This article was written by Nicholas Mitsakos : Chairman and CEO at Arcadia Capital Group.
Transformation, Valuation, Employment, and Deflation
Disruption to some of the world’s most important industries, deflationary pressure caused by scaling lower-cost businesses, and sustained low interest rates challenge traditional valuation models. Technological platforms, from blockchain-based businesses to energy storage to DNA sequencing, enable unprecedented disruption to business and economic models.
Interest rates will remain low, equity values will remain high, innovation will drive deflationary pressure, and volatility will be intense and frequent. A new approach is required to understand dynamic global competition and sustainable value.
The New Maginot Line
It’s working about as well as the first one.
The Maginot Line, France’s “ultimate defense for freedom and prosperity” was miserably inadequate. In much the same way, companies aspired to create sustainable value by building a defensive quote moat” around their businesses – a static monopoly, as it were. While this model certainly has its strengths, a static approach only works in increasingly narrow circumstances and has little flexibility. After all, Blockbuster had a mode for a long time. In an age of transformative innovation, this model may now be inadequate. A narrowly defined monopoly today could become a shuttered business in 10 years.
It is no longer appropriate to see companies through a filter of a competitive “moat.” Disruptive technologies permeating the global economy create bridges and siege engines capable of breaching any company’s static defense.
Creation and Destruction
Stable predictability is more and more anachronistic. Every company or industry will either be a disrupter or disrupted. The leading growth companies of today stand an excellent chance to be memories in short order.
This new world makes stability and defensiveness, along with a static competitive advantage less relevant. Investing will require more technological expertise, knowledge, and understanding of major developments, and understanding the accelerating impact permeating the entire economy.
Tomorrow will not look like yesterday, and a simple straight-line projection from current events is increasingly meaningless.
Business is increasingly digital and information-oriented. All assets and IP, and even the financial system itself, is now digitized. Value creation is less about manufacturing physical products and more about using information technology to improve goods and services, even if that company is a manufacturer.
Which businesses will survive, will any moats hold up, and which newcomers will displace incumbents? What outstanding businesses will exist in 20 years, and do they exist today? What forces will create new and potentially unimaginable value (remember when $1 trillion was an absurd and unattainable valuation?).
We’ve seen this movie. Consider the following transformative innovations, all occurring within a short time. Each truly changes lives with a dramatic impact on communities, nations, and the planet.
- 1876: Alexander Graham Bell develops the telephone and forms the Bell Telephone Company one year later.
- 1882: General Electric (with Thomas Edison at the helm) develops the first electrical grid in lower Manhattan. For the next several decades, General Electric (with Edison) and Westinghouse, (using the technology developed by Nikola Tesla) battle for the establishment of the nation’s electrical grid.
- 1885: Louis Pasteur develops the first vaccine against a disease that is effective for human beings. Over the next several decades, vaccines are developed that effectively prevent diseases such as diphtheria, tetanus, cholera, plague, typhoid, tuberculosis, and others.
- 1886: Karl Benz patents “a vehicle powered by a gas engine” and personal transportation will never be the same. The first mass-produced automobile in the United States was by Oldsmobile in 1901.
- 1903: The Wright Brothers develop motorized flight. We land on the moon less than 70 years later.
- 1916: Westinghouse Radio develops the first broadcast radio station.
Each transformative innovation also created almost enormous value in multiple industries, many nonexistent or unimaginable just a few years prior. We are experiencing this same transformative innovation.
Innovation and Deflation
Specifically, five technological platforms can enable generational disruption and innovation. These are:
- Artificial Intelligence
- Blockchain Technology
- DNA sequencing
- Energy storage
Each represents an unprecedented global impact – for good and bad. Along with beneficial advancements comes reduced overall employment and spectacular deflation.
When Local is Global
Technology is transforming all industries in the global economy, and its impact can be immediate. Inherent value and current cash flow models seem outdated metrics given the changes technology brings. Once again, lives will be changed, and tremendous value will be created. Characteristics of these new businesses are the following:
- Exceptional profitability of information-based businesses.
- Low marginal cost of production.
- Global markets and substantial scale more easily.
- Higher and increasing margins as revenues grow (since products are increasingly software-based with much lower incremental costs).
- Lower capital expenditures to support a growing business (also because of the software-based components of most products).
- A smaller workforce of well-educated computer scientists, engineers, and other highly skilled professionals.
Where Do We Go Now?
These factors have profound implications for the overall economy. Especially because as technology and information play a bigger role, labor becomes less necessary.
A great transition occurred as economies industrialized. Agricultural jobs were lost because of machine-powered equipment, but new jobs were generated in the manufacturing plants developed by automobile, appliance, and other manufacturers. Displaced workers could find opportunities elsewhere.
This is increasingly not the case today and in the foreseeable future. Jobs are lost to automation, imports from cheap labor countries, and a dynamic and larger mix of high-skill jobs. It’s technological industries such as information technology, artificial intelligence, communications, and entertainment that are rising to take the place of more basic manufacturing. These businesses require specialized education for their employees and can increase production and sales without a proportional increase in the number of workers.
There are not many optimistic signs new basic labor opportunities will be created. Technology-based industries are not labor-intensive and require specialized training and education. There simply does not seem to be a broad-based opportunity available for the average worker. This is worrisome because an economy is based on consumption. Consumers create value and if we have fewer consumers, we have less overall value.
So perhaps all those astronomical values given to today’s crop of disruptive companies creating new industries may be somewhat overstated today…?
Inflation, You Say?
Perhaps no other factor will impact valuations and the market more than inflation – expectations or reality.
However, perhaps the risk is not inflation so much as deflation. That may seem naïve since we are experiencing Covid-created supply chain disruptions and pervasive inflation. However, taking a longer view and looking at technologically-enabled innovation, we are entering an era not experienced since the telephone, electricity, and the automobile enabled profound and simultaneous innovation.
Boom or Bust
Here’s a thought: Innovation will drive deflation and counterbalance any inflationary pressures.
These new innovative companies will create tremendous value, but there will also be pressures exerted on more traditional companies who are acting as if the world is not going to change. They are probably saddled with products and services that will become obsolete because of the record-breaking amount of innovation taking place today. A likely competitive response will be lower pricing.
So, there will be a downward spiral forced by lower costs from innovative companies and magnified by more traditional companies lowering prices, causing a “deflationary boom.”
About That Boom
With automation and artificial intelligence, productivity is going to go up dramatically. Productivity increases will bring wealth creation and grow the size of the economy. Current estimates are that the US economy may be worth $28 trillion in the year 2035 (it is currently worth approximately $20 trillion). However, there is a reasonable estimate that, because of automation and artificial intelligence, the US economy could double in that time and be worth this much is $40 trillion.
And Now for Something Contrarian…
Technology will increase productivity substantially while simultaneously creating deflationary pressure. Technology’s positive impact on productivity will contribute to a substantial jump in real GDP and counterbalance the Fed – remember them?
The Fed and Things Unforeseen
The Fed, apparently satisfied with its ability to control inflation and provide “full employment,” seems to have taken on the additional task of keeping the securities markets on an upward trajectory. It has radically lowered interest rates and injected massive liquidity into the economy.
Recently, the Fed has announced that it’s going to “taper” its stimulative program of bond buying, and it is widely expected that it will begin to raise interest rates next year. Will the impact on the economy be highly negative? Will the markets revolt, and will a market correction convince the Fed to go back to a low-interest-rate regime? Will the Fed keep asset prices rising in perpetuity? We will see, but one thing is certain, the Fed will not be passive.
It no longer trusts that there should be a free market for money.
A Free Market?
The is Fed playing an unprecedented role in steering the economy. However, the economy will perform best in the long run if it’s a free market, moving resources to their optimal use. If we believe that creative destruction and a functioning market economy assure the best outcomes over time, a free market in money is the only way. Currently, we do not have that.
- Since 2010, Fed purchases of Treasury debt have funded as much as 60% to 80% of the entire government borrowing requirement. In other words, Fed actions have crowded out the private sector for more than 10 years, pushing yields to lows and stock prices to record highs.
- In fiscal 2021, the Fed purchased $1 trillion in Treasury debt, and the Treasury drained $1.6 trillion from its savings account at the Fed. These actions covered nearly the entire budget deficit, equal to nearly all the pandemic-related government borrowing. Based on monthly estimates, there was actually a funding surplus this past summer.
- Yes, that’s why the 10-year Treasury yield reached a low of 1.17% in August despite high inflation rates. As of this writing at the end of November 2021, the 10-year Treasury yield is 1.67%
So, Guess What?
The U.S. is still able to issue debt at low interest rates – and the main buyer is the U.S.! That low interest rate engine is not going to stop anytime soon.
Here’s what we will see:
- The Fed will keep interest rates low
- Equity values will remain high
- Innovation will drive deflationary pressure
- Markets will be in for continued unprecedented intense and frequent volatility
- Eye-watering valuations will drive a virtuous cycle of innovation, disruption, and high market values.
A few simple conclusions on a few simple topics.