Despite supply chain constraints, the U.S. technology sector has performed well in 2022. Information technology (IT) spending, which is highly correlated with the global GDP growth rate, is healthy, and tech issuers have benefited from higher sales and improving margins. However, risks abound from a deteriorating macroeconomic environment, geopolitical events and their impact on supply chains, and pervasive inflationary pressure in many parts of the globe. This provides the backdrop to our views on:

• The macroeconomic forecast and its impact on IT spending.
• Health of the semiconductor supply chain.
• U.S. tech sector rating downgrade risk.

Macroeconomic Weakness, Rising Interest Rates, And Pervasive Inflation Could Further Slow IT Spending

Tech companies' order growth signals broad and strong demand. However, worries such as component costs and product prices remaining elevated, coupled with increasing concern of macroeconomic weakness, could significantly weaken global IT spending.

We are cautiously optimistic about the state of the tech sector, which has been resilient, notwithstanding the Russia-Ukraine conflict that began in late February and China's COVID-19 zero policy that started in March, further disrupting the supply chain. In July, we revised our 2022 global IT spending growth forecast to 4.3%, down slightly from 4.5% in May and 5.1% in March, reflecting deteriorating macroeconomic conditions and weaker PC and smartphone sales, but we still considered the IT spending environment healthy because it was firmly above our global GDP growth rate.

However, we acknowledge further challenges ahead for the tech sector and the U.S. economy as a whole. The run of remarkably favorable financing conditions has dramatically slowed or perhaps ended. Risk is increasing that sharply higher interest rates and persistent inflation, combined with renewed consumer caution, will push the U.S. into a recession. This makes markedly deteriorating credit conditions possible. If financing cost pressures don't ease or inflation weighs heavily on confidence and demand, profit erosion could become more widespread and steeper than we expect. (See "Economic Outlook U.S. Q3 2022: The Summer Of Our Discontent," published June 27, 2022.)

The U.S. is poised for below-potential economic growth and an increased risk of a technical recession, commonly defined as two or more quarters of economic contraction. We now forecast full-year U.S. GDP growth of just 2.4% in 2022 (down from 3.2% in our March forecast), 1.6% in 2023 (down from 2.1%), and sub-2% real GDP growth into 2025. Additionally, the S&P Global Economics' qualitative assessment of the risk of recession in the next 12 months is now 40% (range of 35%-45%) with the risk greater in 2023.

More recently, we started to see cracks in consumer spending in areas such as TVs, PCs, and smartphones. This is increasingly prevalent globally but more pronounced in China given COVID-19 lockdowns in many cities. Most assuredly, we expected the strong demand growth that lasted almost two years since the onset of the pandemic in 2020 to diminish at some point, possibly this year. But the sales declines in these major product areas have been more rapid than we anticipated.

Other end markets, such as enterprise, data center, industrial, networking, communications, and auto, remain resilient. Supply chain disruptions limited sales for tech vendors in these areas, and many companies' management teams have indicated how much more revenue they could have generated if not for component shortages or logistical challenges. But their record backlog, bookings and billings are proof that demand remains strong. We view demand for products in areas such as 5G infrastructure, electric vehicles, and high-performance and cloud computing to be more stable and lasting given the long secular growth runway ahead. IT spending by large enterprises bears watching closely as these purchases tend to represent significant investments. While they cannot be eliminated, there is discretion on the timing of such enterprise IT product upgrades, hence the cyclicality of tech companies' performance in a weak macroeconomic environment.

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The tech supply chain developments are fluid, with possible interpretations of industry indicators such as extended lead times for certain chip orders, rising inventory, higher semiconductor production from capacity increases, etc. We expect signs that the uptrend will level off or pivot lower.

Semiconductor Market Conditions Are Favorable For Now, Though Macroeconomic Weakening Could Drag Industry Demand More Broadly

Unprecedented growth in the global semiconductor industry since 2019 has likely reached a peak. However, market conditions remain favorable amid demand-supply imbalance, so a significant industry deceleration in 2022 is unlikely, in our opinion. Over the past two years, semiconductor suppliers have benefited from supply chain constraints that drove significant increases in demand and average selling prices. Unit sales were meanwhile limited and orders turned into growing backlogs. Faced with strong demand as indicated by customers' frenzied buying to secure components and expectation for further price hikes, semiconductor suppliers gained pricing leverage and passed on the higher costs to customers largely unabated.

Currently, many large semiconductor companies continue to report strong business outlooks, but we have observed some mixed signals that make interpreting end demand resilience, supply capacity constraints, and healthy inventory less straightforward. On one hand, the global economic environment is highly uncertain, with large economies such as the U.S. and Europe facing rising recession risks over the coming quarters. On the other, semiconductor companies continue to report strong revenue growth and healthy demand in key markets including enterprise and communications infrastructure investments. These markets are correlated to global economic growth, but the consumer-exposed end markets such as PC and smartphones has been meaningfully weak in the first half of 2022.

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Cracks are forming in semiconductor end markets.  Weakening macroeconomic indicators and moderating consumer PC and mobile demand are beginning to raise more questions about possible demand waning in other key semiconductor end markets. These include data center, enterprise, auto, and industrial, especially in advance of significant capital spending commitments announced by large semiconductor manufacturers and foundry players. We believe the trajectory of the semiconductor cycle near term will be determined by the path of the global macroeconomic environment, and less so supply conditions. We anticipate the semiconductor capital spending in late 2019 and early 2020 for manufacturing production expansion will meaningfully increase output beginning in the second half of 2022. Additionally, while supply chain disruption, including policies to combat pandemic outbreaks, may persist, we believe the duration will be shorter and the impact will diminish. Countries will continue to learn and evolve their best practices and as growth-oriented policy decisions become a bigger factor for challenging near-term economic growth.

Semiconductor supply conditions remain tight.  These conditions have prompted foundries and integrated device manufacturers (IDM) to operate at full utilization rates to meet demand. Foundries are semiconductor manufacturers that make chips for fabless semiconductor companies focusing on designs--Taiwan Semiconductor Manufacturing Co. Ltd. (TSMC) and GlobalFoundries Singapore Pte. Ltd.IDMs are semiconductor companies that design and manufacture their own chips--Intel Corp., Samsung Electronics Co. Ltd., Texas Instruments Inc., and Micron Technology Inc. Although inventory in dollar terms has increased over the past two years, we view inventory days outstanding to be a better indicator for assessing future demand and supply. Lately, inventory days on higher-value advanced products at foundries and certain fabless semiconductor firms have been rising, understandable given the weakness in PC and smartphone end markets that represent over 40% of total semiconductor industry revenue. However, inventory at many analog and microcontroller semiconductor firms is low by historical standards, with distributor inventory below 20 days, relative to a normal 27-37 days.

More recently, semiconductor companies have shifted to selective customer fulfillment from the broad-based selling approach of the past two years of high demand, seen in 12-month noncancellable/nonreturnable order patterns. Semiconductor firms increasingly focus on fulfilling matched set orders with their customers and try to reduce instances of selling to customers that may be speculating on future availability or prices rather than its needs. This may signal impending slower growth or decelerating backlogs, but would dampen the semiconductor cycle peak-to-trough, in our view. When demand eventually wanes, we do not believe semiconductor weakness will be broad-based given our assumption that the global GDP growth rate will remain positive but decelerate. However, in a more severe economic downturn, such that global GDP turns negative and with low chance of a quick rebound, we would expect diminishing demand for even relatively resilient end markets (i.e., data center and cloud computing), which may include canceled orders and terminated or renegotiated long-term purchase commitments.

Semiconductor industry cyclicality could be dampened but not eliminated.  Lead times from customer order to delivery remain extended because of component shortages, particularly in legacy nodes for products such as power integrated circuits and microcontrollers. Many companies such as NXP Semiconductors N.V. report a significant portion of their orders with lead times greater than 52 weeks. However, more recently, management teams are citing demand stabilization and less urgency from customers for expedited shipments, which we view is a slight shift in conditions. We believe customers' purchasing behavior is a prominent factor for why certain semiconductor cycles peak-to-trough are exaggerated. Any actions to minimize customers' pulling orders ahead of end demand or limiting substantial buffer inventory would be favorable to the semiconductor industry's overall health. We understand that chip companies have formed a closer collaboration with customers to ensure component availability and reduce double ordering. However, while we believe that will help demand forecasting, it is unlikely to eliminate industry volatility due to complex supply chains and the inherent long lead times.

New capacity will have a muted impact in 2022.  We believe the semiconductor industry is poised to expand a healthy 8% in 2022. Major manufacturers have boosted their capital spending plans over the past year or so. TSMC reiterated its plans to spend as much as $44 billion in 2022 to meet demand growth of about 30% year over year and expects to spend over $100 billion in 2022-2024 to support its 15%-20% longer-term revenue growth expectations. Intel also has aggressive capital spending plans to expand its manufacturing footprint in the U.S. and Europe, $27 billion in 2022 and about $30 billion in 2023. Samsung announced its ambitious goal of becoming the global leader in logic chips by 2030 by spending over $150 billion in its non-memory semiconductor business. We appreciate the concerns about possible overcapacity given these unprecedented spending commitments concurrently by major semiconductor firms, especially heading into a possible macroeconomic downturn. But given the typically two years or more from breaking ground, building the physical infrastructure, filling the fabs with production equipment, and the semiconductor-making process from wafer to chips, these manufacturing expansion plans will have muted impact on supply and demand over the next two years.

Longer term, these semiconductor manufacturers have included in their risk management plans of gradually increasing production capacity based on anticipated demand and are economically motivated to optimize unit output and selling prices to avoid exaggerated peak-to-trough semiconductor cycles. Consolidation in the semiconductor industry over the years has also led to more supply and pricing discipline by suppliers. We believe key secular industry growth drivers are the proliferation of electronic devices, increase in semiconductor content in devices, and most importantly much broader end markets. These empower chipmakers to expand manufacturing capacity in anticipation of demand in spite of near-term cycle dynamics. Data center and high-performance compute (machine learning and artificial natural language processing) have driven the disproportionate spending on advanced node technologies (16 nanometers or below). We believe a meaningful portion of these capacity expansion commitments will be directed at advanced nodes.

Though foundries such as TSMC and Samsung serve the non-leading-edge technologies (40 nanometers or higher), we believe they are reluctant to significantly expand capacity for legacy nodes given the higher risk of oversupply as volumes are typically lower and less profitable for manufacturers. Legacy nodes are used in many end products, and products in industries such as automotive and industrials heavily rely on them, but they represent a small proportion for leading foundries. For example, the automotive end market accounts for just 5% of TSMC's overall output by revenues. But TSMC indicated in its 2022-2024 capital spending plan that it will allocate about 10%-20% of their spending for legacy node products. Major players in these markets include Texas Instruments, NXP, and Renesas Electronics Corp. Texas Instruments, with about 60% of revenues from auto and industrial, announced a significant increase to its capital expenditure target, with plans to spend $3.5 billion annually through 2025 and then 10% of revenues (about $19 billion revenue expected in 2022) after that to support its high-single-digit percentage longer-term revenue growth target. This is significantly higher than the $1.7 billion in 2021 and about $850 million in 2020.

Similar to the significant capital spending commitments by leading edge manufacturers, we view the rising capital investments by Texas Instruments and others that have higher exposure to the auto and industrial end markets to be reasonable. Many of these chipmakers have run into significant capacity constraints over the past few years. Anticipated growth trends favor electrification in auto drivetrains, battery management, advanced driver assistance systems, sensors, infotainment systems, and the internet of things proliferating electronic content from industrial equipment on factory floors to edge devices that aggregate and process data for productivity gains. The risk will likely be determined more by chipmaker discipline in managing production given the demand environment rather than whether to increase capital spending at this juncture.

Risk from these significant capital spending plans are partly mitigated by long-term procurement commitments by leading semiconductor companies and hardware manufacturers. Additionally, rising geopolitical risks have prompted governments to provide economic incentives to semiconductor manufacturers to balance the current regional concentration of manufacturing hubs in Asia-Pacific and Japan, where more than 75% of chipmaking capacity is based.

Discretionary IT Spending At Risk Of Delays Or Cancellations And Hurting Margins

The strong underlying demand for many tech products and services is undeniable, with record backlog, bookings, and billings at tech companies such as Microsoft Corp., Dell Inc., Hewlett Packard Enterprise Co. (HPE), and Accenture PLC. Commentary provided by HPE as recently as late June includes enterprise spending remaining surprisingly resilient. There was a positive tone from some supply chain constraint relief in China, and no evidence of curtailed projects or budget cuts in response to the weakening macroeconomic environment. More recently, guidance for Micron's fiscal fourth quarter (ended in August 2022) is weaker than we anticipated, reflecting weak Chinese consumer demand, the Russia-Ukraine conflict, rising inflation, and weak customer end markets such as PCs and smartphones. The PC and smartphone customers, which account for roughly half of Micron's revenues, are starting to adjust their inventories, portending a potentially weaker semiconductor industry demand backdrop in 2023. However, Micron noted resilience in cloud, networking, automotive, and industrial end markets--an observation that's resonating with commentaries from other tech hardware and semiconductor companies.

We are cognizant that the demand environment could change rapidly if the risk of U.S. recession continues to rise. In that instance, enterprise IT spending growth will likely decelerate in the coming months and orders could be canceled.

The semiconductor supply chain shortage has conditioned customers to double order or place a larger order than necessary with the understanding that their allocation will be lower than required but closer to their needs. Because the tech supply chain is so vast and complex, with lead times often measured in months, any sudden and meaningful change in IT spending would reverberate across the supply chain and cause significant adjustments to production and pricing of tech components and products. Although tech device makers have placed increasing emphasis on working closely with their semiconductor suppliers to improve their product demand forecasting, we expect the severe supply chain shortage of the past two years will invariably exaggerate the next industry downturn, mostly likely in 2023.

We believe reduced IT spending could be felt sooner in a rapidly deteriorating macroeconomic environment, possibly in the second half of 2022. For tech hardware and IT services companies, any relief from the supply chain constraints, while favorable, could be dampened or even overwhelmed by a macroeconomic downturn or U.S. recession. Input costs would likely decline from highs sustained over the past couple years and alleviate margin compression at tech companies. But weaker consumer and enterprise IT spending could also mean fewer sales, possible pricing concessions, and lower fixed-cost absorption.

Discretionary IT spending would be the most vulnerable, affecting particularly consumer-related hardware sales and large-scale IT services projects. We view certain enterprise IT spending to have mission-critical characteristics, less prone to cuts. But deferred investments by customers, if sizable, would still have significant effects on tech vendors' revenue, margin, and liquidity profiles. For IT service providers, revenues from delayed projects may not be lost. However, margin would likely be impaired given the difficulty to redeploy resources to other projects in short notice.

Adding to the challenges is the strengthening U.S. dollar, hurting overseas demand. Currency hedges may be in place for some tech providers, helping their bottom lines, but pricing strategies will be key in determining impact on demand.

Tech companies' ability to pass along higher costs to customers will be tested. Thus far, tech companies have successfully done so, maintaining or even improving margins. However, waning IT spending will affect their ability and willingness to pass along higher input costs. We believe there will be a sharpened focus to manage costs in addition to growth. Uncertainty remains as to where along the tech supply chain the brunt of the margin compression will hit and how that will affect cash flows. If history is any guide, tech manufacturers' margins will compress earlier and reverberate along the supply chain with a lag.

Investment-Grade Rating Stability Generally Intact; Speculative-Grade Firms More Vulnerable To Macroeconomic Downdraft

Most tech companies have not signaled revenue or earnings weaknesses anticipated over the near term. For the most part, we share their cautious optimism given resilient profit pools and still strong customer IT spending patterns. We believe software companies will remain resilient given their highly recurring revenue and cash flow streams. With the current demand-supply dynamic, we expect semiconductor firms to still generate above GDP growth, helped by improving output and good end demand including inventory restocking, partly offset by weaker average selling prices. The tech subsegments most susceptible to a deteriorating macroeconomic backdrop would be hardware or IT services, especially companies with less exposure to secular growth trends (i.e., 5G infrastructure, cloud computing, electric vehicle or digital transformation). Particularly vulnerable would be those with transactional sales business models involving large purchase commitments in which customers can delay such significant investments to preserve their own liquidity in times of stress.

From a credit perspective, we've found U.S. tech issuers rated 'BB' or higher have lower leverage than those in other non-financial corporate sectors. This is partly because of a relatively lower risk appetite but also their ability to command higher margin from products and services that help customers achieve productivity gains. We find many investment-grade U.S. tech issuers have both leading market positions and conservative financial profiles, including strong liquidity to weather challenging market conditions without significant risk of a downgrade.

However, about 72% of U.S. tech issuers we rate are speculative-grade. Of those, we rate 74% in the 'B' category or below. These companies will be vulnerable to a potential U.S. economic recession or significantly weaker IT spending. Additionally, many are financial sponsor-owned, with significant leverage and mostly variable-rate debt capital structures. In our view, the higher risk of a recession and continued rising interest rates will test our rating downside thresholds, adding to financing cost outlays and reducing or entirely consuming free operating cash flow generation for some. In the second quarter, our rating trends pivoted to a clear negative bias, with 11 negative actions versus four positive. Issuers rated in the 'B' category or lower accounted for eight of the negative rating actions and only one positive.

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Our downside scenario considers decelerating U.S. GDP growth in the second half and a year-over-year decline in 2023 before it recovers to modest growth in 2024. Inflationary pressure would remain elevated for longer and margin pressure would intensify as higher input costs, including labor and logistics, are increasingly difficult to pass through in a weak demand environment. In performing our rating assessments, we recognize there could be a variety of paths and qualitatively assign probability to these different outcomes. We clearly see the rising macroeconomic concerns and, therefore, will consider the potential impact to issuers' credit profiles. As such, we expect a negative bias in U.S. tech sector rating trends to remain.

We outline our views on certain U.S. tech issuers below, highlighting certain companies with a higher risk of negative rating actions if macroeconomic conditions deteriorate meaningfully. We also discuss others' exposures to such a weak economic backdrop but levers available to maintain ratings.

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Related Research

• Economic Outlook U.S. Q3 2022: The Summer Of Our Discontent, June 27, 2022
• Macro Risks And Diverging End Markets Overshadow U.S. Tech's Mostly Good Results, May 9, 2022