CONTRIBUTORS
Matt Cioppa, CFA
VP/Portfolio Manager and Research Analyst
Franklin Equity Group
United States
The year 2024 proved to be another strong one for the technology sector. Despite some unevenness, tech is poised to finish the year among the top-performing sectors within the MSCI World Index.1 Absent a December surprise, 2024 will be the ninth year out of the past 10 that technology has outperformed the broader market (2022 was the only exception).2
We believe we could see another strong year of growth in 2025, driven by three factors:
(1) a steady progression up the generative artificial intelligence (AI) adoption curve;
(2) an improving earnings growth trajectory outside of the Magnificent Seven; and
(3) reasonable valuations on a growth relative basis.
Generative AI: More adoption should translate to more beneficiaries in 2025
GenAI powered the tech sector’s rally in the first half of 2024 but in recent months, some investors have questioned if, and when, true economic value will be created. While we are incredibly bullish on the long-term potential of AI, experience has taught us that foundational technologies often take years to prove their full worth (consider mobile and cloud computing in the late 2000s and 2010s).
In the case of AI, there are a few transitory roadblocks on the way to maximum value creation. Businesses need to modernize their IT infrastructure and connect disparate data sources before building proprietary AI applications. They also need to ensure their data stays private and secure, as well as hire the right talent. And they need the budgets and time to do all the above.
At the same time, software companies that manage digital workflows spent 2024 building AI capabilities to make customers more productive, and we expect this to continue into 2025. We’ve observed tangible progress, with the industry coalescing around the concept of AI “agents” capable of executing a task on your behalf. At work, an agent could analyze customer purchase histories and automatically select and deliver personalized email promotions designed to boost sales. At home, an agent might help plan and book travel, tutor your children in math, or create the weekly family meal plan, including coordinating the purchase and delivery of groceries. We believe this shift toward AI agents will be bolstered by the advances we’ve seen in large language models (LLMs) throughout 2024, as they become much more capable of “reasoning” through complex problems.
The foundation for AI value creation remains in development. However, the progress we saw last year leads us to anticipate faster adoption of AI-driven applications both at work and at home in 2025, potentially contributing to an improving growth trajectory for industries like software and consumer internet. We expect the 2025 “AI beneficiary” basket to be much broader than what we experienced in 2024.
Improving earnings growth trajectory outside of the Magnificent Seven
The Magnificent Seven continued to earn its title last year, with outsized earnings growth relative to the broader market (and the tech sector, specifically). While we believe growth for these companies will remain robust, we think we could see the rest of the sector catch up in 2025.
Mag 7 Versus MSCI World IT Index (excluding Nvidia, Apple and Microsoft)
Sources: Factset, MSCI, as of 30 November 2024. “Magnificent Seven” refers to Alphabet, Amazon, Apple, Microsoft, Meta, Nvidia, and Tesla. MSCI World IT ex-Mag 7 excludes Magnificent Seven index holdings Apple, Microsoft, and Nvidia. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Important data provider notices and terms available at www.franklintempletondatasources.com. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
In addition to a broader mix of AI “beneficiaries,” we see several factors contributing to this dynamic. Some areas of the tech sector, particularly those with less exposure to the initial AI “build” phase, experienced cyclical headwinds in 2024. For instance, growth across many enterprise software companies slowed due to tight IT budgets, as corporations dealt with uncertainty surrounding US elections, the pace of interest rate cuts, broader macro indicators, and how to properly resource genAI initiatives. We expect many of these headwinds to fade in 2025, supporting an acceleration in overall sector growth. The outcome of the US election may bring lower corporate tax rates and deregulation, which could support corporate IT spending and small business formation. With election uncertainty resolved, businesses can resume investments with greater visibility into policy impacts, which could naturally flow into IT budget growth. Elsewhere in the sector, semiconductor companies not exposed to AI data centers, but rather to the automotive, industrial, smartphone and PC industries, faced pressure throughout 2024 as these markets were in a cyclical lull. Recent signals point to stability and a path toward reacceleration in several of these market segments, which could bolster the group.
Sector valuation remains reasonable on a growth-adjusted basis
After two years of strong performance, some technology investors are wondering if valuation has gotten ahead of itself. While this may be the case in select pockets of the sector, in aggregate, we don’t believe this is true. We think it’s important to anchor valuation to earnings growth, and the current price to earnings relative to growth (PEG) ratio of the MSCI World Information Technology Index stands just slightly above the five-year average. In other words, despite recent strong performance, we don’t believe current valuations are excessive given the sector’s attractive secular growth and quality characteristics.
As innovation investors, we are incredibly excited about technology’s growth potential in the year, and ultimately, the decade ahead. While the sector will undoubtably experience some periods of volatility, we see tremendous potential for patient, long-term investors.
Endnotes
- Source: MSCI, as of 30 November 2024. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Important data provider notices and terms available at www.franklintempletondatasources.com. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
- Ibid
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