US Tech vs. Value Cyclicals - US Equity Perspectives
#Market Strategy — 09.02.2022

US Tech vs. Value Cyclicals

US Equity Perspectives, February 2022

Alexis Tay, Senior Adviser Equity Advisory Asia

Summary

US Tech – yet to bottom, but opportunity beckons

  • After a phenomenal 18-month run where we saw the Nasdaq Composite Index more than double, the uptrend has come to a stall, with the Nasdaq Composite Index breaking its 200-day moving average support.
  • Other than the Fed’s recent hawkish pivot, other concerns weighing on the market include decelerating revenue momentum, drying up of fiscal stimulus, rising cost pressures, forex headwinds, as well as still-high valuations.
  • The start of 4Q21 earnings season has not been friendly for most stocks that have reported so far. We expect this volatility to continue into the reporting season, and would be wary to add positions ahead of results.
  • We think the current tech rout will at least be similar in magnitude to the liquidity-induced tech sell-off we saw in late 2018, given the expected pace of monetary tightening, higher starting valuations and weakening earnings revisions.
  • Nonetheless, this recalibration of market expectations will ultimately bring about an excellent opportunity to position in “moaty” stocks for the medium term. We suggest investors to focus on profitable companies, backed by strong balance sheet/cashflow and trading at reasonable valuations.

Value Cyclicals should see more catalysts in the near term

  • Financials – The largest US banks have reported their 4Q21 results, rounding out a mixed earnings season. While wage-related inflationary pressures were higher than expected, and trading income fell short for most banks, investment banking remained supported by robust capital raising and advisory activity. Most importantly, loan growth is starting to see momentum, coupled with improvements in net interest margin. The interest rate picture remains supportive for names in the sector, and stock pullbacks should be taken as an opportunity to play sector names.
  • Energy – Investors are viewing the space as not just an earnings story but also an inflation hedge. In addition, the higher oil price is generating significant levels of free cash flow to underpin dividend payouts, share buybacks and debt servicing.
  • Auto – In 2022, we expect traditional automakers to continue narrowing down the valuation and performance gaps with the new electric vehicle (EV) players. Part of the catalyst is the inventory restocking cycle, which should support volume and earnings turnaround for the former. Moreover, electrification is gaining pace, with strong EV model rollouts over the next few years.

US Tech – yet to bottom, but opportunity beckons

After a phenomenal 18-month run where we saw the Nasdaq Composite Index more than double, the uptrend has come to a stall – with the Nasdaq Composite Index breaking its 200-day moving average support at ~14,700. Although the index is short-term oversold and due for a bounce, we expect this sell-off has yet to run its course.

Other than the Fed’s recent hawkish pivot, other concerns weighing on the market include decelerating revenue momentum, drying up of fiscal stimulus, rising cost pressures, forex headwinds, as well as still-high valuations.

The start of 4Q21 earnings season has not been friendly for most stocks that have reported so far. Even in favoured sectors like financials, selective banks stocks were hit as they guided for higher expenses backed by wage pressure. Covid economy winners like the largest streaming player was pummeled as the company gave lower than expected subscriber guidance. We expect this volatility to continue into the reporting season, and would be wary to add positions ahead of results.

The next significant support level for the Nasdaq Composite Index is ~12,000. We see a good chance that this level will be reached, which will bring peak to trough correction to ~25%. In magnitude, this is similar to the liquidity-induced tech sell-off we saw in late 2018, and serves as a meaningful signpost for us to gauge when we can reposition more meaningfully into the sector.

It’s not too early to start formulating a shopping list

While the current tech sector downdraft likely has more to run, we think this recalibration of market expectations will ultimately bring about an excellent opportunity to position in “moaty” stocks for the medium term. As the saying goes – don’t waste a good correction. But how do we formulate a shopping list? We suggest investors to focus on profitable companies, backed by strong balance sheet/cashflow and trading at reasonable valuations – especially companies where valuations have come back to historical average or lower levels.

We like payment names. Not only will they benefit from re-opening (e.g. payment networks’ high margin cross-border business, traditional merchant acquirers’ exposure to offline/omni-channel retailers), these names have faced headwinds and overdone pessimism from fears of disruption (from buy-now-pay-later, cryptocurrency etc.)

Software has underperformed the broad market and semiconductors massively over the last few months. Though there remain pockets of very high valuations, some of the large cap names are starting to look attractive. We think concerns that software demand has been pulled forward over the last two years due to Covid-induced accelerated digitisation trends are valid, and we will await the upcoming results to gauge the pace of revenue deceleration going forward. Nonetheless, we would buy further pullbacks in quality large-cap names with reasonable valuations and strong competitive moats.

Within tech megacaps, the largest ecommerce player has been a key underperformer given worries around a weak 4Q21 (decelerating ecommerce sales, higher labor costs). It remains one of our favourite names as we look through a difficult 1H22, to a more robust 2H22 as easier compares and lower investment intensity benefit earnings. The large platforms geared to search/advertising will continue to benefit from strong advertising tailwinds, while navigating Apple privacy changes much better than smaller peers. Overall we think megacaps will hold up well against other tech segments given their quality bias, as well as reasonable valuations.

The video gaming sector has lagged other tech stocks in 2021, but recent merger and acquisition (M&A) deals in the sector shines a positive light on this group. We think these deals reflect the increasing importance of owning top notch content, as well as the desire to expand into mobile gaming. Many large-cap tech companies have expressed interest in gaming, and we think the scarcity value of stand-alone game publishers will continue to go up as it becomes more apparent that any potential new entrant into gaming distribution will need to acquire strong gaming content in order to compete.

Within semiconductors, we turn more selective. The chip cycle is likely to transition from inventory depletion to inventory build over the course of the year, which should make it a choppier year compared to 2021. On the positive side, the lifting of supply chain constraints should be supportive of earnings estimates over the next few quarters.  We would stick to compute/semiconductor equipment names where fundamentals remain robust, while valuations have derated significantly.

Value Cyclicals – what can we take away from US bank results?

The largest US banks have reported their 4Q21 results, rounding out a mixed earnings season. We note the following trends:

  • Expenses are rising. Wage-related inflationary pressures were higher than expected as banks contend with higher costs to maintain talent. This proved to be a key focus for the market, which led to selling pressure.
  • Improving net interest margin (NIM). NIM ticked up across the banks from the 3Q21, and was the first increase since the pandemic began.
  • Trading disappointed. Having been a supportive revenue driver in recent quarters, trading fell short for most banks, particularly in fixed income.
  • Investment banking remains supportive for now. Capital raising and advisory activities have remained robust.
  • Improving loan growth. Lending has been a key focus for investors after demand remained weak for much of 2021. Encouragingly, there have been signs across the results that this area is seeing momentum, with outstanding loans increasing from the previous quarter. Anticipated increases in short-term interest rates should revive lending profits, one area where banks have struggled.

Despite a more nuanced results season and forward guidance, the interest rate picture remains supportive for names in the sector, and stock pullbacks should be taken as an opportunity to play sector names.

We reiterate our preference for those names that have a purer exposure to the rising interest rate story, particularly in light of the improving lending picture and lower expense pressure when compared to those names with a higher capital markets bias.

Remain constructive on Energy

The Energy sector has had a strong start to the year, with Brent crude trading above USD90/barrel and investors rotating into value and inflation hedge areas of the market.

In terms of the recent supportive backdrop:

On the supply side, The American Petroleum Institute reported that US crude inventories sank by about 1 million barrels last week, with the drawdown in stockpiles suggesting a tighter market. Separately, several OPEC+ producers have also seen interruptions to supply.

On the demand side, global oil demand has proven to be more resilient to the effects of the Omicron variant’s spread than the International Energy Agency expected, according to recent comments from the agency. In addition, investors found increased confidence in the demand side of the equation following Fed Chairman Jerome Powell’s comments that indicated that efforts to rein in inflation would not damage the US economy.

At the same time, 2022 could still throw up additional challenges for the sector.

What could dampen the story?

Although shale companies have shown production discipline in recent quarters, signs are emerging that this is weakening. Industry data have shown accelerating production growth in some key US locations, notably the Permian Basin, with the rate of oil well completions in this region rising by 5% in December 2021. What this likely means is that consistently higher oil prices have finally proven too alluring to resist for some producers, suggesting an uptick in supply.

As the year progresses, investors may also need to keep in mind the November mid-term elections timeline and the optics of a high oil price if consumer prices remain close to 40-year highs. In this context, the risk of windfall taxes on oil companies and regulatory intervention cannot be ignored.

Sector names are investing heavily to improve their Environmental, Social, and Governance (ESG) credentials – at the very least to ensure they are not excluded from investment consideration. Nonetheless, the longer-term existential threat of the energy transition, and the risk of higher cost of capital, will remain as part of the debate surrounding investability this year, particularly for US names.

But for now, Energy is a sector showing momentum (see Chart 1), particularly in light of the inflation picture. Investors are viewing the space as not just an earnings story but also a valuation trade. In addition, the higher oil price is generating significant levels of free cash flow to underpin dividend payouts, share buybacks and debt servicing.

We continue to see value in having exposure to the sector, with companies across the energy complex expected to show the benefits of high oil price in upcoming quarterly results.

Read January 2022 report - Positioning for a Hawkish Pivot

oil price and sp 500

US Autos – the future is electric 

The consumer discretionary sector has benefitted over the past year from a strong US consumer setup at a time of economic reopening and aggressive stimulus. This had unleashed pent-up demand and driven strong revenue growth of many companies in this space. We see a still-strong but more challenging year in 2022, as these companies navigate high base comparisons, supply chain challenges, pandemic-related policy measures, cost inflation and in many cases, elevated valuations. Within the consumer sector, we see relative value in traditional auto original equipment manufacturers (OEMs)/suppliers.

Overall, we remain constructive on the US automotive sector. The V-shaped recovery in global automotive sales from the early 2020 trough corrected to a W-shaped recovery in 2021 (see Chart 2), due to challenges around supply rather than demand. Due to chip shortage issues, 3Q21 saw a sharp dip in production. As supply side issues ease, we expect production to stabilise in 4Q21 and recover sequentially in 1Q22. Considering very low inventory levels in key markets, automakers will likely increase plant utilisation for inventory restocking over the course of 2022, supporting volumes.

us auto sales

In terms of price performance, we note that traditional automakers have been narrowing the performance gap with the new electric vehicle (EV) players in 2021, though the huge disparity in valuations remains. As it stands, the largest pure-play EV company in the US is currently trading at 2022 12x Price-to-Sales Ratio (P/S) and 96x Price-to-Earnings Ratio (P/E), whereas the two largest US OEMs are trading at an average of 0.5x P/S and 9x P/E.

Valuation gap should narrow between auto OEMs vs pure EV plays

In 2022, we expect traditional automakers to continue narrowing down the valuation and performance gaps with the new EV players. Part of the catalyst is the inventory restocking cycle, which should support volume and earnings turnaround for the former. Moreover, electrification is gaining pace, with strong EV model rollouts over the next few years. On the flip side, we expect faster than expected rate hikes and pullback of central bank liquidity to have negative impact on pure-play EV valuations.

Nonetheless, we remain constructive on the largest pure EV play in the US, and will see rates-induced pullbacks as buying opportunities. Global EV volumes rose ~80% in 2021 on strong consumer adoption, especially in EU/China. We expect 2022 to be another year of robust growth, with volumes up 25-35% year-on-year. While the US has less than one third of EU/China’s EV penetration, we expect some form of Biden’s Build Back Better plan to be passed, with likely introduction of EV subsidies to incentivise adoption. This is on top of USD7.5 billion in spending to build up EV charging infrastructure under the recently passed infrastructure package.