Tech's Next Chapter: Recession?

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• The stock market is significantly overvalued, setting the stage for a potential recession that may be closer than many think.
• Peter Berezin, Chief Global Strategist at BCA Research, offers a sobering yet insightful perspective on the economic headwinds facing the tech sector.
• Why the AI hype might not translate into real profits for tech companies.

When we talk about the economy, it's easy to get swept up in the day-to-day fluctuations of the market. We obsess over the latest Fed announcements, parse through earnings reports, and scrutinize every new data point that crosses our screens. But what if we stepped back for a moment and looked at the bigger picture? What if, instead of focusing on the trees, we considered the entire forest?

"The stock market is more than 50 percent overvalued right now, the highest level of valuation since August 2000," warns Peter Berezin, Chief Global Strategist at BCA Research. It's a stark statement, painting a far more precarious picture than the "soft landing" narrative many cling to.

Peter, drawing on his decades of experience analyzing global economic trends, offers a sobering prediction: a recession is coming, and it's closer than many think.

He doesn't mince words when outlining the forces at play: "The excess pandemic savings are gone. More people are faced with higher rate mortgages, and critically, job openings now have sort of normalized to very low levels." His team at BCA Research, backed by their quantitative model incorporating these leading indicators, recently downgraded stocks. It's a clear signal that the economy is shifting, and tech investors need to be prepared.

Alan and I invited Peter for a candid conversation on the Global Macro edition of Top Traders Unplugged, exploring these critical economic indicators and what they mean for the tech sector. We delved into the AI hype cycle, examining whether the current optimism is justified. We also discussed potential investment opportunities in undervalued markets and strategies for building more resilient businesses in a downturn. Here are a few highlights from our discussion.

Decoding the economic warning signs

Peter doesn't sugarcoat his assessment of the current economic climate. "In my view," he states, "most scenarios point to recession." This view, however, runs contrary to the hopes of many. Peter argues that several key indicators point towards a recession.

He points to the housing market as a prime example. "Homebuilder confidence has plunged again," Peter observes, adding that "the housing market is weakening." He notes that people simply can't afford to buy new homes at current prices, and existing home sales are at historic lows. This lack of demand is squeezing homebuilders and further weakening the housing market. This weakening in a traditionally strong sector is a cause for concern.

He also points out that while people might feel wealthier due to increased home values, it's difficult to tap into that wealth. The demand for home equity lines of credit (HELOCs) is weak, and banks are tightening lending standards, making it harder for consumers to monetize their home equity.

Moreover, Peter highlights the precarious state of consumer spending. "The savings rate right now is like 3.5%. This is unsustainably low." This, coupled with the fact that excess pandemic savings are gone, suggests a potential pullback in consumer demand, the engine of the US economy. "People are going to have to save more," he warns, "and the problem is that if they try to save more in aggregate, what that's going to do is reduce demand across the economy."

The labor market, while seemingly robust on the surface, also reveals cracks upon closer examination. Peter notes that "job openings now have sort of normalized to very low levels." This, along with rising credit card delinquency rates, points to a potential rise in unemployment, further impacting consumer spending and overall economic activity. "If labor demand continues to decline," Peter cautions, "we will have this rising spiral of higher unemployment."

He emphasizes that the labor force participation rate is already back to pre-pandemic levels, and employment gains are starting to slow. This, combined with slowing wage growth, suggests that income growth will continue to decelerate, further pressuring consumer spending.

Further complicating matters is the government's limited ability to provide fiscal stimulus. "The budget deficit is very, very large," Peter explains, making it politically and economically challenging to implement counter-cyclical measures to soften the blow of a recession. "It's going to be difficult to do significant counter cyclical fiscal policy next year given the starting point of the deficit and the very unfavorable debt dynamics," he adds.

Peter's team at BCA Research has incorporated these worrying trends into their quantitative models. Their recent downgrading of stocks reflects this pessimistic outlook, sending a clear signal to investors that the economic tide is turning.

Will AI deliver on its economic promise?

The tech world is abuzz with excitement about artificial intelligence (AI), and understandably so. The rapid advancements in AI, particularly in large language models (LLMs), have opened up a world of possibilities. However, amidst the hype, Peter injects a dose of realism. "It's not so obvious where all the big profits from AI are going to come from," he cautions.

While acknowledging AI's transformative potential, Peter questions whether the current valuations of AI-related companies are justified. "You're kind of betting on the most favorable outcome," he observes, pointing out that investors are assuming rapid and substantial returns on AI investments. He draws a parallel to the dot-com bubble, where investors poured money into internet companies with unproven business models, only to see many of them crash and burn.

Peter argues that the competitive landscape for AI is still evolving, and it's unclear which companies will emerge as dominant players. He uses a striking analogy to illustrate his point: "Perhaps these large language models will be more like airlines — very useful but they never make any money."

Just because a technology is powerful and widely adopted doesn't guarantee profitability. He points out that many AI models are converging in terms of their capabilities, making it difficult for any one company to establish a clear competitive advantage.

He further highlights the limitations of current AI models, particularly in their ability to generate genuine innovation. "If you use ChatGPT or Gemini, the answer often comes back more or less the same. Where's the competitive moat?" he asks.

If AI models are primarily synthesizing existing information rather than creating truly novel solutions, their long-term value proposition might be less robust than many assume. "The architecture of these models or the neural nets and the transformers — it's very similar," Peter notes. "The training sets are basically the same. So are you surprised that the answers are the same?"

Peter also points to the disconnect between revenue and profit when it comes to AI hardware. He uses Nvidia as an example: "Nvidia sells a chip, it books a profit, but when Google buys that chip, that's CapEx." This distinction is crucial, as significant upfront investments in AI infrastructure might not translate into immediate or sustained profits for companies deploying these technologies.

Peter warns that this capital expenditure on AI hardware could lead to disappointing returns and even losses for tech companies down the line, especially if the promised productivity gains from AI fail to materialize.

This raises a critical question: could the current AI hype, fueled by speculative investments and inflated expectations, exacerbate the impact of a looming recession on the tech sector? It's a question worth pondering as we navigate today's economy.

Turning economic headwinds into tailwinds

While a recession presents undeniable challenges, it also creates opportunities for discerning tech investors and businesses. Peter, amidst his warnings of an economic downturn, offers valuable guidance for navigating this turbulent terrain.

He emphasizes a cautious approach to AI investments. Instead of chasing the hype, focus on companies with clear paths to profitability and robust competitive moats. Look beyond flashy demos and promises of disruption, and carefully assess the underlying business models and potential for sustainable revenue generation.

"It's going to take a long time to make money off these products," Peter cautions, suggesting that investors with shorter time horizons might be disappointed. He also warns that competition will arise to challenge companies like Nvidia, which currently enjoys high profit margins in the AI chip market.

Peter also suggests exploring opportunities in undervalued markets. He points to Japan, where the yen is significantly undervalued, as a potential area of interest. As other central banks around the world cut interest rates in response to a recession, the Bank of Japan's more stable monetary policy could make the yen an attractive investment.

"The yen remains a very, very cheap currency," Peter observes. "It's close to 40% undervalued relative to PPP." He predicts, "Those interest rate differentials are going to move in favor of the yen, and the yen will strengthen."

Moreover, Peter recommends diversifying portfolios to include defensive assets. Gold, a traditional safe haven during times of economic uncertainty, might provide a hedge against volatility. Bonds, particularly longer-term bonds, could also offer value as yields decline in anticipation of central bank rate cuts. "Our target for the 10-year treasury yield is 3%," Peter states, suggesting a significant decline from current levels.

For tech businesses, Peter advises prioritizing efficiency and cost-cutting measures. A recession demands a leaner, more agile approach to operations, focusing on core competencies and maximizing resource utilization. He points out that even if the Fed cuts rates, it might not have the desired stimulative effect on the economy, as longer-term bond yields have already priced in a significant amount of easing.

He also suggests exploring alternative funding options, such as private credit, as traditional lending might tighten during a downturn. This proactive approach to securing capital can help businesses weather the economic storm and position themselves for growth when the recovery begins. Peter notes that there was a story in the FT about how a lot of startups are going bust because they're unable to access the credit they need.

Finally, Peter emphasizes the importance of building resilience and adaptability into business models. A recession often accelerates existing trends and exposes vulnerabilities. Tech companies that can anticipate these shifts, adapt their offerings, and embrace a culture of innovation will be better positioned to emerge stronger from the downturn. He cautions that "the average interest rate is going to rise, even if the Fed cuts rates," due to the high interest rates on existing loans.

Prepare for the storm, position for the future

Peter's economic outlook is a stark reminder that the tech sector, like the broader economy, is cyclical. Periods of rapid growth and innovation are often followed by periods of correction and consolidation. While a recession presents undeniable challenges, it also offers opportunities for those who are prepared. By heeding Peter's insights — approaching AI investments with caution, exploring undervalued markets, prioritizing efficiency, and building resilience — tech investors and businesses can weather the coming storm and position themselves for success in the long term.

As Peter says, "A recession is coming, and preparation is key."

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.