LONDON, 20 May — Once again, investors in technology shares have had to absorb some bitter losses as the Morgan Stanley Capital International (MSCI) Tech Index has lost 14.42 percent since the beginning of the year. Increasingly, investors have started wondering when if ever they can expect capital spending on IT to pick up and a corresponding rise in the share prices of tech companies.
The opinion prevailing among players in the market is that, without increased capital spending on new equipment, particularly for tech products and services, the burgeoning upturn in the US economy could be in jeopardy.
Unfortunately — or perhaps fortunately! — these same players should remember that the tech sector is responsible for only 4 percent of the GDP in the United States, although it does make up some 50 percent of the volume of trade assessed in the S&P 500. This last disproportion, of course, is precisely why the IT sector enjoys such exaggerated importance in the eyes of the society at large. All it takes to see the fascination exerted by technology is a glance at an newspaper or a popular economic magazine. Compared with this regard, the manufacturing sector, which does after all churn out fully 16 percent of the US GDP, is a wallflower as far as the common folk is concerned.
The Clariden Bank operates on the assumption that a cyclical recovery in IT capital spending (i.e. particularly replacement capital spending) is foreseeable. On the other hand, a structured recovery without an accompanying revolutionary development of new technologies, as was the case during the previous boom phase, is inconceivable.
To make such an assessment, it is important to distinguish between replacement or expansion capital spending, and new capital spending. Until the middle of 2000, expenditure on IT assets (without replacement capital spending) grew by more than 25 percent annually. On closer inspection, however, it becomes clear that two sectors in particular were driving this high level of growth: The telecom service companies and the concomitant communications equipment suppliers. In comparison, IT capital spending in other industries is modest. In the telecom sector alone, capital spending growth reached a high point of 39 percent in 2000. Apart from this sector, however, the rest of the market had already reached its high point by mid-1998.
This is a crucial piece of information for assessing the likelihood of a cyclical recovery. Furthermore, it underscores our proposition at the outset: A moderate upturn in IT capital spending and thus in share prices can be expected over the course of 2002. The main reason for such optimism, we believe, is that IT assets acquired in the past (1998) will be completely outdated by 2003. In fact, companies are starting to undertake replacement and new capital spending in various industries, as for instance in the semiconductor sector.
There is a minor downside to this otherwise positive development: The investments are for the most part cost-induced. A wide range of IT managers are convinced that the progress of standardization could act as a trigger or catalyst for a variety of cost-reduction programs. On the other hand, certain sectors that have to date allowed themselves the luxury of an artificially high cost structure may be feeling the pressure to produce respectable returns. Be that as it may: Margin pressure is on its way up, and will be bringing with it the need for fundamental changes in corporate profitability structures.
In fact, it is likely that, because of overcapacities, margins in the tech sector will remain under pressure for considerably longer. After all, IT margins often follow improvements in capacity usage (same true for profits), and it seems clear that we are at present in a historic trough. Exaggerated expectations of a stunning recovery in profits in 2002 are accordingly to be dampened.
Nevertheless, it would be wrong to warn against making investments in the tech sector altogether. We believe that capital spending, going forward, will take place not in hardware but rather in middleware. By middleware we mean technologies providing connections between and among the various existing technological infrastructures. The tech "gold rush" saw a lot of uncoordinated buying of IT infrastructure, all of which was installed independently and never been tested for its ability to communicate with other systems. This meant that the various discrete IT systems have never been used optimally and still contain great potential for boosting capacity and efficiency.
Clariden Bank views investments in Customer Relationship Management (CRM) software, storage network, and semiconductors as being the most likely to allow companies to profit to the full from the coming recovery. What is unlikely is a rapid recovery in the telecom services and equipment industries.
We therefore recommend under-weighting this sector.
(This article is contributed by Clariden Bank which is a wholly-owned subsidiary of Credit Suisse specializing in asset and client relationship management.)