Technology investors need to forget about the economy. Inflation and interest rate expectations are going to wildly change the valuations for growth businesses in the coming years but nobody in truth can say exactly how. Will the deflationary forces that have been pushing down prices since 2008 return? Or will deglobalisation result in a structurally higher consumer price index inflation? It’s impossible to know and investors should not bet big thinking they do.
In July, Blue Whale Growth Fund ditched its positions in Alphabet (US:GOOGL). This meant it no longer held any positions in the Faang stocks - Facebook (US:META), Amazon (US:AMZN), Apple (US:AAPL), Netflix (US:NFLX) and Alphabet (US:GOOGL). When talking to the Financial Times about the change in strategy, fund manager Stephen Yiu cited inflation, the impending US recession and the subsequent hit on advertising spending as the reason for the change in heart.
In the last month, Alphabet’s share price has jumped 11 per cent. Meanwhile Facebook’s is up 7 per cent, Amazon’s 28 per cent, Apple 18 per cent and Netflix 29 per cent. This looks bad for Yiu. These numbers suggest that these companies have all turned the corner and increased their earnings forecasts.
Tough time for Big Tech
In fact, in the past month all these companies – except Amazon – have posted disappointing earnings figures. Google’s revenue growth has ground to a halt. In its second-quarter release at the end of July, it reported that YouTube advertising revenue had increased just 5 per cent year on year to $7.34bn. This was below analyst expectations of $7.52bn. Meanwhile, Facebook – for the first time in its history – posted a year-on-year fall in quarterly revenue because of the “continuation of the weak advertising demand environment”, and Netflix lost another million subscribers.
Google and Facebook at their heart are both advertising businesses and, as Yiu pointed out, ad-spending is usually the first expense to go at the beginning of a recession. Alphabet chief executive Sundar Pichai thinks the worst still lies ahead. After its earnings release, Pichai called a company-wide meeting to raise concerns about the direction of the business, according to documents seen by US business news channel CNBC.
In the meeting, he said: “It’s clear we are facing a challenging macroeconomic environment with more uncertainty ahead.” He also expressed concern about how effectively the workforce was functioning, saying “there are real concerns that our productivity as a whole is not where it needs to be for the headcount we have”. That’s a lot of issues.
In other words, Pichai is saying that if people don’t start working more effectively then lay-offs will be needed to maintain profitability. Alphabet is not the only tech company suggesting headcounts might need to fall. Meta Platforms, which has been ploughing billions of dollars into its virtual reality business, announced in its quarterly earnings that it’s reducing its “hiring and overall expense growth plans for this year to account for the more challenging operating environment”.
Easing inflation fears
Despite the Faangs’ earnings misses and hiring freezes, the tech-heavy Nasdaq has re-entered bull market territory. In the past month, it has risen 23 per cent and recovered almost all of the losses incurred in the first half of the year. This seems odd given the US entered a technical recession last quarter, but the reason is that inflation fears are easing.
For a while, economists have expected US inflation to peak this summer. Since the beginning of the year, global freight rates have fallen over 30 per cent, according to the World Container Index. Meanwhile, the price of oil has now fallen below where it was when the war in Ukraine broke out. This is now filtering through to US CPI. In July, US inflation was 8.5 per cent on an annual basis but 0 per cent on a month-on-month basis.
These promising inflation figures, coupled with growing fears of a recession, mean many commentators expect a Federal Reserve 'pivot' to come next year. The ING economics team thinks there will be another 50 basis point hike in September, but “with recession risks mounting and inflation set to fall sharply” believes rate cuts are on the cards in 2023.
Counterintuitively, the worse the economy performs, the more likely the Fed is to cut rates and therefore the better growth stocks perform. In the 2017, at the Berkshire Hathaway investor meeting, Warren Buffett said: "If I could only pick one statistic to ask you about the future before I gave the answer, I would not ask you about GDP growth and I would not ask you about who was going to be president. I would ask you what the interest rate is going to be over the next 20 years on average."
Macro forecasting is impossible
Buffett thinks that interest rates are the most important statistic when forecasting asset prices, but admits to having no ability to forecast them. In his 2018 investor meeting, he said "there's nobody whose predictions on interest rates I would pay attention to, even myself, even Charlie [Munger]". And that’s the problem for tech investors at the moment. One number decides the valuations, yet nobody knows what it is going to be.
In July of last year, just as inflation was starting to pick up, Howard Marks, fund manager of Oaktree Capital, posted a memo entitled 'Thinking About Macro' in which he pointed out the dangers of investing on macro predictions. At the time, freight costs were rising off the back of pandemic disruption, and the tight labour market was starting to emerge. “Economic orthodoxy considers the above process about as reliable as they come,” he wrote. “However, I want to take a minute to highlight the uncertainty entailed in thinking about inflation.”
After outlining the reasons why inflation should rise, Marks then considered the fact that Japan has had extremely low rates of inflation despite the Bank of Japan easing monetary policy as much as possible in the past decade. He pointed to the Phillips’s Curve, which for 60 years showed that there was an inverse relationship between unemployment and inflation. Yet, US unemployment has fallen for the past decade and inflation has remained below 2 per cent on average.
Even in July, the US economy added 528,000 jobs, more than double what economists were expecting. A tightening labour market suggests that inflation should still be accelerating according to the Phillips Curve, but the July month-on-month inflation figure was flat. Unemployment may rise in the second half of the year and inflation may pick up again. What is clear is that forecasters aren’t very good at their jobs.
For investors, this means ignoring all the economic noise. In the coming years, economic forecasters are going to miss their predictions time and again because the world, for now, is unstable. Chinese lockdowns, Russian sanctions, global warming and infinite unforeseen reasons can impact inflation. Investors can never be sure.
What investors can do is judge companies on a business-by-business basis. Investors have recently soured on Netflix because it appeared the model wouldn’t be profitable given the huge costs of production and slowing subscriber base. By managing costs more tightly, Netflix is expecting 2022 free cash flow of $1bn. Who knows if they will be right? But taking a bet on this is a lot easier than guessing US inflation, which is the product of many billions of global interactions every day.
At Google and Facebook, investors are effectively taking a view on the long-term prospects of the online retail industry and the way people interact with the internet. If online becomes the dominant avenue for retail sales and people continue to use Facebook for socialising and Google for searching, then these two companies will generate a lot of cash. These are hard questions to answer, but guessing who the internet’s gatekeepers will be for the next decade is a lot easier than deciding what the Fed Funds Rate will be in 2026.
At Blue Whale, they seem to be taking investment decisions based on their economic expectations. So far, as Yiu expected, the Faangs' earnings growth is slowing, but their share prices are rising. Future interest rates have huge power – just don't get caught up in trying to figure out what they will be.
