Are tech stocks now bond proxies?

US tech stocks have been very sensitive to changes in Treasury yields over the past year, to state the obvious. It’s not the only sector to have its relative performance strongly influenced by moves in bond yields, joining the traditional bond proxies of real-estate investment trusts (REITs), utilities and others.

There are good reasons to expect some tech sensitivity to changes in bond yields. The sector’s earnings have a longer duration than most others – they trade more on the profits they might generate in the future than on today’s cashflows, whereas low-growth utilities are treated the opposite way. When these more distant profits are discounted at a higher rate, it has a disproportionate effect on their net present value.

Another angle is that if sharply rising bond yields reflect much greater optimism about future economic growth, then tech companies may stand to benefit less than others.  Earnings growth from the technology sector is arguably more secular than being purely dependent on the economic cycle, so an economic boom is – at least relatively speaking – better for cyclical companies than for technology. Tech businesses also have very little debt, another characteristic that is a relative disadvantage in a more inflationary environment.

But there are also counterarguments to suggest that tech stocks should be less affected by higher bond yields than the above implies. Rising yields have in fact far more often than not gone hand in hand with rising equity prices. Tech has been one of the most reliably high-beta sectors in the market, so this is generally an environment that should suit it. And if higher inflation driven by rising wages is a concern that sends bond yields higher, then tech’s profile as the sector with the least labour-intensive business models should be considered a positive.

Looking back further into history reveals a more mixed sensitivity to rising bond yields, as tech has not always been as sensitive to changes in rates markets as has been the case recently. Over a longer time horizon, the correlation has been positive about as often as it has been negative (as we see in the chart below) so there is no firm conclusion we can draw from history. On average, tech has been in the middle of the sector pack when it comes to rates sensitivity. Cyclicals and financials have been the biggest winners from higher yields, while bond proxies like REITs, utilities and defensives in general have been the biggest losers.

More recent episodes also paint a more positive picture than the past few weeks. The late-cycle rise in bond yields from June 2016 to November 2018 (150 basis points in nominal terms, according to our calculations, and 120 in real terms) was a great period for tech. It’s also comparable with today’s situation because it was a time when the sector had already outperformed the broader market for many years, was a consensus ‘long’, and was trading at a premium. No one would argue that yields were the reason for that outperformance, but they were clearly not a large enough factor to prevent strong returns.

This is also where I come out on the ‘tech versus rates’ debate. Rising bond yields don’t help tech, in my view, but equally they don’t hurt enough to cancel out other fundamental medium-term positives. While there are fundamental arguments for and against tech’s rates sensitivity, the empirical data suggest that the relationship has been volatile over time – albeit that higher yields have been bad for the sector recently.

However, the data also show that unless bond yields move so sharply that they become the dominant driver of equities in general, tech’s fundamentals – such as relative earnings or regulation news flow – should be more important for performance. So, on the basis of strong tech fundamentals, we remain overweight the sector.