The debt ceiling crisis and Covid continue, so why are value stocks winning?
Last week, Congress was able to pass a short-term budget resolution to maintain government funding until December 3, including funding for disaster relief and funding for Afghan resettlement. Although a government shutdown has been avoided, the debt ceiling crisis persists. Treasury Secretary Yellen has warned that the Treasury will exhaust its liquidity and extraordinary measures in October if the debt ceiling is not lifted. Unless the debt ceiling is raised, the United States cannot issue more debt. As detailed previously, while a possible default on our US debt will be discussed, a default remains an unlikely outcome. If Democrats and Republicans fail to agree on terms for raising the debt ceiling, the federal government would ultimately be forced to prioritize spending to avoid default and continue to service the US debt. . This debt ceiling argument is a political fight in which each side thinks it can get something out of the other. Since Democrats control all three branches of the federal government, the debt ceiling could be unilaterally raised through reconciliation, which increasingly looks like the way to go. Ultimately, Congress will raise the debt ceiling, but that might not happen until more serious warnings and the resulting market volatility.
The recent history of stock market performance during a debt ceiling crisis reinforces the expectation of volatility. In 2011, the United States began using extraordinary measures to service the debt on May 16, reaching a deal on August 2. During this period, the S&P 500 fell almost -6%. The debt ceiling is unlikely to be the only reason for the drop, as Europe was in a debt crisis and economic growth was slowing. In 2013, extraordinary measures were launched on May 13 and an agreement was reached on October 17. During this period, the S&P 500 rose almost 4%, although stocks fell almost -6% at one point in the period.
Coincidentally, the S&P 500 recorded its largest intra-annual decline of 2021 at -5% last Thursday. On average, the S&P 500 shows an intra-year decline of -14.7%, but there are many variations around this average in any given year. Interestingly, in the most recent pullback, a seemingly unlikely sector of the stock market, value stocks, outperformed. Recall that when the Covid stock market closed last year, the S&P 500 fell by -34% while value stocks, as measured by the Russell 1000 Value index, fell by more than -38 %. Value stocks tend to be more economically sensitive, so they didn’t rebound as strongly last year and rose only slightly in 2020, while the S&P 500 ended up 16% .
After significantly outperforming growth stocks in the first quarter of this year, value stocks have been lagging until recently. While this is only a short period of outperformance since early September, the timing is fascinating. Part of the consternation in the markets has been concerns about the slowing global economy, so the outperformance of value stocks seems to indicate that markets are starting to incorporate less worries about the economic slowdown. The yield on the 10-year US Treasury bill echoes the sentiment of value stocks. In fact, the graph of the performance of value stocks versus growth stocks surprisingly resembles the graph of Treasury yields. Exposure to value stocks could provide some protection against interest rate risk in the portfolios, so at least some exposure to value is currently warranted.
Will this outperformance of value stocks continue, however? It is impossible to say for sure, but the relative valuation is currently extremely attractive. Value stocks are at the cheapest level relative to growth stocks since the tech bubble. This analysis uses the forward price / earnings ratio, so an unexpected economic downturn, which would likely penalize value earnings more severely, remains a risk. In addition, many growth companies have proven to be superior companies during Covid, so the premium of growth stocks over value could be continuously higher. Relative valuations still look extreme, even assuming a larger premium for growth companies.
Covid is a relative risk for value stocks, as companies are typically more affected by economic upheaval. As Covid infections continue to rise in the United States and many other countries, the declining rate of change is an indication that things are starting to improve. The UK infection momentum appears to have peaked and continues to improve. The rate of increase in Covid cases in the United States has finally shown a significant decline. Japan peaked in late August and continues to improve. News last week of the success of an investigational antiviral drug from Merck (MRK) in treating Covid gives hope that future variants will not be as damaging.
Investors should brace themselves for greater volatility in equities if Congress fails to reach an agreement to raise the debt ceiling this week. While much of the tax and spending bills may take some time, Congress will also continue to negotiate the hefty tax and expense bills that can now be linked to the debt ceiling issue. if reconciliation is used. As there are very few earnings reports this week with just five S&P 500 companies expected, the monthly salary report highlights the timeline. The consensus expects around 470,000 jobs to have been created in September. A level of around 400,000 jobs is expected to meet Fed Chairman Powell’s criteria to start cutting bond purchases this year.