ASX tech shares have pared gains earned throughout 2021 after collectively trending down this past month. Whereas the benchmark S&P/ASX 200 Index (ASX: XJO) has climbed 3% in the past month, the S&P/ASX All Technology index (XTX) is down 4% after sliding another 6% this last week.
As it stands, a number of macro-economic ‘crosscurrents’ appear to be impacting the share prices of the ASX tech basket in 2022.
Most notably is the US Federal Reserve’s recent language shift on inflation and its intention to potentially hike rates “at a faster pace than participants had earlier anticipated” from 2022.
The Fed aims to control inflation and rates via its actions in the US Treasury bond market. It targets the yield (or rate) on various US Treasury debt instruments because these play a pivotal role in asset valuations – stocks in particular – plus aggregate supply and demand.
In turn, the Fed’s interventions are felt as an impulse throughout the economy. The net result aims to contain inflation and interest rates within certain bands, although this has ramifications for the stock market.
In fact, any movement at all from the US Fed and the US bond markets are huge inflectors for global share markets, the ASX included.
The term ‘hawkish’ is now being thrown around investor circles to describe the Fed’s current position on rates, meaning it favours a higher interest rate environment moving forward. This contrasts to previous language from the Fed which suggested rate hikes were a thing of the distant future.
Now, as a result, global fixed income and share markets are talking, and there’s plenty of chatter around what this all means for high-beta tech stocks on the ASX. Let’s take a look.
Why are US Treasury yields so important?
Bonds and notes are a type of debt between an investor and a borrower. For their risk in lending their hard earned capital, bond investors receive interest payments over the tenor and then get their principal back in full when the debt matures.
Seeing as the US Government is considered as investment grade and highly, highly unlikely to default on its debt at any stage, US Treasury bonds are considered extremely safe assets. In fact, the yield on the US 10-year note or 30-year bond is often dubbed the “risk-free rate” due to this point.
As such, the yield, or interest rate on US Treasury bonds (and notes) – particularly the 10-year US Treasury note – are considered quintessential numbers in finance.
Why is this so? Well firstly, central banks use variables like interest rates and Treasury yields to contain or boost the level of GDP, mortgage lending, credit creation and real inflation.
With inflation soaring in the US, the Fed has little choice but to dial up interest rates in order to wind down surging prices in the real economy. That’s how it goes.
Back in early 2021, Fed chair Jerome Powell said the Fed was agnostic to hiking interest rates and/or yields until 2023 or 2024 at least, even with pressures from surging inflation.
Powell used the term “transitionary” to describe the high inflation back then, deeming prices were coming off a low base from 2020 when global economies were in limbo.
However, amid global supply chain disruptions and manufacturing bottlenecks bought on by the pandemic, inflation statistics were well above targets last year. Inflation data in the US in Q4 2021 alone was 6% year on year for example, its highest in decades.
The US Fed doesn’t have a button to precisely target inflation figures in the economy. And whilst US Treasury yields don’t impact inflation directly, both measures do have a direct relationship with the Federal Funds Rate (FFR).
The FFR is akin to the cash rate in Australia and is the interest rate depository institutions charge each other for overnight loans of funds.
As such the Fed uses the FFR to target changes in short-term interest rates on consumer loans and credit. It will also use it to impact the US treasury yield curve. In turn, these moves create an impulse that either boosts or compresses inflation.
In Australia, the RBA uses the same approach to influence the level of inflation. In both the US and Australia, the aim is to maintain inflation between 2% to 3% on an annual basis.
How can US Treasury yields impact ASX tech shares?
The other and most relevant reason to us why US Treasury yields are so essential boils down to the financial mathematics in how assets are valued.
According to the CFA Institute, analysts mostly quote the US 10-year yield to value securities using a discounted cash flow valuation (DCF).
They estimate what a share is worth today using a DCF with either predicted cash flows (either through dividends or company earnings) or earnings multiples, and the US 10-year yield in the equation.
Hence any shift in the yield curve or yield levels on US Treasuries has a direct impact on valuations for asset classes likes shares.
These valuations are essential figures that investors draw upon in their own investment reasoning, in addition to performing their own calculations.
As Warren Buffet says, value is what it’s worth, price is what you pay – so investors seek to understand where a stock is trading relative to its intrinsic value.
Growth shares by definition are often trading at a substantial premium to their intrinsic value, meaning they are trading at lofty valuations that are sensitive to rates changes.
The market recognises this and, without factoring absolute numbers in, automatically begins to price in the valuation effect of a shift in yields to growth and tech stocks. This is how shifting US Treasury yields can impact ASX tech shares.
What might rising US Treasury yields mean for ASX tech shares?
It is well acknowledged that a hike in nominal interest rates is an essential move to cool off hot-running inflation and house prices bought on by the pandemic.
However, this creates a problem for ASX tech shares, particularly highly-priced, unprofitable names that are trading at a premium.
Turning back to our talk on asset valuations, there is an inverse relationship between rates and valuation. A rising rate/yield on the 10-year US Treasury note would compress stock valuations for instance, whereas lower yields are a valuation driver.
If the Fed does hike rates in order to ring-fence inflation, this will be a net-negative for high-growth tech stocks across the board because the impact is disproportionate to tech companies in general.
These valuations in turn have a considerable impact on how the market prices a company’s share price, and how investors seek investment opportunities, as mentioned earlier.
This helps explain why the broad ASX tech indices are down following the Fed’s most recent meeting and the release of its minutes this week, according to analysis from Bloomberg Intelligence.
Foolish takeaway
Global share markets have been buoyed from a period of record low interest rates and ample liquidity for the past 10 years after the global financial crisis.
As such, high-growth tech stocks have flourished during that time, as investors have adopted a risk-on appetite. According to the Nasdaq, investors preferred to have a premium this past decade for a chance at higher gains into the future.
Fast forward to 2022 and the outlook is far less visible. The US Fed has over $8 trillion in debt on the balance sheet and has ‘printed’ more money in the last 2 years than in the last 50 years combined.
In Australia, many commercial banks are expecting interest rate hikes to occur in 2023, ahead of the Reserve Bank’s estimates which sit further out. Several have already made hikes to their fixed mortgage rates in 2021, in an attempt to drive interest to floating rate products and to cover costs.
The pressure is on for a shifting rates regime over the coming years. As such, rising yields on US Treasuries hurts the valuations on ASX tech shares and can ultimately present as a downside risk.
In consequence, rising US Treasury yields are deemed to be a net-negative for Australian technology shares.
The post What might rising US Treasury yields mean for ASX tech shares? appeared first on The Motley Fool Australia.
Wondering where you should invest $1,000 right now?
When investing expert Scott Phillips has a stock tip, it can pay to listen. After all, the flagship Motley Fool Share Advisor newsletter he has run for more than eight years has provided thousands of paying members with stock picks that have doubled, tripled or even more.*
Scott just revealed what he believes could be the five best ASX stocks for investors to buy right now. These stocks are trading at near dirt-cheap prices and Scott thinks they could be great buys right now.
See The 5 Stocks
*Returns as of August 16th 2021
More reading
The author has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
from The Motley Fool Australia https://ift.tt/3n6b2oV
