Big Tech as big tail risk

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

Good morning. McDonald’s reported a drop in sales during yesterday’s earnings call. It looks like the post-pandemic surge in restaurant revenge eating has come to an end, but fast-food investors can be assured: Unhedged continues to eat more than its share of burgers and fries. Email us with diet advice: [email protected] and [email protected].

Big Tech earnings

This afternoon, Microsoft reports earnings. Tomorrow, Meta follows; Apple and Amazon chime in on Thursday. That’s a fifth of the market capitalisation of the S&P 500, a figure that probably understates the four companies’ importance to the market overall. They, along with Alphabet (which reported last week) and Nvidia (which reports in a month), have provided most of the gains in the market over the past few years, and if their outlooks disappoint, there is going to be trouble. 

The sensitivity of these shares to less than thrilling results was demonstrated by Alphabet last week, which reported 14 per cent revenue growth and earnings, slightly ahead of estimates. Its shares fell 5 per cent the next day. However, this could be down to all of the “platform” companies being caught in a downdraft in recent weeks:

To the degree that these declines represent an orderly reduction in expectations and a rotation away from Big Tech, it is good news for the market overall. Too much had been riding on too few stocks. But expectations remain dangerously high. Here are some numbers to consider:

A few things to note:

• Apple and Microsoft are now trading at meaty premiums compared to their longer-term average price/earnings valuations (and for the past five years those valuations have already been consistently high). Not so for Alphabet and Meta (probably because their earnings are dependent on advertising and thus more economically sensitive). Amazon is a special case in that for a long time it was considered to be under-earning relative to its potential, justifying a high P/E ratio. That seems to be less true recently.

• All of these companies, save Apple, have performed extremely well in the past couple of years, both in terms of price appreciation and revenue and earnings growth. Apple’s growth has been notably slower than the rest (is it a pure defensive stock now?). 

• The crucial point: as you can see from the analysts’ consensus estimates for revenue and earnings per share, the market thinks there will be no slowdown in growth. Double-digit revenue growth and earnings growth at or above 20 per cent for years to come is a hurdle these companies must jump. Apple is again the exception, but notice that even the expectations there are for accelerating results. 

Unhedged thinks these are all awesome companies and that the most likely outcome is that they will meet these expectations. But our point is that their star status is already priced in, and any serious mis-step will overturn a lot of furniture throughout the markets. 

There is another risk. These companies have done much to support the market’s AI narrative by making big commitments for increasing capital spending in support of AI services. Microsoft has said “we expect capital expenditures to increase materially” this year and that “near-term AI demand is a bit higher than our available capacity”. Amazon says strong demand for cloud services and AI means it will “meaningfully increase” capital expenditures. Meta says AI is driving higher investment both this year and into 2025. 

If these companies walk back their commitments, even in the most gentle, qualified ways, the impact will immediately be felt by Nvidia and other chip stocks, which have been the other crucial support for markets. This is about as big a tail risk as investors in US stock face right now.

The wild yen

Last week, a rapid strengthening of the Japanese yen coincided with the surprising weakness in US tech stocks. Cue Wall Street speculation: were the two connected?

The theory goes as follows. The yen is a common borrowing currency for a carry trade, in which investors borrow the currency of a country with low rates, and invest the proceeds in a higher-yielding market elsewhere. Shorting the yen has also been a popular strategy in recent months. So when the yen suddenly appreciated last week — triggered by yen intervention by the Japanese Ministry of Finance and reassuring inflation news in the US — both the carry trade and the yen shorts unwound, forcing investors either to sell off tech equities they had bought with borrowed yen or to sell tech equities to cover their short positions.

But there is no hard evidence (that we have seen) of investors borrowing yen to buy tech stocks, or selling tech stocks to cover short positions. From Derek Halpenny at MUFG Strategies:

The carry trade did start to unwind last week. We saw the Mexican peso, the US dollar and other Latin American currencies weaken as investors got out of some common yen to high interest currency carry trades. Some would argue that leveraged tech equity positions were funded through the yen — but we do not know.

There could be more global reverberations — and more wild theories of what is going on — when the Bank of Japan meets on Wednesday. 

First, the dollar’s recent gains over the yen have been caused by the big gap between US and Japanese interest rates. The BoJ hopes to start a gradual rate-rising cycle, but will only do so when they are confident that wage-induced inflation is entrenched. June’s Tankan, a BoJ survey of businesses, suggested that wage inflation was indeed starting to catch on. The BoJ could raise rates as soon as Wednesday.

While the BoJ is not expected to increase its rate by more than 0.25 per cent, a gradual raising cycle would usher in a stronger yen and could mark the beginning of the end of the dollar/yen carry trade. While the trade will still be functional until the rates fully converge, traders may look to other currencies or may be scared off by yen volatility.

Next, the BoJ has signalled that it will end yield curve control (YCC) — a quantitative easing programme started in 2016 in which the BoJ buys nearly ¥6tn worth of Japanese government bonds per month to keep yields close to 0. The BoJ monetary policy committee is expected to announce a plan for reducing the rate of purchases. Many analysts expect an initial 50 per cent reduction in JGB purchases.

The BoJ’s huge bond purchases resulted in institutional capital flight from Japan towards foreign equities and bonds, which may have helped pump up US asset valuations over the last 10 years. Some fear a painful reversal, of the sort that allegedly occurred last week. 

That’s unlikely. The Bank of Japan softened the YCC interest rate goals in 2021 without causing major divestments of foreign holdings. There is still a wide enough spread between JGB yields and most other sovereign bonds to keep Japanese investors in international assets.  

Instead, quantitative tightening could have the opposite effect, if Japanese investors flee falling JGB prices. Thierry Wizman of Macquarie Group notes that:

[The BoJ] slowing [JGB] purchases will make net issuance go up, which is essentially like selling JGBs in the marketplace. They will only want to go in when yields are higher, after QT has had its effect. 

(Reiter)

One good read

Sea temperatures.