Global equity markets fell sharply then recovered in March, the MSCI All Country World gaining +4.1% while the S&P 500 gained +5.7%, and the DJ Euro Stoxx 600 was +1.9% (all returns are in sterling terms). This was still insufficient to prevent the largest quarterly decline in two years (S&P 500 -2.5%; NASDAQ -6%), as investors were confronted by several challenges not seen for a generation, including the highest inflation level in four decades, Russia’s invasion of Ukraine (exacerbating supply-chain stress) and updating expectations for a dramatically more hawkish Federal Reserve as well as further Covid-related disruption in China, specifically Shenzhen as a major shipping hub.
The conflict in Ukraine escalated during the month, with Russia undeterred by expanded sanctions which blocked some Russian banks from the SWIFT financial system and prevented its central bank from accessing some foreign currency reserves. Russia responded to Western sanctions by proposing that friendly countries like China and Turkey pay for oil and gas in roubles, domestic currency, and bitcoin, while unfriendly countries would have to pay in roubles and/or gold. By the end of the month, the rouble had recovered its losses against the dollar since the beginning of the invasion.
Russia has undoubtedly experienced more robust Ukrainian opposition than they expected, with notable counter-offensives around Kyiv. Two rounds of ceasefire talks have finally produced an agreement to designate humanitarian corridors to safely evacuate civilians from the country, and the latest talks in Istanbul have reportedly made more significant progress with peace treaty drafts advanced enough to allow for direct consultations between Presidents Putin and Zelensky. The key issues around the sovereignty of Crimea, the Donbass and Luhansk regions remain unresolved, however, and the range of potential outcomes remains concerningly wide.
Commodity prices continued to be volatile. Brent Oil rose +10.1% during March as the US and UK blocked Russian oil imports, despite efforts to mitigate the move, including the release of strategic petroleum reserves by the US. Sharply higher oil prices are likely to have a lasting impact on the global economy even if a peace accord can be reached. In the US, rising energy prices pushed the headline CPI inflation rate to +7.9% y/y in February (+0.8% m/m), a 40-year high, while the core CPI advanced accelerated to +6.4% y/y (+0.5% m/m). These drove upward pressure on Treasury yields (the 10-Year US Treasury yield increased +26.5% to 2.33%) and inflation expectations.
Unfortunately, gains in the CPI appear to be broad-based, suggesting that price increases will remain persistent. CPI is now likely to climb well above 8% in March given the spike in crude oil and gasoline prices. An eventual drop in energy prices, a gradual easing of supply constraints, more favourable base effects and tighter Fed monetary policy should help reduce inflation longer term.
As expected, the Federal Open Market Committee (FOMC) raised its funds rate target range at the March meeting to 0.25-0.5%. More importantly, the median ‘dot’ in the Summary of Economic Projections now shows seven interest rate hikes in 2022 (up from the three projected at the December meeting), which would require at least one 50bp hike at one of the six remaining meetings this year. There was also a shift in the Fed’s inflation outlook, which now sees inflation as more persistent, along with an upbeat take on growth and the potential for a soft landing. Language emphasising uncertainty around the impact of the war (consumer spending and supply chains) and a readiness to adjust policy if risks emerge that threaten the Fed’s goals were considered favourable for risk assets.
The risk of a policy error remains elevated given the Fed’s hawkish pivot following Fed Chair Jerome Powell’s re-nomination. The yield curve, a widely watched signal in the bond market, has been flashing warning signs. The two-year and 10-year Treasury yields have inverted (when the shorter-dated bond’s yield rises above that of the longer-dated bond) for the first time since 2019, sending a warning that a recession could be on the horizon. Since 1965, this has occurred a median 20 months before a recession, according to Goldman Sachs. Although this does not mean a recession is inevitable, particularly given the Fed’s actions may be distorting the bond market, the risks are clearly rising, and the recent market volatility in part reflects a softening outlook for global growth.
Economic data in the US remains mixed. The February ISM Services PMI, a leading indicator of corporate margins, fell for a third month in a row to 56.5 in February from 59.9 in January, well below market forecasts of 61 (the second largest miss since the global financial crisis). Business activity and new orders slowed down, while employment contracted, and price pressures intensified. Although the absolute level remains robust and above the long-run average, service providers "continue to be impacted by supply chain disruptions, capacity constraints, inflation, logistical challenges and labour shortages.” The March ISM Manufacturing PMI fell to 57.1 in February from 58.6 in January, below market forecasts of 59, pointing to the slowest growth in factory activity since September 2021. The US manufacturing sector remains supply-constrained, although progress was made to solve the labour shortage problems at all tiers of the supply chain.
The Employment Situation report suggests the US economy added 431,000 non-farm payrolls in March, below the market forecast at 490,000, but the February estimate was revised sharply higher (by 72,000 to 750,000) benefiting from the decline in coronavirus infections and the easing of restrictions, coupled with solid consumer demand. There were no signs that the war in Ukraine or the surge in oil prices has put a hold on hiring in any parts of the economy so far.
The US unemployment rate declined to 3.6% in March from 3.8% the previous month, the lowest since February 2020. Average hourly earnings rose by +0.4% (up 5.6% y/y), although inflation continues to outpace wage growth. Encouragingly, the participation rate rose slightly to 62.4%, a two-year high (perhaps due to easing Covid fears and rising wages tempting some back into the labour market). Shorter-term US treasury yields and the dollar both gained, however, with nothing here to suggest the Fed should back off its tightening path (yet). The forward-looking University of Michigan Consumer Sentiment Index deteriorated to its lowest reading since 2011, at 59.4. Inflation has been the primary cause of rising pessimism, with an expected year-ahead inflation rate at 5.4%, the highest since November 1981. Pending home sales also fell -4.1% in February (below estimates for a modest increase), partly due to the deferred new builds coming onto the market, as well as a rapidrise in mortgage rates.
The technology sector rebounded in March as the Dow Jones World Technology Index increased +3.8% in sterling terms. There was significant dispersion between the major subsectors during the month. The NASDAQ Internet Index increased +0.9%, the SOX Semiconductor Index gained +2.1%, while the software sector led, as the Bloomberg Americas Software Index rallied +3.6%.
A noteworthy piece of M&A took place during the month as Anaplan* announced its acquisition by Thoma Bravo (PE) for $10.7bn ($66 per share).
A noteworthy piece of M&A took place during the month as Anaplan* announced its acquisition by Thoma Bravo (PE) for $10.7bn ($66 per share). This all-cash transaction represented a 30% premium to the previous day’s close. The deal implied a 11x EV/sales multiple on 2023 numbers and could signal wider appetite for software assets with attractive revenue growth at the valuation multiples available in the market today.
The off-quarter reporting companies have continued the main theme witnessed over the most recent quarterly earnings season, namely strong quarterly performances but often accompanied by top line or margin guidance that failed to meet investor expectations. The two major changes noted by the companies reporting in March were the additional headwind caused by the conflict in Ukraine and a strong dollar. There are certainly signs of some recent demand softening in European markets beyond direct exposure to Ukraine, Russia and Belarus but US demand appears robust.
In hardware, E Ink Holdings (E-Ink) posted strong revenue growth of +59% y/y driven by robust ESL (electronic shelf label) shipments and surging sales resulting from delayed e-reader module shipments. On the supply front, the company noted that the progress of its capacity expansion plan remains on track with new revenue streams from one newly built production line in 1Q22. The second and third new production lines are expected to start contributing to sales in 2Q22, and E-Ink maintained its y/y capacity expansion target of 130-150% in 2022. Management reiterated its confidence for the near-term outlook and believe the current inflationary environment and labour constraints should help further accelerate ESL adoption.
In software, Adobe Systems (Adobe) delivered a mixed quarterly earnings report as a modest beat on revenues, EPS and ARR (annual recurring revenue) metrics was accompanied by lacklustre forward guidance. In the digital media segment, net new ARR additions, arguably most companies’ most important metric, reached $418m, beating guidance of $400m. However, Q2 guidance that incorporated a headwind across Russia/Belarus/Ukraine was softer than expected. Management called out a strong demand and macro backdrop but highlighted a weaker close to the quarter on account of the conflict in Ukraine. More positively, Adobe announced a pricing increase, its first since 2017, and reiterated FY22 revenue and EPS guidance despite Ukrainian headwinds ($75m), and management expect sequential ARR growth in Q3 and Q4. This likely underpins FY22 revenue and EPS guidance, and offsets the weaker near-term guidance to some degree.
UiPath echoed Adobe as strong quarterly results were outweighed by weak guidance for both next quarter and FY23. ARR accelerated in the quarter, growing +59% y/y to reach $925m, while revenue growth of +39% y/y was ahead of consensus expectations. The initial guidance outlook for FY23 forecasts ARR growth of +31% at the high end, which represents a near halving of the +59% growth reported in FY22. The company noted that the conflict in Ukraine, FX, and a concern about interest rates are affecting its customers heading into FY23.
One of our larger cybersecurity holdings, Crowdstrike Holdings (CrowdStrike), produced an impressive quarter, with revenue and ARR beating expectations. Subscription revenues grew +66% and ARR +65%. Net new ARR of $217m was an all-time high and driven by further expansion into the core endpoint market alongside a record quarter for cloud, identity protection and Humio (log management/search). Management described an inflection point occurring in newer/emerging modules and cited data cost as a key reason: the more modules a customer uses, the more leverage it sees from CrowdStrike’s data cloud strategy. Encouragingly, dollar-based net revenue retention (NRR) expanded +210bps sequentially to reach 124%, while the number of customers adopting four or more modules increased to 69%. Importantly, next quarter and full-year guidance exceeded expectations, with FY22 revenue guidance indicating growth of 47-49%, alongside margin expansion.
Smartsheet produced a mixed earnings report. Billings and revenue growth were both strong in the quarter at +48% and +38% y/y, respectively. NRR improved for the fourth consecutive quarter to 134%, with management expecting this metric to remain above 130% going forward. FY23 billings guidance of +37-40% was maintained but offset by a higher than expected pace of investments into FY23, which led to margin guidance below consensus. Sales and marketing represents the bulk of these investments as global field capacity and in-person field support are expanded. Notably, management remains confident of achieving positive free cash flow in FY24 and meeting the ‘Rule of 40’ in FY25.
Coupa Software (Coupa) delivered a weak earnings report as both quarterly results and forward guidance. Quarterly revenue increased only +18% y/y while subscription revenue grew +28%. Billings growth of +18% y/y also missed investor expectations and FY23 revenue guidance implied a deceleration to +16% y/y growth from +34% y/y in FY22. Pandemic-driven disruption around enterprise budget cycles appears to be lingering for Coupa and the resulting growth deceleration is taking longer to recover as management believes it will be a multi-year effort to return to pre-pandemic levels of growth.
The first quarter provided one of the most challenging market environments in recent years and disappointing, but by no means catastrophic, headline returns belied pain beneath the surface. The S&P 500 fell by -5% during the quarter (in dollar terms), as positive earnings revisions (+4.8%) were offset by meaningful multiple compression (-9.7%) as investors became increasingly concerned about persistent inflation, tighter financial conditions and Russia’s invasion of Ukraine.
Macroeconomic and geopolitical concerns continue to dominate investor conversations in the sector. Many investors have raised their expectations for an impending US recession, as stubborn inflation crimps real wage growth, 30-year mortgage rates have risen from 3.3% to 4.9% at the fastest rate in history, and the Fed maintains an increasingly hawkish approach to the point at which either inflation or economic growth, or both, will roll over. The Fed’s efforts to tame inflation are particularly hamstrung given the supply-side nature of many current inflationary pressures, including Chinese Covid outbreaks/restrictions, global supply chain disruptions and upward pressure on commodities (including from the Russia/Ukraine war), wage inflation from structural imbalances in the labour market and house price rises that have yet to factor fully into rental costs.
Against this increasingly challenging economic backdrop, the market has recovered a reasonable amount of ground from its mid-March lows, albeit on lower volumes.
Against this increasingly challenging economic backdrop, the market has recovered a reasonable amount of ground from its mid-March lows, albeit on lower volumes. As multiples compressed, we moved back to a more fully invested position but have since selectively taken profits in higher growth names and added a little more NASDAQ put protection to reflect the more challenging macroeconomic backdrop and likely conservative guidance in the forthcoming earnings season.
Despite the economic uncertainty, the secular tailwinds supporting most of our core themes remain strong, particularly in areas such as cybersecurity, clean tech/electric vehicles, 5G networks/devices, data centre (DC) capex and artificial intelligence/machine learning (AI/ML), with spend intentions in some of these areas potentially strengthened by events in Ukraine. We are more cautious on the outlook for companies with high discretionary consumer and/or European exposure, as the conflict in Ukraine and higher energy prices will likely weigh on sentiment and spending appetite of consumers and corporates alike. E-commerce and FinTech companies also face continued reopening headwinds and could be further impacted if consumer spending weakens or buying behaviour changes as a result of the current backdrop.
The case for technology exposure remains supported by myriad secular tailwinds and a superior growth profile that looks increasingly scarce in a more challenging global economic environment. In addition, valuations have compressed significantly over the past 12 months. The sector’s typically high gross margins and, in many cases, surprisingly strong pricing power should also ameliorate the impact of elevated inflation.
We remain confident that IT spending remains a necessity for companies to remain relevant, the most recent Morgan Stanley quarterly CIO survey (1Q22) suggesting 2022 budget growth of +4.2% y/y, only 24bps down from 4Q21 and ahead of the 10-year average. We remain cognisant, however, that the economic backdrop needs to remain sufficiently supportive so IT budgets remain available to be spent. It seems likely that Europe will see some disruption and higher energy prices could weigh on demand longer term, but the US continues to look robust on this measure. M&A activity has begun to pick up in software, with private equity being the most active so far, primarily focusing on slower growth companies but nonetheless providing something of a valuation floor.
We continue to tread carefully given the risk of higher inflation and more aggressive Fed tightening. Still, we are not yet anticipating a regime change in terms of the longer-term inflationary backdrop as future inflation expectations continue to remain well-anchored, and we believe technology remains a powerful deflationary force in the medium term. Fundamentals in most technology subsectors remain solid for now, and we look forward to the March quarter earnings season to provide more colour on current trends and the outlook for the rest of the year.
As at 7 April 2022.