"There's been a big rotation in markets": Value surges as growth stumbles

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<p><strong>Emma Rapaport</strong>: Hello, and welcome to Morningstar. I'm Emma Rapaport. There's a lot going on in markets today with the war in Ukraine and major changes in inflation. Here today to talk to us about how investors should be positioning in their portfolio is Tim Murphy.</p> <p>Tim, thanks very much for joining us today.</p> <p><strong>Tim Murphy</strong>: Thanks, Emma. Nice to chat.</p> <p><strong>Rapaport</strong>: Tim, it feels like we're in a new phase in markets and a lot of people are saying that there's a lot going on, but there's also a lot of changes that investors need to be aware of. What is this idea of a new phase and why are we talking about this right now?</p> <p><strong>Murphy</strong>: So, there's been a big rotation in markets the last couple of months. Certainly, inflation has really come through in the developed world, and you've seen that right across the board in Australia, in the U.S., in Europe. And so, investors are notably concerned, and rightfully so, about the flow-on effects of that.</p> <p><strong>Rapaport</strong>: And that inflation is happening because there was this big fiscal input after the pandemic?</p> <p><strong>Murphy</strong>: Yeah, partially to do with that and then, partially due to supply chain issues that have been a result of the sort of ongoing effects of the pandemic that have made things costlier to access and move around and whatnot. And so, those cost pressures have sort of built up and then pushed through the system. And then, a lot of the debate for the last 12 months has been how much of that is going to be transitory versus longer-term in nature. And so, that's definitely been a lot of the debate that's been playing out in markets, and certainly, we've seen a lot of flow-on effects from that.</p> <p><strong>Rapaport</strong>: If it becomes that inflation is going to be a long-term issue, what is the reaction to that occurring?</p> <p><strong>Murphy</strong>: Yeah, well, I think it's fair to say that more of the consensus view has been that the sort of high inflation numbers we're seeing more recently are likely to have been transitory in nature and you're likely to see that dial back later in the year. Now, the recent &ndash; the conflict in Russia potentially complicates that story. But if we sort of talk about the last few months first of all and then we'll come back to the current conflict. The bond markets have been first to react, right? So, there's been an assumption that interest rates are going to rise aggressively, and so, we've seen upward movements in bond rates, which has been a negative for government bonds, any duration-linked type of bond out there. So, we've seen some negative returns, albeit sort of small single digits in most cases on the bond side. So, that's been a bit troubling on the conservative side of people's portfolios.</p> <p>But then, on the equity market, then the sort of second order effects of that we've really seen play out since about November. And so, a lot of the sort of high P/E, high-growth stocks that have supercharged equity market performance in the last couple of years have really gone out of favor, and there's been a big market rotation since November off the back of that.</p> <p><strong>Rapaport</strong>: Yeah. Can you explain quickly why we're seeing this big change in high P/E stocks and also this rotation into energy stocks, into &ndash; sorry &ndash; into value, which includes energy, banks, financials?</p> <p><strong>Murphy</strong>: Yeah. So, certainly, stocks that are high P/E, high growth in nature tend to be longer duration assets. So, they are more negatively affected by rise in long-term interest rates. And so, if you think about sort of a core discounted cash flow approach to valuing an equity, the more you move the long-term discount rate assumption in that, the higher-growth stocks are much more sensitive to that in a current valuation context. And so, you've seen big sell-offs across &ndash; particularly, a lot of the tech space, a lot of the stuff that's led markets in recent years and people have rotated back into lower P/E areas, more value-oriented areas as you mentioned. Sectors like energy and sectors like financials in particular have both benefited from that in the last few months. And so, there's a couple of dynamics going on there. Certainly, we've seen commodity prices rising even for the current conflict, and that's just accentuated that given the amount of traditional energy sources that come out of that region. And so, that is clearly going to have flow-on inflation effects there but is beneficiary to the terms of the energy producers elsewhere that might be part of the equity market and benefit from that.</p> <p><strong>Rapaport</strong>: So, when you're thinking about the model portfolios and you're seeing all this change go in the market, the rotation from growth to value, the issue with especially U.S. tech stocks, what does that mean for the way that you're positioning the model portfolios? Are you adding, for example, more to the value side?</p> <p><strong>Murphy</strong>: I think the biggest thing for us has been discipline in rebalancing. And so, it's fair to say we haven't participated as much in the upside from the growth story in the last year or so. We tend to take a slightly more conservative approach than others out there to building our models that in a market where balanced and equity portfolios are up 20%, 30%, we participated in a lot of that upside, but not all of it. And so, the important part has been we've had value exposure in there along the way, but that's underperformed in recent years. Discipline around rebalancing has been important to maintain those exposures, so that when that rotation has taken place, we've then been able to benefit from that on the other side from existing positioning which hasn't been a benefit to the portfolios in recent years. And so, now the important thing now is we've been equally disciplined about rebalancing now, because growth has underperformed value by so much in the last couple of months that certainly as we come into the end of the quarter, it's something to think about in terms of people managing their portfolios.</p> <p><strong>Rapaport</strong>: Yeah. So, for the next six months, are you &ndash; you've done that rebalancing, you've taken the benefit of the value uptick. You're now looking at growth potentially seeing it as potentially undervalued. Are you making any changes to the portfolio for the next six months?</p> <p><strong>Murphy</strong>: Yeah. I wouldn't go as far as to say we think growth is undervalued at this point. This cycle could have some time to play out. And obviously, moving on to then current scenario with the Russian conflict with Ukraine has taken place, the potential flow-on effects, that's likely to see higher inflation in some areas in particular, things like wheat production and whatnot, for which Ukraine is a big source for the world. We've already touched on the energy sources that come out of Russia that form a big part of world's supply. So, we think we are likely to see all the &ndash; the current scenario is likely to add to some of those inflationary aspects around the world, which is net negative for much of the economy elsewhere. And so, we definitely would not be encouraging people to think about loading up on a rebound in growth, so to speak, at this point.</p> <p><strong>Rapaport</strong>: So, I want to move quickly to &ndash; we spend a lot of time talking about growth in equities, but there's the other side of the portfolio, which is defensive. And you said at the top that this change in the way that markets are operating has meant that longer-term bonds are not performing well.</p> <p><strong>Murphy</strong>: Yeah.</p> <p><strong>Rapaport</strong>: So, what should investors do with the defensive side of the portfolio? Should they be switching into shorter-term bonds or other asset classes that maybe make up for not being able to be long-term government debt?</p> <p><strong>Murphy</strong>: Yeah, sure. I think bonds always continue to play a defensive role in a portfolio. It's a question of how you do it. And I think it's all important to take the overall context in mind. So, 2021 saw negative bond returns on the major indices, 3%, 4% depending on which one you're looking at. But you got to keep in mind, they came in an environment where equities were up 20%, 30% depending on the market that you're looking at. And so, from an overall portfolio perspective, as long as you had exposure to both of those and you weren't 100% bonds, then your portfolio return was just fine. Or it should have been just fine. So, as we move into 2022, the consideration around what to do with duration in your bond portfolios, is the market &ndash; you have bond yields gone to a point now where potentially there is more value there, will they continue to play a defensive role if we do have a sustained sell-off off the back of the current conflict? We think it's sensible to maintain some exposure to the long bonds in that scenario. It shouldn't be the entirety of your fixed interest portfolio, of course. And so, we do maintain selective exposure to certainly investment grade credit and so a lot of the funds that invest heavily in that area. Because despite all the challenges going on, company balance sheets on the whole are generally pretty healthy. And so, you can still get some decent opportunities in investment grade credit sphere without taking undue risk in our view.</p> <p><strong>Rapaport</strong>: Right. Tim, thank you very much for joining us today.</p> <p><strong>Murphy</strong>: Thanks, Emma.</p>

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