Software leaders ServiceNow(NYSE: NOW), Snowflake(NYSE: SNOW), and UiPath(NYSE: PATH) rallied on Friday, up 3.1%, 3.7%, and 4.4%, respectively, in the day's trading.
There wasn't any company-specific news today on these three enterprise software leaders. However, today's solid jobs report, in combination with still-dovish commentary from Federal Reserve officials, sent each stock soaring.
Software stocks to benefit from a soft landing
The past few years of rising interest rates have generally been difficult for software stocks. While ServiceNow has impressively managed to buck the trend and recover strongly after 2022's downturn, Snowflake and UiPath are still down 62% and 76% over the past three years, respectively.
Interest rates have had a lot to do with it. When the post-pandemic inflation took off and the Federal Reserve raised interest rates, it hit software stocks in a number of ways.
First, rapidly raising interest rates caused companies, fearing a downturn, to pull back on software spending, especially since there had been a huge amount of software adoption during the pandemic. Second, rising rates also disproportionally hurt software stock valuations, as software stocks tended to trade at very high multiples of earnings or sales. Rising rates lower the present value of earnings far out in the future, which hurt high-multiple stocks like software. So, software stocks were hit by a "double whammy" of slowing growth and sharply discounted valuations.
What could reverse the trend? Well, a "soft landing" in which inflation and interest rates come down without a recession would be the ideal scenario. Increased confidence and hiring could spur more software "seat" subscriptions or, in the case of Snowflake's pay-as-you-go model, more consumption of computing. Meanwhile, lower interest rates would lift valuations.
Inflation has been coming down recently, which spurred the Federal Reserve to cut the federal funds rate by 50 basis points last month on Sept. 18. Yet while some had thought lower inflation might go hand in hand with a slowing economy, today's September jobs report blew away expectations, with 254,000 jobs added, far above the 150,000 forecast and up from a revised 159,000 jobs added in August.
Solid job growth and lower interest rates is the ideal environment for stocks generally, but especially the rate-sensitive software sector.
Of course, the hot jobs report could mean that inflation may not be subdued yet, and could keep rates high. But Federal Reserve governor Austan Goolsbee, appearing on Bloomberg TV today, said the strong jobs report doesn't mean inflation is going up. He still sees inflation getting back to the Fed's 2% target and also declared no change in the outlook for continued interest rate cuts over the next 12 to 18 months.
The next issue for software: AI disruption
While the interest rate and economic picture looks terrific for software stocks now, there are still a few issues to consider. First, while interest rates are likely to get back to a "neutral" rate soon, they aren't likely going all the way back to pandemic-era low levels. So, one shouldn't expect software companies to reattain the inflated valuations they saw in 2020 and 2021.
Furthermore, the AI revolution has the potential to benefit or disrupt certain software companies. ServiceNow has done quite well as it serves at the nexus of companies' private on-premises data and the outside cloud, and can therefore serve as a manager of enterprises' AI while also incorporating outside LLMs. Interestingly, UiPath and Snowflake are more cloud-based, and while they have been posting growth, they haven't been benefiting as much from AI -- at least not yet.
So while the interest rate picture is getting much better for software, investors will have to be choosy on which stocks will have AI as a value-add and which might see increased competition from the AI revolution.
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Billy Duberstein and/or his clients have no positions in any of the stocks mentioned. The Motley Fool has positions in and recommends ServiceNow, Snowflake, and UiPath. The Motley Fool has a disclosure policy.
