On Thursday, our Macro team presented the 4Q22 Macro Themes data and forecasts (HERE)
Our key takeaways from the presentation include:
- Based on past cycles, the Fed is still early in battling inflation
- Containing inflation implies ongoing USD strength
- Ongoing USD strength brings forward sovereign debt risks
Bottom-line (h/t to Steiner): the Fed is stuck in a cycle of adding volatility to the economy rather than smoothing the extremes of the business cycle.
Offline Follow-Up With HE Sector Head Josh Steiner
- HedgeyeTech Question: if the world is short USD via debt, and USD continues to go up, what exactly is the 'cover' moment/panic? how do you cover on that, you declare bankruptcy? is that just non US sovereign debt hitting bankruptcy or is it US commercial debt also? what happens, other than eviscerating non US equities, what else happens? like another 8 quarters of global recession and weak demand? how will Sovereigns get out of this?
- Hedgeye Sector Head Josh Steiner: "that's kind of why I keep beating the horse on sovereign debt CDS widening each morning. A LOT of countries are seeing their default risk profiles rise not insignificantly. The confluence (and causal) Quad 4 dynamics become this negative circular loop for many of them (foreign co's too that have significant USD debt). Dollar has triggered foreign crises before...Latin American crisis / Asian crisis, etc. Ultimately, it'll transition from being a quad 4 environment to the Fed pivoting to stimulate and that'll send the dollar lower and the RoW will re-equilibrate, but lots of things (countries / companies) can get broken between now and then…the condition set is extremely vulnerable and the central banks around the world are all at the Fed's mercy and the Fed is essentially on the warpath here for quite a while - things will break…the Fed's doing here, it's basically antithetical to what they're supposed to be doing they're supposed to be a smoothing force on economic cycles instead, they've completely created a massive everything-bubble on the way now they're pedaling furiously to pop every bubble out there, which they will likely succeed in doing only to then have to go back in the other direction (again, furiously) and reflate all those bubbles so, as opposed to smoothing the cycle out, they're adding tremendous volatility to it and to asset prices."
Ecosystem Data Update
Our latest update shows ongoing deterioration at the group level (below).
As we translate this data into our sector results and outlook, we expect companies in our sector to notch 3 distinct periods of headcount reductions:
- Initial cuts: summer 2022 freezes/cuts (underway)
- The Meat: Jan-Apr ’23 large RIFs to right size direction of incremental FCF in 2H23 and into 2024 (‘meat’ usually when stocks would be buyable)
- The Cleanup: smaller in size, timeline TBD, completes the headcount de-escalation, and sets up these companies for sustaining positive cash flow growth.
If, however, macro conditions pull forward sovereign debt risk and our tracker continues to show deterioration, we might see more than 3 rounds of headcount reduction.
SaaS M&A
Investors often ask us how we factor catalysts such as M&A in helping create trough conditions in equities. We can’t exactly predict when M&A will be a factor, but we do have thoughts on the kind of M&A we are looking for, and from whom, which should be factored into expectations.
Specifically, the cohort of companies who are in various stages of phasing out of mostly organic growth and into a combination of growth levers (alongside GARP like FCF metrics) will be the most active buyers. Large caps like CRM, ADBE, & NOW will have to hit the bid several times, with an outside shot that TEAM is included in the group.
What will they buy?
- CRM: Anything cheap enough with enough growth to make the pocket calculator work for Benioff will fall squarely in the giddy-up category, as he knows he can whizbang an industrial strategy out of thin air. Benioff and Hock Tan are cousins; Marc is a better salesman and worse operator.
- ADBE: Is this company impaired longer term due to the rise of AI? If yes, there will be several more Figmas ahead.
- NOW: ServiceNow may navigate somewhat ‘ok’ thanks to upsell, but DevOps is a long-term cancer cell growing in the place where NOW originally built its foundations. NOW should buy into DevOps, but they are more likely to buy deflated older tech companies such as PATH.
- TEAM: Atlassian and HCP could make for a power couple.
Private Equity Footnote: we are not holding our collective breaths for the cohort of PE companies who surfed the high end of the bubble wave and its immediate afterglow to come back into SaaS and create a bid for enterprise technology companies. It will be constructive for SaaS stocks, however, when traditional PE companies enter the market as buyers hunting for, and thus also setting the floor for, bargain basement FCF multiples alongside durable growth element.
The Beginnings of a Next Cycle Bull Case
We follow several technology drivers of investment that may stimulate conditions of the next Bull case in Tech.
- Our most recent E-Commerce sales data shows a pivot from an inflationary sales period back towards typical e-commerce price deflation, which is the first step in allowing elasticity to drive demand and continue the long term trend of e-commerce growing faster than overall US retail. This will take time to return to driving positive growth, but the beginnings of the pivot are potentially in place.
- The next wave of AI is sooner than we had thought, potentially invading digital work landscapes and triggering an investment rush to either prepare or defend or capitalize on the opportunity. Our quantified AI hype cycle (chart above) has traveled in waves that each appear larger in succession, implying that each wave can cause a broader investment period as well as potential for disruptive fallout. First thoughts on an AI centric portfolio would include Databricks (still private), AWS or GCP over Azure, NVDA, MU, and both TSMC & Samsung. But the most important challenge for companies in an AI era will not come from choosing vendors, it will be from learning to ask the right question.
- Quantum Computing is the kind of catalyst that can trigger hardware and software replacement or upgrade cycles because Quantum systems can decrypt data that was previously encrypted using today's systems. We think the type of panic cycle that can be ushered in by Quantum is not unlike the catalyst of Y2K on system investment in 1. New computing standards in this area are expected as soon as 2024, with the potential to drive major changes. We consider this potential driver as large but still very murky on timeline.
In sum, AI is the investment catalyst for both Longs and Shorts that we will be increasingly paying attention to, as this cycle moves from hype to reality with potential to disrupt large chunks of digital work and replace expensive digital labor with low cost, machine made, faster, commoditized product. It is a tide that has the potential to sweep aside even large cap technology companies in the process.
Ami Joseph
Managing Director
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Yosef Vaitsblit
Director
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