The US Fed’s rate cut is promising for the IT services industry, but headwinds continue to blow

The US Federal Reserve cut its key interest rate by 50 basis points—half of one percent—its first rate cut since the early days of the pandemic. Outside of emergency rate cuts during COVID-19, a 50-basis-point cut hasn’t been made since 2008, during the dark days of the global financial crisis. This latest cut signals a shift in the Fed’s outlook toward a lower-rate approach. The central bank believes inflation is under control, and its focus should shift toward boosting business sentiment and employment. The Federal Reserve Committee noted that job gains have slowed, and the unemployment rate has increased but remains low.

The Committee has gained greater confidence that inflation is moving sustainably toward 2 percent, and judges that the risks to achieving its employment and inflation goals are roughly in balance.

– US Federal Reserve statement

Over the past few years, almost every quarterly earnings call from leading IT services companies referenced high interest rates as a key reason for their lower deal volumes and values due to less enterprise discretionary spending. The IT services industry is a powerful proxy for the state of tech-led transformation. While outsourcing was once considered a conduit for labor cost arbitrage, it has become a powerful enabler of tech transformation. When services firms struggle, it signifies notable economic challenges. With the Fed turning the corner, HFS evaluates what the move means for the IT services sector and broader enterprise tech-led transformation.

Rate cuts are positive for the IT industry but aren’t a magic pill

The rate cuts by the US Fed, the European Central Bank, and others that could follow should boost sentiment and bring down the cost of capital. As clients start loosening their budgets, IT services companies stand to cash in. With cheaper access to capital, global companies could ramp up larger, high-stakes projects and boost outsourcing to IT services firms. However, the increase in demand will only begin to be seen in Q4 2024 or even in Q1 2025 as the rate cuts take time to transmit across sectors and enterprises reevaluate their spending requirements.

While rate cuts are a positive for the IT service industry, the picture for the coming years will remain complex and determined by a host of factors. A rate-cut tide won’t automatically lift all IT service industry boats. How companies individually react to the number of headwinds and tailwinds facing them will determine what happens in IT services in the years ahead.

The industry’s tailwinds include the enterprise race to drive innovation, increasing demand for AI, cloud transformation, cybersecurity solutions, and relentless cost-cutting pressures that will benefit outsourcing. On the flip side, headwinds loom large: volatile currencies, ongoing economic uncertainty, US election outcomes, wage inflation in countries such as India, and growing pricing competition. The impact of AI on service delivery and the rising interest in global capability centers (GCC) could also erode traditional outsourcing demand (see Exhibit 1).

Exhibit 1: Headwinds and Tailwinds facing the IT services industry

Source: HFS Research, 2024

IT Services are banking on BFSI to restore growth

A prolonged interest rate cut trajectory will increase disposable income for both consumers and companies. As consumers increase spending, sectors such as retail stand to gain directly. With an increase in demand for goods and services, lending from the BFSI sector should also increase. Capital-intensive sectors such as technology and manufacturing should also see an uptick in spending. However, the effects of rate cuts typically lag the cut itself, so the impact will start to be seen a few quarters down the line.

While several sectors will present opportunities for the IT services industry, one industry is more prominent than others. Banking and Financial Services  (BFSI) represents the largest share of revenue by industry for most large IT services players. BFSI enterprises are the sector that spends the most on technology and services. For example, JPMorgan Chase’s 2024 tech budget is $15B, which is bigger than the GDP of some countries. In the same way that declining BFSI business hurt many IT services firms over the past few years, there is strong hope that discretionary spending is back for transformation projects and other tech-led endeavors. Infrastructure modernization and other foundational investments top the list to truly enable enterprise AI and help banks manage profitability challenges. While the modest rate cut won’t solely lead to increased spending, it is a major nudge in that direction.

Exhibit 2: BFSI as a share of total revenue has either declined or been steady

Source: HFS Research Analysis, Company Quarterly Filings

M&A may see an increase as companies look to pivot from labor to technology arbitrage

While rate cuts will help enterprise customers increase discretionary spending, they are also likely to encourage IT services companies to be more aggressive in M&A activity as they reinvent themselves for the GenAI era.

Exhibit 3: IT services companies will need to evolve

Source: HFS Research, 2024

While GenAI has the potential to generate a higher value of work and implementation projects from POCs to production, it also challenges existing labor arbitrage models. Companies are looking to reimagine themselves by incorporating GenAI, and rate cuts should help increase the pace of M&A activity to plug in gaps and expand into new offerings. Rate cuts encourage firms to invest more in long-term digital transformation projects, which drive IT firms to acquire specialized companies, particularly in AI, cybersecurity, and cloud-based solutions.

The past year saw a number of deals, such as IBM’s acquisition of HashiCorp, an infrastructure automation company, for $6.4 billion in Q1 2024. Accenture’s acquisition of Impendi, a sourcing and procurement provider, and Capgemini’s acquisition of Syniti, an enterprise data management software provider. The rate cut will likely release pent-up demand, and cheaper capital will provide the fillip for increased M&A activity.

The Bottom Line: Rate cuts give IT services providers a reason to smile, but they must reimagine themselves to thrive.

Rate cuts are pleasing to IT services companies, but to truly thrive, the firms must reimagine their operating models and embrace the full potential of technologies such as AI and cloud. While headwinds remain, enterprises successfully pivoting from labor arbitrage to technology arbitrage stand to thrive.