Evening Brief – 03.04.24
Growth Stocks Vs. U.S. Treasuries
U.S. equities remain generally more costly than U.S. fixed income. The most significant disparity, however, exists between growth stocks and short-term U.S. Treasuries. Given the valuation gap, the seemingly unstoppable rally in growth companies is likely to continue if earnings continue to surpass expectations and the Federal Reserve lowers interest rates, and real bond yields fall – if it is not in response to a recession.
On the earnings side, the recent strong economic data helps. The reassuring aspect is that these tech leaders, Nvidia, Microsoft, Amazon, Meta, have witnessed strong growth in both revenue and earnings. This contrasts with a mere emphasis on clicks or user engagement metrics.
The balance sheets of these companies are also generally stronger than the balance sheets of the dot.com bubble leaders, with less leverage and more cash. Unlike 1999-2000 there is little IPO activity today to leach away the liquidity supporting the stocks of the market leaders.
One issue going forward is whether the need for generative AI will increase as much as projected. Currently, Nvidia is unable to produce chips quickly enough to meet the demands of its clients, particularly its four largest customers—Amazon, Microsoft, Google, and Meta—which contribute approximately 40% of its revenue.
At the same time, the risk of the recent, albeit modest, upside reversal in several closely followed inflation metrics, along with the renewed move higher in the price of oil, is not just a blip but the beginning of a new inflationary uptrend. Any further upward surprises will make FOMC members more cautious regarding the timing and pace of interest rate cuts.
If the Fed keeps short-term interest rates high while continuing quantitative tightening, the relatively high real yields on bonds, particularly Treasury bills, may begin to weigh on U.S. growth stocks. If inflation surprises on the upside and the central bank defies expectations of rate cuts, Treasury bills may emerge as the preferred investment option.
Many economists still believe that the recent soft landing or disinflationary climate will persist. However, given the enormous valuation difference between T-bills and growth stocks today, as in 2000, it is probably prudent to take some profits.