The Nasdaq-100® Index Meets The Inflation Boogeyman:NEXT?
The Nasdaq-100® Index Meets The Inflation Boogeyman: What Happens Next?
The Nasdaq-100 Index has generated an exceptional record of absolute and relative performance over the past decade and a half. Broadly speaking, large-cap U.S. equities have performed very well, with the S&P 500 Index producing total returns of 357% from year-end 2006 through year-end 2021. The Nasdaq-100 nearly tripled those gains, up 976% on a total return basis. Its concentration of high-growth, innovative large cap companies fueled this outperformance across an extended period of unusually low interest rates in the US. In addition, the Nasdaq-100’s unique sector exposure allowed the index to avert deep fundamental damage during multiple economic and financial crises, including the Great Financial Crisis of 2008-9, the Oil Supply Glut of 2014-6 and, of course, the arrival of Covid-19 in March 2020. With an overweight towards “new economy” sectors like Technology, Consumer Discretionary, and Healthcare, the Nasdaq-100 has felt rather immune to intense risk episodes disproportionately impacting Financials, Energy, and other “old economy” sectors vulnerable to macroeconomic shocks, such as a credit crisis, a deadly pandemic or a major new geopolitical conflict disrupting global supply chains of raw commodities .
The first half of 2022 has proven to be one of the most challenging environments for investors to navigate in decades. Inflationary pressures arose in 2021 as the world gradually, then suddenly reopened following mass vaccination against Covid-19. Some of these pressures were thought to be transitory as different parts of the world, and different areas of the economy even within the US, reopened at different speeds. Supply-chain disruptions impaired the ability of global trade to deliver physical goods at pre-Covid rates. Not only that, but overall consumer demand was elevated by both fiscal stimulus in the US, and by widespread substitution of spending on (lockdown-restricted) services in favor of spending on goods. Just as certain segments of physical consumption saw supply chain pressures ease in early 2022, China’s zero-Covid strategy led to renewed lockdowns of tens of millions of people, and Russia’s invasion of Ukraine led to once-in-a-lifetime disruptions in the markets for physical commodities from oil and gas to metals, chemicals, and foods like wheat and cooking oils. As a result, inflationary pressures have only increased, forcing the Federal Reserve into an extremely hawkish position.
With three rate hikes already complete, the Fed is expected to continue hiking until inflation moderates closer to its preferred target of 2% annualized. China’s reopening and a near-term conclusion to the Russian invasion could alleviate some of the pressure on the Fed, and perhaps put an end to rate hikes somewhere in the range of 3.0-3.5% on the Fed Funds rate. There is a chance the Fed can engineer a soft landing, with inflation and interest rates peaking before substantial economic damage is done. Yet there is also a chance that inflation remains stubbornly high, and the Fed raises rates farther and faster than anyone has seen since Volcker’s chairmanship in the early 1980s. In that type of scenario, a broad-based recession would be likely.
The Nasdaq-100 has borne the brunt of this new era of macroeconomic uncertainty. Investors are primed to believe that high-growth sectors like Technology are especially vulnerable to higher inflation and interest rates, which is why the index began underperforming as soon as the Fed made clear it was going to start hiking at the end of 2021. The key questions for index investors now are thus: other than the impact of higher discount rates on valuation models, how might the index respond to some combination of: 1) rising inflation vs. steadily higher-than-average inflation vs. moderating inflation ; 2) rising rates vs. rates plateauing at a new “neutral” vs. renewed rate cutting; 3) a weakening but still expanding economy vs. a truly recessionary environment.
Putting Recent Performance into Context
With the index already down 29% YTD as of June 30, 2022, there are few reasons for investors to feel encouraged about performance. It has been the worst start to a year for the Nasdaq-100 in its history, and April 2022 was the worst single month of performance since 2008. Meanwhile, the S&P 500 has dropped 20% YTD, registering its worst first half since 1970. In a way, this is somewhat in-line with the equity market declines seen in the fourth quarter of 2018, when the Nasdaq-100 was down 23% at the nadir on December 24. That decline occurred at the tail end of a three-year-long Fed hiking cycle consisting of nine increments of 25 basis points each. The Fed would go on to pause in the range of 2.25-2.50%, and actually reverted to a gradual cycle of easing beginning in August 2019. The buying opportunity for investors was superb, under the assumption that the Fed would not induce an economic recession in an environment of subdued inflation and below-full employment. The difference today, however, is that full employment more or less exists, labor shortages persist in many parts of the economy, the price of labor has increased substantially and inflation outside of wages is in danger of becoming entrenched. Thus the Fed is believed to be willing to increase rates beyond the upper bound seen in late 2018 and early 2019.
Technology stocks were extending gains in late Wednesday afternoon trading, with the SPDR Technology Select Sector ETF ( XLK ) rising about 4.3% and the Philadelphia Semiconductor Index surging 4.5%.
In company news, Tenable ( TENB ) slumped nearly 15% following several cuts to its share price target. The company reported Q2 adjusted earnings late Tuesday of $0.05 per diluted share, down from $0.09 a year earlier, and also offered Q3 revenue guidance that was just shy of the Capital IQ-compiled consensus.
Microsoft ( MSFT ) reported fiscal Q4 diluted earnings late Tuesday of $2.23, up from $2.17 a year earlier, as revenue improved to $51.87 billion from $46.15 billion. On its earnings call, the company said it foresees continued double-digit sales and operating income growth in fiscal 2023. The stock was up nearly 7%.
Spotify Technology (SPOT) reported a widening of its Q2 net loss to 0.85 euros ($0.86) per diluted share, but also issued Q3 revenue guidance of 3 billion euros, slightly ahead of analysts' forecast for 2.95 billion euros. Spotify shares climbed almost 13%.
Given that the Fed Funds rate has already gone up by 150 bps YTD (as has the U.S. 10-year Treasury yield), the impact on $100 of earnings ten years into the future is a reduction in its present-day value by approximately 14%. As the market always does, though, its discounting mechanism is even further ahead of the curve, seemingly acknowledging that the Fed will have to hike more aggressively, by a total of around 300 bps . Given their latest preference for 50-75 basis point hikes, it will take two to three more Fed meetings to reach that goal. If inflation moderates by that time, it is well within the range of possibility that the economy will avoid recession, and the market will rebound as it did in early 2019. But if inflation stays well above 2%, the Fed may need to hike by perhaps up to double or triple that amount – 450 to as much as 600 bps in total – which would reduce those future earnings in year ten by anywhere from 35% to 45%. For investors using traditional valuation methods, high-growth companies with most of their earnings well into the future face the biggest downward revisions in their estimated present values.
Structural Advantages of the Nasdaq-100 vis-à-vis Higher Interest Rates
With the prospect of higher interest rates for an extended period of time, investors should first and foremost seek to determine their equity portfolio’s sensitivity to an elevated cost of capital. Using a variety of metrics, the Nasdaq-100 appears minimally exposed to the risk of increased financing costs eating into its earnings , and thus depressing valuations further. This is largely a function of exceptionally strong, long-running fundamental trends that have built up the operating leverage, pricing power, and cash cushions of many of the index’s largest constituents. One of the clearest indications of above-average fundamental strength is a comparison of the indebtedness of Nasdaq-100 (NDX®) constituents to the broader U.S. large cap equity space via the S&P 500 Index (SPX) . For added emphasis, our analysis incorporates a view of the S&P 500 excluding any overlapping Nasdaq-100 constituents (i.e., SPX ex NDX), which recently numbered 77 companies.
The first series of charts measure the ratio of total debt (short-term plus long-term debt) to total market capitalization, using the latest available financial data as of May 19, 2022, and market caps as of April 29, 2022. Across each of the four variants of the ratio (Median / Average / Weighted Average / Aggregate Total), NDX appears significantly less indebted than SPX , and even moreso relative to SPX ex NDX. The ratio of the median NDX company (7.4%) was 68% lower than that of SPX (22.9%); the average of all NDX company ratios (16.1%) was 58% lower; the weighted average (10.9%) was 60% lower; and the aggregate total across all companies in the index (9.6%) was 65% lower.
The Nasdaq-100 Index has generated an exceptional record of absolute and relative performance over the past decade and a half. Broadly speaking, large-cap U.S. equities have performed very well, with the S&P 500 Index producing total returns of 357% from year-end 2006 through year-end 2021. The Nasdaq-100 nearly tripled those gains, up 976% on a total return basis. Its concentration of high-growth, innovative large cap companies fueled this outperformance across an extended period of unusually low interest rates in the US. In addition, the Nasdaq-100’s unique sector exposure allowed the index to avert deep fundamental damage during multiple economic and financial crises, including the Great Financial Crisis of 2008-9, the Oil Supply Glut of 2014-6 and, of course, the arrival of Covid-19 in March 2020. With an overweight towards “new economy” sectors like Technology, Consumer Discretionary, and Healthcare, the Nasdaq-100 has felt rather immune to intense risk episodes disproportionately impacting Financials, Energy, and other “old economy” sectors vulnerable to macroeconomic shocks, such as a credit crisis, a deadly pandemic or a major new geopolitical conflict disrupting global supply chains of raw commodities .
The first half of 2022 has proven to be one of the most challenging environments for investors to navigate in decades. Inflationary pressures arose in 2021 as the world gradually, then suddenly reopened following mass vaccination against Covid-19. Some of these pressures were thought to be transitory as different parts of the world, and different areas of the economy even within the US, reopened at different speeds. Supply-chain disruptions impaired the ability of global trade to deliver physical goods at pre-Covid rates. Not only that, but overall consumer demand was elevated by both fiscal stimulus in the US, and by widespread substitution of spending on (lockdown-restricted) services in favor of spending on goods. Just as certain segments of physical consumption saw supply chain pressures ease in early 2022, China’s zero-Covid strategy led to renewed lockdowns of tens of millions of people, and Russia’s invasion of Ukraine led to once-in-a-lifetime disruptions in the markets for physical commodities from oil and gas to metals, chemicals, and foods like wheat and cooking oils. As a result, inflationary pressures have only increased, forcing the Federal Reserve into an extremely hawkish position.
With three rate hikes already complete, the Fed is expected to continue hiking until inflation moderates closer to its preferred target of 2% annualized. China’s reopening and a near-term conclusion to the Russian invasion could alleviate some of the pressure on the Fed, and perhaps put an end to rate hikes somewhere in the range of 3.0-3.5% on the Fed Funds rate. There is a chance the Fed can engineer a soft landing, with inflation and interest rates peaking before substantial economic damage is done. Yet there is also a chance that inflation remains stubbornly high, and the Fed raises rates farther and faster than anyone has seen since Volcker’s chairmanship in the early 1980s. In that type of scenario, a broad-based recession would be likely.
The Nasdaq-100 has borne the brunt of this new era of macroeconomic uncertainty. Investors are primed to believe that high-growth sectors like Technology are especially vulnerable to higher inflation and interest rates, which is why the index began underperforming as soon as the Fed made clear it was going to start hiking at the end of 2021. The key questions for index investors now are thus: other than the impact of higher discount rates on valuation models, how might the index respond to some combination of: 1) rising inflation vs. steadily higher-than-average inflation vs. moderating inflation ; 2) rising rates vs. rates plateauing at a new “neutral” vs. renewed rate cutting; 3) a weakening but still expanding economy vs. a truly recessionary environment.
Putting Recent Performance into Context
With the index already down 29% YTD as of June 30, 2022, there are few reasons for investors to feel encouraged about performance. It has been the worst start to a year for the Nasdaq-100 in its history, and April 2022 was the worst single month of performance since 2008. Meanwhile, the S&P 500 has dropped 20% YTD, registering its worst first half since 1970. In a way, this is somewhat in-line with the equity market declines seen in the fourth quarter of 2018, when the Nasdaq-100 was down 23% at the nadir on December 24. That decline occurred at the tail end of a three-year-long Fed hiking cycle consisting of nine increments of 25 basis points each. The Fed would go on to pause in the range of 2.25-2.50%, and actually reverted to a gradual cycle of easing beginning in August 2019. The buying opportunity for investors was superb, under the assumption that the Fed would not induce an economic recession in an environment of subdued inflation and below-full employment. The difference today, however, is that full employment more or less exists, labor shortages persist in many parts of the economy, the price of labor has increased substantially and inflation outside of wages is in danger of becoming entrenched. Thus the Fed is believed to be willing to increase rates beyond the upper bound seen in late 2018 and early 2019.
Technology stocks were extending gains in late Wednesday afternoon trading, with the SPDR Technology Select Sector ETF ( XLK ) rising about 4.3% and the Philadelphia Semiconductor Index surging 4.5%.
In company news, Tenable ( TENB ) slumped nearly 15% following several cuts to its share price target. The company reported Q2 adjusted earnings late Tuesday of $0.05 per diluted share, down from $0.09 a year earlier, and also offered Q3 revenue guidance that was just shy of the Capital IQ-compiled consensus.
Microsoft ( MSFT ) reported fiscal Q4 diluted earnings late Tuesday of $2.23, up from $2.17 a year earlier, as revenue improved to $51.87 billion from $46.15 billion. On its earnings call, the company said it foresees continued double-digit sales and operating income growth in fiscal 2023. The stock was up nearly 7%.
Spotify Technology (SPOT) reported a widening of its Q2 net loss to 0.85 euros ($0.86) per diluted share, but also issued Q3 revenue guidance of 3 billion euros, slightly ahead of analysts' forecast for 2.95 billion euros. Spotify shares climbed almost 13%.
Given that the Fed Funds rate has already gone up by 150 bps YTD (as has the U.S. 10-year Treasury yield), the impact on $100 of earnings ten years into the future is a reduction in its present-day value by approximately 14%. As the market always does, though, its discounting mechanism is even further ahead of the curve, seemingly acknowledging that the Fed will have to hike more aggressively, by a total of around 300 bps . Given their latest preference for 50-75 basis point hikes, it will take two to three more Fed meetings to reach that goal. If inflation moderates by that time, it is well within the range of possibility that the economy will avoid recession, and the market will rebound as it did in early 2019. But if inflation stays well above 2%, the Fed may need to hike by perhaps up to double or triple that amount – 450 to as much as 600 bps in total – which would reduce those future earnings in year ten by anywhere from 35% to 45%. For investors using traditional valuation methods, high-growth companies with most of their earnings well into the future face the biggest downward revisions in their estimated present values.
Structural Advantages of the Nasdaq-100 vis-à-vis Higher Interest Rates
With the prospect of higher interest rates for an extended period of time, investors should first and foremost seek to determine their equity portfolio’s sensitivity to an elevated cost of capital. Using a variety of metrics, the Nasdaq-100 appears minimally exposed to the risk of increased financing costs eating into its earnings , and thus depressing valuations further. This is largely a function of exceptionally strong, long-running fundamental trends that have built up the operating leverage, pricing power, and cash cushions of many of the index’s largest constituents. One of the clearest indications of above-average fundamental strength is a comparison of the indebtedness of Nasdaq-100 (NDX®) constituents to the broader U.S. large cap equity space via the S&P 500 Index (SPX) . For added emphasis, our analysis incorporates a view of the S&P 500 excluding any overlapping Nasdaq-100 constituents (i.e., SPX ex NDX), which recently numbered 77 companies.
The first series of charts measure the ratio of total debt (short-term plus long-term debt) to total market capitalization, using the latest available financial data as of May 19, 2022, and market caps as of April 29, 2022. Across each of the four variants of the ratio (Median / Average / Weighted Average / Aggregate Total), NDX appears significantly less indebted than SPX , and even moreso relative to SPX ex NDX. The ratio of the median NDX company (7.4%) was 68% lower than that of SPX (22.9%); the average of all NDX company ratios (16.1%) was 58% lower; the weighted average (10.9%) was 60% lower; and the aggregate total across all companies in the index (9.6%) was 65% lower.
Trade closed: stop reached