What are the prospects for earnings growth for tech companies over the coming years?
They are exceptionally strong, driven by huge innovation across numerous technology areas. One of these is of course artificial intelligence. AI may have only recently captured the public imagination, but is a game-changing innovation long in the making and for a long time underrated. This is not another fad like crypto, but AI is already driving customer value, market share gains and profits for many of the companies in which we invest.
But above all, the hallmark of real innovation is that it can dramatically drive down prices for customers. No other economic force of nature can hold a candle to it in this regard. In a world of cost of living crises and costs of doing business driven by higher interest rates and inflation, it is a godsend and will be in greater demand than ever.
Covid and valuations
Second, tech stocks were hit very hard in 2022 by rising interest rates, having surged in 2020 as rates plunged during the pandemic. Big changes in interest rates matter a great deal for stocks due to their impact on valuations, and indeed tend to impact tech and other growth stocks much more than the market overall.
However, this impact is felt immediately and in full as and when interest rates change. Extensive academic research indicates that once stock valuations have altered with changes in interest rates, higher or lower levels of interest rates do not have an ongoing impact on them.
From today’s valuation levels, we believe that tech companies that can deliver strong earnings growth and maintain their competitive position over the coming years will also deliver strong stock returns.
In considering whether changes in valuation multiples over the next few years are likely to help or hinder, it is clearly highly preferable to be able to take 5 per cent interest rates instead of zero per cent as a starting point.
The current cycle of interest rate increases that began in March 2022 — and started affecting the stock market in late 2021 — may not quite be over yet, but sooner or later it will be, along with its potential impact on tech stock valuations. Indeed, incremental interest rate increases by the US Federal Reserve appear to be having significantly less effect, with tech and other growth stocks now leading the market even as rate hikes continue.
