Short duration favors value, international equities
By Paul Ehrlichman
Duration of stocks explaining recent market performance
The equity duration dynamics covered in our end of year comment has a strong historical connection to the performance of value stocks. In a 2011 paper, Dr. David Schröder of Birkbeck, University of London, found that equity duration is highly correlated with traditional value drivers such as Fama French’s book-to-market (B/M) ratio. . Short-lived shares also exhibit similar factor behavior and covariances with momentum, as long-lived cohorts are strongly associated with past winners. Schröder’s research even suggested that duration was more explanatory of stock market returns than the B/M factor.
The average duration of stocks in the United States now exceeds 20 years, a two-decade high. Non-US equities are also at near 18-year highs with emerging markets at 15-year highs. As Schröder’s article points out, long durations indicate high sensitivity to changes in the cost of capital and interest rates, as well as to changes in liquidity. stream expectations. In contrast, stocks with shorter duration carry a steep discount, expressed as a risk premium, due to the uncertainty surrounding interest rates and changes in expected cash flows. In short, the best performing stocks of the past decade are making the biggest bet in history on never-rising interest rates and perfectly predictable cash flows.
Exhibit 1: Exiting growth gap/long-duration closing value
Data as of January 31, 2022. Source: Bloomberg.
The political and economic environment that fueled this long-lived equity boom is changing, with central banks focusing on supporting the real economy while removing extraordinary actions that have inflated asset prices. This translates not only into higher interest rates but, more importantly, an end to the long downturn in the velocity of money (Figure 2). Money can be created by central banks, but it is multiplied by the commercial banking system and economic activity. Direct asset purchases through quantitative easing have reduced long-term cash flow discount rates while contributing little to real economic activity. During this period, the global banking system deleveraged. However, loan growth is beginning to accelerate as consumer demand and capital spending strengthen, which will fuel an increase in velocity and nominal GDP growth. From a sector perspective, this is most favorable to shorter duration cyclical and financial sectors.
Exhibit 2: The velocity of money poised to accelerate
Data as of December 31, 2021. Source: Bloomberg. Velocity calculated by dividing GDP growth by M2 money supply in each region.
Investment characteristics starting to outperform are also consistent with a shift towards short-term leadership. High free cash flow, dividends and redemptions (Exhibit 3) and other traditional valuation metrics now offer the best returns.
Exhibit 3: In Europe, takeovers drive performance
Data as of January 31, 2022. Source: Bloomberg.
Shorter duration supports international actions
The thesis of favoring non-US equities in a duration-oriented environment is due to several factors. First, sector/industry differences in benchmarks and industry structure mean that international markets are less exposed to long-running companies in the technology and digital consumer sectors. Second, the overall duration of the US market as measured by the S&P 500 Index is about 25% higher than that of international markets, using the MSCI All Country World Ex-US Index as a proxy. Recent performance in the US market has been dominated by long-duration stocks selling at the highest valuations in history based on the price/sell-correlated duration measure, which is still 20% higher at the peak of the tech bubble of 2000 despite a recent correction. This can be seen in the changing composition of the S&P 500 over the years. In 1993, cyclicals and financials represented 54% of the index and technology only 5%. In 2010, technology had reached 19% of the index, while cyclicals and financials had fallen to 45%. And in January this year, technology made up 39% of the index, with cyclicals and financials falling to 33% overall.
Meanwhile, non-US markets show much greater exposure to shorter duration value drivers such as dividends, free cash flow and low P/Es and have also increased share buybacks over the course of the year. the last year. Cyclicals and financials that are more broadly represented in non-US markets are also seeing strong earnings growth, with positive revisions to long-term growth expectations. This combination of low implied growth and bullish estimates is the exact opposite of what US-dominated growth companies are experiencing, as unrealistic long-term exponential growth hopes are scaled down.
In conclusion, duration, value drivers and monetary velocity are closely intertwined and all point to a strong period of outperformance for global value stocks.