Friday Morning Coffe Nr. 36: Style Rotation

141218 Friday Morning Coffee

Friday Morning Coffe Nr. 36: Style Rotation

We have been arguing in past morning coffees that value investing has been out of favour as an investment style since the financial crisis. In a world with abundant liquidity at low cost, valuations do indeed not matter. In Europe, value has been underperforming growth by 2.1% a year since 2009.   We had been expecting that situation to change slowly with central banks starting to withdraw some of their quantitative easing measures and reducing their balance sheets. Interest rates have started to creep upwards with the US taking naturally the lead as this economy had the strongest momentum. However, it comes as a surprise to many ( including us ) that 2018 has been particularly painful for value investors with MSCI Europe Value Small Cap trailing MSCI Europe Growth large cap by 7% ytd ! Growth and momentum companies have lost steam since September. That did however not mean that value returned to favour as an investment style. The picture has been blurred somewhat by the fact that there was ample indiscriminate selling of European equities: according to JPMorgan cumulative fund flows show that more than 8% of the assets in Europe ex UK have been redeemed since Spring 2018. The political noise linked to Brexit, Italy and now France certainly contributed to the negative sentiment. It is also understandable that selling has particularly impacted small and midcap companies.   As we turn our focus to 2019, we however maintain our conviction that value will return into favour. We are convinced that the path central banks have taken goes in the direction of normalization of monetary conditions. The measures taken in 2008 were exceptional and central banks cannot inflate their balance sheets indefinitely.  Normalization of monetary conditions equates in our opinion with normalization of, hence higher, interest rates.   That should be good for value investing.   Blackrock Investment Institute has done an extensive study recently on how different investment styles perform in different economic environments. They measured the excess return adjusted for risk, called the Sharpe ratio, of quality, minimum volatility, momentum and value strategies when economies are either expanding, slowing, contracting or recovering.  

Source: BlackRock Investment Institute - Global Investment Outlook 2019. Past performance does not guarantee future results.

  We draw three immediate conclusions from the above. Firstly, you are better off as a value investor over the whole economic cycle. Value strategies particularly shine when economies are recovering or expanding. Secondly, value did not see the underperformance of the other 3 strategies in specific economic conditions. As an example, growth strategies did strongly underperform in periods of recovery. Thirdly, the only time value is slightly underperforming is when economies are contracting, i.e. in a recession. Looking at Europe, we have indeed seen an economic slowdown in 2018 with slowing leading indicators. To our knowledge however, economic conditions do not show an imminent contraction of economic conditions. In other words, as we are not foreseeing an imminent recession, we are happy to be value investors in 2019.