Key points
- The technology sector outperformed the broader market in August, with large-cap technology stocks significantly outperforming their small and mid-cap peers.
- Companies’ fundamentals have held up quite well, with most continuing to execute well in a difficult environment that is neither deteriorating nor improving much.
- We remain excited about generative AI leading the next major leg of technology disruption following the internet, smartphone and cloud.
Market review
Global equity markets pulled back in August as the MSCI All Country World Net Total Return Index fell -1.3% while the S&P 500 Index and the DJ Euro Stoxx 600 Index fell -0.1% and -2.5% respectively (in sterling terms).
Investors were alarmed by rising US Treasury (government debt) yields. Despite waning inflation and an easing labour market, the 10-year Treasury yield rose to its highest point since November 2007. This was driven by a number of factors, including increased Treasury issuance (after the debt ceiling was raised), ongoing quantitative tightening (lower demand for government bonds from the Federal Reserve) and a US credit rating downgrade by Fitch Ratings, as well as concerns about China potentially offloading US Treasuries to bolster the yuan.
However, inflation is down meaningfully from peak levels. The US Consumer Price Index (CPI) was unchanged at +0.2% month on month (m/m) in July (matching market expectations), while the annual inflation rate accelerated to +3.2% year on year (y/y) from +3% y/y in June (but below forecasts of +3.3%). Core CPI, which excludes volatile items such as food and energy, eased to +4.7% y/y in July from +4.8% y/y in June, and reached its lowest level since October 2021. Forward-looking inflation measures appear relatively benign. The preliminary University of Michigan Surveys of Consumers pegged year-ahead inflation expectations at +3.3% in August, down modestly from +3.4% in July, but significantly lower than peak levels (+5.4% in April 2022), while five-year inflation expectations remain well anchored at +2.9%.
The US labour market remains resilient but is slowing down. Its economy added 187,000 jobs in July (below forecasts of 200,000), following a downwardly revised 185,000 in June, the two weakest monthly gains in two and a half years. This reading is also below the average monthly gain of 312,000 over the previous 12 months but remains about twice the 70,000-100,000 needed per month to keep up with growth in the working-age population. Wage growth remained elevated, however, with average hourly earnings edging up +0.4% m/m in July, above forecasts of +0.3%.
Companies’ fundamentals have held up quite well, with most continuing to execute well in a difficult environment that is neither deteriorating nor improving much.
The minutes from the July Federal Open Market Committee (FOMC) meeting revealed that “most” participants still saw “significant” upside risks to inflation that could require further tightening, although some committee members observed that risks were becoming more two-sided as policy was now restrictive. The committee noted substantial uncertainty about the lags with which monetary policy affects the economy. They observed “tentative signs” that inflation was moderating and assessed that while it remained very tight, demand and supply in the labour market were “coming into better balance”. Fed Chair Jerome Powell maintained a firm tone on tackling inflation in his Jackson Hole speech and emphasised the central bank would keep policy restrictive until it is confident inflation is heading back to its 2% target. However, Powell made little effort to prepare the market for a potential September rate hike.
Technology review
The technology sector outperformed the broader market in August as the Dow Jones World Technology Index fell -0.6%. Large-cap technology stocks significantly outperformed their small and mid-cap peers; the Russell 1000 Technology Index (large cap) and Russell 2000 Technology Index (small cap) returned -0.1% and -4% respectively.
At the subsector level, the Bloomberg Americas Software Index returned -0.1% and outperformed the Philadelphia Semiconductor Index (SOX) and the NASDAQ Internet Index, which returned -3.4% and -2.4% respectively.
We are coming to the tail end of earnings season. Companies’ fundamentals have held up quite well, with most continuing to execute well in a difficult environment that is neither deteriorating nor improving much. However, stock price reactions have been mixed, in part due to market positioning. Following the run-up in technology stocks this year, there have been some pronounced ‘sell the news’ reactions to in-line quarterly earnings results, especially for widely held names, such as HubSpot and Shopify, or perceived AI beneficiaries unable to show sufficient AI contribution in the near term (e.g. TSMC, ASML and Microsoft). The US debt downgrade and higher real rates have added further volatility, but we are encouraged by the fact that 2023 earnings revisions within the technology sector (c+5%) have been better than the broader market (c+1%).
Apple results were solid given the macroeconomic and currency headwinds, with total revenue meeting consensus expectations at $81.8bn, -1% y/y, and earnings per share beating expectations. Revenue from iPhones declined -2% y/y, with weakness in the US partially offset by emerging markets and China, while its services revenue increased +8% y/y (+10% y/y in constant currency (cc)), driven by greater than one billion paid subscriptions and strength in Cloud, Video, AppleCare and Payments. Next quarter guidance for similar year-on-year growth was modestly below expectations but factors in currency headwinds, while iPhone and services revenue is expected to accelerate. Management remained tight-lipped about the company’s AI efforts, saying they would not talk about AI products until they came to market.
In the internet sector, Amazon reported strong top and bottom-line results. Amazon Web Services (AWS) grew +12% y/y cc (above expectations at +10% y/y cc). While this was down from +16% y/y cc in the previous quarter, growth accelerated throughout the quarter from +11% y/y cc exiting April with management noting that customers started shifting from cost optimisation to new workload deployment. Operating income was materially above expectations, driven by improvements in the North American retail business, as well as operating margin stabilisation at AWS. Next quarter guidance was also better than expected. Management commented on a number of generative AI releases to make it easier and cheaper for customers to train and run models (Trainium and Inferentia chips), customise large language models (Bedrock) and write code much more efficiently (CodeWhisperer).
NVIDIA delivered exceptional top and bottom-line results and guidance, above even the most elevated expectations.
Shopify also reported strong results, with gross merchandise value (GMV) growth of +17% y/y, revenue growth of +31% y/y (benefiting from pricing) and better than expected profitability. Next quarter guidance for low 20% organic growth was also above forecasts, but operating expenses were guided to be “flattish to up” quarter on quarter (q/q), which was a disappointment given expectations for rigorous cost control, with consensus anticipating -15% q/q. This was due to wage increases and investment in new initiatives such as offline point of sale and offline marketing. Fortunately, this should be offset by higher gross margins, which are expected to be up q/q due to increased pricing and the sale of the logistics business. On the AI front, the company launched Shopify Magic, a suite of free AI-enabled features including Sidekick, an AI-powered personal commerce assistant.
In video games, ROBLOX reported bookings growth of +22% y/y cc (modestly below consensus forecasts), moderating from +25% y/y cc in 1Q23. Daily active users (DAUs) reached 65.5 million, with growth accelerating to +25% y/y from +22% y/y in 1Q23. However bottom-line results were below expectations, with adjusted EBITDA of $37.9m, >20% below consensus at $50m due to higher-than-expected personnel costs which grew +42% y/y. Forward-looking corporate profitability was reset lower, although management instituted operational plans to help drive leverage across operating expense lines.
In the online travel segment, Airbnb’s gross bookings volume (GBV) growth decelerated to +13% y/y cc (from +22% y/y cc last quarter), in line with expectations. Nights and experiences booked increased +11% y/y to 115.1 million, 3% below expectations, but the impact on bookings was offset by higher than expected average daily rates (+2% y/y cc). Encouragingly, bookings growth accelerated through the quarter from +10% y/y in April to +15% y/y in June. Revenue was also better than expected due to a higher take rate, while earnings before interest, taxes, depreciation and amortisation were materially higher than expected. Next quarter guidance for nights and experiences booked was below expectations.
In the software sector, Workday reported a strong quarter with all key metrics above forecasts. The important 24-month subscription backlog metric increased +23% y/y, ahead of guidance at +20% y/y, driven by solid new bookings in financial services, healthcare, education and government verticals. Full-year subscription revenue and operating margin guidance was raised. The company could be well positioned to benefit from generative AI given >3,000 customers are already sharing data with Workday’s large language models for model training purposes. Management believes there is “direct monetisation” potential for these, although we will have to wait for Workday’s investor day next month for more details.
HubSpot continued to execute well in a tricky environment, with revenue (+26% y/y) and operating margins above forecast. However, billings growth decelerated more than expected, to +22% y/y cc, down from +28% y/y cc in Q1. Next quarter guidance for revenue growth of +20% y/y was modestly below buyside expectations, but management is likely being prudent. Management still raised full-year revenue growth guidance from +20.5% y/y cc to +22% y/y cc. Operating margin guidance was also edged up from 13% to 14%. Management will give more information on AI products at their INBOUND 2023 conference in early September. HubSpot are not, at this stage, planning to charge for AI functionality separately but will use it as a lever to convert its massive Starter suite customer base to higher-priced tiers.
Salesforce results were better than expected. Revenue grew +11% y/y, while its current remaining performance obligation (the sum of deferred revenue and backlog the company is obligated to deliver over the next 12 months) grew +12% y/y (and was guided to grow >11% in Q3). The company also made better than expected progress on increasing profitability: non-GAAP (generally accepted accounting principles) operating margins of 31.6% in the quarter, up 12% y/y and well ahead of forecasts at 28.4%. Full year non-GAAP operating margin guidance was raised to c30%, up 7.5% y/y, driving earnings estimate upgrades. Although management did say they will look to balance their growth strategy with efficiency improvements, taking advantage of generative AI to potentially drive a growth reacceleration.
In the semiconductor sector, the market breathed a sigh of relief when NVIDIA delivered exceptional top and bottom-line results and guidance, above even the most elevated expectations. Quarterly revenue was $13.5bn, up +88% q/q and 101% y/y, well above consensus estimates at $11.2bn, driven by extraordinary demand for graphics processing units (GPUs) for AI applications. Next quarter revenue guidance of $16bn was even more impressive, with consensus estimates at $12.7bn. Management noted demand visibility "well into 2024", while supply is expected to increase sequentially through that timeframe. CEO Jensen Huang stressed that the global compute world is seeing a twin-track generational platform shift in the move to accelerated compute and generative AI. While the muted stock reaction to the earnings report was a little disappointing, NVIDIA still finished the week +6% and outperformed both the SOX and NASDAQ indices during the month.
Advanced Micro Devices (AMD)’s results and guidance were better than expected. Q2 revenue was -18% y/y, slightly above consensus expectations. Data centre revenue was -11% y/y with lower Milan processor sales due to soft enterprise demand and inventory digestion, partially offset by continued Genoa processor momentum. Next quarter guidance for revenue growth of +6% y/y (with data centre expected to be flat y/y) was slightly below consensus estimates, but the company expects a strong finish to the year driven by the ramp up of new products. Management cited strong, diverse customer interest in their MI300 AI chips, which could be a driver of the data centre segment momentum into 2024 as customers are looking for alternatives to NVIDIA's market-leading GPU portfolio.
Lattice Semiconductor continues to execute well, with top and bottom-line results and guidance ahead of expectations. Growth in the automotive and industrial segment (+55% y/y) offset weakness in the communications and computing segment (-11% y/y) due to the ongoing inventory correction. Management expects a similar dynamic in Q3 leading to company-wide growth of +1% q/q. More important is the ramp of the company’s Avant platform, which should enable it to benefit from AI and general-purpose server spend in 1H24. Management expects the Avant family to grow to 15-20% of the company's total revenues in 2025-26.
Outlook
Technology sentiment has become more measured in recent weeks after a strong run in markets year-to-date. Investors are grappling with the unusual combination of post-crisis highs in both US Treasury yields and technology sector P/E (price to earnings) multiples. While many companies have noted that the IT spending environment has stabilised, signs of green shoots outside AI-related spending are more sparse. Corporate IT spending is still subject to intense scrutiny – one large software company CEO recently reported that a customer CEO or CFO was required to sign off on more than half their deals in recent weeks, up from “almost none” a year ago.
While we fully expect AI to drive up technology spending as a percentage of GDP over the longer term, in the near term there is a risk that AI spending crowds out other priorities. This has been most visible in the data centre but could spread to other areas. To this point, OpenAI has reportedly achieved a $1bn revenue run rate while GPU cloud provider Coreweave has seen $10bn of commitments this year. These rapid shifts in marginal spending priorities occur at the inflection point of a new technology paradigm and support our excitement that the shift to generative AI will be the next major leg of technology disruption following the internet, smartphone and cloud.
We believe we have reached an inflection point in AI capabilities and adoption and have taken an AI lens to existing positions and potential new holdings to ensure we are avoiding companies where we believe AI is of little benefit or a possible headwind. As we head into a busy conference season, the team will be travelling to meet companies and will be looking for signs of improvement in the IT spending environment as well as harvesting early AI data points to inform our positioning.
The shift to generative AI will be the next major leg of technology disruption following the internet, smartphone and cloud.
As investors peer into 2024, the potential for both revenue and earnings reacceleration is one of the main areas of focus. Investor expectations embed assumptions around the macroeconomic and IT spending environment as well as the availability of critical AI infrastructure resources (primarily NVIDIA’s H100 GPUs) to support the move to an AI-led future. Regarding the former, recent labour market and inflation data has been broadly supportive of the soft landing narrative: the Fed’s preferred core PCE measure has moderated to an annualised +2.9% rate over the past three months, the jobs/workers gap and quits rate have nearly returned to pre-pandemic levels and average hourly earnings growth continues to trend lower. However, the juxtaposition of more encouraging inflation data points with the recent moves higher in real interest rates and oil prices gives us some pause, as does the weaker Chinese recovery and the less ‘frozen’ conflict in Ukraine. We also remain cognisant of less encouraging consumer credit and business survey trends as well as concerns about the resumption of student debt repayments. The Bloomberg Consensus 12-month US recession probability has remained around 60% for most of this year.
Finally, we must (again) highlight the concentration of equity market returns this year. In part, this has been due to, in our view justifiable, excitement regarding AI. Nevertheless, it has contributed to one of the largest divergences between large and small-cap technology stocks that we can recall with the Russell 1000 Technology Index (large-cap) outpacing the Russell 2000 Technology Index (small-cap) by 29% year to date, and by more than 100% over the past five years. At time of writing, the ratio of small-cap to large-cap technology is testing 2008 relative lows. This dynamic has not only made it difficult for active managers to outpace market-cap-weighted indices, but also led to our own portfolio (and benchmark) becoming significantly more concentrated. While this market-cap concentration has not been divorced from the largest index constituents’ earnings contribution, we still feel the growing tension between managing absolute and relative risk within the portfolio. Most active managers – us included – would welcome a less narrow market, but for now we must navigate the market we have, rather than the one we want. Thankfully, it is also a market where recent AI breakthroughs have allowed the technology sector to regain leadership status after a tough 2022.
In part due to our excitement regarding the scope of AI opportunities we believe will unfold in the coming years, we continue to invest in the team and are delighted to announce two new hires. Fred Holt joins the team as an Investment Analyst from Janus Henderson Investors and Lina Ghayor joins as an Investment Analyst from Exane BNP Paribas. Fred and Lina represent some of the best young talent in the market today and their addition will further enhance our ability to identify and invest in the most exciting technology themes and companies.
