Equity Duration Should Reinforce Value Rotation
Summary
- Equity duration, the sensitivity of a stock's cash flows to the discount rate, is likely close to peak levels.
- U.S. indexes and growth stocks could be vulnerable to the next move in rates.
- All else equal, higher rates are considered neutral to positive for short-duration value stocks and negative for long-duration growth stocks.
- Supporting a further rise for value stocks is that their fundamental improvements are more than offsetting any rise in relative valuation.
By Sam Peters, CFA
Fundamentals Support Further Value Run
Equity duration is a less familiar term among equity investors, but it should be on everyone's mind. As the reopening heats up, discussion is growing concerning the impact of interest rates on stocks, with several recent papers tackling this subject through the concept of "equity duration." In general, value stocks are considered short duration - more cash flows sooner, and so less exposed to changes in the discount rate - while growth stocks are considered long duration. All else equal, higher rates are considered neutral to positive for short-duration value stocks and negative for long-duration growth stocks.
Equity duration should matter more and more as the economy reopens, likely driving interest rates higher. The major debate facing investors will be how much can earnings growth offset multiple compression from higher rates? This is a critical question as equity duration is likely close to peak level (Exhibit 1), and U.S. indexes and growth stocks could be especially vulnerable to the next move in rates.
Exhibit 1: Equity Duration Near Historic Peaks
As of Feb. 28, 2021. Source: Kailash Capital.
The recent correlation between interest rates and the respective value and growth styles is supportive of this spreading market narrative. However, correlation is not causation: the biggest driver of value stock performance has been rapidly improving fundamentals along with the incredibly depressed valuation starting point, with value stocks actually lagging the move in interest rates that would have been supported by the correlation of recent years (Exhibit 2). Value stocks simply have a ton of altitude to gain relative to growth stocks. This can either come from value enjoying higher valuations or growth stocks suffering lower valuations, or a combination of both.
Exhibit 2: Value, Led by Higher Treasury Yields, Has Altitude to Gain
As of March 31, 2021. Source: ClearBridge Investments, Bloomberg Finance.
As this valuation shift between value and growth ensues, especially in an environment of rising rates, the duration narrative should gather steam. Narratives are incredibly powerful drivers of stocks, and it's always great to have an emerging narrative working in your favor. The equity duration narrative is another argument for value, and for value portfolios with significantly lower duration than their respective indexes.
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