Why tech stocks will continue to lead the market in 2025

• Although the market rally is expected to extend beyond the tech sector in 2025, we foresee the tech sector maintaining its leadership, driven by its superior earnings growth relative to other sectors.

• AI is poised to remain a key driver of earnings growth, with Big Tech companies showcasing their ability to monetize AI, particularly through cloud revenues.

• Big Tech’s capital expenditures will keep rising but should remain at sustainable levels as AI demand stays strong and AI revenues increase.

• We continue to favour Big Tech companies, recognising their leadership in AI innovation, global market dominance, strong competitive advantages, and solid balance sheets.

• Despite the strong performance of the tech sector in 2024, valuations remain compelling. Our target price for the Invesco NASDAQ Internet ETF in 2026 is USD 61, indicating an upside potential of 28%.

Tech stocks delivered impressive returns in 2024. The tech sector, as measured by the Nasdaq CTA Internet Total Return Index, delivered total returns of 30%, outpacing the S&P 500’s strong gain of 25%. Given the substantial rally last year, investors may be concerned about the sustainability of the tech sector’s outperformance, particularly as valuations appear stretched and the market rally broadens to include other sectors.

Strong earnings growth to sustain tech’s stock market leadership

In the first half of 2024, gains in the US stock market were primarily driven by the tech sector. The equal-weight S&P 500 index delivered only one-third of the returns of the market-cap-weighted S&P 500 index, which is heavily influenced by tech giants such as Apple, Nvidia and Microsoft. In the second half of the year, however, both indices posted comparable gains, suggesting that the market rally had begun to expand beyond the tech sector.

Figure 1: S&P 500 rally has broadened beyond tech

While this broadening trend is likely to persist on the backdrop of a resilient US economy, the Federal Reserve cutting rates, and improving earnings growth in non-tech sectors, we expect the tech sector to continue leading markets.

Tech stocks, primarily classified within the Information Technology and Communication Services sectors, are expected to experience stronger earnings growth relative to other sectors (Figure 2). As share prices are fundamentally driven by earnings, the promising earnings outlook of the tech sector suggests that it should continue to outperform over the medium to long term.

Figure 2: Earnings growth of tech-related sectors to remain robust in the coming years

AI is driving revenue growth and cutting costs for Big Tech

One of the key drivers of earnings growth for the tech sector is Artificial Intelligence (AI). Unlike the many unprofitable dot-com stocks in the late 1990s and early 2000s that were valued based on metrics like “eyeballs” and “page clicks”, the current AI boom is led by highly profitable, Big Tech companies that have demonstrated their ability to monetize AI.

Increase revenue

Big Tech companies like Amazon, Google, and Microsoft are experiencing significant growth in their cloud revenue due to the increasing demand for AI solutions. Given the capital-intensive nature of AI development, many companies are relying on Big Tech’s cloud infrastructure and AI tools to train their own large language models, integrate AI capabilities into products, and enhance business operations.

Warner Bros. Discovery, for instance, built an AI captioning tool with Google Cloud’s Vertex AI that can automatically generate a time-coded and formatted caption file for videos, streamlining what was once a time-consuming and manual process. With human input limited to verifying accuracy and synchronization, Warner Bros. Discovery achieved a 50% reduction in overall costs and cut the time required for captioning by 80%.

In addition to enabling enterprises to build their own AI capabilities, Big Tech has enhanced their existing core offerings with AI features. Microsoft, for instance, has integrated AI features into its Microsoft 365 productivity suite through Copilot, enabling users to boost their workflow with AI-driven tools available for an additional subscription fee.

These factors have fuelled strong double-digit year-on-year growth for the cloud segments of Alphabet, Amazon, and Microsoft in the third quarter of 2024 (Figure 3). Google Cloud revenue increased 35% YoY to USD 11.4 billion, driven by accelerated growth in Google Cloud Platform (GCP) across AI Infrastructure, Generative AI Solutions, and core GCP products. Similarly, Microsoft Cloud revenue grew by 22% YoY, reaching USD 38.9 billion, while AWS revenues rose 19% YoY to USD 27.5 billion.

Drilling deeper into AI-specific contributions, Microsoft’s AI business is on track to exceed an annual revenue run rate of USD 10 billion next quarter. Although Amazon and Alphabet did not disclose precise figures for their AI revenues, their management did highlight that their AI businesses are generating billions in revenue.

Figure 3: AI demand is driving cloud revenue growth in Big Tech

In contrast to the cloud-based AI strategies of Alphabet, Amazon, and Microsoft, Meta has not generated direct revenue from its AI products. Instead, it mainly uses AI to enhance user engagement on its social platforms and improve ad performance, leading to increased advertising revenue. During Meta’s 3Q24 earnings call, CEO Mark Zuckerberg said that “Improvements to our AI-driven feed and video recommendations have led to an 8% increase in time spent on Facebook and a 6% increase on Instagram this year alone. More than a million advertisers used our GenAI tools to create more than 15 million ads in the last month, and we estimate that businesses using Image Generation are seeing a 7% increase in conversions.

Cost reduction

Besides monetising AI through products and services, Big Tech is also leveraging its own technologies to boost the productivity of its employees.

At Alphabet, over 25% of all new code is now generated by AI, with engineers reviewing and refining the outputs. This has helped their engineers “do more and move faster”.

Similarly, Amazon has integrated Amazon Q, its Gen AI assistant for software development, into its internal systems and used it to speed up application updates. For example, upgrading applications from Java 8 or 11 to Java 17 now takes only a few hours, compared to the 50 developer-days it used to require for a single app. As a result of leveraging Amazon Q, the company saved an estimated 4,500 developer-years of work. The enhanced security and reduced infrastructure costs that the upgrades bring also translates to an estimated USD 260 million in annual cost savings.

These are but a handful of the many ways AI can help businesses achieve significant cost savings.

Big Tech’s heavy capex is justified

In Big Tech’s third quarter earnings calls, executives were unanimous in expressing the need for greater spending on AI as they see demand remaining stronger than available supply. Amazon CEO Andy Jassy aptly captured the current state of affairs by stating that “pretty much everyone today has less capacity than they have demand for, and it's really primarily chips that are the area where companies could use more supply.”

This focus on AI investment builds on comments made during the 2Q24 earnings call, where executives expressed a willingness to risk overbuilding AI capacity. They emphasised that the cost of missing early AI opportunities far exceeds the risk of overspending.

Taking into account Big Tech’s willingness to spend and management’s latest guidance, we expect Big Tech's capital expenditures to exceed USD 250 billion in 2025.

Figure 4: We expect the surge in capital expenditures to continue

Understandably, there are concerns that potential overinvestment in AI capacity could impact return on investment (ROI) and earnings. However, given the broad utility of AI across industries and the fact that AI adoption is still in its early stages, we expect AI demand to remain durable.

Throughout history, the transformative potential of new technologies has often been underestimated. Morgan Stanley reports that initial market estimates for personal computer, mobile phone, internet and cloud computing fell short by an average of 38% (Figure 5). As AI continues to evolve at a rapid pace, it is possible that we are again underestimating its true market potential. Afterall, we are already seeing a shift from Gen AI applications that rely heavily on user prompts, toward more sophisticated AI agents capable of making decisions and solving complex problems in dynamic situations independently.

One such example is Air India’s AI.g. Developed using Microsoft’s Azure OpenAI Service, this virtual assistant handles 97% of customer queries completely autonomously, saving the airline millions in customer support costs while enhancing customer experience.

Figure 5: People tend to underestimate the long-term effects of new technologies

Source: Morgan Stanley AI Guidebook: Fourth Edition, 23 January 2024; Capital Group

Although AI revenues currently lag capex, we expect that gap to narrow as more businesses realise the immense benefits of incorporating AI into their operations. Big Tech’s capex-to-sales ratio is projected to stay below historical peaks, with the exception of Microsoft (Figure 6). Overall, we do not see Big Tech’s rising capex as a cause for concern.

Figure 6: Big Tech’s capex-sales ratio remains healthy

Big Tech remains our top pick

Although there are plenty of investment opportunities in the tech sector, we continue to favour Big Tech for several key reasons.

Firstly, Big Tech companies are leading the charge in AI development. They not only develop cutting-edge AI technologies themselves, but also back independent model-makers like OpenAI, Mistral, and Anthropic through funding and partnerships. As such, they are expected to be key beneficiaries of future AI growth.

Secondly, US tech giants have global business models and strong competitive advantages. These companies operate on a global scale and have consistently been able to grow their revenue by capturing market share in international markets. As such, these companies benefit from global growth, and not just growth in the US.

Amazon, Microsoft, and Alphabet currently hold 63% of the global cloud market share, while Alphabet, Meta and Amazon collectively capture more than 60% of digital advertising spending. Their key competitive advantages such as network effects and high switching costs, have made their products and services integral to the daily operations of global consumers and businesses, enabling them to sustain growth and profitability over time. For many, it would be difficult to imagine a world without Google’s search engine, Microsoft Office or social media platforms like Facebook and Instagram.

The third reason why we favour Big Tech is because of their strong balance sheets. Big Tech firms have huge cash reserves that allow them to invest significantly in R&D, and acquire or invest in promising up-and-coming companies, further cementing their dominant position. In the unlikely scenario that the AI boom does not play out as anticipated, Big Tech companies certainly have the financial strength to absorb any potential losses stemming from overinvestment in AI. Their manageable debt levels and strong credit ratings also allow them to borrow at lower costs compared to smaller firms. With solid balance sheets, these companies are well-positioned to navigate a higher-for-longer interest-rate environment.

Figure 7: Big Tech companies are cash rich, with healthy debt levels

Tech valuations are still looking attractive

Given the run up in tech stocks last year, it is easy to assume that valuations are overstretched. However, the gains in tech stocks have been underpinned by robust earnings growth.

Applying a fair P/E multiple of 30X to 2026 estimated earnings, we arrive at a target price of USD 61 for the Invesco NASDAQ Internet ETF (NASDAQ: PNQI), which represents an upside potential of 28%. Aside from ETFs, investors looking to invest in the tech sector via an active approach can also consider Fidelity Global Technology A-ACC-USD and Eastspring Investments Unit Trusts - Global Technology SGD.

To summarise, we believe that the tech sector will continue to outperform, even as earnings growth in other sectors improve. We think that AI has immense potential in the long run and that Big Tech is well-positioned to capitalise on these opportunities. Lastly, robust earnings growth has kept valuations in the tech sector attractive, in spite of the strong rally in 2024.

Table 1: Projections for the Nasdaq CTA Internet Total Return Index

NETX Index	2023	2024E	2025E	2026E
Earnings Per Share (EPS)	33.11	48.25	54.74	63.60
Earnings Growth YoY	76.85%	45.73%	13.45%	16.19%
PE Ratio (X)	33.84	30.81	27.16	23.38
Upside Potential (based on a fair PE Ratio of 30X)	-	-	-	28.3%
Source: Bloomberg Finance L.P., iFAST Compilations. Data as of 22 January 2025

Figure 8: Share prices are driven by earnings growth in the long run

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities. The analyst who produced this report holds a NIL position in the abovementioned securities.

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Why tech stocks will continue to lead the market in 2025

Strong earnings growth to sustain tech’s stock market leadership

Figure 1: S&P 500 rally has broadened beyond tech

Figure 2: Earnings growth of tech-related sectors to remain robust in the coming years

AI is driving revenue growth and cutting costs for Big Tech

Figure 3: AI demand is driving cloud revenue growth in Big Tech

Big Tech’s heavy capex is justified

Figure 4: We expect the surge in capital expenditures to continue

Figure 5: People tend to underestimate the long-term effects of new technologies

Source: Morgan Stanley AI Guidebook: Fourth Edition, 23 January 2024; Capital Group

Figure 6: Big Tech’s capex-sales ratio remains healthy

Big Tech remains our top pick

Figure 7: Big Tech companies are cash rich, with healthy debt levels

Tech valuations are still looking attractive

Table 1: Projections for the Nasdaq CTA Internet Total Return Index

Figure 8: Share prices are driven by earnings growth in the long run

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