Why are growth stocks still struggling?

After a rough January for the stocks of fast-growing companies, February hasn’t been any better.

The Morningstar US Growth index is down 16% so far in 2022, while the US Value index is essentially flat year to date. After strong returns in recent years, some of the biggest house-hold names among growth stocks are posting losses. Microsoft (MSFT) is down 13.4%, Facebook parent Meta (FB) is down 38.3%, Tesla (TSLA) is down 17.1% and semi-conductor company NVIDIA (NVDA) is off 16.7%.

Coming into 2022, many of these stocks were trading at lofty valuations, but their status as expensive names to buy was nothing new. Catalysts were required for a sell-off, which came in the form of rising bond yields and expectations that the Federal Reserve would embark on an aggressive strategy of raising interest rates to combat inflation.

“As rates reset to higher levels, expect growth stocks to get hurt more than value,” says Tim Murray, capital markets strategist for the multi-asset division at T. Rowe Price Associates. When it comes to the outlook from here, “it doesn’t matter when the hikes happen. It matters how far will they ultimately get in this hiking cycle,” he says.

Meanwhile, two key groups of value stocks--energy companies and banks--have seen the winds turn in their favor. Bank profits are generally helped by rising rates and energy companies have seen their fortunes rise along with the price of oil.

On the bright side for investors looking to put money to work in the market, the sell off has taken growth stock valuations down from expensive to more reasonable levels.

The performance of growth stocks over the past two months has marked a significant turn from the longer-term trend of growth’s significant outperformance over value in recent years. Among small company stocks, value stocks are now leading small-growth stocks even for the past three year’s worth of returns.

Why interest rates matter

Changes in interest rates flow through to the stock market in several different ways. One avenue is in relation to the effect that rising interest rates have on the economy and on corporate earnings. Worries that rates are rising at such a pace that they will lead to a sharp slowdown in the economy could send stock prices lower. For now, however, most economists, including Morningstar’s Preston Caldwell, expect the economy to continue growing at a healthy pace in 2022 and 2023, albeit at a slower rate than seen with 2021’s bounce back from the pandemic recession.

Another way interest rates can affect stock prices is through rising bond yields offering greater competition for returns. But even with the yields having risen--the US Treasury 10-year note yield is 1.93%, up from 1.5% at the start of the year--the income gap with stocks is relatively low. The dividend yield on the Morningstar U.S. Market index was 1.3% at the end of January, and dividend strategies like Vanguard Dividend Appreciation ETF (VIG) are offering a dividend yield of 1.6% plus potential for growth through stock market returns.

But the hurdle posed by rising interest rates for high-growth stocks such as technology names has been through a different transmission mechanism: how stocks are valued. As Morningstar strategist David Sekera noted, a significant part of the value of growth stocks is their future earnings potential. When rates are low, the value of those hefty future earnings is high. But discount those future earnings at a higher rate thanks to rising interest rates, the present value for these stocks falls further and faster than the broader market, leading to lower prices.

In a nutshell, says T. Rowe’s Murray, “growth stocks are hit harder than value by the change in interest rates because their cash flows are further into the future.”

Meanwhile, a challenge for the market has been that while economists expect inflation to ease over the course of 2022, thus far upward pressure on prices has been sticker than expected. That has led to investors repeatedly upping their expectations for the pace of interest rate hikes from the Fed.

“How much further will rates rise beyond current expectations of (federal funds at) 2%? That’s the big question going forward,” Murray says.

“If we stay at 2%, I’d say that things will stay kind of where they are with a big valuation gap between growth stocks and value,” Murray says. “It might narrow a little bit because you’ll have more growthy stocks will start to find a few of them that couldn’t meet those expectations. So growth will fall from that factor, but that’s the only thing that will really cause this value-growth divide to narrow any further.”

Tech and communications taking it on the chin

With fast-growing stocks dominating the technology and communications sectors, those groups have seen the worst of the damage.

The Morningstar U.S. Technology index lost over 12% in 2022 as of February 17th, and the Morningstar US Communication Services index dropped nearly 14% during the same period.

While technology and communication services stocks have suffered, energy and financial services, two value-heavy sectors, have been much more buoyant. Bank profits can get a lift from a rising rates by charging borrowers higher interest. American multinational financial services corporation Wells Fargo is up almost 18% and card payment services giant American Express gained 14% for the year to date.

Meanwhile, high oil prices have a bolstered bolster the energy sector. The Morningstar US Energy index is up over 20% for the year to date as oil reaches over $100 per barrel, up from just above $60 a year ago. American multinational oil & gas company Exxon gained nearly 30% in 2022 and energy giant Chevron is up 15%.

The sharp declines in growth stocks has had a silver-lining for investors looking to put fresh to work. Growth stocks had broadly been significantly overpriced compared to Morningstar analysts’ fair value estimates. Now, these style box categories are pushing into undervalued territory. As of Feb 17, 50 out of the 120 technology stocks covered by Morningstar analysts were undervalued. That’s double the number at the start of 2022. The ranks of the undervalued now include some of the market’s biggest names, including Amazon (AMZN), Microsoft (MSFT), and Alphabet (GOOGL).