By the management team of the ODDO BHF Polaris range from ODDO BHF Asset Management.

The Nasdaq index and tech stocks in general have outperformed strongly during the pandemic. After a stellar 2020, 2021 has been more difficult with some tech stocks experiencing steep declines while others continued to climb. The fundamental outlook and growth prospects arguably have never been better for tech companies. But there are headwinds: expiry of lockdowns weighing on companies benefiting from them, rising inflation/interest rates and high valuation levels.

What has driven the performance of tech stocks / the IT sector in the last years?

With above-average earnings growth and expansion of multiples IT has been the best sector over the last five and ten years. In 2020, the outperformance even accelerated as tech stocks recovered quickly from the COVID drawdowns with many reaching new all-time highs. While some businesses (e.g., Zoom, Amazon or Shopify) profited from lockdowns, others proved their defensive qualities by delivering consistent growth also in difficult times. Cyclical IT stocks (e.g., semiconductors or IT services) suffered initially, but profited in 2021 because of the strong post- pandemic rebound of the world economy.

In 2021, the IT sector underperformed the broad index by some percentage points. But the real story has been the very big performance divergence below the surface. It was a difficult year for “lockdown winners” as slowing growth rates combined with very expensive valuations led to big drawdowns. “Hyper Growth” companies mostly fell too after the market started to price in higher inflation and interest rates. But operationally, most businesses in that category still perform quite well. Payment names performed quite poorly (e.g. Paypal -18% in 2021, Visa +1%).

The reasons were the normalization of e-commerce demand and negative sentiment on the sector from fear of fintech disruptions. Semiconductor companies continued to perform strongly, both structural (digitalization) and cyclical (strong rebound of the world economy) aspects helped. So-called “Quality Growth” stocks performed quite well, especially in the second half of 2021. Many investors viewed companies like Alphabet , Microsoft or Accenture as safe heavens with still reasonable valuations compared to other tech names.

What is the outlook for 2022?

Slowing growth and rising (real) interest rates are the two major risks for the tech sector in 2022. A slowing economy would have an impact on cyclical companies, e.g. most semiconductor companies. Some parts of the sector are probably late-cycle already (e.g. PC, smartphones components), while others like automotive chips still offer catch-up potential. With continuing post-pandemic normalization “lockdown winners” and “hyper growth” companies are also still at risk.

Although valuations have come down already, higher interest rates, expected by most market observers, are a problem for these so-called “long duration stocks”, where a higher discount rate yields a lower value of the future earnings. Over the last few months, there was a clear correlation between rising rates and underperformance of highly valued stocks which is likely to continue if rates keep on rising. There is also some risk of spillover effects into the quality growth spectrum, especially the mega-cap tech stocks that have performed well in 2021. Valuations here are still somehow reasonable but also higher than in the past.

With structural growth prospects accelerated by the pandemic and generally high quality (e.g., software with a high share of recurring revenues, strong balance sheets and strong economic moats), tech stocks still offer good long- term opportunities for us. Weighing up the opportunities and risks in the tech sector is crucial.

The best strategy is to stick with high quality stocks with (a) good structural growth opportunities (b) low risk of slower growth and (c) still reasonable valuation. You might still underperform with such names in the short-term if interest rates rise quicker than expected, but growth will overcompensate in the long-term.

We would still recommend being cautious on high-growth names in general, as valuations are still above the long- term average for most of them. Also, many of them will show post-pandemic normalization growth rates in 2022. Once valuations are less extreme, such names could become interesting again, but we are not there yet. For cyclical names, be aware of the cycle. Especially for semiconductors, the relative performance usually turns a quarter or two before growth rates peak.

The end markets for automotive and data center businesses still look very attractive with accelerating growth in 2022, while other might peak this year (semicap equipment spending, PC demand, etc.). Finally, better avoid companies with no proven profitability, especially if competition is high. Such companies typically underperform when the monetary environment is tightening.