Hi everyone. Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel.
For today, we are continuing with our series of year ahead conversations. For this morning, we will spend some time reflecting and previewing expectations for the U.S. information technology sector. With that, joining me right here at our 1285 podcast studio in New York, glad to welcome technology and telecom equity strategist for the Americas, Kevin Thedeen.
Kevin, thank you for dropping by. It's nice to have you here at the table. Welcome back.
Great to be here, Dan. Thanks for having me in. Kevin, before we move into your expectations for the year ahead, I'm sure there's a lot there you would like to cover with our listeners, our clients.
Maybe at the start here, let's take a few moments just to reflect on how 2024 shaped up relative to your expectations around this time last year. Yeah, I think 24 has been a really phenomenal year for the technology sector. Coming in today, the sector is up about 38% year to date.
That's about 10 percentage points better than the S&P 500. But I think if you look under the hood, I think it was a little bit different year than people were expecting. So I think a lot of people who are listening are probably familiar with this notion that the gains in the market, the gains in the IT sector have been concentrated.
I don't think people appreciate just how much. So when we think about participation or breadth, we think about the number of stocks that are outperforming the index. And only 27% of the sector actually outperformed 27% of the stock.
So breadth was really poor. And just to put it in perspective, that's the worst participation in over 25 years. The average stock in the sector was up 19%.
Now, that's not a bad year, but that actually underperformed the S&P 500, excluding the technology sector. So it was a great year for the sector. It wasn't necessarily a great year for a lot of technology stocks.
Not a bad year, but certainly not a great year as implied by the overall sector's return. From hearing those numbers, it tells perhaps a different story than what headlines would have investors feel or believe. So with that, let's now shift to the year ahead, 2025.
Can you speak about your performance expectations for the group? And is there anything in particular in the way of risk headwinds that participants within the group should be mindful of as we head in? Yeah, as we think about next year, I think broadly speaking at the sector level, I think the returns are going to be driven mostly by earnings per share growth.
But at the same time, I do think that we're going to see breadth improve both within the so-called AI complex, but also across the entire IT sector. So I do think there could be some PE expansion, but I think it's going to be more stock specific than sort of a rising tide lifting all boats. And in terms of headwinds, I think the headwinds to think about are mostly macro.
I think we have to keep a careful eye on US trade tensions. Tariffs clearly remain a risk. I think we have to keep an eye on the consumer, given that there's a pretty good correlation between consumer spending and smartphone unit growth.
And keep in mind that smartphones account for about 25% of the overall sector's market cap. So that's an important sort of bucket to watch. I think we also have to watch corporate confidence.
That's key for IT spending. I think corporate confidence generally ties back to profitability, to inflation, and interest rates. And I think there we have a pretty constructive picture, but we still have to keep an eye on it.
And lastly, I think we probably could say that there's probably more upside risk than downside risk to the broader group of stocks than what we saw in the past year. So with respect to themes, Kevin, not to front run, however, you did make mention of artificial intelligence, AI, in your commentary a few moments ago. As our listeners, clients know, AI has been a central focus of our chief investment office for a couple of years now.
So thematically speaking, as we're heading into next year, what are some themes tied to the group that you'll be monitoring? Yeah, look, we think AI is still a durable investment theme, both from a stock perspective and actual investment into AI. I do think that we're going to see continued investment into what we call the enabling layer.
So when we think about AI, we think about AI as being a technology stack with three layers, the enabling layer, the intelligence layer, and the application and service layer. That enabling layer is the physical infrastructure. So that's all the computing power, the servers, the networking, the storage, the data centers.
You can even think about the power supplies that go into that. Above that, the intelligence layer, that's where the models live, the large language models and all the data. And then the application and services is where we actually interact with these services.
Right now, and I think over the past year, you've seen a lot of investment and a lot of stock gains concentrated in that enabling layer. We think that's still going to be a very good opportunity, but we do think that we're going to start to see some broadening out, some increased participation across the AI complex. I mentioned smartphones earlier.
That's still a big, important category within the S&P 500 technology sector. That accounts for about 25% of the market cap. By our estimation, that's about the same impact as the AI complex.
So it's a big, important market to watch. I think we're going to get growth next year Just like we had this year, I think one of the challenges that that market's seeing is the market's becoming increasingly bifurcated. You're seeing sort of the mid-tier of the market gets squeezed.
Some of those units are going up into the higher end. More of those units are going downstream into lower-priced devices. So I think we're going to have good unit growth, but maybe the mix of that growth is going to be a little bit different, and has implications upstream and downstream.
IT spending, by our estimates, that's about 35% of the sector's market cap. We think IT spending should have a good year next year. I think there are a lot of software companies that are facing easier year-over-year comparisons.
I think also the tone of software spending will be better. I think last year was a year that was marked by a lot of uncertainty and a lot of confusion around AI strategies. I think the rush to invest in AI might have squeezed out or pushed out some traditional IT spending.
I think we're getting signs of a fourth-quarter budget flush, and I think that bodes well for next year. I think sort of corporates and CIOs and CTOs, I think they're starting to put their strategies together, and I think we'll start to see broader participation there. And then, you know, lastly, we think about the rest of semiconductors.
So semiconductors that aren't tied necessarily to AI or to smartphones. And there, you know, it's been a tough year in 24, and I think that difficulty reflects the end markets. We saw PCs and smartphones grow but a little bit less than expected.
We saw autos and industrials really slow down. I think next year is a story of, we're going to have, as I mentioned, unit growth in smartphones. The complexion of that growth will be a little bit different.
I think PCs and servers get back to growth. AI servers will be strong. I actually think traditional x86 servers will start to improve.
That's going to be good for a broad swath of companies. And I think even autos and industrials, I think that gets better next year. So, you know, I think those are the four key areas that we're looking at, and the way that we think about that is in those market cap buckets, right?
So AI, about 25 percent. Smartphones, about 25 percent. IT spending, about 35 percent.
The rest of semiconductors, about 15 percent. And we put it all together, and, you know, we see reasons to be constructive across each of those sort of pools of market cap. So thematically speaking, a lot of considerations there, even outside of AI.
Those specific to AI, Kevin, as you described it, a multi-tier story. It will be interesting to see how some of those other tiers evolve in the year ahead. So we'll have other conversations as the year progresses.
With respect to positioning, Kevin, looking at subsectors, what do you find currently most attractive within the broader group? Yeah, it's hard actually to pin it down to most attractive because we're actually constructive across the board as I laid out. If we were to think about it sort of by industry groups, you know, we're positive on software companies.
As I mentioned, I think we're going to have a lot of software companies that have easier comparisons in 25. I think IT budgets will be looser. I think the other thing that we're going to start to see in 25 is, I really think there's a lot of software companies that are well positioned to monetize AI.
And when we think about AI longer term, you know, I think it's software companies that sit on top of pools of, large pools of proprietary data that are really well positioned to create business and economic value from AI. Because I think ultimately it's the data that matters. I think it's a data that will differentiate the results of AI outcomes.
And I think SaaS companies, software as a service companies are really uniquely positioned. They have the data, they have scaled up customer bases, and their customers can turn on AI services without having to make any upfront investment. So I think it's sort of like an easier, almost like a glide path to adopt AI.
And I think 2025 could be the year where we start to see SaaS companies actually talk about AI, revenues that they're generating off of AI. We're somewhat positive on hardware companies. You know, as I mentioned, we should see demand improve across the board, PCs and smartphones.
I think we have an aged install base that's ripe for replacement. I think you could have a catalyst from AI enabled PCs and smartphones, but my hunch is that's going to be more in the back half of the year. So it may mean that the front half of the year, the first half of the year, it gets off to a little bit slower start than we've seen seasonally, but I think all in, I think 25 is going to be a decent year.
Servers, you know, AI servers will obviously be strong. I mentioned earlier, traditional x86 servers. I think that improves.
I think that improves from enterprises investing more there. I also think it improves because the big hyperscales, the big cloud service providers, you know, they're generating a couple of hundred billion dollars a year in revenue growing 20, 25%, and they haven't really invested into that physical infrastructure to support a lot of those traditional workloads. So I think we could see a bit of a replacement cycle there.
I also, you know, I think we should be fairly constructive on storage and networking across the board, really as a function of better IT spending. And then lastly, you know, tying it all out, I think we're probably a bit more positive on semis. AI investment, that should continue, and I think semis participate, but I think there could be broader performance in that AI trade as it relates to semis.
We could see more chip companies actually participate there, but I think we're also going to see the cyclical part of semis recover. So I've mentioned servers and PCs, you know, autos industrials, we think that gets better. I think a lot of the sort of downticks that we've seen in some of those, in some of the semi companies levered to those markets have really been the tail end of inventory and the distribution channel inventory of customers getting cleaned up.
It feels like those markets are actually either bottoming or poised to bottom, and that should actually help demand next year. And, you know, lastly, we're constructive on memory. You know, memory goes everywhere.
It goes into every single end market. It's sort of like the canary in the coal mine, as far as I'm concerned, for demand indications. And we're constructive on memory because I think what we're looking at for 25 is a pretty tight supply-demand balance in memory, and that should be supportive of prices.
Well, Kevin, it sounds like a very exciting time for the sector as we're heading into a new year, a lot of opportunities there for investors, clients to consider. So, Kevin, thank you again for dropping by as we close out 24. As I said before, I do look forward to having you back in the new year and continuing these conversations.
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