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Tech Stocks Struggle as Interest Rates Rise and Recession Fears Loom

When Tech Stocks Are Down What Goes Up?

Last year was rough for tech stocks as the Federal Reserve hiked interest rates and investors prepared for a recession. Rising rates hurt tech companies because they need to borrow capital for growth.

Many tech stocks have sky-high valuations. As such, they’re more sensitive to interest rates than other sectors of the market.

Price-to-Earnings Ratio

When experts determine a company’s value, they take several factors into account. For example, they consider things like the price a stock is trading at versus how much the company is actually earning. Tech stocks often trade at a higher price-to-earnings ratio than other sectors, which makes them more susceptible to declines when those earnings don’t meet expectations.

High-growth tech companies are also typically riskier than other stocks, because they may need to borrow money to finance their growth initiatives. That’s why rising interest rates can hurt tech stocks more than other industries.

When the Federal Reserve raises interest rates, it increases the cost of borrowing, which decreases a company’s valuation. This could be especially true for growth-focused tech companies that need to spend big in order to bring new innovations to market.

Interest Rates

Many of these companies are known for charging sky-high valuations and, as a result, they need to generate strong performance and earnings to justify that high price tag. When performance lags, tech stocks can experience big drops.

Rising interest rates are a headwind for tech stocks. That’s because these growth stocks have rapid-growth assumptions baked into their stock prices, and those expectations are magnified when discounting calculations use a low interest rate. A rise in rates eats into the present value of those expected cash flows and causes a big decline on a dollar-per-share basis.

The industry also faces other headwinds, including slowing growth and an overvaluation. And, while a recession is unlikely, it’s always a risk in the long run and will hurt those companies that have high exposure to overseas markets. In addition, few tech stocks pay dividends, so investors must reinvest their returns to get more growth. This makes the sector especially sensitive to a shift in investor sentiment.

Earnings Season

The tech sector makes up a quarter of the S&P 500’s value, so when big names like Apple, Amazon, Nvidia, Alphabet and Microsoft report quarterly earnings, they can have an outsized impact on investor sentiment. That’s why when big tech companies have bad earnings, the market can turn sour. 2022 was a particularly rough year for the tech industry. War broke out between Russia and Ukraine, inflation spiked, interest rates climbed and many investors worried about the beginning of a recession.

Rising interest rates typically hurt Tech stocks because they often rely on capital infusions to grow their businesses. But while the correlation between Tech stocks and 10-year Treasury yields is high, causation doesn’t necessarily follow. And in the longer term, higher rates don’t really affect Tech’s fortunes as much as the market may think. This is because the biggest Tech companies have locked in low borrowing costs and have fat gross margins, which make their profits less sensitive to interest rate changes.

Recession

Recessions hurt stocks across the board, but they’re particularly harmful to cyclical industries that rely on consumer spending. That’s why growth sectors like tech stocks tend to struggle during recessionary periods, especially if they carry lofty valuations.

Higher interest rates also make it harder for tech companies to generate sales and profits, since they must pay higher yields on their debt. However, the rise in rates hasn’t been as bad this time around because the Federal Reserve isn’t hiking them as quickly.

The slowdown in the tech sector could continue if the economy slips into a recession. But if it doesn’t, many of these high-growth stocks, including Shopify and Roku, could soar in a recovery. In fact, the pullback during the COVID-19 pandemic cleared a lot of the froth off these premium-priced stocks. With lower valuations, the tech stocks are poised to outperform. And a better economic climate would probably help boost revenue and earnings at those companies as well.

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