Back in March I wrote this article about the reversal of trends in globalisation. The reversal continues.
Back in March I wrote this article about the reversal of trends in globalisation. The reversal continues.
Macro Letter – No 125 – 17-01-2020
US Bonds – 2030 Vision – A decade in the doldrums
Having reached their yield low at 1.32% in July 2016, US 10yr bond yields have been locked in, just shy of, a 2% range for the last two and half years (subsequent high 3.25% and low 1.43%). For yields to fall again, supply must fall, demand rise or central banks, recommence their experimental monetary policies of negative interest rates and quantitative easing. For yields to rise, supply must rise, demand fall or central banks, reverse their multi-year largesse. Besides supply, demand and monetary policy there are, however, other factors to consider.
One justification for a rise in US bond yields would be an uptick in inflationary pressure. Aging demographic have been the principal driver of the downward trajectory of secular inflation. During the next decade, however, Generation Y borrowing will accelerate whilst Generation X has yet to begin their aggressive saving spree. The table below looks at the borrowing and saving patterns of the demographic cohorts in the US: –
Source: US Census Bureau
Excepting the obesity and opioid epidemics, life expectancy will, nonetheless, continue to extend. The Gen Y borrowing binge will not override the aging demographic effect. It’s influence on the inflation of the next decade is likely to be modest (on these grounds alone we will not see the return of double-digit inflation) and the longer term aging trend, bolstered by improvements in healthcare, will return with a vengeance during the 2030’s, undermining the last vestiges of current welfare provisions. Much more saving will be required to pay for the increasing cost of healthcare and pensions. With bond yields of less than 4%, an aging (and hopefully healthier) population will need to continue working well beyond current retirement age in order to cover the shortfall in income.
Another secular factor which has traditionally kept a lid on inflation has been technology. As Robert Solo famously observed back in 1987, ‘You can see the computer age everywhere but in the productivity statistics.’ Part of the issue is that productivity is measured in currency terms. If the price of a computer remains unchanged for a decade but its capacity to compute increases 10-fold over the same period, absent new buyers of computers, new sales are replacements. In this scenario, the improvement in productivity does not lead to an uptick in economic growth, but it does demonstrably improve our standard of living.
Looking ahead the impact of machine learning and artificial intelligence is just beginning to be felt. Meanwhile, advances in robotics, always a target of the Luddite fringe, have been significant during the last decade, spurred on by the truncation of global supply chains in the wake of the great financial crisis. This may be to the detriment of frontier economies but the developed world will reap the benefit of cheaper goods.
Central Bank Omnipotence
When Paul Volcker assumed the helm of the Federal Reserve in the late 1970’s, inflation was eroding any gains from investment in government bonds. Armed with Friedman’s monetary theories, the man who really did remove the punch-bowl, raised short-term rates to above the level of CPI and gradually forced the inflation genie back into its bottle.
After monetary aggregate targets were abandoned, inflation targeting was widely adopted by many central banks, but, as China joined the WTO (2001) and exported their comparative advantage in labour costs to the rest of the world, those same central bankers’, with Chairman Bernanke in the vanguard, became increasingly petrified by the prospect of price deflation. Memories of the great depression and the monetary constraints of the gold exchange standard were still fresh in their minds. For an economy to expand, it was argued, the supply of money must expand in order to maintain the smooth functioning of markets: a lack of cash would stifle economic growth. Inflation targets of around 2% were deemed appropriate, even as technological and productivity related improvements insured that the prices of many consumer goods actually declined in price.
Inflation and deflation can be benign or malign. Who does not favour a stock market rally? Yet, who cares to witness their grocery bill spiral into the stratosphere? Who cheers when the latest mobile device is discounted again? But does not panic when the value of their property (on which the loan-to-value is already a consumption-sapping 90%) falls, wiping out all their equity? Blunt inflation targeting is frankly obtuse, but it remains the mandate of, perhaps, the most powerful unelected institutions on the planet.
When economic historians look back on the period since the collapse of the Bretton Woods agreement, they will almost certainly conclude that the greatest policy mistake, made by central banks, was to disregard asset price inflation in their attempts to stabilise prices. Meanwhile, in the decade ahead, upside breaches of inflation targets will be largely ignored, especially if growth remains anaemic. Central bankers’, it seems, are determined to get behind the curve, they fear the severity of a recession triggered by their own actions. In the new era of open communications and forward guidance they are reticent to increase interest rates, too quickly or by too great a degree, in such a heavily indebted environment. I wrote more about this in November 2018 in The Self-righting Ship – Debt, Inflation and the Credit Cycle: –
The current level of debt, especially in the developed economies, seems to be acting rather like the self-righting ship. As economic growth accelerates and labour markets tighten, central banks gradually tighten monetary conditions in expectation of inflation. As short-term rates increase, bond yields follow, but, unlike the pattern seen in the higher interest rate era of the 1970’s and 1980’s, the effect of higher bond yields quickly leads to a tempering of credit demand.
Some commentators will rightly observe that this phenomenon has always existed, but, at the risk of saying ‘this time it’s different,’ the level at which higher bond yields act as a break on credit expansion are much lower today in most developed markets.
Conclusions and Investment Opportunities
There have been several drivers of disinflation over the past decade including a tightening of bank regulation, increases in capital requirements and relative fiscal austerity. With short-term interest rates near to zero in many countries, governments will find themselves compelled to relax regulatory impediments to credit creation and open the fiscal spigot, at any sign of a recession, after all, central bank QE appears to have reached the limits of its effectiveness. The table below shows the diminishing returns of QE over time: –
Source: M&G, Deutsche Bank, World Bank
Of course the central banks are not out of ammunition just yet, the Bank of Japan experiment with qualitative easing (they currently purchase ETFs, common stock may be next on their agenda) has yet to be adopted elsewhere and the Federal Reserve has so far resisted the temptation to follow the ECB into corporate bond acquisition.
For the US bond market the next decade may well see yields range within a relatively narrow band. There is the possibility of new record lows, but the upside is likely to be constrained by the overall indebtedness of both the private and public sector.
A hopefully more balanced view of the demographic challenges facing developed economies.
Macro Letter – No 102 – 28-09-2018
UK Financial Services – Opportunities and Threats Post-Brexit – Short-term Pain, Long-term Gain?
In a departure from the my usual format this Macro Letter is the transcript of a speech I gave earlier this week at the UK law firm, Collyer Bristow; Thomas Carlisle may have dubbed Economics ‘the dismal science,’ but I remain an optimist.
Setting aside the vexed question of whether Brexit will be hard, soft or stalled, the impact on financial services (and, indeed, the majority of UK trade in goods and services) will be dramatic.
Financial markets (and businesses in general) loathe uncertainty. Ever since the referendum result, investment decisions have been postponed or cancelled. When investment is being made it is generally tentative and defensive. Exporters and importers alike are striving to develop alternative strategies to maintain and protect their franchises.
As a long-term economic commentator, I try to look beyond the immediate impact of events, since near-term expectations are usually reflected in the valuation of an asset or currency. Brexit, however, is a particular challenge, not only due to near-term uncertainty but because policy decisions taken now and in the wake of the March 2019 deadline could set the UK economy on an unusually wide array of possible trajectories.
To begin an analysis of the impact post-Brexit on financial services, there are several near-term threats; here are a selection: –
Earlier this month Mark Carney, the Governor of the Bank of England, warned cabinet ministers that a ‘no-deal’ on Brexit could see house prices decline by as much as one third and a rapid rise in defaults. The subsequent impact on financial institutions balance sheets and the inevitable curtailment of bank lending could be severe. Jacob Rees-Mogg even dubbed him, ‘The High Priest of Project Fear.’
Assuming no deal is agreed, the access which financial services providers in the UK have had to the EU27 will not be available after March 2019. Many existing contracts and licensing agreements will need to be rewritten.
Divergence between the regulatory regime in the UK and Europe remains a distinct risk. The types of legal issues surrounding, for example, ISDA Master agreements (Deutsche Bank AG v Comune di Savona) will inevitably become more widespread.
The ECB is vocal in its mission to maintain control over the clearing and settlement of Euro denominated transactions. Many financial services activities which currently take place in the UK may need to be transferred to another EU country.
In the near-term, these types of factors will reduce trade and economic growth, both in the UK and, to a lesser degree, in Europe. In May 2017 I wrote an essay entitled ‘Hard Brexit Maths – Walking Away’ in which I estimated the negative impact a no-deal Brexit would have on the EU. The UK’s NIESR estimated the bill for a Hard Brexit to the UK at EUR66bln/annum. I guesstimated the cost of Hard Brexit to the EU at EUR 62bln/annum. Both forecasts will probably prove inaccurate.
The reduced free movement of workers from the EU is another significant factor. It will lead to a rise in a toxic combination of skill shortages (due to new immigration controls) and unemployment, as companies are forced to conserve capital to weather the inevitable economic slowdown.
There are, however, several near-term opportunities, here are a small selection: –
The currency has already weakened. Whilst this may be inflationary it makes UK exports more competitive. Whether the UK can take advantage of currency weakness remains to be seen, history is not on our side in this respect.
Aided by a lavish tax cut, the US economy is growing faster than at any-time since the financial crisis, underpinning its currency. Its trade deficit is growing despite tariff barriers.
The Trump administration appears to have focused its ire on trade surplus countries, of which Germany is the largest European example. The UK is not under the White House microscope to the same degree.
Seizing the opportunity presented by these financial and geopolitical shifts is easier to speak of than to grasp. Nonetheless, just this month Absa Bank of South Africa (recently spun-off from Barclays) announced plans to open a London office to capitalise on post-Brexit opportunities connected with the fast-growing economies of Africa.
The medium-term risks will mostly be borne out of inertia. Until the shape of Brexit is clear, decisions will continue to be postponed. Once Brexit occurs there will be inevitable technical problems, stemming from systems issues and new procedures. Growth will slow further, business operating costs will need to be cut, employment in financial services (and elsewhere) will decline at exactly the moment when greater investment should be undertaken.
But, new trade deals will be negotiated, not just with Europe and the US, but also with the countries of the British Commonwealth, notably (but not just) India. Many of these countries are among the fastest growing economies in the world, often imbued with benign demographics. Here is a rapidly expanding working age population in need of capital investment and financial services. Ruth Lea, Chief Economist at Arbuthnot Latham has commentated on this subject at length during the last two years. In April she wrote: –
Commonwealth countries, taken together, have buoyant economic prospects and their share of global output continues to increase (especially in PPP terms). The EU28 share, in contrast continues to decline.
UK exports to the top eight Commonwealth countries rose by over 31% between 2006 and 2016, but total exports rose by 40%. And the share of UK exports going to the top eight Commonwealth countries fell from 7.5% in 2006 to 7.0% in 2016…
There is little doubt that Commonwealth countries have the potential to be significant growth markets for the UK’s exports, given their favourable growth prospects and demographics. This is all the more likely given the probability of trade deals with individual Commonwealth countries after Brexit.
David Riccardo defined the law of comparative advantage just over two hundred years ago. Perhaps one of the best examples of the continuance of the phenomenon is Switzerland, which has seen its currency appreciate against the US$ by approximately 3% per year, every year since fiat currencies were freed from their shackles after the collapse of the Bretton Woods agreement in 1971. Here is a chart of the US$/CHF exchange rate over the period: –
The Swiss turned to pharmaceuticals and other value-added businesses. The success of this strategy, despite a constantly appreciating currency, has spawned an entire industrial region – the Rhone-Alp economic area, which incorporates German, French, Italian and Austrian companies bordering Switzerland. This region is among the most economically productive in the EU.
The UK has an opportunity, post-Brexit, to focus on economic growth. As a trading nation, we should concentrate our efforts on re-forging links with the fast-growing countries of the Commonwealth, where the advantages of a common language and legal system favour the UK over other developed nations.
An example of this opportunity is in education. We have a world class reputation for education and training. Combine this redoubtable capability with the abundance of new technologies, which permit the delivery of content globally via the internet, and we can provide the full gamut of instruction, ranging from primary to tertiary and professional via a combination of video content, on-line examination and tailored digital collateral.
A recent MOOC (Mass Open On-line Course) In which I enrolled, attracted students from across the world. The course was dedicated to finance and among the students with whom I interacted was a Masi tribesman from Kenya who hoped to develop micro-finance solutions for the local farming community. The world is our veritable oyster.
Conclusion – The Bigger Picture
The economies of the developed world are growing more slowly than those of developing nations. Providing goods and services to the fastest growing economies makes economic sense. Many of the largest companies listed on the UK stock market have been oriented to take advantage of this dynamic for decades. Brexit is proving to be cathartic, we should embrace change: the sooner the better.
The Austrian economist, Joseph Schumpter, described the cycle of economic development as including a period of ‘creative destruction’. Brexit could be an extreme version of this process. The patterns of trade which have developed since the end of WW2 have been concerned with promoting cohesion between European nations, but, as Hyman Minsky famously noted, ‘stability creates the seeds of instability.’ I believe the political polarisation seen in Europe and elsewhere is a reaction against the success of the global financial and economic system and the institutions and alliances created to insure its success. We are entering an era of change and Brexit is but one personification of a growing trend. Technology has shrunk the world, empowered the individual and (in the process) undermined the influence of nation states and international institutions. Individual freedom is ascendant but with freedom comes responsibility.
One of the greatest challenges facing the UK and other developed nations, in the long run, is the provision of pensions and health insurance to an increasingly ageing population. Many of the financial products required by these ageing consumers are ones in which the UK is a world leader. The developing world is rapidly growing richer too. Their citizens will require these self-same products and services. Brexit is an opportunity to look forward rather than back. If we embrace change we will thrive, if not change will occur regardless. Post-Brexit there will be considerably pain but, if we manage to learn from history, there can also be long-term gain.
Macro Letter – No 97 – 18-05-2018
Robots, employment and the mis-measurement of productivity
The subject matter of this Macro Letter is broad, so I shall confine my investigation to the UK. It was, after all, one of the first countries where services became a larger percentage of GDP than manufacturing. The crossover between manufacturing and services is estimated to have happened around 1881. When Napoleon Bonaparte described England as, ‘A nation of shopkeepers,’ his intension may have been derisive, but his observation was prescient. Of course, M. Bonaparte was actually quoting Adam Smith, who first coined the phrase in his magnum opus, An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776: now, he really was prescient.
As we stare into the abyss, anticipating the huge percentage of manufacturing – and now, many services – jobs which are expected to be replaced by machines, it behoves us to begin by reviewing the accuracy with which we measure services in general. A recent paper from the Centre for Economic and Business Research does just that for one sub-sector, although it suggests that mis-measurement of economic activity in services, always difficult to define, may be a factor in the poor productivity record of the UK. I have often described Britain as a post-industrial nation but this research, into one of the most vibrant corners of the economy, makes fascinating reading – The True Value of Creative Industries Digital Exports – CIC, CBER – March 2018 – finds, among other things that: –
The UK’s creative industries exports are: –
£46bn in goods and services – 24% higher than the official figure
£31bn of total creative exports are services – 41% higher than the official figure
£21bn of these creative services are digital services – 40% higher than the official figure
The CEBR goes on to point out other weaknesses in current measurements of economic activity: –
…estimated official figures for 2016 highlight that the majority of creative industries sub-sectors are exporting digital services. The IT, software and computer services sector, for example, exports £8.95bn in digital services. However, according to these figures, the crafts and museums, galleries and libraries sectors’ digital services exports are zero – which we know is not the case.
Many UK YouTube channels, for example, are watched by millions of viewers across the world. It is through these types of platforms that the creative industries export audiovisual content, music, and tutorials. Such platforms and the content they offer, however, may not be registered as a service export. This is due to difficulties capturing data for business models such as those offering free content and based on advertising revenues.
There are also structural challenges with collecting data on such exports. Often, it is difficult for digital intermediaries to determine the point of sale and purchase. The borderless way in which many global firms operate presents additional complications and the origin of the creative content, and of those who consume it, is frequently hard to track.
This brings me to the vexed question of productivity growth in the new machine age. In the Deloitte – Monday Briefing – Thoughts on the global economy – from 30th April, the author reflects on the discussions which occurred at the annual global gathering of Deliotte’s economic experts. I’m cherry picking, of course, the whole article is well worth reading: –
Despite discussion of recession risks I was struck by a cautious optimism about the long-term outlook. There was a general view that the slowdown in productivity growth in the West has been overstated, partly because of problems in capturing gains from technological change and quality improvements. As a result most of us felt that Western economies should be able to improve upon the lacklustre growth rates seen in the last ten years.
We agreed too that apocalyptic media stories about new technologies destroying work were overcooked; technology would continue to create more jobs than it destroys. The challenge would be to provide people with the right skills to prosper. The question was, what skills? We had a show of hands on what we would recommend as the ideal degree subjects for an 18-year-old planning for a 40-year career. Two-thirds advocated STEM subjects, so science, technology, engineering and maths. A third, myself included, opted for humanities/liberal arts as a way of honing skills of expression, creativity and thinking.
Mr Stewart ends by referring to a letter to the FT from Dr Lawrence Haar, Associate Professor at the University of Lincoln, in which he argues that poor UK productivity is a function of the low levels of UK unemployment. In other words, when everyone, even unproductive workers, are employed, productivity inevitably declines:-
…it does not have to be this way. Some economies, including Singapore, Switzerland and Germany, combine low unemployment and decent productivity growth. The right training and education can raise productivity rates for lower skilled workers.
This theme of productivity growth supported by the right education and training is at the heart of a recent paper written by Professor Shackleton of the IEA – Current Controversies No. 62 – Robocalypse Now? IEA – May 2018 – the essay cautions against the imposition of robotaxes and makes the observation that technology has always created new jobs, despite the human tendency to fear the unknown: why should the adoption of a new swath of technologies be different this time? Here is his introduction: –
It is claimed that robots, algorithms and artificial intelligence are going to destroy jobs on an unprecedented scale.
These developments, unlike past bouts of technical change, threaten rapidly to affect even highly-skilled work and lead to mass unemployment and/or dramatic falls in wages and living standards, while accentuating inequality.
As a result, we are threatened with the ‘end of work’, and should introduce radical new policies such as a robot tax and a universal basic income.
However the claims being made of massive job loss are based on highly contentious technological assumptions and are contested by economists who point to flaws in the methodology.
In any case, ‘technological determinism’ ignores the engineering, economic, social and regulatory barriers to adoption of many theoretically possible innovations. And even successful innovations are likely to take longer to materialise than optimists hope and pessimists fear.
Moreover history strongly suggests that jobs destroyed by technical change will be replaced by new jobs complementary to these technologies – or else in unrelated areas as spending power is released by falling prices. Current evidence on new types of job opportunity supports this suggestion.
The UK labour market is currently in a healthy state and there is little evidence that technology is having a strongly negative effect on total employment. The problem at the moment may be a shortage of key types of labour rather than a shortage of work.
The proposal for a robot tax is ill-judged. Defining what is a robot is next to impossible, and concerns over slow productivity growth anyway suggest we should be investing more in automation rather than less. Even if a workable robot tax could be devised, it would essentially duplicate the effects, and problems, of corporation tax.
Universal basic income is a concept with a long history. Despite its appeal, it would be costly to introduce, could have negative effects on work incentives, and would give governments dangerous powers.
Politicians already seem tempted to move in the direction of these untested policies. They would be foolish to do so. If technological change were to create major problems in the future, there are less problematic policies available to mitigate its effects – such as reducing taxes on employment income, or substantially deregulating the labour market.
Professor Shackleton provides a brief history of technological paranoia. Riccardo added a chapter entitled ‘On Machinery’ to the third edition of his ‘Principles of Political Economy and Taxation,’ stating: –
‘I am convinced that the substitution of machinery for human labour is often very injurious to the interests of the class of labourers’.
While Marx, writing only a few decades later, envisaged a time when man would be enabled to: –
‘…to hunt in the morning, fish in the afternoon, rear cattle in the evening, criticise after dinner… without ever becoming hunter, fisherman, herdsman or critic.’
As for Keynes essay on the, ‘Economic Possibilities for our Grandchildren’, his optimism is laudable if laughable – 15 hour working week anyone?
The paranoia continues, nonetheless – The Economist – A study finds nearly half of jobs are vulnerable to automation – April 2018 – takes up the story:-
A wave of automation anxiety has hit the West. Just try typing “Will machines…” into Google. An algorithm offers to complete the sentence with differing degrees of disquiet: “…take my job?”; “…take all jobs?”; “…replace humans?”; “…take over the world?”
Job-grabbing robots are no longer science fiction. In 2013 Carl Benedikt Frey and Michael Osborne of Oxford University used—what else?—a machine-learning algorithm to assess how easily 702 different kinds of job in America could be automated. They concluded that fully 47% could be done by machines “over the next decade or two”.
A new working paper by the OECD, a club of mostly rich countries, employs a similar approach, looking at other developed economies. Its technique differs from Mr Frey and Mr Osborne’s study by assessing the automatability of each task within a given job, based on a survey of skills in 2015. Overall, the study finds that 14% of jobs across 32 countries are highly vulnerable, defined as having at least a 70% chance of automation. A further 32% were slightly less imperilled, with a probability between 50% and 70%. At current employment rates, that puts 210m jobs at risk across the 32 countries in the study.
For a robust analysis, if not refutation, of the findings of Frey and Osborne, I refer you back to Professor Shackleton’s IEA paper. He is more favourably disposed towards the OECD research, which is less apocalyptic in its conclusions. He goes on to find considered counsel in last year’s report from McKinsey Global Institute (2017) A Future that Works: Automation Employment and Productivity.
The IEA paper highlights another factor which makes it difficult to assess the net impact of technological progress, namely, the constantly changing nature of the labour market. As the table below reveals it has hardly been in stasis since the turn of the millennium: –
Percentage change in employment 2001-2017, selected occupations
Notes: April-June of years. Figures in brackets are April-June 2017 levels of employment.
Source: Author’s calculation from ONS
The job losses are broadly predictable; that technology has usurped the role of the travel agent is evident to anyone who booked a flight, hotel or hire-car online recently. For economists there are always challenges in capturing the gains; back in 1987 Robert Solow, a recipient of the Nobel prize from economics, famously observed, ‘You can see the computer age everywhere but in the productivity statistics’ – perhaps the technology has been creating more jobs than thought. Does the 170% rise in Animal Care and Control owe a debt to technology? You might be inclined to doubt it but the 400,000 Uber drivers of London probably do. We are still seeking signs in the economic data for something we know instinctively should be evident.
Between the mis-measurement of economic activity (if technology is being under-estimated to the tune of 24% in the creative industries sector to what extent are productivity gains from technology being underestimated elsewhere?) and the ever changing employment landscape, I believe the human race will continue to be employed in a wide and varied range of increasingly diverse roles. If some of the more repetitive and less satisfying jobs are consigned to robots and machine learning computer code, so much the better for mankind. For more on, what is sometimes termed, the routinisation of work, this working paper from Bruegel – The impact of industrial robots on EU employment and wages: A local labour market approach – April 2018 is inciteful. They examine six EU countries and make comparisons, or highlighting contrasts, with the patterns observed in the US. Their conclusions are somewhat vague, however, which appears to be a function of the difficulty of measurement: –
We only find mixed results for the impact of industrial robots on wage growth, even after accounting for potential endogeneity and potential offsetting effects across different population or sectoral groups.
…We believe that future research on the topic should focus on exploiting more granular data, to explore whether insignificant aggregate effects (on wages) are to the result of counterbalancing developments happening at the firm level.
Bruegel refrain from proposing cuts to personal taxation as favoured by the IEA, suggesting that a more complex policy response may be required, however, their conclusions are only marginally negative. I am inclined to hope that market forces may be allowed to deal with the majority of the adjustment; they have worked well if history is any guide.
Conclusions and investment opportunities
Ignoring the fact that we are nine years into an equity bull market and that interest rates are now rising from their lowest levels ever recorded, the long term potential for technology remains supportive for equity markets, for earnings growth and for productivity. If history repeats, or even if it simply rhymes, it should also be good for employment.
With interest rates looking more likely to rise than fall over the next few years, companies will remain reticent to invest in capital projects. Buying back stock and issuing the occasional special dividend will remain the policy du jour. Assuming we do not suffer a repeat of the great financial recession of 2008 – and that remains a distinct possibility – the boon of technology will create employment with one invisible hand as it creatively destroys it with the other (with apologies to Smith and Schumpeter). If governments can keep their budgets in check and resist the temptation to siphon off investment from the productive sectors of the economy (which, sadly, I doubt) then, in the long run, the capital investment required to create the employment opportunities of the future will materialise.
Macro Letter – No 81 – 21-07-2017
Has Bitcoin come of age?
Bitcoin (BTC) came into existence in January 2009. It was not the first ‘cryptocurrecny’ and there are now an estimated 950 competitors, with new ICO’s ‘Initial Coin Offerings’ appearing almost daily.
BTC’s closest rival in terms of coins in circulation is Ethereum (ETH). The chart below shows how these currencies % of total market capitalisations has waxed and waned:-
I want to concentrate on BTC since it remains the market leader with a total circulation of $33bln (reference BTCUSD 2000) whilst the outstanding issuance of its nearest rival ETH is $16bln.
Below is a four month chart of BTCUSD, its price has fallen by almost one third in just over a month:-
The recent price action needs to be seen in a broader context. The price has increased from less than BTCUSD 1000 in late March. On April 1st the Japanese authorities officially recognised BTC for the first time: perhaps, this was the catalyst for its spectacular rise.
The subsequent precipitous decline in price may be related to a proposed software change to be introduced on 21st July, known as SegWit, which is discussed in Cryptocurrency Value: Growing Pains or Something More? By Ryan Shea – here’s the rub:-
SegWit2x software, which introduces SegWit while doubling the block size to 2MB, will be released on July 21. More than 80% of the network hash rate has agreed to run the SegWit2x code, which suggests that the solution to increasing bitcoin’s scalability will be enacted smoothly.
However, it is also possible that the hard fork required to increase the block size leads to a bifurcation of bitcoin into two separate currencies –something that would unquestionably trigger a sharp price correction by undermining the bitcoin brand. (The key date by which a split can be avoided is August 1 when BIP148 activates – this represents the last opportunity for miners to accept Segwit2x and thereby avoid a chain split resulting in the creation of two parallel bitcoins.)
There have been victories and defeats during the evolution of BTC, as it has evolved from an obscure novelty to a serious contender for investors seeking a store of value. The price volatility reflects these uncertainties but it is not demonstrably different from the volatility seen in several commodity markets.
For a security, commodity or a currency to gain credence, among financial market operators, it needs to offer a store of value, liquidity and convertibility. If can achieve these attributes it should have collateral value, by which I mean, BTC should be capable of being borrowed or lent. This is already happening. Some cryptocurrency exchanges are offering a rate of interest on term deposits and others offer the opportunity for holders of BTC to lend their currency to traders who wish to borrow it, primarily to sell the currency short. Whilst there is not really a ‘risk-free rate’ for BTC an interest rate term structure is beginning to emerge as the table below, derived from a number of exchanges, shows:-
There may well be other exchanges offering a variety of differing interest rates. but this, I hope, provides a snapshot of the current environment.
The other aspect of financial deepening which will help BTC come of age is the development of a derivatives market. I believe the arrival of exchanges for BTC futures and options is a very positive signal.
The futures exchanges include Okex, CryptoFacilties, BitMEX, BitVC, Coinut and Deribit which also offers options – there may be several others. Today (Monday 17th July) I have taken some snap shots of the futures and options pricing from Deribit.
With the BTCUSD spot price at 2027, the July future (expiration 28th July) traded at a discount of $12 ($2015) this is known in futures parlance as a backwardation. The September contract (expiration 29th September) was, by contrast, trading at a premium, or contango ($2070). Because of high demand from leveraged traders to borrow US$ to buy BTC the forward/futures price of BTCUSD normally trades at a premium (contango). The current environment is unusual, the forced liquidation which has fuelled the recent collapse in the price has led to, what is likely to be a temporary, backwardation. John Jansen – CEO of Deribit – explained the anomaly during a recent interview:-
…when the market is bullish, US$ interest rates spike up and BTC interest rates go down: uses want to borrow USD to buy BTC. In other words, short USD and go long BTC…there is an overall tendency for speculators to be long, therefore, the arbitrage traders are short BTC (lending out their USD) or short the future. USD interest rates are, therefore, normally higher than BTC rates which explains the contango in BTCUSD futures prices.
…on BTC platforms, annualized interest rates on US$ are on average maybe 20%…which would imply that the future should trade at a 20% annualized contango. Arbitrage traders take the other side of the trade…but get paid for their trouble.
Over time I expect the BTC market to become more efficient and the natural relationship for BTC futures should (other things equal) eventually become a small backwardation, reflecting the 1.5% differential between lower US$ and higher BTC interest rates. There are a number of arbitrage opportunities for those who want to dig deeper, but remember credit risk, both in terms of counterparties and exchanges, together with risks surrounding convertibility are nuanced. It may not be the free-lunch you perceive it to be.
This brings me to the BTC option market. The prices in the table below are again from Deribit:-
I regret the resolution this table is less than I’d like but it shows some important features. Firstly, implied volatility is trading at a substantial premium to historic volatility. The chart below shows the evolution of historic volatility and the BTC price over the last three months:-
The July option series expires on 28th but the mid-market implied volatility for the September 29th expiration is not significantly lower – implied call volatility stands at 97%, for puts it is 85%. At this stage in the development of the BTC options market, I suspect the majority of the buyers are speculative traders rather than desperate hedgers, but option market-makers are wise to build in a margin of safety given the tendency of the underlying market price to gap lower or higher: delta and gamma hedging is challenging with these price swings. The bid/offer spreads on the options are also wide, another reflection of the nascent nature of the marketplace.
A final measure of immaturity – or perhaps I should say, opportunity – which the option market reveals, may be found in the shape of the volatility surface. The chart below is extrapolated from the mid-market implied volatilities in the table above:-
In a liquid options market one would normally expect the lowest implied volatility to be at-the-money – around the $2000 strike price. In the chart above the nadir of volatility is around the $1900 strike, a level breached briefly last weekend.
Conclusions and investment opportunities
Cryptocurrencies have captured the imagination of many new participants, from geeks to gold bugs, but, as BTC achieves greater legitimacy, the market will deepen and mature. The adoption of scalable technology to deal with the exponential increases in trading volume is a part of this process. The acceptance of distributed ledger technology across other parts of the financial services sector will also be supportive.
From a technical perspective the price of BTC has corrected by around 50% – since March it has risen from under $1000 to $3000 and is now back around $2000 (Monday 17th July). In absolute terms it has fallen by just over one third. This is a healthy price correction, typical of the price action witnessed from time to time in more liquid and established commodity markets: US Natural Gas springs to mind.
As an investment, the argument for holding BTC is more tenuous. It is a currency with no government or central bank to underwrite its value, however, the expansion of the BTC monetary base is strictly controlled, making it more like a hard currency, such as we had during the Bretton Woods era, as opposed to the endlessly debased fiat currencies we are inveigled to consider of value today.
Currencies have no implicit yield but BTCUSD currently offers a theoretical positive carry of around 1.5%. As mentioned above, this relationship is currently distorted by the demand to borrow US$ to buy BTC by leveraged traders. Any investment in an asset which has no earnings and pays no dividend/coupon/interest must by its nature be a trading asset. However, strategies such as high frequency, robotic, liquidity provision and long term, trend following, are among a number of exciting trading opportunities for the active BTC operator.
The fundamentals driving BTC investment revolve around: investor distrust in fiat currencies, loathing of government intervention in asset markets and belief in the tenability of cryptocurrencies as a lasting store of value both from a technical and regulatory perspective. These fundamental drivers of valuation have, in the past and will in the future, cause sudden repricing’s. Outside of these seismic episodes, the price of BTC will be driven by capital flows. With liquid currency pairs like EURUSD, the economic fundamentals of both geographic regions are of equal importance. This is unlikely to be the case for BTC for the foreseeable future. BTC volatility eclipses the majority of its developed currency peers; its true value, whilst it is becoming gradually clearer, will remain ephemeral for some time to come.
Macro Letter – No 75 – 21-04-2017
Will technology change the prospects for emerging market growth?
In July 2016 the International Labor Organisation (ILO) released a report entitled – ASEAN in Transformation – in the preface it relates the apocryphal story of a 1950’s conversation between Henry Ford, Chairman of Ford Motor Company, and Walter Reuther, Leader of the United Automobile Workers Union.
Ford asked, “Walter, how are you going to get those robots to pay your union dues?” to which Reuther responded, “Henry, how are you going to get them to buy your cars?” It reminds us that disruptive technology is not new. As the latest wave of innovation begins to disrupt employment globally, it makes sense to reassess the prospects for some of the world’s fastest growing economies.
The ILO report goes on to focus on the impact of technology on ASEAN countries, a region with 632mln people. This is an under-researched topic. They highlight the industries which are most likely to be affected and suggest ways countries can adapt to minimise the impact of automation on employment. This is their conclusion:-
Considerable opportunities for growth exist within ASEAN. Importantly, the local domestic market is expanding, and ASEAN’s middle class is expected to grow to 125 million by 2025. This represents a massive and emerging regional market.
However, threats remain, and in some cases, are intensifying. In particular, a range of labour-intensive sectors in a number of less developed countries are susceptible to major technological disruption, leading to potential large-scale job displacement. The consequences for these countries could be profoundly negative if they are unprepared to adapt.
We are witnessing the emergence of new markets, the potential relocation of production, the rise of new hiring trends and the displacement of lower skilled jobs. Supplying workers with the appropriate skills and competencies remains a major challenge. Overall, concerted efforts are required from all ASEAN stakeholders. They should act now to build a future of innovation and growth shaped with better employment opportunities.
The World Bank Development Report 2016 – Digital Dividends provides a global perspective. Here are a couple of graphs which illuminate the challenging landscape:-
Source: World Bank
If the unadjusted percentages indicated in the graph above are realised the social and political stability of many countries maybe undermined, however, the next graph shows which occupations are likely to be most at risk. It also shows which occupations can be expected to benefit from the productivity enhancing impact of new technology:-
Source: World Bank
Be an expensive complement (stats knowhow) to something that’s getting cheaper (data).
—Hal Varian, Chief Economist, Google, 2014
Going back to the ILO report, the key to creating workers with the correct skills is designing appropriate education. According to Asian Nation:-
50.5% Asians, age 25 and older, who have a bachelor’s degree or higher level of education. Asians have the highest proportion of college graduates of any race or ethnic group in the country and this compares with 28 percent for all Americans 25 and older.
This graph shows the educational attainment across ASEAN:-
Singapore scores highly but so does Cambodia, however, it is the low skilled worker who will suffer; the retraining challenges, for Asia and elsewhere, will be substantial. More than 60% of salaried workers in Indonesia and 73% in Thailand are at risk from automation. The highest risk group are employed in Textiles, Clothing and Footware. More than 9mln people are employed in this sector across ASEAN and the ILO estimate that 64% are at risk in Indonesia, 86% in Vietnam whilst in Cambodia that figure rises to 88%.
Business Process Outsourcing (BPO) is another industry which is ripe for automation. There is a heavy concentration of BPO in the Philippines where more than 1mln salaried working are employed. The ILO estimate that 89% are at risk from automation.
Earlier this year I discussed the demise of China as a low-cost manufacturing hub in – Low cost manufacturing in Asia – The Mighty Five – MITI V – Malaysia, India, Thailand, Indonesia and Vietnam. I concluded:-
Vietnamese stocks look attractive, the country has the highest level of FDI of the group (6.1% of GDP) but there is a favourable case for investing in the stocks of the other members of the MITI V, even with FDI nearer 3%. They all have favourable demographics, except perhaps Thailand, and its age dependency ratio is quite low. High literacy, above 90% in all except India, should also be advantageous.
Over the next few years I remain confident about these economies but the headwinds of technology will blow through these markets, nonetheless. Low cost manufacturing has to be set alongside, efficient inventory management and transit costs. In the apparel industry, where trends change in a rapid and unpredictable fashion, the advantage of fast design to production lead times makes the benefits of robotic production, geographically close to the consumer, much more alluring.
In a fascinating post on LinkedIn – Robots Take Over – The Apparel Production – Susanna Koelblin – discusses the decision by Adidas to transfer a part of the production of their sports shoes back to Germany for the first time in more than 20 years. Another “Speed factory” will open in the US later this year. Here are some of her observations:-
It took 50 years for the world to install the first million industrial robots. The next million will take only eight. Importantly, much of the recent growth happened in particular in China, which has an aging population and where wages have risen…
German robot maker Kuka, acquired last year by China’s Midea, estimates a typical industrial robot costs about 5 euros an hour. Manufacturers spend 50 euros an hour to employ someone in Germany and about 10 euros an hour in China. Rather than seek out an even cheaper source of labor elsewhere – in another emerging Asian economy, say – Chinese manufacturers are choosing to install more robots, especially for more complex tasks. China isn’t getting rid of the work, just the workers…
It is in fact China which is leading the world in terms of the installation of industrial robots, but relative to the size of its workforce these concentrations are still relatively low. China boasts 4.9 robots/1,000 workers while Germany tops the world ranking at 30.1/1,000. That is almost twice the concentration of the US and four times that of the UK.
The current level of earnings in manufacturing still favours the work force of the MITI V but as the cost of automation continues to fall and average earnings in, lower cost Asia, rises, an inflection point will be reached:-
Source: Trading Economics
Manufacturing wage inflation has been high in Indonesia partly in response to earlier currency depreciations – over 10 years the Rupiah has declined by 46% against the US$ whilst manufacturing wages have increased by 164%. All these emerging economies maintain a manufacturing cost advantage relative to robotic automation, however, for countries like Malaysia, which has seen its currency decline by 46.7% over the last five years, whilst manufacturing wages have only risen by 37.6%, the competitive advantage versus robotic automation is narrowing. Malaysia now has a manufacturing wage cost which is slightly higher than China’s.
Interestingly, India has seen a real-terms improvement in export competitiveness. Its currency has fallen 21.4% over five years but manufacturing wages have only risen by 14.6%. Vietnam and Thailand have seen export competitiveness decline, yet in both cases they have had considerable room for manoeuvre.
I am in agreement with Dr. Jing Bing Zhang, Research Director of IDC Worldwide Robotics, we should not be worried about automation derailing the emerging market growth model over the next decade. This is what he said in a recent interview with the Diplomat:-
There are different schools of thought… From my research, I don’t see it. Maybe we will be less dependent on human labor. But there is no way this will eliminate the need for people in the next 15-20 years. We are entering high speed growth for robotics but in 2014 global density for robotics was still very low at 66 per 10,000 employees, 36 in China, 57 in Thailand, and close to none in India.
The uptake of robots does not appear to have damaged employment in Germany where unemployment recently dipped below 4%, the lowest level since 1981. One can argue that demographic forces are at work here but Germany has the highest concentration of robots relative to workers globally.
Chatham House – Robots and pensioners to the rescue – examines a different aspect of automation and demographics, focussing on Japan:-
Bleak demographics saddle Japan with a potential growth rate of less than 1 per cent, economists say, unless there are aggressive moves to accept more immigrants, boost the role of women in the workforce and overhaul workplace inefficiencies to increase productivity.
Yet despite its real and chronic problems, Japan may arguably be faring better than the image often projected of a country on the brink of an abyss. Japan still feels safe, prosperous and dazzlingly futuristic. While the overall economy has stagnated, GDP per head has outperformed most of the developed world, including Germany and France, according to World Bank figures − partly a consequence of the population crunch…
Most importantly, a shrinking population fosters innovation to boost productivity. Writing in the Financial Times, Michael Lind, a senior fellow at New America, a Washington think-tank, argued that a labour shortage can be a blessing rather than a curse: ‘Where labour is scarce and expensive, businesses have an incentive to invest in labour-saving technology,’ he wrote, ‘which boosts productivity growth by enabling fewer workers to produce more.’
That is precisely what is happening in today’s Japan, with investment pouring into robotics, industrial automation and artificial intelligence. Furuta notes that a similar phenomenon took place in 18th-century Japan, under the Tokugawa shoguns, when sharp population declines due to famine and natural disaster spurred an age of innovation in science, the arts and agriculture. Such thinking has prompted Prime Minister Abe to embrace the idea that Japan’s population crunch may have a silver lining: ‘Japan may be losing its population. But these are incentives,’ Abe said in a speech last year. ‘Japan’s demography, paradoxically, is not an onus, but a bonus.’
In my previous Macro Letter – No 72 – Low cost manufacturing in Asia – The Mighty Five – MITI V – I reproduced the latest Deloitte Global Manufacturing Competitiveness Index, here it is again:-
The MITI V are all expected to rise up the competitiveness ranking over the next three years – with the exception of Thailand which remains unchanged in 14th place.
I remain optimistic about emerging market growth, but keep in mind the industries which will benefit from technology and those which will be harmed. For example, the software developers of India look well placed to thrive; the garment workers of China may not.
Macro Letter – No 33 – 10-04-2015
Technology Indices and Creative Destruction – When Might the Bubble Burst?
I adhere to the belief that technology and other such improvements in manufacturing are the key to delivering productivity growth, which thereby improves the quality of life for the greatest number. Of course, as Joseph Schumpeter so incisively illustrated, the process is often cathartic. For the technology investor this increases both the risk and potential reward.
Technology is affects all industries. In an attempt to be more specific, here is a table taken from a February 2015 report by Brookings – America’s Advanced Industries:-
The report goes on to describe the scale and importance of these industries to the US economy:-
As of 2013, the nation’s 50 advanced industries employed 12.3 million U.S. workers. That amounts to about 9 percent of total U.S. employment. And yet, even with this modest employment base, U.S. advanced industries produce $2.7 trillion in value added annually—17 percent of all U.S. gross domestic product (GDP). That is more than any other sector, including healthcare, finance, or real estate.
At the same time, the sector employs 80 percent of the nation’s engineers; performs 90 percent of private-sector R&D; generates approximately 85 percent of all U.S. patents; and accounts for 60 percent of U.S. exports. Advanced industries also support unusually extensive supply chains and other forms of ancillary economic activity. On a per worker basis, advanced industries purchase $236,000 in goods and services from other businesses annually, compared with $67,000 in purchasing by other industries. This spending sustains and creates more jobs. In fact, 2.2 jobs are created domestically for every new advanced industry job—0.8 locally and 1.4 outside of the region. This means that in addition to the 12.3 million workers employed by advanced industries, another 27.1 million U.S. workers owe their jobs to economic activity supported by advanced industries. Directly and indirectly, then, the sector supports almost 39 million jobs—nearly one-fourth of all U.S. employment.
…From 1980 to 2013 advanced industries expanded at a rate of 5.4 percent annually—30 percent faster than the economy as a whole.
…Workers in advanced industries are extraordinarily productive and generate some $210,000 in annual value added per worker compared with $101,000, on average, outside advanced industries. Because of this, advanced industries compensate their workers handsomely and, in contrast to the rest of the economy, wages are rising sharply. In 2013, the average advanced industries worker earned $90,000 in total compensation, nearly twice as much as the average worker outside of the sector. Over time, absolute earnings in advanced industries grew by 63 percent from 1975 to 2013, after adjusting for inflation. This compares with 17 percent gains outside the sector. Even workers with lower levels of education can earn salaries in advanced industries that far exceed their peers in other industries. In this regard, the sector is in fact accessible: More than half of the sector’s workers possess less than a bachelor’s degree.
The report is not an unalloyed paean of praise, however, they go on to emphasise the need for better education and training in order to maintain momentum.
The last great technology stock collapse was seen in the aftermath of the “Dotcom” bubble which burst in 2001:-
Source: Kampas Research
During the early part of the last decade the growth in valuation of the technology sector returned to its long-term trend. Since 2008, however, central bank policies have changed the valuation paradigm for all stocks by reducing interest rates towards the zero-bound. Their quantitative easing policies (QE) have flattening government bond yield curves to unprecedented levels, especially given the absolute level of rates. Nonetheless, many of the signs of a bubble have begun to emerge as this December 2014 article from the Economist – Frothy.com – explains:-
In December 15 years ago the dotcom crash was a few weeks away. Veterans of that fiasco may notice some familiar warning signs this festive season. Bankers and lawyers are being priced out of office space in downtown San Francisco; all of the space in eight tower blocks being built has been taken by technology firms. In 2013 around a fifth of graduates from America’s leading MBA schools joined tech firms, almost double the share that struck Faustian pacts with investment banks. Janet Yellen, the head of the Federal Reserve, has warned that social-media firms are overvalued—and has been largely ignored, just as her predecessor Alan Greenspan was when he urged caution in 1999.
Good corporate governance is, once again, for wimps. Shares in Alibaba, a Chinese internet giant that listed in New York in September using a Byzantine legal structure, have risen by 58%. Executives at startups, such as Uber, a taxi-hailing service, exhibit a mighty hubris.
…Instead, today’s financial excess is hidden partly out of sight in two areas: inside big tech firms such as Amazon and Google, which are spending epic sums on warehouses, offices, people, machinery and buying other firms; and on the booming private markets where venture capital (VC) outfits and others trade stakes in young technology firms.
Take the spending boom by the big, listed tech firms first. It is exemplified by Facebook, which said in October that its operating costs would rise in 2015 by 55-75%, far ahead of its expected sales growth. Forget lean outfits run by skinny entrepreneurs: Silicon Valley’s icons are now among the world’s biggest, flabbiest investors. Together, Apple, Amazon, Facebook, Google and Twitter invested $66 billion in the past 12 months. This figure includes capital spending, research and development, fixed assets acquired with leases and cash used for acquisitions (see chart 1).
Source: The Economist, Bloomberg
That is eight times what they invested in 2009. It is double the amount invested by the VC industry. If you exclude Apple, investments ate up most of the cashflow the firms generated. Together these five tech firms now invest more than any single company in the world: more than such energy Leviathans as Gazprom, PetroChina and Exxon, which each invest about $40 billion-50 billion a year. The five firms together own $60 billion of property and equipment, almost as much as General Electric. They employ just over 300,000 people. Google says it is determined to keep “investing ahead of the curve”.
…The second area of technology froth is in private markets. Their exuberance was demonstrated on December 4th when Uber closed a $1.2 billion private funding round that valued the five-year old firm at $40 billion. Baidu, China’s biggest search engine, is set to buy a stake, too (see page 101). There are 48 American VC-backed firms worth $1 billion or more, compared with ten at the height of the dotcom bubble, according to VentureSource, a research outfit. In October a software firm called Slack was valued at $1.1 billion, a year after being founded. 2014 looks set to be the biggest year for VC investments since 2000 (see chart 2).
Source: The Economist
Whilst this investment boom has centred around the giants of the technology industry and venture capitalists in the private sector, few large scale scientific research facilities have been developed without government grants or subsidies as this December 2014 FRBSF Economic Letter – Innovation and Incentives: Evidence from Biotech – makes abundantly clear:-
The adoption of biotech subsidies raises the number of star scientists in a state by 15% relative to that state’s pre-adoption number of stars. We find a similar effect from the adoption of R&D credits. These findings are important because of the role star scientists play on the local development and survival of U.S. biotech clusters. In addition, we find that most of the increase in the number of stars is due to their relocation to states that adopt incentives. Meanwhile, subsidies have only a limited effect on the productivity, measured by patenting, of incumbent scientists already in the state. We also find that the increase in star scientists happening after a state adopts a biotech incentive is entirely due to an increase in private/for-profit sector scientists, with no detectable increase in academic scientists.
The authors’ conclusions, however, are qualified:-
We found that, after states adopted incentives, they experienced significant increases in the number of star scientists, the total number of biotech workers, and the number of establishments, but limited effects on salaries and patents. We also uncovered significant spillover effects from biotech incentives to employment in other sectors that provide services in the local economy such as retail and construction.
In terms of policy implications, it is important to keep in mind that our finding that biotech subsidies are successful at attracting star scientists and at raising local biotech employment do not necessarily imply that the subsidies are economically justified. The economic benefits to a state of providing these incentives must be weighed against their fiscal costs—for instance, the loss of tax revenues and resulting loss of public services. Our research suggests that state incentives are successful at increasing the number of jobs inside the state. Nevertheless, our results do not suggest that the social benefit—either for that state or for the nation as a whole—is larger than the cost to taxpayers, nor that incentives for innovation are the most effective way to increase jobs in a state.
Government incentives may appear benign, but, as Michael Dell put it, in a November 2014 Op Ed for the Wall Street Journal – Going Private Is Paying Off for Dell:-
Yet we find ourselves in a world increasingly afflicted with myopia-governments that can’t see beyond the next election, an education system that can’t see beyond the next round of standardized tests, and public financial markets that can’t see beyond the next trade. This was what Dell faced as a public company. Shareholders increasingly demanded short-term results to drive returns; innovation and investment too often suffered as a result. Shareholder and customer interests decoupled.
My personal preference is for a free-market approach, despite the risk of underinvestment in the most capital intensive areas of research.
The valuation of growth stocks has always been fraught with uncertainty, especially when future cashflows are often deferred by several years and earnings forecasts, subject to significant variance. An even greater difficulty, as the chart above makes clear, is to assess, and hopefully anticipate, the herd behaviour of technology investors.
The chart below shows the differential performance of the STOXX Europe 600 Technology Index (FX8.Z) the global IXN Technology ETF and the Nasdaq Composite:-
Source: Yahoo Finance
The European dalliance with technology investment was shorter lived than in the US. So was the violence of the subsequent bust. The market had still not cleared by 2008 and achieved new lows for the decade. The subsequent recovery has been muted. The IXN appears to be roughly halfway between the two extremes. US investor perception of technology seems to be substantially rosier than that of the European investor.
The six month chart reveals a rather different picture. Since the equity market correction last November, European technology has out-performed both the US and other technology stocks globally:-
Source: Yahoo Finance
Looks can be deceptive. This move has been broader based than simply the European technology sector. Led by Germany, most Eurozone stock markets have traded higher. This has largely coincided with the QE actions of the ECB and the steady weakening in the value of the Euro that this policy has abetted. The Euro Effective Exchange Rate has fallen from 100 to 90 over the same period.
Research carried out by LinkedIn sheds a unique perspective on global trends in technology industries. Their analysis focussed on migrating workers, identifying which countries and cities were net beneficiaries. This July 2014 article from Bruegal – Fact of the week: Not one European city in the top 10 for tech talent – takes up the story:-
In terms of skills uniquely identified in movers, Math, Science, Technology and Engineering seem to play a particularly important role. In terms of industries, movers are found to work mostly in media and entertainment; professional services; oil and energy; government, education and non-profit but most importantly, technology-software.
…Five out of ten cities attracting people with tech skills (especially IT infrastructure and system managements; Java development and web programming) are located in India, including the first four of the list. San Francisco only comes fifth, followed by two other US cities and two Australian.
No European city at all makes it to the list. For the 52 cities looked at in the study, the median percentage of new residents with tech skills was 16%, or just under 1 in 6; in many of the Indian cities, its more than double that figure. European cities are the real laggards: the percentage of new residents with tech skills was 18% in Berlin, 15% in Paris, 13% in Madrid and 11% in Paris.
The trend obviously mirror the Indian ongoing technology boom, in a still rather “virgin” environment. Kunal Bahl – founder of Snapdeal, a wannabe Indian Amazon – told USA Today in 2011 that India offers huge opportunity “because there are no mature companies, like Google and Microsoft, over there. The feeling is like in the U.S. in 1999.”
But there may be more to that.. Research by Vivek Wadhwa (Stanford) revealed that half of Silicon Valley start-ups were launched by immigrants, many of them educated in US top universities. But he also noticed that “for the first time, immigrants have better opportunities outside the U.S.” because, among other things, of rather strict immigration laws and California’s steep cost of living. Bahl himself, who studied in the US and spent some time working at Microsoft, reportedly wanted to initiate his company in the US but eventually went back to India because of visa problems.
And this is also why the tech industry – at the (by now almost) desperate search for engineers – is supporting the introduction of specific “start-up visa” for high-skilled workers in the US. The insights provided by this data is particularly important in the context of the recent discussions on the US immigration reform, but it is not without implications for Europe, which is at the bottom of the ranking as far as attracting tech talent is concerned.
This research suggests that the recent outperformance of the European technology sector may be short lived, yet, another article from November of last year by Bruegal – Brain drain, gain, or circulation? – indicates a somewhat more optimistic outcome for parts of Europe, specifically the UK and Spain:-
Source: Bruegal, OECD
This chart benchmarks the median quality of scientists leaving or moving (for the first time) to a country between 1996-2011. The size of the bubble corresponds to total flows (inflows plus outflows). Countries in red are net contributors to the international market for scientists, those in blue net recipients.
Ideally, a country should want to be below or on the 45-degree line, indicating that the quality of the newcomers is just as high (or higher) as that of the leavers. Conditional on this, a country should also prefer a larger rather than smaller bubble, representing a sizeable flow of scientists and indicating a full exploitation of synergies gained from international cooperation. Finally, countries should aim to land in the top-right quadrant, indicating higher quality of both incoming and outgoing researchers.
Over the long-term (pre-crisis) period analysed, Spain and the UK seemed the best placed at attracting high-quality scientists. France and Germany were broadly breaking even in terms of quality, although we note that they were facing significant net outflows of scientists, as was the UK.
All in all, in the sample here presented, while the US (unsurprisingly) comes out as the top performer in terms of net inflow of quality researchers, Italy ranks quite poorly. Not only the country is a net contributor of scientists, it also trades high quality researchers for lower quality ones. Time for a reform of the university system?
The EU Commission is seeking to address the deficiencies of innovation policy within its borders. At a Bruegal event last January in a speech entitled – The New European Research Agenda – Commissioner Moedas – outlined plans to improve the environment for innovation:-
First, create the framework conditions for a more productive exchange of research results, fundamental science and innovation. Things like:
Screen the regulatory framework in key sectors in order to remove bottlenecks
Accelerate the implementation of standardisation
Promote the public procurement of innovation and innovation in the public sector
Promote a venture capital culture
Reduce bureaucracy in science and innovation systems
Second, is to consolidate fundamental research as the flagship for Europe. As the essential foundation for a knowledge-based society. Working towards a single, open market for knowledge though open science.
Third: implement Horizon 2020 and the new Investment Plan to leverage the Europe economy towards a higher plane as a research and innovation-based area. Working towards a single, open market for knowledge though open science. It is better to focus on our potential than to dwell on illusions. We will always be different from other parts of the world. But that difference has many benefits!
These are stirring words, but in the EU turning words into deeds takes time. In unfettered, free-markets, resources are allocated more efficiently. Nonetheless, hope remains.
In terms of absolute valuation, US technology bulls point to the relatively undemanding PE ratio of the Nasdaq – around 24 times, vs 175 times during the zenith of the Dotcom frenzy. On the other hand, commentators such as Dent Research point to a flat-lining phase of the 45 year innovation cycle – this phase commenced around 2010 and will last until around 2032:-
It shows how clusters of powerful technologies increase productivity and move mainstream for about 22.5 years, like what we saw from 1988 into 2010.
Now we’re in the doldrums of this cycle and won’t move into the next upward swing again until after 2032. In short, the productivity revolution is over for the next two decades or so. That means less earnings and wage gains, regardless of demographic trends.
Interestingly, Dent then go on to wax lyrical about the potential for Bio-tech. In technology even the bears tend to be bullish about something.
We need to read Robert Gordon – Is US economic growth over? Faltering innovation confronts the six headwinds, to find a real bear. His CEPR paper was published in 2012 but these are ideas he has been developing for more than a decade. The premise is that the economic growth of the last 250 years is the exception rather than the rule:-
The ideas developed here are unorthodox yet worth pondering. They are applied only in the context of the US, because the worldwide frontier of productivity and the standard of living have been carved out by the US since the late 19th century. If growth of the US productivity frontier slows down, other nations may move ahead, or the slowing frontier could reduce the opportunities for future growth by all nations as the pace of productivity growth in the US fades out…
… The paper suggests that it is useful to think of the innovative process as a series of discrete inventions followed by incremental improvements which ultimately tap the full potential of the initial invention. For the first two industrial revolutions, the incremental follow-up process lasted at least 100 years. For the more recent IR3, the follow-up process was much faster. Taking the inventions and their follow up improvements together, many of these processes could happen only once. Notable examples are speed of travel, temperature of interior space, and urbanisation itself.
The benefits of ongoing innovation on the standard of living will not stop and will continue, albeit at a slower pace than in the past. But future growth will be held back from the potential fruits of innovation by six “headwinds” buffeting the US economy, some of which are shared in common with other countries and others are uniquely American. Future growth in real GDP per capita will be slower than in any extended period since the late 19th century, and growth in real consumption per capita for the bottom 99% of the income distribution will be even slower than that.
Gordon goes on to identify six headwinds buffeting the US economy – slowing the pace of GDP growth:-
These are important impediments to growth but I believe not all of them are as clear cut as Gordon suggests.
Firstly, the demographic dividend may be in decline but technology has made it easier for people to work until much later in life. Added to which, a more flexible labour market encourages greater participation. I wonder whether the decline in labour force participation is to some extent due to the improvement in welfare provision and not just a deficit of permanent “quality” jobs?
Despite the concerns of Gordon and Bruegal, education is in the process of being revolutionised by new technologies. Mass Open Online Courses (MOOCs) are but one aspect of this sea-change. The cost of providing education – which has risen inexorably over the last 50 years – could be reversed. Of course Gordon has cause for concern about educational achievement. Whilst technology will allow “the horse to be led to water” it is another matter “making it drink”. The Economist – Wealth without workers, workers without wealth – from October 2014, discusses this issue in the broader context of new technologies disruption of labour markets globally:-
The modern digital revolution—with its hallmarks of computer power, connectivity and data ubiquity—has brought iPhones and the internet, not crowded tenements and cholera. But, as our special report explains, it is disrupting and dividing the world of work on a scale not seen for more than a century. Vast wealth is being created without many workers; and for all but an elite few, work no longer guarantees a rising income.
Income inequality is a popular economic theme and Gordon pays tribute to Emmanuel Saez – though not Thomas Piketty who has become its popular champion. From my interpretation of Piketty’s book, I believe that income inequality is a natural outcome of the long term benefits of peace. Reducing government intervention in the functioning of free markets is a better solution to this structural problem. Smaller government will not remove inequality but it will increase economic mobility, and, in the process, create faster economic prosperity – thereby more rapidly improving the standard of living for the greatest number of people. In freer markets, the technology entrepreneur, and creative risk takers in general, have a greater incentive to embrace opportunities.
Outsourcing is not new, David Riccardo observed its effects long ago. As rich countries adapt to concentrate on their comparative advantages – hopefully undistorted by government subsidy and protective tariff – the short-term headwind of lost domestic labour will be offset by the lower cost to the consumer of outsourced services. A greater proportion of a consumer’s income will then become available for investment. Once the investment has been allocated, the increased pool of available labour can then be retrained for employment in more productive enterprises. Frederic Bastiat – That Which is Seen and That Which is Not Seen makes this point much more eloquently than I could hope to do.
At the global level, man’s capacity to pollute his environment has not diminished but developing countries are less able to afford the luxury of conscience. Our best hope is technology. Yet technological discovery occurs by evolutionary leaps rather than steady increment. The lag between discovery and commercial application can also be long and variable. The collapse in the price of photovoltaic cells, making solar power dramatically more viable as an alternative to fossil fuel, is but one example. The tantalising potential of the development of tidal energy generation is another – especially given man’s predilection to inhabit the margins of the sea. Carbon sequestration technology – at present uneconomic – might be the next technological “leap”. I remain an optimist about man’s ingenuity. Since the Economist first published its Commodity Index in 1864 the price of commodities has been falling by roughly 1% per annum in inflation adjusted terms – punctuated by sharp price increases normally associated with war. Peace leads to investment and, as new technologies are adopted, prices begin to march lower once more.
This leaves Gordon’s concern about debt. Now, debt is a problem. It can be overcome, but the solution to excessive debt is not more debt. Deleveraging can be achieved by steady reduction or sudden default. Sadly, history favours the latter approach – I wonder whether Polonius’s advice to Laertes today would have been:-
Always a borrower never a lender be,
For loan oft loses both itself and bank,
And borrowing sure as hell beats husbandry.
Last September – Deleveraging, What Deleveraging? The 16th Geneva Report on the World Economy – discussed this global issue in detail:-
Contrary to widely held beliefs, the world has not yet begun to delever. Global debt-to-GDP is still growing, breaking new highs. Figure 1 shows the evolution of total debt (excluding the financial sector) for our global sample (advanced economies plus major emerging market economies). While there was a pause during 2008-09, the rise of the global debt-GDP ratio recommenced in 2010-2011. Data in the report also show that debt-type external financing (leverage) continues to dominate equity-type financing (stock market capitalisation)
Perhaps surprisingly, the authors advise central banks to be cautious about interest rate increases in this environment:-
In such a context, and with still very high leverage, allowing the real rate to rise above its natural level would risk killing the recovery. Beyond pushing the economy into a prolonged period of stagnation, this would also put at risk the deleveraging process which is already very challenging.
Although there is a lot of uncertainty about such predictions, our call is for caution on interest rate rises. The case for caution in pre-emptively raising interest rates is reinforced by the weakness of inflationary pressures.
…The policy requirements for successful exit from a leverage trap are much broader than the appropriate conduct of monetary policy. The report addresses the fiscal challenges, the scope for macro-prudential policies and the restructuring of private-sector (bank, household, corporate) debt and sovereign debt.
The report also argues that – given the risks and costs associated with excessive leverage – more needs to be done to improve the resilience of macro-financial frameworks to debt shocks and to discourage excessive debt accumulation. Finally, we advocate enhanced international policy cooperation in addressing excessive global leverage.
I keep hearing the immortal words of Stan Laurel:-
Well, here’s another nice mess you’ve gotten me into.
Signs of fatigue
With all markets, I begin my analysis with technical patterns. This is a form of self-preservation; to paraphrase Keynes, I may be right in my fundamental analysis but the market is never wrong. On this basis I see no compelling reason to exit the technology sector, although there is a case to be made for rotation out of the Nasdaq and into technology stocks in Europe. I make the caveat, however, that European stocks have inherently less liquidity than US stocks and are therefore likely to exhibit greater volatility, especially on the downside.
The second stage of my analysis is to look at the change in the makeup of tech indexes. The constituents of the Nasdaq are a case in point. The table below shows the top 10 stocks by market capitalisation in 2000 and 2015:-
|MCI WorldCom||MCWEQ||Gilead Sciences||GILD|
Several of the names have changed, added to which, many of today’s valuations, as measured by P/E ratios, are far less demanding – although Amazon (AMZN) at more than 700 times earnings, remains a notable exception. Looked at from another perspective, the technology promise of 2000 has delivered – today’s top tech companies are delivering real earnings. To understand whether the undemanding multiples are a harbinger of a period of “ex-growth” to come or represent an undervalued opportunity, we need to examine each individual stock in detail. This is beyond the macroeconomic analysis of this report, but one “macro” factor worth considering is the question of debt versus equity finance.
Equity versus Debt
At the risk of making a sweeping generalisation, technology companies are more likely to finance their projects via equity than debt – although established, large cap, technology companies make ample use of the capital markets. Technology projects often require long-lead times to deliver positive cashflows and the value created is invariably intellectual rather than physical. An Oil company with proven reserves may have to wrestle with the volatility in the price of crude oil, but it can mortgage those “reserves” – they have a fairly predictable future demand. Technology companies must endure the vicissitudes of disruptive innovation. Todays “must have” products can rapidly become tomorrow’s museum “curiosities”. To this extent, technology firms are better placed to weather a cycle of increasing interest rates because they carry less debt.
Here lies a dilemma. In the absence of the interest rate on debt to signal the riskiness of an investment, the availability of equity finance becomes critical. As the IPO market has become more active, venture capitalists have been pouring money into earlier and earlier investment opportunities to avoid having to pay too high a price for private equity – I’ve heard the phase “pre,pre-seed” which smacks of a lack of discrimination. Access to equity investment should be a signal about the validity of a project – in the current “overinvestment” environment, the informational value of this “signal” is dramatically diminishing.
Conclusions and Investment Opportunities
The current technology boom is very different from the dotcom bubble of 2000. The top companies in the sector have real earnings and trade at less demanding PE multiples. There are still early stage companies which have no cashflows but these are the much less prevalent today. At the risk of stating the obvious, look for companies with low debt to equity ratios, since these will weather the storm of rising interest rates more comfortably. Look for companies with growing earnings and, where possible, growing dividends. Keep a close watch on the price trend of the stock and have a stop-loss level in mind at which you will exit to preserve capital, regardless of your own opinions. Set a price target if you wish but remember that markets are prone to irrationality – I tend to let the “trend be my friend”.
For the present, technology stocks look set to continue rising, but it is important to remember that the correlation between equity indices tend to be high – The Nasdaq and the S&P500 have a one month correlation of more than 90%. Interest Rates may stay low for a protracted period, but the risk is asymmetric – not far to fall, a long way to rise – and conventional wisdom, which advocates investment in stocks because they are negatively correlated to bonds, may be severely tested as central bank interest rates normalise globally. For more on this topic the November 2013 paper from Pimco – The Stock-Bond Correlation is well worth investigation.
A final caveat concerning technology stocks. Most of the constituents of tech indices are growth stocks and therefore tend to have higher betas than the underlying index. This is a simple measure of their volatility – replete with Gaussian assumptions of “normality”. When constructing your investment strategy, keep the absolute level of volatility in mind, albeit is a measure of variance rather than risk. If this is a technology bubble, make allowance for it and you will weather its tempests, underestimate it and you will be forced to capitulate; the bull market isn’t over yet and the broader market will determine the timing of its demise.