The rise in volatility and fall in global equity markets in February has shown once again how much equity markets tend to react in the short term to points of change. Investors became more wary of the outlook for U.S. economic growth and inflation following a positive upside surprise for U.S. wage data.
In a recent survey we conducted, a group of institutional investors identified volatility as their biggest market concern over the next three years. So, following the market moves so far this year, are inflation fears likely to drive volatility higher going forward?
In our view, we remain relatively sceptical that inflation will meaningfully and persistently rise ushering in a new market regime of considerably higher interest rates, given the price-suppressing, secular impact of three major trends: technology, demographics and globalisation.
1. TECHNOLOGICAL PROGRESS - MORE OPTIONS AT LOWER COSTS
Whether it’s Amazon’s retail or IT services offerings, Spotify’s music service, Fanuc’s automation capabilities, or Apple Pay’s contactless payment system, we are seeing disruptive technologies bring not only efficiency and choice, but also lower prices. These technological shifts create benefits for users and have driven phenomenal market share gains for the companies at the heart of successful disruption.
More importantly, they have also unlocked capacity – arguably a deflationary force if resources, including human capital, are not allocated elsewhere. Whether that be in energy (shale), transportation (driverless cars), therapeutics, or of course, traditional information technology, it has had consequences for the companies that are being disrupted (e.g., Dell, Blackberry, Nokia—the list goes on).
But what has surprised us is that the net effect of automation, in a global context, has been to slow the growth of the pie, at least in dollar terms. Why? Because technologies are invented and intersected in a way that makes a market grow slower. The winners win disproportionately because of intellectual property and globalisation. The overall industry in question does not grow and may even shrink.
One certainty is that this technological progress has fundamentally disrupted the traditional corporate capex cycle, because of the relatively asset-light nature of many of these disruptors compared with more traditional ‘old economy’ companies that have pared back investment in the face of declining market share prospects.
2. DEMOGRAPHICS - THE END OF THE DEMOGRAPHIC DIVIDEND?
In tandem with the disinflationary force of technology, we are also now at a tipping point for demographics, with many nations facing working-age population shrinkage over the next 10 or 20 years (see Figure 1). Taking Europe for example, forecasts predict that the size of the working population will shrink by just shy of 10% over the next 25 years. This shrinkage is likely to end the demographic dividend of the past 50 years when growing populations and increasing productivity combined to stimulate economic growth.
Figure 1: Where are all the workers going?
As of June 30, 2017
Source: FactSet. Working-age population = all citizens age 15 to 64.
Put together with globalisation—which has helped to grow global trade in total but has also remapped the share of individual countries’ contribution and compressed production prices—both technology and demographics are undoubtedly disinflationary. In past cycles, most notably in 2007, the influence of these was muted through an increase in sovereign borrowing and spending and tight, inflationary conditions in natural resource production, which spurred a frenzy of old-fashioned capex. With sovereigns unable or unwilling to increase debt, and with China’s demand for natural resources waning, we are perhaps now facing the true steady state level of inflation for the global economy—and it is likely lower.
Factors that don’t sit that well within econometric models are hard to measure, but these influences are real and showing themselves in inflation data that should be higher, all else equal. Therefore, while inflation and rates may rise in 2018, the inflation cycle still looks modest to us, which will give corporates and consumers some time to adjust as interest rates begin to gradually rise. However, it’s still a risk to be conscious of given the lessons learned from the global financial crisis and the unknowns associated with how investors will react if the credit cycle does begin to change for the worse.
WHAT DOES THIS ALL MEAN FOR INVESTORS?
Automation is, and will, lead to a condition of deflationary progress, and investors will have to come to terms with the contradiction of progress and lower growth. Investing in a world where powerful forces of progress contribute to dissatisfaction will be challenging, but three rules of thumb stand out.
1) First, look to own those stocks on the right side of the change.
Identifying the disruptors taking market share from rivals has been a profitable exercise in recent years and, at the right price, will continue to be a source of opportunity. Conveniently, segments defined by change and disruption (especially consumer discretionary and technology) also lend themselves to active management, with the benefits to winners over losers dramatically more pronounced than in segments of the market where change is less dramatic (e.g., consumer staples, utilities, and telecommunications).
Figure 2: The opportunity for outsized returns for the disruptors
S&P 500, as at 31 December 2017
Past performance is not a reliable indicator of future performance.
Source: IMF World Economic Outlook.
2) Second, be carefully contrarian when the market makes big bets on inflation or deflation.
Neither extreme is likely from a low-growth starting point (the “Trump trade” in the fourth quarter of 2016 and the “Trump fade” in the first quarter of 2017 emphasise this). There is no silver bullet for low growth driven by structural change.
3) Third, look for major realignments of industry structure and capacity.
Low growth has a way of getting companies to give up and consolidate, which has the potential to lead to higher returns.
If correct, the late stages of the equity cycle may also take on a different dimension in terms of market leadership if we don’t see the typical late cycle drivers of earnings growth and inflation evolve as history might predict. A measure of selectivity around late cycle stocks is therefore going to be important, as opposed to a top-down cyclical approach to buying interest rate sensitive companies.
More broadly, a period of dramatic secular change where economic share is being redistributed and historical patterns impaired implies that the index may be a poor indicator of opportunity and future economic relevance. Being active, being nimble, and being open to change will be important if disruption continues or if the disruptors become a bubble in themselves.
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