Disruption, deflation and default

Takeaways: Well that was quite a quarter. A litany of ‘worst since’ for many global benchmarks, M&A records, a will-they-won’t-they Fed saga  plus some spectacular share rollercoaster rides. We’re seeing rising confidence and investment in some areas, a maelstrom of concern in others. Perhaps the reason why we’re seeing such bifurcated views is because the traditional macro picture doesn’t tell the whole story. Time to get a little bit disruptive…

Disruption

Of course change and even technological disruption isn’t new. The mobile phone, the supermarket, the car, the spinning jenny, the seed drill, iron, bronze… how far back do you want to go? There’s always been something ‘disruptive’ in the sense that it achieved a dominant market position by providing the same function, in a ‘better’, often faster way, i.e. communication via the telephone versus a telegram.  What is new is the speed and ubiquity of disruption in this digital age. There is scarcely an industry that isn’t looking over its shoulder. There is almost no part of the global economy unaffected. Even the disruptors are being disrupted – ask any passing teenager about their views on Snapchat versus the more ‘mature’ Facebook.  According to Cisco, the internet of everything (things) will have 5-10 times the impact on society than the impact of the Internet to date.

Maybe…who knows? The uncertainty is fundamentally unsettling. What we can say is that the sheer amount of global connectivity – 3 billion humans and rising – the mobile nature of that connectivity, the cloud and the ability to connect almost everything to the internet is speeding up the time it takes to acquire customers, develop products, share ideas and move ideas and even physical objects around the globe. 3D metal printing has the potential to remove whole chunks of supply chains.  Drill breaks down? Just print a new part! Just imagine telling someone in 2000 that in just 15 years’ time they’ll be able to download and print a new hip replacement, whilst ‘video conferencing’ someone thousands of miles away using just their phone, which will also enable them to instantly take and share pictures of their cat with a global audience… Not everything digitally disruptive is useful or productive!

Which seems like a good point to think about the impact on capital. Setting up cutting-edge businesses within large organisations – even in the technology space – is notoriously difficult. They often just don’t have the right internal ‘gorilla’ spirit – hence the drive to buy or at least partner to gain access to the right attitude as much as the right technology.  Otherwise, they quickly face being left behind; or worst, blown away by Schumpeter’s gale of creative destruction to make way for new innovative start-ups. As we’ve been saying for a while, digital disruption is one of the most significant drivers in the current M&A boom. This is most obvious in TMT, but present in more ‘traditional’ industries too.

One of the reasons why UK profit warnings have remained high, despite the relative macro improvement, is the rise in pressures from outside of the normal economic cycle. These are not only providing additional price-crushing competition, but forcing companies to invest more. This includes digital disruption, but also the increasing influence of regulation – financial, climate, medical.  So it’s very interesting to note that the latest analysis from EY ITEM Club shows UK business investment at its highest level as a share of GDP since 2000. Of course, there are other motivations and enablers for investment – such as the rising cost of labour and availability of finance – but the constant drum-beat of change and regulation means companies could also need to spend more to keep up. ITEM forecast that UK business investment will reach a record high by 2019.

That’s assuming that the nature of investment (and how we measure it) remains the same. Employees using personal devices, the cloud,  the influence of the sharing economy, cheaper technology, cheaper innovation, quicker start-ups – as ITEM note, so much in this area could change.

We’re certainly at an interesting point and with markets changing so fast and companies being buffeted by many forces beyond the macro; it’s is no wonder that we can get really bifurcated experiences. Even in the same sector, companies could have very different outlooks, depending on how well they have adapted and allocated their capital. Investors may also struggle to keep up and pick-out what really is a gale that will sweep a sector/company away – or just a light breeze. Over and under-reaction will add to volatility. Arguably, it was ever thus – but the clock is certainly ticking quicker now.

Deflation

All this is not to say that traditional macro indicators aren’t a vital tool in assessing the health of the global economy and one light is flashing at least amber again.

The Eurozone’s troubles are like a zombie in a horror film, you think you’ve killed them and then slowly, inexorably a hand appears out of the soil…. In this week’s feature, deflation returns! The latest -0.1% figure is only just in the red, but a long way below the ECB’s 2% target. Since the main drag comes from energy, which in theory is the good kind of deflationary pressure – temporary, consumption boosting – there is a chance that the ECB will hold fire. Hawks still have plenty of ammunition with core inflation still at 0.9%.

However, there is a growing belief that the ECB will eventually need to act. Even before today’s numbers, Standard & Poor’s said it believed that the ECB will extend its QE program beyond September 2016 into mid-2018, and that it could reach €2.4t – more than twice the original €1.1t commitment.

Default

That would leave the Fed in a very tough spot as global easing continues apace…601 since Lehman …with the Fed hold almost taken as carte blanche to cut. The IMF underline their views again this week with another ‘please not now Fed’ themed report. They’re worried about EM corporate debts – at $18t last year, from $4t in 2004 – and by. weaker balance sheets, making companies more vulnerable to US rate rises. What gives this argument an edge are growing concerns about market liquidity and a dash for the exit when the Fed moves. The IMF say liquidity isn’t in decline, but ‘prone to evaporate’ . It’s a worry with a basis in tantrums that’s been given more teeth by a report in the FT that Saudi Arabian Monetary Agency’s has withdrawn $50bn-$70bn from fund managers over the past six months – maybe to invest in less risky products, i.e., outside of emerging markets.

There’s an argument that says investors have been given fair warning. There’s another argument to say that structural changes such as a less diverse investor base and banks’ retrenchment from trading will mean liquidity can drain quicker…and how prepared are investors really? Are they just hearing ‘wolf’ whilst hunting for yield?  Despite continuing comments from Janet Yellen predicting a 2015 rise, Fed fund futures are still pricing in a below 45% chance the Federal Reserve will raise rates at least once before the end of the year – rising to just over 60% by the end of March 2016.


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