Face-Plant: And the Implication for Trend Returns
FRI 04 FEB 2022
Earlier this week we noted that according to chaos theory, the edge of chaos with maximum complexity exists between paradigm shifts. Following the 4.4% decline in the NASDAQ during the cash session led by the largest one day market capitalisation decline in a single stock on record, that appears to be a massive understatement. While the crash in Meta might be viewed as idiosyncratic, there have been a few too many idiosyncratic declines in this episode. The common element could be a peak in trend returns on equity or capital. It might also be that some revenue growth that had been extrapolated as secular is actually cyclical or a pull-forward of demand from the future. There has also been a collision of macro with micro corporate earnings. The hawkish move by the Bank of England overnight provided a lens into debates currently being conducted by the Federal Reserve and others on the path of future short rates and the balance sheet.
In our humble experience, many equity analysts and investors often tend to extrapolate cyclical earnings/revenue as secular trends at major turning points. That contributes to the self-reinforcing virtuous circle in the bull market, crowded positioning and consensus beliefs. The shock in Meta overnight appears to be the stall in platform and revenue growth in the context of what appeared to be a very crowded name among the levered community (the large correction in market capitalisation is evidence of that as well). While the challenges at Meta might be somewhat stock-specific, there have been other examples during this reporting season of companies that appear to be facing peak returns/revenue. The big picture question is whether it becomes a broader macro earnings challenge for the market?
At first glance, the trend in return-on-equity for the MSCI USA Information Technology Index appears both secular (structural) and impressive in outright and relative to the MSCI World ex USA. As we (and others) have widely discussed, it has been the legitimate reason for the outperformance of the US stock market over the past decade (chart 1).
In theory, very high returns on equity and profit margins ought to lead to competition and compression over time. Of course, that might be the key point for some of the mega-cap names in the United States like Apple and Alphabet (Google) that have some monopoly-like power and the capacity to defend market share and margins. Indeed, that appears to have been part of the challenge for Meta more recently relating to the new constraints on the search engine and revenue. It also likely highlights the importance of owning the operating system in the case of Apple and Google.
The broader question is whether there has been a pull-forward of demand during the past two years? Similar to the trend in returns-on-equity or profits, sales revenue for MSCI USA Information Technology has also been strong in trend terms. However, the past two years has pushed revenue well above trend. That appears more cyclical, rather than secular. While it is probably too early to argue for a more general peak in revenue, what we do know is that there is at least some risk of mean-reversion back to the pre-2020 trend or moderation relative to the current prevailing bias. Contrary to popular belief, many technology stocks have rather cyclical earnings. The good news in Asia is that expectations and valuations are much less optimistic or euphoric in relative terms.
The final point to note is that the recent correction has likely been driven by a rate and liquidity withdrawal valuation adjustment. Of course, the observations above suggest it could also be a reassessment of future trend earnings or revenue. The good news is that markets have moved a long way to price the higher rate/reduced liquidity environment. The bad news is that central banks appear likely to push the pace of interest rate rises and balance sheet adjustment much faster than previous consensus beliefs.
While the Bank of England hiked rates by 25 basis points to 0.5% at yesterday’s MPC meeting, 4 out of 9 members voted for a 50 basis point hike. Of course, similar to the US Federal Reserve, the Bank of England remains well behind the curve. Based on the UK Taylor Rule, the policy rate ought to be over 9%! While the answer probably lies somewhere in between, the big picture point is that policy remains exceptionally loose and could normalise faster if underlying inflation pressure persists. That could set up a more challenging combination of tighter liquidity and slowing growth later this year. In that context, developed market credit risk appears under-priced relative to equity volatility. The good news overnight is that one of the other financial conditions channels (the US dollar) might have peaked overnight, time will tell.