When the Federal Reserve puts interest rates up, it is often described, in the words of a former Chair, as “taking the punchbowl away from the party.” We might argue over the extent of merrymaking in the economy under the shadow of Covid but we cannot now deny that market exuberance has faded.
At the beginning of last December, Jay Powell, the chair of the Federal Reserve, soberly warned that inflation had become persistent. Tapering has begun. The punchbowl has not been removed – but the Fed will not keep topping it up for much longer. Higher interest rate are on the near horizon. This explains why markets have been behaving as if the hangover is already kicking in.
The US 10-year Treasury bond, which had traded with as little yield as 1.35% in early December, has fallen until it now yields over 1.77% – still much less than US inflation at 7%.
Equity markets have also fallen, led by US equities, which had done most to lead them up last year. So far this year, global equities have fallen 6% in dollars (I am writing on January 25th), the S&P US index has fallen by 9% and Nasdaq by 13%. In comparison, European equities have fallen only 5%, UK equities hardly at all and Hong Kong, which was one of last year’s worst performing markets, is actually 4% higher.
Fundamental methods of valuation generally value an equity on the basis of its future cashflows, discounted to a current value. The discount reflects the fact that people prefer to have cash now, rather than in the future. We can often be enticed to wait with the promise of extra in future, but we expect more when inflation is a concern.
Equities whose cashflows are mainly further into the future thus become less appealing and companies with solid returns today seem a better investment, especially if they are good at passing on inflation through higher prices. The natural rotation within equity markets has therefore been away from technology shares, especially those whose profitability is some years away, towards companies on lower multiples of earnings, even if these have little potential for growth.
The Nasdaq, mainly comprising technology shares, has fallen most and the UK equity market, dominated by banking, oil, mining and pharmaceutical stocks, has held up well.
Although the falls have been sharp, they have merely taken the top off some very strong rises in recent years. On a one-year view, the S&P is still 12% higher, though the Nasdaq has now lost all its gains of 2021. The over-valuation of various technology shares was broadly discussed during the last quarter of 2021 and most of the falls have come in this area: year-to-date, Netflix is down by 34%, Amazon by 17% and Tesla by 13%.
It is perfectly reasonable for equity investors to review the valuations of their holdings, especially where inflation may turn out to be more persistent than expected and when central banks are retreating from buying bonds and looking to raise interest rates. With many shares now priced rather more modestly, do valuations look appealing?
We are approaching the season for full-year 2021 results. After many years of generally strong growth, some companies have been making more cautious statements. Toyota has cut its forecasts for production; Netflix’s growth in subscribers is slowing; and analysts have lowered their expectations for growth at Snapchat, Square, DocuSign, Adobe, PayPal and other highly rated stocks.
Some of the largest equities in the index now seem to be trading on attractive valuations. Alphabet (which owns Google and YouTube) is expected to declare earnings of around $123, putting it on a price/earnings ratio of 21x for 2021. It expects to grow sales by another 17% this year.
There are concerns about its market power and attempts by US and European politicians to manage its dominance of internet search, but regulatory intervention does not yet seem sufficient to jeopardise the earnings quoted. In our valuation methodology, we deduct all share options issued to management as a cash cost and assume the company will pay a full tax charge at some point. The valuation still seems attractive against a background of higher inflation.
Pfizer has been central to managing Covid. Omicron seems to be peaking and fading – thanks to vaccinations. It seems likely that annual boosters will become the norm. Pfizer’s sales may therefore peak in 2022 and there will doubtless be a delay in reinvested profits contributing to future growth. Even so, earnings should be around $6.30 this year, giving a price/earnings ratio of 8x and a yield of over 3%.
Nippon Telegram and Telephone (NTT) trades on 10x earnings with a yield of 3.4% in yen. The company has not raised telephone charges for 20 years as there has been no inflation. However, Japanese consumer prices have been rising as increases in the cost of fuel and transport feed into the prices of consumer goods. Bread, tyres and soy sauce have all risen by between 5% and 10% recently. We expect NTT to follow.
Adapting a portfolio
You could buy the much cheaper end of the market, like oils or intel and companies with weak business models and little control over input or output prices. It may be opportune in the short term – but we would rather not.
We prefer high-quality companies supported by current cashflows and able to cope with inflation. This need not exclude technology stocks. It can range from reasonably valued companies with prospects for high growth, such as Alphabet, to companies with little potential for growth, but a very low valuation and ability to manage inflation, such as NTT.
Balancing good companies like this leads to a portfolio which, overall, trades on a lower price/earnings ratio than the market, with less volatility and only a little less expected growth in revenue.
The unwinding of excess valuation in parts of the technology sector may still have some way to go – but this does not make equity markets, as a whole, unattractive. It just means that a different balance may be needed for this year’s economic conditions.