It was another relatively calm week for global equity markets with many oscillating near all-time highs. The U.S. central bank – known as the “Fed” – provided an update on its outlook. Its messaging around inflation and approach to monetary policy was largely consistent with what it has been telegraphing for some time. This stood in contrast to the Bank of Canada, which just last week indicated it would begin to incrementally withdraw some stimulus by reducing its purchases of government bonds. As a result of the divergence between the two central banks, the Canadian dollar has been notably strong of late, reaching a three-year high.
Strong earnings from technology
The global technology sector has become one of the most scrutinized by investors, for a number of reasons. First, it is arguably the most important global sector, representing the largest weight, by far, in global markets. As a result, it has meaningful influence over the direction of global stock market returns. Secondly, it has been on a remarkable run for a number of years, helping propel global markets higher. Lastly, investors have been hoping that robust earnings growth could help offset some of the valuation headwinds that emerged earlier this year as a result of higher bond yields.
This week’s earnings reports, highlighted by very strong revenue growth, helped to remind investors that fundamentals remain solid and future prospects are bright. Moreover, management teams of many businesses struck an optimistic tone about the prospects for stronger near-term demand, fuelled by a reopening of the global economy.
The operating environment remains undoubtedly positive for many high growth technology companies. Nevertheless, it is important to recognize the risks that the stocks, rather than the businesses, face. First, expectations of future growth are already high and reflected in current valuations. The companies will have to deliver growth that exceeds current estimates in order for their stock prices to move meaningfully higher in the future. Secondly, valuations are very sensitive to interest rates. Investors typically value a stock by estimating future earnings and cash flow, and discounting those future streams back to present day values using an interest rate. A stock’s current value is therefore susceptible to changes in the rate that is used, and this is particularly true for high growth businesses. Put simply, higher interest rates and bond yields, could more than offset a stock’s strong earnings growth.
The strong results from the technology sector should be supportive for markets near-term given the sector’s prominence. But, at some point, bond yields may resume their march higher as investors shift their attention back to the potential for building inflationary pressures. We believe it’s important to manage for this risk, by ensuring portfolios are well-diversified, with exposure across factors and sectors that can help offset the vulnerabilities within high growth technology holdings. Ultimately, the threat may come to pass with no meaningful impact, but it’s prudent to err on the side of vigilance rather than risk complacency.
Should you have any questions or concerns, please feel free to reach out.
Have a great weekend,