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Will rising interest rates kill the tech boom?

Anthony Fensom  |  18 Jan 2022Text size  Decrease  Increase  |  
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Ultra-low interest rates and a pandemic-fuelled online shopping boom helped fuel the recent boom in technology stocks. Now with valuations stretched, the spread of the omicron variant and cheap money coming to an end, the easy gains in tech shares could be over, analysts warn.

Investors in international tech shares could be forgiven for popping champagne corks to celebrate the past year’s gains. The tech-heavy US Nasdaq composite index gained over 20% in 2021 driven by gains in heavyweights like Alphabet (GOOGL) up almost 67%, Microsoft (MSFT) up nearly 56%, Tesla (TSLA) up around 47%.

Australia’s tech sector posted relatively lacklustre gains in comparison. The S&P/ASX All Technology Index posted a modest rise of 3.72% (price return) in 2021, well below the 11.4% increase of the benchmark S&P/ASX 200 index. Yet this has masked a wide disparity in performance. Battery tester Novonix (NVX) has soared by 641% in 2021, aided by the boom in the electric vehicle sector, with other major winners including US tech stock Life360 (ASX:360), up over 150%, and edtech Janison (JAN) up around 130%.

However, retail investors have cooled on the buy now, pay later (BNPL) sector, with shares in former market darling Afterpay (APT) down 30% in 2021 along with declines in the rest of the sector as competition intensifies and regulators clamp down.

Inflation risks

Rising inflation threatens to end tech stocks’ winning run in 2022, according to analysts, with higher interest rates increasing borrowing costs as well as curbing valuations, particularly for unprofitable tech companies.

With reports of worker shortages and rising wages, higher personnel costs could also hit the tech sector, warns Morningstar senior analyst, manager research, Ross MacMillan.

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The S&P/ASX All Technology Index has fallen -8% so far this year while the Nasdaq composite is down almost 6%.

“A lot of tech businesses don’t have plant and equipment, but they do have a lot of employees working within those businesses to develop their product or service,” he says.

“And what are we seeing today? Unemployment is continuing to decrease, employers are raising wages trying to attract people, everyone is moving jobs, and part of that is wage inflation.

“So if you have a tech company not making any money or perhaps at breakeven level and then it gets hit with wage inflation, that situation will get worse. And when investors see that, share prices will begin to fall.”

MacMillan also points to the impact of higher prices on the BNPL sector.

“As interest rates go up, consumers will face higher mortgage repayments and will curb spending on discretionary items like fashion and clothing,” he says.

“The BNPL sector will do it very tough in this environment, as will any tech company not making money at the moment. Companies that will do well will be those with good cashflow, that are profitable and have pricing power together with low levels of debt.

“It’s also going to be difficult for the tech companies to get funding in this situation with investors likely to be more cautious.”

Valuations stretched

Stretched valuations will also weigh on the outlook for “growth” stocks such as those in the tech sector. Morningstar rated the Australian equity market “moderately overvalued” as of December 10, with an average unweighted price/fair value estimate ratio (P/FVE) of 1.08 and cap weighted average of 1.16.

Among the sectors though, the most overvalued were consumer cyclical and technology, with median P/FVE ratios of 1.25 and 1.22, respectively and cap weighted ratios of 1.37 and 1.65. In contrast, energy was the most undervalued sector with a median P/FVE ratio of 0.76 and cap weighted ratio of 0.78.

Morningstar equity research strategist, Gareth James has highlighted the threat to tech valuations from rising bond yields.

“Given stretched valuations, the Reserve Bank of Australia moving towards a higher interest rate regime could weigh on technology companies, particularly high growth stocks on expensive P/E [price/earnings] multiples, such as Xero (XRO) James said.

“We favour technology companies with positive earnings, trading at more modest multiples, such as Link Administration (LNK). We also favour companies benefitting from higher interest rates, such as Computershare (CPU), which generates a meaningful proportion of its earnings from the interest it earns on clients’ cash balances.”

James also suggests niche BNPL companies such as Pushpay (PPH), Tyro (TYR) and EML Payments (EML) could produce better earnings growth than their “commoditised” counterparts such as Humm (HUM) and Zip (Z1P).

With Link now being acquired by Canadian software company Dye & Durham in a $3.5 billion deal, James’ top picks for investors include three-star rated Computershare together with similarly rated Wisetech Global (WTC), considered attractive for its “economic moat, large global addressable market, relatively low ESG risk, strong balance sheet, an innovative culture, and a large recurring revenue base.”

Analysts are still bullish on IT firms in the S&P/ASX200, with forecast median revenue growth for fiscal 2022 of 23.6 per cent, EBIT (earnings before interest and taxes) growth of 29 per cent and NPAT (net profit after tax) growth of 31.4 per cent, according to CommSec.

Only the materials sector had higher forecast NPAT, at 37.2 per cent, with energy companies seen producing standout EBIT growth of 63.6 per cent.

Yet for IT firms, CommSec notes: “a key risk to profitability would be the ability of companies to seek debt…at the historically low rates that are present now.”

The removal of the punchbowl of cheap money likely means an end to the super-sized value gains enjoyed by tech firms, with a return to “value” over “growth” stocks.

While the Reserve Bank of Australia has maintained a cautious approach compared to other central banks, market economists have projected higher official interest rates as early as late 2022.

“Investors have to play this cautiously – you don’t want to be fully invested in equities, you want to have a reasonable amount of cash to invest to take advantage if the market falls,” Morningstar’s MacMillan says.

“Also, if we’re going to go through a period of rising interest rates, there will be a point at which there will be some medium to long-term bond opportunities that you can lock in.”

is a Morningstar contributor.

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