The fortunes of long-suffering value stocks may be about to take a share turn for the better while growth stocks could start underperforming from here due to the inverted yield curve.
That's the prediction made by Credit Suisse and it isn't only growth stocks that could be in trouble as the broker is also anticipating tougher times ahead for passive funds, which includes highly popular exchange traded funds (ETFs) that track the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index.
Value stocks are those that trade at a discount to the market or historical averages (usually due to their underperforming share price), while growth stocks tend to trade at a premium as investors are happy to cough up for their strong growth outlook.
Some examples of high-flying growth stocks include the Afterpay Touch Group Ltd (ASX: APT) share price and CSL Limited (ASX: CSL) share price; while value stocks like the BlueScope Steel Limited (ASX: BSL) share price and Worleyparsons Limited (ASX: WOR) share price have lagged.
Yield curve inverts strategy
But we are entering into an inverted yield curve environment and the tables are turning, according to Credit Suisse.
An inverted yield curve is when the yield on a long-dated government bond (typically the 10-year US Treasury) falls below the short-dated bond (e.g. the 2-year US Treasury). When this happens, the US almost always suffers a recession – and when the world's biggest economy contracts, everyone else suffers.
While the debate about the recessionary risks rages, Credit Suisse points out that there is one thing that is more certain than a recession. This is correlation.
"The certainty is that correlations within a portfolio, or between GDP components, have risen from zero or negative, towards one," said Credit Suisse.
"Both portfolios and GDP have rapidly lost diversification. As such, they are highly susceptible to higher volatility and large drawdowns from an external shock."
A negative correlation means the two variables move in opposite direction. A correction of one means they move in perfect tandem, while zero means there is no correlation between the two.
Value stocks outperform in recessions
What the broker is saying is that it doesn't matter whether you buy defensive or higher risk stocks. They both will move in unison when yields invert. Diversification is hard to find in this climate!
But there is a way to better diversify risks.
"For stock pickers and factor investors, the problem is that momentum is very much behind high-quality exposures," said Credit Suisse.
"Value investing has been the laggard. Value has arguably become the diversifying factor, while correlation risk has risen in the defensive complex."
Don't worry if the world does fall into a recession either. The broker noted that value stocks have outperformed in past recessions.
