October 15, 2018
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US economic recovery is entering its tenth year, yet the historical laws of economics don’t appear to be applying.
After such an extended cycle, unemployment in the US is now below 4% and companies are reporting record numbers of job vacancies. Normally you would expect this supply contraction to result in higher wages as employers fight for staff. But this has not occurred. The last monthly job numbers from the US confirmed the positive employment momentum but wage growth remained stubbornly low at just 2.7%.
Many different explanations have been given for the break in the traditional link between employment levels and wage growth. The most compelling explanation, I believe, is that we are witnessing the structural deflationary implications of technology and its powerful disruptive influence across multiple sectors of the economy.
Technology has dramatically changed the competitive dynamic in many segments of the economy as new platforms, new routes to markets and new abilities to service customers have developed. The digital revolution has lowered barriers to entry in various markets, allowing new competitors to challenge the incumbents.
With such a competitive dynamic, incumbent operators struggle to raise prices and are forced to manage costs, including labour, aggressively to protect margins. This is a powerful disinflationary force and is reflected in headline macro-economic data, including subdued wage inflation.
We all know about Amazon and its disruptive effect on the global retail sector. Amazon’s platform allows shoppers around the world to order almost everything they need from the comfort of their homes and enjoy next-day delivery on a number of products. With Amazon’s Prime subscription service, there isn’t even a delivery charge. Since the only physical infrastructure that Amazon requires is warehousing and logistics, rather than bricks and mortar shops, its fixed cost base is significantly lower than traditional retailers, allowing it to keep prices down.
Netflix is having a similarly disruptive effect on the global media industry. Traditional media distribution channels, such as TV, DVD and cinema, are coming under enormous pressure as Netflix uses its massive global subscriber base to build a library of movies, TV shows and original content. These can be accessed online for a relatively modest subscription, without having to endure the frustrating advertising breaks associated with traditional media. Once again, this is a powerful disruptive strategy but one that also has important disinflationary characteristics.
In SA, a more widely known disrupter is Uber. It provides an efficient and convenient service at an affordable price which is preventing conventional taxi firms from being able to raise their prices.
As consumer businesses, these companies are well known disruptors. What is less visible, however, is the plethora of companies applying similar disruptive strategies in different parts of the economy, servicing both the consumer and corporate sector. It is clear that many more segments of the economy are affected by this trend than was expected a mere five years ago. For example, if you listen to investor presentations from Google, Microsoft and Amazon, you’re more likely to hear them talking about their disruptive strategies in healthcare and financial services than about their traditional markets.
Technology companies are also attracting high levels of investment to support their business models. To put some numbers behind this investment trend: in the US, financial data company Thomson Reuters has reported that technology related capital expenditure grew substantially in the first quarter of 2018 and we have seen a massive increase in the number of new technology businesses. Many of these start-ups come with disruptive digital strategies. Deloitte’s 2018 technology survey has identified a number of areas within the technology landscape that are experiencing exceptional growth. These include cloud computing, flexible consumption (pay as you go models), cognitive computing (machine learning) and Big Data.
And these businesses have grown using models that are not primarily focused on short-term profit but rather towards market share gain and undermining existing competitors. How do they do that? Typically, price and convenience/service are the key weapons of choice against incumbent providers.
So assuming this investment has been deployed successfully, then it will be an ongoing and substantial disinflationary force. And that is before we even think about the employment and wage growth implications of technology areas like Artificial Intelligence and Big Data initiatives.
Despite these positive dynamics, there are a number of market commentators who believe that technology shares are on elevated valuations and are a bubble which will burst and bring down the broader market, as occurred in March 2000 in the last technology boom and bust. Based on headline numbers, these concerns are not supported by the facts. When you compare the top 10 technology companies in the US in March 2000 with the top 10 today, you will see that earnings growth is fairly similar between the two periods. What is noticeably different is the price: earnings (P:E) valuations. At the peak of the 1990’s cycle in March 2000, the P:E ratio was an amazing 86 times while today it’s a more modest 30 times. Headline valuations today are nowhere near as demanding as in the previous technology boom and subsequent bust. So hopefully there are more realistic expectations from investors.
The risk for many of the headline technology companies is that they have become such large enterprises. Simple maths means that historical heady growth rates may be more difficult to achieve from these levels, and this may explain their moves into new markets. More concerning is that with the size dynamic comes the risk that regulators and politicians will take more interest in these businesses. That is not necessarily positive, as Facebook is experiencing.