Stocks rallied yesterday in front of Microsoft’s# earnings report. At first, after Microsoft reported results shortly after 4 pm, the stock rallied over 2% confirming yesterday’s strength in the market. But once the post-report conference call began, what appeared from the numbers to be earnings in line with expectations melted as management added color that showed a decelerating trend within the quarter and a poor outlook for the rest of fiscal 2023 (June).
If you recall the third quarter earnings season, all the major tech names with the exception of Apple# issued similar reports. That included Microsoft. At a time when caution replaces optimism, corporations slow down spending on future growth projects. They don’t eliminate them. They just defer spending in a way that matches reduced near-term growth expectations. Nowhere is that more apparent than cloud spending. Microsoft’s Azure offering is the second largest to Amazon’s# AWS, but has been gaining share and growing at a faster rate. A year ago, that growth rate was well above 40%. In the fourth quarter, excluding the impact of changing currencies, that growth rate was still close to 38%, but in the conference call, the company highlighted a noticeable decelerating trend throughout the quarter. There is still movement toward the cloud away from private data centers, but when it’s time to pinch pennies, the pace of movement slows.
Microsoft is one of our nation’s preeminent companies. It is one of only two with AAA-rated bonds. Its growth rate is the envy of most businesses. Virtually everyone uses a Microsoft product on a daily basis somehow. So, when Microsoft tells you business is slowing, it’s likely slowing for everyone.
In 2020, as the pandemic began, there was a rush to move toward the cloud. It was tough to run an office-based server room when the office was closed! Not only did businesses accelerate the movement of data to the cloud, they also moved toward remote computing. That meant more PCs and better PCs populating home offices. For Microsoft, it meant more sales of Office 365, Windows, and Surface devices. By 2022, however, the need to buy new PCs had evaporated. Growth rates turned sharply negative. PC demand, by year end, was falling by more than 20% year-over-year. Just as the 2020-2021 surge wasn’t sustainable, PC demand isn’t going to decline at an annual rate of over 20% for very long either. But, for now, we are in the eye of the storm and it is difficult to tell when it might end. Is there a recession ahead? Has it already begun? The answers aren’t going to be known definitively until after the fact.
With all this said, Microsoft’s stock moved from a 2%+ gain immediately after the earnings report (clearly a relief rally) to a 2%+ decline afterwards. That isn’t good news for Microsoft shareholders, but the decline simply put its stock in the middle of its recent trading range. In simple terms, much of the bad news had been discounted.
That likely isn’t just true for Microsoft. Soon we will see earnings reports from the other tech giants. We are likely to see similar trends. Names like Alphabet#, Meta Platforms# and Amazon# have been market leaders during the first 3+ weeks of 2023 at least partly on the belief that the worst had been discounted. Notably, Microsoft had lagged its tech giants in recent weeks. They are not in identical businesses. Amazon’s AWS business should mirror Azure trends expressed last night, but its retail business is a horse of another color. Digital advertising will have greater impact on Meta, Google and Amazon. But what is likely to be consistent is that the economy is clearly slowing and none of the above names are immune to that trend.
For many months, everyone has been discussing a pending recession. The optimism of January so far reflects, in part, an increasing belief that a soft landing is possible. Last night’s comments from Microsoft will displace some of that optimism. At least when it comes to investment spending, businesses are slowing their pace meaningfully. Microsoft alone can’t define for investors whether a recession is near or not. Microsoft wasn’t the only tech company to report last night. Like Microsoft, Texas Instruments reported results near expectations followed up with somber guidance. TI operates in the analog world while Microsoft operates in the digital world. Both are slowing.
What we will find out quickly over the next several days is how much of what we learned last night is priced into the market. Today is likely to be a down day, particularly on the NASDAQ, which has been on a hot streak this month. As I continually note, valuation concerns crop up quickly as stocks rally. The year-long downtrend has not been broken yet. Recent gains lifted stocks into the upper regions of a declining trend. Remember that stock prices are forward looking. They have been pricing in a slowdown for months, but how much of a slowdown? And for how long? If more adjusting is needed, stocks will retreat, but this time there are offsets. 10-year Treasury yields are close to 3.5%. In October, they were 4.25%. A softer economy and lower inflation will push against any pressure for those yields to rise. Not all parts of the economy are weak. Travel is still robust. Housing is even showing faint signs of coming to life as mortgage rates fall below 6%. Consumers are still spending, but not on home goods, electronics, and used cars. The market shouldn’t overread the Microsoft news.
Last night’s report clearly will prick the bubble of emerging optimism. Economically, we are entering or have already entered the rough patch, a consequence of the Fed’s efforts to slow inflation. Job growth in coming months will slow. It might even turn negative at some point in 2023. That’s how slack gets rebuilt, critical in an effort to keep future inflation contained. Green shoots of economic improvement aren’t visible yet.
We have repeated often our belief that 2023 will be an up year for equities. By late 2023, the skies will be much clearer. We just have to get through the worst of times now and over the next few months. As economic weakness becomes more evident, and as inflation continues to recede, the Fed will back off, first by stopping its steady pace of rate increases, and then, eventually, cutting rates if the economy slows too quickly. I still believe there is a 50-50 chance that the pending 25-basis point increase in the Fed Funds rate next week will be the last one of this cycle. If growth and inflation numbers show a clear trend lower by the next time the Fed meets in mid-March, the need for another increase can be deferred. If that trend continues into May, it will be clear that no more increases are necessary.
Thus, I don’t see why the October lows need to be revisited. At the same time, I think a material move higher isn’t justified either. The lack of any signs of economic bottom and relatively high equity valuations will contain the near-term upside. We are in for a volatile sideways market until there is more clarity.
Today, Alicia Keys is 42. Ukrainian President Volodymyr Zelensky turns 45.
James M. Meyer, CFA 610-260-2220