Key points

• Global equity markets had a strong July, largely on the back of better-than-expected economic data.
• Technology outperformed the broader market, with small and mid-cap tech stocks leading the way.
• As AI continues to develop, many software companies are starting to clarify how they could monetise new AI functionality, although they are more cautious on the timeline to material revenue contribution.

Market review

Global equity markets continued their strong run in July as the MSCI All Country World Net Total Return Index returned 2.5%, while the S&P 500 Index and the DJ Euro Stoxx 600 Index delivered 2.1% and 1.9% respectively (all returns are in sterling terms unless stated otherwise). Economic data pointed to better than expected growth (Q2 real US GDP growth of +2.4% annualised), inflation continues to wane and employment remains resilient, which supported hopes that a severe recession can be avoided – a ‘soft landing’ scenario. Value and cyclical sectors including energy and financials led the market higher, and the old economy Dow Jones Industrial Average matched a long-standing record for 13 consecutive daily gains in a month.

Data during the month supported the ‘soft landing’ thesis. The US Consumer Price Index (CPI) rose +0.2% m/m in June, modestly below market expectations of +0.3%. Core CPI, which excludes volatile items such as food and energy, slowed to +4.8% y/y, the lowest since October 2021. Forward-looking inflation measures suggest further deceleration ahead. Looking further out, preliminary University of Michigan Surveys of Consumers pegged year-ahead inflation expectations at +3.4% in July, up modestly from +3.3% in June, but down significantly from the peak levels (+5.4% in April 2022), while five-year expectations remain well-anchored at +3.1%.

The US labour market remains robust although it appears to be gradually losing momentum. The US economy added 209,000 jobs in June (below forecasts of 225,000), the lowest reading since December 2020; April and May estimates were revised down by 110,000 combined. Wage growth remained elevated, however, with average hourly earnings edging up +0.4% m/m in June, above forecasts of +0.3%.

After a June pause, at its July meeting the Federal Reserve (the Fed) raised the benchmark interest rate by 25 basis points to a 5.25-5.50% target range, a 22 year high. Chair Jerome Powell reiterated the Fed is focused on bringing inflation down to its 2% target, admitting they have “a long way to go”. He acknowledged tighter credit conditions are likely to weigh on the economic activity, however, and oil prices increased +16.1% during the month to pass >$80 per barrel, the highest monthly gain since January 2022. The Fed will continue to make decisions meeting by meeting, dependent on incoming economic data.

Technology review

The technology sector outperformed the broader market in July as the Dow Jones World Technology Index returned 2.9%. Large-cap technology stocks trailed their small and mid-cap peers as investors became more comfortable with the economic trajectory: the Russell 1000 Technology Index (large cap) and Russell 2000 Technology Index (small cap) returned 3.1% and 3.9% respectively. Despite a NASDAQ 100 Index rebalance designed to reduce the weight of mega-cap technology companies, this group still outperformed, as the Goldman Sachs MegaCap Tech Index returned 4.8% (all in sterling terms).

There was high dispersion between technology subsectors. The Philadelphia Semiconductor Index (SOX) returned 4%, while the NASDAQ Internet Index and Bloomberg Americas Software Index returned 6.6% and 0.9% respectively.

The technology sector outperformed the broader market in July as the Dow Jones World Technology Index returned 2.9%.We are in the middle of second-quarter earnings season. In the internet sector, Alphabet reported revenue and earnings per share above expectations. Google Search grew +5% year-on-year (y/y), accelerating from +2% y/y last quarter, driven by strength in the retail division, while YouTube was better than expected, suggesting the advertising market has stabilised. Google Cloud grew +28% y/y in constant currency¹ (cc; thereby eliminating the effect of currency fluctuations) terms and did not decelerate from the previous quarter, although management noted “continued moderation” in cloud consumption trends. Overall, operating margin was better than expected and CEO Sundar Pichai emphasised the company continues to slow expense growth and the pace of hiring, focusing on “durable savings” to fund investments in artificial intelligence (AI). Commentary on the AI opportunity was encouraging, with management noting that 70% of generative AI ‘unicorns’ (early-stage private companies with a valuation in excess of $1bn) are Google Cloud Platform customers. The AI opportunity means capital expenditures are expected to increase in 2024, driven by AI chip purchases.

Meta Platforms delivered strong results, with revenue growth accelerating to +12% y/y cc (from +6% y/y cc in Q1), driven by improving advertising market trends. Management gave guidance for further revenue growth acceleration to +12.5-21.5% y/y in Q3, well ahead of expectations. CEO Mark Zuckerberg commented that the company was seeing “strong engagement across apps”, while it has “the most exciting roadmap I’ve seen in a while with Llama 2, Threads, Reels, new AI products in the pipeline and the launch of Quest 3 this fall.” We should find out more at the company’s developer conference in September. Management surprisingly lowered its capex (capital expenditure) guidance from $30-33bn to $27-30bn, reducing non-AI-related spending and delaying some investments until 2024.

Uber Technologies (Uber) reported strong 2Q23 results with the number of trips growing +22% y/y to 2.3 billion and bookings up +18% y/y cc, while profitability materially exceeded consensus expectations, driven by strength across mobility and delivery segments. The freight market continues to be weak, although this is a small part of the business. Next-quarter top and bottom-line guidance was also above expectations, with the company on track to meet or exceed its long-term profit targets. This was not enough to drive a positive stock price reaction, however, after a strong run ahead of results.

In software, Microsoft delivered solid results with revenue +10% y/y cc, above estimates, with strength across segments. Azure revenue growth of +27% y/y cc was at the upper end of the +26-27% guided level and met investor expectations. AI services contributed one percentage point to Azure growth this quarter, as expected. Impressively, Microsoft now has >11,000 Azure OpenAI Service customers, representing dramatic growth of 8,000-9,000 since March. Guidance for +25-26% y/y cc growth for Azure next quarter was in line with expectations, but only embedded a two-point contribution from AI services (some investors were hoping for more) as growth is expected to be “gradual” and the impact will be weighted towards the next calendar year. There was also no news on when M365 Copilot (a new AI-infused version of Microsoft’s productivity suite products) will be generally available. The stock reaction was also dampened by the lack of FY24 revenue guidance, although management said they expect quarter-on-quarter (q/q) growth in capex during the year, which we believe is a positive future demand signal for AI services.

ServiceNow delivered a solid quarter with top and bottom-line results better than expected. The company signed a surprisingly high number of large deals given the macroeconomic environment, with 70 deals worth >$1m, of which 12 were >$5m and three >$10m. The Q3 outlook was broadly in line with estimates, while management nudged up FY23 subscription revenue guidance by more than the Q2 upside, taking growth to +24% y/y cc, and reiterated expectations for a 30% free cashflow margin. Management characterised the demand environment as “very durable” and described their guidance as “prudent” once again. The company also announced a new product offering called “Pro+” which offers generative-AI capabilities for a 60% premium to list pricing, and a new partnership with NVIDIA and Accenture to help fast-track enterprise generative AI capabilities.

In payments, Mastercard reported net revenue up +15% y/y cc, ahead of estimates at +13% y/y cc, driving earnings upside. Volumes were modestly lower than expected in the US and worldwide, but transaction growth was higher (ie more smaller transactions). Encouragingly, growth trends in the US and cross-border transactions improved modestly from June to July, while guidance for revenue to grow low-teens y/y cc was in line with expectations.

In semiconductors, TSMC lowered its 2023 revenue growth guidance from -3% y/y to -10% y/y due to weaker-than-expected demand across most end markets and continued inventory adjustments by customers. Management noted strong demand for AI applications, which accounted for 6% of revenue in the quarter, but this will be insufficient to offset the overall cyclicality of the business. The ramp of its leading edge three nanometre (3nm) process for high-performance computing and smartphones will contribute to revenue growth in 2H23 but will also have a negative impact on margins. Although TSMC faces a challenging 2023, management continues to see 15-20% revenue growth over the long term driven by high-performance computing, with server AI processor demand expected to grow at close to 50% on average for the next five years.

In software, Microsoft delivered solid results with revenue +10% y/y cc, above estimates, with strength across segments.Semiconductor production equipment (SPE) vendors sold off when TSMC guided capex to be at the lower end of the previous $32-36bn range in 2023, while management said it is too early to talk about 2024. ASML’s top and bottom-line results were better than expected, however, and management increased its 2023 revenue guidance from +25% y/y to +30% y/y. However, bookings were down -47% y/y and the company’s backlog declined to €38bn from €38.9bn in the previous quarter. Management’s commentary about 2024 was incrementally cautious as they believe a broader semiconductor recovery could be pushed out as global macroeconomic uncertainties persist. Management also flagged delays to semiconductor fabrication plant construction in the US due to a lack of skilled workers required to build them (TSMC has pushed out its Arizona production plans to 2025 which corroborated this).

Tesla’s results were mixed but broadly in line with expectations. Revenue was +47% y/y (above expectations), while automotive gross margin (excluding regulatory credits) was 18.1% (approximately in line), only -90bps q/q despite further price cuts in April due to scale and cost reduction efforts. Management maintained guidance for 1.8 million vehicle deliveries in 2023, but the key question remains whether they will be able to generate sufficient demand for the Model 3/Y at these price points to sustain their volume growth ambitions. CEO Elon Musk did not rule out further price cuts (which may lead to lower margins if they outweigh cost reductions), emphasising the long-term potential of the installed base if full self-driving can be achieved. The company is open to licensing its full self-driving solution and is currently in discussions with an automaker.

Outlook

Q2 results were better than expected, albeit with some ‘sell the news’ reactions to earnings reports that were broadly as expected. This reflects raised investor expectations following a strong year-to-date performance for many technology companies. In some cases, large near-term stock reactions have reflected elevated or depressed investor expectations as much as business fundamentals or major earnings surprises, and unloved segments of the market such as unprofitable technology have moved higher (the Goldman Sachs Non Profitable Tech Index rose +15% in July) alongside an increase in retail investor participation (Goldman Sachs High Retail Sentiment +16% in July).

We had raised a little cash coming into earnings season given the near-term risk/reward appeared less favourable for companies that have performed strongly over the past several months, but we remain constructively positioned given market breadth has shown signs of improvement and we remain very positive on the transformative impact of AI over the longer term.

Q2 results were better than expected, albeit with some ‘sell the news’ reactions to earnings reports that were broadly as expected.In recent weeks, we have received greater clarity on the different ways in which AI features and functionality will be monetised for a number of software companies. This includes separate generative AI versions of products such as Microsoft’s CoPilot, Salesforce’s EinsteinGPT and ServiceNow’s Pro+ as well as adding generative AI capabilities to premium tiers to drive upgrades and a consumption element to pricing to reflect higher use of computing resources. Initial pricing expectations have been higher than expected (eg M365 CoPilot priced at $30 per user per month versus expectations of $10-15), but the timeline to adoption and material revenue contribution has been more conservative than some AI bulls might have hoped. This is consistent with IT survey and spending data where there is early evidence generative AI is  gaining traction in IT spending intentions, such as >50% of CIOs reporting generative AI innovations are having a direct impact on 2023 spending priorities, but <5% have launched significant new projects (according to Morgan Stanley). Keybanc’s recent Chief Information Officer survey found generative AI as the newly established number one priority.

More broadly, IT spending surveys indicate a stable environment, although the path for a cloud computing consumption recovery is still uncertain. While things should improve as long as the macroeconomic environment remains consistent with a ‘soft landing’ trajectory, real interest rates and longer-term rates (eg US 30-year bond yield) are moving higher, which suggest the range of outcomes could be broadening and the market rally might take a pause after the sharp move higher this year. While we might see higher near-term volatility after the recent downgrade of US debt by Fitch, we are encouraged by the fact that 2023 earnings revisions within the technology sector (+5%) have been better than the broader market (+1%).

^{1 Constant currency reporting is an accounting technique used by companies to present financials year-over-year for comparative purposes without the effects of currency movements}