It would be an understatement and a half to say the shine has come off the veneer of growth stocks in recent months. The Dow Jones US tech sector has shed more than 26% year to date. A tightening from central banks, resulting in burgeoning interest rates, has led to a ‘perfect storm’ across the markets, with pandemic winners and leading tech companies being knocked off their perch.

The triumvirate of popular brands Zoom, Netflix and Peloton became synonymous with the pandemic bounce that brought many first-time investors to the markets. They are now synonymous with the sell-off that has hit growth stocks in 2022. But the question is, is their time up?

What’s driving the market dip?

In the last two years, the changing economic landscape across the globe has led to a rapidly accelerating rate of inflation. The war in Ukraine, rising energy prices, global supply chain dislocations, and China’s pursuit of a zero-Covid policy, set against a backdrop of tighter global monetary policy and renewed post-Covid economic demand, have all conspired to turbocharge inflation. In the UK, inflation now stands at 9%, nearly five times the Bank of England’s aim of 2% per year. And it is forecast to rise further.

During the pandemic years, low levels of inflation allowed interest rates to be kept at historic lows. In turn, this enabled companies to invest in their growth cheaply via low interest loans and bonds, an environment supportive of growth stocks. Meanwhile investors were happy to take on more risk with the prospect of future returns, rather than place money in value stocks or lower yielding bonds. Ultimately this supported higher P/E ratios. Cash flow was not king in investors’ eyes.

But since inflation has reached new highs, the economic outlook has become clouded, and central banks have taken action. Rising interest rates have had a huge impact on valuations, not least for investors who value the discounted cash flow model. Discounted cash flow models are commonly adopted by investors and traders who value future cash flows lower when the discounted interest rate is higher. In short, the lower the discount rate, the higher future cash flows are valued today. With interest rates rising, the valuation of future cash flows has fallen, impacting stock prices.

How have rising rates impacted growth stocks?

The end of cheap debt and murkier economic outlook have taken their toll on growth stocks. After a torrid start to the year, in April the Nasdaq, often seen as a basket of growth stocks and pandemic winners, saw its worst monthly performance since 2008.

It might appear 2020’s darlings have become 2022’s basket cases. For the likes of Peloton, Zoom and Netflix, the drops in share price have amounted to between an eye-watering 50% and 70% since the start of this year.

What will happen next?

There are a number of indicators that will help our understanding of what the long-term future for the pandemic winners will look like. Writing off companies’ prospects entirely can backfire too. After all, Amazon emerged as a long-term behemoth despite its share price performance when the tech bubble popped.

Market traders and investors will be looking at company results and announcements closely in order to glean an understanding of their long-term profitability, and their strategy to get there. We’ve seen a raft of companies already undertake cost-cutting measures, and it will be no surprise to see more of this in coming months.

Furthermore, the wider economic picture will help inform our understanding of the performance of growth stocks. How far interest rates go in the next 12 months and whether global inflation cools will also have an impact on the market. Should we see a need for a looser monetary policy in 2023 to combat an economic downturn, for instance, the tables could turn once more for growth stocks.

Published: 31 May 2022

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