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We do know something, though. We know, for instance, that different kinds of stocks react differently to changes in interest rates. Companies with much of their earnings value far into the future, i.e. classic growth stocks, are much more sensitive to changes in interest rates than companies with more of their value in present earnings – viz. value stocks.

Note that none of the future earnings that go into this net present value are known. They are estimates, guesstimates or just something we can infer from the development of stock prices. This inference, on the other hand, can be quite precise. Calculating implied equity duration has become more common in stock market studies, probably a consequence of large interest rate movements this millennium. It resembles modified duration as we know it from fixed income but is more of a conceptual way of thinking about interest rate sensitivity.

Does it matter in practice? It sure does. The MSCI World Growth and Value sub-indices, which represent the growth and value halves of the world index, behave systematically differently in response to interest rate changes.

In 2022, the MSCI World Growth index lost more than 27% (local currency gross return), while the MSCI World Value loss was halted at 3%. These results were an obvious response to the sharp interest rate increases through the year.

In 2023, it’s totally reversed. In May alone, the growth index gained 3.2%, while the value index lost 3.7%. Of all the indices I follow, these were the largest movements in May, which otherwise was fairly flat. Year to date, the growth index is up more than 20%, while the value index is down more than 1%.

Was this something we should have foreseen? Well, this is where it starts to get complicated. Yes, long rates have fallen this year, but not by much, and short rates have risen. In May, the yield on 10-year US government bonds rose to 3.64% from 3.45%. If stocks reacted mechanically to such changes, May should have been a good month for value stocks. It wasn’t.

The obvious, it not immediately intuitive, explanation is that market participants see an end to the rate hikes and have begun to factor in future rate cuts. In May, the negative term spread grew further in size, reaching 76 basis points in the US (10-year less 2-year yields). This is a classic recession indicator. While stock market indicators reflect a larger dose of optimism (like they often do), many investors may expect future rate cuts to stave off a recession of at least some magnitude. That would likely take more than symbolic cuts.

We don’t know exactly what they’re expecting, if at all they know themselves. We do know that they take interest rates into account, and by the stock price responses, we can infer that there exist expectations of substantial future rate cuts – just as we could assume, with acceptable certainty, that the US debt ceiling would be lifted. As of course it did.

In the meantime: If you are a unitholder in a decidedly value-tilted stock fund that is doing ok despite the disparate value/growth development, you should be pleased with the good security selection. You may also take some comfort in the long-run outperformance of value stocks. Indefinitely falling interest rates is not a very likely scenario.

 Historical returns are no guarantee for future returns. Future returns will depend, inter alia, on, market developments, the portfolio manager’s skill, the fund’s risk profile, as well as fees for subscription, management and redemption. Returns may become negative as a result of negative price developments. This is marketing communication.



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