US/China trade friction is symptomatic of a deeper confrontation that has technology at its core, say Richard Clode, Alison Porter and Graeme Clark, Global Technology Portfolio Managers. The pathway to a denouement and the direction of the yield curve should shape global technology equity markets in 2019.
What are the key themes likely to shape markets in 2019?
The benefits of US tax reform were a key highlight of 2018 but with US mid-terms now out of the way and a divided House and Senate hampering Trump’s domestic agenda going forward, markets should now focus on any signs of an impending global recession, the yield curve trajectory and geopolitics.
While markets tend to focus on escalating trade friction, we see that as merely a symptom of a deeper root issue. We believe the rising tensions between today’s global superpowers, the US and China, are much broader and have technology and the control of intellectual property (IP) at their core. As we reach an inflection point in artificial intelligence, technology and national security become ever more intertwined. We view Trump’s desire to protect US technology IP as a key pillar of his current policies, manifesting itself not just in trade tariffs but also tighter controls on the export and transfer of US technology IP. On the other side, for exactly the same reasons, developing their domestic technology industry is a core part of China’s 2025 targets. Consequently, we do not believe a resolution of these tensions is likely short term. This creates risk as tensions escalate, especially for an industry like technology with a global supply chain, albeit one that – with scale and maturity – is much more flexible than it was in the past.
The treasury yield ‘break-out’ of September 2018 - which saw yields on 10-year US Treasury bonds reach a seven-year high having traded in a range for much of the year - finally put pressure on extreme valuation, high-duration stocks, notably some technology names that had performed well for most of the year as they were more insulated from rising trade tensions. We are currently at an impasse as these stocks remain very highly valued despite the sell-off, but we have yet to see the long-forecasted meaningful rotation from growth to value really take hold given cyclical trade tension and China slowdown-related pressures. Heading into 2019, which way this impasse breaks will be key to the direction of markets and will be defined by the yield curve trajectory and the impact of China stimulus from late 2018.
Where do you see the most important opportunities and risks within your asset class?
With more than half the world now online and accessible anytime, anywhere via smartphones and able to pay digitally, and with cloud infrastructure enabling companies to scale faster and at lower cost than ever before and artificial intelligence enabling the next wave of disruption, technology should continue to take a bigger share of the global economy. 2019 should see further validation of the prospects for technology to disrupt new industries, with the launch of a commercial autonomous ride-hailing platform by Waymo in the US and the potential initial public offering (IPO) of the world’s highest-valued private unicorn, Ant Financial, a title earned having already massively disrupted financial services in China. In addition, we are already seeing the first wave of 5G investment, which will accelerate in 2019 as the infrastructure for Internet of Things (IoT) develops over the next decade. We will continue to provide clients with exposure to these exciting growth themes, but overlaid with our proprietary and unique ‘navigating the hype cycle’ investment philosophy providing valuation discipline and risk awareness to try to reduce the volatility of returns. With interest rates finally normalising after almost a decade of quantitative easing (QE), we believe our valuation discipline will be all the more relevant going forward.
As we head into 2019, while the multiple secular growth trends of technology are very much intact - and in some cases accelerating - we are seeing some natural moderation in other areas. Hyperscaler cloud capital expenditure in 2018 was exceptionally strong and we believe will result in some digestion in 2019 despite ongoing strength in cloud adoption. The tailwind of US tax reform drove strong enterprise information technology (IT) spending for the first time in a decade, benefiting more mature areas of technology like PCs, servers and networks. We expect that to naturally tail off through 2019. Regulation will remain a headwind for the technology sector, but the landmark implementation of GDPR in the EU in May 2018 provides a much clearer framework for which to assess regulatory risk and makes it more manageable in our opinion.
How have your experiences in 2018 shifted your approach or outlook for 2019?
2018 saw a widening bifurcation in performance between growth and value, even within the technology sector, leading to the largest gap in performance between these two styles in more than a decade. Cheap money and growing cyclical concerns as China slowed and trade tensions escalated led to investors hiding in an ever-narrower group of companies; predominantly in domestic US-focused growth software and internet. Scant regard was paid to the valuation of these companies. It took the break-out of US Treasury yields in September to finally remind investors that some of these valuations were too extreme. Our valuation discipline precluded us from buying some of these names, even if we do continue to hold many higher-valued technology companies. While that led to some relative performance pain through the first three quarters of 2018, the sharp sell-off of those extreme valuation names in October validated our valuation discipline and made us all the more determined not to be seduced by the narrow pockets of overhyped technology stocks as we head into 2019.
Which themes have the potential to redirect markets in 2019? Download our Infographic to find out
Extreme valuation: a stock that is priced very expensively compared to other companies.
Growth investing: an investment approach used when an investor believes a company has strong growth potential and company earnings are expected to grow at an above-average rate compared to the rest of the market.
Value: value investors search for companies that they believe are undervalued by the market, and therefore expect their share price to increase.
Duration: how far a fixed income security is sensitive to a change in interest rates, measured in terms of the weighted average of all the security’s remaining cash flows. It is expressed as the number of years. The larger the duration, the more sensitive it is to a movement in interest rates.
Cyclical: a cyclical company sells discretionary consumer items, such as cars. The prices of equities and bonds issued by cyclical companies tend to be strongly affected by the ups and downs in the overall economy.
Yield curve: a graph that plots the yields of similar quality bonds against their maturities. A yield curve can signal market expectations about a country’s economic direction.
Initial public offering (IPO): when shares in a private company are offered to the public for the first time.
Unicorn: a unicorn is a privately held startup company with a value of over $1bn.
Quantitative easing (QE): an unconventional monetary policy used by central banks to stimulate the economy by boosting the amount of overall money in the banking system.
Capital expenditure: spending on fixed assets such as buildings, machinery, equipment and vehicles in order to increase the capacity or efficiency of a company.
GDPR: the General Data Protection Regulation is a set of EU-wide data protection rules that aim to protect the privacy of individuals.
Cheap money: an environment of low interest rates and plentiful supply of money to borrow from banks.
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