Source: FactSet
The value of a sovereign bond is calculated by adding the discounted values of the face value (principal value) of the bond, plus the sum of all its discounted cash flows (i.e., interest payments). As interest rates move higher, this increases the rate at which these future payments are discounted and reduces the current value of the bond. If interest rates shift lower, this process is reversed, and the present value of the bond moves higher.
Similarly, the value of a company can be deemed to be the discounted value of its future earnings and/or dividends. In the case of many technology companies that do not pay dividends, this means valuation must focus on future earnings and therefore, its earnings growth. The rate at which those earnings are discounted will depend upon current interest rates. If interest rates move higher, the result is a lower present value of that future earnings stream. Companies that pay dividends (i.e., give cash to shareholders along the way) tend to be somewhat less impacted by interest rates, as the investor receives payments along the way, not just at the end. Higher interest rates can be a drag on growth stocks.
To determine the appropriate discount rate for evaluating both stock and bond prices, it is important to consider the impact of future inflation. An important tool to estimate future inflation, are inflation adjusted bonds or TIPS as they are known in the U.S.
As one can see from the chart above, the value of the NASDAQ 100, a tech heavy stock index, and the price of the 5 Year TIPS Bond, is well correlated. However, recently this linkage has been severed and is now quite volatile. Initially, TIPS price rose (yields fell) as NASDAQ prices fell. They then reversed the process so that, at the beginning of July to normalize the relationship, either yields or share prices needed to drop. This process is already in motion and the question is whether the relationship will normalize or again overshoot, resulting in a situation where Yields are rising at the same time as Tech stocks are rising and becoming increasingly overvalued.
We believe that the breakdown and recent volatility of this relationship, is caused by the polarized views on whether we are going to experience a short-lived bout of inflation, as suggested by the U.S. Federal Reserve and most central banks, or a more extended dose of inflation which would put pressure on the lofty valuations currently being experienced by many technology companies.
Disclaimer: Please note that the publication is designed to provide general information only. It reflects the thoughts and opinions of Logan Wealth Management and should not be construed as financial advice, nor should the information be considered a substitute for personal advice. Information used in this publication has been gathered from sources believed to be reliable. Logan Wealth Management is not responsible for and assumes no liabilities or responsibility for any loss or damages suffered as a result of the use or misuse of, or reliance on the information or content of this publication. Please consult your financial adviser to determine whether the information is applicable to your personal situation.
