At the end of last year, we speculated that market returns this year would be moderate, but divergent performance beneath the surface would be an opportunity. This has played out, as value has outperformed growth and small caps have outperformed large caps. Furthermore, equal-weighted benchmarks have outperformed market cap-weighted benchmarks, signaling that the “average” stock is doing well; this has led to the highest percentage of U.S. large cap equity managers outperforming their benchmarks in more than a decade. But with the S&P 500 up more than 10% year-to-date and certain parts of the market looking frothy or stretched, what is in store for the back half of this year? Does the value trade still have room to run?

Interest rates should rise further, reflecting robust economic activity both in the U.S. and abroad. Generally speaking, value tends to outperform growth during periods of above-trend economic activity and rising interest rates. Part of this has to do with the fact that the earnings of value-oriented sectors tend to be more sensitive to the pace of economic growth.

Exhibit 7: Earnings in value sectors are more sensitive to economic growth

S&P 500 sector earnings correlation to real GDP 1Q09-4Q20

Source: FactSet, FTSE Russell, NBER, J.P. Morgan Asset Management. Growth is represented by the Russell 1000 Growth Index and Value is represented by the Russell 1000 Value Index. Beta is calculated relative to the Russell 1000 Index. *Communication services correlation is since 3Q13 and based on backtested data by JPMAM. Guide to the Markets – U.S. Data are as of May 31, 2021.

The return differential between growth and value since the March 2020 low has primarily been a function of differences in earnings growth; nearly 25% of the return of the Russell 1000 Growth has been driven by earnings, versus 13% for the Russell 1000 Value. Put simply, growth stocks saw earnings rise sharply last year, while earnings on the value side struggled. Given our expectation for vigorous economic activity during the second half, we believe that value stocks will resume their outperformance on the back of robust profitability.

More broadly, using earnings as a guide will increase in importance against a backdrop of rising rates. Our work shows that rates and equities should be able to rise together until the 10-year U.S. Treasury yield approaches 3.5%; importantly, the primary channel through which rising rates pressure equities is valuations. This means that story stocks, meme stocks and some of the other, frothier parts of the equity market will likely come under pressure as rates continue to move higher.

Exhibit 8: Stocks come under pressure when rates approach 3.5%

Stock returns and interest rate movements before and after the global financial crisis, rolling 2yr. Correlation of monthly S&P 500 price returns, 10yr UST yield

Source: FactSet, J.P. Morgan Asset Management. X-intercept for each data set is calculated using a quadratic regression where interest rates are the independent variable and the rolling 2-year correlation of stock returns and interest rate movements is the dependent variable Guide to the Markets – U.S. Data are as of May 31, 2021.

At some point, the post-COVID-19 surge in economic activity will run its course. In advance of that, markets will begin to focus on a return to a more moderate growth environment, although with somewhat higher inflation than we saw in the aftermath of the Global Financial Crisis. As this macroeconomic backdrop comes into view, high-quality growth companies will likely resume their outperformance. There is room for the value trade to run, but trees do not grow to the sky — the prudent investor will own growth, and rent value.