While global equities rose overall in the first quarter of the year, investor preferences shifted away from information technology (IT) companies and market volatility increased in the face of four key factors: elevated valuations; rising interest rates; increased inflation expectations; and a rotation into “reopening” sectors expected to benefit from an improving COVID-19 vaccination trajectory.
IT sector valuation had been elevated in absolute terms early in 2021 but appears more reasonable to us now in relative terms following the recent period of selling pressure. We also believe that the sector likely should command a valuation premium to the broader market given the improving quality of companies within the space—e.g., a growing number of recurring revenue sources, strong balance sheets and strong overall EBITDA1 margins—and their growth characteristics. We believe the sector offers solid exposure to strong secular opportunities relating to the digital transformation (DT) theme, which we believe is just getting started, and also could prove a solid cyclical winner with high leverage to post-pandemic reopening and infrastructure investment activity.
We remain focused on the big theme of DT, which is about using software and data to better understand customers and business processes and technology to radically transform how businesses work. We believe DT represents a multi-trillion dollar opportunity that is still in its early days. While the pandemic shone a bright light on our thesis, we do not think that this opportunity is over.
Even as people begin to get vaccinated and economic conditions return to normal, we expect enterprises to use the years ahead to evaluate what did and did not work during the crisis, scale what did work, abandon what didn’t and continue to progress or evolve in their digital journeys. Customers have also learned new behaviors related to the digitization of previously in-person activities, which we think will be enduring. Simply put, we believe we are at the beginning of what is possible as consumer experiences and businesses digitize, and we foresee a multitude of potential investment opportunities in the years ahead.
Impact of Rising Interest Rates on the Tech Sector
Over the past quarter, investors weighed continued optimism around policy stimulus and economic reopening against concerns about higher bond yields and potential economic overheating. Credit markets influenced stock markets for much of the quarter, with the 10-year US Treasury note’s yield finishing near its highest levels in more than a year amidst rising inflation expectations and improving macro prospects.
Increases in interest rates potentially represent headwinds to long-term growth sectors like technology, where much of the earnings power comes many years down the road. However, we believe that if rates are rising for the “right reasons”—specifically, an improving economic backdrop—they likely also foretell sustained investment in technology and growth by enterprises that are seeing their own business prospects improving. In addition, the IT sector is net cash positive, suggesting that it will not likely face the interest-expense headwinds that other sectors might face as they are forced to refinance their debt. We believe the sector is likely to grow much faster than inflation, having pricing power (owing to its leverage to productivity) and is also asset-light, which represent balancing factors. As such, we believe that the sector’s fundamentals should hold up well in an inflationary environment.
Some of the decline in technology names has been attributed to investors rotating out of technology winners from last year and into names that are expected to benefit from expanded infrastructure spending. It is our view that technology has become both a secular and cyclical growth area of the market. Secular growth supported by the long-term trend of digital transformation, but on the cyclical side, enterprises and consumers spend more on technology when their prospects are improving. Over the last 50 years, spending on technology equipment, software and research and development has grown to exceed 50% of all total private fixed investment, according to the US Chamber of Commerce.2
Some examples we see of infrastructure spending impacting tech include benefits to suppliers of components for chargers and vehicle systems, and communications equipment companies, both wired and wireless, benefiting from a push for more broadband access. Any technology spend is going to benefit chip suppliers as well—while this space is already seeing supply constraints, we anticipate that work will be done to ramp up domestic production over the next year.
Risks we are monitoring still include COVID-19, as variant strains and relaxed social-distancing measures stoke the potential for renewed outbreaks and community lockdowns. With vaccines now being aggressively deployed, we believe enterprises are starting to feel more confident about their prospects and will subsequently invest more in all things tech.
The US-China trade situation represents another potential risk. With US President Joe Biden in the early days of his administration, we have yet to hear a detailed China trade strategy. That said, it appears the administration is holding the line on what the prior Trump administration secured, while also offering an olive branch for engagement. We have also been surprised by the assertiveness with which Beijing has sought to exert more control over China’s big tech companies, including Alibaba.
We also are keeping a close eye on the regulatory environment in general, particularly in the United States and European Union, where investigations into the business practices of key digital leaders have involved Alphabet, Amazon, Facebook and Apple.
Despite potential headwinds, and the recent volatility, we are very optimistic on the long-term prospects for the technology sector. We continue to see opportunities in areas like application software, semiconductors, and systems software—areas of the market which contain many quality businesses that have secular growth opportunities related to digital transformation, largely by providing the tools and services companies need to update their products and processes to a more data intensive, digital format. While there is the potential for short term market dislocations along the way, we see digital transformation and its sub themes as enduring through an economic recovery.
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1. EBITDA = earnings before interest, taxes, depreciation and amortization.
2. Sources: Bloomberg, US Chamber of Commerce, data as of August 17, 2020.