Tech Stocks, Interest Rates, Growth Scares

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Tech Stocks, Interest Rates, Growth Scares

With the continued slide in US Treasury yields beginning to worry equity markets, we will devote today’s Disruption section to what that means for Tech stocks in our usual 3-point format:

#1: Valuation math. Any Tech company worth owning is a growth story, meaning its earnings should grow faster than those of the S&P 500. This is evidence that the business has a strong competitive advantage and either operates in a large addressable market or is on its way to creating a new one.

Growth stocks benefit more from a declining rate environment than the broader equity market. The reason is straight from Finance 101 and centers on the C/(R-G) formula to value a perpetuity stream of cash flows. “C” is cash flow/earnings, “R” in this case is the cost of capital, and “G” is the growth rate of cash flow/earnings.

A simple example, valuing annual cash flow stream of $100/share:

  • Imagine a company growing that income stream at 3 percent annually.
  • If Treasuries yield 3 percent and the equity risk premium is 5 pct, then the total cost of capital is 8 percent.
  • That $100/share of earnings is worth $2,000 ($100/(0.08 – 0.03))
  • If Treasury yields decline to 1 percent, that same $100/share is worth $3,333 ($100/(0.06 – 0.03)), or 67 percent more than when yields were 3 pct.
  • The same math for a company that doesn’t grow earnings:
  • At 3 pct Treasuries, $100/share is worth $1,250 ($100/(0.08 – 0.0))
  • At 1 pct Treasuries, $100/share is worth $1,667 ($100/(0.06 – 0.0), or 33 pct more than when yields were 3 pct.

Now, you might be thinking “there’s no way equity markets work in such an exaggerated fashion”, bidding up a growth stock so much more than a no-growth stock just because rates decline. But … Consider this data from FactSet, which shows current forward earnings multiples versus their 10-year averages (i.e., over a period of generally declining interest rates).

  • Technology: 56 percent higher multiples now than the 10-year average (26.5x vs. 17.0x)
  • Consumer Staples: 14 percent higher multiples now (18.3x vs. 20.8x)
  • Health Care: 15 pct higher multiples now (15.2x vs. 17.5)
  • Materials: 10 pct higher multiples now (15.8x vs. 17.4x)
  • Financials: 10 pct higher multiples now (12.6x vs. 13.8x)
  • Energy: 4 pct higher multiples now (14.3 vs. 14.9)

Takeaway: while the valuation math may seem purely academic, the shift in sector multiples over the last 10 years of ever-lower Treasury yields shows that Tech stocks have seen far more benefit than slower-growth sectors.

#2: 10-year Treasury yields reflect the bond market’s best guess regarding future US economic growth and whether it will be hot enough to create structural inflation. They do not reflect whether US GDP growth will be 1, 3 or 5 percent. Rather, they assess whether growth will be hot enough to spur sustainably higher prices.

As such, short term moves 10-year Treasury yields are a reasonable predictor of earnings surprises at cyclical (i.e., not growth) companies. If Treasuries go from 0.6 percent yields to 1.7 pct, as they did from August 2020 to April 2021, one can posit that the bond market is expecting a hot economy and cyclical businesses will have better-then-expected profits. This is, of course, exactly what happened as Q2 corporate earnings season has shown.

When 10-year Treasury yields decline, as they have since the last day of March, the opposite dynamic comes into play. Investors will take this as a sign that more-cyclical businesses have a smaller chance of beating earnings because the US economy is not running hot enough to allow them outsized operating leverage.

Takeaway: declining yields signal a lower probability of large earnings beats at cyclical companies, so investors naturally rotate back into growth stocks in such an environment. The one-word answer to the question “what moves stock prices?” is “surprise”. Slowing economic growth means a smaller chance of surprises at cyclical companies. Growth companies, at least, provide the possibility of “surprise” because their underlying earnings trend is structurally positive.

#3: Capital has to go somewhere. To explain what we mean by that, consider the following investment choices:

  • Say you had to lock up a part of a portfolio for 5 years. Would you choose Apple, with a 0.6 percent current yield, or a 5-year Treasury with a 0.66 pct yield?
  • Same 5-year timeframe, but now choose between Microsoft/large cap US Tech (both with a 0.8 pct yield) or 5-year Treasuries.
  • Harder one now: large cap Tech sector (XLK, with that 0.8 pct yield) or Consumer Staples (XLP, 2.4 pct), knowing Staples stocks have compounded at 5 pct/year over the last 5 years versus Tech’s 26 pct 5-year compounded annual growth rate over the same period.

Takeaway: one popular criticism of low Treasury yields is that it forces capital to take risk, but exactly how much risk is there in holding Apple or Microsoft or the entire US large cap Tech sector for the next 5 years? Anything can happen, of course, but if these names are materially lower in 2026 we’d argue something has gone very, very wrong not just at Cupertino or Redmond but in the world at large.

Summing up: not to make too much of one days’ market action, but the decline in 10-year Treasury yields seems to be dinging market confidence about future macroeconomic growth. We’re entering one of two August weeks that historically sees summertime volatility peaks, and a “growth scare” narrative could certainly encourage history to repeat itself this month. Against that backdrop, US large cap Tech should be one safe haven for all the reasons we’ve outlined today.