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Tech ETFs: Inventory Issues Could Weigh on Sector

This article was originally published on ETFTrends.com.

The technology sector and exchange trade funds, including the Technology Select Sector SPDR ETF (XLK) , have been leaders this year, but some analysts believe the largest sector in the S&P 500 could face inventory challenges.

XLK, the largest tech ETF by assets, tries to reflect the performance of the Technology Select Sector Index, which is comprised of technology and telecom sector of the S&P 500. The ETF includes companies from technology hardware, storage, and peripherals; software; diversified telecommunication services; communications equipment; semiconductors and semiconductor equipment; internet software and services; IT services; electronic equipment, instruments and components; and wireless telecommunication services.

Gaps between inventories and revenue throughout the U.S. could portend an economic slowdown, which would weigh on the cyclical technology sector.

“A rising disparity between revenue and inventory trends across the US may signal a potential near-term slowdown in technology, given the sector closely follows the broader economy,” says Fitch Ratings. “Softness in end-market demand became apparent for technology companies recently reporting earnings, particularly those in the upstream hardware subsector. The severity of periodic revenue volatility across subsectors will be influenced by supply chain length. This was already factored into credit ratings and is currently viewed as manageable.”

Tech Sector Is All About The Data

For the companies that have reported first-quarter earnings thus far in the technology sector, 78.9% have beaten EPS estimates and 71.1% beat revenue estimates.

“Macroeconomic data through February 2019 from the US Census Bureau indicates yoy revenue growth decelerated at the retail, wholesale and manufacturing levels,” according to Fitch. “Sales growth slowed to a low single-digit rate, from the mid to high single digits in 2017 and most of 2018. Moreover, the broader economy's wholesaler inventory/sales ratio is at the highest level since July 2016, as revenue and inventory trends are out of sync. This indicator previously coincided with extended periods of manufacturing weakness.”

In 2019, momentum in cyclical sectors quickly recovered from both a performance and flows perspective as investors looked to areas like communication services, technology and financials over recent weeks.

“We believe working through excess inventory could result in below-trend manufacturing activities for the technology sector in future quarters,” said Fitch. “Implications will be most noticeable in the upstream hardware subsector due to a lengthened supply chain. Inventory accumulated at various stages of the chain may exacerbate the effect of inventory correction.”

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