How do different equity styles perform during an economic slowdown?
We examine which equity styles have performed best during slowdowns or recessions and explain why value stocks may continue to outperform.
Lockdowns in China and the Russia-Ukraine war have meant that stagflation remains at the top of investors’ minds. Higher inflation has also forced central banks to react and start to rein in years of loose monetary policy. As interest rates rise across the key developed economies, the market has become increasingly worried about recession risks.
From an equity style perspective, how should investors position their portfolios in a slowdown or recessionary world?
Like stagflation, the slowdown phase is when economic activity is slowing, inflation is rising, and central banks are tightening policy. We find that the more defensive equity styles have been the winners. But unlike past slowdowns, the performance of value stocks has been unusually strong this time. Later we explain why this is.
By comparison, during recessions, policymakers are typically cutting interest rates in response to the slump in growth and inflation. As households and companies repair their balance sheets, investors start to anticipate a rebound in economic activity and corporate earnings. This leads to a rotation towards the more cyclical equity styles.
Equity style primer
Table 1 provides an overview of the different equity styles in our analysis. We show the beta to illustrate the sensitivity of the investment strategy towards the performance of the overall market. For instance, the more defensive equity styles have a beta of less than one and they tend to outperform when the market sells off.
Historically, the more defensive equity styles have outperformed their more cyclical peers (chart 1). On average, the style winners have been high dividend yield and minimum volatility strategies. It appears that investors have sought shelter from stocks that are better at weathering the challenges of weaker economic growth and accelerating inflation.
Instead, small caps are the laggards during slowdowns, as these companies have less pricing power than large caps. So they particularly feel the squeeze on profit margins from higher costs.
Meanwhile, value stocks have tended to perform slightly better than their growth counterparts. But the return profiles of these two styles have not been very different during slowdowns.
But the performance of value has been different this time
So far this year, both high dividend yield and minimum volatility styles have experienced strong gains which is consistent with previous slowdowns (chart 2). But unlike past slowdown periods, the divergence between the performance of growth versus value stocks has been stark. In fact, the excess returns from investing in value versus growth this year has been the third highest since the mid-1970s.
Table 2 shows that the growth style is the most negatively correlated with US real bond yields (measured using 10-year inflation protected Treasury or TIP bonds) over the last five years. Similarly, both momentum and quality stocks have underperformed along with rising bond yields. Over the same period, value has been one of the equity styles most positively correlated with higher yields.
That said, the composition of these equity styles are not constant through time, and so the characteristics and drivers will change. For instance, the negative correlation between growth stocks and real yields have been stronger over the last five years compared to the past 30 years. This is because of the current dominance of technology stocks in the growth bucket, which are more sensitive to higher rates.
Looking ahead, assuming recent history is repeated, if real yields continue to rise, value stocks could continue to outperform relative to growth in this environment.
What does recession mean for the equity style investing?
While quality stocks continue to do well during recessions, there is a noticable reversal in style leadership towards the more cyclical equity styles (chart 3). Growth stocks have generally regained their spark during recessions. This is because the value of these companies are boosted by the fall in interest rates and bond yields as central banks respond to the collapse in economic growth.
Meanwhile, small caps have tended to beat their larger peers as investors start to discount the recovery in corporate profitability of these companies. Relative to large caps, they are also more likely to benefit from looser monetary policy.
Learn more about investing in Schroder Global Recovery Fund.
This document is issued by Schroder Investment Management Australia Limited (ABN 22 000 443 274, AFSL 226473) (Schroders). It is intended solely for wholesale clients (as defined under the Corporations Act 2001 (Cth)) and is not suitable for distribution to retail clients. This document does not contain and should not be taken as containing any financial product advice or financial product recommendations. This document does not take into consideration any recipient’s objectives, financial situation or needs. Before making any decision relating to a Schroders fund, you should obtain and read a copy of the product disclosure statement available at www.schroders.com.au or other relevant disclosure document for that fund and consider the appropriateness of the fund to your objectives, financial situation and needs. You should also refer to the target market determination for the fund at www.schroders.com.au. All investments carry risk, and the repayment of capital and performance in any of the funds named in this document are not guaranteed by Schroders or any company in the Schroders Group. The material contained in this document is not intended to provide, and should not be relied on for accounting, legal or tax advice. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this document. To the maximum extent permitted by law, Schroders, every company in the Schroders plc group, and their respective directors, officers, employees, consultants and agents exclude all liability (however arising) for any direct or indirect loss or damage that may be suffered by the recipient or any other person in connection with this document. Opinions, estimates and projections contained in this document reflect the opinions of the authors as at the date of this document and are subject to change without notice. “Forward-looking” information, such as forecasts or projections, are not guarantees of any future performance and there is no assurance that any forecast or projection will be realised. Past performance is not a reliable indicator of future performance. All references to securities, sectors, regions and/or countries are made for illustrative purposes only and are not to be construed as recommendations to buy, sell or hold. Telephone calls and other electronic communications with Schroders representatives may be recorded.