Let's keep it real. Barring an unforeseen collapse in inflation or some other surprise, the Federal Reserve is raising interest rates in 2022.
The lingering questions are when and how many times. Predictably, market participants are turning their attention to assets that are correlated, in both directions, to rising rates. Almost as predictably, at least when it comes to stocks, much of the conversation revolves around embracing positively correlated fare, such as bank stocks, while avoiding sectors that historically wither as rates increase, such as utilities.
There's also plenty of angst regarding technology stocks against the backdrop of rising rates. Much of that stems from technology companies having longer-term cash flows, making the group vulnerable to slumping discount rates.
In other words, it's plausible that clients might want to head for the exits and ditch growth and technology stocks, but things don't have to be that way. Interestingly, three decades worth of history with the tech-heavy Nasdaq-100 Index (NDX) indicates that particular benchmark isn't as vulnerable to rising rates as clients are led to believe.
Pleasant Surprises Possible
History isn't guaranteed to repeat and it's possible 2022 could be a rough year for equities across the board. Those are valid disclaimers advisors should discuss with clients. It's also worth noting that the Nasdaq-100 could be sturdier than expected as the Fed tightens.
Semiconductor giant Nvidia (NASDAQ:NVDA) “rose more than 27% and 11% during months after the 2015 and 2004 rate hikes, respectively. Plus, Wall Street analysts see Nvidia rising more than 21% in the next year,” reports CNBC.
Nvidia is just one stock, but it is the fifth-largest member of the Nasdaq-100. For clients needing more convincing, consider the following.
“Additionally, U.S. large-cap/growth stocks, such as theNasdaq-100® (NDX™), have outperformed during the yield pickup periods. The outperformance of NDX was the joint effect of having the highest EPS growth and a more favorable valuation matrix,” says Richard Lin of Nasdaq.
Add to that, the index is negatively correlated to 10-year Treasury yields, more so than the S&P 500. The Dow Jones Industrial Average is positively correlated to 10-year yields. Of course, interest rate sensitivity is the primary concern and there's some encouraging data on that front.
“Besides correlation, we are also interested in interest rate sensitivity. As measured by the price change per unit of interest rate change (1%), interest rate sensitivity tells us both the direction and the scale of equities’ price reaction to changes in interest rates,” adds Lin. “Based on the study, NDX has the highest (and) positive interest rate sensitivity among the three equity indexes, with a sensitivity of 2.0. It might suggest that, historically, growth/tech stocks should be expected to benefit the most from long-term yield pickups.”
Higher Rates Don't Have to Sap Earnings
Some clients are conditioned to believe that higher borrowing costs pressure corporate earnings, which is detrimental across the board, but is particularly punitive for growth stocks, such as NDX components. Good news: That's not always the case.
“The higher EPS growth is priced into the equity valuation and offsets the deterioration of discount rate due to rising rates,” concludes Lin. “Meanwhile, NDX still enjoys the highest EPS growth in both scenarios, 14.3% for long-term average and improved to 15.6% under the rising rate environment.”
Getting down to brass tacks, the Nasdaq-100 performs well in lengthy rising rate environments. Since 1987, there have been 13 rising rate regimes that lasted six months or longer. The Nasdaq-100 returned an average of 22.6% in those periods, double the 11.3% average for the S&P 500.