What's next for tech given Facebook's Q2 surprise?

Peter Garnry

Head of Equity Strategy

The earnings season is well under way with more than half of the companies in the S&P 500 having reported already. As expected, the numbers are strong with earnings per share up 24% year-on-year and revenue up 10% y/y. Despite strong tailwinds from the corporate sector, however, US equities are only up 0.6% over the past two weeks. Investors knew that earnings would be great so the attention is on companies’ outlooks and where the economy is headed.

The overall outlook has severely changed for the worse due to rising trade war concerns; the ZEW Expectations Index is down to its worst levels since 2012. The economy is clearly showing signs of fatigue with the euro area growth rate (measured on the Eurocoin Growth Indicator) currently standing at half of where it was at the beginning of the year.

The US economy is still relatively stronger than all the others, but China is looking increasingly fragile. China finds itself in an economic slowdown with weak sentiment in its financial markets, slower construction spending, and negative credit growth in some segments.

On top of all that, it is now fighting a trade war with the US.

The problem for China is that the economy needs a weaker currency. This is is happening, but it will only make things worse in terms of trade with the US, thus creating a self-reinforcing negative spiral. The only sensible path out of this trap is to transform the economy into being more domestic demand-driven, but that cannot be engineered in the short-term.

The next six to 12 months are critical for China and financial markets.

On top of the Chinese situation, central banks are all on the path of tighter monetary policy, which will begin to have its own effect on world markets. Viewed in light of all these factors, it is quite surprising to find global equity markets at their highest levels since February and so broadly calm.

The key has been the technology sector, which brings us to the heart of today’s topic:

Is the Facebook rout an air pocket for technology?

Investors have gotten used to the FAANG stocks (Facebook, Apple, Apple, Netflix, and Alphabet/Google) as an almighty force delivering outperformance driven by high growth rates, above-average profitability, and consistent earnings surprises. That changed in the Q2 earnings season with Facebook’s shock miss, including lower operating margins going forward (long-term guidance was mid-30s) amid massive spending in infrastructure and security; the EBITDA margin in the last 12 months was 56.5%.

Facebook shares plummeted 19% on the release but the price stabilised at levels from early May. As a result, the reversal factor has become very positive in our equity model, pushing Facebook’s shares into the model’s top 20 on US stocks. While many believe the valuation is fair given the company’s monopolistic power in the online advertising industry, the key risk going forward is the downward trajectory of Facebook's margins which could offset most of the revenue growth from monetization of WhatsApp, Instagram, and Messenger.

Twitter and Netflix have also been beaten by investors during the earnings season for not delivering on growth expectations, with the development giving rise to a new acronym: MAGA (Microsoft, Apple, Alphabet/Google and Amazon). The narrative here is that this collection of tech giants offers a potentially more stable outlook as these companies are more infrastructure-inclined.

Enlarge
Source: Bloomberg

Looking at the numbers, however, this MAGA group is not outperforming the FAANG stocks in an equal-weighted basket over 2018; the FAANGs are up 33% year-to-date compared to 29% for MAGAs. The key take-away from these acronyms is not so much their performance, because that is just random in the short-term. But Facebook’s Q2 result is a clear wake-up call for investors that increasing regulation and social media might be topping out, or at least could be in for a bumpier future.

Facebook is definitely centre of the ongoing push-back from regulators, but Google is also increasingly in the crosshairs. As we have alluded to in previous equity webinars, companies deriving their majority value from users and their data will increasingly be under pressure in the current environment.

Firms such as Microsoft, Apple, Amazon, Netflix, and Spotify are also using user data but it’s not their core product; these companies derive their revenue from selling a service or product free of advertising. Facebook, Alphabet/Google and Twitter are synonymous with selling “free services” in exchange for user data and serving online ads, and these companies will find themselves in an increasingly hostile environment from regulators (and perhaps also society as a whole as the pendulum swings back on privacy issues).

The technology sector is still attractive, however, and can continue to contribute to the overall equity market as it is still the best place for growth and its valuation is still reasonable on an aggregate basis. The sector is also the least sensitive to higher interest rates as it has a very low debt level to earnings and assets.

In our monthly equity update on Wednesday we will elaborate on our thoughts regarding the overall equity market and technology shares.

Enlarge

You can access both of our platforms from a single Saxo account.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments. Saxo Capital Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Capital Markets or its affiliates.