Understanding this recent correction in tech stocks

With the recent sharp rise in treasury yields (we’ll address that below) global stock markets pulled back sharply last week on profit-taking activity with the NASDAQ and S&P 500 Index -4.92% and -2.45% respectively. Asian markets also joined in the selloff with Hong Kong’s Hang Seng Index and China’s CSI 300 Index -5.43% and -7.64%. This was one of the biggest weekly market corrections we’ve seen since October 2020.

AQUMON’s diversified US ETF portfolios were -0.10% (defensive) to -3.77% (aggressive) last week and -0.25% (defensive) to +1.99% (aggressive) year to date. AQUMON’s SmartGlobal HK ETF portfolio, with more regional exposure to the Hong Kong or China region, was -0.17% (defensive) to +1.73% (aggressive) year to date. The main portfolio laggers last week beyond US technology stocks were both Chinese stocks (-8.45%), emerging market stocks (-6.37%) and gold (-3.18%). Beyond treasuries and money market funds almost all asset classes sold off last week.

AQUMON’s newly launched SmartStock thematic stock portfolios also had a down week. Last week, the best performer was Business Winners (US stocks) standard portfolio -2.23%, while the worst performer was the Chinese Tech Stars (HK stocks) standard portfolio at -13.17%. Year to date best performer was Chinese Tech Stars (HK stocks) premium portfolio +4.48% and worst performer was the Hidden Gems (Chinese stocks) premium portfolio at -8.57%.

From the recent market peak in mid February, the MSCI World Index and Nasdaq Index are -4.35% and -9.73% respectfully. The big question on all investors’ mind is, is the current market volatility the start of an extended selloff or is this more of a rotation out of technology (growth orientated) stocks?  

The short answer? Even though investors are still very risk-on, this correction is mainly a rotation out of growth stocks but there are forces driving further selling pressure that investors should be aware of. Let us explain why.

So what’s driving the recent market selloff?

Chances are in the past 2 weeks you’ve heard the media talk over and over again about rising treasury yields (specifically the US 10 year treasury) and interest rates are causing the market, but more specific growth orientated technology stocks, to selloff. To most retail investors, treasuries (a type of government bond) is something they rarely invest in so why does this matter?

There are 2 main reasons why rising interest rates hurt tech stocks:

1) Technology companies can grow more easily when borrowing cost is low: Most investors when investing into tech stocks like Apple or Amazon they are more likely investing for the ‘future’ earning potential when compared to investing in the stock of an established utilities company. Considering technology companies require large amounts of capital to continually reinvest into the company and spur future growth it benefits them most when the cost of borrowing that money is low. 

When interest rates (percentage charged by a lender for a loan) rises it means it is now more expensive to borrow (and in turn grow) and this hurts tech companies.

2) Pricing for tech stocks will also become more ‘expensive’: When financial professionals are assessing the appropriate pricing for a stock they normally look at 2 things: how much cash that company will generate over time and how much we are paying for $1 of that cash. Most investors expect that these tech companies will generate larger amounts of cash in the future. When interest rates are low, the yield (the return that you receive) from a bond such as US treasuries will also be low. As a result you will likely be willing to pay more for a stock with high future earning potential than wait around for a bond which is paying very little. But when interest rates and yields are rising, bonds will seem more attractive (and stocks less so in comparison) and furthermore with borrowing costs higher it will be more costly for these tech companies to generate each additional dollar of future earnings. This means the higher valuation and pricing for tech stocks will be less justified and investors will look elsewhere for more reasonably priced investment opportunity.

So why are interest rates and yields rising in the first place?

Optimism for future economic growth and/or expectation of higher inflation ahead are the 2 main reasons why we would see rates rise so it’s relatively positive this is happening. But growth versus inflation driven factors will have different beneficiaries.

As we start to hear more news about stronger economic growth ahead, new vaccines allowing economies to successfully reopening from COVID-19 along with accommodative stimulus provided by central banks, as we saw last week see more investors will rotate into rates sensitive small/mid caps stocks along with cyclical stocks that are poised to benefit from lockdowns ending. Because economic growth is currently the main factor driving increase in rates this is a big reason why we saw the rotation out of tech stocks the past 1-2 weeks.

But if it is actually inflation that is driving the rise in rates (and not growth) then certain sectors like technology and healthcare may be better positioned in comparison to beat inflation in this environment. Although prices are indeed rising quickly across multiple fronts we think the perception of increased inflation ahead may be further skewed by the recent rise in oil pricing (WTI oil is +32.73% year to date). So our base case is still near term pricing increase more so than sustained pricing increase. 

How have markets reacted?

Looking from a sector perspective, driven the prospects of more growth ahead, during the recent technology selloff in the US we saw a rotation into lagging cyclical sectors like financial and industrials along with a resurgence in energy stocks:

 For those wondering why US consumer discretionary is also seeing a sizable pullback, it is mainly because the 2 largest stocks in this sector are Amazon and Tesla (-9.71% and -17.04% since February 18th).

 There’s a few things that jump out at us when looking at the recent sector specific returns:

1) Investor rotation into cyclical sectors still gathering legs: We believe this rotation from growth orientated technology stocks into lagging cyclical sectors is still in the early stage although it’s the recent rising bond yield situation and positive vaccine news is adding pressure to the speed of this rotation. There will be subsequent rotations back into technology names (especially when valuations come down a bit) so staying diversified across sectors over rushing into cyclicals still makes most sense for investors in terms of capturing upside from future rotations. If you are not exposed to cyclical sectors that are COVID-19 recovery beneficiaries it makes sense to carefully add some exposure.

2) Keep a lookout for the energy sector in 2021: The US energy sector was the worst performing sector -36.88% in 2020 due to COVID-19 wreaking havoc on both oil demand and prices collapsed as a result. This was no surprise. What has been a surprise has been how energy companies have come back in 2021 leaner, with healthier balance sheets and along with the support of economies slowly reopening, has made the sector the best performing one in 2021, +31.53% year to date. The energy sector staging a comeback is a positive sign we are seeing economic recovery from COVID-19. Although this won’t be smooth sailing, the energy sector likely has more to run up in 2021. 

Should we be concerned about this rising rates situation?

The short answer is “not really yet” but we should definitely continually monitor the situation. This is only cause for concern unless we get to a point where rising interest rates stagnate economic growth or more importantly inflation reaches a point that Central Banks such as the US’ Federal Reserve need to reverse their current monetary policy by hiking up interest rates and/or reducing asset buying. 

Federal Reserve Chairman Jerome Powell just came out Thursday to speak. Recent economic figures including job growth has been strong so it does look like the US is recovering from COVID-19. The Chairman also pointed out consumer prices will likely increase this summer (meaning inflation is ahead) but he stressed that he doesn’t think the economy is overheating (and the Fed needs to step in). Since there was no indication of more accommodative guidance ahead, markets sold off Thursday night as a result. We think this is a bit of an overreaction. The Federal Research’s monetary policy at this point is still very supportive of markets.

Looking at past data from 2000, global stock markets tend to trend up when both real yields (inflation adjusted) and inflation expectations are both up.

But investors should be aware there will be some added selling pressure resulting from this beyond just technology stocks. Although retail investors may not be so sensitive to treasury yields, large institutional level investors particularly those seeking yield are. Why? Because longer (e.g. 10 year) US government bonds are now actually yielding (~1.55%) at levels that are higher than the average dividend paid by US stocks (~1.46%):

 This is important because ‘technically’ with longer government bonds like US treasuries there is no risk but this is not the case with buying stocks. You have a much higher chance of potentially losing money in the stock market (called “capital risk”) versus buying government bonds. So the dividends paid by stocks (similar to the interest paid by a bond) needs to be higher to compensate for this added risk. This is called “equity risk premium”. At current levels this premium has disappeared and for yield hungry investors (particularly large institutional ones) may move larger sums of money back into bonds (after the recent bond selloff) when they can get equal yield for no risk. So this could add further downward pressure to stock markets in the short term.

Investors should expect more volatility ahead

This is something we’ve been communicating to investors since Q4 of 2020. There are a few reasons why investors should expect more volatility ahead:

1) Broad market highly weighted towards tech stocks: With currently 20.95% of the S&P 500 weighted in Facebook, Amazon, Apple, Microsoft, and Alphabet’s Google (FAAMG) stocks any selloff in tech essentially becomes a broad market selloff. Although we think rotation out of tech is still relatively early this is a reality that investors should understand.

2) Market fundamentals finally returning: Since March 2020, with both major liquidity injection of cash into financial markets by central banks along with a surge of retail investors, the market has been more momentum and less fundamental driven. This is a big reason why we’ve been successfully suggesting to investors since March 2020 to “follow the cash” by central banks. But when fundamentals finally return to markets investors will also need time to transition.

3) COVID-19 recovery time variation: With the recovery speeds at which major regional markets are very different (Asia specifically China/Taiwan/Singapore/HK more ahead of the curve recovery wise relative to its western counterparts) we anticipate this will cause added friction and volatility to global financial markets in 2021.

The correction was not totally unexpected

We think it is important for all us investors to keep some perspective since after this outsized rally from early last, in order for markets to have a chance to reach higher levels, there will likely be multiple pullbacks like the ones we saw this past 1-2 weeks. Even though the MSCI World index is down -4.35% since February 15th, it is still +68.93% since markets hit the bottom in March 23rd 2020:

Although we couldn’t anticipate the fast speed at which markets surged in the first 6 weeks of 2021, the market volatility that came along with it was not unexpected. This is the key reason why we have been communicating to investors since Q4 of last year that investors’ top priority is managing their investment portfolio risk because 2021 is a year of heightened market volatility.

Based on the current risk-on sentiment by investors, economies starting to reopen from COVID-19 and support from central banks we are still positive that financial markets will see further upside in 2021 but we want to make it clear investors should expect a bumpy ride on the way up. If investors feel it is too much risk for them to handle, reducing your portfolio size is clearly an option. Given the likely fast and unpredictable rotations from both a regional and sector perspective ahead we have been asking our investors to 1) stay diversified and 2) hold a little more cash both from a protection standpoint and to potentially utilize if markets pull back more and you can get even more attractive investment pricing.

If you have any questions, please don’t hesitate to reach out to us at AQUMON. We’re always happy to help. Thank you again for your continued support for AQUMON. Stay safe outside and happy investing!

Ken

About us

AQUMON is a Hong Kong based award-winning financial technology company. Our mission is to leverage smart technology to make next-generation investment services affordable, transparent and accessible to both institutional clients and the general public. Through its proprietary algorithms and scalable, technical infrastructure, AQUMON’s automated platform empowers anyone to invest and maximise their returns. AQUMON has partnered with more than 100 financial institutions in Hong Kong and beyond, including AIA, CMB Wing Lung Bank, ChinaAMC, and Guangzhou Rural Commercial Bank. Hong Kong University of Science and Technology, the Alibaba Entrepreneurs Fund, affiliate of BOC International Holdings Limited, Zheng He Capital Management and Cyberport are among AQUMON's investors. 

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