an A-lister on the Nasdaq, has been flying high. So have lots of other growth stocks. But they’re all going to hit some rough air shortly—and it will have nothing to do with the companies.
It’s all on the piloting of the economy by the Federal Reserve, and the fallout from the central bank’s monetary policy on the bond market.
The MSCI World Growth Index has gained 13% since March 14, when it hit a closing low for the year. Apple (ticker: AAPL), the index’s largest holding, is up 18%.
Central banks worldwide helped trigger the massive selloff—the S&P sank into a correction—by unwinding their government bond purchasing programs.
Less money moving into the bond market lowers bond prices and lifts yields. In turn, higher yields on safe long-dated government bonds make future profits less valuable—and growth stocks are valued on the basis that they’ll churn out a chunk of their profits far in the future.
Investors excitedly bought the dip, but now they’re starting to take a deep breath. They realize that government bond yields are still below the average annual inflation rate of 2.8% that markets forecast for the next decade.
Such low yields are rare because bonds ordinarily yield more than the inflation rate. As yields move above inflation, those safe long-dated government bonds become an attractive alternative to growth stocks, which have a much higher likelihood of failing to produce the cash flows that investors want—and are waiting on.
And yields are indeed moving closer to the inflation rate. Right now, the 10-year Treasury yield is 2.55%, which is below that 2.8% yearly inflation rate expected into the 2030s.
Subtracting the inflation projection from the yield equals the real yield: minus 0.25%. A positive number, of course, would be better, but minus 0.25% is a whole lot better than the minus 1.2% at the end of 2021.
As real yields creep back up, growth stock valuations should slide.
When the real yield on a 10-year Treasury note hits 0%, for example, the aggregate price to forward earnings ratio on the MSCI World Growth Index should drop to around 19 times from its current 27 times, according to
data showing the historical correlation between real yields and growth valuations.
A falling earnings multiple would hold these stocks back from gaining too much and could trigger a steep drop for some time. Growth stocks “may be vulnerable to higher real rates,” wrote Citi equity strategist Robert Buckland.
This doesn’t mean growth stocks are doomed, though.
To be sure, forward earnings estimates will climb again over time—and they could increase even as soon as earnings season gathers steam in the next few weeks. That would put a floor under growth stock prices.
And several things point to strong performance for a longer stretch ahead.
The growth index has outpaced the MSCI World Index, which is up about 10% from its March low point.
And historically, when central banks tighten monetary policy to reduce inflation, growth stocks usually trounce value names for several years, according to RBC data.
That’s because tighter monetary policy slows down economic growth, which growth companies don’t rely on to increase their earnings. And slower growth eventually puts a ceiling on bond yields, which is good for growth stock valuations.
So, the takeaway of all this talk about bond yields, the projected inflation rate, the real yield, and growth stock valuations is very much like so many other things in the stock market: anyone’s educated guess.
Now, though, investors won’t be surprised if they have to put on their seat belts to ride out the turbulence in the coming months.
Write to Jacob Sonenshine at [email protected]