Looking for a tech rebound

• The S&P/ASX 200 Information Technology ASX:^AXJE (XJE) index is down 30% on the year.
• A combination of forces is pressuring technology stock valuations.
• What forces are holding down tech stock valuations, and what needs to happen for them to rise again?

Inflation and tech

Conventional financial theory leans heavily on the relationships between assets. When deciding the value of stocks and bonds, one starts with the yield on an inflation-adjusted government debt security, incrementally adding to that return the expected perishable returns from the investment.

As inflation rises, the stock valuations for growing companies like tech stocks, which do not have concrete returns, but expected returns, diminish rather quickly.

This is a function of two parameters. Firstly, the valuation of future money declines when inflation is compounded to the valuation horizon. Secondly, comparable, and less risky newly minted investments, such as US government bonds, become more attractive, particularly when factoring in the higher rates used to combat inflation.

Inflation abounds

After what was thought to be a transitory moment of inflation following geopolitical unrest on the European continent and a spike in demand following the release of the pandemic movement restrictions, inflation is proving to be far stickier.

The energy complex provides a decent proportion of the overall inflation but not the majority. Agricultural, services, shelter, and others form the bulk.

While food and energy inflation has, by and large, been suppressed in recent months, shelter in some international markets is proving to be a more difficult ask. Long delays in new builds following COVID-19 and developer misfortune managing price spikes have kept housing inventory low. Rental prices in Australia and abroad are still elevated.

To add to the housing inventory issue that will take many months and years to unravel is the present and impending services hikes, driven in part by wage inflation. With wages now being adjusted for the record 2021-2022 commodity and shelter price spikes, policymakers are struggling to put a lid on prices with their conventional tooling.

The dual-pronged attack from the US of releasing strategic oil reserves and raising benchmark US dollar borrowing rates has kept the lid on energy markets for several months: services and wages are now threatening their good work.

Pull factors

While inflation’s direct impact on tech valuations and indirectly via the adverse effects in the broader economy weighs heavily on tech stocks, what are some positives?

Artificial intelligence (AI) and machine learning (ML) are on the cusp of wider applications worldwide. OpenAI’s recent release of ChatGPT has brought accessible AI to the masses.

Microsoft NASDAQ:MSFT (MSFT) recently announced another potential $10b investment in OpenAI and is now widely expected to blend the tech with Bing and a whole raft of other MSFT applications.

This investment is likely to set off a new golden age in technology investment and development as the industry races to find consumer and enterprise applications, and companies quickly adopt them so as not to be left behind.

Summary

The immediate future for technology stocks relies heavily on inflation coming to heel. Either the Fed finds an exit for its rate hikes, or a sharp rise in rates will find the exit for the market. Either way, the end game for this act will likely arrive soon.

In the months ahead, AI and ML will likely set off another golden age for technology stocks as companies vie for this next multi-trillion-dollar opportunity.