We have seen widespread losses in world stock markets this year. After a decade-long bull run, many venture capital funds have found themselves with overvalued shares of companies whose IPO prospects have been scrapped or significantly delayed.
The markets have now become nervous, as evidenced by the widespread correlation between asset classes. Certainly, there are structural factors that sow the seeds of pessimism, such as severe inflation; a hawkish US Federal Reserve leading a global trend of interest rate hikes; an evolving European energy crisis; the first land war in Europe in 70 years; various interruptions in the supply chain; an ongoing global pandemic; rising global trade tensions 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. Regarding the US tech sector, the Nasdaq Composite Index is down sharply year-to-date, P/E multiples are at six-year lows, and risk funding has slowed significantly. Revenue and earnings of public large-cap tech companies have generally held up well to date, but are expected to falter in coming quarters as a result of Federal Reserve-induced demand destruction.
Despite all these current and high-profile pressures, we believe the narrative of the technology and innovation supercycle remains unchanged, and many companies are poised to grow. Private tech companies are refocusing on fundamentals and valuations are returning to reasonable levels.
We also believe that current economic conditions create a unique opportunity for venture capital funds that have dry powder to earn significant returns, as was the case with VCs that were deployed in the 2010-2014 period.
Despite the Federal Reserve preventing the natural three-year transition period from yield inversion to the Golden Period, we continue to believe that the 2023/2024 vintages will achieve Golden Period status.
A sound investment process looks at both macro trends and fundamental data to assess the likelihood of various potential outcomes. We have identified two distinct potential outcomes for the US private tech sector over the next six to 12 months.
Scenario 1: additional pain before recovery
A few weeks ago, Federal Reserve Chairman Jerome Powell forecast that the Fed’s efforts to contain inflation would involve a “sustained period of below-trend growth” that would “bring some pain to households and the companies”.
This implies a period of US stock price stagnation in a lower range for the next 12-24 months. Such an outcome is likely in the short term if the following negative economic and geopolitical developments were to occur:
aggressive Federal Reserve
An overly hawkish Fed in the face of deteriorating US economic conditions could trigger a stall in public equity markets and potentially cause another 20%-25% drop in public equity prices. Such circumstances would continue to suppress price-earnings multiples and negatively affect top-line performance.
While certain parts of the economy remain strong, it now seems obvious that Fed Chairman Powell is having a Paul Volker moment: a single-minded focus on breaking inflation’s back, no matter the consequences. Orchestrating a “soft” landing was a “hopeful” strategy that is proving increasingly elusive.
Assuming we see further interest rate hikes in the short and medium term, the long-term return outlook for the US tech sector, perhaps counterintuitively, remains strong. A repressed market would likely lead to above-average returns for the technology sector (particularly SaaS and cloud-enabled companies) due to its ability to scale rapidly without the additional infrastructure and supply chain increments that come with it. traditional bricks will be required. and mortar businesses.
Increased geopolitical tensions over Ukraine
It has been more than six months since Russia invaded Ukraine and the economic impact of rising commodity prices is starting to seep across Europe. While it is too early to predict the military outcome of the conflict, it is clear that Europe and the US are morally and financially committed to preventing Russia from successfully annexing parts of Ukraine.
Current circumstances suggest a stalemate at best. The Ukraine conflict 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 effort to stress the Russian economy and thus force withdrawal from the region. A threatened and cornered Russia could resort to last-minute tantrums, either including nuclear threats or restricting/eliminating Europe’s access to its energy and raw material resources.