Inflation concern won’t change positive outlook for tech stocks

Rahul Ghosh March 09, 2022 12:03

Technology stocks have been particularly vulnerable at the start of the year. Despite the current market weakness, we believe technology will continue to be a principal driver of change in today's increasingly digital global economy, and a key determinant of whether a company will succeed in a rapidly changing environment. Our long-term outlook for the technology sector remains positive and here is why.

Technology Enables Changes Across Every Industry

Much of the recent volatility for tech stocks has been driven by the US Federal Reserve switching to a more hawkish stance, indicating earlier rate hikes, and removing all reference to the word “transitory” when it came to discussing inflation. As a result, investors panicked with one of the sharpest rotations on record, away from growth stocks in favor of value and defensive stocks.

We acknowledge that there are macro headwinds for tech stocks. In the short term, there is always going to be some impact on multiples compressing at a time when investors have become more concerned about inflation. However, there is no observable rule that if interest rates increase, then tech stocks must underperform because to the extent that economic growth remain strong, ultimately, that is what drives investments and innovation creativity of the tech sector.

If we take a longer-term view, we are experiencing a digital revolution in technology that is changing the way we work, consume, socialize and interact in many different ways. The pace of innovation is accelerating, having been given a boost by the Covid-19 pandemic with its emphasis on work-from-home. A study by Oxford Economics in 2016 estimated that the digital economy broadly defined accounted for approximately 16% of global GDP (gross domestic product), having grown 2.5 times that of overall GDP in the past 15 years. Technologies are increasingly interconnected, with innovation everywhere and anywhere, all around us, with few areas unscathed by the "digitalization of everything".

What we see happening is that technology is a key driver of change in the world today that affects everyone from consumers to businesses to governments. Given that, as a forward-looking investor, we cannot stand still but must continue seeking to invest in new technologies. With technology having become the enabler of so much change, it is hardly surprising that the sector has essentially become a staple holding for many global investment portfolios.

We have also seen an acceleration in tech earnings per share over the past decade. Since 2010, the tech sector has compounded earnings at a growth rate double that of the broader MSCI All Country World Index. This indicates that technology has become ever more integral to growth in a global economy. As a result of this secular earnings trend, the sector is set to remain a fertile hunting ground for good potential long-term value.

Bottom-up Stock Picking Is Key in a Highly Active Sector

In our view, technology is not a stable sector, but a highly active one with potentially wide performance differentiation between the different technology sub-sectors (such as hardware, software, semiconductors, internet for example). This is very different from a stable sector like consumer staples that tends to grow in line with GDP. Differentiation in performance between the different categories of technology means that bottom-up stock picking skills are at a premium in global technology investing.

Based on MSCI All Country World Index data, since 1995, the tech sector has delivered the strongest performance of any sector, though at the cost of higher volatility (standard deviation of returns). Underpinning this outperformance, tech sector earnings have posted the best median earnings per share growth over the past 20 years. Thus, the sector has given higher returns in recent decades because tech companies have been able to grow their sales, earnings, revenues and profits at a pace that is better than most others. What this means for the active bottom-up investor is that the tech sector can offer opportunities to take advantage of the volatility to build up average returns over time.

What Do Investor Look for beyond the Immediate Volatility?

In our stock picking, we like to look for nonlinear opportunities in global tech where the company has a large, growing addressable market and a distinctive business model capable of driving growth in the coming years. We are looking for good entrepreneurial managers who have innovative ideas, and who can drive their business as well as good capital returns over time.

With this approach of finding different innovative companies, technologies and managers, it helps to create a diversified portfolio that reflects the major changes and themes that are happening in the world of information technology today, whether it be in cloud computing, artificial intelligence, autonomous vehicles, infrastructure as a service, or software as a service - not just in the US or China, but globally.

We view many of the tech companies as not being part of the inflation problem, but part of the solution. That is because digitalization drives efficiency and productivity gains, helping to lower costs and avoid some of the potential pressures from higher inflation.

There may be some significant short-term hiccups within global tech as valuations adjust to higher inflation and interest rate scenarios. However, once these adjustments are out of the way, then we believe investors’ focus will return to the fundamentals that really matter most – seeking to identify those companies that have the best prospective earnings growth over time.

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Rahul Ghosh

Portfolio Specialist for T. Rowe Price's Global Technology Equity Strategy