We have seen widely Losses in global stock markets this year. After a decade-long bull run, many venture capital funds have found themselves holding inflated shares of companies whose IPO prospects have been canceled or significantly delayed.
Markets are now volatile, as evidenced by the broad correlation across asset classes. There are certainly structural factors that sow the seeds of pessimism such as hyperinflation. The hawkish US Federal Reserve is leading the global trend to raise interest rates; a developing European energy crisis; Europe’s first land war in 70 years; various supply chain disruptions; an ongoing global pandemic; Growing global trade tensions, and a Chinese credit bubble is slowly collapsing.
While public markets have priced in some of these headwinds, their severity and duration remain unclear. In the US tech sector, the Nasdaq Composite has fallen sharply since the start of the year, price-earnings multiples are at their lowest in six years and project funding has slowed significantly. Revenues and profits for large-cap public tech companies have held nicely so far, but are expected to falter in the coming quarters as a result of demand destruction by the Federal Reserve.
Despite all these current and prominent pressures, we see that the narrative of technology and innovation for the super-cycle has not changed, and many companies are poised for growth. Private tech companies are refocusing on the basics, and valuations are back to reasonable levels.
We also see that current economic conditions create a unique opportunity for venture capital funds with dry powder to earn significant returns, as was the case for venture capital deployed in the 2010-2014 time period.
Even though the Fed prevented the normal three-year transition period from reversing the yield to the golden period, we still believe the 2023/2024 models will indeed achieve golden period status.
A sound investing process analyzes both macro trends and underlying data to assess the likelihood of different potential outcomes. We have identified two distinct potential outcomes for the US private technology sector over the next six to twelve months.
Scenario 1: Additional pain before recovery
A few weeks ago, Federal Reserve Chairman Jerome Powell predicted that the Fed’s efforts to contain inflation would necessitate a “sustainable period of below-trend growth” that would “bring some pain to households and businesses.”
This means a period of low 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
Excessive Fed action in the face of deteriorating US economic conditions could trigger a slump in public stock markets, and likely cause public stock prices to fall by 20% to 25%. Such conditions will continue to suppress the price-to-earnings multiples and adversely affect the performance of the top line.
While certain parts of the economy remain strong, it now appears clear that Fed Chair Powell is having a Paul Volcker moment: a unilateral focus on breaking the back of inflation, regardless of the consequences. Organizing a “soft” landing was a “hopeful” strategy and proved increasingly elusive.
Assuming we see more interest rate hikes in the short and medium term, the potential for long-term profitability of the US tech sector, perhaps unexpectedly, remains strong. The pent-up market will likely lead to above-average returns for the technology sector (in particular SaaS and cloud-enabled companies) due to its ability to rapidly expand without the additional infrastructure and growing supply chain that would be required through traditional brick-and-mortar.
Rising geopolitical tensions over Ukraine
More than six months have passed since Russia invaded Ukraine, and the economic impact of rising commodity prices has begun to spread across Europe. While it is too early to predict the military outcome of the conflict, it is clear that Europe and the United States are both morally and financially invested in preventing Russia from successfully annexing parts of Ukraine.
Current conditions suggest that a stalemate is the best case scenario. The Ukrainian conflict is similar to the Soviet-Afghan War of the 1980s, a protracted war of attrition in which the West funded, trained and armed local fighters in an attempt to stress the Russian economy and thus force them to withdraw from the region. Threatened and besieged Russia may resort to last-ditch tantrums, either including nuclear threats or restricting/eliminating Europe’s access to its energy and commodity resources.