Bad, worse, but not worst for tech shares

Stocks tumbled yesterday after getting a reminder from the Fed that rates are going higher. Though rate hikes in 2022 are broadly expected, FOMC minutes hinted at the possibility of those hikes coming sooner than later.

N O T E W O R T H Y

Ladies and Gentlemen, the Doves have left the building.  There is something about interest rates being at 0% or, in some cases negative, that stock investors seem to fancy. I suppose we can posit that 0 or negative return is so undesirable that potential bond investors will simply divert their funds to the stock market, which has infinite potential upside… and um, downside. In stocks, investors are paid to take risk with, yes, dividends in some cases, but most importantly the potential for price appreciation. That is one of the reasons stocks are often referred to as risk assets. 

There are other potential reasons for equity investors to favor low rates. If you are seeking to invest in a company that sells durable goods like cars or dishwashers, you would want interest rates to be low because most purchases are financed with credit, which becomes more expensive during a rate hiking regime. I suppose we can take the argument further and state that some folks use credit cards to purchase Lulu Lemon yoga pants, so maybe sales at the famous athleisurewear company may suffer. How about things like smartphones, software, video games, or semiconductor chips? How would higher interest rates affect those things? 

Smartphones are very expensive and very few people purchase them outright. They are typically financed by carriers or the manufacturers, themselves, allowing customers to pay monthly fees, typically tacked on to their monthly bills.  Clearly the monthly payment is somehow linked to interest rates, though they never appear on the statement. If you needed a new, say iPhone, and you can get one for $20 month with the ability to upgrade after a year, would you refuse to buy it if you knew it was just $19.50 a month last year?  Probably not. Do you use Microsoft Office or Adobe Photoshop and pay a monthly licensing fee? Will higher interest rates affect whether you continue to use these software tools? Probably not. How about Netflix, Disney+, Hulu, or whatever streaming service you like? Are interest rates part of your purchase decision making? Probably not.  None of us purchase semiconductor chips directly from the manufacturers, but just about everything we buy these days, except for maybe a butter knife, has semiconductors in them. Those are typically purchased by upstream manufacturers such as makers of cars, smartphones, toys, televisions, computers, etc. From the time that those chips are ordered to when the end products are in your hands can be a long, long time.  Manufactures must continuously order those semiconductors to ensure that they are available when needed. As we saw over the past few years, depleted semiconductor inventory can cause entire production lines to shut down. So, when Ford orders components from NXP Semiconductors, do you think that the purchase manager’s decisions are based on short term interest rates or the Fed’s balance sheet?  Probably not.

Why then, are technology and media stocks like the ones just mentioned under such pressure every time 10-Year Treasury yields spike or if the Fed reminds us that they might raise overnight lending rates between banks? Internet security is increasingly critical as more and more of our lives join the digital domain. Will higher interest rates cause us to use less internet security from firms like Fortinet or CrowdStrike? I doubt it. Ok, enough banter. When analysts value stocks they attempt to determine the company’s expected cash flows and then discount them into today’s dollars. When those are all added up, they get a theoretical stock price. The formula for discounting those cash flows uses interest rates in its denominator, so when that number gets higher, the current value of those future cash flows goes down, thus lowering the theoretical price of a stock. Let’s talk about growth stocks. We buy them because we expect fantastic growth, as the moniker implies, in the… wait for it… future. That is why tech companies trade at such high PE multiples. In fact, some of them are not even profitable yet they enjoy oversized market caps. All because of the hopes of those future returns… which are theoretically worth less in today’s dollars with higher interest rates. That is why many suggest that growth stocks are underperforming cyclical stocks in recent weeks. You decide.

Finally, it is important to note that if the economy falters, consumers will certainly buy less cars, smartphones, yoga mats, televisions, and even butter knives. Hulu and Disney+ subscriptions are likely to be canceled. If the economy enters a recession, Ford will certainly cut back on semiconductor orders or possibly put off building new manufacturing facilities. What does a recession have to do with interest rates? Most of them have historically occurred after the Fed hiked rates too aggressively, not only slowing the economy, but actually halting its progress completely, AKA recession. Do rates need to go higher to slow runaway inflation? Yes, for sure.  Does the Fed need to stop buying bonds and ultimately sell some back? Absolutely, positively.  Will all these things hurt the ability for growth stocks to continue to grow? Only if the Fed manages to cause a recession in the process. If that happens, the suffering will go well beyond growth stocks… and their theoretical present values.

THE MARKETS

Stocks sold off yesterday led by tech and growth shares as rates rose and the Fed FOMC Minutes hinted that rate hikes can come sooner than expected. The S&P500 fell by -1.94%, the Dow Jones Industrial Average sold off by -1.07%, the Nasdaq Composite Index dropped by -3.34%, the Russell 2000 Index was lower by -3.30%, and the S&P500 ESG Index lost -1.95%. Bonds fell and 10-year Treasury yields gained +6 basis points to 1.70%. Cryptos fell by -4.86% and Ethereum dropped by -7.10%.

NXT UP

• Initial Jobless Claims (Jan 1) are expected to come in at 195k, down slightly from last week’s 198k claims.
• ISM Services Index (Dec) may have slipped to 67.0 from 69.1.
• Factory Orders (Nov) are expected to have grown by +1.6% after climbing by +1.0% in the prior month.
• This morning, Walgreen Boots Alliance beat on EPS and Sales. Later we expect to get earnings from Conagra Brands, Constellation Brands, and Bed Bath & Beyond.