Tech is king – everywhere?

Equities

Tech is king – everywhere?

Silicon Valley's lead is widening. We are impressed but not across the board, as the sector is pretty heterogeneous.

Given the political news flow, equity markets have weathered the summer astonishingly well – at least from an American standpoint, which the U.S. President seems to never tire of stressing as the one that really counts: when America is doing well, the world is doing well. Well, not quite. First, global economic prosperity now almost equally depends on the well-being of China, whose GDP, adjusted for purchasing power, outstrips that of the United States. Second, too many American wins may also have a cost, triggering U.S. interest-rate hikes and a stronger dollar that could hurt emerging markets. But there's no doubt that, from the American perspective, things have been going exceptionally well. In May, U.S. indices decoupled from their global counterparts, and since then have hit a raft of new all-time highs. Since August 22, Wall Street has experienced the longest S&P 500bull run in its history – 3,453 days without a 20% pullback. The bullish reasons are easy to find. Thanks to a robust economy and the tax reform, the net profit of S&P 500 companies was up by an average of 25% in the second quarter, thereby beating 80% of analyst projections – a multi-year record. Furthermore, CEOs know exactly how to please their shareholders, who do not want repatriated foreign profits to trickle down through capital expenditure (capex) and higher operating profits but prefer the direct route: juicy share buybacks. In the first half of this year, buybacks, up by 48%, exceeded capex, up only 19% year-on-year, for the first time in ten years. One key driver of this development has been technology (tech). Its market dominance is giving us good reason to take a closer look.

We spent two months in Silicon Valley, the beating heart of the tech sector, and spoke with over 100 experts and senior executives during visits to both private and listed companies. Silicon Valley is truly astonishing. It is home to only 1.25% of the U.S. population but accounts for one third of the market cap of the S&P 500. Half of the U.S. venture capital is invested there. The starting salaries of top college graduates exceed even those on Wall Street. And rents have skyrocketed: it would take 4.7 minimum-wage jobs to afford a 2-bedroom apartment in San Francisco, as this can cost anything between 2,000 and 7,000 dollars per month. All this one can read. But in order to fully understand the exceptional status of this region and its companies, a field trip was necessary. After all, the investment decisions of active fund managers are also based on first-hand impressions. The most formative of these were:

• From a European perspective, Silicon Valley appears to be years ahead of much of the rest of the world in some regards.

• This has to do with the Valley's proverbial network effects but also with the vast sums top players here can plough into tech projects that may take years to monetize.

• Much of the available cash flows into acquisitions, driving prices for young companies to levels that few outside the Valley can afford.

• The big, successful players also cement their concentration of power in other ways. In the competition for talent, a company must be able to score points for innovation leadership or a hip image. Even established tech companies from the turn of the millennium struggle to keep up with the trendiest new entrants.

• In the Valley, it's (almost) all about scalability and speed. The objective is to seize new markets ahead of the competition, create barriers to access through size and achieve exponential sales growth. If a company shows it is on track to achieve these goals, no one cares about operating losses, even if they are large.

So much for our impressions on the ground. What can we incorporate from this into our investment strategy? We have undoubtedly gained respect for this powerhouse, which in many regards looks unassailable. For some time it looked as though Chinese firms, in their protected domestic market, could hold their own against the big boys from the West Coast. But the Chinese tech sector has lost almost one quarter of its value since its high in the summer, with the trade war unleashed by President Trump undoubtedly a contributing factor. European or Japanese competition has meanwhile become almost negligible, as can be clearly seen in the chart showing the development of the market capitalization of the respective tech indices. We left the Californian coast suitably impressed, especially since we believe that the new wave of digitalization and networking will bring structural tailwinds to the sector for years to come. Valuations on certain metrics are high, but price-to-earnings multiples are not as demanding as at the beginning of the millennium – because profits are so impressive. And yet, surprising as it may seem, we are downgrading the sector to Neutral on tactical grounds.

Leaving aside medium-term concerns about regulation, competition and changed customer preferences and focusing on the short term, the summer has demonstrated just how high the expectations pinned on this far from homogeneous sector are. Some heavyweights saw their stock prices plummet after their apparently unassailable competitive position was called into question. But our downgrade also has to do with the restructuring of the MSCI Information Technology Index on which we base our sector weighting. At the end of November, some of our favorite stocks will move to the newly created "Communication" Index, thereby increasing the weight of the more cyclical semiconductor stocks. (This reclassification has already happened in the S&P 500 index). We are therefore upgrading the "Communication" sector, which comprises the old Telecom Index, to Neutral. Consequently, we are entering the fall with no clear regional and sector preferences. But the coming months will bring key political developments, on Brexit, the trade conflict and Italy as well as the results of the U.S. mid-term elections. What happens in the coming months will give us a better basis on which to build our next forecast cycle.

U.S. tech stocks extend their lead

Europe's and Japan's tech sectors are losing ground versus the United States', while Asia is closing the gap.

Valuations

Valuations overview

United States: Neutral (Neutral)*

The last few months have seen U.S. equities reinforce their special status by racing ahead of the other global exchanges. Seldom before has the U.S. market decoupled so quickly and so far – also in terms of valuation – from other markets. The primary factor here is the tech sector – alongside short-term support from the tax reform and a higher oil price. From here on, we, however, believe the potential for positive surprises is limited.

Europe: Neutral (Neutral)*

European equities are currently coming under pressure from numerous sides. The trade conflict and the weakness in emerging markets are having a major impact on this region that relies so heavily on exports. In Germany, this also includes an auto sector struggling with its own specific problems and a slowdown in global demand. Earnings growth, valuation and the potential for positive surprises do, however, speak in favor of this region.

Japan: Neutral (Neutral)*

The picture in Japan is unchanged. The reform process is running its course, also reflected in returns on equity that are slowly approaching the international average again. The latest quarterly numbers were also convincing, but earnings growth is currently losing momentum. As in Europe, the trade conflict and the weakness in emerging markets are also hurting Japanese equities. We are waiting for a new trigger.

Emerging Markets: Neutral (Neutral)*

This year, investors are closely monitoring emerging markets. Since February, equity markets there have lagged behind their foreign counterparts after rising U.S. interest rates and a strong U.S. dollar had amplified the problems of some frail countries. These are primarily outside Asia where, however, the trade war is casting a longer shadow. Nevertheless, we do not expect market contagion. We continue to see opportunities primarily in Asia.

*Our assessment is relative to the MSCI AC World Index, the last quarter's view is shown in parentheses.