November 13, 2022

CIO Strategy Bulletin

David Bailin
Chief Investment Officer Too Soon to Pivot to Tech
and Head of Citi Global
Wealth Investments
SUMMARY
Steven Wieting
Chief Investment Strategist • While tech shares rallied sharply this past week, the sector
and Chief Economist won’t be immune to economic weakness like it was in the
COVID recession of 2020.The Fed will likely maintain higher
Joe Fiorica rates until unemployment rises, further adding pressure to tech
Head, Global Equity Strategy shares in the coming six months. This does nothing to dissuade
Cecilia Chen us from a bullish view of key tech developments for the longer
Global Equity Strategy term.
• None of the 72 economists who participated in the Bloomberg
Malcolm Spittler
Senior US Economist consensus poll won the $2 billion Powerball lottery this week
and none had forecast headline inflation to be just 0.4% month
over month. With bearish sentiment at highs, this better-than-
expected news caused a highly correlated move higher for all
risk assets.
• We acknowledge that valuations reflect new, higher capital
costs and more conservative growth estimates, but immediate
increases in profits and dividends are unlikely. After this 3Q
reporting season, it is clear that tech won’t be spared from this
particular downturn.
• We now see tech valuations that are much closer to longer-run
averages. While we expect interest rates to fall later in 2023, a
challenging earnings backdrop is likely to initially offset some
modest re-rating toward higher PE tech multiples in 2023.
• We continue to prefer quality names with less economic
sensitivity, which in practice means a bias toward profitable
tech over unprofitable moonshots.
A pause in valuations for the digital revolution
It has been a brutal year for tech investors, even after Thursday’s 8% rally. The five largest US giants have lost
over $3 trillion in market cap since the start of the year. The S&P 100 IT sector has dropped 25% year-to-date,
while the Nasdaq is down 28%.
A less aggressive Fed path will ultimately benefit technology shares. But the US central bank is far from making a
true policy pivot, even though this week’s CPI report suggested that inflation was abating in some sectors.
In the meantime, slowing economic growth is unlikely to spare these large platforms. Though fintech and e-
commerce firms operate with a smaller physical footprint and less capital than banks and big-box retailers, they are
likely to see slowing sales in the coming quarters as discretionary consumer spending fades. And for other tech
segments, the likely deferment of capital expenditures by some firms will pressure bottom lines.
Technology shares benefited from the pandemic environment. With the cost of cash nearly “zero,” the ability to
“spend to grow revenues” and to take risk for big future payouts was enabled. Now the opposite is true. Risk
appetite has faded, and the certainty of growing cash flows is valued. Remember that the Fed is not just raising
rates – it’s increasing the cost of capital by reducing the size of its balance sheet.
From a tactical viewpoint, we are hesitant to chase sharp moves higher in technology shares until the extent of
impending economic weakness becomes clearer. We acknowledge that valuations reflect new, higher capital costs
and more conservative growth estimates, but immediate increases in profits and dividends are unlikely. With the
likelihood that the Fed will maintain higher rates until real unemployment occurs, tech shares will therefore remain
under pressure.
As Goes Tech, Adjacent Businesses Follow

We see the emerging tech weakness as “typical” of a Fed-induced economic slowdown, not one brought on by an
airborne respiratory virus (see figures 1-2). With real wages running in deeply negative territory, it is likely that
discretionary spending – both online and in person – will weaken as job losses materialize in 2023 (see our October
Quadrant).
While pandemic lockdowns led to a boom in demand for household electronics, the pull forward of that demand is
starting to materialize in falling lead times for chipmakers and fewer orders for PCs and devices ahead of the
holiday season. At the same time, the sharp drop in housing activity has been crushing for real estate fintechs,
while the peaking in used car prices has pushed one online car retailer to the brink of bankruptcy.
Though tech spending boosts productivity in many industries, the underlying fundamentals of industries like
retailing, advertising, and household electronics have not meaningfully changed. Meanwhile, digital advertising
budgets face cuts as brands deal with their own pre-recessionary cash flow challenges. Bellwethers in social media
and search have cited pullbacks among their largest advertisers, especially from customers in financial services
and crypto.
The October CPI Provides a Ray of Hope

None of the 72 economists who participated in the Bloomberg consensus poll won the $2 billion Powerball lottery
this week and none had forecast headline inflation to be just 0.4% month over month. Only one economist had the
actual print of 0.3% growth in core inflation estimated correctly.
After a string of higher-than-expected inflation prints that have justified more and more Fed tightening all year, the
pendulum swung back this week. Headline inflation rose 0.4% in October (7.7% Y/Y) versus expectations for a
0.6% increase.
What is clear is that markets were not positioned for an “inflation miss” either. With bearish sentiment at highs, this
better-than-expected news caused a highly correlated move higher for all risk assets. Equities ended the week 6%
higher, with more rate-sensitive tech leading the way up 9%. The two-year and 10-year Treasuries dropped by 32
basis points and 34 basis points, respectively, and the Bloomberg US dollar index plummeted by 3.5%.
It is not wise to read too much into one inflation print, but this week’s data means that the probability of deeply
negative economic outcomes due to Fed policy faded a bit. Nonetheless, the Fed’s large, fast rate hikes are
starting to affect the real economy. And after this 3Q reporting season, it is crystal clear that tech will not be spared
from this particular downturn.
Cost Cuts Have Picked Up Steam Since 3Q Earnings

Tech employment and investment growth in 2021 reached its highest levels since the late 1990s (see figure 3). But
since late October when most tech firms began to report 3Q profits, the sentiment across the tech landscape
shifted toward “hunkering down.” Dozens of major firms have announced hiring freezes or outright layoffs in recent
weeks in an effort to preserve free cash flow, maintain margins and appease investors amid an uncertain profits
outlook (see figure 4).
Management teams also promised cuts to capital expenditures during earnings calls. Initial cost-cutting
announcements have in some cases been cheered by markets, as a focus on slimming down operations is
probably warranted after a binge in post-pandemic spending. If previous downturns are any guide, outright declines
in technology employment and investment next year could materialize, which will have ripple effects on global tech
supply chains.

Figure 1: US e-commerce sales Figure 2: Range of EPS declines by sector during

recessions since 1990

Source: Haver and Bloomberg as of Nov. 10, 2022. Grey lines note recessions. All forecasts are expressions of opinion and are subject to change without notice and are not
intended to be a guarantee of future events. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not
represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is
no guarantee of future results. Real results may vary.
Figure 3: Technology employment and investment Figure 4: High-profile technology employment
growth announcements*

Source: Bloomberg as of Nov. 8, 2022. *Bloomberg, Nov. 3, 2022, Bloomberg, Nov. 2, 2022; Bloomberg, Nov. 9, 2022; Bloomberg, Nov. 3, 2022. Note: All forecasts are
expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. Indices are unmanaged. An investor cannot invest
directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses,
fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.

Send in the Cloud? Hardly.

Cloud has been a growth engine for several US mega-caps over the past several years, though competition is
heating up as new entrants see a large and growing market for computing power (see figure 5). It now appears that
even a fast-growing segment like cloud is not immune to discretionary IT budget cuts. MarketWatch (10/29) noted
that “Cloud-computing growth has finally reached a plateau, as companies around the world cut costs to address
the slowing economy.” Forward-looking cloud bookings decelerated from 48% in 2Q to 38% in 3Q.
As the economy softens, cloud customers have become more price-sensitive than previously thought. They have
focused on optimizing their cloud usage to reduce costs for the same jobs, while new commitments are being
signed with shorter durations. And this is impacting the margins for cloud companies. With a deceleration in
customer demand, it has been impossible for cloud providers to pass along their higher energy bills, resulting in
lower cloud margins.
Tech Valuations Have Normalized, but Are Not Cheap

The carnage in the broad technology space this year reflects where we started 2022. Just a year ago, valuations for
the US IT sector were trading at their most expensive levels since the dot-com bubble. Multiples that were
acceptable when interest rates were low have had to re-adjust to a sharply rising cost of capital and a rapid shift in
preference among investors for near-term cash flows. We now see tech valuations that are much closer to longer-
run averages (see figure 6). While we expect interest rates to fall later in 2023, a challenging earnings backdrop is
likely to initially offset some modest re-rating toward higher PE tech multiples in 2023.
Figure 5: Competition among cloud providers is heating up

Source: Haver and Bloomberg as of Nov. 10, 2022. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of
future events. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any
specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real
results may vary.

Figure 6: S&P 500 Tech cyclically adjusted price-to-earnings ratio

Source: Bloomberg as of Nov. 10, 2022. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not
represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is
no guarantee of future results. Real results may vary.

Digitization Remains an Unstoppable Trend

The unstoppable trend of digitalization remains in full force. It was not an anomaly – such as COVID period strength
– that has allowed tech spending to outgrow the broader economy over the last three decades. Long-term
economic development favoring digitization has sent IT profits higher than other sectors, and shares to outperform
the S&P 500 (see figure 7).
Despite a challenging year and an uncertain outlook into 2023, we still believe many technology firms will be
leaders in the digital revolution of the next decade. Indeed, these technologies are becoming ever more deeply
embedded in how we live and work. In the years ahead, we expect intensifying innovation driven by well-funded
research and development. And we believe that businesses will either have to embrace new technologies and
processes or face extinction. We therefore would view any further volatility in tech shares over the coming year as
an opportunity to build positions for the long run.
Positioning in Tech: Own Quality Leaders and Avoid Economically Sensitive Shares

So how should growth-oriented investors position for the uncertain period just ahead? We continue to prefer a
focus on quality names with less economic sensitivity. What this means in practice is a continued bias toward
profitable tech over unprofitable moonshots (see figure 8). At the sector level, we see software – and especially
cyber security – as likely more defensive once rates peak. This is because earnings are less levered to the
business cycle than hardware and semiconductors (see figure 9).
Differentiation between leaders and laggards will become clearer over the next six months. Those companies able
to maintain margins and achieve lofty growth goals will see shareholders rewarded. We also expect a re-rating of
tech later in 2023 allowing for higher PE ratios when the end of the economic downturn is in sight.

Figure 7: S&P 500 information technology sector profits and market cap as % of S&P 500

Source: Bloomberg as of Nov. 10, 2022. Gray areas are recessions. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative
purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower
performance. Past performance is no guarantee of future results. Real results may vary.
Figure 8: Large cap vs unprofitable tech Figure 9: Tech EPS by industry group

Semis & Equipment EPS

1,200 Software EPS
Tech Hardware EPS
1,000

800

2005 = 100
600

400

200

0
'05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 '19 '20 '21 '22

Source: Haver and Bloomberg as of Nov. 10, 2022. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of
future events. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any
specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real
results may vary.

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