Inflation can drive up a company’s costs while lowering its pricing power.
Is inflation beneficial to technology stocks?
High-growth equities have struggled throughout 2021 and this amazing start to 2022, owing to fears that the Fed may raise interest rates to battle inflation, putting pressure on their valuations. Professor Vittorio de Pedys criticizes all three pillars of the mainstream argument in this contribution based on his impact paper.
The Fed is unquestionably behind the curve when it comes to dealing with inflation. The M2 money supply indicator, which increased by 40% from 2019 to 2021, is a clear indicator of price pressure. Today’s supply chain bottlenecks are the outcome of economic limitations being countered with a significant shift in demand for products vs services, rather than a global economy unraveling. Companies are addressing this issue by re-engineering their supply chains and constructing factories (see Intel, Taiwan semiconductors). The IHS Markit PMI indices in emerging markets have all recently increased considerably, indicating that manufacturing capacity is improving. Money’s velocity is decreasing: because to productivity-enhancing technology, businesses are spending money less fast. Prices will continue to fall as a result of this secular trend. Finally, comparisons will be easier: inflation will be recorded in the second quarter of 2022 versus the substantially higher numbers witnessed throughout 2021. In 2022, tougher comps will inevitably hold down headline inflation. Market data backs up this assertion: the 5×5 years forward-forward in Libor/inflation swaps, a leading indication of market expectations, indicates that market dealers estimate inflation to be 2.5 percent in five years.
Fed funds rates will aim 2.5 percent in 2024 under the most extreme scenario. It’s hardly a frightening figure. Given the high quantity of business and student debt and its low quality, if the Fed hikes rates above the inflation peak, it risks halting the economic growth and unleashing a cascade of bankruptcies, resulting in an economic crisis. The cost of government debt servicing might soar, pushing out other, more vital public spending. On the other hand, if the Fed decides to maintain its current policy, its dovish posture will further fuel inflationary expectations. As a result, the inflate or die trap appears to be the best option. A strong US dollar will also assist in the long run. Because the real rate is minus 5.5 percent, the government can sit back and watch its mountain of debt (now at 136 percent of GDP) shrink. When looking at Fed Funds Future deliveries for the end of 2022 on the CBOT, the market is pricing a 0.874 percent O/N rate one year from now with three rate hikes. A similar message can be found in the EuroDollar Futures, with the expected 3-months rate for June 2024 trading at an unimpressive 1.37 percent. Chairman Jerome Powell is no Paul Volcker, so the Fed will put on a hawkish mask to gain time, then back down as inflation starts to fall in the second half of 2022.
According to Vittorio de Pedys, 2022 will be a stronger year than 2021 since rate hikes are beneficial to hypergrowth stocks. It’s the “roaring technological twenties”!
Since their all-time high in March 2021, high-growth technology stocks have been steadily declining. According to this logic, the higher the interest rate, the higher the discount rate employed in valuation models such as DCF and CAPM, and the lower the value of a growth stock. Higher inflation, on the other hand, has not historically sunk markets. Rates that are higher do. To destroy growth stocks, substantially higher rates than those proposed by the Fed will be required. Even if most people are unhappy, the economy is essentially in good shape. SPACs, Reddit investors, “meme” stocks, cryptocurrencies, and IPOs are all showing signs of froth. In terms of rates, the “danger” zone begins at 5%. According to studies, there has never been a recession with a rate of less than 4%. Over any 19-year period, US stocks have outpaced inflation 100% of the time, according to Goldman Sachs. The market is telling us that the Fed raised rates eight times between 2016 and 2018, and that growth companies prospered throughout that time: just look at Cathie Wood’s flagship ARK Innovation ETF (ARKK), which soared 90 percent during that time. Growth stocks are damaged by the worry of rising interest rates: the pain is limited to the prospect of higher rates. Once this occurs, these equities benefit because their greater growth potential is accurately valued above a minor multiple compression due to somewhat higher discount rates. The adoption of technology by a larger number of people is unstoppable. Hypergrowth stocks are at the heart of these factors, and they will gain from a strengthening economy.
Why are rising interest rates harmful to technology stocks?
What’s at stake: The stock market is off to a bad start due to a big hike in rates in early 2022. Rates could rise as the Federal Reserve makes noises about trying to keep inflation under control.
The yield on the 10-year Treasury note, the most widely followed indicator of interest rates, hit 1.87 percent on Tuesday, the highest since January 2020.
- Stocks are down around 4% so far this year, marking the worst start to a year for the S&P 500 since 2016.
The big picture: Conventionally, rising rates are regarded to represent more of a danger to bonds than to stocks. However, Wall Street analysts have noticed that equities have begun to behave more like bonds, which fall as interest rates rise.
The impact of internet companies is reflected in equities’ greater sensitivity to rates in the United States.
- Because they have high price-to-earnings ratios and often pay little in the form of dividends, technology stocks are more exposed to interest rate movements.
- The increasing market weight of Big Tech in indices like the S& has linked the markets’ fate to these rate-sensitive behemoths. (Apple, Alphabet, Microsoft, and Tesla accounted for more than a quarter of all stock market returns last year.)
Go deeper: The term “duration” is a phrase used in the art world to express such sensitivity to interest rates.
- Duration is measured in years and is based on the number of years it would take for investors to return their investment through dividend payments.
- Don’t be alarmed by this. Duration is also a rough estimate of how much Wall Street experts believe an investment’s price would fall or climb if benchmark yields shifted by 1%. (Learn more here.)
- With example, for every one percent increase in interest rates, the price of a ten-year investment is predicted to reduce ten percent.
According to BofA Global Research, the S&P 500’s length has increased to roughly 37 years as of the end of 2021. (check out the chart below).
- That means a one-percentage-point hike in rates would send stocks down about 37%, wiping away the previous year and a half’s gains.
Yes, but keep in mind that these forecasts are based on Wall Street models, which are known for having a skewed link with reality.
- After all, no one expects benchmark yields to rise that much in the near future. According to FactSet statistics, the 10-year note is expected to yield around 2% by the end of the year in 2022.
On the other hand, recent experience reveals that in the face of increased rates, the market has obviously swayed.
- Long-term Treasury yields jumped 0.25 percentage points in mid-2015, and the S&P 500 lost as much as 11% in the following 12 months. (This is a more significant drop than the duration model would have expected.)
The bottom line: For the time being, the stock market’s direction is largely determined by the course of interest rates.
Why is rising inflation detrimental to stocks?
During a “risk-on” period, when investors are optimistic, stock prices DJIA,+0.40 percent GDOW,-1.09 percent and bond yields TMUBMUSD30Y,2.437 percent rise and bond prices fall, resulting in a market loss for bonds; during a “risk-off” period, when investors are pessimistic, prices and yields fall and bond prices rise, resulting in a market loss for bonds; and during a risk-off period, when When the economy is booming, stock prices and bond rates tend to climb while bond prices fall, however when the economy is in a slump, the opposite is true.
The following is a preview of the Fed’s announcement today: Jerome Powell’s approach to calming the market’s frayed nerves
However, because stock and bond prices are negatively correlated, minimal inflation is assumed. Bond returns become negative as inflation rises, as rising yields, driven by increased inflation forecasts, lower their market price. Consider that a 100-basis-point increase in long-term bond yields causes a 10% drop in the market price, which is a significant loss. Bond yields have risen as a result of higher inflation and inflation forecasts, with the overall return on long bonds reaching -5 percent in 2021.
Only a few occasions in the last three decades have bonds provided a negative annual return. Bonds experienced a long bull market as inflation rates declined from double digits to extremely low single digits; yields fell and returns on bonds were highly positive as their price soared. Thus, the previous 30 years have contrasted significantly with the stagflationary 1970s, when bond yields rose in tandem with rising inflation, resulting in massive bond market losses.
Inflation, on the other hand, is negative for stocks since it leads to increased interest rates, both nominal and real. When a result, the correlation between stock and bond prices shifts from negative to positive as inflation rises. Inflationary pressures cause stock and bond losses, as they did in the 1970s. The S&P 500 price-to-earnings ratio was 8 in 1982, but it is now over 30.
What impact does inflation have on technology stocks?
Points to Remember. Inflation can drive up a company’s costs while lowering its pricing power. Rising interest rates, which fight inflation, will lower future earnings predictions for a high-growth tech corporation. Although the current environment is difficult for tech companies, investors should not dismiss the industry entirely.
What happens to the stock market in a hyperinflationary environment?
Inflationary periods, such as those seen in the United States in the late 1970s and early 1980s, are generally not considered beneficial economic times, as prices often rise faster than salaries. Hyperinflation is considerably worse because it is accompanied by a sharp increase in prices. The most well-known instance of hyperinflation occurred in Germany shortly after World War II, when a loaf of bread was said to require a wheelbarrow full of paper money. Stock prices, like all other prices, will soar under hyperinflation.
Do stocks offer inflation protection?
You might not think of a house as a smart method to protect yourself against inflation, but if you buy it with a mortgage, it can be a great way to do so. With a long-term mortgage, you may lock in affordable financing for up to three decades at near-historically low rates.
A fixed-rate mortgage allows you to keep the majority of your housing costs in one payment. Property taxes will increase, and other costs will climb, but your monthly housing payment will remain the same. If you’re renting, that’s definitely not the case.
And, of course, owning a home entails the possibility of its value rising over time. Price appreciation is possible if additional money enters the market.
Stocks
Stocks are a solid long-term inflation hedge, even though they may be battered by nervous investors in the near term as their concerns grow. However, not all stocks are equivalent in terms of inflation protection. You’ll want to seek for organizations with pricing power, which means they can raise prices on their clients as their own costs grow.
And if a company’s profits increase over time, so should its stock price. While inflation fears may affect the stock market, the top companies are able to weather the storm thanks to their superior economics.
Gold
When inflation rises or interest rates are extremely low, gold has traditionally been a safe-haven asset for investors. When real interest rates that is, the reported rate of interest minus the inflation rate go below zero, gold tends to do well. During difficult economic times, investors often look to gold as a store of value, and it has served this purpose for a long time.
One effective way to invest in gold is to acquire it through an exchange-traded fund (ETF). This way, you won’t have to own and protect the gold yourself. Plus, ETFs provide you the option of owning actual gold or equities of gold miners, which can provide a bigger return if gold prices rise.
Why are technology stocks falling in value?
Slowing economic growth and rising interest rates have accounted for the majority of the sell-off. Because of the extended duration of their earnings, growth and many technology stocks have been particularly heavily affected.
Why are tech stocks falling?
For the same reasons as before, tech stocks are being hammered. Worries about greater inflation, expectations of tighter monetary policy from the Federal Reserve, andmost recentlya significant increase in bond yields can all be blamed by investors.
The Nasdaq Composite index, which is heavily weighted in technology, fell 1.8 percent on Tuesday. Apple (ticker: AAPL), Microsoft (MSFT), and Tesla (TSLA) were all down, with 1 percent, 0.6 percent, and 0.1 percent losses, respectively.
When interest rates rise, why do growth stocks underperform?
It’s crucial to realize that in any economic and financial context, there are several complex storylines at play. This time is no exception. Furthermore, broad-based markets can smooth out underlying volatility in specific sectors (thus diversification), but other tendencies, such as the post-Covid value run-up, are more widespread. Here are a handful tendencies in the stock market to watch when interest rates climb.
Valuations
Because of the factors mentioned above, values have been stretched for some time by most criteria. The forward price-to-earnings ratio for the S&P 500 is estimated to be 20x, one standard deviation higher than the long-term average of 16.8x. Despite the fact that the forward P/E ratio has been declining for several months, present valuations predict practically flat average annual returns over the next five years, according to a J.P. Morgan research.
Corrections are a necessary part of the market’s functioning in order to keep valuations in check and avoid asset bubbles. This is a component of what’s going on right now. We’ve been waiting a long time. The biggest drop in the S&P 500 was 5.1 percent in 2021. The average intra-year price decline since 1980 has been 14 percent. Instead, in 2021, the index hit 70 new all-time highs.
All of this isn’t to say that investors should have stayed away from the market in 2021. While it may not feel good to invest at all-time highs, it has traditionally produced above-average returns. Last year was no exception: with dividends reinvested, the S&P 500 returned about 29%. Although you cannot time the market, you can pick how you invest in it.
Growth vs value
A single stock or sector may move considerably differently than the market as a whole. With interest rates on the rise, it makes sense to sell growth equities this year. Companies that trade at greater price-to-earnings multiples than other equities, most notably value, are classified as growth stocks (dominated by technology). On the basis of future forecasts of continuous above-average growth, investors may be willing to accept higher prices now. Growth stocks don’t usually pay dividends and don’t always make a profit.
Waiting for future growth to materialize has a low ‘cost’ in low-interest-rate environments. When interest rates rise, however, future growth is discounted back to present value and becomes less valuable, thus investors may not be willing to pay as much.
Value stocks, on the other hand, are made up of well-established, dividend-paying companies such as financials, consumer discretionary, and energy. In comparison to growth stocks, value equities have lower P/E ratios and are more closely linked to the US economy/GDP and interest rates (10-year treasury).
Growth is down -12.3 percent year to date, while value is only down -3.6 percent.
1 Value has outperformed growth throughout history, but growth has outperformed value on an annualized basis in the previous ten years. Whether or not this new rotation continues, it demonstrates the value of including both in your portfolio.
What is creating 2021 inflation?
As fractured supply chains combined with increased consumer demand for secondhand vehicles and construction materials, 2021 saw the fastest annual price rise since the early 1980s.