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The Equity Duration Fugazi

As interest rates have mounted higher over the course of 2022, both equity and bond valuations have come under pressure as financial conditions tighten. Technology stocks in particular have been affected, leading many market participants to believe that tech stocks are more vulnerable in a rising rate environment. To put a neat little bow on the narrative that rising rates will be bad for tech – and more broadly, growth – investors are leaning into the concept of “equity duration.” Duration is the weighted-average life of a bond’s scheduled stream of payments, which approximates how the value of the bond will change in response to a shift in interest rates.

This opinion piece from Institutional Investor debunks the simplistic narrative that bond math works well for equity markets and explains why equity duration shouldn’t be considered a real thing. While it is a reasonable theory that companies expecting to generate a greater share of their earnings in the future should have valuations that are more sensitive to changes in interest rates (relative to companies generating greater cashflows today), this theory breaks down when considering that the underlying stream of corporate earnings does not respond consistently to interest rate changes, and does not have a set maturity date. The author of the article further elaborates on this by stating that “S&P 500 tech earnings are less sensitive to changes in interest rates than are overall S&P 500 earnings because tech companies have just over half the debt financing that the index ex-tech does, and because the two companies that account for nearly half of the sector market cap, Apple and Microsoft, do not sell big-ticket items that their customers have to finance.”

The second fatal flaw in the equity duration narrative, and arguably the most important (to Viewpoint, at least), is that the empirical data doesn’t support this narrative: besides the recent example of the COVID-19 pandemic when tech stocks exhibited a negative correlation with interest rates, the empirical data does not support the theory that “over the 32 years that sector price indexes have been constructed in accordance with Global Industry Classification Standard (GICS) sector classifications, tech returns have exhibited a weak positive correlation with interest rates.” This weak positive correlation suggests that tech stocks have performed slightly better when rates are rising. However, the bigger takeaway is that interest rates have no empirical explanatory power over the relative return of tech stocks. Therefore, investors should be suspicious of their recency bias conflating correlation with causation, as the equity duration narrative and the vulnerability of tech stocks in a higher interest rate environment may be a fugazi (a fake).