Is this a sign the value rally has peaked?

According to many commentators, the US market is in a strange situation where bad news is actually good news.

So far, 2021 has been a strong year for equity markets, most notably the US. In the first four months of the year, the US’ main market index, the S&P 500, appreciated by more than 11%.

Driving this performance is continued optimism about the recovery of the US economy, thanks to the seeming success of its vaccine roll-out. The importance of the economic recovery to these gains is shown by the continued outperformance of value and cyclical stocks compared to growth and tech stocks since the start of the year.

Year-to-date, the S&P 500 Value index is up 14.9% compared to 9.14% for growth stocks. The year-to-date performance for value was also comfortably above the wider market’s year-to-date return of 11.84%.

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Strong economic and business data have helped fuel the idea that the US is in the midst of strong economic recovery and therefore the outperformance of value and cyclical stocks is justified. For example, the most recent earnings season reports showed stronger-than-expected performances from US companies. The view is that the US is seeing a strong economic recovery and this is feeding through to the earnings growth of US companies.

However, on Friday 7 May, new data about the US labour market threw doubt on this bullish narrative. Economists had expected the US economy to add almost a million new jobs in April, cutting unemployment and bringing it to where it was pre-pandemic. Instead, the data showed that the economy added just 266,000 jobs, and unemployment rose. 

Such disappointing job figures could suggest that the economic recovery that investors have been bullish about has not yet taken hold – or at least not as strongly as expected. Usually, markets would react to this “surprise on the downside” with a sell-off. Not this time, however. Instead, on the day of the disappointing data, the S&P 500 hit a new all-time-high.

This was in part explained by a recovery of growth and tech stocks. A slower-than-expected economic recovery, in theory, lessens the risk of inflation and interest rate rises, both of which are a threat to the valuation of growth and tech companies. However, the rally on Friday was more broad-based than just tech, with all major S&P 500 sectors making gains.

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The explanation, according to many commentators, is that the US market is in a strange situation where bad news is actually good news. A weaker recovery means that the US Federal Reserve will hold rates lower for longer. As already noted, this is good news for growth and tech stocks. But a continuation of loose financial conditions and support from the Fed for longer is also interpreted as good news for the wider market.

However, the poor jobs report does raise the prospect that the US economic recovery may not be quite as strong as markets have now come to expect. So, what does that mean for the value rally and “reflation trade”?

One possible scenario is that we are now at “peak positive data”. Erik Knutzen, chief investment officer of multi-asset at Neuberger Berman, points out: “Market participants are increasingly talking about ‘peak growth’ or ‘peak PMIs’ – the idea that rates of change in key economic data are likely to plateau and decline over the coming weeks.”

Knutzen argues that a realisation of this may already be feeding into financial markets, evidenced by the relative poor performance of value and cyclical stocks against tech and growth stocks in April. He explains: “This may be why investors have hit the pause button on the key recovery trends of the first quarter – the sell-off in US treasuries, as well as the rotation from large growth stocks into smaller, cyclical and value stocks. Pausing for breath and rebalancing portfolios seems prudent.”

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However, there is another way to interpret the weak jobs report, which bodes better for the potential performance of value and cyclical stocks. Instead of the weaker-than-expected jobs growth being driven by a lack of demand for workers and, therefore, indicative of weaker-than-expected recovery, the issue may be with the supply of labour.

According to Mohammed El-Erian, chief economic adviser at Allianz, writing in Bloomberg: “It is hard to argue that the problem is on the demand side. If anything, there is solid and increasing demand for workers in an expanding range of sectors. The economy is reopening, consumption is surging, unusually high average household savings are being deployed and, with solid balance sheets, the average employer seems eager to expand the workforce.”

Instead, many argue that the brisk recovery is causing shortages of labour and material inputs. Richard Hunter, head of markets at interactive investor, argues: “Indeed, there may be evidence of a labour supply shortage in addition to blocks in the supply chain, both of which indicate that the strength of the recovery is encountering pressure points as it may be outpacing the availability of materials and workers.”

Assuming these supply bottlenecks are overcome, the reflation trade may still have legs.