Now Wall Street is fretting over the monetary danger in a week that Jerome Powell signaled his resolve once again to keep the policy stance tight — sparking a rout across Big Tech and beyond.
His tool of choice to cool the still-hot US economy: Ensuring interest rates adjusted for inflation — seen as true cost of money for borrowers — stay elevated. Real yields, which touched decade-highs this week, need to stay meaningfully positive “for some time,” the Fed chief said at the policy gathering.
It’s a chilling message for the top-heavy US equity market. Double-digit gains this year have been fueled by optimism that nascent technologies such as artificial intelligence will unlock a new wave of growth for technology companies, justifying the sector’s eye-watering valuations. Yet skepticism is setting in as the cost of capital climbs, threatening to pressure companies big and small.
“A higher cost of capital is detrimental to equity valuations,” said Que Nguyen, chief investment officer of equity strategies at Research Affiliates. “That said, big tech are unique companies with low leverage, fat cash flows, and wide economic moats, and these characteristics justify higher than average valuations. But at some point, the absolute and relative valuation can’t be stretched more, and we may be approaching that point for several tech names.”
The prospect of higher rates hit assets across the board. Homebuilders fell for the seventh time in eight weeks as a group, while a basket of unprofitable technology firms tumbled with echoes of the market turmoil in March. No wonder: Benchmark 10-year real rates climbed as high as 2.12% intraday on Thursday, the highest level since 2009.
“As part of the Fed’s role is to be a champion for the US economy, Powell runs the risk of overplaying the optimism – leaving risk assets vulnerable to fallout from higher real yields,” wrote Ian Lyngen of BMO Capital Markets in a note.
Sustainably high real rates serve to tightening financial conditions — an oft-stated goal of the Fed chair. More expensive funding costs increase the cost of doing business and put pressure on the likes of tech shares because their long-term earnings prospects now have to be discounted at higher rates. At the same time assets that lack income streams like cryptocurrencies look less appealing given the opportunity costs to hold them compared to a Treasury bond that pays out a real return.
The tech-heavy Nasdaq 100 has dropped more than 5% so far in September, on track for a back-to-back loss and its worst monthly showing of 2023 as high-flyers such as Tesla Inc. and Microsoft Inc. stumble. Even with the hosing, the index is trading at more than 31 times annual earnings — lower than the halcyon days of 2021, but higher than almost any point in the past decade.
UBS Group AG is among those that expect the central bank won’t hike again this year. But Powell’s emphasis that higher real yields are needed in the last leg of his fight against inflation introduces uncertainty to that sanguine projection.
“The FOMC clearly sees higher real rates as needed to restore price stability,” UBS economists including Jonathan Pingle wrote in a report. “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.”
Yet the credit cycle remains weirdly resilient with risk premiums across investment-grade and high-yield bonds steady. As such to Apollo Global Management Inc.’s Torsten Slok, the rallies across risky assets this year are unsustainable. Funding costs are poised to stay elevated, and investors across assets should prepare accordingly, he said.
“We’re going to see the cost of capital bite harder and harder on companies every single day,” Slok, Apollo’s chief economist, said on Bloomberg Television. “We begin to run the risk of course that we’re going to see more companies defaulting and on the consumer side, more people falling behind on their payments.”