Chief Investment Strategist
Summary: Payments stocks are under pressure today as Worldline shares plunge 57% as the company is downgrading its fiscal year organic revenue growth adding question marks to long-term expected growth rates in the industry. Equity analysts have been remarkably wrong on their views on the payments industry and one key threat in the industry might be Apple Pay.
Yesterday’s decline of 2% in Nasdaq 100 and the US 10-year yield getting closer to 5% sets the stage for scrutinizing where US technology stocks go from here. Using yesterday's close in the Nasdaq 100 futures and the closing high on 18 July the Nasdaq 100 is down 11% from its recent top. However, good Q3 earnings results from Amazon and Intel have lifted sentiment today causing rebound in US technology stocks.
It is interesting that Nasdaq 100 is down during this period as JPMorgan’s GDP nowcast on economic growth q/q has shown that the US economy has accelerated from mid-July at around 1% GDP growth to around 1.6%. Now in that same period, the US 10-year yield has risen 108 basis points to 4.86%. With inflation expectations remaining well-anchored the higher yield reflects higher expected real rate growth. Maybe the market is truly believing that generative AI will become a significant productivity enhancing technology? What we infer from the Nasdaq 100 futures price decline is that US technology stocks are right now more sensitive to rising interest rates than rising growth rates. This is because of the high valuation in the Nasdaq 100 (see low free cash flow yield below).
This naturally means that if the US 10-year yield breaks above the 5% level, then it could cause the Nasdaq 100 to sell off more, so this is something to be aware of, if one is trading US technology stocks. Many have argued that US technology stocks have decoupled from interest rate levels but it is important to understand the price developments of financial instruments cannot be compared to interest rate levels. This is because the one time series is stationary (fluctuates around a mean – in this case interest rates) and the other is not, so these two time series will always divert at one point.
The reason why there is not necessarily a decoupling is that equities do not have fixed cash flows like bonds. Besides the discount rate, investors must take into account operating margin developments, revenue growth, and investment needs. We actually tried to see if there was any relationship between the free cash flow yield of the Nasdaq 100 and the US nominal or real yield. There is not because of the other factors above. In financial markets it is often not the level but the rate of change in that level. But even if we look at the change in nominal or real yield we do not observe any strong relationship to the expected future change in valuation levels. Another way to think about this is, that if it was so easy to reduce equity markets to simple one dimensional relationship we would all be rich.
What matters for long-term equity returns are two things. Valuation starting point and future growth in free cash flows. As US technology companies have slashed costs since the 2022 downturn, the free cash flow of Nasdaq 100 companies is coming back fast (see chart below). Free cash flows have grown 12% annualized since 2004 and this growth rate was also observed in the fours years before the pandemic. Right now, the free cash flows are catching up with the long-term trend which means that they are growing faster than 12% which are maybe justifying why the 12-month rolling free cash flow yield looks a bit expensive relative to the period just before the pandemic.
The key risk to US technology stocks is the valuation as the current free cash flow yield of 2.9% is substantially below the around 4.2% free cash flow yield observed the year before the pandemic. I’m not sure the structural growth rate has changed, unless generative AI is the real thing on growth. If Nasdaq 100 free cash flow catches up with trend over the next year and the Nasdaq 100 remains unchanged then the 12-month rolling free cash flow yield gets to 3.8%, so not as expensive suddenly. It should be clear by now that in the very short term the break or not of the US 10-year yield above 5% is key, but medium term the growth rate will dictate what happens to US technology stocks.
Take Meta as an example. Investors were not happy about its Q4 outlook despite its revenue guidance mid-point was very close to consensus estimates from analysts. The long-term investor would step back and look at Meta’s FY24 expected free cash flow yield which is close to 6%. So, yes I can get 5% risk-free in US 10-year Treasuries with little expected downside risks (unless we get a significant jump in bond yields over a short period), but the investor can get almost 6% free cash flow yield in Meta in a business that it is expected to grow at low double-digit growth rates in the coming three years. In government bonds your income stream is fixed exposing the investor to inflation risks.
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