This year is shaping up to be a tug of war between two forces: the negative pressure on asset valuations caused by an expectation that interest rates will rise, versus the positive effect of expected above-average earnings growth.
In early January, investors began to reprice the odds of central banks becoming more aggressive in their approach to combat elevated inflation. This led to a weak start to the year. Thereafter, the earnings season began. Investors were reminded that corporate profits remain solid and have the potential to grow at a reasonable pace this year, driven by the services sector and the more cyclical parts of the global economy. More recently, a number of global technology juggernauts reported results. Central banks provided updates that have required investors to reassess the outlook for interest rates. We address these recent developments below.
The Bank of England and European Central Bank made policy announcements over the past week. The Bank of England announced a quarter point increase in its Bank Rate, which adds to the first hike it made late last year. This increase was widely anticipated by investors. The Bank also revealed that it will begin to reduce the size of its balance sheet in the near future, and that a number of its members were in favour of an even larger rate increase. The European Central Bank, which was widely expected to remain stagnant this year, delivered a similarly hawkish message. It left its policy rate and balance sheet plans unchanged, but its comments suggest that it is growing increasingly uncomfortable with the inflation backdrop. Investors now believe that the door is open to some potential rate action from the ECB as soon as this year, instead of 2023 as was previously expected.
The technology sector, the world’s largest sector and one of its most important, has been a poor performer to start the year. Much of the weakness can be attributed to the dynamic explained above: the potential for higher interest rates is putting pressure on a sector with elevated valuations that are dependent on earnings skewed far into the future. In addition, the past few weeks have delivered mixed earnings results. Among the large cap companies, some have provided very good results and guidance that reassured investors that growth prospects remain robust. Others missed expectations. It is no surprise that stocks of companies who miss expectations get punished as we have transitioned to a climate where investors are closely scrutinizing valuations.
On the whole, the technology sector still possesses some enviable growth prospects and exposure to powerful secular trends that are not going away. The sector may, however, remain vulnerable until the broader market can get comfortable with the degree of monetary policy tightening that may take place. Ultimately, central banks will need more time to assess inflationary pressures and recalibrate policy, leaving investors to ponder the pace and extent to which central banks may raise rates. With this in mind, our investment approach is to remain patient with high-conviction holdings and to be nimble if new opportunities arise. We also ensure that portfolios are adequately diversified in the face of a new interest rate cycle.
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