As with other sectors, macroeconomic developments were a driving force behind the trajectory of global technology in 2022. We expect that to remain the case until greater visibility emerges on the future path of inflation and its effect on interest rates. Given the secular-growth profile of many mega-cap tech and Internet companies, the sector was inordinately impacted by the unprecedented rise in rates, which feed directly into the discounting mechanism used to value a company’s future cash flows. Additionally, a higher cost of capital is a headwind for cyclically exposed tech companies as it restrains both big-ticket corporate investments and aggregate consumption across the economy.

We believe the macro backdrop – and tech’s reaction to it – is likely to unfold in one of two ways during 2023: Either aggressive monetary tightening overshoots policy makers’ objectives, resulting in weaker corporate earnings and weighing even more on growth stocks’ valuation multiples, or central banks deftly pause, providing a respite for compressed valuations but likely not offering immediate relief for economically sensitive tech companies. Neither scenario represents smooth sailing for the sector. In fact, our base-case is for a challenging several months as investors continue to hang on every macro data point and utterance of central bankers.

Positioning for better days

It’s important to note that many of these headwinds have been priced in, especially via the previously referenced multiple compression. While we, too, await greater clarity on the future path of inflation, rates, and the broader economy, we also recognize the forward-looking nature of financial markets. This is especially true for the semiconductor (semi) complex. Historically, chipmakers’ stocks tend to rally in advance of the economy’s nadir as investors anticipate a recovery in demand for the building blocks of an increasingly digital global economy. While not imminent, that inflection point is drawing nearer.

A softening economy can be regenerative as it exposes weaker businesses and creates the conditions for competitively advantaged companies to emerge on the other side in an even stronger position. We expect this dynamic to play out in Internet-related ecosystems as higher-quality platforms expand their reach by proving their services’ value to customers.

With risk comes opportunity

Investors must always look around the corner with the aim of identifying underappreciated risk. We cannot, however, remember a time when an array of risks has been so fully appreciated. In addition to inflation and a slowing economy, there is the war in Europe along with China’s continuing attempts to address its property downturn and approach to COVID-19. Perhaps one risk whose ramifications are yet to be completely understood is the sunsetting of globalization and a renewed push toward onshoring and “near-shoring” of technology manufacturing. Nowhere is this more evident than in semis. Over the past few decades, the global share of chips manufactured in the U.S. and Europe has inverted, falling from 80% to 20%. This looks set to reverse as regions seek to secure their own supply of what we consider the 21^st century’s most strategically important geopolitical resource.

The race for chips not only applies to the complex components powering artificial intelligence (AI) and cloud computing, but also to analog sensors and controllers. The importance of the latter group was on display during the pandemic as supply disruptions resulted in the golden screw phenomenon, where a single missing chip could shut down an entire assembly line.

Another area where a slowing economy could represent opportunity is cloud computing. Cloud-based software suites and other services have the potential to enable business customers to defend margins by maximizing productivity. Many public cloud vendors are seizing the downturn not to expand their own margins but to partner with clients to help them defend theirs, building considerable goodwill in the process. Such relationships illustrate the nonzero-sumness that we believe is inherent in the global economy’s increasing reliance on tech applications.

Digital advertising may not enjoy the same fate. While we expect a flagging economy to weigh on corporate ad budgets in the near term, major online ad platforms may not exit a slowdown stronger as these businesses are increasingly facing structural privacy-related issues. To a lesser degree, e-commerce may not receive a major post-downturn boost either as the segment inches toward maturity.

Business models first

The past 12 months have been tough on tech stocks, but not on tech businesses. Fundamentals have held up well and we expect this to continue as technology becomes even more pervasive across all business functions. The sector is primed to grow at a faster pace than the global economy and command an ever-greater share of aggregate corporate earnings. The powerful secular themes of AI, cloud computing, the Internet of Things, and 5G connectivity are, in our view, only becoming more critical to how the global economy functions, especially with respect to fueling productivity and, in many instances, creating entirely new industries.

IMPORTANT INFORMATION

Concentrated investments in a single sector, industry or region will be more susceptible to factors affecting that group and may be more volatile than less concentrated investments or the market as a whole.

Growth stocks are subject to increased risk of loss and price volatility and may not realize their perceived growth potential.

Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general economic conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.