While it’s been a difficult start to the year across financial markets, it’s been particularly tough for the technology sector. Rising inflationary pressures and central banks’ evident commitment to rising rates has made some of the bloated valuations in the technology sector difficult to sustain.
However, some of the falls have started to look indiscriminate: could this be an opportunity to pick up a long-term growth sector on the cheap?
Data from Morningstar shows that fears over the impact of war in Ukraine sent markets around 6% lower over the first quarter overall. However, consumer cyclicals and technology were hit particularly hard, down 15.7% and 14.7% respectively. Within consumer cyclicals, it is often the ecommerce names that have been hit hardest – Amazon, for example, is down 19% from its peak, while shares in Just Eat have dropped to less than a third of their value a year ago.
The technology sector is not directly vulnerable to higher inflation in the same way as, say, some industrial companies that are facing higher input prices. While technology companies may be caught up in a general decline in confidence, the main reason for the falls has been a technical one.
As inflationary pressures build, it increases the likelihood of interest rate rises, which in turn affects the value investors place on long-term cash flows. In recent guidance, central banks have redoubled their commitment to rising rates with the Federal Reserve now anticipating six more rate hikes for the year ahead. Only the European Central bank is still holding out.
Disconnect between short-term fears and long-term prospects
Is there a sense that this has gone too far? After all, almost every major trend – from the transition to clean energy, to digitisation, to ecommerce – requires the involvement of technology companies. These trends have often accelerated in the wake of the pandemic.
During 2021, it was clear that investors now viewed technology as a defensive sector, because it is now so integral to the day-to-day operations of governments, businesses and individuals. As such, there may be a disconnect between short-term fears and long-term prospects.
Analysis from Factset on first quarter earnings shows the revenue growth for the technology sector is below the S&P 500 sector average. It’s behind energy, materials, real estate, industrials, healthcare and communication services. Earnings growth is also slower than a range of other sectors, even utilities. To give some context, materials and real estate have seen revenue growth of around 19% for the quarter, against 10% for technology and 10.8% for the S&P 500 as a whole.
The projections for the second quarter are similarly weak – information technology is behind the S&P 500 average in terms of forward earnings and revenue growth. There is a chance its relative position might change if it proves less vulnerable to the knock-on effects of the Ukraine crisis, but it may still struggle if rising inflation hits consumers and businesses’ propensity to spend.
At the same time, valuations for technology companies are notably higher than average. The forward P/E ratio is highest for consumer discretionary stocks – which would include some traditional ‘technology’ names such as Amazon or Tesla – at 27x forward P/E, while technology is second, on 22.9x forward P/E. Even after the recent falls, technology is still behind its five-year average.
Ahead of the curve on net zero progress
While this would suggest that technology does not yet provide significant opportunities, it is worth noting that these are aggregate figures. The technology sector still has a higher percentage of buy ratings than any other sector apart from energy, at 64%, and one of the largest gaps between the bottom-up target price versus closing price.
As it stands, the Communication Services (+32.8%), Information Technology (+25.9%), and Consumer Discretionary (+23.2%) sectors are expected to see the largest price increases.
The technology sector still wins plenty of plaudits from investors with a longer term view. Blackrock’s Investment Institute recently said that it favours technology because it remains ahead on progress to net zero: “We favour sectors with clear transition plans. Over a strategic horizon, we like sectors that stand to benefit more from the transition, such as tech and healthcare.”
Blackrock also points out that the worries over rate hikes may now be in the price of technology shares: “Yields on benchmark 10-year US Treasuries hit three-year highs last week after data showed inflation was still running at levels not seen since the early 1980s. This understandably created angst about equities, especially about stocks of fast-growing tech companies.
“Higher discount rates make future cash flows less attractive. We believe fears about a further downdraft in equities are overblown. The rate hikes we expected are happening faster, but we don’t see central banks raising policy rates beyond neutral levels that neither stimulate or restrain the economy.”
Not all boats will be lifted
Ultimately, the recent sell-off in technology has created opportunities, but they need to be navigated with care. Mike Seidenberg, portfolio manager on the Allianz Technology Trust, says: “I don’t think it’s a ‘rising tide lifts all boats’ sort of market. You’ll see much more stock specific characteristics at work. This sets up a more stock pickers market.”
He says that business is still very strong for most of the companies in his portfolio, they have strong pipelines and they are hiring: “From a business point of view, these companies are feeling good about their outlook.”
Many of the key technology projects – such as the transition to the cloud – are still in their infancy and will provide a rich seam of growth for the next few years at least. There are vulnerable spots, particularly among consumer-facing segments, but the sector looks less vulnerable than most to the difficulties created by the Ukraine crisis. There may still be further to fall, as higher valuations unwind, but this may prove an opportune moment for investors to re-engage with technology.
