Big Tech is a big tail risk

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Big Tech Revenues

This afternoon Microsoft reports earnings, followed by meta tomorrow, followed by Apple and Amazon on Thursday. That's a fifth of the S&P 500's market cap, but that figure likely understates the importance of these four companies to the overall market. These companies, along with Alphabet (which reported last week) and Nvidia (which reports a month later), have delivered most of the market's gains over the past few years, but if their outlook disappoints, they could be in trouble.

Just how sensitive these stocks are to disappointing results was made clear last week when Alphabet reported earnings. The company reported slightly better-than-expected revenue and profit growth of 14%. The following day, the company's shares fell 5%. But that could be because all the “platform” companies have been caught up in a downdraft in recent weeks.

To the extent that these declines represent an orderly reduction in expectations and a shift away from Big Tech, it's good news for the overall market. Too much was 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 currently trading at a fairly high premium compared to their long-term average price-to-earnings ratios (over the past five years, these valuations have already been consistently high). Alphabet and Meta are not (probably because their revenues are advertising-dependent and therefore more cyclical). Amazon is a special case in that for a long time, its earnings were thought to be low relative to its potential earnings, and thus a high P/E ratio was justified. However, this does not seem to be the case recently.

• All of these companies have performed very well over the past few years, both in terms of stock price appreciation and revenue and earnings growth, except for Apple, whose growth has slowed significantly compared to the others (is it now a pure defensive stock?).

• The key point is that the market doesn't expect growth to slow, as evidenced by the consensus analyst estimates for revenue and earnings per share. Double-digit revenue growth and 20%+ earnings growth over the next few years are the hurdles these companies will have to overcome. Again, Apple is the exception, but it's important to note that even there, they're expected to see accelerating growth.

At Unhedged, we believe that these are all great companies and most likely to live up to these expectations, but our point is that the star status of these companies is already priced in and any material failure would create a lot of turmoil across the market.

There are other risks, too. These companies have heavily boosted the market's AI narrative by making big promises to increase capital spending to support AI services. Microsoft said it “expects capital spending to increase significantly” this year, noting that “near-term AI demand slightly outpaces our available capacity.” Amazon said strong demand for cloud services and AI means it will “significantly increase” capital spending. Meta said AI will drive increased investment not just this year but through 2025.

If those companies were to back down from their commitments, even in the most mild and limited way, it would have an immediate impact on Nvidia and other semiconductor stocks that have been another important support for the market — about as big a tail risk as U.S. stock investors currently face.

Wild Yen

The sudden rise in the Japanese yen and the unexpected weakness of U.S. tech stocks coincided last week, sparking speculation on Wall Street that the two might be related.

The theory goes like this: The yen is a common borrowing currency for carry trades, in which investors borrow the currency of countries with low interest rates and invest the proceeds in other, higher-yielding markets. Shorting the yen has also been a popular strategy in recent months. So when the yen surged last week, sparked by Japan's Finance Ministry intervention in the yen and reassuring U.S. inflation reports, both carry trades and yen short selling were unwound, forcing investors to sell tech stocks they'd bought with borrowed yen or sell tech stocks to unwind their short positions.

But there is no hard evidence (that we have seen) that investors have borrowed yen to buy tech stocks or sold tech stocks to unwind short positions.

Last week, the carry trade began to unwind. The Mexican peso, the U.S. dollar and other Latin American currencies fell as investors pulled out of the carry trade from the popular yen into higher-yielding currencies. Some have argued that leveraged tech stock positions were financed through the yen, but that's unclear.

When the Bank of Japan meets on Wednesday, there are likely to be further global repercussions and more wild theories about what is going on.

First, the dollar's recent rise against the yen is due to the large interest rate differential between the United States and Japan. The Bank of Japan wants to start a cycle of gradual interest rate increases, but will do so only when it is confident that wage increases have taken hold. The Bank of Japan's June Tankan survey of businesses suggested that wage increases have indeed begun. The Bank of Japan could raise interest rates as early as Wednesday.

While the Bank of Japan is not expected to raise rates by more than 0.25%, a gradual hike cycle could lead to a stronger yen and signal the beginning of the end of the USD/JPY carry trade. Until rates fully converge, the trade will likely work, but traders may turn to other currencies or be spooked by the yen's volatility.

Secondly, the Bank of Japan signaled it would end its quantitative easing program, Yield Curve Control (YCC), which began in 2016. This involves the Bank of Japan buying around 6 trillion yen worth of Japanese government bonds each month, keeping yields near zero. The Bank of Japan's Monetary Policy Committee is expected to announce plans to lower the rate of purchases. Many analysts expect bond purchases to be initially cut by 50%.

The Bank of Japan's massive bond purchases have encouraged institutional capital flight from Japan to foreign stocks and bonds, potentially helping to boost U.S. asset values ​​over the past decade. Some fear a painful reversal like the one reported last week.

That's unlikely. The Bank of Japan eased its interest rate target for the YCC in 2021, but it did not trigger a major sell-off of overseas holdings. There is still enough of a gap between Japanese government bond yields and those of most other government bonds to give Japanese investors room to hold on to overseas assets.

In fact, quantitative tightening could backfire if Japanese investors flee falling government bond prices.

[The BoJ] Slow down [JGB] The purchases will increase net issuance, which is essentially the same as selling Treasury bonds on the market. They will only want to buy Treasury bonds when yields rise after the QT has taken effect.

(Writer)

Good read

Sea water temperature.

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