Clive McDonnell, head of Equity Strategy at Standard Chartered Bank, looks at the causes behind the decline.
The technology sector, now facing challenges on a number of fronts, is supposedly the main cause behind the decline.
While President Trump’s policies get blamed for a lot of events impacting global equity markets, he is probably less responsible for the upset in the technology sector than many would have you think.
There are three primary challenges facing the US technology sector:
1. The sector’s high overseas revenue share: over 60% of total revenue comes from abroad.
2. The threat of regulation on accessing and using personal data.
3. Monopoly powers and the risk of an antitrust investigation.
Let’s consider each factor. US economic growth appears resilient in the face of weaker growth prospects in the euro zone and emerging markets.
However, since US technology companies generate more than 60% of their revenue from overseas, they are acutely sensitive to slower growth prospects outside the US. In the past, they have been able to offset slower growth in the euro zone with robust growth in emerging markets led by China.
The next downturn may witness slower growth in both regions, which would leave US technology companies exposed relative to US banks and utilities which have the lowest overseas revenue exposure amongst US companies.
Additionally, there is a risk that China responds in kind to the US President’s targeting of Chinese technology companies. There is also a risk that US dollar strength creates a negative effect on US technology sector earnings once overseas revenue is converted into US dollars.
The threat of regulation on accessing and use of personal data looms large for technology companies, particularly those in the social media space. Europe has been at the forefront of regulating use of personal data via the General Data Protection Regulation (GDPR).
These regulations changed the balance of power between individuals and companies over the use of personal data. The rules give EU citizens more control over their personal data held by companies and the right to have their data removed from databases, the so-called “right to be forgotten” law.
The challenge for US companies is these rules cover their processing of personal data in Europe, regardless of the residential location of the individual generating the data.
The rules give EU citizens more control over their personal data held by companies and the right to have their data removed from databases.
Similar to the long arm of US financial regulators – which impact banks regardless of where they are incorporated once they engage in US dollar transactions – European rules on personal data are impacting US technology companies in ways that are not covered by domestic laws.
The central business challenge for US technology companies, in particular those in the social media sector, is their business models are built on free access to consumer data in exchange for free use of their software, including search, email and productivity tools, such as those available on Google Drive.
If these companies lose unfettered access to personal data, they would likely start charging consumers for use of the same software.
This, in turn, will have a significant impact on their advertising revenues, as the precision they have been able to offer companies targeting customers would decline. No doubt their business models would evolve, but this could be at the cost of lower net margins relative to the near-20% margins they currently enjoy.
Finally, the perceived monopoly power of some of the sector’s leaders and the resultant risk US technology companies face from antitrust investigations is probably the biggest risk to the sector.
The definition of monopoly power in the US, focusing on the short-term price impact on consumers from company actions, has been unchanged for over 40 years.
Specifically, if company actions lead to higher prices, it could be designated as a monopoly (and importantly, the reverse also applies). This is relevant for technology companies as many have helped to lower prices for consumers.
The definition of monopoly power is changing. This is led by Lina Khan, a Legal Fellow at the Federal Trade Commission and an academic Fellow at Columbia Law School.
In a paper, entitled “Amazon’s Antitrust Paradox (1)”, she challenged the current interpretation of antitrust law which is designed to curb monopolistic power. She proposed that lower prices were not necessarily good for consumers if prices were used as a tool to choke off competition and eventually restrict consumer choice.
The primary tool available to technology companies to manipulate consumer choices (and some would say restrict competition) is their search algorithm.
Whenever a social media or e-commerce company implements a change to their search algorithm, the ensuing uproar amongst its users and customers is a measure of the importance this tool has to drive sales and choices for consumers.
The search algorithm assumes unique power once a platform becomes dominant in an industry and consumers no longer look at other platforms as they believe that their chosen one offers them all the choice they need.
The risk is: their choices are being determined by companies who pay more to appear higher up the search results than those which pay less, even though the latter companies may offer lower prices.
If regulators’ definition of monopoly power evolves, as Lina Khan suggests, there is a risk of antitrust investigations against US technology sector leaders, with penalties ranging from fines to reversal of prior acquisitions.
The challenges facing the US technology sector have converged at a time when valuations are elevated and earnings growth has weakened.
They are shining a light on their business model, which can undoubtedly evolve, but may require changes that the market is not currently anticipating.
Clive McDonnell is Head of Equity Strategy at Standard Chartered Private Bank.
The views expresssed here are entirely the writer’s own.
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