27 September 2023

Playing off each other: Interest rates vs tech stocks

Start the conversation

Michael Janda* says interest rates are rising and tech stocks are likely to head in the other direction.


We live in strange and ridiculous times. Nowhere is this more evident than on financial markets.

After blithely trading on to record highs while the seeds of a pandemic germinated in China in January and February last year, supposedly forward-looking share markets cratered when the obvious became apparent in late February and March.

Then, with almost as much panic as the sell-off, shares came roaring back in a speculative frenzy, leaving many markets (notably the US) hitting fresh records, even as the nations they were based in suffered their sharpest recessions since at least the Great Depression.

As is often the case, once the buying started, it seemed the less connected a stock or other asset was to an identifiable income stream the faster and higher it rose. Bitcoin anyone.

Why?

In part, it was the forward-looking nature of markets, with early bets on the vaccines, which are only now just being rolled out, ending the pandemic.

But the biggest driving force was the unprecedented flood of money and record-low interest rates from central banks that has left the world awash with ultra-cheap cash with few financially rational places left to invest it.

When the real rate of return on ‘safe’ assets, like AAA-rated Government bonds, is deeply negative — you are losing money holding them — the cost of parking money in assets that offer no income but the potential for speculative gains falls and the temptation rises dramatically.

Along with growing disquiet and distrust around the central bank actions that have pushed interest rates so low, these negative rates are a major reason why professional investors have been right in there with amateurs throwing money at bitcoin and other cryptocurrencies, as well as tech companies that either make no profits or generate earnings that are a fraction of their soaring share market valuations.

For more conservative investors, the perceived safety of bricks and mortar has been the investment of choice.

Rate trigger for a ‘long overdue correction’

So, now that these benchmark bond rates have begun rising, sharply, it’s no wonder many investors are starting to sweat.

For some, the heat is getting too much and they’re fleeing the kitchen, causing sell-offs in the most vulnerable markets, such as tech stocks and cryptocurrencies.

AMP Capital’s head of investment strategy Shane Oliver says we could see further sell-downs but not, he thinks, a crash.

“Bond yields [interest rates] could still go a lot higher in the short term before they settle down again and this could cause the long overdue correction in equities,” he says.

As we’ve seen in the sell-offs so far, companies that don’t make profits and speculative assets with no income streams are the most vulnerable, but others are also at risk.

“Particularly at risk are tech and healthcare stocks that will see less of a cyclical uplift in earnings and trade on higher PEs [price-to-earnings ratios],” Mr Oliver explains.

“Because these stocks rely on more earnings in the future, they are seen as ‘long duration’ stocks and so they are more vulnerable to an increase in the bond yield used to discount those earnings.

“Also at risk, but less so, are yield plays [higher dividend stocks] that benefited from the ‘search for yield’ flowing from falling interest rates and bond yields — e.g. telcos and utility stocks.

“Cyclical stocks like materials [miners/energy producers], retailers, industrials and even financials are less at risk as their earnings will rise more with economic recovery and so are more likely to see earnings upgrades.”

And this is exactly what we’ve seen on share markets over the past 24 hours, with the tech-heavy Nasdaq down but Australia’s commodity and banking dominated ASX 200 index rising solidly.

Fed chair Powell delivers Goldilocks message

This may prove to be a short-term hiccup, with central banks once again moving in to soothe the jitters.

The Reserve Bank tried to do this on Monday after the three-year bond yield rose above its 0.1 per cent target, but the market practically laughed off its billion-dollar intervention.

Most RBA watchers expect it to follow singer Janis Joplin’s advice to “try just a little bit harder”.

“The most likely response from the RBA is a show of resolve, with significantly increased YCC [yield curve control] buying in coming days and weeks,” say CBA’s rate watchers.

The US Federal Reserve chairman, Jerome Powell, has had his turn, with the opportunity to offer soothing words talking down the risk of rising interest rates during two days of public congressional testimony.

And the market verdict is that the Fed chair managed to walk a narrow tightrope; after an initial heavy sell-off, tech stocks pared their losses.

Mr Powell did this by tacitly endorsing the rise in bond yields: “In a way, it’s a statement on confidence on the part of markets that we will have a robust and ultimately complete recovery.”

At the same time he committed to holding interest rates around zero and keeping money pumping into the US economy.

“The economy is a long way from our employment and inflation goals, and it is likely to take some time for substantial further progress to be achieved,” he said.

Effectively, Mr Powell delivered on the Goldilocks story that has got US markets trading at record highs — you can have your economic recovery and your super low interest rates too.

That’s exactly what Rabobank’s head of financial markets research in the Asia-Pacific, Michael Every, expected would happen.

“If central banks were to act otherwise right now, they really would be sawing market prices in half — at least,” he warns.

“Indeed, if those magicians have to face a choice between rising real rates and levitating markets, which one do you think they will make disappear?

“Obviously rising yields, through outright yield curve control.

“At which point, almost all price discovery will follow through the hidden trap door.”

In other words, if money is free for big investors and they think central banks will keep the party going indefinitely the sky is no limit for asset prices.

When good news again becomes bad news

The irony is that the rising bond yields are a sign that economies are recovering from COVID-19, that firms will be able to increase both sales and prices, and that profits should rise.

They should be welcome good news after the worst year for most economies since the 1930s.

But investors are simply petrified that any recovery in economic growth and profits won’t keep up with the rise of interest rates from rock bottom levels.

Remember, at current levels with US 10-year bond yields still below 1.5 per cent, a return to something even approaching a more normal rate of 3 per cent would see interest rates more than double.

That’s one of the traps of ultra-low rates — a small percentage point increase is a massive percentage rise in interest costs.

‘Bringing down the house’

But, while central banks may move to keep a lid on rising rates in the short term to buy markets a bit more time, it’s unlikely they can keep doing that indefinitely.

“It is again magical thinking to believe this trick can be pulled off without literally bringing down the house,” argues Michael Every.

“Decades of inequality-driving neoliberalism followed by unlimited free money only for the people who drove that same policy to prevent a Minsky moment [financial crash] comes at a political price.”

Shane Oliver is less dramatic in his forecast, but still sees a return to the gravity of higher interest rates as inevitable.

“There is a strong case to be made that the disinflation seen since the 1970s is coming to an end and that the long-term trend in inflation is at or close to bottoming,” he observes.

“Central banks are now throwing the kitchen sink at beating deflation and disinflation just as they threw it at high inflation in the 1980s and early 1990s.

“There is a good chance — that helped along by massive Government spending, Governments becoming more interventionist in economies, a reversal in globalisation and a decline in workers relative to consumers — they will win this time, ultimately resulting in a sustained rise in inflation, but that’s probably still a few years away.”

Hopefully, enough time for policymakers, investors and consumers to figure out how they are going to survive financially in a world of higher interest rates.

*Michael Janda is a business reporter with the ABC.

This article first appeared at abc.net.au.

Start the conversation

Be among the first to get all the Public Sector and Defence news and views that matter.

Subscribe now and receive the latest news, delivered free to your inbox.

By submitting your email address you are agreeing to Region Group's terms and conditions and privacy policy.