Tech Stocks On Trial

Key points

• Recent weakness in technology stocks reflects rising risks, but we see strong earning growth driving future returns.
• U.S.-China trade tensions hogged the headlines once again, spurring big swings across global markets.
• An agreement on NAFTA could be unveiled next week, while a speech by Chinese President Xi Jinping could lay out China's trade strategy.

Global tech stocks - stars of the post-crisis bull market - stumbled in recent weeks. Worries that trade tensions and regulatory scrutiny could dent profitability have shaken confidence. We believe recent weakness reflects rising risks but is not a tech wreck in the making. Strong fundamentals underpin our preference for the sector.

Sales growth for the global tech sector is expected to outpace that of the broader market, as the chart above shows. The synchronized global recovery is a boon for both, but we believe current estimates for the tech sector have yet to fully factor in a wave of business investment into tech equipment and services (see below). This could propel estimates even higher.

Tech earnings momentum is broad-based, spread across hardware, software and semiconductors - unlike the 1990s, when it was dominated by hardware. And technology stock valuations generally appear reasonable relative to other sectors and their own history. U.S. tech, which makes up 70% of the global sector, trades at 17.4 times forward earnings - only a small premium to both its five-year average and the broader market. Emerging Asia tech, accounting for 18% of the global sector weight, trades at 14.1 times forward earnings - also a small premium to broad emerging market stocks. These valuations appear fair, in our view, given the superior sales and earnings outlook for the sector.

A new phase

Technology stocks have dominated equity market performance and global corporate earnings growth in much of the post-crisis era. Enthusiasm for the sector is now facing a test. Trade tensions between the U.S. and China center on key issues for the tech sector: intellectual property, technology transfers, market access and investment restrictions. A series of unrelated, high-profile scandals from data breaches to self-driving car accidents has raised the specter of more stringent regulatory scrutiny.

Tech stocks are well-represented in benchmark indexes and make up a 31% share of the developed market momentum style factor. The high weight combined with strong performance leaves the sector vulnerable when investors cut risk. But we see robust demand growth for tech products and services as a powerful ballast for the sector.

For example, semiconductor makers are well placed to benefit from broad demand as a wide swathe of industries incorporate chips into their products. Mega-cap tech companies geared toward enterprise spending are also benefitting from an uptick in demand. See Tech for the long run of September 2017 for details.

The tech sector was a laggard in the binge of earnings upgrades following the U.S. tax overhaul, as it had one of the lowest effective tax rates. But an indirect benefit may be in the offing: Our text analysis of corporate conference calls suggests companies across industries are looking to deploy their tax windfalls on tech spend. This could spur more upgrades for tech sales.

The pitfalls should not be ignored. Internet companies may be vulnerable amid consumer concerns over privacy and greater regulatory scrutiny. Proposed U.S. tariffs target products tied to China's plan to become a leader in innovation - from tech hardware to artificial intelligence. Our bottom line: Policy risks reign and markets have quickly priced in greater uncertainty. We do not see a swift rebound in valuations, but expect earnings growth to power returns. We stick to our preference for tech within our positive view on equities.

• Financial markets were held in thrall of tit-for-tat trade actions between the U.S. and China. Global stocks initially bore the brunt of China's proposed retaliatory tariffs on U.S. imports. Signs of willingness from Washington D.C. to negotiate a deal spurred a recovery, later snuffed out by a fresh White House proposal for additional tariffs on Chinese goods.
• European economic data underwhelmed. The final March eurozone composite PMI hit its lowest level since early 2017, even as it still signaled firm underlying GDP growth. Weak new export orders were a drag on Asian PMIs.
• The LIBOR-OIS spread - a measure of the cost of bank funding relative to the risk-free rate - stabilized after a sharp rise in recent weeks. The New York Federal Reserve started publishing the proposed LIBOR replacement: secured overnight financing rate (SOFR).

Global snapshot

Weekly and 12-month performance of selected assets

Equities	Week	YTD	12 Months	Div. Yield
U.S. Large Caps	-1.4%	-2.6%	10.5%	2.1%
U.S. Small Caps	-1.0%	-1.1%	12.4%	1.2%
Non-U.S. World	0.3%	-1.1%	17.0%	3.2%
Non-U.S. Developed	0.6%	-1.1%	16.1%	3.4%
Japan	0.0%	0.1%	20.6%	2.3%
Emerging	-0.6%	0.7%	23.3%	2.8%
Asia ex-Japan	-0.7%	-0.2%	24.1%	2.6%

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Bonds	Week	YTD	12 Months	Yield
U.S. Treasuries	-0.1%	-1.3%	0.0%	2.8%
U.S. TIPS	-0.1%	-0.9%	0.5%	2.8%
U.S. Investment Grade	0.0%	-2.3%	2.3%	3.8%
U.S. High Yield	0.3%	-0.6%	3.8%	6.3%
U.S. Municipals	0.0%	-1.1%	2.3%	2.7%
Non-U.S. Developed	-0.4%	3.2%	11.2%	0.8%
Emerging Market $ Bonds	0.4%	-1.3%	4.3%	5.7%

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Commodities	Week	YTD	12 Months	Level
Brent Crude Oil	-4.5%	0.4%	22.3%	$67.11
Gold	0.6%	2.3%	6.5%	$1,333
Copper	0.8%	-6.6%	15.6%	$6,769

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Currencies	Week	YTD	12 Months	Level
Euro/USD	-0.2%	2.3%	15.4%	1.23
USD/Yen	0.5%	-5.1%	-3.5%	106.93
Pound/USD	0.5%	4.3%	13.0%	1.41

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^{Source: Bloomberg. As of April 6, 2018.
Notes: Weekly data through Friday. Equity and bond performance are measured in total index returns in U.S. dollars. U.S. large caps are represented by the S&P 500 Index; U.S. small caps are represented by the Russell 2000 Index; Non-U.S. world equity by the MSCI ACWI ex U.S.; non-U.S. developed equity by the MSCI EAFE Index; Japan, Emerging and Asia ex-Japan by their respective MSCI Indexes; U.S. Treasuries by the Bloomberg Barclays U.S. Treasury Index; U.S. TIPS by the U.S. Treasury Inflation Notes Total Return Index; U.S. investment grade by the Bloomberg Barclays U.S. Corporate Index; U.S. high yield by the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index; U.S. municipals by the Bloomberg Barclays Municipal Bond Index; non-U.S. developed bonds by the Bloomberg Barclays Global Aggregate ex USD; and emerging market $ bonds by the JP Morgan EMBI Global Diversified Index. Brent crude oil prices are in U.S. dollars per barrel, gold prices are in U.S. dollar per troy ounce and copper prices are in U.S. dollar per metric ton. The Euro/USD level is represented by U.S. dollar per euro, USD/JPY by yen per U.S. dollar and Pound/USD by U.S. dollar per pound. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.}

Asset class views

Views from a U.S. dollar perspective over a three-month horizon

Asset Class		View	Comments
Equities	U.S.		Extraordinarily strong earnings momentum, corporate tax cuts and fiscal stimulus underpin our positive view. We like the momentum and value style factors, as well as financials and technology.
	Europe		We see economic expansion and a steady earnings outlook supporting cyclicals. Our neutral stance acknowledges that earnings momentum lags other regions. Euro strength also is a source of pain.
	Japan		Positives are improving global growth, more shareholder-friendly corporate behavior and solid earnings. We see Bank of Japan policy and domestic investor buying as supportive. Further yen strengthening would be a risk.
	EM		Economic reforms, improving corporate fundamentals and reasonable valuations support EM stocks. Above-trend expansion in the developed world is another positive. Risks include a sharp rise in the U.S. dollar, trade tensions and elections. We see the greatest opportunities in EM Asia. We like Brazil and India, and are cautious on Mexico.
	Asia ex Japan		The economic backdrop is encouraging. China's growth and corporate earnings appear likely to remain solid in the near term. We like selected Southeast Asian markets but recognize a faster-than-expected Chinese slowdown would pose risks to the entire region.
Fixed Income	U.S. government bonds		We see rates rising moderately amid economic expansion and Fed normalization. Shorter maturities offer a more compelling risk/reward tradeoff. They and inflation-linked securities can be buffers against rising rates and inflation. We like 15-year mortgages relative to their 30-year counterparts and to short-term corporates.
	U.S. municipals		Solid retail investor demand and muted supply are supportive of munis, but rising rates weigh on absolute performance. A more defensive stance is warranted near term, we believe, though any material weakness due to supply may represent a buying opportunity. We favor a barbell approach focused on two- and 20-year maturities.
	U.S. credit		Sustained growth supports credit, but high valuations limit upside. We prefer up-in-quality exposures as ballast to equity risk. Higher-quality floating rate instruments and shorter maturities are well positioned for rising rates, in our view.
	European sovereigns		The ECB's negative interest rate policy has made yields unattractive and vulnerable to the improving growth outlook. We expect core eurozone yields to rise. We are cautious on peripherals given tight valuations and the prospect of the ECB reducing its asset purchases.
	European credit		Recent spread widening driven by increased issuance has created some value, while ongoing ECB purchases should support the asset class. Negative rates have crimped absolute yields - but rising rate differentials make currency-hedged positions increasingly attractive for U.S.-dollar investors. Subordinated financial debt looks less compelling versus equities.
	EM debt		Gradual Fed rate rises favor local-currency exposures - particularly given their higher yields relative to major bond markets. A shift by EM central banks toward tighter policy reduces our return expectations. We see solid fundamentals and investor inflows limiting EM currency volatility.
	Asian fixed income		Regional growth and inflation dynamics are supportive of credit. China's rising representation in the region's bond universe reflects its growing credit market. Higher-quality growth and a focus on financial sector reform are long-term positives, but any China growth slowdown would be a near-term challenge.
Other	Commodities and currencies	*	A reduction in global oil inventories is supporting oil prices. We are neutral on the U.S. dollar. The factors driving its recent slide are likely temporary, but it's unclear when the U.S. yield differential with other economies will reassert itself as the main driver.

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* Given the breadth of this category, we do not offer a consolidated view.

This post originally appeared on the BlackRock Blog.