As U.S. Treasury yields fall toward zero, and the Federal Reserve deliberately erodes the value of U.S. debt, investors will be forced to seek new safe havens.
A broken and dysfunctional U.S. Treasury market, no longer appealing in terms of yield income or downside protection, will create a bond-sized hole in a great many investor portfolios.
That hole will have to be filled with something.
Precious metals and Bitcoin will be clear winners in this environment and will benefit greatly from the prospect of negative real yields — U.S. Treasury values eroded by inflation — for years on end.
But investors will still crave positive income yield, even if it comes in the “zero coupon” variety.
Zero-coupon bonds are like normal bonds in most respects, but they come with an important twist. A zero-coupon bond does not make interest payments. All of the payoff comes at the end.
As a general rule, U.S. Treasuries pay interest semi-annually. This means that, every six months, the asset holder receives an interest payment. And then, at the end, they get their principal back when the bond matures.
Zero-coupon bonds, or “zeroes” for short, are called that because they have a “zero coupon,” meaning the semi-annual interest payment does not exist.
When you buy a zero, you still get a rate-of-return equivalent that can be calculated as yield. It simply all piles up at the end. If par value for a zero-coupon bond is 100, you would buy the bond at a discount to par, let us say 85 for this example. Then, when the bond matures, you would receive the full 100 as a principal payment. The difference between the price you paid (85 in this example) and the principal payment of 100 would count as your yield, all delivered at the point of maturity in a single lump sum.
It is also technically possible for zero-coupon bonds to have a negative return. This would work out by purchasing the bond for more than 100 — say you bought it at 102 — and then only getting 100 back at the end. The net loss between the price paid and the principal received, spread out over the life of the asset, would determine how negative the yield is.
As for why anyone would buy negative-yield debt, ask the banks and institutions that hold nearly $16 trillion worth of negative-yield debt worldwide. Sometimes it’s a trade, in the expectation that the price will go even higher — and the yield even more negative — and sometimes it is a way to park cash while staying in compliance with an investment charter.
Because they deliver a lump-sum payment at the end, with no interest payments between here and there, zero-coupon bonds tend to be more volatile, and more sensitive to interest rate changes, than other types of debt securities. As a result of this, and with the help of leverage, traders have been known to make, and sometimes lose, fortunes in zero-coupon bonds.
What does this have to do with investing, one might ask, for those who don’t trade exotic debt securities?
Well, clarifying the basics of zero-coupon bonds helps us lay out the following hypothesis: Big Tech is the zero-coupon U.S. Treasury substitute.
A stock with excellent long-term growth potential, generating plenty of cash flow but no yield, in many ways behaves like a zero-coupon bond.
- With a zero-coupon bond, you don’t get payments, just price appreciation as the bond heads toward maturity. It is the same with a cash-rich growth stock that offers no dividends.
- Zero-coupon bonds are highly sensitive to interest rate changes and will tend toward a premium in low-rate environments. So too with cash-rich growth stocks.
- Zero-coupon bonds are rated on their perceived safety — the likelihood of getting one’s principal back — in addition to their long-term payoff. So too with cash-rich growth stocks.
- Zero-coupon bonds look even more attractive when the broader investment landscape is “meh,” with few stable and reliable sources of yield to be found. So, too, once again, with cash-rich growth stocks that have a strong probability of delivering profits quarter in and quarter out.
In order for a cash-rich growth stock to behave like a safe-haven zero-coupon bond, it needs to be reliable, steady, profitable, and robustly impervious to economic shocks. The big tech names fit this bill.
We highlight big tech specifically — meaning the five juggernauts, Amazon, Apple, Alphabet, Facebook, and Microsoft — in light of the stunning juxtaposition that occurred last week.
Namely, in the same week that the U.S. economy saw the worst Gross Domestic Product (GDP) estimate since the 1940s, four of the big five tech names — Apple, Amazon, Alphabet (the parent company of Google) and Facebook — reported earnings results that were broadly considered a home run.
There were legitimate concerns as to whether or not big tech would make it through the second quarter unscathed. It is hard to sidestep economic devastation in the real economy with revenues and profits measured in the tens of billions. But the big five more or less seemed able to do it.
There were setbacks and cost increases and sore points. But overall, it appears to be the case that spending habits in the top third of the economy are so robust, big tech can keep on trucking.
And when the U.S. government gets back to writing large stimulus checks — something likely to happen sooner or later, even if the halls of Congress are beset by arguing in the interim — a good chunk of that “helicopter money” should yet again flow indirectly, by way of consumer spending habits, into the pockets of big tech.
In addition to a genuinely impressive earnings showing, in the midst of an awful week for the U.S. economy, big tech appears to offer growth in a low-growth world and an embedded ability to raise prices in the event of inflation. Beaten-down “value” stocks offer neither.
A great many traditional value investors are waiting around, with an increasing sense of impatience, for the value investing style to make a comeback. Part of the reason this is not happening is because companies stamped with a “value” designation are getting manhandled by technological change.
To put it another way, if Acme Widget Corp. has a compellingly low price-to-earnings ratio or price-to-book value because Amazon is muscling its way into the widget business and producing more volume with greater efficiency, then Acme Widget’s beaten-up share price is not likely to see capital appreciation any time soon.
The big five tech companies are on the dominant side of this trend, in which great swathes of American enterprise are getting left behind technologically, and thus being subjected to a drip-drip erosion of both profitability and market share.
Then, too, the big tech firms will be in a commanding position to raise prices in line with inflation, once long-term inflation pressures finally return. The return of inflation will happen eventually, and when it does, a great many non-dominant companies will simply have to eat their inflation costs in the form of lower profit margins, due to a lack of pricing power in a brutally competitive landscape.
Not the big tech names, though, because for monopolized areas like search, social, and cloud services, there will be no place else to go.
For these reasons and more, the big tech names will increasingly have a “safe haven” appeal in line with that of a zero-coupon bond, offering no yield but the distinct likelihood of price appreciation over time, rooted in a profile of growth optimism and future inflation protection in a world where both of those attributes are rare.
It will certainly become possible to pay too much for these names, in the same way that a zero-coupon bond, or any type of debt security, can become overpriced if investors get ahead of themselves.
There is, at least in theory, a valuation multiple at which no discounted stream of future cash flows is worth paying for, no matter how attractive the underlying profile and prospects of the business. The thing is, thanks to the Federal Reserve, we no longer have any idea what that too-high valuation level is, or just how high the multiple might go.
If Federal Reserve Chairman Jerome Powell gets aggressive enough, in other words, 80 times earnings might become the new 40 times earnings for a top-tier stream of cash flows, and 250 times earnings might become the new 125 times earnings for an attractive-enough dominant growth profile.
We honestly don’t know where acceptable valuation multiples will top out in this bizarro market landscape — and neither does anyone else.
We can say with confidence, though, that the discipline afforded by trend-following techniques and price-action awareness has more utility than ever these days.
With traditional valuation metrics being not just decommissioned, but defenestrated (thrown out the window) by the unprecedented policy actions of the world’s central banks, having price as a guide is an essential navigation mechanism. And right now, price is confirming our big tech thesis (the tech juggernauts serving as zero-coupon safe havens).