GF Securities: Was the burst of the previous science and technology bubble caused by the Fed raising interest rates?

Since March of this year, with the changes in the US-Iran situation and the change in the Chairman of the Federal Reserve, the US interest rate hike expectations have been fluctuating, disturbing global markets. Earlier, we discussed the impact of the Federal Reserve's interest rate hikes in several reports. However, during the recent roadshow, we still felt a lot of concerns about the Federal Reserve's interest rate hikes, especially the impact on technology stocks. We have observed that the reason why this lingering concern has not subsided is because of a common first impression of many people: the last tech bubble was burst by the Federal Reserve's interest rate hikes. Is this really the case? We believe it is necessary to once again break down the detailed situation of 1999-2000. This type of review is not meant to compare the current AI with the experience of the 1999 tech bubble, as there are too many differences in the external environment, and no historical situation can be completely replicated. This article aims to use this classic case to prove, from a first-principles perspective, how interest rate hikes, liquidity contraction, and rising interest rates actually affect the booming tech stocks industry. 1. The interest rate hike path and background starting in 1999: Interest rate hikes began in February 1999 Following the end of the Asia Financial crisis (three consecutive interest rate cuts totaling 75 basis points by the Federal Reserve in September-November 1998), the global deflation cycle reversed, and commodity prices began to rise. In addition, at the beginning of 1999, OPEC and non-OPEC countries agreed to reduce production, in addition to the outbreak of the Kosovo war (March-June 1999), threatening transportation in the Balkans and the Mediterranean. The market was concerned about supply disruptions, causing oil prices to skyrocket from $10 per barrel to over $30 per barrel. At this time, the US CPI inflation also rose rapidly, and in June 1999, the Federal Reserve re-entered an interest rate hike cycle, raising the federal funds rate from 4.75% to 6.5% by May 2000. The approximate timeline is as follows: - In the interest rate meetings in February-March 1999, the Federal Reserve did not give a clear signal for rate hikes, but they expressed concerns about inflation risks and discussed the rationale for the current loose monetary policy. - In the May 1999 interest rate meeting, the Federal Reserve basically confirmed that they would start raising rates in the future, leading to a short-term adjustment of around 8% in the Nasdaq index, followed by a continued upward trend. - In June 1999, the Federal Reserve officially started the rate hike cycle, with no significant adjustments in the Nasdaq, continuing its upward trend. - In August 1999, the Federal Reserve raised rates for the second time, with no significant adjustments in the Nasdaq, continuing its upward trend. - In November 1999, the Federal Reserve raised rates for the third time, with no significant adjustments in the Nasdaq, continuing its upward trend. - In February 2000, the Federal Reserve raised rates for the fourth time, with no significant adjustments in the Nasdaq, continuing its upward trend. - In March 2000, the Federal Reserve raised rates for the fifth time, and the Nasdaq had already reached the peak of the tech bubble by this point. From the first rate hike by the Federal Reserve to the peak of the bubble, the Nasdaq had accumulated a gain of over 90%. - In May 2000, the Federal Reserve raised rates for the last time, with a 50 basis point increase, totaling an increase of 175 basis points in the rate hike cycle. 2. From the moment the rate hike cycle began in May 1999, the Dow Jones index was suppressed first and peaked well before the tech bubble The Dow Jones Industrial Average was suppressed due to high oil prices and rate hikes in Q3 of 1999, had a brief rally in Q4 before peaking in January 2000. In other words, from the moment the Federal Reserve's interest rate meeting in May 1999 signaled the beginning of a rate hike cycle, the Dow Jones entered a period of volatility. From a pricing logic perspective, this indicates two issues: 1. For sectors with general demand, facing high interest rates (financing costs) and high oil prices, the fundamental aspects may face more pressure (compared to industries with demand surges). 2. For companies with relatively stable profit cycles, pricing considerations often take into account long-term cash flow discount models. When interest rates and oil prices increase, these companies' valuations tend to be suppressed. Therefore, for the Dow Jones index, which had a slow growth rate at the time (EPS compound growth rate of around 3% in 1998-1999), even if the valuation was not expensive, it was the first to face the pressure of rate hikes. 3. However, with the Federal Reserve's first four rate hikes starting in June 1999, the Nasdaq rose by over 90% From the first rate hike by the Federal Reserve in June 1999 until the tech bubble peaked in March 2000, the Nasdaq increased by 91%, with the peak of the index lagging the rate hikes by 9 months. This also illustrates several points: 1. When there is a demand surge, although rate hikes may have some impact, companies will not be too concerned about the increase in interest rates (financing costs) and it may not be a core part of business decision-making. 2. For companies with short-term performance surges, investors are aware that this kind of surge is likely to last for 2-3 years, rather than 5-10 years. Therefore, the short-term EPS and cash flow cannot be discounted based on the interest rate, and therefore, from a pricing perspective, the interest rate increase may not have much impact. 3. When rate hikes lead to liquidity tightening, investors may choose to sell slow-growing or non-growing companies first and focus on a few industries with strong growth potential. Therefore, when the NASDAQ 100 index's EPS growth rate increased from 15% in 1998 to 60% in 1999, even though the index's PE valuation was static at 55X and dynamic at 45X in 1998, during the period of continuous rate hikes by the Federal Reserve, the valuation actually increased significantly. 4. What factors drove the performance surge of the Nasdaq in 1999? In the early stages of the tech market boom around 1995, the Nasdaq 100 index's growth rate gradually increased, but remained in the range of 20-30%. During 1997-1998, the fundamentals of tech giants had declined, but the surge in orders brought about by Y2K expectations created a "brief prosperity" for companies in 1998-1999. Y2K, known as the "millennium bug" turnover wave, created expectations of an unprecedented surge in orders due to the risk of a massive network failure if servers, systems, and PCs were not upgraded to the latest versions by the arrival of the year 2000. Under policies from agencies such as the OCC, FDA, and Department of Defense prioritizing the repair of system bugs, global governments and companies embarked on a "panic buying" spree for old servers, mainframes, personal PCs, and software operating systems in 1998-1999, igniting a capital expenditure frenzy ignited by the switch to newer devices. As a result, the performance of many software and hardware companies surged again, propelling the Nasdaq 100 index's EPS growth to 60% in 1999, the fastest pace in the 1990s. 5. If it wasnt rate hikes, what burst the bubble? The capital expenditure surge brought about by Y2K not only helped the Nasdaq withstand consecutive rate hikes starting in 1999 but also created the biggest tech bubble in history. However, it was a double-edged sword. The Y2K crisis in 2000 did not materialize as anticipated, and the pre-deployment of hardware purchases overdrew future demand, making it difficult to sustain future capital expenditure on hardware. During the period from 1998 to 1999, global companies pre-emptively resorted to capital expenditures in their information technology departments in order to preemptively address potential system outages caused by the Y2K date coding issue. However, when 2000 arrived, it appeared that the Y2K issue was not as severe as thought, leading to a decline in demand for technology equipment. Companies like Dell, HP, and IBM faced shrinking orders, increased inventory pressures, and the global semiconductor industry reached historically high inventory levels by the end of 2000. In addition, in the first quarter of 2000, the tech industry and core companies faced a series of negative signals: - Starting in February-March 2000, the US media extensively covered the Department of Justice's antitrust charges against Microsoft, with significant evidence suggesting that Microsoft's monopolistic behavior was established, negatively affecting market sentiment. - Financial reports from March 2000 showed poor sales performance of tech products during the 1999 holiday season. - Microsoft's financial report in April revealed lower-than-expected revenue and a slowdown in PC market growth was expected, IBM's first-quarter financial report in April also showed lower-than-expected revenue. Several previously successful tech companies went bankrupt during this period (such as luxury fashion e-commerce platform Boo.com, online news platform APB Online, and online retailer Value America). Ultimately, the EPS growth rate of the Nasdaq 100 index plummeted from 60% in 1999 to just 12% in 2000. 6. Returning to the present, if fears of a US recession have been triggered by rate hike expectations, AI may also not be spared In the current situation of AI, apart from changes in AI demand itself, if fears of a US recession arise due to rate hike expectations, concerns about the impact of a recession on the traditional core businesses of US CSP cloud giants may further affect cash flow and future capital expenditure capabilities, ultimately affecting the demand for computing power as a whole. Around April 2025, during the global market's trading of US recession expectations, sectors such as GPUs, optical modules, and PCBs all experienced a significant downturn in recent years. But should concerns about a potential recession due to rate hike expectations not be exaggerated? A typical example is the years 2022-2023, which faced high oil prices (due to the Russia-Ukraine war) and high inflation, where the Federal Reserve executed the fastest rate hikes in history. At that time, most investors believed that the US would experience a recession in 2022-2024. However, additional fiscal expansion policies such as the three major bills offset the effects of rising interest rates. In the current environment, many economies around the world show signs of monetary policy tightening or have already started tightening, but major economies still employ very proactive fiscal policies, ensuring relative stability in traditional demand. During war crises in history, only when war led to sustained and significant spikes in oil prices, combined with the US economy being in a fragile state at the end of an expansion, high inflation, and entering a rate hike cycle, would an official recession be triggered. If the impact of war on oil prices was short-lived and there were many fundamental driving factors, even during a rate hike cycle, a recession may not necessarily be triggered. Meanwhile, the characteristics of the US economy since the pandemic have been, No obvious recession on the downside, no strong recovery on the upside, with support elements undergoing several rounds of switching DRIVES, but have not shown signs of widespread overheating. No spikes, no crashes. If the US economy is at a high point in a cyclical peak, with all indicators in a state of overheating, then facing high oil prices, high inflation, and rate hike expectations, it could be more dangerous. Currently, the support for the US economy comes from resilient consumption and high growth in AI investments, as well as the possibility of fiscal stimulus under the political cycle. Looking forward, growth momentum may slow down, but concerns about a recession are premature. 7. Otherwise, there is no need to fear rate hikes, as the core issue still lies in the AI industry itself In fact, the best way to resist rate hikes, rising interest rates, and liquidity contraction is through a rapid surge in demand on the demand side. Several instances in the history of the A-share and US stock markets have proven this, where industries have experienced surges with liquidity contraction. Lastly, a sharp question remains - if rate hikes lead to an increase in financing costs, will this affect the capital expenditures of CSP and cloud giants? This seems to also depend on the demand for the AI industry itself. If the capital expenditure is primarily driven by FOMO, then the increase in financing costs may be a cause for concern among the big players. However, if it is sustained explosive cloud service orders and demand, would the big players slow down their capital expenditures due to a 25 basis point increase in financing rates? In the first two decades of the 21st century, did Chinese people refrain from buying houses because of high-interest rates? Source: WeChat official account Morningstars Strategic Thoughts, Author: GF Strategy Team, GMTEight Editor: Andy Chen