IT’ll be back

Key takeaways

• Tech stocks have underperformed the broader stock market for the last 12 months as consumer demand shifts and rates rise
• Valuations in the sector are still adjusting as markets factor in 2023’s growth expectations
• The specific stories behind Twitter in tech and FTX in cryptocurrencies should not detract from broader opportunities
• We retain a selective approach, favouring tech firms with stable revenues passing-on higher costs to corporate clients, especially semiconductors and software.

Technology stocks used to grow pretty dependably. But in a difficult 2022 for equities, tech has underperformed even the wider market’s fall. We look at why investors might expect a turnaround in 2023.

Between 2009 and 2021, the Nasdaq Composite index only posted one annual decline, in 2018, of 1%. 2022 has been brutal in most asset classes, but especially in tech stocks. Year to date, the broad Dow Jones Industrial Average benchmark has declined 8% and the S&P 500 index by 17%. Over the same period, the Nasdaq dropped 29%, continuing a fall from a record November 2021 high. Several factors explain the disparity. Half of the Nasdaq’s market capitalisation consists of technology firms, with no energy stocks and few healthcare names to cushion the index’s fall. The Nasdaq has a bias to growth stocks that are more affected by the rising cost of capital. At the stock level, many large tech stocks such as Meta Platforms Inc., Amazon.com, Netflix Inc. and Google’s parent, Alphabet Inc., posted disappointing performance and lowered earnings expectations. Finally, the US dollar’s strength has also affected large tech companies, who on aggregate depend more on international sales than the American market.

The pandemic boost behind sectors linked to working from home and domestic entertainment that supported stock values from Alphabet to Amazon and made Zoom a household name, has faded. The outlook for the industry’s earnings has clouded. In response, business models are adapting. Meta is looking to diversify away from social media, Netflix is offering a cheaper, advert-funded subscription and Amazon has cut its third-quarter sales outlook and staff. The tech industry story dominating news in recent weeks is Elon Musk’s management of Twitter Inc. While uncertainties over Twitter’s future attract much attention, there are probably few lessons to be learned from the forced acquisition, and it should not detract from the broader tech industry’s fundamentals.

Valuations in the sector were high at the start of 2022, and they have adjusted to reflect rising borrowing costs and investor preferences for value stocks. As tech companies adjust to weakening revenues, especially in those segments most dependent on consumer sales, investors are recalibrating their growth expectations for 2023. Many stocks are now trading at prices below pre-Covid levels and their longer-term averages. Still, since mid-October, the tech sector has started to recover, and once confidence in the earnings outlook improves, valuations should start to expand.

Chip Buffett

One way to see this coming is to look at semiconductors. Computer chips drive everything from kitchen toasters to car navigation systems, and offer a bellwether for the industry, because chips are critical to every technological appliance. As a result, the sector reflects wider economic demand, and so can signal turning points in the market as much as nine months in advance (see chart). The segment’s shortages and disrupted supply chains of the past two years are improving, and inventories are building as demand for personal computers, gaming, and handsets slows. Demand from data centres and carmakers remains relatively resilient thanks to rising demand for cloud-based data storage and analysis, as well as consumers’ interest in electric cars.

Earlier this month Berkshire Hathaway Inc. took a USD 4.1 billion stake in TSMC (Taiwan Semiconductor Manufacturing Co.), as part of its USD 350 billion equity portfolio. The investment by Warren Buffett is interpreted as a vote of confidence in a more stable US/China relationship, and recognition that the global economy depends on Taiwan’s semiconductor supplies. Linked to that news, Apple Inc., TSMC’s largest customer, said last week that it is preparing to begin sourcing chips from a plant being built in Arizona, and likely owned by TSMC. There are currently multiple projects to relocate some semiconductor manufacturing capacity in the US, supported by the USD 52.7 billion infrastructure package approved by the US administration in August. The beneficiaries of this package must agree not to expand their capacity in China for ten years. That stipulation follows the US department of Commerce’s 7 October restrictions on chip exports to China.

Cryptocalamity

Not every asset class linked to tech looks sound. Cryptocurrencies have mirrored tech companies’ decline in 2022. While rising interest rates have curbed investor appetite for growth-focussed tech firms, cryptocurrencies have suffered more from rising risk aversion. The total market capitalisation of all cryptocurrencies reached more than USD 3 trillion a year ago, and now amounts to less than one third of that peak. Rather than offer diversification, crypto assets have tended to decline in line with falling markets, and proven very volatile, with two high-profile disasters; the collapse of ‘stablecoin’ TerraUSD in May, and crypto-exchange FTX’s bankruptcy, valued at USD 32 billion before its default. These have damaged the valuations of both crypto coins and crypto-companies, undermining traditional financial firms’ appetite to work with crypto. It will probably translate to less venture capital funding for the sector, and eventually greater regulation.

Yet FTX’s story illustrates failures in corporate governance and counterparty risk, not flaws in the underlying blockchain architecture. Cryptocurrencies are not the only application for this decentralised, dependable technology. The shared, transparent data recording system can create tamper-proof procurement or insurance contracts, trade finance reconciliation, and non-fungible tokens (NFTs) that guarantee digital ownership. In the furore over FTX, the potential for such useful applications should not be lost.