Tomorrow Augmented: The digital economy's next stage of evolution
Investing in the digital economy
The digital economy is becoming ever-more ubiquitous. Yet, its implications for investors remain largely unaddressed, as the link between the micro developments found in all types of start-ups, the wider economy and asset prices, is not always clear. In this thematic review, we are seeking to address this issue – how the digital revolution at the micro level is changing the macroeconomic environment, and with it, the investment world.
We are not pretending that we have all the answers. But our analysis leads us to believe that the digital economy will drive investors to diversify further across alternative investment sources, provided regulation allows them to do so. However we also firmly believe that there are a number of digital economy “truths”, which have been misinterpreted and as such warrant deeper interrogation.
“Technology is a risk to low-skilled employment” (not necessarily)
It has been widely thought that because technology disrupts routine jobs it will reduce employment numbers, wherever there is the possibility of automation. But conversely, we should keep in mind that where creativity prevails, jobs are flourishing in different forms, not necessarily in a traditional employee format. Hence entrepreneurial adventures rise. If this structural change accelerates significantly, it may lead to a rise in unemployment during a transitory period while skills adapt. However, because technology will lead to improved skills and may enhance productivity across sectors, it is unlikely to lead to higher unemployment levels, after a possible transition period. Conversely, it could even lower levels in the medium term - provided labour, product and services markets are flexible enough.
“Technology disrupts the workplace” (aside from fledgling start-ups, this trend is not so obvious)
Telecommuting appears to be more about convenience than a change in lifestyle, as the number of days per month worked from home has barely changed over the past decade1, and work remains in work places. Virtual and augmented reality (VR) technologies could prove more of a game changer by increasing the quality of remote human interactions, which in turn could potentially reduce the need for individuals to live closer to work. VR may also bring the office into everyone’s home, redefining the purpose of office space in general. But in a world where human interactions are at the core of most jobs, it remains unclear how such roles could be performed remotely. Both the importance of creativity, which enhances the importance of human interactions, and the rise of the “gig” economy, where freelancing has become more common, call for stronger network effects and lead to more local work clusters. All of this points to a stronger concentration of economic activity in dense urban areas.
“Technology is deflationary” (certainly in the short run)
While technological advancements have contributed to the emergence of large companies with high pricing power, such as the so-called GAFA stocks - Google, Amazon, Facebook and Apple – they have also lowered costs by cutting out intermediaries and eroded the margins of many traditional firms. In addition, the rise of the sharing economy, as well as constant quality enhancements, continue to put downward pressure on prices in the digital era. The extent of this decrease in inflation is debated but most recent academic studies converge towards 0.4-0.5 percentage points (pp) estimates2. This may pose challenges for central banks in the short run but it would be hard to draw many conclusions about what might happen in the longer run as the impact of digital innovation on inflation may continue to evolve and change over time.
“Innovation requires large investments” (probably one of the largest “fake truths”)
A significant characteristic of this digital era is the reduction in the need for capital investment - beyond open architecture for IT networks, 3D printing has the ability to shrink the value chain, the Internet of Things (IoT) can reduce maintenance costs, ensure longer life products, cut operating costs as well as goods trading. Conversely, even with the cloud, data storage is rising in importance. Overall, it is difficult to argue that digital disruption may have caused a reduction in overall investment, which in turn, and until productivity rises, weighs on trend growth. Yet it may have affected the composition of investment into technological machines and perhaps less productive data storage. However, we are still likely to be in a transition period and the jury is still out on the relative productivity of investments, which we expect to be productivity enhancing3 overall.
“Digital has little impact on policy-making except in terms of regulation” (actually its influence stretches far further)
We have identified three areas where the digital economy may influence policy-making. The first is monetary policy – and here two challenges are set, one being the possibility of lower inflation for a period that is difficult to determine, while the other is the impact of networks. Without fantasizing about crypto currencies, the rise of the digital economy is changing not only the means of payment and possibly money creation but also the transmission of monetary policy4. Second, cybersecurity is a rising concern for regulators across a plethora of industries, not just the financial sector. Any disruption to cables and data transportation may have a massive impact on the financial services industry and, more widely across all sectors. While the most severe cyber security breaches on FTSE 100 firms point to an average 1.8% drop in the share price of the unfortunate target – small compared to usual stock market variations – the risks to data justify the steady increase in information-security spending (10% per year over 2009-2014) and the need for micro-prudential measures. It also raises questions over the opportunity for a global coordination on taxation, which is certainly hot topic at the moment… as highlighted by the recent Franco-German-Italo-Spanish coordinated statement on corporate taxation5.
Conclusion: Technology might offer greater benefits to private equity and other types of investments
The digital revolution, as was the case during previous periods of technological disruption, constitutes a positive supply shock, which is enhancing productivity and therefore economic growth. It may, in turn, accelerate corporate profits which should ultimately benefit shareholders.
However, digital transition is a process of destructive creation which implies massive value creation by some firms and value destruction by others. For now, value creation has clearly started as the GAFA stocks show but value destruction has not yet fully materialised except in sectors where digital disruption arrived earliest (e.g. media, music and consumer electronics). Likewise, the tech sector is benefiting from a broad optimism which will spill over into a large number of industries, with the emergence of the likes of ‘fintech’, ‘foodtech’, ‘insurtech’ and ‘legaltech’ etc. The sector definitions within equity indices will likely have to change to reflect new realities.
Perhaps more importantly, an important characteristic of the digital economy is its financing. Unlike in the dotcom years, most start-up companies seek capital primarily through private equity (venture capital, crowdsourcing and more recently initial currency offerings) and remain private for much longer. This means that public equity investors may in fact miss out on a large part of value creation in the digital transition. Within public equity, the winners of the digital transition will probably be very concentrated among a few companies in the large cap space, but more disseminated in the small cap universe.
Likewise, corporate bonds appear particularly unattractive in this context in the longer run. Irrespective of their current valuations, investor payoffs may be more skewed to the downside than usual. This is because bondholders do not participate in the upside in the case of companies that thrive in the digital transition but could face significant losses if a company fails in the digital era. For example, the transformation currently at work in the auto sector makes it very difficult to have much visibility 10 years from now. It is in fact likely that companies that appear strong today in the sector will no longer exist. As a result, except for those investors highly confident in their ability to pick the long-term winners, pencilling in larger-than-usual default risk in corporate credit makes sense.
Overall, the digital economy may lead investors to look at alternative investment sources, provided regulation allows them to do so, especially for institutional investors.
1 Jones, J., “In US, telecommuting for work climbs to 37%”, Gallup, 19 August 2015.
2 See Aghion P. et al., “Missing Growth from Creative Destruction”, Federal Reserve Bank of San Francisco, Working paper series, August 2017 and Groshen, E. et al., “How Government Statistics Adjust for Potential Biases from Quality Change and New Goods in an Age of Digital Technologies: A View from the Trenches”, US Bureau of Economic Analysis, 2017.
3 See Cette, G. et al., “Long-term growth and productivity projections in advanced countries”, Banque de France, Working Paper, December 2016.
4 See He, D. et al., “Virtual currencies and beyond: initial considerations”, IMF staff discussion note, January 2016.
5 See “France, Germany, Italy, Spain seek tax on digital giants’ revenues”, Reuters, 9 September 2017.
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