Markets Weekly podcast - 01 March 2021

Henk Potts (HP): Hello its Monday the 1st of March and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.

My name is Henk Potts, Market Strategist with Barclays Private Bank, and each week I'll be joined by guests to discuss both risks and opportunities for investors.

This recording will last around 20 minutes and will be broken down into three component parts. Firstly, I will analyse the events that moved the markets and grabbed the headlines over the course of the past week.

We'll then move on to our focus section, where we’ll spend a few minutes discussing a specific investment theme. This week I'm pleased to say our special guest is Neil Malik, he’s the Chief Executive Officer of K1 investment management.

We will discuss the technology sector through the lens of private equity. And finally I'll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Let's begin by reviewing last week. As we know it was a volatile, it was a bruising week for a broad range of asset prices as investors calculated the impact of rising inflation expectations on policy projections, reassessed sectors with rich valuations, and began to price in the possibility of a commodities super cycle playing out.

Dovish words from Fed Chair Jerome Powell, positive stimulus developments in the United States, consensus beating corporate results did little to calm market nerves. In terms of equity markets, well they debated whether high yields may begin to provide greater competition for equities.

There was weakness in the pandemic tech champions, we saw flows into the travel and leisure sector along with energy. In terms of the S&P 500, it was down 2.4% over the course of trading week. Similar picture in Europe where the STOXX 600 posted its worst week in a month, it was also down 2.4%.

As you know the real action, of course, in bond markets last week. The selloff in global bonds extended through most of last week although bonds did rally on Friday. The 10-year Treasury yield hit 1.61% on Thursday, that's the highest level since February last year.

Economists are certainly starting to push year end yield forecasts significantly higher. Inflation expectations have been rising, why is that? Well, it's in anticipation of a normalisation of activity, seeing falling infection rates and accelerating vaccination programmes coupled with ongoing ultra-accommodative policy, got historically low interest rates, this flood of fiscal support.

There's also technical factors in there as well: supply bottlenecks are pushing up costs, seen a reversal of VAT cuts. Against this of course is the backdrop of weak base levels, particularly shining through in components such as energy.

All of which suggests year on year inflation prints could rise significantly over the course of the year. For the UK, Europe, and the United States we think headline inflation will be 1 percentage point higher than in 2020.

The real question beyond seasonal and technical factors is how sustainable inflation pressure will be. Unemployment is elevated compared to pre-pandemic levels, therefore we're not seeing wage growth associated with core inflation pressures.

Digitalisation and technology investment is expected to keep wage growth muted even when labour markets recover and of course there's still plenty of slack in the economy.

If we look at current inflation forecasts they remain well below central banks mandated level. We’ve got US core PCE we think will average 1.8% this year and next, for Europe we’ve got CPI averaging 1.1% this year, 0.9% in 2022.

UK CPI we think will be at an average of 1.9% this year, 1.8% as you look through next year. The next question of course is what does that mean for rates - are these projections enough to push policymakers into tightening action sooner than expected?

The short answer to that is no. I think in order to ensure the recovery we expect overwhelming monetary support to be maintained. In most regions we would predict that central banks will keep interest rates down at historically low levels over the course of the next couple of years.

So if you start to look at central bank forecasts in the US, think rates on hold into 2023. If the speed of the recovery allows, we anticipate a tapering of asset purchase programmes starting in 2022 but it's only likely to be a targeted and controlled approach and they would try to avoid any tantrums playing out.

In Europe we expect the deposit rate to remain at minus 0.5% over the course of the next two years, the European Central Bank to maintain its bond purchases and to focus on providing liquidity.

Looking at the UK, well in the last few weeks actually the Bank of England has offered this more optimistic economic outlook than was previously projected. They've been easing market fears the instruction of negative interest rates was imminent so for us I think the MPC (Monetary Policy Committee) remains on hold but vigilant.

The risk, if anything, you could argue are for cuts rather than hikes. So if you look in inflation investment strategy we think equities offer a solution to mitigate the impact of higher prices specifically those that offer pricing power, so they include things like luxury goods, chemicals, and the tobacco companies.

Ones to perhaps avoid are highly competitive sectors, the telecoms, and those that are aggressively regulated, particularly the likes of the utilities.

Moving on to commodity prices, where they've risen rapidly over the course of the past few months, driven by expectations of rising economic activity, a surge in infrastructure investment and the weaker US dollar.

The tougher environment from a regulatory backdrop, along with weak investment levels, has also been constraining supply growth. Look at last week, we saw Brent trading above $66 a barrel - that's the highest level in a year.

Copper traded above $9000 a metric tonne, the highest level in nine years. Platinum has rallied to a six year high over the course of the past couple of weeks, seen of course as a key component to the transition to cleaner energy.

If we look at the commodity complex, hit its highest level in almost 8 years last week. If you look at the Bloomberg commodity spot index that tracks price movement to 23 raw materials, its gained more than 60% from the four-year low in March last year.

Look at the research coming through from the likes of JPMorgan and Goldman Sachs now predicting a new super cycle has begun. A super cycle is defined as a period in which prices are well above their long term trend.

There have been four such identifiable periods over the course of the past century. If we do see a sustained upward trend in commodity prices, of course it would have broad ramifications for inflation projections, foreign exchange forecasts, and indeed trade flows. For us, gold is the key commodity to watch.

Gold has not benefited to the same extent as industrial commodities; it doesn't of course have that same direct correlation with the economic recovery trade. Demand for gold as a safe haven asset has eased back in this risk-on environment.

Higher bond yields, we should remember, also creates tougher competition for the precious metal which is a zero interest bearing asset, but gold is seen as a hedge against inflation, but for us we still think it remains an important part of a portfolio from a diversification perspective.

So that was the global economy and financial markets last week. We’re now going to move on to our focus section. I'm delighted as I say to be joined by Neil Malik, he's the founder and CEO of K1 investment management, an LA based private equity firm investing primarily in software and technology private companies.

Neil is responsible for managing the firm's strategy, governance and investment activities. Neil, great to have you with us today and to get your perspective on the opportunities for investors in the technology sector.

We know of course the tech sector has been experiencing an extraordinary period of growth as adoption rates have surged during the course of the pandemic. Can you start by explaining the sector's growth potential, it's increasing influence on society and the economy, and why you think it's vital that investors have significant exposure to this high growth area?

Neil Malik (NM): Absolutely and again thank you so much for having me, it's a pleasure to be here. Look our economy is driven by productivity and GDP growth. Productivity has been driven by advancements in the agricultural sector like the hook and plough, the steam engine, and later the internal combustion engine, and later by specialised labour on factory floors.

But today our economy does not value, in many cases, the same kinds of businesses from just a decade or two or certainly a century ago. The wealthiest companies today are knowledge based companies: companies in biotechnology, companies in entertainment, streaming music and movies, and software both in the B2C (business to consumer) context as well as in B2B (business to business) software.

And so rather than investing in traditional brick and mortar or widget-like companies, we feel the best opportunities are to invest in companies making those industries more productive through software and really embracing the fact that we've moved into a knowledge economy from those traditional industries and sectors from just a decade or two ago.

HP: Okay let's pick up on some of those points. I wanted to talk to you about risks. We know there are a number of concerns I think investors have when looking at the technology sector. Number one valuations, perhaps number two regulatory risks.

Let's start with valuations. How much good news is already priced in? How easy is it to find good investment opportunities? Perhaps most importantly, how do you go about evaluating companies?

NM: That's an excellent question. Look valuations are particularly challenging right now, especially in the public market but across the spectrum.

Look, easy monetary policy has devalued currencies, zero interest rates have created asset bubbles and we see in the public market certain companies are trading upwards of 40 times revenues and while they are handful of very special companies they will have to continue to perform at a remarkable rate just to justify the valuations that are evident today.

Now, most public companies are trading in the 15 to 20 times range but we're seeing more value opportunities, more attractive opportunities from a valuation perspective in the private markets.

In the mid to mega caps we’re seeing valuations of the 10 times revenue range and in the lower middle market, where we play, valuations more consistently in that five to six times revenue range, so I think it gives us an opportunity to look at a much broader set of companies.

We are out there targeting in our database almost 40,000 software companies around the world, predominantly in North America, and so we have I think a much broader universe set to go after and frankly there's less money chasing a lot more deals down in that private market at the lower end of the space than these very well-known publicly traded companies which in many cases some can argue are priced to perfection.

HP: On the regulatory side, policymakers appear to have become increasingly vocal about the amount of power technology firms hold over key economic and societal functions. How do you view the regulatory risks for the sector?

NM: It's also another very interesting time for the technology sector. Look, half of the NASDAQ is concentrated in just five or six companies. The top ten S&P 500 businesses represent 30% of that index and markets if they're left unchecked can consolidate rather quickly.

We've seen each of those NASDAQ leaders testify before Congress in the past year. So there's never been I think more scrutiny than we're seeing right now of the technology sector.

Although there is one historical event: the breakup of AT&T back in 1980, the United States only telecom firm, and that break up from almost 40 years ago now unleashed tremendous innovation and competition and I think research has shown that smaller companies are more innovative, file more aggressive patents and larger companies generally speaking are more prone to defend their market positions than take chances and innovate, so we actually think some regulatory involvement here in the near term may actually be beneficial for the broader economy.

HP: Okay, so what are the other risk factors that investors should be considering when evaluating the sector?

NM: Look, when we look at software companies it's not just enough to look at the top line growth. When we underwrite and look at B2B software companies we have to really go deeper and look at the diversified nature of the client base.

Are there large customers that influence the product road map or pricing? We have to look really deeply at the retention rates of the client base and see that these are need-to-have not nice-to-have products.

You know, there's a lot of companies out there that are growing very quickly but have retention rates of 85% or less and as these companies grow it's increasingly difficult to backfill those lost customers while also continuing to maintain high rates of growth as they scale to be larger businesses.

And then finally, we think it's incredibly important to understand the character of those revenue streams. Are they predominantly subscription models or are they transactional business models?

 Look, in the middle of COVID last year we saw transactional business models in rideshare, booking gym and spa appointments, for example, we saw tremendous softness in many B2C companies and transactional revenue models when general economic activity slowed and so these I think are incredibly important nuances to investing in the technology space that are not inherently evident by simply looking at top line growth.

HP: So we know investors have a choice when deciding where to direct their allocation. They can gain exposure through both public and private markets. Can you comment on the benefits of choosing the private route, what trends are you seeing in this space?

NM: Yes, we think there are some significant and important factors in investing not just only in the public market but also in the private market. Look, in 2000 there were almost 10,000 public companies in the United States.

Today there's an index called the Wilshire 5000 and because there's far fewer than 10,000 companies that Wilshire 5000 index has only 3400 components.

Now, there's more billion-dollar software companies than ever before, but in the private market we’re tracking upwards of 40,000 companies in technology in B2B software and so we believe we have the opportunity to be rewarded for actively sourcing and diligencing opportunities in that much broader universe.

And just like the concentration of the largest companies in the NASDAQ and S&P being so dominant, there's quite a number or a large amount of capital that's been hoarded by some of the largest private equity firms looking for the largest of deals.

You know, we're tracking over 1000 B2B software deals announced every year in the private market. 5% of those are valued over a billion dollars. 85% of those deals are valued at around 250,000,000 or less.

So we think there's just far more opportunity to choose from each week at our investment committee, which allows us to be disciplined and also discerning on which companies to go after and frankly we believe it's a less competitive market given the number of choices and companies to go after in a much more fragmented part of the marketplace.

So yeah, we think that there's a real opportunity for investors to have exposure not just to some of the leading public companies but in a broad array of private companies that are not necessarily household names.

HP: Well listen, I'm sorry to say the clock is a little bit against us so in the last couple of minutes could I ask you to summarise for us which geographies and specific areas of the tech sector currently look the most appealing?

NM: Of course. Look, we have found opportunities frankly outside the traditional bastions of the San Francisco Bay Area and the Boston technology corridors. We see entrepreneurs more than ever before building and even bootstrapping great companies without private equity initially all over North America in secondary and tertiary cities.

And increasingly at K1, we're doing more out on acquisitions and investing around the world internationally to accelerate product road maps, increase market share, and while we focus predominantly in North America we've done deals on every continent except Antarctica today. So we see increasingly emerging opportunities in Latin America, Australia, Europe, and Asia of course.

And so, as it relates to sectors, we've also been investing in a range of industries that have proven to be resilient through the COVID downturn, which I think is a remarkable stress test that we now benefit from, looking at that in hindsight.

The legal industry for example does not appear to be sensitive to cycles. Fiscal stimulus from the government has helped the aerospace and defence sectors. Anything that automates the manual activities and paper based processes of organisations: security software, select areas of delivering healthcare, and of course any and all platforms that allow collaboration to distributed organisations, storing and distributing video content.

These are just a handful of areas that have seen accelerated adoption and I think that's a trend that will continue even as the world begins to go back to normal, hopefully over the coming quarters.

HP: Well thank you Neil once again for joining us and providing some insight into the private equity view of the technology sector. Certainly a topic our listeners are interested in, no doubt we will have you on in the coming weeks and months to highlight developments and discuss prospects for this important segment of the market.

Moving on to the week ahead. Of course the focus will be on the budget in the UK on Wednesday, with the Chancellor expected to offer some short term gain but long term pain. It'll be a balancing act.

We think we'll see measures to ensure the recovery, but we're also likely to see some early signposting surrounding the need to put the nation's finances back onto a sustainable path, given the unmatched rise in peacetime borrowing as a result of the pandemic.

Key support measures to watch out for well the furlough programme of course, estimated to have already cost £54 billion, is expected to be extended. The job retention scheme is currently protecting 4.7 million jobs, that equates to 16% of eligible workers.

Currently due to run out at the end of April, likely as I say to be extended into the summer. Also likely to see an extension to the self-employment income support scheme and the Universal Credit uplift.

Other measures to watch out for in terms of support and investment, well sectors that have been hard hit are demanding further exemptions from property rates and VAT cuts. The stamp duty holiday is expected to be extended for a further three months to the end of June.

The Chancellor may also announce a multi-year investment programme encompassing infrastructure coupled with measures to address the climate change agenda. We could also see an increase in government backed loans for specific sectors.

When it comes to revenue raising, the Chancellor is expected to lay out a series of corporation tax hikes going out to 2024 taking the rate from 19% towards 25%. He could also announce an excess profit tax aimed at companies that have benefited from the pandemic and that could be very much focused on online retailers and the tech companies.

Despite the budget deficit forecast to continue to rise over the course of the next two years, the government appears committed to their 2019 manifesto pledge to leave the main revenue raisers of income tax, VAT, and National Insurance unchanged. Also unlikely to see a wealth tax introduced which is perceived as being against Conservative principles.

With that I'd like to thank you once again for joining us. We hope that you found this podcast interesting, informative, and it’s given you a perspective on the technology sector from the private equity guys.

We will of course be back next week with our latest instalment but for now may I wish you every success for the trading week ahead.