AI boom masks persistent weakness in broader tech sector

Financial Times discloses that the current landscape of the technology sector is being shaped by a complex mix of factors.

Despite the excitement surrounding artificial intelligence, many parts of the technology sector remain weak, with numerous companies still grappling with a downturn that began in 2022, according to investors and recent financial reports. While substantial share price increases for AI-focused giants like Nvidia and Microsoft have helped overshadow the severe losses of 2022, when the tech-heavy Nasdaq Composite plummeted by nearly 30 per cent, many tech firms outside the AI sphere have struggled to recover.

Tony Kim, head of technology investing at BlackRock’s fundamental equities division, noted, “Technology beyond AI isn’t seeing much progress. Many sub-sectors are still in a recession. AI has been the main area of growth.” Traditional tech sectors, such as software, IT consulting, and electronic equipment manufacturing for industries like automotive and general manufacturing, continue to face challenges. These include weak demand and the aftereffects of overexpansion and excessive inventory from the pandemic. Additionally, some have been adversely affected by AI's growth, as budget constraints prompt customers to shift their investments.

Dustin Moskovitz, the Facebook co-founder and current CEO of Asana, recently highlighted the current state of many companies as Asana revised its forecasts for the remainder of the year. "What we’re witnessing in tech is essentially the aftermath of over-hiring and overspending from the early pandemic period," he explained to analysts. "This situation is compounded by significant economic uncertainty and questions about how AI will evolve."   Recent financial reports reveal that most large tech companies have experienced slower growth compared to previous periods, with many smaller firms actively downsizing. Data from Bloomberg indicates that revenues for S&P 500 IT sub-index companies grew by an average of 6.9 per cent over the past year, down from a five-year average of 10 per cent.

Approximately 75 per cent of these companies have seen slower growth than their recent norms. Earnings per share increased by an average of 16 per cent in the past year, compared to 21 per cent over the previous five years. Small-cap indices, like the Russell 2000, show even more pronounced weakness, with technology being the second-worst performer in revenue growth for the second quarter, according to LSEG data. Revenue in this sector fell 6.1 per cent year-over-year, and profits decreased by 2.8 per cent.  

Ted Mortonson, a tech strategist at RW Baird, commented, "Generative AI is masking a cyclical downturn in many core sectors. While there’s hope for improvement in the coming quarters, hope alone isn’t a reliable investment strategy." Even within AI-centric subsectors such as semiconductors, some areas are struggling. Brice Hill, CFO of chip equipment supplier Applied Materials, noted last month that while there is strong demand for AI and data center computing, there are "pockets of weakness" in the automotive and industrial markets. 

John Barr, a portfolio manager at Needham Funds, echoed this sentiment, observing that many industrial sectors are similarly struggling and highlighting the importance of investing in companies with stable business models and innovative initiatives.   As investor enthusiasm for AI-focused companies wanes since early summer, many experts anticipate a shift in investor interest from Big Tech stocks to sectors like financial services and industrials. Some tech specialists are hoping for an intra-industry shift from the largest AI stocks to lesser-known areas of the tech sector. While few companies expect the rapid growth seen by Nvidia in recent quarters, there are indications that some of the most troubled areas of the tech sector might be stabilizing.

Tony Wang, portfolio manager for T Rowe Price’s science and technology fund, noted, "We are seeing stabilization in more macro-sensitive areas, and a decrease in interest rates could provide further relief. The notion that AI is the only thriving sector might have been true for the past two years, but it may not hold for the future."