Equity markets modestly extended their gains during the month, the FTSE World Index gaining +0.7% in GBP terms. January 2017 will likely best be remembered for the Inauguration of Donald Trump as 45th President of the United States. To the surprise of many (who had hoped for a milder rhetoric once in office), President Trump wasted no time in following up on his campaign promises, signing a total of 22 executive orders within his first two weeks in office. For comparison, President Obama issued a total of 277 executive orders over his two terms. Markets have remained resilient in the face of early evidence he intends to fulfil his main campaign pledges – regardless of how controversial they may be – and his unorthodox approach (tweeting many policy decisions). This suggests investors are instead focusing on the underlying health of the US economy and the hope that the new President will deliver market-friendly policies including corporate tax reform, overseas cash repatriation, deregulation and fiscal stimulus. While these would likely prove supportive to markets, any announcements relating to a more protectionist agenda (border taxes/tariffs) or the removal of tax deductibility of interest payments would likely result in short-term volatility.
Economic data points continue to portray a robust US and European economic environment, albeit seemingly within a subdued growth trajectory. Fourth quarter US GDP came in at an annualised rate of +1.9% (+1.6% for the full-year 2016). On a brighter note, US industrial output rose at the fastest pace in more than two years in December (with the year-over-year (y/y) growth rate crossing back into positive territory). The December ISM Manufacturing purchasing managers index provided further evidence of improving factory output as the index hit 56.0, the highest point in two years. The US Dollar and inflation data produced arguably the most noteworthy moves. The trade-weighted US Dollar fell 2.6%, reversing some of its Q4 strength. There were also signs of inflation picking up in the US as December CPI reached +2.1% y/y, breaching 2% for the first time since 2014. In Europe CPI jumped to +1.1% in December, a high not seen for almost four years. However, these moves are in part influenced by the oil-related base effect – due to the significant y/y declines in early 2016 – as such 10-year US Treasuries yields remained virtually unchanged at 2.45%.
The technology sector outperformed the broader market during the month as growth stocks recovered some ground lost during late 2016, the Dow Jones World Technology Index gaining +3.4% (in GBP terms). At time of writing we are in the thick of fourth-quarter earnings season with results thus far generally positive. Within hardware, Apple* returned to revenue growth this quarter and delivered iPhone units ahead of consensus estimates. The company aims to double its services business over the next four years which will help to offset potential iPhone margin degradation. During the quarter its services business grew +18% y/y driven by the App store which grew +43% y/y. With guidance better than feared, Apple stock rallied post earnings as investors begin to anticipate the iPhone 8 cycle due to be launched in the autumn. While we have de-emphasised the maturing smartphone theme over recent years, this could be a year where Apple delivers a more innovative iPhone upgrade (with OLED screens, new form factors and wireless charging all expected to make a debut). As such, we have modestly increased our Apple exposure given that the stock remains inexpensive (trading at 13.1x FY18 consensus earnings, before adjusting for its balance sheet) with the potential for earnings and/or its multiple to move upwards over the next six months.
Within the semiconductor sector, arguably the best turnaround story has been AMD* – its Q4 earnings and recent product release announcements providing evidence of another positive step towards recovery. After four consecutive years of PC chip market share loss (and nine-years of server market share loss) several new product launches have the potential to reverse this trend. AMD's Naples server chip, Ryzen/RavenRidge desktop/notebook CPU and their Polaris/Vega GPU chips (for high performance computing and graphics) are now expected to regain share in their respective markets. TSMC* also produced strong results as margins hit 19-year highs. Utilisation swings have been more moderate since 2010 than the last 2002-2007 cycle and TSMC's margins, like many semiconductor companies, have benefited from this trend.
In the Internet sector, Alphabet (Google)*, Facebook*, Alibaba* and Amazon* once again demonstrated the strength and durability of the key structural trends underpinning their business models – ecommerce, digital advertising and cloud computing. Alibaba* posted revenue growth of +54% y/y beating expectations. Both commission revenue and marketing services revenue contributed to the upside surprise. Active buyers grew +9% y/y to 443m while mobile MAUs grew +25% y/y to 493m, highlighting the scale and dominance of the platform. Cloud computing division AliCloud grew revenues +115% y/y off a low base (a very large market opportunity for Alibaba). Alphabet produced another impressive quarter with revenues growing +24% y/y (constant FX) with mobile search, YouTube and programmatic being the key drivers. An acceleration in Google's Paid Click growth to +43% y/y is very impressive considering the scale of the Google business. Operating margins continued their gradual progression higher as evidence of a more disciplined cost environment persisting.
Facebook* confounded sceptics with revenue growth of +51% y/y. A fifth consecutive quarter of growth in both Ad impressions and Price per Ad highlights the strong demand within its network. Guidance for 2017 included an expectation that expenses could grow approximately 47%-57% compared to 2016, showing Facebook remains in investment mode. This makes the Q4 +800bps y/y increase in GAAP operating margins even more impressive. If there was a soft spot amongst the Internet behemoths it was Amazon*, which after a collection of recent blow out quarters delivered a relatively moribund set of results. In combination with a step up in investment spend the near term outlook appears somewhat subdued but it retains a dominant position in both ecommerce and Cloud Computing. Whilst both slowed sequentially, North America Retail and International Retail grew +22% and 23% y/y (constant FX) respectively, alongside AWS at +47% y/y.
In Software, Microsoft* beat earnings but delivered slightly weaker guidance than expected. In the mid-cap space Proofpoint* and 8x8* both beat consensus revenue numbers although to a lesser extent than in prior quarters. A more impressive performance was delivered by ServiceNow* which significantly beat the important billings and bookings metrics that are much studied by investors. This made two strong quarters in a row for ServiceNow and its share price was duly rewarded. Post quarter end this trend has continued with robust results from many mid-cap software stocks including Medidata*, Paycom** and Zendesk*. Software stocks also received a boost during the month from Cisco’s* acquisition of AppDynamics** for $3.7bn, one of the most expensive software acquisitions in recent history at 17.3x EV/trailing sales. We believe this highlights the strategic value of many mid cap software stocks to growth-challenged incumbents, especially those with greater distribution capability, able to significantly scale acquired assets. We expect M&A to remain at elevated levels this year (as Cloud disruption intensifies), aided by a likely tax/repatriation bill from the new President.
This year has seen the sector (and our portfolio) get off to an encouraging start, aided by a robust earnings season and a partial reversal of the post-Trump reflation trade. While Q4’2016 was frustrating, the year-end valuation compression experienced by growth stocks has likely enhanced the set-up for 2017 with many higher growth sub-sectors ending the year below their five-year EV/sales valuation averages while the premium paid for growth in our sector is the narrowest we have seen for some time. Fortunately, along with strong results from many higher growth technology stocks, Cisco’s bid for AppDynamics has helped refocus investor attention on the considerable strategic value many small/mid-caps offer.
While we await greater clarity from President Trump and the Republicans regarding key corporation tax, repatriation and trade policies, the US appears to be strengthening naturally ahead of additional stimulus. With inflation under control for now, we believe our interests remain aligned with policymakers while a stronger US economy should prove beneficial to many of our small/mid cap domestically orientated US holdings. Whilst we expect continued volatility tied to policy announcements, we also remain constructive on the broader market believing that as the economy strengthens and bond yields rise (at a controlled pace) equities should benefit – particularly if accompanied by less regulation and lower taxes.
Against this backdrop – after a two-year period where higher growth stocks have suffered from multiple compression – we believe 2017 could mark a turning point, even if valuations only maintain current levels, allowing the underlying growth of our portfolio to drive absolute and relative returns. It is becoming obvious now that technology is disrupting almost every traditional industry but the advent of artificial intelligence (AI) and machine learning (ML) is only likely to accelerate the pace of technological innovation. This is expanding our addressable market – allowing technology to attack the profit pools of many traditional indices – but along with low levels of stock correlations should provide a significant tailwind for stock pickers. This may be particularly true in technology where market capitalisation weighted indices (on which most ETFs are based) are likely to face a headwind from smartphone maturity and the deflationary impact of cloud computing, now that adoption appears to have inflected.
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