Denny Fish, a tech portfolio manager at Janus Henderson, believes tech’s recent volatility was the result of valuation adjustments as equity markets recalibrate for an era of higher interest rates.
2022 has been a rough year for stock market investors so far. Given the vast sway the technology sector holds over global equity markets, it is little surprise that tech stocks have been a driver of broader market fortunes.
As of February 16, the MSCI All-Country World Index had returned -4.5% year to date, largely weighed down by the tech sector’s 9.4% slide.
Such performance might suggest that tech’s time in the sun has passed. I do not think that is the case. Instead, I believe tech’s recent volatility has been the result of valuation adjustments as equity markets recalibrate for an era of higher interest rates. In fact, I believe that when analysing a company’s fundamentals – what should drive stock performance over the long term – the prospects in much of the sector have improved in recent months.
It is no accident that the tech sector has led markets over the past few years. With growth concerns prevalent during the US-China trade war, and then the Covid-19 pandemic, investors sought growth where they could find it. And in the face of uncertainty, the secular growth themes powered by the products and services of mega-cap tech and internet companies were very much in favour. Many of these themes accelerated during the pandemic as businesses and households increasingly relied upon digital solutions to navigate trying times.
More recently, a resumption of economic activity and supply-chain constraints have led to elevated inflation, and with it, a policy response from central banks. At the end of 2021, futures markets were predicting three interest rate hikes of 25 basis points each by the Federal Reserve in 2022. In the wake of inflation’s persistence, market expectations have now climbed to six hikes. This matters as interest rates directly influence the discount rates used to value riskier asset classes. The impact of higher discount rates is most pronounced in long-duration assets, including the secular growth stocks that have a large share of their value derived from cash flows years in the future.
This is exactly what we have seen in 2022. In aggregate, the price-earnings ratio of the global tech sector has compressed by 13%, year-to-date through to February 15.
Few would doubt loose monetary policy has been a contributor to lofty valuations across financial markets. Understandably, the multiples that investors are willing to pay for a unit of future earnings would fall upon the removal of that largesse. Valuations of tech stocks are no exception. It is worth noting, however, that in some instances, the baby has been thrown out with the bath water.
Stocks within the semiconductor complex and the applications software sector¬, which includes many cloud-computing companies, have experienced some of the most pronounced multiple compression. Yet semiconductor chips and cloud computing are fundamental building blocks of the transition to a more digitised global economy. These themes will not be going away any time soon.
Business models first
Interest rates are a consideration, not a determinant, in tech investing. While acknowledging that the maths underpinning valuations has changed, what has not changed are these companies’ business models. Prospects for the tech sector rest upon its ability to wring out efficiencies across the economy, and in the process, compound earnings growth and command an ever-greater share of aggregate corporate profits. As illustrated in recent earnings results, many sector leaders are still on track.
Over the past three months, full-year 2022 consensus earnings expectations for the global tech sector have been revised upward by 4%. Notably, semiconductor stocks, which have returned -7.3% year to date, have seen the most aggressive upward revisions. Meanwhile, applications software, which can serve as a proxy for cloud computing stocks, have returned roughly -15%, despite full-year earnings prospects nudging upward by 1.9%.
The incongruence between flagging stock prices and bullish earnings estimates indicates that something other than fundamentals is at play in the sector’s recent trajectory. Yes, valuation compression at the hands of higher rates may be painful in the near term, but investors should keep in mind that it is these business models’ ability to execute their strategies over the longer term that matters most in generating attractive returns.
A convergence of secular and cyclical
I believe the resilience of the sector’s earnings is owed to a favourable cyclical backdrop. With inflation threatening to eat into margins or hamper customers’ purchasing power, companies across the economy are looking to improve operational efficiencies. Whereas technology was deployed during the height of the pandemic to maintain front-office operations, we are now seeing companies focus on streamlining back-office functions to maintain profitability. Reflecting this are increasingly optimistic outlooks from an array of software companies.
The prospects of semiconductor producers have improved for different reasons. Progress is being made in fulfilling order books by working through lingering supply-chain disruptions, and pricing remains strong given robust demand for both analog and more complex digital chips.
Driving this hunger is the growing recognition by corporate leaders that the data collection, analysis, machine learning and automation made possible by a proliferation of chips has the potential to continuously improve a company’s operational economics over a mid- to long-term time horizon.
Welcoming the re-rating
Investors seldom welcome elevated volatility. However, the accompanying re-rating of stocks across the tech sector should be viewed in a positive light. Much capital has flowed into the space, pushing up valuations – sometimes indiscriminately. The shift towards monetary tightening has removed support from many unworthy names and, more importantly for disciplined investors, has created attractive entry points for stocks with sound business models that had also seen valuations stretched beyond what fundamentals would merit.
Tech investors should still be mindful of risks. More rate hikes than are already priced into the market could result in additional volatility. They could also tilt the economy toward recession. While that would likely crash the party for cyclical growth tech stocks, secular growers may once again find themselves being one of the few pockets of the market in which longer-term investors can have confidence.
Denny Fish is global technology and innovation portfolio manager at Janus Henderson Investors.
This feature originally appeared in the April 2022 edition of Funds Europe.
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