Nvidia: Inflation-Recession One-Two Punch (NASDAQ:NVDA)

Nvidia’s stock (NASDAQ:NVDA) has lost more than 40% of its value this year, as its lofty valuation premium to peers continues to topple on persistent inflationary pressures that have eroded consumer demand for devices and solutions powered by the company’s technologies. In addition to weakening fundamentals, valuation compression ensuing from adjustments to surging interest rates aimed at keeping inflation in check has also stymied the stock’s upside potential this year, which we had discussed in our most recent post-earnings coverage on Nvidia.

As a result, short-sellers in the stock have booked more than $3 billion in mark-to-market gains this year, with the number positioned to edge higher in the coming months. Although Nvidia has recovered more than half of its market value since the mid-October bottom through mid-December, the rapid selloff observed in the week following the Fed’s December rate decision continues to underscore the shares’ vulnerability to souring market sentiment. In the following analysis, we will zero in on the stark shift in investors’ angst over inflation observed in the past year, to recession heading into 2023, and how that would impact Nvidia’s near-term fundamental and valuation prospects.

While we remain confident in Nvidia’s long-term bullish thesis given the critical role it plays in enabling key next-generation growth trends, current market conditions are bound to carve out better entry opportunities with an improved risk-reward proposition in the coming months. Specifically, Nvidia is still trading at an elevated valuation relative to peers. Considering the worst of macroeconomic conditions have yet to come, and Nvidia’s underlying fundamentals already buckling across the board with no immediate respite in sight, its lofty valuation premium is becoming increasingly vulnerable to a further downtrend in tandem with weakening market conditions. With volatility still the broader market theme ahead of the expected recession, we believe the near-term upper hand still lies with short-sellers of Nvidia’s stock.

Inflation To Recession

Despite continued deceleration in the pace of persistent price increases observed over the past year, the market continues to be overshadowed by risk-off sentiment, especially as the Fed remains ever more hawkish in its campaign to stem inflation. The rapid selloff since Fed Chair Powell’s commentary following the FOMC’s December rate decision last week – illustrated by a more than 5% and 7% selloff in the S&P 500 and Nasdaq 100, respectively, and more than an 11% drop in Nvidia’s stock – underscores the stark shift in investors’ sentiment from “inflation angst” to “recession fear”.

While 40-year high inflation this year has unleashed one of the most aggressive rate hike cycles in the history of America’s economy, which led to an unforgiving valuation correction across assets, the looming recession is what will take markets another leg lower. There are already signs of a structural cooldown in demand across the economy, with ensuing impacts poised to eat deeper into corporate fundamentals heading into 2023.

Recall that inflation was by and large the dominating market theme for 2022. This meant rising input costs that impacted profit margins, rising borrowing costs that impacted valuation multiples, and diminishing consumer budgets for discretionary spending that led to growth deceleration across goods like consumer electronics and PCs – and all of these challenges were prevalently visible in Nvidia’s fiscal 2023 results observed to date.

But heading into 2023, things are set to get worse before they get better. Record household savings racked up from pandemic-era stimulus are starting to decline faster than it can be replenished. Despite record inflationary pressures this year, Americans accumulated a “cash stash” that totalled $4.7 trillion still as of mid-year, compared to average levels in the $1 trillion range observed prior to the pandemic – no wonder consumer spending has remained largely resilient through the year. But substantial deceleration in holiday shopping season spending this time around underscores that the cash pile saved during the pandemic is diminishing:

The U.S. personal savings rate has declined to 2.3% in October, the lowest since 2005. The latest data underscores the increasing burden of rising borrowing costs and surging inflation on consumer budgets and overall purchase power. U.S. household net worth has also fallen for the third consecutive quarter as a result of battered valuations across asset classes this year.

Source: “Amazon: The Rout Could Get Worse“

Instead, credit card debt has been accumulating at an accelerating pace, while the labour market is headed towards an imminent cooldown. Specifically, credit card balances that were low during the pandemic thanks to federal stimulus have increased 15% y/y during the third quarter, normalizing towards pre-pandemic levels. Deteriorating macroeconomic conditions are also dialling up market angst on how much longer “borrowers will be able to continue to make payments on their credit cards”, especially as savings shrink.

The record-low unemployment rate of 3.7% is also likely to worsen in the coming months, with the Fed pencilling in 4.6% unemployment in 2023. The anticipated slowdown is further corroborated by a recent uptick in recurring unemployment claims towards levels not seen since early February, underscoring increasing difficulty for those that have lost jobs to find jobs. The combination of diminishing savings, rising unemployment, and growing debt pile is a recipe for further demand slowdown, which will only worsen fundamentals that have already been pressured by the inflationary environment this year. With no signs of a Fed pivot in sight, the latest market pullback suggests investors might finally be succumbing to the fate of an imminent recession.

The “So What?” For Nvidia

Despite having already lost close to half of its market value this year, Nvidia continues to be a top underperformer in markets. This is consistent with the violent ~11% plummet observed in the stock since the Fed’s December rate decision, which outpaces the single-digit declines observed across key market benchmarks. This circles back to our opinion that the generous premiums previously rewarded to Nvidia’s stock for the company’s longer-term prospects are actually a risk under today’s dire market climate, priming the shares for an inevitable pullback on near-term fundamental weakness.

Although both Wall Street and management forecasts for the semiconductor sector have already been revised downward in anticipation of looming weakness in the demand environment, we believe Nvidia’s valuation premium and near-term fundamental weakness elevates its exposure to further volatility driven by increasingly fragile market sentiment. With the Nasdaq 100 still trading above its 10-year average at about 21x estimated earnings, and tech industry profits estimated to “contract by 1.8% next year, compared with expected growth of 2.7% for the broader U.S. market”, we expect further turbulence ahead. And the anticipated recession-driven market downturn over the coming months is likely to drag Nvidia alongside in its ride down.

Gaming

Nvidia’s gaming segment has been the hardest hit corner this year, reeling from both a slowdown in consumer PC demand and turmoil in crypto markets. While management has set expectations for a return to sequential growth in gaming for the current fiscal fourth quarter, with “channel inventories on track to approach normal levels”, we see most of the cautious optimism buoyed by seasonality and related to the holiday shopping season’s helping hand.

With 2023 currently projected to be a “tale of two halves“, represented by a likely recession in the first half and recovery in the second, the consumer-heavy gaming segment is unlikely to see sustained relief until at least 2024. Specifically, 2023 is expected to bring about more weakness to Nvidia’s gaming segment, which will continue to weigh on sentiment in the near-term.

This is corroborated by rapid declines in consumer dollars spent on gaming this year, which toppled -5% in the third quarter to about $12 billion (3Q21 consumer gaming spending: $13 billion). While consumer spending on consumer hardware increased by 16% this year, it was primarily driven by the return of stock compared to last year’s supply-constrained environment. The rapid decline in purchases of related content, which “contributed most to the overall drop in [gaming] spending”, however, underscores the adverse impact of deteriorating macro factors on consumers that is likely to persist into the new year. The 18% drop in online prices for PCs during November, which represented the third consecutive month of acceleration in price declines in the category, also underscores worsening demand for Nvidia’s gaming solutions ahead of further tightening in financial conditions in the upcoming year.

Data Center

Nvidia’s data center segment, which is really the sole bright spot that has remained relatively resilient through the macroeconomic noise this year, is now dealing with demons of its own. The segment has found itself in the crossfire between the U.S.’ and China’s fraying relationship, with sales growth decelerating from 61% y/y growth in the fiscal second quarter to 31% in the fiscal third quarter due to softness in the Chinese market. The more profitable segment also saw its margins impacted by changes to its Chinese operations, with more than $700 million in related inventory charges booked during the fiscal third quarter. Despite expectations for continued ramp-up in “early production shipments of H100“, its newest GPU based on the Hopper Architecture, and a new A800 data center GPU made exclusively for the Chinese market to comply with recent U.S. regulatory changes, management has guided modestly for data center sales due to “continued softness in China”.

Beyond the China headwinds, deteriorating macroeconomic conditions at home are now eroding IT spend, which will likely dull management’s already tempered optimism for Nvidia’s data center segment further. Previously viewed as a relatively recession-proof corner in tech, given digital transformation urgencies to stay operationally and economically competitive, corporate IT spending has started to show signs of weakness in response to mounting macroeconomic uncertainties. With boardroom executives now “talking pennies, and not millions”, the corporate IT spending environment is bound to remain challenging as the looming macroeconomic downturn plays out.

This is consistent with the anticipated slowdown in hyperscaler demand, which is crucial to Nvidia’s data center business. The near-term challenge is corroborated by increasing weakness observed in recession-prone consumption-based revenue models employed by hyperscalers counting Amazon’s AWS (AMZN), Microsoft’s Azure (MSFT), and Alphabet’s Google Cloud Platform (GOOG / GOOGL) in recent months as corporate IT budgets hone in on cutting excess capacity. For instance, Meta Platforms’ (META) recent cancellation of data center expansion plans in Denmark underscores the growing extent of pullback in capex spend across tech to regroup ahead of stiffening macroeconomic headwinds. Specifically, there is a “growing view that Meta Platforms could cut capex in particular by as much as 30% to 50% relative to the initial guide”, which focuses primarily on “increasing AI capacity”. With Nvidia being a key supporting partner to Meta Platforms’ AI aspirations, coupled with further recession-driven challenges to server processor demand, the company’s data center segment is likely to experience persistent softness in the near-term.

Final Thoughts

Two of Nvidia’s most critical operating segments continue to face stiffening headwinds from worsening macroeconomic conditions heading into 2023. And smaller segments counting Nvidia’s automotive solutions and software sales are likely to face further weakness as well. Specifically, Nvidia’s automotive segment sales have only just started to show a pickup in momentum, as auto manufacturing resumes after a year blighted by acute chip shortages. Yet, persistent inflationary pressures, coupled with rising risks of recession are likely to weigh on consumers further, and shift auto’s supply-constraint theme into a demand problem, bringing back weakness to Nvidia’s struggling-to-grow automotive segment. Meanwhile, Nvidia’s slate of more profitable AI-driven software critical to its full-stack business model, aimed at reinforcing hardware sales, is also likely to experience near-term weakness as IT spending declines.

Nvidia’s stock still trades at a lofty 40x estimated earnings today, despite having lost close to half of its market value this year. Even if the multiple sustains, the anticipation for weaker-than-expected fundamentals as a result of the one-two punch from inflation this year and recession in the next is likely to take the stock’s valuation a leg lower. The stock’s lofty valuation premium also faces susceptibility to more turbulence ahead in tandem with broader market declines that are expected to carry into the upcoming earnings season next year – which is expected to show prominent weakness with tech earnings in the S&P 500 estimated to drop by at least 2%. Although Nvidia’s solutions remain the critical backbone to key digital growth trends in the years ahead, looming macroeconomic weakness is bound to weigh on its performance in the near-term, with the ensuing rout likely to create better entry opportunities than current levels.