The information technology sector in the US has been the driving force behind the continued rally of the S&P 500, but it won’t escape a cyclical downturn, according to John Higgins, chief markets economist at independent research house Capital Economics.
The US index has rallied strongly over the past few years and has produced solid returns for investors. Over the past five years it has returned 83.96 per cent, outperforming other major global indices such as the FTSE 100 and the MSCI World.
One of the drivers for this growth has been the performance of the information technology (IT) sector, which has seen 163.73 per cent growth in that period, nearly twice that of the S&P 500, and over 50 per cent more than that of the next best-performing sector (Consumer Discretionary).
Performance of US sectors over 5 years
Source: FE Analytics
More recently, although the IT sector had a weak run in March thanks to the data scandal and fears of further regulation, it has surged again since 25 April and returned nearly 12 per cent and, again, outperforming all other sectors of the S&P 500.
This pattern has been seen on a global platform as technology has continued to outperform broader equities over the longer term and year-to-date.
In Capital Economics’ June global markets update Higgins attributed this display of performance to regulatory fears subsiding and strong earnings data coming through.
“As well as reflecting less concern about regulation, the renewed surge in the IT sector of the S&P 500 can partly be explained by very healthy earnings for Q1, with those of most firms beating analysts’ estimates,” he said.
“Indeed, strong earnings growth has kept a lid on the sector’s PE ratio, which, unlike during the dot com bubble, has not risen sharply relative to the PE ratio of the broader market.”
He added that weighting to the sector has not reached the “dizzy heights seen at the turn of the century”.
Around the year 2000, allocations to the tech sector rocketed to highs of more than 30 per cent at the peak of the dot-com boom, which saw investors pile their money into any internet, or dot-com, company regardless of its valuations.
The dot-com bubble burst later that year and saw internet stocks decline by as much as 75 per cent in value while allocations to the IT sector shot down as quickly as they had gone up in the years leading up to 2000.
Higgins said: “Although it is higher now than at any time since the dot com bubble burst, some of this reflects a structural increase which will probably continue.”
Indeed, the IT sector has had an increasing market capitalisation of the S&P 500 in recent years and currently takes more than 25 per cent of the index.
Table of S&P 500 sector allocations
Source: S&P Dow Jones
Higgins said that if this structural increase continues, further allocation to the sector could boost it over time.
Technology is the most overweight sector around the globe, according to Bank of America Merrill Lynch’s global fund manager survey with 23 per cent of those surveyed saying they are overweight the sector.
Also of note in the survey was that, for the fifth month in a row, the FAANG-BAT (Facebook, Amazon, Apple, Netflix, Google, Baidu, Alibaba, Tencent) stocks are the most crowded trade and actually the most crowded trade outright since January 2017.
All of this considered, Capital Economics’ Higgins still believes the IT sector will be hit by the US economic slowdown that he says will come either this year or next.
“Although its valuation is still not stretched and its weighting in the index will probably rise even further over time, we continue to think that it is vulnerable to an eventual cyclical downturn in the US economy,” he said.
Higgins added that the last time a recession hit the US the IT sector didn’t have high valuations or a high weighting to the index, but it “still fell sharply alongside the broader market”.
This can be seen in the below chart, where both the S&P 500 and the IT sector fell in line with each other during the 2008 financial crisis. At the height of the crisis, the IT sector was actually hit harder than the wider US market.
Performance of indices during 2008 recession
Source: S&P
However, he did not suggest the sector would underperform as heavily as it did at the beginning of the millennium.
Not everyone agreed with Higgins, however, with Janus Henderson’s Global Technology managers Alison Porter, Graeme Clark and Richard Clode having a more positive outlook on tech.
“We believe prospects for tech companies remain strong despite investor concerns, with long-term growth trends intact and a near-term boost from US tax reform encouraging corporates to loosen enterprise IT budget purse strings,” they said.
However, they warned that investors must try to drown out the overwhelming noise that can surround new technology such as artificial intelligence or driverless cars.
“With significant capital attracted to the tech sector, both private and public, we must remain vigilant of valuations and hype, and not mistake cyclical business-cycle dependent growth for secular long-term growth, given a buoyant global economy. This can be an issue for more niche thematic portfolios,” they said.