By Philip Lawlor, Head of Global Investment Research, FTSE Russell.

Philip Lawlor, Head of Global Investment Research, FTSE Russell.

Vaccine-lifted hopes of a quicker return to economic normalcy have triggered dramatic reversals across global financial markets in recent weeks.

Government bonds sold off sharply, pushing the US 10-year Treasury yield to its highest levels since March. This, in turn, fueled a powerful shift from longtime growth winners into more cyclical stocks that had taken the brunt of the pandemic fallout.

Could this be the early stages of a durable rotation into long-suffering value stocks?

Viewed through the prism of equity factors, as shown below, there is a strong and global linkage between the relative performance of the Value factor versus its Quality counterpart (a proxy for growthier, financially healthy stocks) and moves in US Treasury yields.

Value vs Quality factor returns (TR, rebased) vs FTSE US Govt 10yr bond yield

Source: FTSE Russell.

The reflationary possibilities of a successful vaccine rollout next year underpinned the recent back-up in long-term bond yields. This backdrop also bodes more favorably for value stocks, which are heavily weighted to the cyclically sensitive industries decimated by the pandemic’s economic shockwaves. These include oil & gas and basic materials companies, which stand to benefit from stronger global demand and higher prices. Financials, notably banks, also rank as major beneficiaries, as higher interest rates (and steepening yield curves) bolster their profitability.

Indeed, as the chart below illustrates, forward EPS forecasts have taken a bullish turn for the two largest value sectors—oil and banks. Upgrades have been less pronounced for the growth leaders in tech and health care.

Select FTSE World sector 12-month forward EPS forecasts

Source: FTSE Russell.

The case for value stocks is also bolstered by the extreme disparity in the valuations between value-oriented and growth sectors, particularly those of high-flying technology and other stay-at-home stocks.

That gap, as measured by the forward P/Es of the Russell 1000 Growth relative to that of its value counterpart, has expanded significantly alongside the steady slide in long-dated US Treasury yields (showed inverted here) over the past several years. It currently stands at a 13-point spread. Declines in interest rates, especially when driven by worsening economic conditions, tend to widen the premiums investors are willing to pay for stocks offering reliable profit growth.

Growth/Value 12-month forward P/E spreads vs long-term US bond yields

Source: FTSE Russell.

Until recently, the best-case hopes for markets were based on new rounds of fiscal stimulus and a lower-for-longer rate environment. Though the initial vaccine euphoria has worn off as markets turned their focus to the near-term “COVID Winter” threats to the global recovery, further progress on the vaccine front could prove the catalyst for a sustained stretch of value outperformance.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)