Throughout much of the year, stock investors were captivated by the trillion-dollar promise of artificial intelligence (AI), which seemed to overshadow a looming threat in the era of a hawkish Federal Reserve: rising real-world borrowing costs across Corporate America. However, Wall Street is now waking up to the monetary dangers as Jerome Powell reaffirms his commitment to maintaining a tight policy stance, triggering a market selloff that extends beyond Big Tech.
The Fed’s policy stance and its impact
Jerome Powell, the Federal Reserve Chair, has once again signaled his determination to keep policy tight, causing a market rout across the technology sector and beyond. His primary tool for cooling the still-hot US economy is ensuring that interest rates adjusted for inflation, seen as the true cost of borrowing, remain elevated. Powell emphasized that real yields, which reached decade-high levels this week, need to remain meaningfully positive “for some time.”
This message from the Fed carries significant implications for the US equity market, particularly for the technology sector, which has seen double-digit gains this year, driven by optimism that emerging technologies like AI would usher in a new era of growth. However, rising capital costs are now casting doubt on this narrative and threatening companies of all sizes.
Impact on Equity valuations
Que Nguyen, Chief Investment Officer of Equity Strategies at Research Affiliates, notes that “a higher cost of capital is detrimental to equity valuations.” While major tech companies boast low leverage, robust cash flows, and strong competitive advantages, these characteristics justify their higher-than-average valuations. However, there’s a limit to how far valuations can be stretched, and for several tech firms, that limit may be approaching.
The prospect of higher rates has had a broad impact on various asset classes. Homebuilders have suffered losses for seven out of the last eight weeks, and unprofitable technology companies have seen declines reminiscent of the market turbulence in March. Benchmark 10-year real rates reached as high as 2.12% intraday on Thursday, the highest level since 2009.
Financial conditions and funding costs
Sustainably high real rates tighten financial conditions, which aligns with the Fed’s goal. Higher funding costs increase the cost of doing business, putting pressure on tech shares, as their long-term earnings must be discounted at higher rates. Meanwhile, assets without income streams, such as cryptocurrencies, become less appealing compared to Treasury bonds that offer a real return.
Despite recent losses, the equity market remains at relatively high valuations, trading at over 31 times annual earnings, lower than the peak of 2021 but still higher than most of the past decade.
Uncertainty surrounding rate hikes
Some analysts, including UBS Group, anticipate that the central bank won’t raise rates again this year. However, Powell’s emphasis on the need for higher real yields in the fight against inflation introduces uncertainty to these predictions.
UBS economists, including Jonathan Pingle, noted, “The FOMC clearly sees higher real rates as needed to restore price stability. The FOMC signaling their intentions for a higher real rate, more restrictive for longer, than we previously assumed, suggests the risks to our rate call clearly skew upward.”
Resilient credit cycle but warning signs
Despite the concerns surrounding rising rates, the credit cycle has remained oddly resilient, with risk premiums in both investment-grade and high-yield bonds remaining stable. However, experts like Torsten Slok, Chief Economist at Apollo Global Management, warn that the rallies seen across risky assets this year may be unsustainable. Funding costs are likely to stay elevated, increasing the financial strain on companies.
Slok states, “We’re going to see the cost of capital bite harder and harder on companies every single day.” He adds that there’s a growing risk of more companies defaulting and consumers falling behind on their payments.
As the Federal Reserve maintains its hawkish stance and real-world borrowing costs continue to rise, the promise of AI and the tech sector’s eye-popping valuations face a reckoning. Investors are now navigating a landscape where the cost of capital looms large, and the ability of companies to maintain their earnings growth is increasingly uncertain. It’s a sobering reminder that in the world of finance, the allure of emerging technologies can quickly be overshadowed by the realities of interest rates and inflation.
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