Boston Partners’ Josh Jones talks high rates and the closing gap between growth and value as fundamentals play a bigger role
Boston Partners’ Josh Jones talks high rates and the closing gap between growth and value as fundamentals play a bigger role
The end of 2021 was an important starting point for the year to come, with central banks changing their outlook on the considerable post-pandemic inflation they had helped to create. As 2022 progressed, it seemed obvious that the dynamics had changed fundamentally from the post-GFC period.
For more than a decade, bank lending was relatively constrained, as was fiscal spending. As a result, “quantitative easing” (QE) was met with a rapid drop in money velocity and had little impact on inflation. Central banks grew comfortable with that trend, but everything changed after 2020. There was an explosion in fiscal spending, banks were in a healthy position to lend, and money velocity picked up as economies reopened.
This pick-up in money velocity, combined with supply-chain issues and commodity shortages, led to the largest bout of inflation since the 1970s. Our simple observation about the 1970s is that high levels of inflation led central banks to tighten policies, producing brutal bear markets. At the time, investor losses were the worst in high-valuation multiple stocks, or growth equities.
Unfortunately for many investors, this scenario is resurfacing. Comfort with low rates and inflation from the past 10 years produced valuation premia for growth stocks. This herd mentality produced a relatively large anomaly, as even short-duration, high free cash flow, value stocks should have seen their multiples improve as the market accepted a permanently lower risk-free rate. Yet, value stocks have seen their multiples compress, despite improving fundamentals.
As inflation has started to unwind this premia, low-quality, expensive stocks have been hit particularly hard. Unsurprisingly, this has produced the best environment for shorting equities since the inception of the fund. As such, our fund posted its strongest year since inception in 2022.
How will 2023 − and beyond − look?
We won’t fall folly to trying to predict the future, a near-impossible exercise. We will, however, offer a few thoughts as to why the next decade might be different from the last. No new cycle has delivered the same winners from the previous cycle. Consistently good businesses have tended to outperform over time, but when equity returns have outpaced earnings growth, as in the 1960s and 1990s, this has resulted in five- to eight-year periods of digestion as earnings catch up with valuations.
We believe central banks will quell inflation with enough tightening. This does not necessarily mean the return of excessive valuations for growth stocks. After producing the worst inflation since the 1970s, the hurdle for central banks to use QE to stimulate the economy will be high. We also believe that it would be used more to control rates from going too high, as Japan is now doing, rather than growing the money supply to stoke risk assets. In this sense, we caution that QE is synonymous with growth outperformance. There has been structural underinvestment in “tangible things” in the post-GFC era, most importantly in commodities since 2015. Reshoring trends, rising commodity prices, and higher fiscal spend create risks that when central banks inevitably ease, inflation could return higher than the last cycle. We believe the most underappreciated observation is that the fundamentals of many traditionally valued sectors, like energy, materials, and financial services, have improved as management teams respond to a decade of poor returns.
Despite the recent issues at Credit Suisse, which appear largely self-inflicted, European banks now look more conservative than their US counterparts, particularly US regional banks. Regulators in Europe forced the banks to over-collateralize duration mismatches and the banks have used swaps to hedge their interest rate risk. This should insulate them from the issues that affected US regional banks. Lastly, real interest rate differentials favor a strong dollar today, but bank issues may eventually force the US Federal Reserve to respond by lowering rates, weakening advantages, and normalizing real rate differentials. This should lead to a weaker dollar and create tailwinds for non-US equity outperformance.
About
Josh Jones is a Portfolio Manager on the Boston Partners Global Equity, Global Long/Short Equity, and International Equity strategies. Prior to this role, he was a research analyst specializing in the energy, metals, and mining sectors of the equity market. He joined the firm from Cambridge Associates, where he specialized in hedge fund client consulting. Josh holds a BA degree in economics from Bowdoin College, along with a CFA designation, and has 18 years of investment experience.