On the face of it, the Scottish Mortgage Investment Trust (LSE: SMT) share price looks incredibly cheap. It is now down 36% in six months. This downturn coincided with the sell-off we saw in the Nasdaq, which the trust’s main holdings are exposed to. A recent rally may have convinced some investors that it is in bargain territory. But worse could still be ahead of it.
Rising cost of capital
The sell-off in the broader US equities market in January was a direct result of investors’ fear of rising interest rates, to cool down inflation.
Today’s macro-economic environment is unlike anything we have seen during the last four decades. The policy mistakes of the past, I believe, are what have led to the present conundrum. Primarily, loose monetary policy in order to rescue the economy from successive downturns, led to the creation of a suppressed interest rate environment.
In turn, this has fuelled a kind of speculative mania in all manner of growth stocks that has only ever been witnessed three times before – in the Roaring Twenties, the Nifty Fifty blue-chip stocks of the early 1970s and the dotcom craze.
As interest rates are heading upwards, we are in a completely different ball game. Expected future cash flows now need to be discounted back at a higher rate to offset elevated inflation.
Tech bubble 2.0
The obvious counter-argument to this thesis, is that today’s market bears no comparison to what we saw during the tech bubble at the end of the last century.
Today, growth stocks are on a much stronger footing than they were back then. A great deal of them are highly profitable with strong business models and large cash reserves. But they come at a hefty premium for that privilege.
Further, the top five companies by market cap in the US account for a significantly greater share of the total stock market than back in 2000. Look beyond the mega-cap stocks, and a great deal of the companies are highly indebted start-ups or early-stage enterprises in nascent industries that have yet to turn a profit. Scottish Mortgage invests in some of these.
It is this more speculative side of the market that really concerns me about Scottish Mortgage. The ARKK Innovation ETF, which plays almost exclusively in this space, has recently given up virtually all its post-pandemic gains.
Recession fears
Recently, the yield on a 10-year US Treasury bond fell below that for a two-year bond. This matters, because several times in history when the yield curve on this spread has inverted in this way it has preceded a recession.
The Fed has already signalled its intention to tighten financial conditions by stopping quantitative easing and raising interest rates throughout 2022. As the demand side for US treasuries starts to dry up, then the yield on a 10-year bond will increase.
On top of this, the massive increase in personal savings of households driven by a once-in-a-generation handout helped to artificially boost company profits.
The evidence suggests peak earnings for tech companies may have passed. Forward guidance from the likes of Amazon, Meta, DocuSign and many more has been slashed. With Scottish Mortgage tied to the fate of US growth stocks, I fear that tougher times could still be ahead of it. I won’t be investing.
