Next Market Rotation Could See Value Stocks on Top

The pandemic-related recession ended in April, but you probably couldn’t tell by the way markets have been behaving.

Value-priced and economically sensitive cyclical stocks had their moment from late 2020 through March of this year, in line with improving prospects of an economic recovery. However, as concerns about slower economic growth took hold, markets decidedly turned toward defensive growth-style stocks, sending technology names—and tech-heavy indices—ever higher. 

Throughout the summer, investors embraced the “growth scare” story and the “lower for longer” view on interest rates. The Federal Reserve’s restatements of patience around inflation risk rewarded that narrative. To many of us, such positioning resembled the 12-year post-financial-crisis cycle, which was characterized by low economic growth.

The result? A wide performance dispersion in stocks, with the S&P 500 benchmark of the broader U.S. market up an impressive 13.8% since the beginning of the second quarter. Much of that performance has been driven by investors flocking to growth stocks, which are up 20.9%, making the S&P notably top-heavy, anchored to richly valued tech stocks that are closely tied to today’s near-zero interest rates. Value stocks, in contrast, are up just 5.9%.

In a way, investors’ pivot toward growth stocks looks prescient, given the flattened near-term growth outlook due to a number of anomalous negative developments, such as the COVID-19 Delta variant, supply-chain issues further exacerbated by extreme weather events, and the surprising severity of China’s recent regulatory crackdowns. Morgan Stanley & Co. Chief U.S. Economist Ellen Zentner has lowered her third-quarter GDP estimate from 6.5% to 2.9%.

Even so, we see these negative factors as temporary headwinds that could resolve toward year-end. We expect global economic growth to reaccelerate and bring about another round of sector rotation that could spur value- and cyclical-stock outperformance.

Our view rests on the bedrock foundation of the U.S. labor market, which is arguably at its strongest in decades. Unlike the previous cycle, where the job market took nearly 10 years to recover, today’s business cycle dynamics suggest unemployment rates could fall under the pre-pandemic low of 3.5% by December, 2022.

Some remarkable datapoints to consider: Job openings raced to a new high in July, hitting 10.9 million, according to the U.S. Labor Department. Meanwhile, the number of workers voluntarily quitting their jobs also rose, to about four million, just shy of a record set in April, suggesting significant confidence in mobility on the part of job hunters.

Wages also rose. August’s jobs report showed that average hourly earnings increased by 0.6% for the month—above estimates—helping drive a 4.3% increase from a year earlier. While that same report showed lower-than-expected hiring last month, the shortfall was mostly in the services sector, which has been hit hardest by the surge of the Delta variant.

Given that COVID infection rates in the U.S. appear to have peaked and vaccination rates are accelerating, we anticipate increased demand for service sectors, such as travel, hospitality, entertainment and dining, which will ultimately help drive even more job growth.

Together, these observations buoy our view that the strength of the U.S. labor market broadly presages higher consumer confidence and spending, especially as we head toward the crucial year-end holidays.

This could help sustain economic growth and an upward bias to interest rates. Meaning, equities that are closely linked to economic growth look well-positioned, while richly valued mega-capitalization tech leaders remain vulnerable to a pullback due to higher rates that would pressure their stock price-to-earnings multiples.

Investors who want to prepare for such a rotation of market leadership should consider taking some of their profits in passive indices, especially tech-heavy exposures, and adding diversification through cyclical sectors, with an eye toward quality. The financials sector remains our top pick. Also, consider stocks in Japan and Europe, respectively, which could benefit from rising regional vaccination rates and continued economic reopening, all against an expansionary policy backdrop.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Sep 13, 2021, “Time to Play Offense.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.