• Tech stocks had a strong performance to start off the year, but market sentiments may be too exuberant.
• Valuations are not cheap relative to the broader US stock market and are unattractive when compared to fixed income.
• The dry up in capital inflow could weigh on near term growth, as the age of easy money has ended with rising interest rates and tightening lending conditions.
• Despite the expected slowdown in growth, big tech companies continue to serve as good hideouts within the technology space due to their robust balance sheet, high-quality earnings and deep entrenchment of their product and services within our everyday lives.
• We maintain a 2.5 Stars “Neutral” rating for Digital Economy given the slowdown in growth and rising recession risk. Investors can expect an upside potential of about 20% by the end of 2025 for the Invesco NASDAQ Internet ETF (NASDAQ: PNQI).
The digital economy has experienced more than a decade long of growth on the back of secular tailwinds and digital transformation. However, a tightening interest rate environment combined with overly optimistic market sentiments mean a market correction is likely imminent for the sector.
With the lack of fundamental, macroeconomic support for strong and continued economic growth further into 2023, the current rally from January to March has been driven more by expectations and may not be sustainable.
Technology stocks have been on a tear on the back of exuberant market sentiments
The Invesco NASDAQ Internet ETF (NASDAQ: PNQI) has delivered strong returns YTD, outpacing most other sectors (Figure 1). An easing outlook on inflation and the potential for rate cuts in the second half of the year led investors to pour large amounts of money into growth and long duration stocks such as technology stocks.Figure 1: Digital economy and technology sector have outperformed other sectors YTD
Figure 2: Markets are expecting rate cuts in the second half of the year
However, if the markets are wrong and the Fed continue in its rate hike regime and holds rates steady for an extended period of time, the possibility of a recession would become even more pronounced, which may cause a significant correction in tech stocks. Therefore, we maintain a cautious stance on the technology sector despite their strong start to the year given mounting layoffs, recession risk, elevated valuations and rising interest rates.
Valuations of technology companies are not cheap
With the recent rally in share prices, valuations of tech stocks have become a lot more expensive. Even with the recent bank turmoil and the decline in bond yields, the spread between the earnings yield of the digital economy sector and 10-Year treasury yield is at its narrowest in over a decade (Figure 3), suggesting that technology stocks are overvalued in comparison to bonds.
Furthermore, after the surge in technology stocks in recent months, the premium between PNQI and the broader S&P500 has widened significantly, putting technology stocks at risk should there be any multiple compression or economic downturn.
Figure 3: Technology stocks are not attractive relative to fixed income
On an absolute basis, technology stocks are by no means cheap, trading well above its historical 10-year average PE ratio (Figure 4).
Figure 4: Technology stocks are expensive when compared to the broader S&P500
Dry up in capital inflows may impede near term growth
Next, aside from the lofty valuations the current macroeconomic conditions remain unfavourable to the technology sector, especially with liquidity drying up and rising recession risk. As a result, growth in the technology sector is forecasted to decelerate in 2023 as corporate investments and consumer spending on technology will be impacted by further monetary policy tightening due to the higher borrowing cost (Figure 5).Figure 5: US Technology spending is expected to slowdown in 2023
Over the past few years, US technology firms have benefitted from a short-term surge in demand and easy global liquidity conditions following the COVID shock. As a result, technology equity valuations surged, and the sector saw massive capital inflows.
However, since the start of 2022, this cycle has reversed. Furthermore, in light of SVB's importance to the technology sector, it is likely that there could be more tech layoffs, lower spending on technology products, and greater difficulty in access to new capital, which could potentially become an outright credit crunch for the tech sector.
When analysing the estimated value of funds raised via IPOs in recent years, it is clear that capital flows have largely evaporated in 2022 (Figure 6). This collapse alone may be sufficient to cause material downside surprises throughout the technology sector as 2023 unfolds. Furthermore, technology companies had a greater amount of budget in 2020 and 2021 relative to history, which has likely feed through to higher spending by technology companies.
Figure 6: Technology deal volumes and deal count have cratered in 2022 as liquidity tightens
Unfortunately, the technology budget for 2023 will be set against a backdrop of $25 billion raised from the IPO market in 2022. A similar contraction can be found across the broad capital markets, including steep declines in venture capital, private equity, and the bond market generally.
This contraction in capital markets is occurring in tandem with an unfolding recessionary backdrop for the broad economy, as some parts of the economy have already started to crack, with the banking system coming under pressure recently, which may ultimately impede the growth of technology companies in the near term.
Big tech companies can remain resilient in their earnings
Not all tech companies are made equal. Despite the mounting headwinds, we believe that big tech companies can remain resilient in their earnings.
With the deep entrenchment of technology, investors often associate certain products synonymously with our limbs as they have become integral in our everyday lives. As the economy cools, most companies face slowing revenue growth while at the same time, inflation continues to increase the cost of inputs.
While individual companies cannot control macroeconomic factors or monetary policy, they can optimise costs, which can clearly be seen with the large number of layoffs within the technology industry, including tech titans like Amazon, Google, Meta and Microsoft (Figure 7).
As the CEO of Meta, Mark Zuckerberg, stated in its most recent earnings call, 2023 is dubbed “the year of efficiency”, touching on topics such as reduced spending, pulling back on expansion and focusing on productivity, setting the tone for the tech industry.
This can clearly be seen in the huge number of layoffs within the tech industry, led by big tech with figures surpassing six digits just three months into 2023. While this creates short-term pain within the tech giants, these resizing plans would enable them to drive down costs and improve their efficiency, setting themselves up in a better position across the longer term.
Figure 7: Layoffs in the technology sector have been surging lately
Although the revenue growth rates in the big tech names are expected to slow down in the near term (Figure 8), with compressing profit margins and a slowdown in earnings, their market dominance in their respective sphere of influence (e.g., e-commerce, advertisements, cloud computing etc) and the reliance of corporates and consumers on their services is undeniable.
For instance, while the sales of remote cloud computing and services may be slowing, it is due to the high base effect from the heights of the pandemic. During Amazon’s earnings call in February 2023, it mentioned that its profitable cloud business, Amazon Web Services, was generating revenue at an annual rate of more than USD 80 billion and had grown north of 20% YoY in the fourth quarter of 2022. Similarly, Microsoft, the second largest cloud company, reported that sales of Azure, its cloud product, had grown 31% YoY.
These results show a similar pattern, that the continuous advancements in software make tech spending less cyclical compared to the past. While technology companies are definitely not immune to a downturn, they are more resilient than it has ever been throughout history, especially the bigger names with a dominant market position.
This can be seen when compared to the earnings growth of the broader S&P500, which lags behind that of the large technology companies.
Figure 8: Earnings growth of Big Tech to slow down in the near term but accelerate looking ahead
Lastly, the recent SVB fiasco has also exposed the weakness within the technology startup space, and one of the biggest winners would be the big, established technology firms, due to their strong balance sheets, which are better poised to tide through the upcoming economic recession.
Maintain 2.5 Stars “Neutral” as recession risk increases
With the recent chaos in the banking sector, bond yields have eased rather substantially, which has helped to propel the share prices of technology companies higher. With that being said, the chance of financial shocks causing a recession has risen and it is tough to ignore the potential for a significant pullback in credit as banks tighten their lending standards.In such a challenging economic environment, investors should be cautious when investing in equities, especially those of long duration (stocks that are expected to generate the bulk of their cash flows in the future) which are likely to be more negatively impacted given the higher interest rates.
Looking ahead, we continue to maintain a rating of 2.5 Stars “Neutral” for the Digital Economy, especially after the recent surge in technology stocks and with the overly optimistic expectation that the Fed will cut interest rates before the end of the year. Based on a fair PE ratio of 30X, we arrive at a target price of USD 169 for the Invesco NASDAQ Internet ETF (NASDAQ: PNQI), representing an upside potential of 21.1% (Table 1) by the end of 2025.
Table 1: Projections for NETX Index
|
Nasdaq CTA Internet Index |
2022 |
2023E |
2024E |
2025E |
|
PE Ratio (X) |
38.6 |
34.9 |
29.1 |
24.8 |
|
Projected Earnings Growth (YoY %) |
-16.5% |
10.7% |
19.8% |
17.6% |
|
Projected Earnings Per Share (EPS) |
22.35 |
24.7 |
29.6 |
34.8 |
|
Target Fair Price (Based on a fair PE ratio of 30X) |
- |
- |
- |
169 |
|
Potential Upside (%) |
- |
- |
- |
21.1% |
|
Source: Bloomberg Finance L.P., iFAST Estimates |
||||
Although growth and technology stocks are likely to meet challenges ahead in the near term, it is difficult to deny their growing importance in the world that we live in today. Therefore, we believe that the digital economy still remains an important piece of the global economy and investors’ portfolios.
Across the longer-term horizon, we remain optimistic in technology stocks, especially the larger and more profitable names, which are better positioned to weather the upcoming storm. Therefore, we recommend the Invesco NASDAQ Internet ETF (NASDAQ: PNQI), which has a majority of its allocation to the big tech companies such as Microsoft (NASDAQ: MSFT), Alphabet (NASDAQ: GOOGL), Amazon (NASDAQ: AMZN) and Meta (NASDAQ: META).
However, as valuations are slightly more expensive at this point in time, we recommend investors to consider using a regular savings plan, before switching to lump sum investments in the future should valuations come down.
Related Article: Hello PNQI! Invest in Big Tech through this ETF
Figure 9: NETX Index Price vs EPS
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