Why cooling inflation might be good news for tech stocks

Why cooling inflation might be good news for tech stocks

Inflation cooled for a year, and the tech sector helped find some heat.

The technology is incredibly sensitive to inflation trends, as it is particularly sensitive to interest rate fluctuations. When inflation is high, the Fed feels compelled to raise interest rates (and vice versa), which can affect the Fed Growth stock valuationsLike technology.

“Inflation is not necessarily a negative for technology,” said Ivana Delevska, founder of SpearInvest. “It’s more about what inflation means for the direction of interest rates… All of the technology sub-sectors will benefit from lower interest rates. A roughly 50 basis point move in interest rates is (about) a 10% impact on stocks.”

Market participants largely expect the Fed to maintain its current record rate at the September FOMC meeting, CME FedWatch tool Offers. And the Fed’s latest projections indicate that Fed officials are not looking for lower rates until the end of 2024.

“Lower inflation indicates less need to raise prices, which has an inverse relationship with technical valuations given the long duration,” Wells Fargo analyst Michael Turin told Yahoo Finance. “Most tech companies are still in growth mode, so investors value[free cash flow]well into the future.”

“With the decline in long-term real interest rates, it has been difficult to justify the valuations currently being observed in many technology and other digital stocks,” added David Bianco, chief investment officer of DWS Americas.

Technology pricing power

It’s also worth considering how inflation will affect pricing. Some technology is often seen as having a “deflationary effect” due to improvements in productivity, and the opportunity to lower prices could spur growth for consumer-facing technology companies.

“Inflation also helped test pressure on sellers who have pricing power,” Turin said. “Lower inflation is likely to allow companies to moderate price increases, leaving more room for price-driven growth in future periods as needed.”

Of course, the inflation picture is not without its complexities, as companies now have to adjust to a mixed price environment.

In July, inflation picked up again, but higher-than-expected price increases were nonetheless muted compared to 2022 heights.

So how should investors think about the relationship between technology and inflation in the future?

“The technology sector has traditionally been viewed as a cyclical sector, which means that it is not immune from the macro forces of an economic cycle,” Jordan Irving, portfolio manager at Glenmed, told Yahoo Finance. “The previous decade from low inflation to no inflation and zero interest rate policy, however, has caused a shift in the investment narrative leading to a belief that technology is immune to traditional macroeconomic forces.”

The narrative is in flux, Irving added, so expect that to continue as inflation and interest rates head toward some kind of normalization.

“The struggle investors face today is that inflation may come down from its highs, but interest rates are not,” Irving said. “If inflation proves more steady than consensus believes and interest rates remain at current levels, investors will likely wonder what valuation multiples are currently being allocated to many technology stocks.”

The Google logo appears on a balloon in the Google office.

The Google logo appears on a balloon at Google’s office in a historic building on Main Square in Krakow, Poland on November 29, 2022. (Photo by Beata Zaurzel/NurPhoto from Getty Images)

However, there are sectors and companies that look strong.

Turrin is “optimistic on software while minimizing the effects of inflation,” including Microsoft (MSFT), Adobe (ADBE), Salesforce (CRM), and ServiceNow (now).

And it will not be the biggest names in the world of technology that will benefit.

“There are many small and medium-sized companies in software and semiconductors that offer compelling opportunities at their current valuations while cash flows are attracted to larger companies,” Irving said.

Ali Garfinkel Senior Technical Correspondent at Yahoo Finance. Follow her on Twitter at @tweet and on linkedin.

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