In the opening months of 2024, the information technology and communication services sectors have again pulled the rest of the stock market higher. While the performance of some segments may seem overextended, these moves have in many cases been supported by businesses delivering strong fundamental results and guiding for continued improvement, write Pamela Hegarty and Vincent Nichols.
Many comparisons are being made to the dotcom era of the late 1990s, but to us it seems more like the middle of that decade rather than the finish. A new technology with immense economic impact was being integrated into everyday life with significant implications: the introduction of the internet created enormous efficiencies in how the world did business (among many conveniences elsewhere).
Spectacular earnings growth followed and protracted market euphoria eventually led to a bubble with stocks trading at ridiculous valuations.
However, for several years before that bubble (1995-1997), market performance had been exceptionally strong, while valuations were anchored to reality.
Currently, generative artificial intelligence (AI) is having an immense impact on many of the enablers and beneficiaries of this technology and their stock prices have similarly benefited.
This has led to an expansion of valuation multiples implying an acceleration in future earnings growth. Some of these companies will meet or exceed the growth implied by their multiples, while others whose stock has benefited from a superficial affiliation with the buzzword will disappoint and experience a price correction.
Infrastructure to support artificial intelligence will be a must
Actively managed portfolios with effective execution will be key for investors seeking to prosper from the disruptive AI technology, while avoiding the companies that may disappoint. Passive strategies will indiscriminately capture both sides with higher allocations to the companies that have already experienced the largest gains.
Meanwhile, adopters and potential beneficiaries of the efficiencies created by AI have not meaningfully participated in the market rally. A CIO survey by Morgan Stanley reported that 33% of CIOs expect their first AI/Large Language Model (LLM) projects in the second half of 2024. That could lead to massive spending that would continue to benefit the enablers initially, but would eventually create efficiencies and increased profitability for the adopters.
As more and more industries and companies embrace AI, the need for more and improved supporting infrastructure becomes imperative. This includes datacentres and companies in fields such as storage, semiconductors, foundries, cybersecurity, AI integration, networking, energy solutions, and many more.
Peak US policy rates set up a benign environment
There is another parallel to the 1990s. The middle of the decade was the last time the US Federal Reserve was able to engineer a soft landing for the economy after a cycle of rapid policy rate hikes. As we move to the middle of 2020s, a renewed soft landing is in the offing.
A benign environment for higher-growth companies with an appetite for market financing looks likely. Easing inflation is leading to market expectations of a less restrictive monetary policy with most of the investor debate centred around the pace and degree of easing rather than the direction of policy rates.
There is still a risk that the impact of higher interest rates will eventually lead to a considerable degradation of the economy, but higher-growth companies aligned to secular themes – such as technological progress – should be correlated less with cyclical momentum and therefore would likely outperform the wider market even if a soft landing did not materialise.
Software and IT services to drive growth in 2024
According to technology research and consulting firm Gartner, global IT spending is expected to grow by 6.8% in 2024, totalling USD 5 trillion.
Software and IT services segments are expected to be the leading growth drivers this year and account for about half of the projected total spending.
Cybersecurity is expected to be one of the major drivers of growth in the software segment as 80% of technology executives told Gartner that they plan to increase spending in this area, in part due to concerns that AI adoption will increase vulnerabilities for IT security.
Spending on devices, which has contracted for two years after robust growth immediately following the onset of Covid, is expected to turn up, starting a new cycle of expansion.
Last year we saw signs of growth stabilisation in cloud computing trends from the hyperscalers (the large-scale datacentres that offer massive computing resources, typically in the form of elastic cloud platforms). After the recent fourth-quarter 2023 earnings reports, it now appears a reacceleration is underway as headwinds from workload optimisations are abating. We are optimistic about a further acceleration in 2024.
AI workloads are one area of rapid growth that has been contributing to the broader improvement in revenues from the cloud businesses of these companies. Some US tech giants, or hyperscalers, should be the most obvious winners from this reacceleration, but there are numerous corollary beneficiaries with significant upside potential. Networking software and equipment could be one area where growth rebounds faster than expected.
There is more to come
We remain confident in the durability of the secular growth drivers – cloud computing, artificial intelligence, automation, and the internet of things – as well as the foundational technologies that enable these areas. They form the bedrock of our investment strategy in the tech sector.
We continue to believe that the leaders and beneficiaries of digital transformation will deliver superior revenue growth, earnings, cash flows, and returns over a long-term investment horizon as companies strive to cut costs, operate more efficiently, and innovate to differentiate.
Disclaimer
