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In direct interaction with clients, one of an advisor's primary functions is helping the client see the forest through the trees and that's especially true in trying macroeconomic and market climates.
These days, the trees are soaring inflation and rising 10-year Treasury yields, the latter of which is likely a harbinger of the Federal Reserve raising interest rates this year – likely multiple times in a now late effort to damp inflation.
One of the forests is the technology sector. The largest sector weight in the S&P 500 usually isn't one of the destinations think of when they think of rising rates protection. In fact, they're probably thinking the opposite and year-to-date price action confirms those suspicions. The specter of Fed tightening isn't the only culprit here. Higher valuations are coming home to roost and as is to be expected at this point in the economic cycle, investors are losing tolerance for unprofitable companies.
Understandably, clients are concerned about the state of affairs in the technology sector today and with potentially more upside looming for Treasury yields, those concerns are likely to be amplified as the Fed's tightening cycle unfolds. Good news: Tech isn't likely to be the wasteland some clients are envisioning.
Not Financials, But...
Advisors know that financial services stocks are usually the most positively correlated to rising 10-year yields, but that doesn't mean all other sectors should be cast aside when rates rise.
“In our view, higher rates may be more positive for Financials than they are negative for Information Technology stocks,” observes David Kastner of Charles Schwab. “However, sector winners and losers likely will depend on the pace at which the Fed raises short-term rates, and the impact those higher rates have on the overall stock market, longer-term interest rates and the yield curve.”
It's often said “a picture's worth a thousand words.” On that note, advisors may want to consider showing the below chart to clients because it illustrates the point that link between rates and technology stocks isn't as strong as they think it is.
Courtesy: Charles Schwab
Something else that might surprise clients is that while valuation is often framed as central to the technology sector thesis – and that can be problematic in an environment such as the current one – is valuation isn't the end all and be all of tech stock evaluation.
“The problem with oversimplifying valuations in this way is that things don’t remain equal—they change all the time,” adds Kastner. “Higher inflation, which can push interest rates up, also likely increases revenues and potentially earnings—resulting in higher future cash flows—particularly if a resourceful company can increase productivity through automation, for example. Some stocks command higher valuations because the companies have shown that they are cutting-edge innovators, so in investors’ eyes a change in interest rates may not be as relevant as the companies’ future potential.”
What Matters with Tech
No one is saying to ignore the risks the Fed and valuations present to the technology sector, but advisors should also make clients aware of the long-term case for tech.
That revolves around business investment and the expansion of disruptive growth industries – a category in which technologies frequently intersect with one another.
“In the case of Information Technology, there is an ongoing strong long-term tailwind. The sector continues to play a pivotal role in advances in robotics and automation; the transformation toward big data and cloud computing; the software and artificial intelligence that make it work; and smartphones, tablets, and network interfaces to enable us to use it,” notes Kastner.