2023 started on a cautious note. Although inflation had started to fall, it was not yet beaten. The impact of rising interest rates was beginning to be felt in the real economy, and there were concerns about how high rates may need to rise. A winter energy crisis had been averted, but a ‘hard landing’ still appeared a plausible scenario for the world economy.
There were glimmers of hope. Some of the supply chain bottlenecks that had contributed to inflationary pressures were starting to unwind. Freight prices had started to drop and the pandemic-related backlogs started to ease. There was also the prospect of a stronger performance from China as the country relaxed its strict quarantine restrictions.
However, the fragility of the economic environment was exposed by the collapse of Silicon Valley Bank in March. Its weakness was attributed to losses on its bond portfolio. It had significant exposure to startups and venture-backed firms, but the US regulator stepped in swiftly to protect deposit holders. The crisis threatened to destabilise the world’s banking system, with Europe’s Credit Suisse also proving vulnerable. A forced merger with UBS appeared to put an end to the crisis, but it left investors wary of other bear-traps in the financial system.
In the meantime, attention continued to be minutely focused on inflation and when the Federal Reserve’s rate rising cycle might draw to a close. Rate rises continued in the first half of the year, albeit at a slower pace. The problem for policymakers was that while headline rates of inflation decelerated sharply over the year, core inflation proved stickier.
Ultimately, however, the US Federal Reserve paused its tightening cycle in July, even though it continued to talk tough on inflation. US Federal Reserve chair Jerome Powell insisted they would stay the course until the inflation battle had been won. At his Jackson Hole speech in August, he said: “We are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective.”
Towards the end of the year, speculation mounted that US interest rates may soon be lowered as inflation continued to drop, and by December, the US Federal Reserve had pivoted to forecasting 0.75% points of interest rate cuts in 2024. Fears of a US recession appeared to be overblown and hopes grew of a Goldilocks outcome for the US economy (with growth neither too hot nor too cold). US GDP growth continued to be strong, rising 5.2% in the third quarter fuelled by a strong consumer.
Elsewhere, growth was mixed. Economic activity in Europe remained anaemic at best. However, the European Central Bank and Bank of England continued to insist that the battle against inflation was far from over. Their hawkishness versus the US Federal Reserve saw the euro and British pound strengthen against the US dollar. The Japanese yen weakened against all three currencies, in spite of a revival of economic growth and inflation in Japan as the country’s central bank continued its loose monetary policy. China’s economic rebound from pandemic restrictions disappointed, with the health of its property sector a major concern.
Fears of inflation briefly revived in the summer, after oil prices rallied in response to oil-producing countries agreeing to cut output. Nevertheless, Brent crude closed the year slightly lower at just under US$80 a barrel. Overall oil prices fell around 10% over 2023, marking the first annual decline since 2020. 2023 ended with inflation pressures easing, with interest rate cuts on the horizon and with economic growth holding up. It proved a far better outcome than many had anticipated at the start of the year.
Global stock markets made progress in 2023, with the MSCI World Index up 17.2% over the period. However, it was a rocky ride and for much of the year, market leadership was held by a narrow range of artificial intelligence-related companies. These ‘Magnificent Seven’ – Amazon, Alphabet, Apple, Meta Platforms, Microsoft, NVIDIA and Tesla – benefited from growing excitement in the potential for AI and its applications, following the launch of generative AI programme Chat GPT.
These stocks drove global indices higher, but many areas did not participate in the rally. While companies in the information technology, communication services, consumer discretionary and industrials sectors turned in a creditable performance, defensive stocks in the consumer staples, utilities and health care sectors barely rose, while energy stocks were held back by weakening oil and gas prices. With economic growth uncertain, investors retreated to those companies with reliable earnings, even if they had to pay a little more for them.
Stock market performance was still highly dependent on interest rate expectations. There were two notable setbacks over the year: the first was prompted by March’s banking crisis, but this was swiftly resolved after regulatory intervention; the second came in October after higher oil prices prompted a brief spike in inflation, driving fears that rates would need to stay higher for longer.
This narrow market leadership widened out in the final months of the year, as investors started to anticipate rate cuts in the year ahead. November and December saw a significant, broad-based rally. November was the strongest month for markets in three years and supportive statements from the US Federal Reserve ensured the rally continued to the end of the year. Overall, the MSCI World Index recorded its strongest year since 2019.
Just as they did in 2022, 2023 was a year when investors watched the US Federal Reserve. Once again, the fortunes of individual companies appeared to matter less than the latest comments from central banks as investors tried to judge whether central banks would be able to tame inflation without collapsing the economy.
Ultimately, however, markets are now reassured that the US Federal Reserve has managed to engineer a ‘soft landing’. The much-anticipated US recession remains a possibility in the year ahead, but most market participants now believe it is likely to be short-lived and shallow if it materialises at all. Rates cuts could come as early as March in the US and would be welcomed by markets.
The fragile geopolitical landscape continued in 2023. The war in Ukraine was ongoing, with little progress on either side. World powers continued to pick sides, which saw some redrawing of trading relationships. Those countries that could remain neutral, such as Vietnam or parts of Latin America, saw their economies benefit.
There was new fragility in the Middle East after the unprecedented terrorist attacks by Hamas on Israel on 7 October, and Israel’s subsequent military response which has seen ongoing conflict in Gaza with huge loss of life.
There was some easing of US/China relations, with Presidents Xi and Biden meeting in November. Nevertheless, a return to the unfettered trading relationship of recent history appeared improbable.
The launch of Chat GPT and its rapid adoption showed the potential for artificial intelligence – and some of its risks. It holds the potential to drive productivity gains for companies at a time when productivity has stagnated in many Western economies. In a report in April, Goldman Sachs said generative AI could raise global GDP by 7% - equivalent to almost $7 trillion.
Forward-thinking corporations are already looking at how AI could improve their business and 2024 may be when these plans start to come to fruition. Companies are investing significant amounts in AI. Microsoft, Google and Amazon have done a number of blockbuster deals with AI start-ups in 2023. This accounted for two-thirds of the US$27bn raised by fledgling AI companies in 2023, according to data from private market researchers PitchBook.
The Company’s net assets rose 46.4% for the year to 31 December 2023. This was marginally behind its benchmark, the Dow Jones World Technology Index (sterling adjusted, total return), which rose 48.2%. The strength of the ‘Magnificent Seven’ and their dominance in the index made it difficult to beat. We continued to hold below index weights in these stocks to avoid concentration risk in the portfolio.
The broad-based rally at the end of the year was more favourable for the Company, with market attention returning to some of our higher growth, mid cap companies. This has tended to be a more fertile spot to find opportunities, where a focus on bottom-up fundamentals and industry expertise can provide an edge versus the market. The third quarter earnings season had confirmed the strength of earnings momentum in a number of our holdings, particularly those focused on cloud computing. We took bolder positions in these areas, which helped us participate in the rally in full.
Weakness tended to come in idiosyncratic areas, rather than from any major themes. For example, Pay.com was a notable detractor, hit by concerns over the outlook for the jobs market and some operational issues that saw it miss on earnings. Okta was also weak, impacted by execution challenges.
It was a mixed year for the semiconductor sector. It was important to differentiate between ‘leading and lagging’ semiconductor groups. While Nvidia soared on the back of demand for its AI-focused chips, it was a tougher year for generic semiconductors and those exposed to auto-related sectors. The Company moved away from auto-related semiconductors in the first half of the year, and benefited from not holding generic semiconductor groups such as Texas Instruments. Nvidia was a major holding from February onwards.
Geopolitical tensions continued to support demand for cybersecurity companies during the year, particularly at the end of 2023 when software and IT services outperformed other areas. Artificial intelligence also drove demand, with more data requiring greater protection. Cyber attacks continued with a major Chinese espionage campaign infiltrating the US government. A new SEC ruling requiring disclosure of events within four days also impacted demand for cybersecurity solutions. Overall spending on cybersecurity continues to grow faster than other major technology segments.
The Company also benefited from the areas it didn’t hold. For example, for most of the year it did not hold anything in China. The weakness of Chinese markets was a dominant feature of the year and this helped performance.
The performance of the Magnificent Seven was the key highlight for equity markets overall. Five of the Magnificent Seven (Apple, Alphabet, Meta Platforms, Microsoft and Nvidia) are held in both the Company and in the benchmark, generally at a lower concentration than the Company’s benchmark index. The exception was Meta, where the Company held a near-double benchmark weight (at 6.3%). This provided the strongest contribution to returns over the year. Having previously exited our historic position, we bought back the stock at the end of 2022 on the back of expectations that its cost-cutting initiatives, lower valuation level and secular growth would drive shares higher. Over the year, an improving competitive position and new product development helped push it higher. The Company also held Amazon.com and Tesla, the two remaining Magnificent Seven stocks, which are not part of the benchmark and were additive to performance.
MongoDB was another notable performer over the year. The database software company posted consecutive quarters of strong earnings, ahead of market expectations. Earnings were fuelled by a faster recovery in consumption trends for the business, driven by the growth of generative AI.
China was a particular weak spot over the year, as international investors withdrew from the market. We have been wary of the Chinese market for some time, believing government interference threatens shareholder returns. Not holding Tencent Holdings and to a lesser extent Alibaba contributed to overall performance versus the benchmark during the year.
The one Chinese stock we owned was JD.com, holding it briefly between January and February. It is an online direct sales company offering a wide range of products through its website and mobile applications. We thought it may be a beneficiary of China’s reopening trade. As it was, the Chinese consumer failed to revive and we sold it quickly. Although it detracted from overall performance, it proved a prudent sale, with the share price tumbling after we exited.
Identity management group Okta was a weak spot. It had a number of operational problems: it had over-hired, leaving sales territories cut too small for sales reps to meet their numbers. The company also struggled from increased competition, while a large number of cyber attacks weighed on its credibility. Paycom Software was also a performance detractor, having suffered a series of disappointing earnings reports. As a designer and developer of software solutions to manage the employment life cycle, it was hit by concerns about the jobs outlook and a moderation in economic growth.
The Company’s cash weighting was lower than last year – at around 2% on average. This detracted from returns given the strength of markets, particularly at the start of the year. Nevertheless, it allowed us to retain optionality in the portfolio during periods of uncertainty.
At the start of 2023, valuations were compelling. After a significant market improvement - along with higher earnings – technology companies appear to be trading at around fair value today. That said, there are some tailwinds for the year ahead and we believe the equity market recovery over the past few months can extend into 2024.
At the December 2023 Federal Open Market Committee meeting, the US Federal Reserve signalled multiple rate cuts could come in 2024. Inflation continues to weaken and, while the jobs market remains buoyant, growth is moderating. With interest rate cuts on the horizon and an economic soft landing expected, investors are likely to be confident enough to look beyond the mega-caps into other parts of the market. Broader earnings growth may accelerate this trend.
There are going to be bumps along the way and the market might be due for a short-term pause after its recent strength, but there are reasons to be optimistic about the long-term secular growth prospects for technology. These include artificial intelligence and machine learning, the Internet of Things, cyber security, digital assets and mobility. The macroeconomic challenges of the past few years are likely to ease, which should give investors greater confidence.
The challenges of the past few years have forced companies to look at their cost structures, re-engineer their businesses and cut unprofitable lines. The result is that the survivors are far stronger, with better competitive positions and stronger earnings. We continue to believe the technology sector can provide some of the best absolute and relative return opportunities in the equity markets.
Mike SeidenbergLead Portfolio ManagerVoya Investment Management Co LLC12 March 2024
