As we have been noting for several months now, volatility is back. This usually occurs as we transition from an “everyone wins” early-stage cycle to one led by quality growth stocks. On top of this, inflation is running rampant and adding more questions for investors. Long -duration assets do not enjoy rising rates. By long duration, I am referring to go-go growth stocks which have minimal revenue streams and are losing money today, but optimistically will be high revenue/earnings companies sometime down the road.
Interest rates have been declining for decades. Over the past several years, Fed Funds have been stuck near zero. When the cost of funding is nil, money goes to higher-risk ventures. When borrowing costs rise, these risky projects do not get funded as much. Cryptocurrencies, SPACs, electric vehicles, NFT’s and online businesses have been able to garner plenty of capital over the years. Some are warranted, but many will not exist in a few years. Granted, this is how innovation works. Plenty will win over time. With low-cost funding and investors disregarding current earnings, we have been able to produce plenty of winners like Amazon#, Netflix#, Tesla, Shopify and Airbnb since the turn of the century. While Blockbuster was worried about cash flow and turning a profit, Netflix focused solely on subscriber growth and a 20-year view. Investors did not care that they spent more on content than their revenues could handle for the first 15 years of existence. Today, low-cost funding is helping create many new, billion-dollar companies.
This week brought about another gem in Rivian Automotive. Its IPO raised $12B in cash for the company and is the biggest offering since 2014. Current valuations put their market cap above $100B, and greater than that of Ford and GM, but they are all well behind Tesla’s $1 trillion value. So far, Rivian has delivered 156 vehicles in total, while Ford and GM are expected to sell 7–10 million annually when supply chains normalize. However, Rivian has deep pockets from prior investments via Amazon# and even Ford. While the cost to borrow is nil, cheap money is looking for a home. Those with the best “concept” or battery technology can raise enormous sums of cash.
Electric vehicle company bulls are not expecting them to solely be manufacturers of cars and trucks. The expectation down the road is that they will come with autonomous driving capabilities, and leading-edge battery technologies including storage, advertising features and other cash-producing business lines. Long-duration assets like this are fine when rates are low. However, what happens when central banks around the globe have to start raising rates? What happens when the cost to fund ventures increases? History shows that capital starts to dry up and valuations collapse.
Fear of this hit markets hard on Wednesday after October’s CPI Index report came in hotter than expected. Headline inflation rose 0.9%, while core, excluding food and energy, rose 0.6%. On a year-over-year basis, that puts inflation at a whopping +6.2%. Supply chains have wreaked havoc and helped cause a massive 26% increase in used car and truck prices. Tobacco was up +8.5%. Numerous food categories were up 5%+ as well. The bulk of these will prove transitory. However, housing, shelter and even energy costs may not be temporary. They are in categories considered sticky. As if inflationary jitters weren’t already high, reports like this only add to the fear of a tighter Fed and higher cost of funding.
The end result was wild action across the board for stocks. Technology and go-go growth stocks, although not Rivian Automotive, took it on the chin with 4% – 7% drops commonplace in semiconductor, software and crypto land. Short-term interest rates joined the fracas with another flattening of the yield curve. 2-year Treasury yields jumped 10 basis points to 0.51%. While a small number by itself, that equates to a 25% move higher in just one trading session. Financial models that look at long-duration assets and interest rates are not built to handle this type of volatility, so selling ensues.
Further, next month’s CPI reading is already being projected to be just as worrisome. Inflation will continue to be a headline risk while economies reopen. Consequently, Fed Fund futures are nearly pricing in three rate hikes by the Federal Reserve next year. A few months ago, one wasn’t even expected until mid-2023. It is unlikely that inflation will collapse over these winter months, allowing even more volatility to occur. A quicker than expected pulling of the punch bowl should add to volatility for high P/E stocks.
This economic reopening is getting more difficult to predict as well. Germany just saw its highest daily Covid cases. China is back on lockdown mode across many provinces. All of this adds up to a confusing picture. Supply chains can’t be fixed if closures exist. Closures won’t stop while Covid cases are high. Emerging markets’ vaccine acceptance rates are still quite low. Shutdowns helped cause this supply crunch. CPI equivalents in emerging markets like China and Brazil are even higher at 11%+. This story won’t go away anytime soon, but the real question is what will inflation look like next Fall.
Bond markets were closed yesterday, offering some reprieve to stock investors who did not have to worry about the next rate move. A relief rally ensued on sectors that were crushed on Wednesday, with the Nasdaq advancing 0.5%. The Dow Jones ended negatively, driven by a less than stellar report from Disney#, which is having some issues with subscriber growth on Disney+. Earnings season is winding down now, with retailers the last to report next week on their update and outlook. The all-important holiday season is sure to be riddled with supply issues and earnings guidedowns. Most of this should be known by investors.
Lastly, this is turning into the week of company mega-cap breakups. After General Electric# announced it is moving from the conglomerate model and breaking into 3 different entities, this morning Toshiba and Johnson & Johnson# announced they are splitting up as well. The latter will provide a nice boost to the Dow Jones today, if pre-market indications hold up with JNJ stock up ~4%.
Big screen birthdays today as Wallace Shawn (The Princess Bride), Ryan Gosling and Anne Hathaway turn 78, 41 and 39 respectively. Neil Young is now 76.
James Vogt, 610-260-2214