19.04.2023
Tech. Priced for perfection?
The S&P 500 has rallied 7.6% from its March low, led by Tech and Communication services.
Regional banks, at the epicentre of the early March weakness, are still close to their lows. With the smaller cap Russell 2000 charting a path closer to regional banks than the S&P 500.
Alongside this, we saw an 8 standard deviation drop in 2yr yields last month. And this was a crucial fact enabling investors to jump on the longer duration, growth-orientated Technology heavyweights. Companies with the strongest balance sheets.
VIX dropped to sub-17, a level not seen before inflation fears started manifesting in 2022. In a way, the SVB shock did a favour for the broader US equity market – the market was able to compartmentalize the shock.
The question now is for how long is this sustainable? Despite the VIX at these levels, sentiment and positioning data are not at orange signs and data over Q1 has been good – just look at the nowcast or Citi surprise indices.
But that is where we were, and we need to contend with the seemingly divergent view between the rate and equity market.
The rates market is priced for peak rates this summer and cuts over H2, i.e. a credit crunch is coming and the labour market will weaken.
Equities, given the rally towards 6mth highs and the earnings yield gap to bonds at multi-year lows, seem to be suggesting the drop in expected bank lending will be enough to quell inflation but not enough to warrant a recession.
Two possible scenarios:
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- First, rates markets are too bearish. So far US data has been good, the US economic surprise index still ticking higher, a recession may not happen and rates may remain higher for longer with cuts pushed out towards 2024.
- In this scenario, the move higher in yields will hurt a driving force for Tech outperformance which has carried the market thus far. In so doing, the overall index will remain on the backfoot.
- Second, equities are indeed rich to bonds in the face of cuts in H2 of this year with the recession coming accompanied by higher credit spreads, weaker earnings. At the start of this month, the MOVE / VIX ratio was at multi-year highs reflecting the more sanguine equity view. In this scenario, that ratio would converge and Technology likely will also weaken given its higher beta status.
- This comes at a time where PE relatives are also at multi-year highs, supporting the view that optimism on a falling cost of capital has been important for Tech strength.
According to Qi, the Nasdaq 100 stands at just over 1 sigma rich to macro warranted valuation, having trading 1 sigma cheap into 2023. Higher economic growth (consensus GDP forecasts have been rising over Q1), tighter credit spreads and falling rate vol have all been important macro drivers.
Relative to the S&P 500, the largest macro driver has been falling rate vol. Model value is still rising but the rich valuation puts greater onus on the macro drivers continuing to move favourably
We face a higher growth expectation hurdle rate going into Q2. Since 2010, the annualised return of the SPX is ~10%. However, if you first look at annualised returns when the Citi US Economic Surprise index is falling from peak to trough – those periods are associated with ~5% annualised return. When its rising from trough to peak, 20% annualised returns.
The Citi economic surprise index is inherently a mean-reverting index – it will more likely be falling than rising this quarter. The expectations hurdle for the Tech sector from the perspective of the forthcoming earnings season is also likely high – especially if we are indeed close to the end of the Fed rate hiking cycle. Bottom-line, in Q2 data dependency will increase.
