Value options overtake growth vehicles as new expectations shake up investment approaches

INVESTORS may have noticed a change in portfolio behaviour in the last three months.

For the first time in five years, value shares have outperformed growth stocks in the US and Europe.

Typically, value shares go up and down with the economic cycle, but growth businesses are more resilient. Growth stocks had enjoyed a ten-year bull run, but will this now unwind?

Recent months have seen a selling of bonds and shares that tend to behave like bonds.

Shares that were seen as offering a superior yield to bonds, but with resilient business models and steady growth, have been suddenly shunned.

This ranges across tobacco, pharmaceuticals, food and consumer staples like Unilever. They have been the winners over many years of a disinflationary environment.

Markets are now betting on a change.

Certainly, growth stocks have had a big boost in recent years from easy monetary policy. Low interest rates raise the value of future earnings by reducing the discounting factor. This has allowed ratings to expand well above historic norms.

Bond investors now seem to think inflation will return. Value stocks tend to do better in an inflationary environment, benefiting from operational leverage and price rises despite an inherent lack of pricing power.

Certainly, after the collapse in the pound, UK inflation will pick up in the short term. UK inflation expectations for the year ahead have more than doubled over the last three months.

Competitive devaluations are a feature of the global economy, with each giving an immediate boost to inflation in a devaluing economy. The UK will experience this over the next couple of years.

But, typically, these currency related blips in inflation do not become embedded – they are a response to global competition and weak productivity growth.

Few businesses have scope to allow significant real wage growth. There is no sign of this cycle of devaluation ending soon as China and India both appear to have over-valued currencies.

There can be no certainty that inflation will now take off – previous upticks have failed to gain traction. Each time the disinflationary pattern has reasserted. It seems to reflect a reduced share of labour in economic income, possibly driven by technology and lack of productive capital investment.

Even in the US, which has stronger growth than most, median real wages have stagnated for a generation.

That not only helps to explain the surprising US election result, but points to the pressure incumbent politicians are under across the world.

Technology and labour supply put pressure on prices and wages globally. In many nations debt has been increasing.

In the US, UK and Ireland, recovery since the financial crisis has been at the cost of considerable borrowing. This is unsustainable, and likely ultimately to be deflationary. In a downturn, debts will need to be written down.

And the potential for interest rate rises in a recovery is also dampened by the huge cost that would create for government debt servicing.

We may be seeing some respite in disinflationary pressures this year and next, but longer-term headwinds for value sectors such as banking and mining remain. The global economic environment favours businesses with genuine organic growth and some pricing power. Colin McLean is managing director of SVM Asset Management.