Market review

Global equity markets rebounded strongly in October as the MSCI All Country World advanced +3.5% while the S&P 500 gained +5.4% and the DJ Euro Stoxx 600 +2.8% (all returns in sterling terms).

Commodity markets enjoyed another strong month, further stoking inflationary pressures. Brent oil increased +8% to $83 per barrel, extending year-to-date gains to +65.4%, while key industrial bellwether copper rose +6.8%. Agricultural prices continue to set new records with wheat prices climbing above $8/bushel in intraday trading during early November for the first time since 2012.  It was therefore hardly a surprise that September US CPI data provided another upside (+0.4% m/m) driven by food at +0.9% and energy at +1.3%. Housing costs are something that US Fed officials have signposted as having the potential to provide more durable upward pressure on inflation; it was therefore notable housing-related prices were much firmer as rent of primary residence grew +0.45%, and owners’ equivalent rent increased +0.43%, the fastest pace since May 2001 and June 2006 respectively.

China’s September factory-gate inflation did little to quell global inflation fears as the producer price index (PPI) rose +10.7% y/y, the biggest rise since the China National Bureau of Statistics began compiling the data in 1996. The bulk of the increase was energy-driven as widespread power cuts disrupted output. Power cuts and supply-chain issues were also headwinds to China’s economic growth in Q3 as the economy grew +4.9%, slowing sharply from the +7.9% achieved in Q2. The Chinese government’s efforts to rein in the real estate and technology sectors are further weighing on growth. The US economy similarly disappointed with a +2% annual GDP growth rate in Q3 as the Delta variant of COVID-19 peaked. However, European GDP growth of +2.2% ahead of expectations and accelerating q/q suggests supply bottlenecks have been more than offset by still-surging demand, especially in the services sector.

European countries are among the top performers while the bottom readings are currently concentrated in Asia.

Leading economic activity indicators continue to highlight slowing recoveries globally due to supply chain disruption. European countries are among the top performers while the bottom readings are currently concentrated in Asia. October provided further evidence that Europe will follow the US and Asia into a slowdown. After a surge to a 15-year high in July, sentiment among Eurozone purchasing managers declined for a third time in a row in October. Worsening supply bottlenecks, labour shortages and rising prices are constraining output growth amid strong demand. The flash composite PMI fell to 54.3 in October after registering at 56.2 in September and 60.6 in July, although it remains well above the 50 mark which signifies expansion.

The US manufacturing ISM survey for October faded by 0.3 points to 60.8. The underlying details of the report provided further disappointment with a 6.9 point drop in the new orders component to 59.8, the lowest level since June last year. In China, the official manufacturing PMI fell more than expected to 49.2, registering the second consecutive month below 50, although the more export heavy Caixin index beat expectations and remains in expansion territory at 50.6.

Technology review

The technology sector outpaced the broader market with a sharp rebound in September, the Dow Jones Global Technology Index rallying +5.7% (in sterling terms). Large caps outpaced small caps, the Russell 1000 Technology Index (large cap) returning +7.4%, while the Russell 2000 (small cap) returned +5.8%. There was significant divergence between the major technology subsectors – the Bloomberg Americas Software Index rallied +11.3%, while the Philadelphia Semiconductor Index and the NASDAQ Internet Index lagged, gaining +4.3% and +1.5% respectively.

October was a busy month – with earnings season in full swing.  While companies delivered largely strong reports, some were impacted by supply-chain issues and higher input costs. These issues are non-trivial and are expected to persist into the fourth quarter, although some companies have been able to pass on higher costs given the robust demand environment; many technology subsectors, such as software, are largely insulated from these impacts providing a tailwind for these stocks.

Despite delivering robust growth in most cases, the internet sector had a challenging quarter. Snap’s results and guidance missed consensus expectations due to a larger than expected headwind from Apple’s IDFA changes. Apple’s provided advertising attribution solution worked well initially but did not scale as expected. Snap also saw softer demand from some of its advertising customers due to supply-chain disruption and cost inflation. That said, encouragingly, user growth continued by more than +20% y/y. While there is no change to the long-term thesis, we reduced our position ahead of and after the print given the less favourable operating environment, which appears to challenge Snap’s >50% multi-year revenue growth target.

Facebook engagement remains less robust, but surprisingly stable (both North America and Europe added one million DAUs q/q), but management also underestimated the headwind from Apple's iOS14 changes and advertising revenue ‘only’ grew +32% y/y cc in the quarter. Guidance for opex and capex in Q4 and 2022 were materially higher than expected (astonishingly, Facebook’s capex guidance for 2022 at $29-34bn is higher than TSMC’s). There were two notable positives, including a new reporting structure beginning in Q4 which will provide greater disclosure, splitting the business into two operating segments (1) Family of Apps and (2) Facebook Reality Labs (AR/VR, Hardware/Oculus, Metaverse, etc) while buyback authorisation was increased by $50bn.

Twitter delivered a solid quarter, with revenue +37% y/y, in line with expectations. The impact from IDFA was less than management had forecast, and they incorporated only a modest impact into Q4 guidance. Twitter’s direct response ad product is a relatively small part of the business, and its attribution was less impacted by the switch to Apple’s SKAd Network. Management also disclosed that more than half of the company’s advertising revenue year-to-date is associated with services and digital goods, and therefore not impacted by supply-chain disruption.

Alphabet (Google) appeared unscathed by Apple’s IDFA changes and delivered a reassuring quarter in the face of advertising market concerns, with upside from revenue growing +41% y/y, operating income up +88% y/y and free cash flow (FCF) 17% better than expected. Management noted broad-based strength across Search (+44% y/y) in all verticals – a pushback against macro/supply-chain concerns. YouTube and GCP (Google Compute Platform)/cloud both came in modestly below elevated expectations. YouTube still grew +43% y/y adding $2bn in revenue. While Amazon AWS and Microsoft Azure both saw revenue growth accelerate q/q, GCP (+45% y/y) decelerated from +54% y/y last quarter. Alphabet also reduced Play Store subscription fees to just 15% which may pressure Apple to reduce its App Store fees, which could benefit some of our holdings, including Match.com.

Netflix reported strong results, adding 4.4 million net subscribers, ahead of guidance at 3.5 million and consensus at 3.8 million, but buy-side expectations were already elevated given the success of Squid Game. Q4 guidance was in line with expectations at 8.5 million net adds, but this could prove conservative, given the strong quarterly content slate (Witcher, You, Tiger King, Cobra Kai, Money Heist, Red Notice, Don't Look Up). Churn continues to improve and remains healthy considering Netflix’s selective price increases. FCF guidance for 2021 was reiterated and management believe Netflix will be FCF positive on an annual basis from 2022 onwards.

Amazon revenue +15% y/y and operating income -22% y/y, lagged expectations, accompanied by cautious (hopefully now conservative) guidance for Q4. Retail segment growth decelerated, but the operating income performance was the main negative surprise, with several billion dollars of additional costs expected due to labour shortages, increased wage costs, supply-chain issues, and increased freight and shipping costs. It will be at least another quarter before we get any clarity on the mix of transitory and permanent cost increases. AWS was a key positive, with growth accelerating to +39% (from +37% y/y last quarter) with its operating margins returning to 30% (after a dip last quarter). Despite near-term headwinds, we understand (and agree with) CEO Andy Jassy’s view that “when confronted with the choice between optimising for short-term profits versus what’s best for customers over the long term, we will choose the latter.

While companies delivered largely strong reports, some were impacted by supply-chain issues and higher input costs.

As expected, the software sector proved to be a relative safe haven from supply-chain issues, advertising market changes and input cost inflation. Microsoft delivered a strong quarter, with its cloud computing segment Azure accelerating to +48% y/y cc growth from +45% y/y last quarter, driving total revenue growth of +22% y/y (at a >$180bn run rate). Gross margins were 100bps above consensus expectations, while operating margins were up almost +200bps y/y, allaying investor concerns over the margin trajectory in FY22 given the tough comparison. We continue to see Microsoft as one of the biggest winners from digitisation of the enterprise and believe these results set the stage for continued >20% EPS growth and >30% FCF growth. Our view was echoed by CEO Satya Nadella, who noted that “digital technology is a deflationary force in an inflationary economy. Businesses – small and large – can improve productivity and the affordability of their products and services by building tech intensity. The Microsoft Cloud delivers the end-to-end platforms and tools organisations need to navigate this time of transition and change.”

ServiceNow also reported a strong quarter, with demand metrics broadly ahead of expectations and revenue +30% y/y cc, driven by public sector momentum, COVID-19-impacted sectors rebounding, and continued execution with strategic accounts. Q4 and FY21 subscription revenue and billings guidance midpoints were raised above consensus, as was FY21 PF operating margin guidance, reflecting the strong digital transformation spend environment.

Elsewhere, Tesla posted its largest ever quarterly profit, with deliveries up 40,000 q/q, well ahead of expectations, despite the fractured supply-chain environment. Revenue was slightly lower than expected due to a mix shift toward lower-priced vehicles (fewer high-priced Model S and X), but its operating margin was exceptionally strong at 14.6%, driven by automotive gross margin (ex-regulatory credits) expansion of 300bps q/q to 28.8% (well above consensus at 26%) and cost control (opex flat q/q). Tesla later reached a $1trn market capitalisation after announcing an agreement to sell 100,000 vehicles to Hertz Global.

Apple revenue grew +29% y/y to $83bn, but missed consensus expectations at $85bn, with CEO Tim Cook blaming “larger than expected supply constraints” which they estimate was a c$6bn headwind (more than the revenue shortfall). The services segment was stronger than expected, growing +26% y/y, only a small deceleration from +27% y/y last quarter despite tough COVID-19 comps, and above consensus at +21% y/y. Supply constraints due to manufacturing disruption and semiconductor shortages led to lower than anticipated sales in the key iPhone segment, but management commentary noted very strong demand for iPhone 13 reflected in extended lead times. No official guidance was given for next quarter, but management commentary indicated that revenue growth is expected to be solid despite supply-chain disruption, with all products expected to grow y/y with the exception of iPad.

Semiconductor results were also generally solid despite component shortages limiting smartphone and automotive sales. The sector should benefit from a meaningful ramp up in cloud data centre capex as hyperscale players invest ahead of strong demand. AMD delivered strong results and guidance, with FY21 revenue outlook now +65% y/y due to the EPYC Server ramp (+25% q/q) and strong graphics sales (likely benefiting from buoyant cryptocurrency markets), offset by PC sales which were down sequentially in Q3 and expected to be flat in Q4. We continue to expect AMD to gain market share from Intel (not held), which sold off after management revealed the turnaround/foundry strategy is going to be more expensive and take longer than expected. The company announced $25-28bn in capital spending, and guided margins down to c51-53% for the next 2-3 years before rebounding.

Semiconductor capital equipment stocks, including ASML, stand to benefit from raised semiconductor capex budgets and the need to diversify regional supply chains for security reasons. At the company’s Capital Markets Day, management issued a revenue target of €24-30bn for FY25, driven by global megatrends and partners actively adding and improving capacity to meet future customer demand.

Outlook

The shape of the recovery into a post-COVID-19 world remains steeped in uncertainty, not least in terms of the ongoing public health measures and restrictions on activity that will remain as the virus (hopefully) moves from the pandemic to endemic phase. What excites us most is the role technology has played underpinning more rapid vaccine and anti-viral drug development – a fantastic example of the accelerating pace of innovation occurring, enhanced by artificial intelligence, in the real world.

Following a strong macroeconomic recovery in 2021, global growth is anticipated to wane in 2022 as the fiscal boost to real GDP growth fades. Financial conditions remain easy versus history, but supply constraints, labour shortages and logistical bottlenecks continue to impede the recovery and elevate concerns around persistent inflation. The US five-year breakeven reached 3% for the first time during the month and the yield curve flattened materially – due to a move higher in two-year rates as investors become more concerned about tighter Fed policies. Short-dated rates moves were even more acute in Canada, Australia and New Zealand and there is a concern that central banks (including the Fed and ECB) will be being forced to scramble to catch up in their response to upward pressure on inflation expectations.

Longer-term rates remain subdued, however, given concerns around long-term growth, excess savings and the risk aggressive central bank tightening results in a policy error. Low long-term yields and low real yields continue to provide valuation support to long-duration growth assets, although this is contingent on continued investor confidence in central banks’ willingness and ability to respond effectively to near-term inflationary pressures. This environment presents a potential headwind for growth equity investors. Research by Bernstein has suggested long-duration stocks are more expensive than ever before – the group of stocks most negatively exposed to a rise in yields are trading around their highest relative multiple ever versus the broader market.

Within our own sector there is a narrow group of high-growth, high-multiple companies trading at extraordinary valuation premia, even after accounting for their superior growth profiles and scarcity value. We know these companies well but are unable to underwrite many of their current valuation multiples which we believe are pricing in defiantly optimistic scenarios. In this context, we believe it is particularly important to retain conviction in our approach of holding a diversified portfolio of growth technology equities which provide exposure to a collection of powerful long-term themes. We are therefore positioned in a more balanced way across the portfolio with modest exposure today to high growth/high multiple stocks but awaiting a pullback to get more constructive. In the meantime, we are still finding plenty of growth and long-term disruption potential in companies trading at more reasonable valuations. The near-term outlook remains potentially choppy, but valuations versus growth in the portfolio gives us more confidence in the outlook next year.

It is also important to remember that technology companies themselves are relatively less exposed to some of the near-term challenges facing the economy.

It is also important to remember that technology companies themselves are relatively less exposed to some of the near-term challenges facing the economy. Average hourly earnings growth at 4.6% remains well above average, with lower-skilled wage rises increasing at a faster rate than higher-skilled wages. The technology sector itself has long had to deal with upward wage pressure and a tight labour market for skills in software development, cybersecurity, semiconductor manufacturing and enterprise sales, among other areas. Digital goods and software are not subject to physical supply-chain shortages, and the ever-growing application of AI will allow technology companies to drive more value from the data they capture.

While the near-term outlook remains potentially choppy, largely due to macro factors (particularly if bond yields jump sharply), robust growth rates and strong fundamentals give confidence in the outlook for many of our holdings next year. Earnings season has been dominated by reopening crosscurrents and our ‘hybrid world’ thesis – in which we retain confidence in the longer term – is being tested by uncertainty about near-term growth numbers (against challenging year end comparisons). We have curtailed our exposure here given the need for more clarity but expect many of these stocks to remain central to our lives and deliver strong future growth. Despite this, we remain reasonably fully invested given our constructive view of technology, its increased relevance in a more digital world and the widespread technology- (and specifically AI) driven disruption we believe is still to come.

As at 29 October 2021