The global economy may be slowing again. A trade war between the US and its largest trading partners is threatening to disrupt short-term projections for the second half of 2018 and 2019. Even if the current tensions give way to new trade agreements in the interests of stability, most economists expect the US economy to post a contraction by 2020, as interest rates increase and cyclical factors come into play. Historically, the US economy is overdue for a contraction, having posted a long streak of growth since 2009.
Why and whenever the next economic downturn arrives, the impact on IT spending should be more muted than previous contractions. Last year was a banner year for tech spend, partly because of strength in the economy but also because of underlying strength in fundamentals and the strategic importance of ‘digital’ 3rd Platform technologies. Where previous downturns have taken place amidst general debate about the business and economic value of IT spending, technology is now central to operational efficiency and competitive strategy. Increasingly, businesses across all sectors of the economy seek to differentiate themselves by their adoption of technologies such as big data and analytics, cognitive AI and IoT.
A Mature Sector of the Economy
The technology industry is now a relatively mature sector of the global economy overall, and growth rates reflect a more mature installed pace and higher rates of penetration for key categories. IT spending grew by 6% last year in constant currency, a significant improvement from growth of 2.5% in 2016; but is set to cool slightly to less than 5% growth this year in a benign economic scenario, as some of the pent-up demand and cyclical spending begins to wane. Including telecom and business services, overall ICT spend will grow at around the same rate as last year (4%).
The flip side to increasing maturity is that the boom-bust gyrations which characterized IT spending in previous economic cycles should be more muted in the future. In the past, IT spending tended to overshoot the overall economy on both the upside and the downside. In 2009, for example, IT spend crashed by 4% (GDP declined by only 2%). Before that, IT spending declined for three consecutive years between 2001 and 2003 while GDP posted positive annual growth throughout that period.
For hardware, the gap was even starker. Hardware spending crashed by 9% in 2002 (on top of a 6% decline in 2001) as businesses tightened their belts following the dot.com crash. In 2009, hardware spending declined by 6% (before soaring back with growth of 13% in 2010 as corporate profits improved and pent-up demand drove a capital spending surge). The gap, though, is narrowing over time partly due to the increasing proportion of ‘as a service’ spend which is less sensitive to short-term volatility.
As more businesses move their applications and infrastructure to the cloud, more IT spending transitions from Capex to Opex and becomes a cost of doing business rather than a discretionary line item. Just as importantly, a higher proportion of capital spending is concentrated on service providers which need to maintain investments in infrastructure in order to deliver services to end-users.
No Immunity from a Trade War
This is not to say that an economic downturn in the next 6-12 months, likely triggered by the current round of tit-for-tat protectionist measures between the Trump administration and key trading partners including China, the EU, NAFTA and Japan, would leave the IT market unscathed. Increased vulnerability comes from the fact that pent-up demand is lower than a year ago. For example, if European businesses need to enact cost-cutting measures in order to ride out another economic downturn, postponing PC upgrades for another year is still an obvious contingency.
An economic downturn might accelerate migration to the cloud in some cases, which would be good for service providers (and vendors selling to service providers) but could increase the pace of cannibalization and the lurch from legacy 2nd Platform revenues which still represent a large proportion of revenue for some ICT suppliers. Meanwhile, ASP increases which now form a vital source of growth for suppliers of smartphones, tablets, PCs and storage systems would inevitably be pressurized by a tighter economic environment in which many companies revert to a mode of ‘good enough computing’, especially if the direct impact of tariffs and other protectionist measures results in prices pressures for lower configurations. This last factor is still a big unknown, with hardware manufacturers grappling not only with the potential impact of tariffs but also the possibility of increased costs related to shipping delays, fines and other protectionist measures. The impact on supply chains could be significant.
But some areas of IT spending would be relatively insulated, especially in the event of a short (6 months or less) economic downturn. Cloud services spending, so integral to operations for many companies, might slow a little in terms of new growth, but is unlikely to go into reverse. A slowdown in job creation could impact hardware capacity and software license requirements, but much of that could initially be at the expense of traditional on-premise spending. Similarly, cloud providers will have to keep investing in the infrastructure and software to deliver their services, or else suffer the competitive consequences.
Importantly, this will also have an impact on ASP stability. While the pivot to cloud has been negative for ASPs in some hardware segments, there is now a degree of built-in stability resulting from cross-border competition. During the last period of exchange rate volatility two years ago, European cloud and infrastructure providers found it more difficult to raise their prices in line with Euro devaluation because this might mean losing business to competitors in other countries. It will therefore be more difficult for cloud providers to pass on the increased costs of tariffs to their customers; bad news for profit margins, if that happens, but probably good news for market stability.
Downside Risks are Higher
Economic risks are now more elevated than at the beginning of the year. Our baseline forecast continues to assume Real GDP growth of around 3% in 2018 (constant currency), resulting in IT spending growth of between 4 and 5% (constant currency). In a downside scenario related to a trade war, where the global economy quickly slows to around half that pace (more like 2002 than the scale of the 2008/2009 financial crisis), IT spending would still post positive growth this year thanks to ongoing contributions from software and services, including cloud.
Most economists already expect a US contraction in the next 2 years. A full-blown trade war in the next 6 months could alter the timing and the scale, but a contraction is overdue. Whenever it happens, given the continued importance of the US as a trading partner to every region, the downturn will result in some degree of slower or shrinking global trade, higher inflation, weaker consumer spending and a global slowdown in GDP growth, none of which are good news for IT spending. But the risks associated with a full-blown trade war are particularly high, compared to other downside risks, in terms of the macroeconomic impact (especially because a chain reaction could have unforeseen consequences).
IT Spending Impact
IT spending is not likely to plunge into a sharp contraction which overshoots the GDP slowdown by as much as previous downturns. Continued growth in cloud and digital/3rd Platform would make up for a sudden contraction in hardware categories to some degree. If a recession and trade war persisted and broadened into much of 2019, driving budget cuts beyond the first wave of contingency measures, then a contraction next year is possible. But IT spending won’t overshoot the rest of the economy as much as in previous recessions.
Discretionary services spending (consulting related to new 3rd Platform/Digital Transformation projects) might suffer some postponements, although large enterprise buyers are unlikely to abandon their strategic path towards these technologies and so any slowdown in project-oriented spending would be temporary and limited. A broader contraction would depend on a longer and broad-based economic downturn (services spending tends to lag GDP by 6-12 months, and historically isn’t impacted by a first wave of contingency measures).
Consumer spending would probably be the most affected, but consumer IT spending is already stagnant and contributes less growth to the industry than a decade ago. A wild card is the impact on consumer smartphone spending. In countries where the subsidy model still drives upgrades, and where higher ASPs are still absorbed by service agreements, shipments could be more stable. But it remains to be seen if a deep slowdown in consumer spending power could take a big bite out of smartphone spending, especially if tariffs and other measures directly target this segment of the market.
The same is true of other hardware markets which could be targeted directly or indirectly by protectionist measures, such as PC and server components. The list of unforeseen consequences resulting from a chain reaction of retaliatory measures, especially where China is concerned, is long and potentially troublesome for the IT industry.
Barring an economic crisis and trade war of unforeseen proportions, however, a broad tech downturn on the scale of 2002 or 2009 is currently not anticipated. Businesses will continue to prioritize tech investments as a means to both save money and make money. While some on-premise hardware and software categories may decline and hardware shipments stand to be directly targeted by protectionist policies and politics, enterprises will continue to pursue broadening opportunities related to the 3rd Platform and digital transformation which will continue the long-term trend of convergence between total IT spending and GDP growth.