Four reasons why the rally in value stocks may broaden in 2022

India’s value-style equities (MSCI India Value Index) gained 32 per cent in 2021, outperforming growth-style equities (MSCI India Growth Index) by 23 per cent, following a strong outperformance in 2020, when value equities rose 26 per cent compared with a 11 per cent rise for growth equities. After two years of strong outperformance of value-style equities, the key question for investors is can the rally continue for a third year in a row? In our view, fundamental drivers remain in place for the continuation of value outperformance.

First, value-style equities generally benefit from a reflationary macro environment. Economic growth is expected to remain well above its long-term trend, with the likelihood of further upgrades to consensus GDP growth for the financial year ending March 2023. This would get a boost as the recovery broadens with a revival in consumption and private capex amid a still-supportive policy environment, as fiscal policy takes over the mantle from monetary policy. Improving inflation expectations since 2020 has been a positive tailwind for value stocks’ outperformance. In our view, Consumer Price Index (CPI)-based inflation is likely to remain above the Reserve Bank of India (RBI)’s medium-term target of 4 per cent over the next 12 months, as higher commodity prices, persistent supply issues and improved pricing power among corporates is likely to exert upward price pressures. Lastly, value stocks have a strong positive correlation with nominal bond yields — i.e., when bond yields rise, value-style strategies have historically outperformed.

Normalisation of monetary policy by the RBI and the US Federal Reserve, amid higher fiscal spending by the Indian government, is likely to exert an upward pressure on bond yields over 12 months. Overall, the above reflationary macro environment of rising growth, rising inflation and higher bond yields is a strong tailwind for value equities’ outperformance.

Second, valuation and earnings are supportive of value-style equities. Despite outperformance of value stocks, they still trade cheap compared with growth stocks on various valuation metrics (e.g. MSCI India Value Index trades at a 12-month forward P/E of 19x compared to 12-month forward P/E of 36x for MSCI India Growth Index). Further, value stocks have delivered higher earnings growth against growth stocks over the last year. More importantly, future earnings growth expectations and positive earnings per share (EPS) revisions for value stocks continue to outpace growth stocks.

Third, sector positioning is likely to favour value, as MSCI India Value Index gives a greater weightage for cyclical sectors such as information technology, financials, consumer discretionary and materials compared to MSCI India Growth Index, which has a larger weight to retail-focused financials, energy and consumer staples. In our view, a reflationary macro environment, favourable valuations and above-trend economic and earnings growth in 2022 are likely to benefit cyclical sectors.

Fourth, investor positioning remains light. Despite strong performance of value-style strategies amid improving sentiment towards value equities, positioning is light. Among the various mutual fund categories, value and contra funds were one of the few categories to register outflows in 2021 despite strong outperformance. This indicates value stocks are still broadly under-owned compared to growth stocks.

Overall, the above conditions are conducive for a further deepening of rotation to value in 2022. IT and materials were the major drivers of 2021’s value outperformance. In our view, the value rally is likely to broaden beyond the leaders to the laggards. Financials are likely to benefit from improving growth expectations, likely uptick in credit demand, a more benign stressed asset outlook than earlier and low credit costs. Higher interest rates is an additional tailwind for the sector, supporting yields and spreads in general.

Industrials is another sector to benefit from the value rotation given an investment-led economic rebound, superior earnings expectations and structural tailwinds from policy support. Lastly, public sector enterprises (PSEs) could see significant value unlocking given a reflationary environment, greater financial leverage and higher public spend as they tend to have a large cyclical tilt. In addition, valuations for PSE’s remain close to record lows.

In conclusion, though we believe value outperformance could broaden in 2022, equity markets are likely to transition from “early-cycle” to “mid-cycle” as monetary policy normalises. Volatility rises during the period of transition, with equity returns being more modest during this phase, mirroring earnings growth. Thus, it would be prudent for investors to raise allocation to value strategies within a diversified equity allocation.

(The author, Vinay Joseph, is Chief Investment Strategist at Standard Chartered Wealth, India. Views are his own.)