Why the cloud investment opportunity

will outlast an economic downturn

Magellan Asset Management

November 2022

The global shift to cloud computing is a seismic and transformational trend that we have backed for several years at Magellan.

For the hyperscale public cloud vendors outside China - Amazon, Microsoft, and Google (the Magellan Global Fund holds all three companies) - it has created unprecedented market opportunity. These vendors have consistently generated strong double-digit revenue growth at scale and continue to do so to this day. Yet in the most recent two financial quarters, hyperscale cloud revenue has faced decelerating growth as enterprise customers reign in spend amid the uncertain macroeconomic backdrop. Has the story come to an end?

Note: Blue bars represent aggregate quarterly cloud revenue of Amazon Web Services, Microsoft Azure (MFG estimate), and Google Cloud. Green line represents the quarterly year-over-year growth rate. Red line represents the growth rate compared to two years ago on an annualised basis. Growth rates are in constant currency to reflect underlying growth.

The trend this year is apparent. Excluding the impact of currency movements, hyperscale cloud revenue grew in aggregate 42% year-over-year in Q1. In Q2, the growth rate fell to 38%, and in the most recent Q3, the growth fell further to 34%. The two largest vendors, Amazon and Microsoft, expect this deceleration to continue, which means we should expect the growth rate to decline even more in Q4. On top of that, margins are falling, with both companies dealing with rising energy costs in their data centres while continuing to maintain their pace of double-digit operating expense growth. All of this may seem dire but let us unpack it further.

We start by recognising that the deceleration this year appears more severe because it is being compared to several quarters of strong growth in 2021 due to cloud demand created by the pandemic responses. To try to adjust for this by looking at this year's quarterly growth rates on a 2-year annualised basis, we see a steadier growth trend, albeit one that is still slowing - from 40% in Q1, to 39% in Q2, to 38% in Q3. (The fact that we are seeing this type of growth on an aggregate US$160 billion in annualised revenue is staggering on its own). These decreases are more marginal and subject to noise, but there is broader evidence that IT spend is generally tightening.

The unfavourability of these recent IT spending trends are, we believe, cyclical not structural. Market uncertainty has compelled enterprise customers to become more prudent or selective about their IT investments. Some customers are in industries facing challenges of their own such as supply chain issues, inflation, or labour shortages. We also expect some spend was driven by the period of excessive cheap, available money and this spend will not return. And as their customers seek to tighten their belts, hyperscale cloud vendors are taking it a step further and in fact helping customers to improve the efficiency of their spend (e.g., through lower priced options). In other words, the cloud vendors are effectively contributing to their own growth headwinds.

Why do this? It is about driving trusted partnerships with customers for long term growth, rather than short-sightedly focusing on maximising growth today. This makes sense if one believes, as we do, that cloud has a significant multi-year growth runway ahead. In fact, the ability for customers to proactively dial up and down cloud spend according to their needs - rather than being burdened with the large, fixed costs of an on-premises data centre when times are tough - is one of the fundamental value propositions of the cloud, and the current environment reinforces this validity. Put another way, hyperscale cloud is doing exactly what it was meant to do.

The effect of rising energy costs on the hyperscale cloud vendors has been negative but comparably modest so far. Amazon cited a 200bps impact to AWS margins in aggregate over two years, and for Microsoft we expect an impact of less than 100bps to its cloud margins this financial year, unless costs rise significantly higher. The cloud vendors are absorbing these higher costs in the near term, but we believe they possess the pricing power to share rising costs with customers over the longer term. An underappreciated point is that the energy efficiency of hyperscale data centres is far superior to what customers can achieve on their own, which is further demonstrating to these customers the advantages of being in the cloud.

Cloud computing is proving its value to customers as much in this environment as it ever has, and we can see this when we delve beyond the quarterly headlines. It is why we continue to view this investment opportunity as compelling on the longer time horizon. It is an attractive, enduring, and multi-year opportunity that will deliver robust growth and attractive margins on the other side of the economic cycle we find ourselves in today.

Author: Adrian Lu, Investment Analyst

Sources: Company filings and Magellan estimates

Funds operated by this manager:

Magellan Global Fund (Hedged), Magellan Global Fund (Open Class Units) ASX:MGOC, Magellan High Conviction Fund, Magellan Infrastructure Fund, Magellan Infrastructure Fund (Unhedged), MFG Core Infrastructure Fund

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RBA likely to move to quarterly tightening in 2023

Pendal

December 2022

THIS week's 25-point rate rise probably won't be the last — but the Reserve Bank's pace of tightening is likely to move from monthly to quarterly increments next year.

The cash rate will now sit at 3.1% for the summer. The RBA's next monetary policy statement is due on February 10.

Between now and then we will see fourth quarter inflation data released on January 25.

It will be high. The annual headline inflation rate will be around 8% for 2022.

This will set the case for another hike in February.

Tuesday's RBA statement contained nothing new. The central bank remains data dependent while the global outlook has deteriorated.

Domestically the labour market remains tight. Economic growth has been strong and household spending will start to slow due to policy tightening delivered so far.

For some this is yet to occur, given the higher-than-usual number of fixed-rate mortgages that are yet to reset.

This is the reason why the RBA doesn't need to be as aggressive. Fixed-rate mortgages at rates around 2% will be resetting closer to 5.5% mid next year.

The RBA acknowledges they are walking a tight rope.

"The path to achieving the needed decline in inflation and achieving a soft landing for the economy remains a narrow one."

The further they push policy, the harder the landing becomes.

The RBA doesn't want to cause a recession. But given a choice of embedded higher-inflation expectations or better growth, the former wins out for any central banker.  

The longer-term task is no simpler.

Policy action to date "has been necessary to ensure that the current period of high inflation is only temporary", the RBA statement said. "High inflation damages our economy and makes life more difficult for people."

In a speech late last month RBA governor Phil Lowe pointed out that variability in inflation outcomes was more likely to increase than what we've become accustomed to.

He cited four key areas where supply issues in the longer term will occur:

1. Reversal of globalisation
2. Demographics
3. Climate change
4. The energy transition in the global economy.

The RBA has under-shot or over-shot its 2-3% target band more often than not over the past 15 years.

More variability in inflation outcomes? Who would want to be a central banker.

Central banks have tightened policy significantly over 2022 — and that will weigh on demand over 2023.

The current Christmas spendathon — where we are let loose for the first Christmas in three years — will hold activity up for now. But it's unlikely continue into the new year hangover.

The supply side of the global economy is also likely to see capacity increase and downward inflationary pressure next year.

The supply issues that have resulted from the pandemic and Russia's invasion of Ukraine will resolve over time.

But with it comes another set of challenges. And those are more likely to be skewed towards higher inflationary pressure in the longer term.

Author: Steve Campbell, Head of Cash Strategies

Funds operated by this manager:

This information has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and is current as at December 8, 2021. PFSL is the responsible entity and issuer of units in the Pendal Multi-Asset Target Return Fund (Fund) ARSN: 623 987 968. A product disclosure statement (PDS) is available for the Fund and can be obtained by calling 1300 346 821 or visiting www.pendalgroup.com. The Target Market Determination (TMD) for the Fund is available at www.pendalgroup.com/ddo. You should obtain and consider the PDS and the TMD before deciding whether to acquire, continue to hold or dispose of units in the Fund. An investment in the Fund or any of the funds referred to in this web page is subject to investment risk, including possible delays in repayment of withdrawal proceeds and loss of income and principal invested. This information is for general purposes only, should not be considered as a comprehensive statement on any matter and should not be relied upon as such. It has been prepared without taking into account any recipient's personal objectives, financial situation or needs. Because of this, recipients should, before acting on this information, consider its appropriateness having regard to their individual objectives, financial situation and needs. This information is not to be regarded as a securities recommendation. The information may contain material provided by third parties, is given in good faith and has been derived from sources believed to be accurate as at its issue date. While such material is published with necessary permission, and while all reasonable care has been taken to ensure that the information is complete and correct, to the maximum extent permitted by law neither PFSL nor any company in the Pendal group accepts any responsibility or liability for the accuracy or completeness of this information. Performance figures are calculated in accordance with the Financial Services Council (FSC) standards. Performance data (post-fee) assumes reinvestment of distributions and is calculated using exit prices, net of management costs. Performance data (pre-fee) is calculated by adding back management costs to the post-fee performance. Past performance is not a reliable indicator of future performance. Any projections are predictive only and should not be relied upon when making an investment decision or recommendation. Whilst we have used every effort to ensure that the assumptions on which the projections are based are reasonable, the projections may be based on incorrect assumptions or may not take into account known or unknown risks and uncertainties. The actual results may differ materially from these projections. For more information, please call Customer Relations on 1300 346 821 8am to 6pm (Sydney time) or visit our website www.pendalgroup.com