Key Takeaways

Tough Q3 puts info tech sector earnings focus back on cloud, phones as results approach

China’s economic softness and trade conflict with United States remain possible rough spots

The info tech sector’s earnings growth expected to rise, but valuations remain high versus other major sectors

Info tech sizzled in the first half of 2023. Then came the third quarter’s fizzle.

It wouldn’t be fair to say a perfect storm hit technology stocks, which dove nearly 6% in Q3 after climbing 40% in the first half of the year.

However, it was close. Tech performance reflected the combined impact of accelerating U.S. Treasury note yields, slowing Chinese growth paired with increased friction in the U.S.-China trading relationship, and underwhelming Q2 results from many key companies, including Apple (AAPL) and Microsoft (MSFT). Most recently, Bloomberg reported slower iPhone sales in China amid competition from domestic products.

All this has investors worried about tech valuations, which remain the second highest of any S&P sector heading into the Q3 earnings season, though they’re down from recent peaks. Declining revenue at AAPL and slower cloud computing growth at MSFT remain two areas of focus ahead of those companies’ reports.

The cloud industry, which also includes Alphabet (GOOGL) and Amazon (AMZN), though neither is part of the info tech sector, comes under a particularly close microscope every quarter. So does artificial intelligence (AI), which played a key role driving tech stocks higher in early 2023. The question remains: How do tech companies take the tool of AI and generate profits from it?

Another thing to keep in mind: Tech earnings could have an outsized impact on the overall market this quarter because these stocks have been a big part of the 2023 rally. Failure to meet or exceed investors’ expectations could hurt sentiment beyond just this one sector, popping a hole in the thesis that tech can continue carrying the rest of the market upward.

Also, the top five stocks by market weighting, which includes AAPL and MSFT, account for about 25% of the total value of the S&P 500® index (SPX), another reason why their earnings results can be so influential.

Dollar, geopolitics in focus after recent turbulence

Another element this quarter is the possible drag from a U.S. dollar that remained firm throughout the summer and recently hit new 2023 highs. Greenback strength might be a weight on guidance as companies look ahead.

The strong dollar was a hindrance for the sector in 2022 but eased in early 2023 before the recent rally, which corresponded with 16-year highs in U.S. Treasury note yields. No sector has more international exposure than tech, which gathers about 60% of its revenue from overseas, according to research firm FactSet. A strong dollar makes U.S. tech products more expensive in other countries, often compressing demand.

Tech’s heavy exposure outside the United States also puts a geopolitical spin on earnings after the recent Hamas attack on Israel. Not that Israel is a major market, but international exposure for U.S. companies was already a challenge thanks to the conflict in Ukraine and the tense situation between China and Taiwan—a center for semiconductor chip manufacturing. And many U.S. tech companies, especially in semiconductors, have partnerships with Israeli firms or recently acquired firms there.

Other major elements investors will likely want to see when tech firms report include supply chain and pricing improvements in semiconductors, stronger PC demand, and stable cloud market growth.

Two weeks of turmoil

The info tech sector’s earnings season is concentrated this quarter in the weeks of October 23 and October 30, a stretch that’s expected to see earnings results from MSFT, AMZN, AAPL, GOOGL, Advanced Micro Devices (AMD), IBM (IBM), Texas Instruments (TXN), and Intel (INTC), according to Earnings Whispers. Amazon isn’t formally a tech company, but its cloud computing business has been its fastest-growing area for many years and competes with MSFT and others. Nvidia (NVDA), another mega-cap tech firm, reports later next month.

Like AMZN, AAPL has a consumer component for many of its main products, especially the iPhone. It just introduced a new version, and that rollout is likely to be discussed in the company’s earnings call.

Negative news for AAPL in Q3 included reports from China that the Beijing government had forbidden its employees from using the iPhone during work hours. These reports coincided with the introduction of a competing phone built by a Chinese company. It’s unclear if this had any impact on AAPL’s business there, but AAPL and other U.S. companies face Chinese troubles already thanks to the trade war between the two countries. China has already clamped down on some sales of Micron’s (MU) chips.

Not to discount the granular aspects facing tech companies as earnings season approaches, but some overarching themes embrace tech as well as all S&P 500 sectors in these unusual economic times.

“Earnings seasons have been murkier than pre-pandemic,” said Kevin Gordon, senior investment strategist at Schwab. “The revenue/profit dynamic is key to focus on for every corner of the market. For the current season, we’re just as focused if not more on revenue growth, both in nominal and real terms, as we are on earnings growth. If we see a repeat of what we had in Q2—where earnings beats were coming via aggressive cost cuts—I would interpret that to be a bit of a negative signal.”

Better earnings might not move the needle

In other words, we might see tech and other stocks punished if they can’t seem to grow earnings through mechanisms beyond cutting costs. Investors likely want to see companies that can grow their revenue organically though new products, grab market share, or improve existing products. Unlike cost cutting or raising prices, these trends often can propel future results.

Just beating what are typically conservative Wall Street estimates won’t likely be enough to keep tech stocks from sliding, as MSFT learned last quarter when its shares fell despite a quarter that exceeded expectations. Guidance from MSFT disappointed last time, and it wasn’t the only tech company that didn’t spark enthusiasm with its outlook. Guidance could be an increasingly important element this earnings season and in the future for MSFT and the rest of tech.

Valuation metrics

The info tech sector recently traded at a forward price-earnings (P/E) multiple of 26, down from 28.4 heading into Q2 earnings season, according to research firm CFRA. That reflects recent weakness in sector performance, but tech remains second only to real estate in terms of forward P/E.

Analysts have gradually raised their earnings expectations for tech since summer. As of mid-October, they expect 4.2% overall earnings per share growth for S&P 500 tech companies, according to FactSet. That’s up from 0.4% on June 30 and reflects better expectations for many large tech stocks including NVDA, AAPL, INTC, and Applied Materials (AMAT).

FALLING BEHIND: S&P 500 tech shares (IXT—candlesticks) recovered in October after a tough Q3, where they were generally outpaced by the S&P 500 index (SPX—purple line). Data source: S&P Dow Jones Indices. Chart source: thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

What to watch

As tech earnings season gets underway, tech investors might have some of the following questions:

How’s cloud demand shaping up? Has the outlook improved, and why, and how does this affect popular platforms like Amazon Web Services and Microsoft Azure?What’s the current consumer demand for popular electronic products, such as video games, cars, phones, and other devices that use technology like chips?Personal computers showed signs of improved sales last time out. Did that improve in Q3?Has China’s slower-than-expected economic progress been an impediment to growth?How’s the merger and acquisition environment shaping up after a slow 2022?Are more layoff announcements on the way after several were already made in late 2022 and early 2023?How has the trade war with China affected the chip industry, with some companies facing sales bans?Does the info tech sector face any challenges from the conflict in the Middle East based on many tech companies’ exposure to Israel?Does AAPL expect the new iPhone to help it improve revenue growth after recently seeing weakness in quarterly revenue gains?Is cloud competition from companies like Oracle (ORCL) and IBM having a major impact on the biggest cloud firms?

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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