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By Lewis Krauskopf

NEW YORK (Reuters) - Signs of a resilient U.S. economy are boosting the appeal of semiconductor stocks, even as worries over the Federal Reserve's monetary policy tightening weigh on the sector along with the broader market.

The Philadelphia SE Semiconductor index is up about 16% so far this year, dwarfing the 3% year-to-date gain for the S&P 500 and the Nasdaq Composite’s 8.5% rise.

Semiconductors were among the worst hit areas in last year’s market rout, which saw the SOX index lose 36%, fueled by worries of an imminent recession. They have been standouts in the market’s 2023 rebound, supported in part by evidence that the U.S. economy continues to be robust even after the Federal Reserve unleashed its most aggressive monetary policy tightening in decades to fight inflation.

With semiconductors a key component in countless products, some investors are betting economic strength could help the shares outperform.

Despite last year’s recession fears, the market now believes "the economy is going to continue to chug along," said King Lip, chief strategist at Baker Avenue Wealth Management, whose firm owns shares of Nvidia (NASDAQ:NVDA) and On Semiconductor. "If that’s the case, then I think semiconductors can do very well.”

Of course, economic strength has been a double-edged sword for stocks lately. Semiconductor shares have pulled back recently along with broader markets on worries of a "no landing" economic scenario in which strong growth keeps inflation elevated and prompts the Fed to raise interest rates higher for longer. More insight into the state of the economy comes next week with a raft of data due, including consumer confidence and durable goods.

Still, virtually all of the 30-component Philadelphia semis index have outperformed the broader market this year, led by heavyweight Nvidia's roughly 60% year-to-date gain.

The chip designer's shares rose 14% on Thursday after it forecast first-quarter revenue above estimates as its CEO said use of its chips to power artificial intelligence services had "gone through the roof in the last 60 days."

The rally in Nvidia’s shares has catapulted its market value to $570 billion, making it the sixth most valuable S&P 500 company after electric automaker Tesla (NASDAQ:TSLA).

Graphic: Chip stocks vs the S&P 500 https://fingfx.thomsonreuters.com/gfx/mkt/dwvkdzarjpm/Pasted%20image%201677191358965.png

Whether the group maintains its momentum could depend on companies hitting earnings estimates that were marked down severely in the last year.

Forward 12-month earnings estimates for semiconductor companies declined 28% from June of last year to January, the largest such downward revision in a decade, according to Stacy Rasgon, an analyst at Bernstein.

“We have had one of the larger earnings resets that we have had in a quite a while," Rasgon said.

Earnings for the S&P 500 semiconductor and semiconductor equipment industry, which has a nearly 6% weight in the index, are expected to fall 20% this year, but are seen perking up in the last quarter of the year, according to Refinitiv IBES.

"It’s not that fundamentals are incredibly good right now," said Peter Tuz, president of Chase Investment Counsel. But, he said, "the outlook down the road seems to be a little bit better than it was in late 2022.”

Not every chip stock has thrived. Intel (NASDAQ:INTC) shares have slumped 5% this year. The company earlier this week cut its dividend payout to its lowest in 16 years amid slowing demand for its chips used in personal computers and data centers.

While chip stocks might benefit from a stronger economy, few expect them to be immune to the adverse effects of higher Treasury yields, which have surged along with Fed rate expectations. Rising yields offer investment competition to stocks and make equities more expensive in standard analyst valuation models - particularly for tech companies, whose market value is more dependent on future profits.

And if tighter Fed policy eventually brings on a recession in the second half of the year, as some fear, semis could suffer.

Burns McKinney, a portfolio manager at NFJ Investments, also sees declining demand in the personal computer market after the pandemic boom as yet another obstacle for the sector.

Nevertheless, he believes the sector could thrive in the longer-term, especially if signs of cooling inflation eventually allow the Fed to slow its monetary policy tightening later in the year. McKinney holds positions in Texas Instruments (NASDAQ:TXN) and ASML Holding (NASDAQ:ASML).

“Lower data prints should give the Fed the ability to take their foot off the brakes, and if that takes place it would be a positive for cyclical tech stocks,” McKinney said.