Key points

• Global equity markets had a tough month, partly on the back of a further rise in US Treasury yields
• The technology sector modestly underperformed the broader equity market, with all subsectors under pressure
• We remain very enthusiastic about the AI opportunity and look forward to several potential catalysts over the next few months

Market review

Global equity markets continued to decline in September. The MSCI All Country World Net Total Return Index returned -0.6% while the S&P 500 Index and the DJ Euro Stoxx 600 Index delivered -1.2% and -0.4% respectively (in sterling terms). This was the fourth September in a row that both the S&P 500 and DJ Euro Stoxx 600 declined.

Market sentiment was impacted by a further rise in US Treasury yields and, despite an easing labour market, the 10-year yield rose to its highest point since October 2007. The move was driven by several inflation measures which accelerated year-on-year (y/y), driven by rising energy prices. Brent crude increased from $87 per barrel to $95 during the month. Other factors may have included increased Treasury issuance after the debt ceiling was raised, ongoing quantitative tightening (lower demand from the Federal Reserve) and commentary from some Federal Reserve board members indicating they expect interest rates to stay higher for longer.

The US Consumer Price Index (CPI) rose +0.6% m/m in August, in line with market expectations but a notable acceleration from +0.2% in July, driven mostly by rising gasoline costs. The annual inflation rate accelerated from +3.2% y/y to +3.7% y/y in August (above forecasts of +3.6% y/y) but remains meaningfully below peak levels. Core CPI, which excludes volatile items such as food and energy, slowed for the fifth month to +4.3% y/y, from +4.7% y/y in July. Forward-looking inflation measures, however, continue to appear relatively benign. The Producer Price Index (PPI) only increased +1.6% y/y in August, although this was above forecasts of +1.2% y/y due to higher energy prices.

The US labour market remains resilient but is, encouragingly, slowing down. The US economy added 187,000 jobs in August (above forecasts of 170,000), despite the Hollywood writers’ strikes and the bankruptcy of Yellow, a large trucking company. However, payroll growth over the previous two months was revised down by 110,000, taking the three-month moving average down to 150,000 – the lowest level since 2021. Average hourly earnings only increased +0.2% m/m in August (below forecasts), down from +0.4% m/m in July.

As anticipated, the Federal Reserve (Fed) left its policy rate unchanged at 5.25-5.5% (a 22-year high) at its September meeting. There was, however, a significant adjustment to its interest rate projections. One more 25 basis point (bp) rate hike is expected this year and only 50bps of cuts in 2024 (down from 100bps in the June projections). The implication is the Fed wants the markets to believe in its ‘higher for longer’ mantra. This was justified by upgraded economic forecasts, with higher economic growth and lower unemployment projections implying an increased likelihood of an ‘immaculate disinflation’ path whereby inflation can come down without a meaningful increase in the unemployment rate.

Technology review

The technology sector underperformed the broader market during September as the Dow Jones World Technology Index returned -2.3%. Large-cap technology stocks outperformed their small and mid-cap peers; the Russell 1000 Technology Index (large cap) and Russell 2000 Technology Index (small cap) returned -2.4% and -4.4% respectively.

All major technology subsectors came under pressure. The Philadelphia Semiconductor Index (SOX) returned -2.8%, while the NASDAQ Internet Index and Bloomberg Americas Software Index returned -1.8% and -1.4% respectively.

[Adobe Systems] recently announced the commercial launch of Firefly, its generative-AI web app, and Firefly-powered capabilities are now integrated across other products.

During the month, there were a few notable results. In the software sector, Adobe Systems (Adobe) delivered better than expected top and bottom-line results and guidance. Operating margin was 46.3% in the quarter, the third-highest quarterly margin in the company’s history, despite bearing costs related to generative AI without yet realising any revenue to offset those costs. Management attributed this performance to a higher level of scrutiny on expenses. The company recently announced the commercial launch of Firefly, its generative-AI web app, and Firefly-powered capabilities are now integrated across other products. The pricing strategy involves a combination of subscription (for a certain number of credits which will reset each month) and consumption (for additional credits required).

Cloud infrastructure provider Zscaler delivered strong results, beating expectations across the board, with the key billings growth metric of +38% y/y coming in above market forecasts of +27% y/y, driven by healthy new customer growth, particularly within the large enterprise segment. Initial FY24 billings growth guidance was better than expected at +25% y/y, although free cashflow margin guidance was a touch light as the company intends to invest in more datacentre capacity. Long-term growth drivers remain intact. Recent Chief Investment Officer surveys¹ showed that the secure access service edge (SASE) segment where Zscaler is well positioned is a growing spending priority within cybersecurity, and their data protection capabilities help prevent the leakage of sensitive data through AI prompts.

MongoDB, an opensource database platform, reported strong results with revenue up +40% y/y and operating margins well above expectations. The results show the resilience of the core database product in the face of a difficult operating environment. Management issued better than expected guidance for the next quarter and raised their full-year guidance as better consumption trends are expected to flow into the rest of the year. We believe the company has a long runway for growth given its low penetration of the $91bn database market and the potential for the database layer to be an important beneficiary of AI growth.

Chinese online travel agency Trip.com reported strong results, with net revenues +180% y/y (29% above 2Q19, before the pandemic) and an operating margin of 31% (up from 19% in 2Q19) driven by robust pent-up demand domestically, steady outbound recovery and operating leverage. Management commentary about Q3 was also positive, noting strong seasonality thanks to the summer holidays and National Day Golden Week, and continued robust demand, primarily driven by leisure travel. That said, Chinese domestic travel momentum may see a slowdown due to weak seasonality in 4Q23, so we reduced our exposure.

In other news, Cisco (not held) announced its intention to acquire Splunk for c$28bn (a 31% premium to the prior closing price) in an all-cash deal. This would be Cisco’s largest acquisition ever and it is expected to close by 3Q24. Encouragingly, the valuation multiple paid (6.4x enterprise value/calendar year (CY) 2024 sales or 26.2x enterprise value/CY24 free cashflow) is higher on a growth-adjusted basis than other recent takeouts in software/security.

Outlook

The significant rise in US bond yields to multi-decade highs has put downward pressure on many risk assets including growth equities and raised concerns about the downstream impact of interest rates that might remain higher for longer, even as inflation expectations remain well-anchored. The scale of the move in yields has been significant and by the end of the month Treasury yields had posted their largest quarterly rise since 1Q09 (bond yields move inversely to prices). The risks associated with the increased cost of debt are widespread. Goldman Sachs have estimated that US federal interest expense could rise from 2% of GDP in 2022 to 3% in 2024 and surpass the early 1990s peak by 2025, with concerns about the political will to tackle the growing US fiscal deficit to which this would contribute. The narrowly averted US government shutdown and recent downgrade by US rating agency Fitch have focused investors’ attention from monetary policymakers (central bankers) towards their fiscal counterparts (politicians).

Political risk appears elevated across multiple vectors and continues to cloud the inflation outlook. This includes oil production cuts and the ongoing impact of the Ukraine war on energy prices, as well as risks from a more assertive Iran which can now produce material for a nuclear bomb within two weeks, according to a recent US report. It remains an open question as to whether the domestic US political backdrop is conducive to lower inflation as President Biden became the first sitting President to walk a picket line with the United Automobile Workers, and striking Hollywood writers only agreed to go back to work following a deal with the studios regarding working conditions and rules governing the adoption of AI. The next round of elections globally is likely to be fought on areas which will have far-reaching implications for inflation (e.g. fiscal spending, domestic industrial subsidies, the green transition and security spending).

The regulatory environment for Big Tech remains hostile as the US Federal Trade Commission (FTC) launched a long-awaited case against Amazon, and the Department of Justice case against Google continues. We will continue to monitor these closely although their resolution typically takes many years. Technology companies operate in highly competitive markets and we were encouraged by the testimony of the Microsoft CEO, Satya Nadella, during the Google trial in which he remarked “Do you think Google would continue to pay Apple if there was no search competition? Why would they do that?”. There is always the possibility of genuinely detrimental remedies or enforcement actions as well as large fines, but we take comfort that while governments may take such actions, they also need to support their technology champions to stay at the forefront of AI innovation for geostrategic reasons.

As we move into Q4, there are several reasons to be more constructive on the technology outlook despite the headwind from higher interest rates. The technology sector is unique in enjoying a net cash position and within the portfolio we have always placed great emphasis on companies with strong balance sheets and at least line of sight to cashflow generation in the near term. When interest rates were lower, investors placed limited emphasis on this characteristic, but it may now bolster the sector’s perceived defensiveness as the impact of higher rates exposes reliance on leverage in other areas of the market. Earlier this year mega-cap technology outperformed during the US regional banking crisis as a relative safe haven, in part, on this basis.

We fully expect the sector to grow in excess of the broader market as customers seek to use technology to drive efficiency and prepare for the onset of the AI era.

After a sharp pullback, expectations for Q3 technology earnings are somewhat muted. We expect the first indications of company growth expectations for 2024 to be conservative (even on easier y/y comparators) given the tight IT spending environment, but we fully expect the sector to grow in excess of the broader market as customers seek to use technology to drive efficiency and prepare for the onset of the AI era. Technology research specialists Gartner expects global IT spending growth to recover momentum and grow 6.8% in FY24, up from an expected 4.4% in FY23, and remain above 7% through to FY27 supported by generative AI spending.

There are a number of near-term catalysts which could ignite further enthusiasm for the AI investment theme, with products from a number of companies including Microsoft, Adobe and Meta Platforms becoming more generally available. Early feedback will be noisy but potentially significant in assessing the timeline to adoption and widespread monetisation of this extraordinary technological breakthrough. Over the longer term, we remain very enthusiastic about the AI opportunity and the potential for significant economic and market ramifications. A recent study from Morgan Stanley found that 25% of labour can be impacted by generative AI capabilities today, potentially rising to 44% of labour within three years, which could translate to a c$4.1trn economic impact. Given the challenging market and rates backdrop we have raised cash and added a small amount of NASDAQ put option protection – used to limit risk – but retained our pro-AI positioning across the portfolio. We believe we should be able to take advantage of any near-term price dislocations, should the market environment deteriorate further.

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