Higher bond yields could spell trouble for the tech sector

US share markets have raced ahead in 2024 led by Nvidia and the strong performance of technology shares.

Gains have come despite a rise in long-term bond yields and investors need to be cautious in the months ahead as share prices could disappoint if yields keep on climbing and rate cut expectations keep being pushed out, which could put a brake on market confidence.

Strength in the US share market has been fuelled by the boom in technology stocks linked to the creation of artificial intelligence (AI) and the winding back of expectations that the US economy will fall into recession.

Nvidia has been the stellar beneficiary of the AI rally as its computer chips power AI processing. However, other companies have also dominated headlines, including Microsoft after it overtook Apple as the world's largest company earlier this year, more closely linked as it is to AI than the iPhone seller.

However, in terms of valuations, Innova uses a composite of four valuation metrics which show the S&P500 is currently trading on valuations only seen twice before since 1995: in 2021 and 2000.

The S&P500 is currently trading at a significant premium to its 25-year average, and is currently higher than the peak of the GFC - yet not quite as high as it reached in 2021 or the 2000 tech bubble. The Nasdaq is not yet trading at the extremes of the 2000 tech bubble, but it is trading on rich valuations compared to history.

At these valuations, even with robust economic growth, the price being paid for US shares has always ended badly from this point, both for the S&P500 and the Nasdaq. Share markets are still very vulnerable to a fall and investors need to be careful of buying into the euphoria at a cost that can't be recouped.

However, given the concentration of this rally there are plenty of other sectors that are more reasonably priced.

With inflation receding and the likelihood of US recession falling, we would expect that the concentration of the rally should broaden to other areas if this is a true rebound in market and economic activity.

Areas typically considered 'cyclical' do very well in an economic rebound, and if the US can engineer a soft landing, cyclical areas should be likely beneficiaries - as well as other areas in the AI value chain as competition increases for market share.

Much of the recent euphoria has been related to expectations of cuts in interest rates in the US and other developed economies.

After reaching multi-decade highs in 2022, inflation amongst most developed market economies appears to have peaked. Given this normalisation of inflation, financial markets have been pricing in multiple interest rate cuts by the US Federal Reserve and other central banks this year.

However, it is possible that strong economic fundamentals and corporate earnings in the US could reduce the impetus for the US central bank to cut interest rates and interest rates could stay higher, for longer.

Central banks will not want to reignite inflation by cutting interest rates too early, particularly with the US Government running account deficits of 7%-plus, offsetting the restriction coming from higher rates. That's why we think financial markets have gotten ahead of themselves on rate expectations; rate cuts may not come as quickly as financial markets think.

Indeed, if economic growth remains robust, this could put a floor under inflation and bond yields could potentially rise further, which could lead to lower stock valuations in the US and elsewhere.

While there has been no build-up in risk in debt markets as there was with the 2008 global financial crisis or the dot.com tech crash of the late 1990s, US tech stocks and share markets overall are still vulnerable to the rising cost of credit and higher rates.

Higher real rates indicate that borrowing costs are rising faster than inflation. This can have a ripple effect on economies by reducing investment and business activity, slowing down consumer spending, and leading to a potential slowdown in economic growth in the US and in Australia.

Rather than expensive technology stocks, we believe that there are plenty of safer places for investors to park their money. We have adopted an overweight position in cash and bonds in case of further turbulence or market volatility - however as the likelihood of a recession has fallen, we have reduced this and redeployed capital to equity markets we think look attractive.

While we are still underweight equities overall, we believe there are areas of the market that could provide higher upside potential if things go well, but also offer less downside exposure if something unforeseen were to happen and equity markets corrected.

This should help offset the equities underweight position if the thesis plays out - it includes allocations to Australian shares, Asia, Value-style equities and higher-quality small companies.

If global economies remain somewhat robust, these areas aren't yet priced for an economic or market rebound and so likely possess greater upside potential as their future earnings are not yet factored into their price.

On the other hand, if rate cut expectations in the US get pushed out far enough that it causes a deterioration of market multiples and consumer confidence, whilst they won't be immune from market falls, their price means they have a margin of safety and should fall less than areas more richly priced.

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