AI drives sky high returns for Polar Capital Technology Trust

Polar Capital Technology Trust (PCT) has released its annual report for the year ended 30 April 2024. The company’s NAV per share increased by 40.8%, versus an increase in the benchmark of 38.9% in sterling terms over the same period. Shares were up 50.8%. The discount was 7% at the time of publishing. The manager noted that the strong performance was largely due to its decision to rotate towards AI as a primary investment theme and focus on the enablers and beneficiaries in this space including semiconductor and component subsectors. It also mentioned that the diminution in the risks of prolonged high inflation and recession have helped equity markets generally.

In addition to the release of the annual report, the company also announced proposals for a 10-1 share split, noting that the price of its existing ordinary shares has increased in recent years and they now trade regularly above £30 per share. Whilst this is a positive, the company notes that a higher share price might be a barrier to investment for certain investors including regular savers who may wish to invest smaller amounts per transaction on a regular basis.

Discussing the company’s performance and the outlook for PCT and the wider technology sector, Ben Rogoff & Ali Unwin commented:

“If the market surprise of 2022 was how high inflation remained for so long, 2023’s revelation was how little impact the fastest monetary tightening cycle in a generation had on the real economy. Various explanations include a delay in the ‘transmission’ of higher rates given the high proportion of mortgages and corporate debt fixed at very low rates during the ‘zero-rates’ era, the benefit of interest income on ‘excess consumer deposits’ in supporting consumer spending, and corporate unwillingness to let go of the workers they had fought hard (and paid up) to attract and retain. In contrast with prior years, our base case for 2024 is broadly in line with consensus on many of the key near-term debates (inflation, rates, valuations) and our belief is that where we do differ, the range of outcomes is narrower. Some of the other ‘known’ risks are more binary in nature (e.g., US presidential elections).

“In its April 2024 update, the IMF projected 3.2% global growth in 2024, 30bps higher than its October 2023 forecast, and 3.2% in 2025. This outlook is described as “surprisingly resilient, despite significant central bank interest rate hikes to restore price stability”. The persistence of US growth is striking, now expected to accelerate modestly from 2.5% in 2023 to 2.7% in 2024, against expectations for a deceleration to 2.1% for both years in the IMF’s January 2024 update. Despite strong economic growth, the disinflation process remains broadly on track and “monetary policy should ensure that inflation touches down smoothly”: global headline inflation is expected to fall from 6.8% in 2023 to 5.9% in 2024 and 4.5% in 2025.

“Our base case remains that central banks have won the battle on inflation. Much of the earlier excess inflation proved to be supply-side driven, including covid disruptions (e.g., container freight rates increased 5x between 2020 and late 2021) and exogenous commodities price shocks from Russia’s invasion of Ukraine. Demand imbalances have also played a part, including government stimulus and demand swings for goods versus services. Common causes have seen common solutions: disinflation dynamics have been reasonably homogeneous across countries. Goods disinflation has been widely observed, while services have proven stickier, around 3-5% in developed economies.

“For its part, the Fed kept long-term inflation expectations ‘well-anchored’ and prioritized credibility above all else; the ‘5yr5yr’ – a market-implied expected average inflation rate over a five-year period that begins five years from today – remained in a 2-2.5% range despite headline CPI inflation in the high single digits. This proved sufficient to deliver a ‘soft landing’ most thought impossible, judging by the 75% of economists who expected a recession coming into 2023, and the Fed futures curve which anticipated the Fed would have to cut rates by the second half of 2023. We expect the Fed to manage the balance between keeping rates restrictive enough to ensure inflation returns to target and cutting early enough to prevent a recessionary outcome.

“The path of inflation is the key determinant of Fed policy, and it will (rightly) remain ‘data dependent’, but policymakers are clearly cognizant of the need to manage de facto tightening from higher ‘real’ rates as inflation trends lower and policy rates sit unchanged. Indeed, real rates are already around 2%, versus an average 3% level at which the Fed has historically started cutting, and other central banks including Sweden’s Riksbank, the ECB, and the BoE have either begun cutting or signaled they will soon. The ‘maximum employment’ aspect of the Fed’s ‘dual mandate’ will also likely receive more attention, and arguably Chair Powell introduced a form of ‘labor market put’ at the January FOMC press conference: “If we saw an unexpected weakening in… the labor market, that would certainly weigh on cutting sooner. Absolutely.

“Equities tend to rally after the Fed begins a cutting cycle, although the returns are (unsurprisingly) better in non-recessionary scenarios. Deutsche Bank found that the S&P 500 has returned +7% in the 12 months following the first rate cut in recessionary scenarios, and +18% in non-recessionary scenarios. Longer-term, Goldman Sachs found a 50% positive return over 2 years absent a recession and negative mid-teens returns when a recession occurred. Interestingly, the overall level of the market coming into the rate cutting cycle has made little difference historically. Since 1980, there have been 20 times when the Fed has cut rates when the S&P 500 was within 2% of all-time highs, and the market has been higher a year later on all 20 occasions.

“Investors should also be comforted by central banks’ increasing ability and confidence in using their balance sheets to deal with sector or asset-class specific issues. Indeed, one of the great challenges last year was understanding how an aggressive Fed tightening cycle did not cause a spike in unemployment or a recession. In addition to the reasons suggested above, liquidity provided by years of Quantitative Easing plus covid-era balance sheet expansion (from 18% of GDP in 2019 to 28%) mollified the impact of monetary tightening from rate cuts. In addition, central banks have been very willing to use their balance sheets to support the economy and the debt and labor markets (and, by extension, risk assets), as seen with the Fed’s Bank Term Funding Program (BTFP) and the Bank of England’s successful intervention during the LDI crisis. We expect balance sheet operations to remain a permanent part of the landscape.

“Valuations appear extended but not unreasonable. Equity market valuations have rebounded since June and October 2023 lows (15.5x) and the S&P now trades on 21x 2024 consensus earnings and 18.5x 2025, based on 11% and 9.5% EPS growth. Historically, equity valuations have expanded following the end of Fed hiking cycles, but multiple expansion is typically accompanied by a decline in bond yields. Economic growth appears positive but moderating (total revenue growth tracks nominal GDP growth normally), which suggests upside to revenues (absent AI-related areas) might be limited. S&P profit margins are back to pre-GFC highs and elevated versus history, having troughed in Q4 2022. Several incremental headwinds to further margin expansion suggest profit growth could be more similar to revenue growth in 2024, although analysts are still assuming significant operating leverage with S&P 500 expected earnings growth (11%) ahead of revenue growth of 4.9%. However, we are optimistic longer-term that AI could drive sufficient labor productivity for knowledge workers to make a material difference to the $53trn global wage bill (54% of GDP). Our valuation base case is that significant further multiple expansion is unlikely from this point, and equity returns should better track EPS growth absent a recession or bull case scenario.”

PCT : AI drives sky high returns for Polar Capital Technology Trust