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How Tech Sector Fares as Fed Turns Hawkish

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Yesterday, the Fed raised rates by 0.75%, 25 basis points (bps) higher than indicated earlier, although analysts had been out there talking about the need for a 75 bp (or higher) increase. The 41-year high inflation rate (from Friday’s report) likely decided things for them.

The Fed is essentially trying to protect the consumer and the job market, because those are the two pieces that can prevent -- or at least stall -- a slide into recession, as further rate hikes are announced. Powell said that a 50-75 bp hike would be announced after the FOMC meeting scheduled for July 26-27, although this could change depending on where the economy is at that point. The total hike slated for the year is 1.75%.

Inflation is still expected to be 5.2% by the end of the year, but go down to 2.6% by the end of 2023. The unemployment rate is expected to increase only slightly through this period and remain under 4% at the end of next year.

The whole idea is that as the cost of borrowing increases (currently targeted at 1.50% to 1.75%), so will the cost of production, and therefore, consumption. This will turn consumers away, and voila, prices will start to come down.

Of course, if the situation persists, and they can’t pass increasing cost to consumers, producers will start to make less, and will therefore, buy less, employ less and send the economy into a recession. So, the goal has to be to stop the process before this happens. It's tricky because there is a lag between Fed actions and their repercussions.

As may be expected, GDP growth expectations for the year were also lowered. The U.S. economy is currently expected to grow 1.7% this year, down from the 2.8% growth expected just three months ago. The targeted short-term borrowing cost is 1.50% to 1.75%.

Growth stocks typically suffer the most when there are rising interest rates or a recession. That’s because they trade on the expectation of relatively higher future growth. Uncertainty in the economy hits these future projections, sending them further down than other stocks. Since most technology stocks are also growth stocks, the whole sector gets quite a walloping.

Looking at aggregate numbers and financial ratios for the sector at large reveals much. And so we see that despite the sector’s cost of goods sold (input cost) continuing to increase through 2021 and the first part of 2022 (barring the last two quarters when there was slight moderation), its gross margin has continued to expand throughout.

This would be because of higher selling prices or higher volumes sold, or a combination of the two. The net margin has also expanded similarly, although slightly impacted by higher depreciation and interest expenses.

However, it is interesting to note that the sector’s cash per share continues to shrink. Since it is not because of declining profits (as seen above), it must be because of increased investment in assets. Going by the sharp increase in the tangible book value per share in the last quarter, we can tell that there is an increase in either inventory or fixed assets.

As far as fixed assets are concerned, the return on assets has increased steadily throughout the period and dipped only slightly in the last quarter (explained by the decline in net income).

As far as inventories are concerned, the inventory turnover ratio dropped sharply in the last quarter, and including the improvement in the December quarter, one still sees a declining trend. This seems to indicate the accumulation of inventories. This would happen if volume sales declined or if the value of fresh inventory increased.

The strong gross margin would not normally indicate that volumes have weakened. But more valuable inventory builds seem like a strong possibility. For example, if semiconductor inventories increased and if producers were getting good prices for them, the value of inventory would increase, lowering the inventory turnover ratio.

Overall, this means that imbalances could be improving in the technology sector even as the demand outlook weakens, which is not a great incentive to invest. Even if valuations are attractive.

That said, some stocks are better than others because their growth outlooks are not as weak. For example, electronics manufacturing services providers Celestica, Inc. (CLS - Free Report) and Sanmina Corp. (SANM - Free Report) , electronic component provider CTS Corp. (CTS - Free Report) , and analog and mixed signal semiconductor providers MaxLinear, Inc. (MXL - Free Report) and ON Semiconductor Corp. (ON - Free Report) are a few examples.

A number of factors make these stocks attractive. Apart from the Zacks #2 (Buy) ranks and value-growth-momentum (VGM) scores of A that they share, they all belong in the top 50% of Zacks-ranked industries, which means that they have a good chance of appreciation over the next month or so.

What’s more, Celestica’s estimates for 2022 and 2023 have increased a respective 7 cents (4.3%) and 8 cents (4.6%) in the last 60 days.

Sanmina’s estimates have increased a respective 35 cents (8.4%) and 22 cents (5.0%) in the last 60 days.

CTS Corp’s have increased 27 cents (12.6%) and 25 cents (10.9%), respectively.

Analysts have raised MaxLinear’s estimates a respective 36 cents (9.7%) and 43 cents (10.9%).

And finally, ON Semiconductor’s estimates have risen 73 cents (17.5%) and 48 cents (10.8%).

So not all tech is the same and if you choose wisely, you may still be able to make some money. Rate hikes notwithstanding.

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