CIO continues to like mid-cycle industries like software and internet, both of which are well positioned to benefit from broadening AI demand. (UBS)

Tech stocks tend to be more vulnerable than the broader market to elevated rates, which diminish the discounted present value of more distant years of profit. Valuations for the sector also remain above the average for the past two decades.

But with the earnings season coming up, we see support for the sector, along with targeted opportunities in resilient and beaten-up parts of tech:

A turn in tech earnings looks likely in the third quarter, and we forecast this will be the fastest-growing sector in 2024 in terms of profits. Globally, tech earnings fell by mid- to high-single-digits year-on-year in the first half of this year due to negative base effects and weak consumer demand. However, with a rising contribution from AI, better base effects, and pricing power, we expect global tech earnings to turn positive in the third quarter and grow by around 16% for full-year 2024 (compared to around 9% for global equities). As a result, the tech sector should emerge as the fastest-growing segment within global equities next year.

While the global tech sector overall is not cheap—trading at a forward price-earnings ratio of 24–25 times versus a 20-year average of around 20 times—and we are neutral overall, we do see tactical opportunities.

Beaten-down parts of the industry provide greater potential upside, in our view. Since the recent market peak on 18 July, semiconductors and hardware stocks have underperformed broader growth benchmarks. We see opportunities in select semiconductor stocks following the recent correction.

Investors should also consider adding exposure to the most resilient parts of the industry, as volatility remains elevated. The stocks that have fallen the least since the July peak are in the software, internet, and services industries—sub-sectors that are generally more defensive and have a higher recurring revenue base than early cyclical industries like semiconductors and hardware. With markets expected to stay choppy, we continue to prefer mid-cycle industries like software and internet given their solid above-average growth prospects for 2024 and their strong AI monetization potential.

With rising rates, it is natural for investors to worry about debt, insolvency, and cash flows. The good news is that most established tech companies enjoy strong balance sheets and cash flow generation. Consequently, we don’t think leverage is a major issue for leading tech companies; but on a relative basis, smaller companies—mostly profitless companies—would be at risk if rates stay elevated for long. Companies with high free cash flow margins should also be more resilient.

So, we continue to like mid-cycle industries like software and internet, both of which are well positioned to benefit from broadening AI demand. Investors can also consider emerging tactical opportunities in semiconductors stocks, some of which offer value following recent declines.

Main contributors: Solita Marcelli, Mark Haefele, Sundeep Gantori, Christopher Swann, Jennifer Liu, Vincent Heaney, Jon Gordon

Read the original reportOpportunities in tech amid volatile trading, 6 October 2023.