Tech Sector Faces Headwinds as Interest Rates Rise

Tech Sector Faces Headwinds as Interest Rates Rise

Dear friends,
We hope you and your family have enjoyed a pleasant summer.
The third quarter began with risk assets continuing their relentless march upwards as US stock indices touched all time highs at the end of August. September, however, saw a bit of a reversal as the S&P 500 fell by approximately 5% on the month. Bonds also saw selling as the Bloomberg US Aggregate Bond Index dropped by approx 1% in September. A market where stocks and bonds sell off concurrently is a bit unusual (investors typically flock to the safety of bonds during times of stock selling), so what caused this to happen?
In our view, a shift in the Fed’s stimulus and interest rate policies are mainly responsible. The Fed has indicated they plan to begin raising rates next year and expect to taper their bond purchasing program later this year. Some market observers believe the Fed’s hand is being forced by recent inflation data, which appears to be more significant than transitory supply chain imbalances. If inflation continues to rise, the Fed’s accommodative policy response to the Covid-19 pandemic no longer seems prudent
(and may actually make things worse), warranting a change.
We believe these factors are primarily responsible for the recent volatility in stocks and bonds. The Fed’s bond buying program has provided ample liquidity, leading stock investors to rely on the Fed’s continuing support. In March 2020, the Fed’s announcement of a massive bond buying program signaled the market bottom. Conversely, if Fed liquidity goes away or is substantially reduced, stock investors would see it as a signal to reduce exposure to risk assets, hence the selling. Bond rates meanwhile have remained artificially low with the Fed’s 0% interest rate policy and monthly bond buying providing a constant bid for bonds. If the Fed’s bid goes away, then bond yields will revert to a market determined level which, given recent inflation data, could be considerably higher.
The threat of higher interest rates is also starting to drag on the technology sector, which has been the best performer coming out of the Covid-19 market correction. In recent years, Big Tech has become the juggernaut driving returns for the S&P 500. In fact, at the end of Q3, the top five companies by market cap were all tech names (Apple, Microsoft, Amazon, Google and Facebook) comprising nearly 25% of the index. This is an enormous number, illustrating how an index of 500 components has become top-heavy and concentrated. The last time the S&P 500 was anywhere close to this level of concentration was in 2000, at the height of the tech bubble, when the top five companies represented 18.2% of the index. You’d have to go back to the 1960’s, when the US economy was a very different animal, to find a number higher than 25%. While high concentration doesn’t necessarily portend a market correction, it can lead to a shift in investor sentiment. And the Fed’s change in interest rate policy may stoke that shift. Big Tech companies, like other growth stocks, are more sensitive to rising interest rates since their high multiples are based on the growth of future cash flows. When rates rise, the value of that cash flow is discounted. As a result, investors may lose their appetite to speculate on high multiple tech stocks and instead reallocate to value stocks which are trading at more reasonable valuations.
Shifting now to international markets, a story that made headlines in the third quarter was the emerging crisis in Chinese real estate. For the past 20 years, China has enjoyed tremendous growth in the construction and property sectors. Much of this is underpinned by real need as a large population migrated from rural areas to cities. But as is often the case during times of rising asset prices, the real growth has been supplemented by pure speculation. For years, we have observed these excesses without any real sense of whether they might come to a head. In the past month, two major Chinese real estate companies, Evergrande and Fantasia, have defaulted on debt obligations. The assumption among foreign investors has always been that the Chinese government would not allow such a critical sector to suffer widespread failure. That assumption is being tested. The response from China’s financial authorities so far appears to be to retreat behind the veil. The domestic listed securities of both companies have been suspended and there is no indication as to when they may resume trading. As China’s real estate sector has ballooned, various financial instruments have grown in its share to fund the enormous level of investment. A significant portion of this is held by households. All of which makes for an explosive situation, not dissimilar to classic bank runs. It remains to be seen whether this crisis spills over to China’s larger economy and impacts global markets, so we’re monitoring the situation closely.
As we head towards year end, we continue to maintain a cautious outlook and recommend moderate allocations to risk assets. While growth stocks look overvalued to us and could be at risk if we see interest rates continue to rise, we do see opportunities in value stocks. We think if inflation continues to run hot, commodities, inflation-protected bonds and precious metals will be prudent portfolio diversifiers. For long term investors, we think renewable energy stocks and emerging markets offer good risk/reward.
Please let us know if you’d like to discuss any of the above in more detail.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

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