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INTRO
Investors expect the U.S. economy to race ahead in the coming months. The FED now expects U.S. GDP to rise by 6.5% in 2021. This estimate is sharply higher than the 4.2% it projected in December 2020.
The sharp increase in activity is supported by the positive prospects brought by vaccinations campaigns and a fresh round of government stimulus
This has raised fears of inflation yet the central bank has repeatedly voiced that inflation should stay under control after an initial spike
Following the FED’s FOMC meeting, yields on the 10-years and 30-years treasury bills have continued to rise
NEW NORMAL
The COVID pandemic gave a boost to technology stocks as interactions moved online. These saw a rapid rise in usage and this translated into surging sales and inflating valuations.
“Zoom has emerged as one of the leading tools to keep businesses up and running, students learning and people connected through virtual birthday parties, happy hours and yoga classes.” Alex Konrad for Forbes
Is this the new normal? Going forward, we tend to ask ourselves three questions:
How much of the technological shift is permanent versus temporary?
Could the economy overheat?
Is there any debt-problem to watch?
TECHNOLOGICAL SHIFT
Investors are right to be optimistic. The pandemic has given technology a central place in the world as cashless payments, e-commerce, video conferences and online gaming became the norm.
Early into the pandemic, McKinsey & Company reported that e-commerce penetration in the U.S. booked a 10-year gain in 3 months. Growing from 16% to 34%.
A report from Square, Inc. indicates that the shift away from cash would have taken 3 years but instead took just a year
“In the United States specifically, we estimate the shift away from cash usage in this past year would have taken nearly three years without the pandemic.” Square, Inc. Research
On a earnings call, Satya Nadella, Microsoft’s CEO, spoke about the boost in digital transformation caused by the pandemic
“We’ve seen two years’ worth of digital transformation in two months.” Microsoft CEO Satya Nadella
ROOM FOR ERROR
There is no doubt that the pandemic accelerated the pace of change as the leaders of yesterday saw their demise quicken while the challengers of tomorrow came into the spotlight. Combined with ultra low interest rates, this has boosted technology stocks’ valuations to considerable heights and strengthened a belief in the world of tomorrow.
As investors, we tend to find attractive opportunities today, buy these at a fair price (remembering that quality doesn’t come cheap) and stick to our investments as the underlying businesses grow over time
Yet, today’s valuations have climbed to above-average levels on a relative basis (enterprise value to sales and price-to-earnings ratio). Leaving little room for error for stocks and investors
LOW RATES AND A STICKY SHIFT
We thus need to ask ourselves whether we want to hold stocks priced for near perfection. In other words, would these valuations hold if rates increase and consumer demand shifts (partially) back to physical (versus digital) streams?
Rates increase may pose a threat to technological stocks by reducing future expected cash flows, increasing financing costs and increasing bankruptcy probabilities of unprofitable companies
Looking forward, it is rather unlikely that inflation overshoots the FED’s target on a sustained basis. Yet, the spikes in (expected) inflation may trouble the market
Inflation may still require the FED to intervene and start increasing rates again. As a standalone event, this is not a bad as it would signal a strong economy
Yet, higher rates may also have an adverse effect on consumer spending and dim spending that is highly dependent on rates (e.g. mortgages, auto-financing, consumer credit)
At current valuations and with rising rates, pricey technology stocks as a whole may have a hard time breaking out of their range as considerable rise would mean a further stretch of their valuation multiples
Demand moves in part back to physical (versus digital) streams as the economy re-opens, employees move back to their offices and consumer spend more time outside
Investors need to see for themselves what stocks might be hurt the most by the reopening. Consumers may favour in-store shopping, in-person meetings and spend more time outside rather than in front of their screens
THE TAKE
Buying technology stocks in the midst of the March 2020 debacle has provided outsized returns to investors. Part of these were supported by growing product adoptions while another part was provided by a low rates.
Valuation (on a relative basis) have reached new heights and most technology stocks are now priced for perfection. Decreasing potential profits for investors as a further increase in enterprise value to sales ratios is rather unlikely given rising inflation expectations
We are still confident that reasonably valued technology stocks might offer the risk-adjusted returns investors look for as growing sales translate into a growing enterprise value
Stocks have risen because of strong underlying fundamentals. But also because valuation multiples were able to stretch in a low rate environment. This may change as rates rise. Supporting the need to find stocks that can grow their sales while growing their valuation - and not just their valuation multiples.
NEXT TIME
In our next newsletter we will take a look at our next question: Could the economy overheat? We will have a look at the pre-COVID conditions which were marked by historically low unemployment levels, rising inflation and rising corporate debt levels.
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Disclaimer: Return is not an investment advisor, we have no access to non-public information about publicly traded companies, and this is not a place for the giving or receiving of financial advice, advice concerning investment decisions or tax or legal advice. We are not regulated by the Financial Services Authority. Investors should conduct their own analysis before making any investment. The value of shares, assets and investments and the income derived from them can decrease as well as increase. Investors may not get back the amount they invested - there is a real risk of partial or total loss. Past performance is not a guide to future performance.
Picture: Hans Eiskonen