AI exuberance masks broad weakness in tech sector, say investors

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AI exuberance masks broad weakness in tech sector, say investors

Many companies unconnected to artificial intelligence boom are yet to recover from post-pandemic downturn

Enthusiasm about artificial intelligence masks weakness across most of the technology sector, with many companies “still in a recession” following a slowdown that started in 2022, according to investors and analysis of recent financial reports.

Massive share price gains for large companies that were predicted to be early beneficiaries of AI, such as Nvidia and Microsoft, helped to erase memories of a dreadful 2022, when the tech-dominated Nasdaq Composite tumbled by almost a third. 

Beneath the surface, however, many tech businesses that do not focus on AI have struggled to regain momentum.

“When you look at technology outside of AI, there’s not that much happening,” said Tony Kim, head of technology investing in BlackRock’s fundamental equities division. “Many [sub]-sectors are still in a recession. The only thing that has been really growing has been AI.”

More traditional tech areas such as software, IT consulting and the production of electronic equipment for other sectors such as manufacturing and the auto industry have faced difficulties, including weak demand and the hangover from overexpansion and overstocking of inventories during the coronavirus pandemic. Some have also directly suffered from the growth of AI, as customers with limited budgets redirect investment.

Dustin Moskovitz, the Facebook co-founder who is now chief executive of Asana, last week summed up the situation for many companies as the business software group scaled back its forecasts for the rest of the year.

“What we’re seeing in tech is still kind of the unwinding of the over-hiring and overspending that we saw at the beginning of the pandemic,” he told analysts. “And then that all couples with what I think is massive uncertainty in the economic environment. And then, also, just with how AI is going to play out.”

Recent financial reports show the majority of large tech companies have been growing more slowly than in the past, while many smaller ones are actively shrinking.

Groups in the S&P 500 IT sub-index increased revenues by an average of 6.9 per cent over the past 12 months, according to Bloomberg data, compared with a five-year average of 10 per cent. About three-quarters of companies grew more slowly than their recent average.

Earnings per share increased by an average of 16 per cent in the past 12 months, down from 21 per cent over the past five years.

The weakness is more obvious in small cap indices, where there is no boost from megacap groups. In the Russell 2000, technology was the second-worst performing sector in terms of revenue growth in the second quarter, according to data from LSEG. Revenue fell 6.1 per cent year on year, while profits were down 2.8 per cent.

“Generative AI is masking a cyclical downturn in a lot of other core sectors,” said Ted Mortonson, a tech strategist at RW Baird. “Everyone is hoping things get better in the next few quarters, though hope is not an investment strategy.”

Even within subsectors that have been caught up in the AI enthusiasm such as semiconductors, some business lines have been struggling. Brice Hill, chief financial officer at chip equipment supplier Applied Materials, told analysts last month that “we’re seeing particularly strong pull related to AI and data centre computing”, but there were “pockets of weakness in the auto and industrial end-markets”.

“Everywhere you look on the industrial side it’s similar,” said John Barr, a portfolio manager at Needham Funds who has invested in several semiconductor companies including Applied Materials. “Current growth is not so great, so what we’re looking for are companies that have a stable business and are investing in something new.” Recommended Artificial intelligence Rethinking the AI boom, with Daron Acemoğlu

Investor exuberance around AI-focused companies has faded since the early summer, leading many commentators to predict a prolonged rotation of investor attention away from Big Tech stocks towards sectors such as financial services and industrials. 

Some tech specialists are hoping for a similar intra-industry rotation from the biggest AI stocks to more unloved corners of the industry. While few companies are predicting the sort of triple-digit growth that Nvidia has reported in recent quarters, there are signs that some of the worst-performing parts of the tech sector are turning a corner.

“I think we are seeing a stabilisation — things have stopped getting worse in those more macro-sensitive areas, and if rates go down then that will help,” said Tony Wang, portfolio manager for T Rowe Price’s science and technology fund.

“I feel like the idea that AI is the only thing that is working has been the case for the last two years. I’m not sure it will be the case for the next two.”