September's interest rate rise by the Bank of England was a surprise to most and the move has genera...
September's interest rate rise by the Bank of England was a surprise to most and the move has generated a debate about its investment implications particularly for growth stocks
At the beginning of 1999 many professional investors favoured growth stocks. The reasons were rooted in pessimism regarding the prospects for global economic growth
Certainly, back in January, the signs were not auspicious. Credit spreads were widening meaning the cost of borrowing was increasing both for companies and governments. The collapse of Long Term Capital Management provoked fears that huge losses might be incurred by financial institutions who had lent to the heavily-geared hedge fund. Emerging markets were in the midst of a debt crisis
Overlaying all this, bond yields were falling and the growth outlook for the US was gloomy
In the UK, the prognosis appeared equally grim. Survey data from the fourth quarter of 1998 indicated collapsing output in both services and manufacturing. Household expenditure had undergone a sharp slowdown. Everything seemed to point to weaker than expected growth through 1999
As a consequence many UK fund managers adopted a defensive stance overweight on growth stocks and underweight on cyclicals. However, during the first six months of this year, prospects for global growth changed dramatically and the main trigger was stronger-than-expected quarter four GDP figures for the US
Bond yields, which had been falling, started to rise once more. At the same time, there have been equally unexpected revisions to growth forecasts for Japan and south east Asia. This quickly resulted in a marked sector rotation, with investors switching out of growth stocks and into economy-sensitive cyc-lical stocks
The most recent interest rate rise looks set to further the process of sector rotation. Highly rated growth stocks such as those in the technology sector will suffer from further rate rises. There is an understandable reluctance for investors to buy stocks whose valuation is based on prospects of future cash flow, and which might be disproportionately affected by the ebbs and flows of interest rates
That said, there is a long-standing historical justification for investing in growth stocks. These have outperformed cyclicals by a remarkable 80% over the past 15 years
Over the past few months, however, with the increasing sense of optimism regarding the health of the global economy, cyclicals have begun to outperform growth stocks. Will this situation endure? Medium-term prospects for growth stocks rest heavily on the path of long term interest rates. Almost by definition the future earnings of such stocks are relatively immune to the vagaries of the economic cycle
However, the discount rate that investors tend to use to value the future profits of such stocks is in part determined by the long bond yield. Higher long rates will result in a de-rating of growth stocks, while a decline in rates will have the opposite effect
Nevertheless, looking at the longer term, we remain confident that the accepted growth sectors pharmaceuticals or technology for example are destined to outperform traditional cyclicals such as chemicals or building materials
Mark Phillips is UK portfolio manager at Scottish Equitable Asset Management
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