February Update
Tariff Tantrums: Market Volatility and the Small Cap Dilemma
February 2025 proved to be a challenging month for global equity markets, as uncertainty surrounding tariffs sent ripples through investor sentiment. We are dubbing this as "TTT - Trump Tariff Tantrums," the prospect of new trade restrictions sparked volatility, leading to a pullback in U.S. equities while prompting a notable shift in capital flows toward international markets, particularly Europe and select emerging markets.
This is Healthy!
Despite the short-term pain, sell-offs are a necessary and healthy function of financial markets, particularly after a year of strength. The relentless rally in equities over the past year had stretched valuations, making pockets of the market vulnerable to corrections. A pullback allows for excesses to be worked out, preventing speculative bubbles and resetting expectations. It also provides long-term investors with better entry points into high-quality businesses at more reasonable valuations. Ultimately, market corrections help sustain the longevity of bull markets by preventing overheating and bringing asset prices closer to their intrinsic value.
The Impact of Tariff Talk on Markets
Markets loathe uncertainty, and February was rife with it. The mere mention of tariffs reignited fears of global trade disruptions, bringing back memories of previous trade wars. This led to broad-based selling in U.S. equities, with the S&P 500 slipping 1.3% and the Nasdaq Composite tumbling 3.9% over the month. The technology sector, already stretched in valuation, felt the brunt of the selloff, while defensive sectors held up relatively better.
Adding fuel to the fire, consumer confidence took a dive, with the Conference Board’s index dropping to an eight-month low of 98.3. While the economy remains fundamentally strong, the combination of elevated valuations, policy uncertainty, and softening sentiment triggered a recalibration in risk assets.
Volatility Takes Center Stage
February's turbulence underscored a key reality: volatility is back. With interest rates stabilizing and central banks less accommodative than in prior cycles, investors are grappling with a new paradigm—one where equity markets are no longer cushioned by the ‘Fed put.’
One key indicator reflecting this shift is the VIX, Wall Street’s so-called "fear gauge." The VIX surged above 20 for the first time since October 2024, signaling heightened investor anxiety. While this level is far from extreme panic, it marks a departure from the unusually low volatility environment seen in late 2024.
While short-term fluctuations can be unsettling, it’s important to recognize that volatility often creates opportunities. Investors who remain disciplined and focus on fundamentals can navigate these choppy waters more effectively than those reacting emotionally to market swings.
Small Caps: High Growth Expectations, High Risk of Disappointment
Small caps, often seen as a barometer of economic growth, entered 2025 with lofty earnings expectations. Analysts project a staggering 39% earnings growth for the year. However, history suggests caution is warranted.
From 2011-2023, annual earnings estimates for large and mid caps were revised down by 3.7% and 5.8% on average, respectively. Small cap earnings, by contrast, were slashed nearly 24%.
Expectations for 2023 and 2024 initially pointed to growth of 13% and 24%, yet small cap earnings ultimately contracted by 12% and 14%, respectively. A similar shortfall in 2025 could completely erase projected profit growth.
Mid-cap stocks have demonstrated more stability, with earnings missing estimates by just 2-3 percentage points over the past two years. Looking ahead to 2025, they are expected to grow at a steadier pace of 11%.
Small caps may deliver higher potential returns but come with greater risks, including the likelihood of substantial earnings downgrades. Only time will tell, especially with Tariff Tantrums well underway, growth projections will be revised down for this year.
The Rotation Out of U.S. Equities
One clear trend emerging from February’s volatility is the shift in capital flows. While U.S. equities struggled, European markets outperformed, with the MSCI Europe ex-UK Index climbing 3.4%. This suggests investors are rotating out of the U.S. and into regions with more attractive valuations and improving economic conditions, and the prospect of the Russia-Ukraine War ending on the premise that ceasefire negotiations progress and succeed. Our house view is that this is being priced in.
China’s tech-heavy Hang Seng Index also surged 11.7%, reflecting renewed enthusiasm for AI and supportive policy measures. These flows reinforce the idea that global investors are seeking alternative opportunities as U.S. markets grapple with uncertainty.
Tech stocks are hurting - the "Magnificent 7" stocks have hit correction territory, with the equal weight Bloomberg Magnificent 7 Price Return Index down 10% from a December peak during February.
Anxiety around tariffs, AI spending, valuations, crowded trades, high earnings hurdles.
Earnings Snapshot
It was a significant month for earnings, with the remaining members of the Mag7—Amazon, Apple, Alphabet, and Nvidia, reporting their quarterly results. This earnings period proved to be challenging, with exceptionally high expectations for the Mag7. It wasn't enough to simply surpass earnings estimates; companies had to deliver mega forward guidance to maintain their momentum.
Amazon reported earnings per share (EPS) of $1.86, surpassing the estimated $1.49. The company showed strong revenue growth across both its e-commerce and cloud computing segments. However, the growth of Amazon Web Services (AWS), while still a major profit driver, showed signs of slowing. AWS has an annualized revenue run rate of $115 billion, continuing to be a cornerstone of Amazon’s profitability.
AI and Cloud Infrastructure, investment in artificial intelligence (AI) is accelerating, though its AI business could be growing faster if not for delays in acquiring chips from third-party partners, which are coming in slower than before. In the next few years, Amazon’s growth in this sector will be "lumpy" due to enterprise adoption cycles and ongoing technological developments. Amazon’s partnership with NVIDIA on Project Ceiba will support the company’s AI and cloud infrastructure through NVIDIA’s R&D supercomputer. AWS has released nearly twice as many machine learning and generative AI features as competitors in the past 18 months, with its AI business growing at a triple-digit rate, over three times faster than AWS itself grew at a similar stage.
Prime Day and Prime Big Deal Days were the largest and most successful sales events to date, saving customers over $5 billion, with total savings reaching $25 billion across all major sales events. Highlights the company's dominance in the retail and subscription-based services market.
Amazon's advertising business has been a key highlight, with a $69 billion annual revenue run rate, more than double the $29 billion it achieved just four years ago.
Worthy mentions, Amazon Pharmacy delivers prescriptions to 95% of new customers within two business days and 20% of Prime members within 24 hours. On the product front, Amazon launched a new lineup of Kindles, continuing to innovate within its core retail ecosystem.
Capital Expenditure and Future Outlook
Amazon announced a projected $100 billion capital expenditure (capex) for 2025, primarily focused on AI and cloud infrastructure. While this investment has raised concerns among investors, the company is positioning itself for future growth by building out AI capabilities and expanding its cloud infrastructure. Amazon’s emphasis on these areas suggests that its growth trajectory will remain strong, though more volatile in the short term due to the nature of enterprise adoption and technological cycles.
Alphabet posted an EPS of $2.15, slightly above estimates of $2.12, with strong ad revenue growth from YouTube and Google Search, despite ongoing pressures in the advertising market. Google Cloud continued to grow, though it still lagged behind competitors like AWS and Azure. Alphabet’s investment in AI infrastructure continues to expand, with new cloud regions and data center campuses, as well as plans for subsea cable projects to boost global connectivity. The company’s AI capabilities were highlighted by the launch of Gemini 2.0 and its groundbreaking models like Vo2 and Imagen 3. With over 4.4 million developers using Gemini models, Alphabet is well-positioned as an industry leader in AI.
In Google Cloud, the company secured significant deals with clients like Mercedes-Benz and Mercado Libre, with several strategic contracts exceeding $1 billion. Google Cloud's AI infrastructure, particularly its AI hypercomputer and Trillium TPUs, saw strong adoption. Vertex AI, the company’s developer platform, also grew substantially, with a 20x increase in usage during 2024.
Beyond AI, Alphabet made notable strides in other areas, including Android XR, developed with Samsung and Qualcomm, marking a significant advancement in Android’s evolution for the AI-driven future. In autonomous vehicles, Waymo completed over 4 million passenger trips in 2024, expanding its network to new markets, including Tokyo. Meanwhile, YouTube continued to grow, with Shorts gaining traction and increasing monetization rates, and the Vo2 video generation model being set to roll out for creators.
Overall, Alphabet's Q4 results demonstrate its strong position across key areas, particularly in AI and cloud, while laying the groundwork for future growth in autonomous vehicles, video generation, and mobile platforms.
Nvidia reported an EPS of $0.89, slightly exceeding the $0.85 estimate. This performance was primarily driven by robust demand for its GPUs in AI and data analytics sectors. However, the company projected a slight decrease in gross margin for the upcoming quarter, anticipating a tightening to approximately 71% from the previous 73.5%, attributed to the ramp-up in production of its new Blackwell AI chips. There is optimism regarding Nvidia's position, demand for the company's Blackwell GPUs is far outstripping supply. Multiple enterprise AI customers are revealing no signs of slowing down or altering AI investment plans, despite emerging competition. The upcoming GPU Technology Conference (GTC) should be a pivotal moment, serving as a wake-up call for tech investors, refocusing attention on the AI revolution and substantial tech spending in the coming years.
Overall, while Nvidia faces challenges such as potential margin compression due to increased production costs, the company's strong revenue growth and sustained demand for its AI solutions position it well for continued leadership in the AI and data center markets.
Apple reported EPS of $2.40, in line with expectations, and showed strong demand for its iPhones and services, particularly in the App Store, iCloud, and subscriptions. New product launches in wearables and services helped drive growth, and the company demonstrated resilience in managing its supply chain amidst global challenges. Apple continued to focus on integrating AI across its devices and services to improve the user experience. However, this hasn’t fully met expectations, particularly with Siri, which has seen limited progress in terms of meaningful innovation. In response, Apple has turned to external innovators, incorporating AI-enhanced Siri functionality through a partnership with OpenAI's ChatGPT. While this integration hasn't been entirely smooth, there are signs that Apple's AI efforts could intensify, with Apple Intelligence and potential Google Gemini integration expected in the near future.