Recent events have created an unusual situation where tech stocks are rising while the Federal Reserve is shrinking the money supply. This peculiar combination begs the question: what does this mean, and what can we expect moving forward? History has shown that when faced with such circumstances, tech stocks are usually the ones to bear the brunt of the impact.
The decision to reduce the money supply has been a crucial tool in the Fed’s strategy to combat inflation over the past year. In fact, it has effectively brought down inflation rates from about 9% to a more manageable 3%. Central banks around the world, including the European Central Bank and the Bank of Japan, have also followed suit by decreasing their money supplies. This approach involves withdrawing cash from banking systems, creating a reduction in consumer demand.
According to Bank of America, the balance sheets of major central banks have seen a significant decline of $1 trillion in just a few months, dropping from $13 trillion to $12 trillion. The Fed alone has seen a decrease of approximately $400 billion in its assets since March, bringing its balance-sheet assets down to approximately $8.3 trillion.
While the Fed’s monetary tightening may be effective in addressing inflation, it poses challenges for businesses. Reduced demand has led to a squeeze on sales, revenue, and ultimately profits for many companies. Naturally, this pressure on profits has negative implications for stocks in general. However, growth stocks, particularly those in the tech sector, face an additional vulnerability due to the impact of the Fed’s monetary tightening on the bond market.
A smaller money supply translates to decreased demand for bonds, resulting in lower bond prices and higher yields. This increase in yields is particularly disadvantageous for tech companies as they rely on rapid earnings growth. A significant portion of their profits is expected to materialize in the future, and higher bond yields diminish the value of those anticipated profits.
Based on data provided by Bank of America, it becomes evident that the decline in the Fed’s balance-sheet assets is correlated with a decrease in the tech-heavy Nasdaq 100 index. Comprised of around 100 of the largest nonfinancial Nasdaq stocks by market value, this index serves as a reliable indicator of tech stock performance.
Interestingly, despite the prevailing circumstances, tech stocks are defying expectations and experiencing upward momentum. In fact, the Nasdaq 100 has surged by over 40% this year alone.
The Future of Tech Stocks: Earnings and Valuations
The booming trend of artificial intelligence is one of the driving factors behind the higher earnings estimates in tech stocks. Companies like Nvidia, Microsoft, and Alphabet are experiencing increased sales of data center chips and cloud services.
However, it’s essential to recognize that a significant portion of the gain in these stocks is due to the rise in their valuations. Despite the potential pressure from higher bond yields, these valuations have continued to soar.
Looking back at the past, the Nasdaq 100 has typically experienced a decline when there is a notable divergence between the technology sector and the Federal Reserve’s balance-sheet assets.
In 2021, there was a brief decline in the Fed’s balance sheet, followed by several months of relative stability. During this period, the Nasdaq 100 actually witnessed a 12% increase. However, history suggests that a significant drop of around 33% might be the index’s next move.
The stock market has recognized the potential threat of inflation and anticipates that the Fed may need to sell off assets to address it. However, it’s important to note that this time around, tech stocks may not be doomed. Strong earnings trends contribute to part of their growth, indicating that Wall Street isn’t solely relying on the Fed’s injection of funds.
Nevertheless, it’s crucial to be wary of the increase in valuations and earnings multiples. These factors could potentially lead to a stumble for the Nasdaq 100. Just like in life, there is a fine line between regaining balance and hitting the ground. Let’s hope that the Nasdaq 100 can navigate this path successfully.
