We turn cautious on tech names for first time since Jan 2019

Calm before the storm as there is little good news on the near term horizon
US stock market have remained calm in the face of most economic data, pointing to weakening outlook as Covid-19 infections and fatalities continue to climb. Although the VIX fear gauge index still remains elevated, it has been drifting lower, testing its six month lows when the pandemic first led to surging volatility in late February. Meanwhile, President Trump’s executives orders over the weekend to extend the Covid relief programs using disaster relief funds could provide some respite for plunging consumer activity but a more comprehensive fiscal aid, especially for financially stressed states and their employees still look out of reach as bipartisan negotiations between US lawmakers have all but broken down.  

In Japan, the only source of stock market support seems to be coming from BOJ’s unrelenting equity ETF purchases while overseas investors have continued to shed their weighting in yen denominated stocks with most funds now notably underweight in Japanese stocks. The combination of generally weak corporate earnings results, anaemic guidance for the rest of the fiscal term, Abe government’s inaction in tackling the spread of the virus, not to mention, weakening dollar against the yen have all dampened sentiment in our own market. With geopolitical tensions on the rise as US continues to toughen its stance against dealing with China’s government and its technology companies, besides growing hopes for effective Covid-19 vaccines in the pipeline, there really is very little short term positives to get too excited about, leaving us increasing cautious in the shorter term. 

Technology earnings starting to wobble while geopolitics weigh on their outlook
For the first time since becoming very bullish in January 2019, we are starting to turn more cautious of near term outlook for technology stocks, particularly the semiconductor-related plays. Indeed, for all of this year we have been bullish on the sector, arguing how the pandemic is accelerating the global digitalisation trends and considering our recommended overweight stance in the tech space as one of the better defensive strategies during this global health crisis. Needless to add, the strategy has paid off handsomely, far more so than we had hoped only a few months ago. 

However, even this sector seems to be entering a soft patch with data centres now looking to digest their heavy purchases of semiconductors acquired over the past two quarters as inventory levels have become elevated. Meanwhile big rebound in sales of PCs and laptops are starting to also cool off and chip demand for factory automation equipment, autos and other industrial-related segments have yet to post strong enough rebound to provide any downside protection. Indeed, the only sub-segment where there is some good evidence for a recovery is the global smartphone market led by 5G handset sales in China. 

But even in this area, geopolitical uncertainties could weigh heavily on the related names. News that the US government could ban the use of not only TikTok, but also the WeChat app in the US and by US companies could add much anxiety for tech investors. Although the wording of the ban remains vague to fully understand its global implications, as we have long forewarned, should WeChat and its mini-apps be forced out of Apple’s iOS echo system world-wide, its sales in China would plummet. Although we had always seen this as a risk facing the US smartphone giant should China retaliate for Google being banned to supply its latest Android OS to Huawei, we never thought the WeChat ban could be initiated by the US itself, which for all practical purposes, would be a huge own goal. Needless to add, such a scenario would pose a serious risk to the entire technology supply chain. 

Looking to raise exposure to high quality cyclical/industrial names 
Although we have been steering clear of traditional cyclical/industrial names for all of this year, and having avoided suggesting to participate in their short-lived rally that started in late May, we now feel that with their poor earnings outlook having finally been released, some of the related high quality names are starting to look fairly attractive on the assumption that the effects of the pandemic will become far less pronounced by March of next year. On the other hand, we now feel that expectations for tech names are so inflated that any downward adjustment to their short term order outlook leaves them prone to sharp sell-offs. In our own market we have seen this in names such as Advantest (6857), Lasertech (6920) and Sumco (3436) whose shares have been punished for pointing to some short term cooling off in bookings by chip makers. In the US, recent sell-off in memory names led by Western Digital (WDC) after unveiling its expectations for a weaker quarter is also worth noting. 

As a rule, we are currently looking for Japanese firms which have relatively high market share in their respective segments, strong balance sheets and trade at historically low earnings multiples relative to their peak earnings which ideally should have been reached in the past two terms. We think the combination of potential launch in Covid-19 vaccines by the year-end and a high probability of change in the leadership in the White House which we think will ultimately lead to a less combative US stance against trade and business with China could lead to a dramatic rerating in some of Japan’s most bombed out cyclical/industrial names.