What happened
Shares of high-growth enterprise software stocks Snowflake (SNOW -1.61%), Datadog (DDOG -1.43%), and MongoDB (MDB -0.86%) were falling hard again today -- down 2.9%, 2.7%, and 2.7%, respectively, as of 12:48 p.m. ET -- even as the broader market was up. They were down much more to start the day, before the market roared back into the green on what looks like a short-covering rally.
The relative underperformance can be attributed to, like most things these days, inflation and interest rates. This morning, the Consumer Price Index (CPI) report for September came in hotter than expected for the second month in a row, putting upward pressure on interest rates and pushing down the valuations of high-growth, more expensive software stocks.
In addition, one Wall Street analyst conducted a survey of IT professionals concluding that demand for software investment would weaken in the year ahead.
So what
On Thursday, analysts at Citibank released a recent survey of chief information officers (CIOs) showing a slowdown in the intention to grow IT services. Expectations for IT budget growth came in at 1.8% for this year, down from the 2.2% mark logged in the prior survey in June. Unsurprisingly, much of the weakness came from Europe, which is being battered by steep energy costs and fallout from the Russia-Ukraine war.
The survey came out on the heels of today's CPI report, which showed hotter-than-expected inflation for the second month in a row. The CPI increased 0.4% month over month, above expectations of 0.3%, while the core CPI, which excludes food and energy prices, rose a more problematic 0.6%, above estimates of 0.4%.
The core number was especially disappointing, as this is one of the main inputs the Federal Reserve uses to calculate how much it should raise interest rates. In response, long-term bond yields spiked, with the 10-year Treasury note spiking above 4%, before reverting back below 4% to 3.95% as of this writing.
Expensive growth stocks are some of the most sensitive to long-term rates, as higher interest rates mean future earnings are discounted by a greater amount. With Snowflake, Datadog, and MongoDB trading at high valuations of 30, 19, and 11 times sales, respectively, it's no wonder the inflation report caused these stocks to sell off more than the market, especially when combined with the downbeat CIO survey.
Now what
One silver lining in the Citi survey was that it noted cloud and consumption-based software models would be relative winners, even within an overall slowdown.
That should actually benefit these three companies, as each has some degree of usage-based pricing, as opposed to fixed subscriptions. Snowflake in particular is a 100% consumption-based model, which earns revenue depending on how its customers use the platform. That's an attractive model for cash-strapped customers looking to limit fixed costs and employ more variable cost models.
If the economy does eventually slow or even go into a recession, these types of stocks could actually eventually benefit. That's because a recession would likely spur lower inflation and interest rates and get us back to the pre-pandemic environment. Meanwhile, "mission critical" software like these three would still probably grow, though maybe not as fast as they would otherwise.
However, since inflation has been more persistent than expected, it's really unclear if rates will come back down anytime soon. The higher-rate environment could last for a while, so it may be a good idea own a diversified mix of lower-valued dividend stocks, which may be less affected by higher rates, along with super high-growth names like these three.
