Can the outperformance of US growth stocks continue?

Volatility in the Equity Markets – A Key Trend Emerges

The past few months have seen volatility in the equity markets, yet a prominent trend has emerged. The outlook for US equities has undergone a significant shift since the beginning of the year. Growth stocks are decisively outperforming value stocks. This development has become the primary narrative of the US equities market in 2023.

Considerable Gains in US Growth Stocks This Year

In 2023, big-cap growth stocks in the US have performed robustly, while value stocks have lagged. For instance: Amazon has year-to-date gains of approximately +22%, Tesla is up by around +50%, and Meta Platforms has surged by roughly +81%. Meanwhile, value stocks have delivered a lackluster performance. Procter & Gamble is flat, Johnson & Johnson is down by about -9%, and Pfizer has declined by approximately -21%. This contrast highlights a broader market trend. Comparing the iShares Russell 1000 Growth ETF with the iShares Russell 1000 Value ETF illustrates this disparity. For reference, the performance of S&P 500 futures, which include both growth and value components, serves as a benchmark.

US Interest Rates Remain a Key Factor

The outperformance of growth stocks over value stocks can largely be attributed to interest rates and bond yields. Throughout 2023, the markets have grappled with the possibility of peak rates from the Federal Reserve. Investors have two key questions: When will the Fed stop hiking? When will rate cuts resume? In recent months, fluctuations in US interest rate futures have reflected this uncertainty. After pricing peak rates of almost 5.70% in early March, expectations scaled back significantly during the banking crisis. With markets stabilizing, rate futures now stand above 5.00%. According to the CME Group FedWatch tool, the probability of a rate hike in May is around 84%, with limited room for rate cuts toward the end of the year. Despite this, lower bond yields in recent months have led to a decrease in real bond yields (yields minus inflation), which has fueled the strong performance of US growth stocks.

A Move Higher in Yields Could Be Bad for US Stocks

Although the prevailing market sentiment is that the Fed is nearing the end of its hiking cycle, rising yields could drag on US equities. The E-Mini S&P futures and the US 10-year Treasury Inflation-Protected Securities (TIPS) have exhibited a strong negative correlation. As real yields fall, growth stocks tend to perform well due to their reliance on lower interest rates to justify higher valuations. However, the recent uptick in real yields has slowed the pace of gains in E-Mini S&P futures. If yields continue to rise, US futures will likely be pulled lower.

The Warning Signs Are There

The growth-versus-value debate also reveals some cautionary signals. Declining volatility: The VIX Index, which measures S&P 500 options volatility, has dropped to its lowest level since January 2022, around 17. This could signal market complacency. Narrow market leadership: The Advance/Decline line on the NASDAQ is trailing, suggesting that a small number of large-cap stocks are driving the market. This may make the current trend unsustainable. For growth stocks to remain buoyant, US real bond yields would need to stay stable. A hawkish tone from the Federal Reserve during its next rate hike announcement could lead to higher yields, negatively impacting US equities—particularly growth stocks.

Conclusion

While growth stocks have had a robust performance this year, rising yields could act as a headwind. If yields move higher, the underperformance of value stocks may persist, but growth stocks—despite their recent success—could face significant challenges as well. As always, market dynamics will hinge on Federal Reserve policies and broader economic conditions.

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