Portfolio Manager
2022 started with fresh optimism that the world economy would, at last, start to emerge from the shadow of the pandemic. That optimism quickly faded as Russia’s invasion of the Ukraine plunged the world into another crisis. It fuelled a mounting inflation problem that forced major central banks across the world to raise interest rates. It proved a challenging backdrop for financial markets, and the technology sector in particular.
The reverberations from the war in Ukraine were felt across the world. The sanctions imposed on Russia as a result of the invasion pushed up energy costs, which were reflected in higher inflation figures. The war exaggerated existing fault lines in the US/China relationship and inflamed geopolitical tensions more widely. Countries started to increase protectionism, particularly around key technologies such as semiconductors.
The war’s impact on energy prices and inflation proved the most immediate problem. The US Consumer Price Index rose steadily from 7% in January to a peak of 9.1% in June. Early assessment that inflation would be transitory proved misplaced and the Federal Reserve (‘Fed’) was forced into rapid action. The US Fed funds rate moved from a range of 0.25-0.5% at the start of the year to a range of 4.25%-4.5% by December, pushing borrowing costs to their highest level since 2007.
The Fed continued to talk tough on inflation even as pressures started to ease in the second half of the year. In the December meeting Fed chair Jay Powell said: “Historical experience cautions strongly against prematurely loosening policy. I wouldn’t see us considering rate cuts until the committee is confident that inflation is moving down to 2% in a sustained way.” With inflation still at 7.1% by the end of the year, there was still some way to go.
Part of the problem has been wage inflation. Employment levels have remained high, which has created wage pressures. Nevertheless, strength in the jobs market has helped cushion the hit from higher inflation and interest rates for the economy. The IMF forecasts that global growth will slow from 6.0% in 2021 to 3.2% in 2022 and 2.7% in 2023. It said: “This is the weakest growth profile since 2001 except for the global financial crisis and the acute phase of the COVID-19 pandemic.”
The Euro area has been most affected by the energy crisis and growth is expected to fall to just 0.5% in 2023, with many of its major economies in recession. The US is also widely expected to experience recession in the year ahead. For emerging and developing Asia, much will depend on the relative strength of China, which continued to be held back by Covid restrictions for much of the year. By the end of the year, it had relaxed its zero-Covid policy and there were hopes that its economy could revive.
There were a number of notable legislative initiatives in 2023. In the US, the Inflation Reduction Act allocated significant funding for green energy initiatives and domestic energy investment. The CHIPS and Science Act sought to encourage domestic production of semiconductors and exclude unfriendly foreign powers from the technology ecosystem. In the EU, the RePower EU initiative brought more funding for renewable energy, as European powers sought to wean themselves off Russian fossil fuels. Largely overlooked in 2022, these may set the tone for economic development in the year ahead.
This uncertain backdrop led to significant weakness in global financial markets. Markets were already wobbling at the end of 2021, and in 2022, the FTSE World Index dipped 6% from 2,774 to 2,603 over the year. The technology sector was particularly weak, as higher interest rates pushed investors to reappraise valuations.
High valuations had been sustained by a very low risk-free interest rate, which had seen the long-term cashflows they offered highly prized by investors. In a climate of rising interest rates, these cashflows were worth less. The fastest growing companies – where more of their valuation was tied up in future revenues - proved particularly vulnerable. Even though many companies continued to deliver high growth and outpace earnings expectations, it held back their share price progress.
The year was generally characterised by a growing gap between operational and share price performance, but there were some weak spots on earnings. Amazon, for example, struggled as the consumer environment weakened, while Meta’s foray into the metaverse proved more expensive and less remunerative than hoped. Companies exposed to advertising revenues proved vulnerable as economic growth slipped, including Alphabet. Nevertheless, there were also pockets of resilience. Demand for iPhones held up, supporting Apple’s earnings, while Microsoft’s cloud computing division helped earnings for the wider business.
Stock markets had started to recover by the end of the year in response to stronger signs on inflation. This may be premature. The Federal Reserve remains committed to further rate rises and there are relatively few signs of weakness in the all-important labour market. However, there can little doubt that the majority of the rate rises are now in the past and markets substantially reflect the new environment. Valuations are significantly lower than a year ago.
2022 was a year when everyone was watching the Fed. The fortunes of individual companies appeared to matter less than the latest comments from Chair Jay Powell as investors tried to judge whether central banks would be able to fight inflation without collapsing the economy. Financial markets were slow to recognise the Federal Reserve’s commitment to curbing inflation, but were ultimately forced to accept the reality of higher rates.
It is not yet clear whether the Federal Reserve will manage to engineer a ‘soft landing’ for the US economy. If inflation continues to fall, investors can expect a more benign interest rate environment in 2023. It is likely that there will be further rate rises, but these are expected by markets and the significant adjustment necessary in 2022 is unlikely to be repeated. Considerable uncertainty remains for the global economy.
Geopolitical tensions have been a growing feature of global trade in recent years, but the problems accelerated in 2022. Russia’s invasion of Ukraine saw many countries pick sides and put the US and China in opposing camps.There is now a recognition that globalisation is reversing.
This has significant implications for the corporate sector, with companies increasingly prioritising security of supply over cost. Companies have brought manufacturing back to the US, increased inventories and re-routed supply chains.
There are opportunities in key sectors: manufacturing closer to home is likely to be more expensive, so companies are turning to automation, bringing opportunities in areas such as robotics. As countries bring in protectionist policies, companies are making investments. In response to the CHIPS and Science Act, Micron was emboldened to invest in supply. It will build a new $20bn chip factory in Clay, New York to take advantage of the new subsidies.
Companies with high growth have been in the ascendancy over the past decade. There can be little doubt that 2022 marked the start of a different environment. Even if inflation falls, the world is unlikely to revert to previous low interest rates. Markets had to make this painful adjustment in 2022, which partially explains the weakness of technology and the strength of ‘value’ parts of the market.
However, this does not mean that markets will not recognise growth in the years ahead. The growth versus value debate will remain pertinent, but with the major adjustment to interest rates now in the past, we expect an environment where stock characteristics play a bigger role than macroeconomic factors.
This was unquestionably a tough year for the Company, both in relative and absolute terms. The Company’s net asset value fell 33.6%, compared to a fall of 26.4% in its benchmark, the DJ World Technology index over the calendar year. While longer-term performance remains strong, this weakness is undoubtedly disappointing.
The reasons for the underperformance are relatively easy to diagnose. The Company has traditionally held a larger weighting in higher growth, mid cap companies. This is, we believe, the long-term sweet spot to find fast-growing, dynamic technology companies. However, this was the area hit hardest in 2022 as investors reappraised valuations in light of the changing interest rate environment.
This sell-off included areas of structural growth, such as cloud software and cybersecurity. In general, there was little regard for the underlying performance of individual companies. Cybersecurity group Zscaler, for example, was the largest detractor from performance over the year, but beat market expectations on sales and adjusted income and continued to grow rapidly without burning cash. This experience was commonplace: many companies continued to deliver strong revenue growth and earnings, but were battling investor concerns about their future prospects.
At the same time, the Company was underweight the benchmark in those companies that proved the most defensive. Apple, for example, was a large absolute position in the Company, but it forms a even larger part of the benchmark and therefore was a drag on relative performance. The same was true, to a lesser extent, for Microsoft.
We continue to believe in the long-term prospects for many high growth companies in areas such as cloud computing, data analytics or cyber security, and retain a weighting in the portfolio. Nevertheless, we recognise that sentiment is likely to be against them while the economic climate remains weak. Against that backdrop, we have reduced risk in the portfolio over the course of the year, moving away from some of the higher growth, high risk areas and towards more defensive positions. Apple, Microsoft and Alphabet are the top positions in the portfolio today.
We were also quick to cut companies where there were signs of weakness. For example, we saw Okta struggle to integrate its Auth0 acquisition and exited the position. Company-specific problems were dealt with brutally by the market during the year, with management teams seldom given the benefit of the doubt.
The Company also held a relatively high level of cash during the year – around 6% on average. This was a reflection of the uncertainty of the environment and a desire to retain optionality in the portfolio. With significant swings in pricing, it made sense to keep the flexibility to take advantage of opportunities as they arose.
The weakness in the cybersecurity sector has been a surprising feature of 2022. Company management teams remain committed to cybersecurity spending in the face of mounting threats and the sector should have been more resilient. However, investors treated it like another high growth area and sent share prices tumbling. While Zscaler was the most significant contributor to the Company’s underperformance over the year, CyberArk and Okta were also weak. Only Palo Alto Networks bucked the trend.
Other high growth segments suffered: cloud analytics and AI group Snowflake was weak as investors worried about its valuation and its competitive prospects. Ride-sharing group Lyft also detracted from performance. Collaboration technologies such as ZoomInfo and Atlassian, and productivity tools such as Asana also struggled. While the long-term growth of flexible working appears to be intact, share prices for these companies had moved a long way and expectations were high. Asana, for example, had risen 155% in 2021. As such, some pullback in a more difficult environment was not surprising.
Global demand for semiconductors continues to rise, with areas such as electric cars and cloud analytics demanding increasingly sophisticated chips. However, the sector could not shake off its reputation for economic sensitivity and this was another weak point for the Company during the year.
The Company’s position in Amazon was also a detractor. Amazon is not part of the benchmark, but the Company had a small position. The online retailer has struggled in an increasingly difficult spending climate, though its cloud business held up relatively well. Not holding Shopify, which proved very weak as household incomes dropped, was an advantage.
The Company swerved a number of the problems with other megacaps. A low average weighting in Meta, for example, was an important contributor to performance as the company struggled with its transition away from its core business towards its new ambitions in the metaverse.
The payments area provided some defensive characteristics over the year, with Mastercard, Visa and Paycom all resilient. These were stronger than smaller groups such as Square or Paypal, which had greater exposure to the smaller company and consumer segment.
Shares of ON Semiconductor, a provider of semiconductor intelligent sensing and power solutions, continued to benefit from a healthy demand and limited supply environment. The management team delivered very good execution in a challenging macro environment, which led to resilient profitability. The returning of cash to shareholders was also seen as positive news by the market. We believe the company is well positioned to take advantage of long-term growth in key automotive and industrial segments and it may weather any potential macroeconomic headwinds better than its peers.
Flex reported solid results in the period and raised fiscal 2023 guidance. We continue to believe the company is well positioned to take share and improve margins as its strategy yields results and supply chain disruptions create net new demand. Despite weaker consumer markets, the broad customer portfolio is acting as a natural hedge. However, if conditions worsen significantly, management has flexibility to quickly pull back spending. The company is seeing strong demand from multiple secular growth themes including cloud, auto technology, and industrial automation.
While inflationary pressures have started to ebb, there is still some pain to come on the global economy. There may be further interest rate rises in the year ahead, and the Federal Reserve is unlikely to reverse direction in the short-term. Recession looks likely for many major economies, while the re-emergence of China could be a double-edged sword. It may move the dial on global growth, but may also contribute to inflation. Against this difficult backdrop, the Company remains defensively positioned.
However, there are reasons to be more optimistic. Share prices have fallen a long way and now reflect much of the bad economic news. Many technology companies continue to deliver strong earnings in spite of the economic conditions and have a significant runway of growth ahead of them. Equally, potential weakness in the Dollar should help those technology companies with large global markets, such as Apple and Microsoft.
On 25 July 2022 the team and I became employees of Voya. There has been no change to the investment process and it has been a seamless transition in terms of the management of the Company. I have found the Voya culture to be customer centric and supportive of generating the best possible returns for our shareholders. I look forward to what the future holds for all associated with Allianz Technology Trust.
This has been a tough period, but many of the structural growth opportunities for technology are intact. Digital transformation, cyber security and cloud computing are multi-year growth themes and the recent uncertainty has not changed their outlook. Technology remains an exciting sector in spite of its difficulties in 2022.
Mike SeidenbergLead Portfolio ManagerVoya Investment Management Co LLC10 March 2023
