Fra BNP Paribas:
Light at the end of the tunnel for Value?
KEY MESSAGES
After a long period of under-performance, the Value style factor is showing signs of life in Europe. We see a potentially sustained rotation to value driven by rising producer price inflation, traditionally accompanied by temporary pricing power and higher profit margins in European (value) cyclicals.
Caveat emptor – “value” factor indices can deliver widely varying results, highlighting that
methodology selection is key for factor investment. Exposure to value in Europe can be proxied by exposure to cyclical/defensive relative value, such as the DAX v SMI indices.
While numerous academic studies have demonstrated that the value factor outperforms over the long term, value has been an out-of-favour investment style globally since 2007. During this period, the MSCI World Value index has cumulatively underperformed
the MSCI World by 17%, and the momentum factor by much more (Fig. 1), driven largely by the strength of momentum stocks in the US.
This looks like it might finally be about to change in Europe though, with the BNP Europe value index starting to rebound following significant underperformance
YTD. What could be prompting this long-awaited rotation to value?
Macro drivers of value – momentum and inflation. We see two long-term drivers of value factor performance in Europe: revisions to macro momentum and the
prevailing inflation trend. Value is correlated to regional growth momentum. As
Fig. 3 illustrates, there has been a tight relationship between the euro-area Now-Casting index (demonstrating the prevailing trend in economic activity) over the past seven years.
This makes sense to us as the European stock market tends to be relatively cyclical, with high weightings to industrial cyclical, commodity-related and financial sectors – much more so than in the US stock market, for example.
The Now-casting index peaked for the eurozone back in January and has exhibited a steady loss in momentum ever since (last reading in September). But with the key German IFO business climate index registering gains in August and September relative to prior months, this downtrend could be about to change for the better in the eurozone as a whole, which would be favourable for the relative performance of European value stockRising inflation tends to benefit value.
We have previously pointed out that the aggregate profit margins of European corporates are positively correlated to headline CPI (see our report Europe vs US: Like a
stopped clock, 15 October 2018) – ie, rising inflation tends to confer temporary pricing power on European cyclical stocks, in particular, which allows them to raise prices to more than compensate for their higher costs.
This relationship also holds true for European value stocks, given that they tend to be more cyclical in nature. Hence, it is hardly surprising to see a positive relationship between eurozone manufacturing output prices, on the one hand, and the relative performance of the BNP Europe value index, on the other (Fig. 4). With a combination of higher wages and commodity prices presenting a risk of an upside inflation surprise both in the US and Europe as we head into 2019 (not to mention potentially higher import prices due to the
imposition of trade tariffs), we could see producer prices rise further, providing support for the further outperformance of the value factor in the months ahead