The prevailing narrative in markets recently has been that rising interest rates would not be an issue for investors, given growth is accelerating and a pick-up in inflation would actually be a good thing.
As discussed over many months now, our view has been this is wrong when it comes to technology stocks because:
1. They represent a significant risk to investors given positioning;
2. They represent a significant risk to the market as a whole given technology’s outsized weighting in the index.
It is equally true that some funds, like Talaria, have a process which will benefit were this to come to pass.
Given the duration of technology stocks (aka high valuation stocks), any rise in inflation expectations and long end rates would see the sector under pressure from a valuation perspective. For while it may be true that rising rates are not bad per se – it’s the relative relationship that matters.
This is not a reflection on the quality of the tech companies represented – it’s simply maths.
Source: Bloomberg, S&P, Talaria
For context, going back to 2017 (see charts) when the spread between the 10-year treasury yield and the prospective earnings yield of the technology sector (inverse of forward p/e) approaches or moves below 280bps (using S&P Global 1200 Index) – markets as a whole have sold off.
As of yesterday the 10-year treasury yield was 1.41 and the earnings yield of tech sector 3.86, meaning the spread is 245bps – below the danger zone.
So to take this spread back to 280bps earnings yield gap (the prior danger level) the world technology sector would need to decline 8.2%.
These are still the same great businesses, just potentially risky investments.
So to recap:
- A modest pick-up in inflation will leave the majority of investors significantly exposed to de-rating risk of the order of around 10%
- Fiduciaries should be actively diversifying portfolios to cover a wide range of eventualities.
- It is a warning to anyone taking care of client money to recognise the risks they are running and move decisively to reduce this. The potential for this to go a very long way in certain scenarios is very real. And in a benign scenario – 10%.
In our view, best to stay away from the danger zone.
