Last December, inflation was the big US macro story. The US consumer price index (CPI) had just reached 7 per cent on an annual basis and Federal Reserve chair Jerome Powell decided to “retire” the word ‘transitory’. With inflation inevitable at this point, the market was already starting to turn on expectations that interest rates would have to rise throughout the year. Correspondingly, in January the Nasdaq fell 12 per cent and the S&P 500 dropped 7 per cent.
Even so, at this point the consensus was more optimistic than reality would prove. Goldman Sachs forecast core inflation would peak at around 4 per cent in 2023. Meanwhile, five-year US Treasury yields were hovering at just over 1 per cent. Neither economists nor the markets thought inflation would be too bad. However, investors who took a more negative view would have made money. Instead of 4 per cent, core inflation peaked at over 6 per cent. In response, the Federal Fund rate has been hiked 3.75 percentage points throughout the year, pushing up the five-year Treasury yield to a peak of 4.2 per cent at the start of November. It turned out stocks had a long way to fall. Year to date, the Nasdaq and S&P have fallen 30 per cent and 19 per cent, respectively.
This high inflation and high interest rate environment impacted the US tech sector most severely, because these growth stocks are valued on speculative future cash flows. When rates are higher, current cash flows become more valuable. This led investors to rotate into defensive income stocks such as pharmaceuticals, as well as companies that benefited from the war-fuelled spike in energy prices. At the time of writing, pharma giant Johnson & Johnson (US:JNJ) was up 3 per cent in 2022 and oil company Chevron (US:CVX) was up 44 per cent, while Tesla (US:TSLA) had fallen 55 per cent. Electric vehicles are clearly the future, but Tesla‘s incredibly stretched valuations lost their appeal amid the volatility.
A year on, things look brighter on the inflation front – relatively speaking. In October, US consumer price inde (CPI) inlation was still 7.7 per cent, but this was down from a peak of over 9 per cent in June. In a speech to the Brookings Institute at the end of November, Powell pointed to the fact that core goods inflation had fallen nearly three percentage points from earlier this year to 4.6 per cent, saying “bottlenecks in goods production are easing and goods price inflation appears to be easing”. Freight rates are now almost back to their pre-pandemic level.
With these indicators suggesting inflation is slowing, Powell thinks it could be time to start slowing the rate rises. “Monetary policy affects the economy and inflation with uncertain lags, and the full effects of a rapid tightening so far are yet to be felt. Thus, it makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down.”
Optimism that this is the turning point in the fight against inflation has been driving a stock market recovery in the past month, particularly in technology stocks. As the chart shows, since the October inflation figures were released, five-year yields have started to fall and the Nasdaq has reversed some of this year's losses.
However, the other side of this coin is that inflation will only fall when demand is sufficiently dampened. The point at which the Federal Reserve decides to lower interest rates will also not arrive until it believes the economy has slowed too much. Lower rates enhance valuations, but recessions are terrible for earnings.
The concern for US investors this year is not whether inflation will fall, but whether it can fall without gross domestic product (GDP) shrinking. In its 2023 outlook, Goldman Sachs believes the US can still manufacture a “soft landing”. The bank’s economists are forecasting that core inflation will slow from 5 per cent to 3 per cent, and that unemployment will rise just half a percentage point from its current 50-year low of 3.7 per cent. Meanwhile, Goldman expects the Fed to hike interest rates by just another 125 basis points to 5 per cent.
Goldman is also forecasting that US GDP will grow 1 per cent next year. This is much better than its hopes for the eurozone, which is expected to shrink 0.1 per cent, and for the UK economy, which is forecast to contract 1.2 per cent; Russia is the only major economy expected to shrink more. India and China are the only major countries with better growth prospects than the US, with predictions of 5.9 per cent and 4.5 per cent growth, respectively.
Compared to consensus, Goldman is taking the optimistic route. “Unlike a year ago, when our forecast for both 2022 and 2023 was below consensus because we expected a negative impact of monetary and especially fiscal tightening, our current 2023 forecast is well above consensus,” it wrote. “We estimate a 35 per cent probability that the US economy enters recession over the next 12 months, well below the median of 65 per cent among the forecasters in the latest Wall Street Journal survey.”
A survey of leading economists, conducted by the Financial Times and The University of Chicago Booth School of Business in November, was more pessimistic. Over 50 per cent expect unemployment to peak at over 5.5 per cent, with 24 per cent thinking it will rise to over 6 per cent. Most expect a recession to be called in the middle of 2023 and for the Fed to then start lowering rates by the end of the year.
This would create a challening situation for consumer-facing industries such as retail, automotive and airlines. Higher unemployment rates would mean less expandable income and by this point US consumers would have burnt their way through the pandemic savings that were boosted in 2021 by stimulus cheques. Bellwethers Amazon (US:AMZN) and FedEx (US:FDX) have already started making redundancies. FedEx announced plans to launch a $2.5bn cost-saving programme after its operating profit dropped 15 per cent in its recent quarterly results.
Consumer weakness also means there will be a continued pullback in advertising spending. We have already seen the impact this is having, with Meta (US:META), Alphabet (US:GOOGL) and Snap (US:SNAP) all posting underwhelming quarterly results in the past few months. For the first time since its listing, Facebook’s revenue shrunk on a quarterly basis; its share price is down over 60 per cent for the year.
Most of the big US tech winners of the past decade are platforms that benefited from scale and network effects, and then ultimately monetised these through advertising. But next year will be a challenging environment for them. Pandemic stimulus and lockdowns were a huge boost to ecommerce and consequently the online advertising industry. But that was the exception rather than the rule, and next year there will be a correction.
When inflation slows and interest rates start to fall again, technology companies will see their valuations grow. However, the internet platforms’ overexposure to advertising means earnings growth will not return to pre-pandemic levels. Instead, it’s the companies that are building the next-generation technology to improve productivity that will drive US stock market returns. Recessions drive companies to seek efficiencies. In the past, this was done via offshoring and globalisation. This time, it will be through technology.
Artificial intelligence is going through a renaissance after years of under-delivery. OpenAI, which is funded by Microsoft (US:MSFT), has released AI language models that look set to redefine the way humans process and interact with information. Alphabet’s DeepMind is also using AI to do groundbreaking work in drug discovery and computing. DeepMind recently discovered a new algorithm to improve the efficiency of matrices calculations which will make the graphic processing units (GPUs) that run the AI programme more powerful. There is a flywheel – ie momentum – effect at work.
The companies that produce these GPUs could be in for a windfall. Nvidia (US:NVDA) designs the GPUs needed to run these large AI algorithms on the cloud computing servers. Its share price has struggled as rates have risen, but it will be at the centre of technological development for the next decade. Meanwhile, Taiwan Semiconductor Manufacturing (TW:2330), the subject of recent investment from Berkshire Hathaway, will manufacture most of the chips designed by Nvidia.
In 2022, the US was a story of an overheating economy. Next year, investors will experience the lagged cooling effects of this year’s rate rises. With bond yields coming down, technology stocks will be back on the agenda. However, the corresponding recession means it will be the productivity-boosting enterprise technology that generates the most returns. Platform economics fuelled by advertising spending has peaked. Next year will be about making things as efficient as possible.
