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December 15, 2022

Growth versus value, Europe’s cold snap and inflation expectations

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Julius Probst
Nicolas Tremel
Arnaud Lieugaut
Patrick Malm
Karl-Philip Nilsson
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Looking back at winning and losing growth and value sectors

This table ranks winners and losers among US equity sectors for every year between 2015 and 2022. Two distinct eras jump out.

The Covid year of 2020 was defined by recession, anemic inflation, low interest rates, low commodity prices and elevated risk aversion. It was the perfect environment for growth stocks in sectors like IT and communication services. (Interestingly, 2019 equity trends were similar.)  

The second era is the 2021-2022 “post-Covid” period: stronger growth, stronger inflation, higher rates and commodity prices, and lower risk aversion. It was the sweet spot for value stocks, such as energy and financials.

The change of leadership from growth to value has been extreme. In 2023, we will probably see more balanced returns from the two investment styles, as both economic growth and inflation expectations are cooling.

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Watching Germany as its biggest trade partner relaxes Covid zero

The following chart is a version of the European Commission “clock” that tracks economic progress through the business cycle, divided into four quadrants: contraction, upswing, expansion, and downswing.

Germany’s economy has deteriorated more quickly than France, Italy and Spain, as our chart shows. That’s due to the knock-on effect of China’s Covid-zero policy and a greater impact from this year's energy crisis.

Growth in Europe’s largest economy has long been export-driven, and China is Germany’s biggest trading partner. As China loosens the Covid-zero policy, Germany may benefit. But the experience of other countries suggests cases may surge, and it’s not guaranteed that supply-chain and trade disruptions will disappear. 

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Cold European winter is as much of an outlier as the warm autumn

After a mild autumn, many Europeans are shivering in a much-colder-than usual winter. 

The cold snap is important because of the potential for energy shortages. German regulators recently warned that firms and households must save much more gas to avoid winter rationing or outages. 

The chart below shows how temperatures in Germany, as tracked by the purple line, have plunged below not just the historic average but the 10 to 90 percentile range of previous years.

The opposite was the case as recently as mid-October – when we wrote that Europe was taking advantage of balmy temperatures to refill its gas storage facilities. 

Europe’s energy needs have been in focus this year after Russia slashed gas deliveries, increasing scrutiny of previous German policy to phase out nuclear plants.

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Visualising the growth and value eras

As we pointed out in our first chart this week, value stocks drastically outperformed growth stocks over the past year. The first of the two charts below is a different visualisation of this trend. 

Blue areas denote periods of outperformance by growth stocks, as defined by FactSet. Green areas show when the value style outperformed.

The second chart shows that growth, relative to value, is now trading at a valuation discount versus its long-term average (the red line). Not long ago, price-earnings ratios were almost 60 percent higher for growth stocks, a differential last seen in the 2000 dotcom bubble.

Relative profit expectations for growth stocks have rebounded from their record low in September. As we said previously, 2023 could be a balanced year for growth versus value.

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US growth and inflation expectations are sliding

The following chart graphs the progress of US inflation and growth expectations since January 2021, as measured by the five-year breakeven rate (inflation) and the composite Purchasing Managers Index (growth).

Amid criticism of its past hesitancy to raise rates, the Federal Reserve’s tighter policy successfully resulted in falling inflation expectations this year, as our chart shows. But growth expectations are declining too.

The PMI fell to 46.3 in November; numbers below 50 indicate contraction. As investors debate whether the Fed will avoid a hard landing and “pivot” to rate reductions in 2022, the PMI reading suggests a recession in the first half of 2023 is very possible.

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M2 suggests US inflation will tumble

Many people got it wrong on inflation over the past two years. In early 2021, some analysts took a micro approach – focusing on used car prices or specific bottlenecks. 

In our view, it’s become clear that much US inflation is demand-driven and reached all sectors of the economy, caused by excessively easy monetary policy combined with generous fiscal support.

We can consider monetary aggregates like M2 – cash, chequing deposits, and assets that can easily be converted to cash – to examine inflation. (This is appropriate now that the US is no longer in a liquidity trap; the relationship breaks down with interest rates at zero. And to be sure, velocity of M2, not just supply, matters for how inflation behaves.) 

Our chart shows the correlation between M2 money supply, pushed forward by 18 months, and the consumer price index. Excess money growth in 2020-21 contributed to peak inflation this year.

If money growth falls off a cliff, can we really expect inflation to also decline quite substantially in the coming months too?

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Americans are switching jobs to get big wage increases

If you want to get a big salary boost in the US, you should switch employers – at least according to data from the Atlanta Fed.

The following chart tracks nominal wage growth for people who stay in the same job versus people who join a new company. 

In the US, nominal wages are growing at their fastest pace since the late 1990s. And the differential between job stayers and job switchers recently touched the highest level ever recorded. 

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The Bank of England has been overly gloomy on unemployment

Britons may well hope the Bank of England keeps up its past record of overestimating unemployment.

The following chart tracks the actual UK unemployment rate against different vintages of the BOE’s forecasts for joblessness. 

In 2021, the BOE initially expected unemployment to be much stickier than what actually occurred post-lockdown. And it overestimated unemployment throughout 2022 by one to two percentage points; the rate plunged to 3.5% this summer.

However, the outlook is considerably less bright as the BOE forecasts a brutal recession that lasts from early 2023 until potentially mid-2024. 

The BOE recently revised its unemployment forecast upwards. Amid a darkening outlook, the BOE expects the jobless rate to almost double, reaching 6.5 percent by early 2026.

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The correlation between UK house prices and unemployment

Perhaps unsurprisingly, UK house prices and unemployment are tightly correlated.

Several economists, most notably Roger Farmer, have examined this relationship. Asset-price declines affect private-sector confidence and induce a negative wealth effect, both of which are obviously detrimental to the labour market. 

The causality goes the other way, as well. A negative shock to the labour market hurts house-price fundamentals.

As our chart shows, UK house-price growth slowed markedly over the course of 2022. And unemployment is edging up as the UK recorded negative third-quarter growth. 

Going forward, expect further pain for property prices and unemployment. Perhaps counter-intuitively, real estate is the leading indicator – by about five months, as our chart shows.

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China relaxes Covid zero as cases rise

At long last, China is relaxing the Covid-zero policy, which saw regional lockdowns constrain economic growth and disrupt global supply chains. 

Coronavirus cases are on the rise, as our chart tracking notable Chinese regions shows.

It is notable that Shanghai experienced an earlier surge and plateau of cases than the other regions.

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