2022.12 The Taiwan Banker NO.156 / By David Stinson
US economic weakness remains localized – for nowBanker's Digest
In some ways, it’s a classic story of a market bubble. Tesla is a company whose product has transformational potential. Its stock price grew to $400, driven by easy financing conditions. Its overconfident CEO, Elon Musk, strove forth into an unrelated sector – social media – overpaying for Twitter by a significant amount just as the market reached its peak. Twitter had lackluster financials to begin with, but Musk embarked upon a massive purge, firing most of its staff. Advertising, previously Twitter’s main source of revenue, has fallen sharply, and it remains unclear what revenue source might replace it, much less surpass it. Most worryingly, in case one was inclined to consider a software company like Twitter as separate from the real economy, Twitter’s poor finances have caused Tesla stock to fall 50% since the deal was announced, indicating contagion back into the industrial sector. Musk recently sold 15% of his Tesla holdings. The business empire of Musk, formerly the world’s richest person, is an extreme case, but this story is broadly representative of the US tech sector as a whole. The FAANGs, consisting of Facebook (now called Meta), Apple, Amazon, Netflix, and Google (now Alphabet) are collectively down over 1/3 on the year – each for their own reasons, but also representing an overall market trend. FAANG comprises about 15% of the S&P index, and they have dragged overall down to lose over 15% on the year. Is big tech a leading indicator for the economy as a whole, heading into an uncertain 2023? The sector had been driven by excess liquidity for a long time, and there were reasons to anticipate that it would be the first to be affected by market weakness. On the other hand, there are also reasons to imagine that the tech bubble is a separate phenomenon disconnected from the rest of the economy, and not indicative of broader weakness. Market canary The social media business model pushed the asset duration frontier, driven for a long time by the long-term low-rate environment. It will naturally be one of the first sectors to be affected by deteriorating conditions. This deterioration does not come from rising interest rates, as a great deal of recent commentary suggests. Real rates (which also consider inflation) are below zero, the lowest they have been for years. These companies should be able to more than compensate for higher financing costs through revenue inflation. Instead, the most important headwind in the tech sector is declining advertising revenue, which indicates corporate customers’ increasing perceptions of uncertainty. This is also the strongest piece of evidence connecting the tech sector’s financial pressure to the health of the general economy. Future expectations of positive real rates also undoubtedly affect valuations, but this part involves equity rather than debt. It may also be helpful to understand the buyers of this equity. The pandemic changed the risk profile of investors as cash handouts created an entire class of retail investors who helped prop up a wave of meme stocks over the past couple of years. The collapse of the crypto market, most prominently the trading platform FTX, demonstrates the resulting change in investment habits. The formal tech sector, despite being outside of this segment, may also be affected by the same trend. Investors are seeking to move inwards along the risk-reward curve, which may indicate further tightening in the future. Lucky firings The alternative explanation for the current tech-focused weakness is a secular rotation between different sectors of the economy. On the most basic level, the pandemic was a boon for the tech sector, whose products and services were in high demand. The pandemic drove transformation, and the public also had more time to consume digital services. Now, with the recovery, demand may rotate to other sectors. Layoffs at the affected tech firms have amounted to thousands, a scale which is quite significant for the companies involved, and some local economies, but minor for the national economy as a whole. “Tech layoffs are…an unfortunate side effect of the growth slowdown and tighter financial conditions necessary to rebalance the broader labor market,” according to a recent Goldman Sachs report, “but for now appear narrowly concentrated and are probably not indicative of labor market dynamic in other sectors.” Recent rate hikes have unmistakably impacted certain markets, most importantly housing. Squeezed by the rate hikes and large inventory still under construction, national prices came down at an annualized 8.5% in the three months from September, according to the Case-Shiller National Home Price Index. Like tech stocks, housing is another long-term asset and one of the markets most sensitive to rates. At the same time, housing weakness has appeared highly regional so far, supporting a more sector-specific explanation to the current slump. West coast cities such as San Francisco, Seattle, San Diego, and Portland have been strongly affected. These locations are noted not only for their tech workforces, but also constrained housing supply, causing prices to become highly sensitive to demand. These price declines have been made possible in part due to migration away from these areas. In the optimistic scenario, the dispersion of highly-skilled people with highly-transferrable skillsets could result in improved productivity overall. Supporting this proposition, a recent analysis by Revelio Labs found that most laid-off tech workers are finding new work; over half are even earning more pay than before, which would be unlikely to occur in a cooler economy. 12% are also moving for their new jobs, reinforcing the role of geographic mobility. Despite the high-profile layoffs, job openings in tech remain significantly higher than before the pandemic. In this regard, it is important to point out that the tech sector is not monolithic. Sub-sectors like cybersecurity and robotics conform to more traditional product and service models than social media, and will likely thrive in current conditions. An inflationary economy provides the flexibility and dynamism to quickly move production factors into emerging hotspots. Down, but not out The past few years have reinforced an expectation that black swans will emerge from every corner. Within the formal US financial sector, however, the current pressure is unlikely to cause something like the 2008 financial crisis, which was truly a once-in-a-generation catastrophe. The dot-com bubble, or a self-contained market implosion, is a good model for the present situation, even if it may somewhat understate the severity. In Mid-December, the Fed raised rates to the 4.25% to 4.5% range, slowing the pace of its rate hike cycle from 0.75% each meeting to 0.5%. Markets reacted somewhat negatively, despite the mild reduction in pace to observe the time-delayed effects of previous rate hikes. The reaction was not to the hike itself, but rather to the accompanying projections for future trends. The interest rate projection for 2023 increased from to 4.6% to 5.1%, while unemployment and growth both decreased somewhat. On the one hand, these figures do imply contagion from the tech sector into the broader economy, refuting the notion of a completely soft landing. On the other hand, however, they also indicate at least moderate confidence that markets will not force the rate hike cycle to end prematurely, as in 2019. (Estimates from 2024 out diverge.) “The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time,” according to the Federal Open Market Committee press release, as it has also said for past rate hike announcements. Employment and growth are normally lagging economic indicators compared to long-term assets like housing. They have proven significantly more resilient than in past market downturns, raising hopes that inflation could be stopped painlessly. That is scenario is becoming less likely as inflation persists, but the US will likely remain the cleanest among dirty shirts when compared to alternative investment markets. Overseas, especially in economies with large debt-to-GDP ratios, the only figure worth watching is the interest rate. Other countries may not necessarily be able to bear the same contractions in liquidity that the US can – yet with the globalization of capital movement, they will not be able to escape US monetary policy. This pressure will show up in expected places, such as in the UK. Continental Europe will be another region to watch, having already undergone one debt crisis in the wake of the recovery from 2008, and now facing long-term energy supply issues. It may also be useful to consider the implications of the tech downturn for hardware. TSMC is not usually considered alongside the FAANG, but is affected by many of the same forces, and with a market cap of over US$ 400 billion, it is comparable in scale to the other members. The semiconductor sector is rapidly entering a period of glut following its time as a bottleneck for the entire global economy. It is exposed to both the industry-specific aspects of the tech bubble crash, and also any potential general economic weakness. This reinforces the need for Taiwan to diversify both its domestic economy and export portfolio to the extent possible.