Tech rally grounded in fundamentals

Summary

Russ Koesterich explains how tech’s resurgence signals shifting economic expectations and strong earnings, supported by historically reasonable valuations.

Key Takeaways

• As expectations have shifted toward slower growth, higher inflation, and higher rates, investors have rotated back to sectors like large-cap technology and semiconductors, capable of delivering durable earnings in a tougher macro environment.
• Despite the sharp rebound, tech valuations appear justified by strong profitability and elevated return-on-equity, suggesting continued leadership is possible.

Stocks have surged to new highs, but leadership has shifted. Since the start of the Iran war, the U.S. tech sector has advanced roughly 33%*, while semiconductor companies have gained more than 45%*, both easily outperforming the broader market.

When I last discussed technology earlier in the year, things looked very different. Between the end of Q2 last year and the start of the war, the technology sector underperformed both the market and value stocks. Performance was particularly challenged for software companies, with the industry losing more than -25%*. What changed? Two things: the economic landscape and relative earnings.

*Source: Bloomberg. U.S. Tech Sector performance represented by BBG GIC Information Technology Sector Index. Semiconductor companies’ performance represented by Bloomberg GIC Semiconductors & Semiconductor Equipment Industry Index. Software companies’ performance represented by Bloomberg GIC Software & Services Industry Index.

Less growth, more inflation

As recently as late February, most investors assumed a supportive economic backdrop, one defined by strong growth, falling inflation and lower interest rates. Since the start of the war, expectations have rapidly adjusted. A survey of Bloomberg economists expects 2026 growth of 2.1%, down from 2.5% in early March.

Not only do investors expect slower growth, but faster inflation and a less supportive Fed. The consensus for changes in the consumer price index (CPI) has risen from 2.65% three months ago to 3.5% today. In the process, markets have shifted from expecting two ratecuts to a rate hike.

This shift in economic expectations, coupled with a significant increase in long-term interest rates, has led investors away from many of the themes – European equities, value, small caps – that dominated late last year. In an environment of slower growth and higher rates, investors have rotated back towards secular growth names able to generate earnings even in a less supportive economy.

Earnings surge

Investors have been rewarded for their faith in large tech companies. For Q1, tech sector earnings grew by approximately 50%, twice the pace of the broader market. Parts of tech, notably semiconductors, did even better. Superior growth coupled with the sector’s outsized weight means that tech companies contributed more than half of all earnings growth for the quarter.

Going forward, we believe this is likely to continue. With tech capex continuing to expand, benefiting semiconductor and hardware firms, technology companies should continue to lead the market in earnings and sales growth (see Chart 1).

Chart 1
Global sector earnings & sales growth
12m forward earnings and sales growth estimates (MSCI World sectors)

Not as expensive as you would think

The obvious objection to continued tech leadership is the magnitude of the recent gains. That said, by historical measures the sector does not look particularly expensive. The tech heavy Nasdaq Index is trading at approximately 25x forward earnings, below its 5-year average valuation. Valuations look even more reasonable when adjusting for the market. Currently the S&P 500 technology sector trades at a 40% premium versus the market, well below the 2026 peak. Today’s premium is arguably justified given the sector’s remarkable 34% return-on-equity (ROE). While tech stocks have enjoyed a spectacular rebound, given earnings momentum and the evolution in the economic outlook, they can continue to lead.

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