Article

Technology sector stumbles – but what next?

Investor sentiment has changed course significantly. Rob Morgan looks at why and how investors might react.

| 5 min read

It has been an interesting few weeks in markets. Former stock market darlings such as Tesla have tumbled, and the once hot technology sector has fallen spectacularly from grace with the Nasdaq index down over 10%. What’s going on, and is this the end of the dominance of big tech in stock market returns?

The main change is expectations of where interest rates may be heading. Investors have been weighing up the magnitude of financial stimulus being thrown at pandemic recovery, notably in the US, and are increasingly entertaining the idea recovery might be so vigorous that the global economy overheats, and inflation rises. The required antidote to higher inflation is, traditionally, higher interest rates. Raising borrowing costs pours cold water on the flames.

Expectations haven’t moved a huge amount, but they have moved quickly, and this has had a big impact on bond markets previously priced for a very long period of low rates and accommodative policy. Most bonds such as UK gilts and US treasuries pay a fixed amount, so as inflation and interest rates rise their capital value must fall to provide the ‘right’ amount of return to investors.

Why does this matter for tech companies? In short, they are ‘jam tomorrow’ businesses investing to secure big future profits as opposed to near term ones. Higher inflation and interest rates have the effect of making the value of those profits worth less in today’s terms.

Having benefitted from falling interest rate expectations over the past few years, technology and growth stocks have suddenly been confronted with a headwind, and investors have started to change tack. As well as questioning the value of these areas, they have been attracted to parts of the market likely to benefit from easing lockdowns and an economic recovery. Banks, for instance, are seen as a beneficiary of higher interest rates, while areas hit hard by the pandemic are being scrutinised for their potential for a quick turnaround in fortunes.

The interest rate worries also come at a time when market sentiment in some areas is somewhat exuberant, and this has magnified short-term falls. I recently wrote about 'Investing or speculating – what’s the difference?' the higher-than-usual speculative interest in stock markets, and already many recent investors in various popular areas, spurred on by Reddit communities and social media, are nursing heavy losses.

However, the wider tech sector is a world away from Reddit, SPACs and meme stocks. Shares in companies such as Amazon, Alphabet and Microsoft remain fairly expensive, but they continue to deliver on their strategies, meet earnings expectations and appear to have many years of strong growth in front of them. The fundamental prospects for technology investment remain very good, so while share prices might continue to be vulnerable in the short to medium term if interest rates were to recover to pre-pandemic levels, overall business cases are mostly unchanged.

It is also important not to become overly concerned about interest rate rises. If rates do go modestly higher, the debt in the economy will become more of an issue and curtail the overheating that the market views as a ’problem’. That’s an issue for debt-laden businesses but not for well-funded or profitable tech businesses that continue to execute their planned growth. Indeed, the large tech and e-commerce stocks could offer resilience in difficult times with their stand-out growth.

In the short term we think there may be more volatility to come. The Nasdaq is still up about 40% from since the start of 2020, so valuations may still be viewed as extended by many. Moreover, the tussle over interest rates has further to run. The leading central banks and governments remain of the view that inflation will not get out of control, and that there is more risk to the downside than to the upside in economies, but markets aren’t convinced and are simply fixated by the magnitude of the stimulus. All eyes will be on the Federal Reserve in the US where Chair Jerome Powell may need to reassert his authority. Yet bond yields rising as investors get jittery doesn’t mean inflation will necessarily follow. In fact, markets have a rather poor record of predicting interest rate rises.

Long term investors in more growth orientated investments such as Baillie Gifford’s Scottish Mortgage (long an investor favourite for exposure to high growth companies capable of disrupting existing industries and creating new ones) can afford to remain sanguine. The growth potential of the collection of companies making up the portfolio should, ultimately, be a more important variable than where interest rates end up.

However, we reaffirm our view that investors should have a balanced portfolio that insulates them as far as possible from the impact of different economic scenarios. Rising inflation tends to be bad for most asset classes, but economically sensitive areas that benefit from an end to the pandemic and a recovery in the economy may be a worthy diversifier. Property and infrastructure assets may also be useful, and in terms of geographical exposure the UK and Japan could be worth exploring as better-value markets with an economically sensitive tilt.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

Technology sector stumbles – but what next?

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