Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
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Head of Fixed Income Strategy
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Big tech regulation heats up on both sides of the Atlantic
Peter Garnry
Chief Investment Strategist
Summary: Facebook shares are lower but not by a lot relative to the overall technology sector despite yesterday's FTC lawsuit against the company aiming to break-up the social media giant. Investors for now seem confident that the government has a bad case and that the evidence of wrongdoing is thin but the FTC lawsuit fits into a bigger narrative of rising technology regulation on both sides of the Atlantic. Uncertainty on how regulation will impact profitability is still high but investors need to pay attention because it could change the entire technology sentiment in 2021.
Facebook shares were down 2% yesterday as the FTC (the US Federal Trade Commission) together with 46 states filed an antitrust case against the company for choking competition. The short version is that the objective of lawsuit is to break-up Facebook’s Instagram and WhatsApp businesses into separate entities. Facebook’s main defense is that the very same FTC has approved both acquisitions. The fact that WhatsApp is not being used commercially to make money yet so many years after the acquisition is used as an example as an acquisition made not for commercial reasons but only to quell competition. Facebook likely knew about this angle in its defense as it recently presented a plan for monetizing WhatsApp.
Facebook is arguing in the case of Instagram that there was no evidence that Instagram would be big stand-alone and that it became big because Facebook invested a lot of money into development. The fact that the shares were only down 2% indicates that investors believe that the US government does not have a strong case yet and that the case will take years in court while Facebook grows profits even more before maybe a settle with the government. Shares are down another 1% in US pre-market session. If Facebook’s business is broken up it would be a big blow as Instagram generated $20bn in revenue in 2019 and thus account for almost 30% of the overall business in addition to being a key driver in the future growth of revenue. While WhatsApp is not generating meaningful revenue for Facebook it is a potential future revenue driver.
The case against Facebook follows a recent antitrust case against Google and new regulation by Beijing to unlock more competition in the Chinese technology sector being quelled by the major players such as Alibaba, Tencent and Baidu. And today, Financial Times is writing about a new EU draft regulation on big technology companies operating in the EU. If a technology platform has more than 45mn users, it will now be catagorised as a systemically important technology platform which will have special obligations to shape information flows. Failing to comply with the new rules could end in fines of up to 6% of their annual turnover. No matter where you look regulation and rules will be applied against the biggest technology companies in the coming years. The main question is how it will impact these companies’ profitability and growth trajectory. It will never be a binary outcome so investors will have time to adjust valuations accordingly.
The case for a very different year for technology stocks
Technology regulation depending on the size and speed next year could begin to impact investor sentiment and valuations of the large technology companies. This could hold back main technology indices, but even more scary is the large pocket of smaller technology companies with very elevated valuations. DoorDash which started trading yesterday is a good example as it is valued at twice the EV/Sales ratio than that of its Chinese counterpart Meituan which is seven times larger on revenue. The high valuations of technology companies are a function of the growth profile, high risk-reward ratio, lower variance on earnings but most importantly low discount rates which inflates high duration (high growth companies with cash flows far into the future) assets.
However, with signs of cost pressures on logistics costs across shipping and last-mile delivery on top of rising food prices and elevated industrial metals prices the potential input costs are rising throughout the global supply chain. The missing piece is higher energy prices which could come if, as we believe, the vaccine rollouts happen much faster than expected. That would create a powerful input cost shock to the system and force the US 10-year interest rate far above 1% and with it pressure on high duration assets such as US technology stocks. We have said before on our morning podcast that the 1% threshold remains our trigger point for calling the big rotation on value vs growth stocks. And if it happens it will be interesting to see how the new influx of retail investors overweight technology stocks react. There are indeed many paths to an interesting 2021 in equities.
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