The Third Industrial Revolution is under way, and it is rapidly affecting sectors and industries across the global economy. Unlike the prior two industrial revolutions – which were centred on organising labour and capital, and then the mechanisation of labor with the creation of the assembly line – this one is all about shared resources. What I mean by shared resources is: the Uber effect, the Amazon effect, the cloud-computing effect.
All of these forces are very structurally deflationary (a persistent decrease in the level of consumer prices). This is not necessarily a bad thing as it is not corrosive deflation. In fact, it could be very positive in a lot of ways. The shared-resources phenomenon has the potential to free up capacity of both human and capital resources, which then can be reallocated to pursue other endeavours.
That said, we are going to see disruptive effects across the economy. For example, the Amazon effect will continue to challenge retail to rethink business models. Healthcare is another place where significant change is coming. Already, real innovations in biologics and genomics have the potential to drive down healthcare costs. This could be incredibly deflationary and I suspect we could have huge productivity gains in those areas. We should also see it in financial services. For example, bank branches are no longer as necessary as they used to be. Overall, I suspect we will see reduced capital cost in large parts of our economy.
But what is good for one may not be good for others. When you look at the markets in general, they usually don’t reflect the economy as a whole. Financial markets are still very much geared to just what is publicly traded, and the allocations across sectors don’t reflect the economy. Therefore, an economy can be fine, but it can present challenges for a market.
Next five years may look different
As the economy is in the process of hitting a reset button, I believe the next five years may look incredibly different for the financial markets. This is very similar to what you would expect from a market correction. There are two ways the markets might correct themselves – either through price or time. If they correct by price, price has to decline to clear the market. If they correct through time, you can maintain your price level but it goes sideways for a while until fundamentals catch up.
If the next monetary and fiscal policy choices are correct, then we can probably reset through time. We would be able to slowly rebuild some inflationary pressures in the system. The way that might manifest itself in the markets is you could see declines in margins but expansion of P/E ratios and long-term growth rates. Then the level of asset value existing in the economy could be maintained for a while. In this scenario, there probably wouldn’t be significant, abrupt changes in people’s consumption habits and savings habits. Therefore, this would be a fairly benign process – not great, but not a crisis.
Overall, I believe investors need to realise that returns from an index such as the S&P 500® will most likely be considerably less than they have witnessed during the past five years. Individual security selection will become more and more critical.