The end of quantitative easing could cause the tech bubble to burst and highly leveraged ‘zombie’ companies to collapse, leading investors have warned.
According to Brooks Macdonald fund manager Dr Niall O’Connor, a bubble has been created in the tech sector by quantitative easing driving money out of cash and into risk assets.
When the central banks turn off the tap and this easy money dries up, the bubble could burst, he suggested.
This week technology stocks capped an incredible run by surging past a peak last seen at the height of the dotcom era. The sector has been the best performer on the S&P 500 this year, up more than 22 per cent, and the Nasdaq has hit one record high after another.
Reporting season is in full swing and many of the tech heavy report their second quarter earnings this week. Google’s parent company Alphabet has seen a 27 per cent rise in its share price this year, but the stock traded 3 per cent lower after the release of its quarterly report yesterday (24 July).
Jordan Hiscott, chief trader at Ayondo Markets, said the group’s impressive earnings were not enough to give it the boost it needed, as it faces advertising revenue challenges in the longer term because of the shift from desktop to mobile.
Netflix released results last week which were well received by the market, while Amazon and Facebook are due to report this week. Amazon’s shares in particular have had an incredible run, passing the $1,000 mark. Meanwhile, Microsoft, eBay and Facebook have all set new records recently.
But there is concern current valuations are not based on fundamentals, and the rises are all just dotcom-era style froth.
Proponents says P/E ratios are lower this time around, companies have more solid business models and are generating strong earnings and cashflow.
The strength of the dollar has also been a helpful tailwind.
But when the easy money becomes harder, will some of the heat will come out of these bubbly tech names?
Josh Spencer, manager of the T. Rowe Price Global Technology Equity fund, said the tech sector has been an “oasis of growth” in recent years against a backdrop of muted economic growth globally, although he notes some market participants are sceptical about whether there are any more gains to be had at current levels.
“Regardless of the debate over whether the pace of acceleration will eventually slow, it is clearly sweeping across every sector at a rapid rate, upending entire industries. Not only is disruption separating winners from losers, but it is concentrating nearly all the rewards in the hands of the former – resulting in a ‘winner takes all’ environment.”
Zombie companies
Another risk to markets as QE ends is that it will reveal which are the highly indebted ‘zombie’ companies being kept alive by cheap borrowing alone.
The loose monetary policy seen since 2009 has allowed companies to leverage up their balance sheets and, as long as the cost of servicing their debt remains low, ailing companies may appear to be in excellent health.
Eoin Murray, head of investment at Hermes Investment Management, said these companies are ill equipped to cope with a new environment free of artificial stimulus.
“Like animals in captivity, companies incubated on the milk of QE and low rates may no longer exhibit the natural behaviours needed for success in the wild of a stimulus-free market.”
He adds that, unfortunately for bondholders, a tipping point will come as the great monetary experiment draws to a close.
“QE and ultra-low rates have insulated many companies, and unwary investors, from the dangers that normally lurk; they are now treading a dangerous path through the jungle floor.”
As rates rise, companies that have been able to borrow cheaply and keep rolling over their debt will be exposed as zombie firms which would not exist if not for QE, Mr Murray said.
Dr O’Connor noted recent data from the Bank of International Settlements showed the cost of borrowing is already outpacing earnings growth.
Over 10 per cent of established listed firms have interest costs which are higher than their pre-tax earnings, a steady increase since 2007.
Eugene Philalithis, co-manager of the Fidelity Multi Asset Income fund, said when researching companies, he looks at whether they can afford to refinance their debt in future.
“If you look at the broad metrics of balance sheets, companies have been able to borrow at low levels, the cost of debt is low, the problem comes when they need to refinance, what happens then? We look at the level of debt that needs to be rolled over or refinanced as we think it is a better indicator.”
However, the manager says he does not see a lot of refinancing that needs to take place over the next 12 to 18 months.
“We don’t see a material impact on credit quality, it is more likely to be sector or company specific rather than a systemic credit event.”
To paraphrase the old saying from Warren Buffett, when the tide goes out, it will show who is swimming naked.
