IT: short-term headwinds versus long-term tailwinds

However, at the end of 2020 this outperformance stalled. And as the Fed turned more hawkish in recent weeks, sentiment towards IT stocks weakened significantly. This raises the question what to expect from IT stocks in the coming quarters and years. How long will the correction in IT stocks and other (hyper) growth stocks continue? And does this correction jeopardize the positive long-term prospects of the IT sector?

Growth stocks, including IT stocks, have had huge tailwinds in the last decade: low interest rates, low inflation and very expansionary monetary policies. And in the last two years, these kinds of companies also benefitted tremendously from corona-related factors. Think, for example, of IT firms providing products and services that enable remote working. This background is rapidly changing. Interest rates are rising, which can lead to pressure on the rich valuations of (hyper) growth stocks. In recent years, investor optimism about companies’ future growth potential has pushed many valuation measures to well above their historical averages. But now, higher interest rates are starting to weigh on how investors perceive the value of future earnings.

Next to the Fed’s hawkish shift and the rising long-term interest rates, developments around the coronavirus could have an adverse impact on IT-related stocks. The pandemic seems to become endemic and the risk of strict future lockdown measures is fading fast. For IT-related companies that thrived during the pandemic, the time of explosive growth might be over. As a result, the IT investment landscape is starting to change. Against that background, we believe it is important to acknowledge that not all IT-related growth companies share the same growth characteristics. Three distinctive sub groups can be identified:

1. Mega-cap stocks: stocks of companies with solid earnings growth, which are perceived as relatively safe. Currently, momentum in these stocks is stalling. This is mainly due to the rise in interest rates, which is one of the reasons for investors to shift towards other parts of the market. In addition, the risk of increasing anti-trust regulation, which may be introduced following this year’s US midterm elections, could diminish the appetite for these stocks. 
2. Hyper growth stocks: excessively overvalued stocks of companies that are mostly not profitable yet. These stocks have done very well during the first phase of the pandemic, but have already fallen sharply in price. The momentum of these stocks is currently very weak and given the lack of earnings and still high multiples, price pressure seems far from over. 
3. The remaining stocks: stocks that are not extremely overvalued, of companies that are profitable. These stocks are currently dragged down with the broader IT sector, but they could offer attractive opportunities.

Given our expectation that long-term interest rates will rise in 2022 (we currently expect the yield on 10-year US Treasuries to be at 2.6% by year-end), valuations in the IT sector are likely to remain under pressure this year. Volatility in the sector is expected to remain high. In particular hypergrowth stocks could face volatility in the coming months.

Although we cannot draw overly positive conclusions from this short-term analysis, we need to keep in mind that the IT sector will continue to play an essential role in some very strong underlying megatrends. Within developments concerning – amongst others – cloud-computing, the increasing importance of big data, robotics, automation and artificial intelligence, the sector plays a crucial role. To enable the use of such applications and technologies, smartphones, tablets, network interfaces and server capacity remain an absolute necessity. This leads to stronger demand for higher-quality IT-related products and services. In the meantime, speed (faster internet, faster computers) is becoming increasingly important and cybersecurity must be taken to a higher level as well. We expect growth in these parts of the IT market will continue to be strong. As a consequence, we expect earnings growth in the IT sector to remain higher than in other market segments, as it has been the case for several years.

Given this tug of war between tailwinds and headwinds, we maintain our neutral stance on the IT sector. We expect IT stocks to continue on their path towards more normal valuation levels. We also believe that the current ‘rotation trade’, with investors shifting from growth stocks to value stocks, is not over either. That said, we believe that the lack of growth opportunities in some other market segments will ultimately draw investors back to (parts of) the IT sector, especially when economic growth starts to slow down (in the course of this year) and when yields on 10-year US Treasuries will start to stabilize (in the course of 2023).

Olivier Raingeard – Global Head Equities
Joost Olde Riekerink – Equity Research & Advisory Expert