With inflation on the rise, the Federal Reserve has signaled that it plans to begin raising interest rates in 2022. Do rising rates mean trouble ahead for the tech stocks that have led the bull market run over the past two years? Here we share our analysis.
• The Fed announced in December 2021 that it will double the pace of tapering its bond purchase program and will be increasing the number of interest rate hikes, as a response to rising inflation.
• The relationship between interest rates and tech stocks is not so clear, as there have been periods when the two move in tandem and periods when the two move in the opposite direction.
• Interest rates alone do not give the full picture of tech stocks price movements. Rather, earnings results and future earnings expectations play a big part in tech stock prices.
• With the current macroeconomic backdrop of inflation and rising interest rates, certain companies potentially do better, such as those with pricing power and lower debt ratios.
In December last year, US inflation reached an all-time high of 7%, and such high levels was not seen since June 1982. As inflation in the US creeped up throughout 2021, investors anticipated news of interest rate hikes. The uncertainty of the Fed’s rate hikes plans added volatility to stock markets.
In the past month, the Fed announced that it will speed up tapering its bond purchases and increase interest rates, as a response to rising inflation. The million-dollar question on how this will impact tech stock has boggled investors across the world, and we aim to discuss this here in this article.
Fed gives clarity on its rate hike plans
In December last year, the Fed announced that it will be firstly, doubling the pace at which it is tapering its bond purchases and secondly, increasing the number of interest rate hikes, as a response to managing the persistent inflation.
The Fed intends to complete its bond purchase program by March 2022, instead of the original aim of June 2022. This would then set the stage for the Fed to raise interest rates, which they have made clear will begin only after it ends the bond purchase program.
Raising rates is expected to cool off demand and hence inflation by making it more expensive for consumers and businesses to access credit.
The Fed’s new economic projections suggest that rates, which have been at rock-bottom since March 2020, might rise to 2.1% by the end of 2023, according to three Fed officials as of December 2021. This is a significant increase from just a while back in September 2021, when officials projected rates to be as high as 1.6% at the end of 2023.
A change in the interest rate environment has led to a sector rotation, with investors now turning away from the once-loved technology sector. The tech-proxy Nasdaq 100 has fallen by a -10% so far in 2022 (as of 20 January 2022). The O’Shares Global Internet Giants Index is also down by -13% this year, while Cathie Wood’s Ark Innovation ETF – seen by analysts as a proxy for high-growth unprofitable tech companies – has slumped -22% in 2022.
Figure 1: Share prices of tech has fallen
Interest rates and tech stocks have no clear relationship
Across 2021, it is observed that rising yields have coincided with short-term pullbacks in tech stocks at various points throughout the year (Figure 2). Most recently, from 10 December 2021 till 11 January 2022, as the US 10 year treasury rate rose from 1.48% to 1.74%, the Nasdaq 100 – a proxy for US tech stocks – fell -3.00%, demonstrating a negative relationship between the two.
Figure 2: Nasdaq 100 versus the US 10 year treasury rate – 1 year
Theoretically speaking, the negative relationship between tech stocks and interest rates can be explained by the changes in their valuations as interest rates adjust. When interest rates rise, the present value of a company’s future earnings becomes lower, which in turn leads to lower valuations. The opposite is true when interest rates fall.
This is why the valuation of tech stocks, which are usually high growth stocks valued based on their expected future earnings tend to be more sensitive to changes in interest rates.
On the other hand, value stocks are stocks with steady present earnings, meaning lower risk, although usually lower future growth. Hence, in a rising interest rate environment, investors tend to feel safer holding value stocks that can deliver earnings sooner, rather than holding growth stocks that probably will not deliver much earnings in the near-term.
Certain value stocks, such as banks, tend to perform better in a rising interest rate environment as net interest margins widen. Therefore, whenever there is news of rising interest rates, tech stocks tend to experience a pullback, as investors rotate out of growth stocks and into value stocks.
However, if we observe the relationship between tech stocks and interest rates over the last decade, we can find many occasions where rising rates do not result in lower share prices for tech companies (Figure 3).
Figure 3: Nasdaq 100 versus the US 10 year treasury rate – 12 years
For example, between July 2012 and December 2013, the US 10 year treasury rate rose from 1.43% to 3.04%, but at the same time the Nasdaq 100 climbed by 40.9%. Similarly, from July 2016 to November 2018, treasury rates climbed from 1.37% to 3.24% while tech stocks rose 58.1%, demonstrating that the two do in fact move in tandem on occasion.
As demonstrated above, there are periods when tech stocks and the US 10-year treasury rate move in tandem and periods when the two move in the opposite direction, meaning that there is no clear relationship between the two.
Moreover, from 2010 till today, the correlation between the Nasdaq 100 relative returns and US 10 year treasury rates is 0.39. A correlation of 1.00 means the two move in tandem, while -1.00 means the assets move completely inversely to each other, so a 0.39 correlation implies little relation.
Earnings growth is a bigger determinant of share prices
While the relationship between interest rates and share prices are not as clear, earnings growth and share prices shows a more stable relationship.
For a clearer picture of what moves share prices, investors should pay attention to earnings trend. Valuations of the tech sector have reached highs as companies delivered strong earnings growth through 2020 and continued to 2021 for some companies, as the pandemic drove digitalisation.
However, through 2021, as valuations reached highs, investors have become increasingly cautious and looked to whether the companies can continue to produce strong share price performance, or if they should start taking profits now. With valuations near a record high, the slightest negative news may trigger a sharp pull-back in prices.
For example, within the digital advertising industry, Snap Inc.’s (NYSE: SNAP) stock plummeted -27% in October last year after warning that customers are cutting back on digital advertising spending. This news alone sent shivers across the digital advertising industry with Meta Platforms (NASDAQ: FB) and Twitter Inc. (NYSE: TWTR) falling around -5%, and Google (NASDAQ: GOOGL) fell -3%.
It goes to show that rather than purely reacting to the news on interest rate hikes, tech stocks also react to news on earnings. Moreover, we observe that historically share prices are largely driven by earnings in the long run (Figure 4).
Figure 4: In the long run, share prices are driven by earnings
In the earlier sections we discussed how interest rates may affect tech stock price movements. Another way to look at interest rates would be at how it impacts earnings, which is the fundamentals of the company.
Generally, in an inflationary and rising interest rate environment, companies with pricing power and lower debt potentially have stronger earnings.
In an inflationary environment, rising costs and wages would weigh on a company’s expenses, unless the company has the bargaining power over its suppliers, or is able to pass the cost on to its customers.
In a rising interest rate environment, the cost of debt for a company increases as the interest paid for the company’s debts will increase. In this case, companies with a lower debt-to-equity ratio may be less affected than those with a higher debt-to-equity ratio.
Therefore, taking into account the varying impact of interest rates and inflation on the earnings of a company, and how earnings drives share prices, it is important for investors to be prudent and make proper analysis before investing. And that is our aim – that through our investment articles it will help investors make appropriate investment decisions.
What should investors do?
To sum up, the relationship between interest rates and tech stocks is not so clear, as there have been periods when the two move in tandem and periods when the two move in opposite direction. Secondly, interest rates alone do not give the full picture of tech stocks price movements. Instead, earnings results and future earnings expectations play a big part on the tech stock prices.
Finally, with the current macroeconomic backdrop of inflation and rising interest rates, certain companies can potentially do better, such as those with bargaining power and lower debt ratios.
Nevertheless, in the long term we believe that the digital economy is here to stay and that internet companies will make up a larger part of the global economy, as more and more of our daily activities shift online.
Additionally, megatrends such as the digital transformation of corporates and industries is expected to be the next driver for the digital economy, regardless of interest rate movements. It is for this reason we recommend investors to include the digital economy as part of their core allocation.
The bottom line for investors is that rising interest rates does not always mean that tech stocks will do poorly. Besides focusing on earnings, a more important metric to look at would be valuations. On that front, we believe the lofty valuations and headwinds faced by the sector may limit the upside of internet companies in the near-term.
The O’Shares Global Internet Giants ETF (BATS:OGIG) is currently trading at 44X 2023 earnings, suggesting that it is more or less fairly valued based on the fair PE multiple of 45X we have assigned for this sector, hence we maintain our rating of 2.5 Stars “Neutral”.
Investors who have yet to include the digital economy in their portfolios but wish to do so at this point may consider using a regular savings plan, before switching to a lump sum investment should valuations come down even further. This will ensure that they buy more units when prices are low and less when prices are high, bringing the weighted average cost down.