Interpreting Innovation

Why is innovation so important for investors?

Technological change is at the intersection of employment, nominal economic growth and inflation risk – the focus areas of global policymakers. Central banks are prepared to risk falling behind the curve because they see little inflation risk and focus on increasing employment. Innovation can help keep a lid on the former (suppressing wages and prices) but hurt the latter (producing more with fewer people).

In this report, we detail the links between innovation, productivity and inflation. We also identify potential winners and losers (both companies and countries), and gauge innovation’s impact on interest rates and investing strategies. Below are our main conclusions:

• Repetitive tasks in manufacturing are now performed mostly by machines. This is nothing new: robots have roamed factory floors for decades. Yet we could be near a tipping point in adoption. Robots are getting cheaper – and smarter.
• The next leg of innovation is just starting. Think of the exponential increases in computer power, machine learning and the ability to analyse vast reservoirs of data. Many companies – and investors – have yet to tap these data riches.
• Faster diffusion of technologies makes it harder for companies to maintain a competitive edge. The Internet economy enables companies to piggyback off existing infrastructure, reducing the need for capital investments.
• Innovation erodes the traditional edge of many emerging markets: cheap labour. Also, diffusion of technology is slow in much of the emerging world due to poor infrastructure and weak legal protections.
• Techno optimists argue we are on the cusp of a productivity renaissance as new technologies are adopted more broadly. Pessimists counter the productivity boon from the Internet era is waning. We lean toward the first group.
• Innovation cuts out middlemen in supply chains and leads to commoditisation. The former tends to reduce demand for existing services; the latter boosts supply. The net result is a steady downward pressure on prices.
• Technological change is helping put a lid on US jobs and wage growth. This means the US Federal Reserve’s next tightening cycle is likely to be more gentle than in the past – with rates peaking at a lower level.
• Subdued inflation, ageing populations and high debt loads will likely depress nominal gross domestic product (GDP) growth the in long run. Long-term yields could stay low for a while. Yield curves are likely to flatten further as long-term bonds receive a steady bid from insurance companies and others amid limited supply.
• Corporate financing will likely stay cheap. Bond markets are effectively subsidising equities. Yet the longer financial conditions remain easy, the greater the potential recoil. The link between equities and bonds also means the two could become more correlated, challenging traditional portfolio diversification.

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