Federal Reserve, the recent decision to keep rates steady was widely anticipated. However, the question remains whether another hike is on the horizon. We expect one more rate hike but it may not significantly impact the market. The Fed’s primary focus remains on bringing inflation back toward its 2% target, even at the expense of growth. Despite some signs of economic softening, particularly in leading indicators for employment, inflation is still running above trend, compelling the Fed to maintain its tightening bias.
Interestingly, the Fed may be willing to tolerate slightly higher inflation, particularly if it results from wage growth among lower-income earners, as this could help compress the wage gap. However, inflation at current levels—around 4%—remains too high for comfort, making it likely that the Fed will opt for at least one more hike before potentially pausing.
Navigating Fixed Income in a Precarious Environment
In the fixed-income space, we believe the focus should be on relative value across the three central balance sheets: government, corporate, and consumer. The consumer balance sheet, once a stronghold, is now deteriorating rapidly, driven by higher mortgage rates and financing costs. Meanwhile, government balance sheets, particularly in developed economies, are also under pressure, although they still offer relative stability.
Corporations present a more mixed picture. While the highest-quality companies have benefited from low interest rates and strong cash positions, the broader corporate landscape faces challenges as refinancing looms in a higher-rate environment. In this context, we recommend a shift from lower-quality credits toward higher-quality, more cyclically resilient opportunities. Additionally, we recommend moving credit exposure to shorter durations while using U.S. Treasuries and agency mortgages as a hedge against interest-rate volatility.
Conclusion: Positioning for a Complex Market Environment
The current market environment presents a unique set of challenges and opportunities. The valuation gap between value and growth stocks, coupled with a potentially prolonged period of higher interest rates, suggest that value and income-oriented strategies could outperform over the long term. Meanwhile, in the fixed-income market, a focus on quality and duration management will be crucial as the Fed navigates its dual mandate.
While another Fed hike may be on the horizon, its impact on long-term investment strategies is likely to be minimal. Instead, the focus should be on building resilient portfolios that can weather the uncertainties of a higher-for-longer rate environment, where both equities and fixed income will play essential roles in achieving balanced and sustainable returns.
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