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Market weekly – Transforming tech: Innovation and regulation (read or listen)

At the centre of a pandemic-induced boom, the technology sector continues to evolve at breakneck speed. Pamela Hegarty, lead portfolio manager for our disruptive tech strategy, reviews recent developments and talks about the areas where she sees investment opportunities.   

Read the article or listen to the podcast with lead portfolio manager Pamela Hegarty for the disruptive technology strategy.

There are clear opportunities across the sector even if valuations of tech shares have now more than doubled from the pandemic lows of last March as technology emerged as the answer to many of the challenges the virus outbreak presented.

Admittedly, valuations look overblown in certain areas, but overall, there is still room for positive performance in a multifaceted area that stretches from cloud computing and artificial intelligence (AI) to robotics & automation and the internet of things.

We should note that relative to the S&P500 index, the IT sector is currently trading at 1.26x forward price/earnings. That is above its long-term median of 1.15x, but well below the roughly 2.2x peak during the internet bubble and its aftermath.

In our view, the sector stands out given the expectations of strong secular growth.

IT spending is forecast to grow by 9% in this year and 5% in 2022 (source: Gartner) with outlays expected to target cybersecurity, cloud migration, collaboration and data analytics. The Biden administration’s multibillion dollar spending plans add to the bright prospects with a focus on 5G, broadband access and alternative energy in the US. 

Semiconductor boom – A super-cycle   

At the same time, the semiconductor segment is in my view currently in the early-to-middle stage of a super-cycle that could last for three years or more.

This super-cycle is driven by powerful secular growth in technology. Reports currently focus on shortages – in specific types of semiconductor such as microcontrollers – and the inventory and production problems these are causing in businesses such as the car industry, computers and smart phones.

In the long run, though, this is a segment whose technology Is foundational to enabling cloud computing, AI, automation & robotics and the internet of things. As such, it stands to benefit from the robust demand in every end-market (be it the car industry, industrial sectors or the more traditional IT and smartphone markets).

Adding capacity – as planned in the US and Europe to reduce the dependence on sources abroad –  will take time, so we are cautious about the scope for a mid-cycle correction, but our overall assessment is that the outlook is positive for semiconductor capital equipment and specialty materials suppliers.

Fintech innovation – Cryptos, DeFi and NFTs

At the moment, the tech sector’s constant evolution is nowhere more apparent than in the area of fintech. Here, blockchain is probably the fastest evolving area of innovative technology today, but where advances in digitisation, payments technology and fraud prevention also feature large.

Blockchain has significant applications in a number of areas. This database technology, or distributed ledger, enables cryptocurrencies, but also decentralised finance (DeFi) and non-fungible tokens (NFTs) – all fast-developing areas using non-traditional platforms often away from the typical central intermediaries such as regulated exchanges or supervised banks and brokerages.

In cryptocurrencies, we are seeing a trend away from bitcoins amid questions over its quality as a store of value given its lack of backing or collateral.

You can see a shift in the markets towards stable coins, which are backed by physical assets, and government-issued cryptos – central bank digital currencies (CBDCs). These can be seen as fungible tokens – one token is essentially interchangeable with another.

Separately, there is the emergence of NFTs – a set of data (code) that certifies the uniqueness and ownership of a digital asset. The asset can be a piece of art, a financial contract or sports memorabilia, for example, but also goods flowing through the supply chain. Given the active innovation in this area, we believe it is an important space to watch for future developments.

This – loosely regulated – growth market has expanded rapidly in value – from USD 250 million in 2020 to more than USD 2 billion in the first quarter of 2021. [1]

These are fascinating areas that have the potential to change the landscape for traditional players not only in financial services. However, there are also concerns about protecting consumers and addressing abuse and criminal use. The inherent lack of supervision, reflecting the decentralised nature of these products, can open them up to money launderers and financiers of illegal activities.

Platforms, exchanges and marketplaces that stray into regulated areas can face the scrutiny of supervisors. A crypto exchange offering loans or other types of securities should expect the financial regulator to launch an investigation or possible issue a ban.

Scrutiny and concerns over criminal exploitation could slow the development in the field of blockchain over time and affect the process of picking winners and losers.

Regulation – More of an issue in China than the US

We have also seen stepped-up regulation and supervision in other tech areas such as social media.

In the US, Democrats and Republicans are both considering more tech regulation, each for their own reasons. Democrats are concerned about issues such as market power and abuse, and consumer protection, while many Republicans share those concerns, but also worry about the liberal bias of the big social media platforms.

We will be following the progress of the various bills introduced into the US legislature with great interest. It is difficult to make a call on the likely outcome. Nor can we estimate accurately just how long the legislative process might take. In the short term, though, I do not expect any major development.

Even more prominently, we have seen supervisory action in many areas in China including ecommerce (apps), digital payments and gaming. This has weighed on markets in recent weeks. We expect to see more regulation of, for example, internet companies. 

The authorities have voiced concerns over data security, national security and demographics, but are also seeking to ensure common prosperity by tackling the wealth gap and address what are seen as excesses in, for example, the ride-hailing, food delivery and private education industries.

We are working closely with colleagues on the China equity team and the emerging market equity team as we assess the implications for our investments.

In the end, we expect Beijing to make sure it still balances innovation and regulation, but in the meantime, our teams are looking at incrementally shifting to less targeted industries such as IT services and semiconductors. We see it as a bigger issue for the market than potential US regulation.

In my view, all these developments underscore the need to follow this very dynamic sector closely and critically and manage any holdings actively, while being mindful of its long-term potential. 

[1] NFT sales top $2 billion in first quarter, with twice as many buyers as sellers     

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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