We have seen widespread losses in global stock markets this year. After a decade-long bull run, many venture capital funds have held overvalued stocks of companies whose IPO prospects have either been eliminated or significantly slowed down.
The markets have now become skittish, as evidenced by the widespread correlation between asset classes. There are certainly structural factors that sow the seeds of pessimism, such as severe inflation; an aggressive US Federal Reserve leading a global trend of rate hikes; an evolving European energy crisis; the first land war in Europe in 70 years; various supply chain disruptions; an ongoing global pandemic; rising tensions in world trade and, to top it off, a slowly collapsing Chinese credit bubble.
While public markets have priced in some of these headwinds, their severity and duration remain unclear. Turning to the US technology sector, the Nasdaq composite index has fallen sharply since the start of the year, price-to-earnings ratios are at their lowest level in six years and venture capital funding has slowed significantly. The earnings and profits of major publicly traded technology companies have generally held up well so far, but are expected to falter in the coming quarters due to the Fed-driven destruction of demand.
Despite all this current and high-profile pressure, we believe the technology and innovation story across the supercycle remains unchanged and many companies are poised for growth. Private technology companies are refocusing on fundamentals and valuations are returning to reasonable levels.
We also believe that the current economic conditions create a unique opportunity for venture capital funds holding dry powder to achieve significant returns, as was the case for VCs deployed during the 2010-2014 period.
While the Fed has prevented the natural three-year transition from yield inversion to golden period, we still believe that the 2023/2024 vintages will indeed reach golden period status.
A sound investment process analyzes both macro trends and fundamental data to assess the likelihood of various potential outcomes. We identified two different potential outcomes for the US private technology sector over the next six to 12 months.
Scenario 1: Extra Pain for Recovery
A few weeks ago, Federal Reserve Chairman Jerome Powell predicted that the Federal Reserve’s efforts to contain inflation would entail a “sustained period of below-trend growth” that would bring “households and businesses would hurt.”
This implies a period of lower-bandwidth stagnation in US stock prices over the next 12-24 months. Such an outcome is likely in the near term if the following negative economic and geopolitical developments occur:
Aggressive Federal Reserve
An overly aggressive Federal Reserve in the face of deteriorating economic conditions in the US could lead to stagnation in public stock markets and possibly an additional 20%-25% drop in public stock prices. Such conditions would continue to dampen price-earnings ratios and negatively impact sales.
While certain areas of the economy remain strong, it now seems clear that Fed Chairman Powell is having a Paul Volker moment: a determined focus on breaking inflation regardless of the fallout. Orchestrating a “soft” landing was a “hopeful” strategy that is becoming increasingly elusive.
Assuming we see more rate hikes in the short and medium term, the prospect of long-term profitability for the US technology sector remains strong, perhaps counterintuitively. A suppressed market would likely lead to above-average returns for the technology sector (particularly SaaS and cloud-enabled companies) due to its ability to scale quickly without the additional infrastructure and supply chains required by traditional brick-and-mortar businesses.
Higher geopolitical tensions over Ukraine
It has been more than six months since Russia invaded Ukraine, and the economic impact of the rise in commodity prices is starting to trickle down across Europe. While it is too early to predict the military outcome of the conflict, it is clear that Europe and the US have invested morally and financially to prevent Russia from successfully annexing parts of Ukraine.
Current circumstances suggest a stalemate as the best-case scenario. The conflict in Ukraine resembles the Soviet-Afghan war of the 1980s, a protracted war of attrition in which the West finances, trains and arms local fighters in an attempt to pressure the Russian economy and thereby force a withdrawal from the region. An endangered and cornered Russia could resort to ultimate outbursts of rage, including nuclear threats or restricting/excluding Europe’s access to its energy and raw materials resources.
