- The relative performance of US equities and the outlook for the Technology sector are closely aligned.
- This short note aims to highlight headline risks that the Technology sector may face in 2021.
- When allied to high valuations, these risks have the potential to impact relative performance not only of the Technology sector, but also of the S&P 500 itself.
The Tech sector is 27% of US equities and approaching 10% in Europe. Given its scale in the US, the outperformance of Technology has propelled the outperformance of US equities globally. Similarly, a weaker outlook for Technology could hold back US equities in relative terms.
We find valuations for the sector today more than reflect the earnings trajectory for the majority of listed companies. Valuations have risen sharply over the last four years, both in the US and in Europe:
Yet headline risks appear to be rising. Below we highlight five policy risks that may crystallise in 2021:
- A Global Digital Tax.The OECD is leading global negotiations for a global digital tax. Details of this tax may appear as early as this April with more comprehensive details due in July. In late February, US Treasury Secretary Janet Yellen removed the Trump administration’s previous obstruction to an agreement, paving the way for the new tax to be implemented.
- Anti-Trust Investigations.Biden is assembling a team at the Federal Trade Commission and the National Economic Council who are arguing for a break-up of the Big Tech platforms. The European Union has already filed a series of anti-trust investigations into Big Tech and the UK’s Competition and Markets Authority has stated it is soon to follow.
- Increase in Corporation Tax.An increase in the US Corporate Tax Rate from 21% to 25% is likely under the Biden administration. Whilst this does not single out the Technology sector, it will impact highly valued securities the most. The higher the valuation, the longer the duration of future cashflows, the larger the valuation impact of tax changes.
- Increase of US Tax on Foreign Sourced Revenue.Today foreign sourced revenue faces a tax rate of 10.5%. Biden has proposed increasing this to 21%. The Tech sector is the largest earner of foreign sourced revenue and so would be disproportionately impacted.
- Increase in Capital Gains Tax.Biden has stated he wants capital gains tax to be moved in line with income tax and set at 40%. Whilst a move to 40% will be politically difficult to implement, an increase from today’s 15-20% rate to 25-28% is possible. Investors sitting on large capital gains will be incentivised to sell ahead of such a change. The Technology sector, having had excellent stock market performance and high retail investor participation in recent years, may face heavier selling than other sectors.
Many of these policy risks are US centric, but they are following a global pattern. This is not just a US and European phenomenon. In China, Tech investors have been surprised at the scale of regulatory interference in recent months. The reason for these announcements is that the political reality has changed. The Tech sector has operated in a regulatory blank space for the last decade. This had allowed for outsized returns. But no longer. Policy makers and regulators have the sector in their sights. Valuations do not reflect these changing risks.
The proposed tax changes in the US not only impact Technology, but also the relative attractiveness of US equities. Higher taxes reduce post tax returns. Heavy weightings in US equities may seek other destinations, including Europe. This shift has the potential to improve the relative performance of global ex-US equities and perhaps weaken the US Dollar.
The LF Lightman European Fund remains cautious of the Technology sector in 2021. The combination of rising bond yields, rising taxes, political interference, heavy professional and retail investor allocations – and full valuations – suggests a deteriorating risk reward for the Tech sector. This development has the potential to spill over into relative weakness for the S&P 500. European equities have the potential to be a relative beneficiary from this change in fundamentals.
Lightman, Strategas – March 2021
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