Forecast explores economic forces of technological proliferation on economic sectors, productivity, and debt
Capital Markets Forecast Commentary Cover
“When I was a child, technology was situational,” said Tony Roth, chief investment officer at Wilmington Trust Investment Advisors, Inc. “TV stations would go off at the end of the day. My boyhood home was truly dark at night—free from the glow emitted by digital clocks, blinking lights, and power strips. Contrast that to our world today with always-on TV channels, smart homes, and even the computer timepiece on my wrist that counts my steps, notifies me of messages, and, of course, tells the time.
“Technology has profoundly transformed our lives and the economy. We are in the midst of the Fourth Industrial Revolution, spurred on by an exponentially paced sequence of technological advances. Horizontal digitization—digital and data at the core of nearly every economic sector and enterprise—has transformed the entire industrial complex, with sweeping and critical implications for the economy and markets. In our 2019 forecast, we look at this continuing trend, through the lens of economic sectors.”
Wilmington Trust’s Investment Committee projects:
- GDP growth will abate to 2.25% on slower consumer spending and sharper capex deceleration
- The labor market will continue to tighten, though the unemployment rate is unlikely to drop below 3.5% due to higher labor market participation by the younger workers; wages will continue to grind higher, but in a controlled manner
- Inflation will settle into a longer-term run rate of 2.5% (CPI) and 2% (Fed-preferred PCE)
- The Fed will increase rates two times, with potential for a third hike
“Our outlook is heavily influenced by our views on the ongoing technological revolution, which is driving capex and productivity—keeping inflation low and extending the economic cycle,” said Chief Economist Luke Tilley. “The structural shift due to the proliferation of technology has profound effects on the economy and our society. Technology can be a positive force for the global economy, but like everything else, we must be wary of unintended consequences.”
HORIZONTAL DIGITIZATION OF TECHNOLOGY ACROSS ECONOMIC SECTORS
Technological transformation is shaping the long-term investment implications for the entire spectrum of industries. The lines continue to blur between what is a “tech” company and what is not. Companies that produce computers and microchips are tech companies—but what about a grocery store supplier that relies heavily on artificial intelligence and robotics in its warehouse? Based on the current trend, in fewer than 10 years, it may no longer suffice to define an entity simply as a tech company since virtually all industries will be colored by tech to a large degree. It is increasingly woven into the fabric of corporations so sector descriptions will need to be more nuanced.
“Companies are spending on technology to gain market share and increase efficiencies, helping to improve profitability,” said Senior Investment Strategist Meghan Shue. “But increased technology interfacing carries additional security challenges that require even more technological investment. The financial and healthcare industries, for example, have been big spenders on digitization and technology, which increases their cybersecurity needs to protect their customers’ money, data, and privacy.
“We see technology spending driving the capex cycle, and we expect companies across economic sectors to continue spending on technology investment. In our view, this capex cycle will accelerate productivity, keep inflation down, and allow the Fed to raise rates gradually. We expect this to result in an extension of the economic cycle beyond 2019.”
Structural trends, like advances in technology, play a key role in Wilmington Trust’s investment decisions—though short-term positioning shifts take into account many factors, like valuations, cash flow, and expectations for corporate profitability. While exciting, tech trends are not without their risks. As was the case in the tech wave of the late 1990s, when some areas of the economy invested too much, too quickly, and were forced to significantly pull back on capex when confidence began to falter.
Wilmington Trust’s expectation for slowing global growth in 2019, along with risks related to trade, could put the capex cycle in jeopardy.
LABOR PRODUCTIVITY’S RACE AGAINST THE CLOCK
The technology that drove the productivity of the late 1990s, namely internet adoption and digitization, continues to power productivity. The U.S. economy today looks strikingly similar to that market cycle with unemployment rates at a historically low level, stoking fears the labor market might overheat—squeezing profit margins and raising costs—forcing the Fed to increase rates to tamp down inflation. Yet, there are few signs of inflationary pressures.
“As we’ve observed in the past, increased productivity keeps inflation low,” said Tilley. “Productivity growth comes from firms investing in new equipment and new technologies. A firm can boost its productivity quickly with such measures. For the economy as a whole, though, the impact is seen only after multiple years of capex.
“We expect that productivity growth is on the upswing, and will be boosted further by the surge in financial outlay by firms this year in response to the Tax Cuts and Jobs Act of 2017. Although we are optimistic about productivity increasing, there remains the risk of it not lifting soon enough to ameliorate the tightening labor market.”
Wilmington Trust projects the current cycle will persist for a while, as the Fourth Industrial Revolution continues to permeate all sectors, keeping down costs, inflation, and interest rates. The belief is we are in the early stages of this revolution, with material gains ahead, due to 5G, self-driving cars, and AI. Still, vigilance is needed to watch for inflationary signals that may bring an end to the economic cycle.
RATES AND THE GLOBAL DEBT SUPER CYCLE
A pronounced side effect of technology’s contribution to lower inflation is the reaction of global central banks in maintaining accommodative monetary policy and low interest rates. Technology adoption and higher productivity have allowed rates to stay low and companies have taken notice, assuming such high levels of borrowing that it has given birth to the next debt super cycle. Non-financial U.S. corporate debt grew from 63 percent of GDP in 2006, to 74 percent at the end of 2017.
This phenomenon is not unique to the U.S., and in fact, the U.S. is less levered than many other countries. As of 3Q 2018, Canadian, eurozone, and Japanese economies claimed nonfinancial corporate debt around or in excess of 100 percent of GDP. The system can tolerate higher debt levels than in the past because debt servicing costs are low. But beneath the surface are troubling statistics, e.g., about $525 billion of Russell 3000 companies’ debt will mature within the next two years, which would be subject to higher interest rates if Wilmington Trust’s expectations for the Fed are correct.
Second, the amount of outstanding debt rated BBB—classified as “investment grade” but just one rung
above “junk”—has grown over 275 percent since 2009. Over 50 percent of the investment-grade bond index is hovering above junk, more than doubling in size over the past decade.
If cash flows slow, from a recession or other growth scare, companies in the BBB group are at risk of being downgraded into junk territory. This could trigger a wave of selling of those downgraded bonds. The BBB part of the investment-grade index is also almost 2.5 times the size of the high-yield market, so these newly junk-rated bonds would have to be absorbed by a much smaller market. Credit spreads could increase drastically, making the investment-grade and high-yield fixed income markets the weak link in the financial system when growth slows—risking spillover into other asset classes and the broader economy.
“While this paints a somewhat dark picture, it does not mean the next crisis is upon us,” said Roth. “On the contrary, this trend could continue for years, as we expect healthy economic activity and low rates to keep debt servicing costs manageable for corporations. We expect a slight deceleration in U.S. economic growth in the coming year, but believe that technological innovation permits the cycle to continue beyond 2019.
“Opportunities to build wealth are certainly still present, but we must remain wary of the perils around growing leverage as one area of financial excess.”
Wilmington Trust Investment Advisors, Inc., a subsidiary of M&T Bank, is a SEC-registered investment adviser providing investment management services to Wilmington Trust and M&T Bank's affiliates and clients.
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