Why cooling inflation may be good news for tech stocks

Inflation cooled for a year, and it helped the tech sector find some heat.

Tech is incredibly sensitive to inflation trends, because it’s especially sensitive to interest rate fluctuations. When inflation is high, the Federal Reserve feels compelled to raise rates (and vice versa), which can affect the valuations of growth stocks, such as tech.

“Inflation is not necessarily negative for technology,” Spear Invest founder Ivana Delevska said. “It’s more about what inflation implies for the direction of interest rates. … All tech sub-sectors will benefit from lower interest rates. A roughly 50 basis point move in interest rates is [about a] 10% impact for stocks.”

Market participants largely expect the Federal Reserve to maintain its current benchmark rate at September’s FOMC meeting, the CME FedWatch Tool shows. And the Fed’s latest dot-plot projection indicates Fed officials aren’t looking for lower rates until the end of 2024.

“Cooling inflation suggests less need to raise rates, which have an inverse relationship with tech valuations given the long duration,” Wells Fargo analyst Michael Turrin told Yahoo Finance. “Most tech companies are still in growth mode, hence investors are valuing [free cash flow] well into the future.”

“The lower long-term real interest rates, the less difficult it is to justify the valuations currently observed at many tech and other digital stocks,” DWS Americas chief investment officer David Bianco added.

Tech’s pricing power

It’s also worth considering how inflation affects pricing. Some tech is often seen as having a “deflationary effect” due to improvements in productivity, and the chance to lower prices could spur growth for consumer-facing tech companies.

“Inflation also helped stress test which vendors have pricing power,” Turrin said. “Lower inflation likely allows companies to moderate price increases, leaving more room for price-driven growth in future periods as needed.”

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Of course, the inflation picture isn’t without its complications, as companies now have to adjust to a mixed environment for prices.

In July, inflation ticked up again, but the higher-than-expected price increases were nevertheless muted compared to the highs of 2022.

So how should investors be thinking about the relationship between tech and inflation moving forward?

“The technology sector has traditionally been viewed as a cyclical sector, which means that it isn’t immune to the macro forces of an economic cycle,” Glenmede portfolio manager Jordan Irving told Yahoo Finance. “The previous decade of low to no inflation and a zero interest rate policy, however, caused a shift in the investment narrative which led to a belief that tech was immune to the conventional macro forces.”

The narrative has been in flux, Irving added, so expect that to continue as inflation and interest rates drive toward some sort of normalization.

“The struggle that investors face today is that inflation may be cooling from its highest levels, but interest rates aren’t,” Irving said. “Should inflation prove stickier than consensus believes and interest rates remain at their current levels, it is likely that investors will question the valuation multiples that are currently being assigned to many tech stocks.”

Nevertheless, there are sectors and companies that are looking solid.

Turrin is “bullish on software as inflation impacts lessen,” including Microsoft (MSFT), Adobe (ADBE), Salesforce (CRM), and ServiceNow (NOW).

And it won’t just be the biggest names in tech that stand to benefit.

“There are many small to mid-cap companies in software and semiconductors that offer compelling opportunities at their current valuations while money flows gravitate to the mega caps,” Irving said.

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Allie Garfinkle is a Senior Tech Reporter at Yahoo Finance. Follow her on Twitter at @agarfinks and on LinkedIn.

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