Tech sector

Autumn storms in the tech sector

Exaggerated share price levels in the US tech sector have been somewhat mitigated by a sharp correction. But this is unlikely to be a major turning point. The prevailing environment of negative real returns and structural drivers such as digitalisation and automation may well continue to boost the appeal of this equity segment for investors.

It happened all of a sudden: At the start of September, the Nasdaq Composite index plunged by 10 per cent in just three days following a run that had seen its value increase by three quarters since March. Certain individual shares suffered even bigger losses, but had also previously generated even greater gains. The share price of electric vehicle manufacturer Tesla, for example, had increased sevenfold since March but then collapsed by more than a third within a few days. Is this correction only a passing autumn storm or a harbinger of a major downturn?

Correction puts an end to marked outperformance of tech stocks

Indexed performance since 1 January 2020
Correction puts an end to marked outperformance of tech stocks
Source: Bloomberg, as at 10 September 2020.

Union Investment’s analysts expect that technology shares will generally remain well supported and that this was not a fundamental change of direction leading to repricing but rather just the market ‘letting off some steam’. However, prices are now unlikely to keep rocketing upward on the same linear trajectory as in the past few months. Instead, they will probably rise at a more moderate pace in an environment of greater volatility. Uncertainty about the further course of the pandemic remains high, after all, which is putting a damper on economic growth. In addition, government support measures in the US have expired and Congress has so far been unable to agree on a fiscal package. The upcoming US presidential elections on 3 November could also trigger volatility in the market, for example if the trade dispute with China starts to heat up again.

Not a bubble on the brink of bursting

bubble on the brink of bursting, like the dot-com bubble twenty years ago. Three factors suggest that the setback in prices will be limited and that tech stocks could remain attractive for investors with a long-term horizon.

  • Firstly, most of the large-cap companies that have recently been recording disproportionately large gains in the equity market are highly profitable and generate large amounts of cash. Companies from the software and e-commerce sectors have been reporting surprisingly strong results even during the coronavirus crisis. The business models of these companies are not built on sand; they have proven successful over years, if not decades, and the companies are benefiting from a dominant market position and (in some cases global) economies of scale.

  • Secondly, the coronavirus crisis has actually generated an additional tailwind for these companies. The digital transformation of the economy has accelerated further as a result of the pandemic. The shift from physical retail shopping towards online sales is benefiting e-commerce companies and payment service providers. Rising cost and efficiency pressures are fuelling automation. And the need to be able to access applications remotely, e.g. when working from home or using e-learning services, is driving up demand for computing power, data analysis and data processing, and is increasing data centre and data transmission capacity. These structural trends will probably persist beyond the coronavirus crisis and extend to more and more parts of the economy, such as the industrial sector.

  • Thirdly, the environment of low interest rates is making it challenging to invest profitably. And due to the pandemic, interest rates will remain low for much longer than initially expected. The US Federal Reserve, for example, has now incorporated a higher tolerance to inflation into its monetary policy strategy. Increases in the key interest rate are therefore fairly unlikely in the coming years. Real returns, i.e. returns after adjustment for inflation, will also remain very low, if not negative, for the time being. This could drive investors on the hunt for returns towards risk assets such as equities, which – in turn – puts the spotlight on companies with stable business models and solid balance sheets. Add to that the prospect of further growth due to expanding end markets, as is the case for many software, semiconductor and e-commerce providers, and you have a proposition for which many investors appear willing to pay a premium.

This phenomenon first became apparent in the 1960s and early 70s. At the time, fifty large-cap stocks (the ‘nifty fifty’) substantially outperformed the wider market for several years amid significant geopolitical uncertainty, weak economic growth and low real returns. They achieved this thanks to their ability to generate robust and reliably predictable profits. When inflation began to rise, their winning streak eventually came to an end for a variety of reasons.

Expectation of rising profits

The fundamental drivers in the technology sector thus remain intact. The strong performance of tech shares means that the markets have already priced in a significant rise in profits. This is happening because the companies in question have been meeting, or even beating, expectations despite the coronavirus crisis. But taking profits on selected positions and shifting to a slightly more balanced weighting of tech stocks in the portfolio might also be worth considering. And last but not least, constant monitoring will be required in order to assess whether the underlying profit drivers remain intact and how the pandemic is evolving.

 

As at 11 September 2020