The U.S. tech sector has single-handedly powered Wall Street’s rally in recent years, but is being battered by the dramatic repricing of bond yields and Federal Reserve interest rate expectations.
And it may slump further before it recovers. Until recently, the surge in U.S. borrowing costs has largely been driven by changes in expectations on how quickly and how far the U.S. central bank will raise its federal funds interest rate.
But ‘quantitative tightening’ - ‘QT’, or the Fed shrinking its balance sheet - is now on the 2022 agenda. That has opened up the potential for even higher bond yields, and the potential for further weakness in stocks, particularly tech.
The Nasdaq Composite is having its worst start to a year since 2016. On Tuesday it chalked up its third daily decline of 2.5% or more this year - it is down 7% so far this month, and off 10% from its record high in late November.
The 10-year Treasury yield has leapt more than 50 basis points over the last six weeks. The huge question now is: how close is the bond market to pricing in the full extent of Fed tightening this year?
History shows that much of the impact on bond yields from quantitative easing, or QE, comes on announcement of the policy, not implementation. The same with QT.
The notion of QT in 2022 only really surfaced on Jan. 5 when minutes of the Fed’s Dec. 14-15 policy meeting showed that it was discussed. In an interview with Reuters a week later, Atlanta Fed President Raphael Bostic said there is at least $1.5 trillion of excess liquidity to be drained from the system.
Estimating the direct impact of QT on bond yields is prone to so many variables as to make it almost a fool’s errand.
But analysts at Morgan Stanley have taken a stab, and find that “a rule of thumb (with a lot of hand-waving) suggests a 4-6bp change in the 10-year interest rate from a $100 billion change in the balance sheet.”
Applying Morgan Stanley’s model to Bostic’s excess liquidity estimate, basic math suggests that a $1.5 trillion runoff could push the 10-year yield higher by some 60-90 basis points.
Morgan Stanley just raised its year-end 10-year yield forecast to 2.30%. This would be bad news for growth stocks sensitive to rising yields because future cash flows and profits are discounted at higher rates. Tech, which is expected to post stronger earnings than most sectors, is particularly vulnerable.
Peter Garnry, head of equity strategy at Saxo Bank, shows just how vulnerable. He looks at how the Nasdaq, S&P 500 index and Eurostoxx 600 perform against the MSCI World equity index depending on daily moves in the 10-year U.S. Treasury yield.
His starting point is what he considers the turning point in the coronavirus pandemic in early November 2020, when Pfizer Inc said its COVID-19 vaccine was more than 90% effective in preventing the virus among those with no previous infection.
He finds that on days when the 10-year Treasury yield rises 5-14 basis points, the Nasdaq underperforms global stocks by an average 0.6%, and on days when the yield falls 5-16 basis points, the Nasdaq outperforms world stocks by 0.4%.
Treasury yields are breaking higher, with the two-year above 1% and the 10-year above 1.85% on Tuesday for the first time in two years. With inflation at a 40-year high of 7% and the Fed teasing QT, tech investors should seek shelter.
“A higher discount rate is a very stiff headwind. If you are a smart tech investor today, you need to fine tune your investment, re-evaluate your other parameters,” he said.
Big Tech may be the safest port in a stormy sector. Behemoths like Amazon.com, Google or Microsoft are sitting on mountains of cash and will be better positioned to pass on higher costs to their customers.
But smaller caps and more ‘disruptive’ names in the tech sector have cheapened significantly. Nothing encapsulates this more than Cathie Wood’s fabled ARK Innovation ETF.
It is now down more than 50% from its peak last February, and down almost 40% since early November when the Fed rhetoric went into hawkish overdrive and Treasury yields really took off.
Since the Nasdaq’s peak on Nov. 22, its total returns have plunged by a third. The same goes for the ARK Next Generation Internet ETF, and other tech and smaller cap tech ETFs have also underperformed the broader index to varying degrees.
Alex Ely, chief investment officer for U.S. growth equity at Macquarie Asset Management, recognizes that tech stocks are a long-duration play and so could fall further, but says growth and fundamentals are far more important than bond yield swings.
“We are in a bull market until the end of the decade. We’re not cautiously optimistic, we’re bullish,” he said.
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