2 - Creating opportunity in value style. Since 2009, growth style has benefited from a recovering global economy through faster earnings growth, and in the last 18 months, U.S. growth’s domination has intensified following the U.S. tax reform. In addition to a supportive GDP backdrop, low/declining yields have pushed up valuations for growth companies (lower discount rate = higher price). Rising yields and tightening monetary conditions now threaten growth’s valuation premium, while the prospect of tightening monetary conditions should eventually impact economic growth, and hence earnings. Value style has underperformed for over a decade, and we believe rising yields could translate into a leadership shift.
3 - Making defensives great again. As yields increase, the competition between bonds/defensives and equities/cyclicals will become more even. When yields hit “restrictive levels”, and eventually peak, defensives and cash should fully take the lead. In the U.S., short-term bonds (U.S. 2-year 2.85%) are now yielding over 100 basis points more than the S&P 500 dividend (1.8%), and the widening spread should favor bonds/cash over the next 12-18 months. Bottom line: We believe exposure to cash and defensives should increase as yields rise.
Strategy view: We believe pending negative revisions to world GDP and earnings growth threaten the macro environment, while valuation and sentiment are already a great concern. Although rising yields warrant a cautious strategy for equity portfolios, it could also translate into investment opportunities in defensive sectors and value stocks.
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