S&P/ASX 200 Index (ASX: XJO) tech shares have caught a bid on Thursday as risk sentiment shifts between various asset classes following US inflation data overnight.
Consumer prices for the month of July remained largely unchanged from the previous month, thanks to a wind back in gasoline prices.
Following the update, ASX shares have advanced today, prompting high growth and technology stocks to rally the most.
Both the S&P/ASX 200 Information Technology Index (ASX: XIJ) and the S&P/ASX All Technology Index (ASX: XTX) are leading sectors in the session, with the latter today's top gainer.
However, global inflation is still at multi-decade highs, and the US still recorded an 8.5% year on year gain in the consumer price index (CPI) for July.
Why the shift in tone from investors then?
Whilst the raw data is still concerning, it appears as if investors are optimistic about what the flat CPI print means for the future of risk-assets like stocks.
As Randy Frederick, VP of trading and derivatives at Charles Schwab said in a note from yesterday, "8.5% if still very high, but there is optimism that perhaps June was the peak".
Perhaps more importantly, is what a reduction in headline inflation actually means for the real economy, and for us as investors.
If we just rewind for a second – central banks are the ones typically tasked with curbing inflation. One of the Reserve Bank of Australia (RBA)'s core functions, for instance, is to maintain inflation within a level of 2–3%.
However, central banks also have no direct influence on productivity, output, or things like business efficiency for instance – all factors that impact price stability.
Instead, they use monetary policy, that is, setting key policy interest rates to influence the level of aggregate demand and supply within the economy.
Put simply, using Australia as an example, if inflation begins to rise beyond 2-3%, the RBA will lift its key interest rates.
This is called monetary tightening, and the interest rate in question is called the 'cash rate' in Australia.
This ideally results in a pullback to flows of credit and money, whilst also influencing the cost of capital investment. Beauty, inflation sorted! (although, and of course, it's not so simple). Alas, the RBA has done this several times in the past with success.
As such, and in reality, these moves from central banks have reigned in soaring global inflation on numerous occasions over the past 100 years.
There does exist, a key tradeoff, however.
With each increase in base interest rates, the probability of the country entering into an economic recession increases as well.
That's because, typically, in order to wind back surging producer and consumer prices, market forces must also be willing to accept this.
By lifting base interest rates, central banks also increase the cost of obtaining credit (business financing, overdrafts, etc.) and the cost of servicing existing debt, leaving less free cash flow available for discretionary purposes or business expansion, ultimately reducing the level of economic activity.
So with rising inflation also comes the prospect of rising interest rates that spell trouble for the real economy in terms of GDP and economic growth.
Therefore, investors see a potential cooling inflation as a signal that central banks may be less aggressive in their tightening regimes, thereby reducing the chance (or severity) of potential economic recession.
It might seem farfetched, but it is completely logical for sophisticated investors and money managers to position for 'where the puck is going', not where it came from. We don't get paid from the past, or from what's already happened, that's for sure.
Mike Owens, trader at Saxo Markets, agreed in a note from yesterday. "The sign of slowing in the rate of inflation offers hope the Fed's rate increases won't need to go as far as previously thought," he said.
This is what's happened overnight, and the yields on US Treasury notes – often served as a proxy for risk sentiment – also receded.
As such, technology shares, whose valuations are sensitive to changes in Treasury yields, have advanced in today's session as the US 10-year yield contracted sharply overnight.
The strength has continued into the Australian session and the result has been an uptick in ASX 200 tech shares.
The upside has been especially generous to beaten down tech names such as Block Inc (ASX: SQ2), Wisetech Global Ltd (ASX: WTC) and Xero Limited (ASX: XRO), who've each secured a bid today.
As to how far this turnaround-tech-rally can last, only the market will decide, and it's been anyone's guess as to what direction it will head next this year.
