What happened
Shares of several high-growth fintech stocks rebounded Tuesday after a brutal sell-off last week that was triggered by the Federal Reserve's decision to hike its benchmark interest rate by 75 basis points. The last time it made such a large single-step increase was in 1994.
Shares of the "buy now pay later" (BNPL) company Affirm (AFRM -0.59%) had risen by roughly 12.6% as of 11:11 a.m. ET Tuesday. Artificial intelligence-powered lending tech specialist Upstart (UPST -2.73%) was nearly 12% higher, and shares of Brazilian digital bank Nu Holdings (NU -1.71%) were up by more than 13%.
Image source: Getty Images.
So what
The Federal Open Market Committee (FOMC) decided on its unusually large federal funds rate hike last week after recent government data showed that consumer prices were still rising at a strong pace in May, rebutting the idea that inflation had peaked. The FOMC has made it clear that it is making the fight against inflation its top current priority, but investors are concerned that the moves of an overly hawkish Fed could tip the economy into a recession or a stagflation scenario.
Rising interest rates are bad news for high-growth tech companies because they reduce the value of those companies' future cash flows and earnings power. Higher interest rates also give risk-free and low-risk assets better yields, which makes growth stocks less attractive investments.
For businesses like Affirm and Upstart, there are two main concerns as interest rates rise rapidly: loan quality and funding. Both of them originate consumer loans, so as rates rise, the cost of debt goes up, which can put a strain on consumers' finances. Furthermore, savings rates are on the decline, and consumer loans are usually among the first to go unpaid when a borrower gets into financial trouble.
A recent survey found that 42% of BNPL users had made late payments on at least one BNPL loan. It's hard to imagine this number getting more favorable as interest rates continue to rise. In a recent analysis of Upstart-originated loans, the Kroll Bond Rating Agency said it expected the loss percentage for the lender's next asset-backed securities will be 3 percentage points higher than for the securities the company issued earlier this year.
The other issue is funding. Upstart and Affirm are not banks. Therefore, they are more reliant on external institutional investors to purchase and fund their loans. But as the macroeconomic environment becomes riskier, this funding could dry up, especially if their loss rates continue to creep up. Investors are likely going to demand higher returns for taking on the risk, which will result in higher loan pricing and lower demand, which could cut into the companies' revenues.
Now what
Due to some of these challenges mentioned above, I am not currently interested in investing in Affirm and Upstart.
I also think we will continue to see market volatility in the near term. The Fed does not appear to be even close to finished hiking interest rates, and there still could be much tougher economic conditions ahead, which does not bode well for fintech, although I am of the opinion that if there is a recession, it will not be severe.
I am, however, more bullish on Nu, which has acquired close to 60 million users and significantly disrupted the Latin American banking scene. The company is growing revenue rapidly and has a massive market opportunity.
