Within tech, CIO continues to like the software industry due to its solid growth trends and defensiveness. (UBS)

CIO thinks rising yields, geopolitical risks such as new US export controls targeting China, and mixed third-quarter reporting all contributed to the downtrend. But because of weak overall sentiment, markets failed to celebrate solid third-quarter earnings performance from industry leaders. In our view:

Fears over tech fundamentals are unjustified. Based on the quarterly results so far, global tech earnings grew at a mid-single-digit percentage rate, better than market expectations of low- to mid-single-digit growth. After several quarters of earnings declines, global tech earnings are finally turning positive again. We expect global tech earnings to grow by 16% in 2024, making tech one of the fastest-growing segments within global equities.

Software is attractive amid margin expansion. While the share price reaction to tech company results has been mixed, we were impressed by solid margin expansion across the board and a rising contribution from AI for many industry leaders. The quarterly results reinforce our long-term positive view on AI and the software industry in particular, which reported broad-based better-than-expected earnings thanks to improving pricing power. While software stocks are not cheap—on average these companies are trading at a 15–20% premium versus broader tech—we believe the premium is justified as more than two-thirds of revenues are recurring and margins of around 35% are some of the highest in the industry.

The recent correction in semiconductors is a buying opportunity. The US government's additional controls on technology exports to China helped push down the Philadelphia Semiconductor Sector index down by a mid-teens percentage from its peak in July. But we think the sell-off is overdone. In the medium term (i.e., in 2025 and a few years thereafter), we would expect only a low- to mid-single-digit revenue impact for the industry even if China is barred from purchasing any advanced AI chips and equipment. In the nearer term, we believe overall fundamentals have bottomed and have scope to improve. Supply is very tight, and the overall industry is benefiting from strong pricing tailwinds. We remain comfortable with our 2024 global semiconductor industry revenue growth forecast of above 25% and profit growth of more than 50%. The industry is trading close to 18–19x forward P/E—a big discount to global tech's 23–24x P/E, considering our forecast for profit growth.

So, within tech, we continue to like the software industry due to its solid growth trends and defensiveness. We also recently turned positive on global semiconductors in anticipation of a strong earnings recovery in 2024.

Main contributors - Solita Marcelli, Mark Haefele, Vincent Heaney, Christopher Swann, Jennifer Stahmer, Jon Gordon, Alison Parums

Read the original report: Tech correction obscures improving fundamentals, 6 November 2023.