A Potential Headwind for Big Tech That No One is Talking About

The U.S. Technology sector has delivered blistering returns so far in 2023. Through the end of June, the sector was up +39%, more than double the S&P 500’s 16.2% year-to-date return. Investors should recall, however, that these positive returns follow a dismal 2022, when Technology disproportionately sold off during the period of rising interest rates and the bear market.¹

The turnaround has been welcomed, and investors are largely pointing to two tailwinds supporting the strong rally in the new year.

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The first tailwind is the excitement surrounding Artificial Intelligence. Google’s CEO, Sundar Pichai, referred to AI as a technology “as important—or more important—than fire and electricity.” This may seem like hyperbole coming from a key stakeholder in AI’s future, but when compared to other comments about AI from thought leaders across the economy, it is clear that AI may indeed be the next Internet or iPhone moment.

Companies are announcing one after the other how they plan to develop AI tools or implement them within business models to raise productivity. Enthusiasm is making its way into earnings calls as well. As seen below, the share of Russell 3000 index companies that mentioned AI on earnings calls has soared over the past six months:

According to Goldman Sachs, generative AI could raise labor productivity growth by 1.5% over 10 years while increasing annual global GDP by 7+%. In dollar terms, this means AI could create $7 trillion of new economic value over the next decade. That’s not a small number – $7 trillion is bigger than the third largest economy in the world, which is currently Japan.

To be fair, the economic effects of AI do not seem likely to be felt immediately or perhaps as greatly as the enthusiasm suggests. And the economy may need to confront swaths of lost jobs in the process, which can disrupt the labor market and dent consumer spending. The upshot, however, is that historically automation and other technological breakthroughs have created far more jobs than they’ve destroyed. A vast majority of long-term employment growth has come from the emergence of new occupations following technological innovation. The combination of drastic savings in labor costs, new job creation, and productivity gains can raise the prospect of economic growth—and profit growth—significantly. Investors seem to be buying into this possibility now.

The second tailwind for Technology in 2023 has been the interest rate cycle. As readers are aware, the Federal Reserve raised the benchmark fed funds rate from near zero to over 5% in the span of a year, which arguably hurt growth stocks the most. Since higher rates discount the value of future profits, investors tend to favor companies with stable earnings (value stocks) versus ones with high-profit potential (growth) in rising interest rate environments. That’s what we saw in 2022.

But that headwind shifted in 2023. In addition to enthusiasm for AI, we think Technology stocks have been outperforming this year because of the expected peak in the interest rate cycle. Inflation has been locked in a downtrend, and the Fed now expects to raise rates only one or two more times before a long pause. If investors feel as though they know where interest rates will peak—and there’s a sense that rates are more likely to fall than rise in the medium term—it only adds to the willingness to shift back into growth/technology stocks, in our view.

The Potential Headwind No One is Talking About

In a word: taxes.

For as long as major technology companies have been growing their profits, users, and expanding services around the world, they’ve been able to concentrate their earnings in home countries or countries with attractive tax rates. That could be changing very soon.

The old tax rules were written in an era where multinational corporations needed physical presence, i.e., production and sales, in a country to earn profits there. A company would likely need to set up a factory or a store to reach customers in a foreign market. Taxing those earnings and operations was fairly straightforward for foreign governments.

Not so with major technology companies, which often offer services in digital format only.

Governments around the world, particularly in Europe, have grown frustrated watching technology companies’ profits soar from digital services while tax revenues haven’t budged. Some governments began to introduce their own taxes, largely in an effort to bring the U.S. to the table to overhaul the rules.

That brings us to early July 2023, when tax officials from 143 jurisdictions have been working to ink a deal that would create a new tax structure for approximately 100 of the world’s biggest companies, mostly in technology but also in other industries like pharmaceuticals. All told, the compromise seeks to reallocate the taxation of approximately $200 billion in corporate profits around the world.

The headwind for technology companies does not seem to be the taxes themselves, which would largely amount to reallocation of where the tax money flows. The risk is in a deal not being reached at all, which may result in governments around the world imposing their own levies – known as Digital Services Taxes – which can create a maze of new tax laws and obligations that technology companies must adhere to. And that’s the last thing these companies want.

Bottom Line for Investors

The previously determined timeline to reach an agreement was early 2023, which we have clearly crossed over. The countries involved appear to be aligning on many points, but some notable holdouts include Canada and Russia. Getting them over the line could be a challenge.

Failure to reach a deal could neutralize the brisk tailwinds Technology companies are currently feeling from the promise of AI and peaking interest rates, especially if the end result is a web of individual country taxes that crimp earnings. Investors should keep their eye on this story – big news should arrive later this summer.

Most investors can get where they need to go over the long term by owning a diversified portfolio of stocks and/or ETFs. Positioning a portfolio across sector, style, size, and country will almost always provide exposure to the best performing areas of the market while minimizing the impact of the weak performing areas of the market. Volatility gets smoothed out over time, and an investor can earn attractive equity-like annualized returns. It doesn’t have to be more complicated than that, and investors don’t need a huge win in a single stock or IPO or SPAC to get there.

In fact, “diversify your portfolio” is one the most basic pieces of investing advice. Sadly, in our experience many investors still put all (or most) of their eggs in one basket.

At Zacks Advantage, we strive to help every investor properly allocate their assets. In fact, we’ve put together a helpful guide to help you understand the basics of portfolio diversification, including:

• 4 myths of a properly diversified portfolio
• Why the average investor’s returns trail almost every other investment category
• How to create a truly well-diversified portfolio

Get our free guide, Is Your Investment Portfolio Actually Well-Diversified?,⁴ to learn how to create a truly diversified portfolio.

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*This rating was awarded by The Robo Report on 7/1/2023 in respect of the period 4/1/2023 to 6/30/2023. We do not compensate The Robo Report to obtain this rating. However, we pay compensation to the Robo Report to use their logo in connection with advertising this rating.

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¹ Wall Street Journal. July 12, 2023.

² Zacks Investment Management may amend or rescind the Is Your Investment Portfolio Actually Well-Diversified? guide offer for any reason and at Zacks Investment Management’s discretion.

³ Goldman Sachs. 2023.

⁴ Zacks Investment Management may amend or rescind the Is Your Investment Portfolio Actually Well-Diversified? guide offer for any reason and at Zacks Investment Management’s discretion.

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