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The digital revolution will be a game changer in relationships between macroeconomic factors such as production, consumption, labor and inflation. Lukas Daalder outlines the effects on investors. “The disruptive effect of digitalization promotes the case for active equity investing.”
“In the eighteenth century, if you had asked people how the steam engine would affect society, no one would have had a clue. The impact of an important invention only becomes apparent years later. The same applies to today's digital revolution. It is already having a far-reaching impact on the economy, but that doesn't mean we know where it will all end." According to Lukas Daalder, Chief Investment Officer for Robeco Investment Solutions, there is no doubt as to the impact of digitalization on the real economy. Take, for example, all the well-known chain stores that have filed for bankruptcy in the last month and are disappearing from our streets. But we still cannot be sure of exactly where we are in this trend at this point in time.
It is clear that the technological revolution, in this case digitalization, is causing changes in how supply and demand interact. Daalder cites the music sector as a telling example of the economic impact of digitization. Because music is now kept as a digital file rather than on an LP, cassette tape or CD, the costs of production, reproduction, distribution and sales are only a fraction of what they were in the era of the physical 'sound carrier'. The marginal costs are almost zero and that puts profits and turnover in those segments under considerable pressure. "There is always change. Increasing production efficiency and falling costs are not a new phenomenon. But in some sectors and industries we are approaching levels close to zero that we have not previously encountered,” says Daalder. “It is also evident in news dissemination. For sectors that can be directly digitized, the effects are huge. But there are also many sectors that can't be – like the food and automotive industries.”
Lower costs resulting from digitalization are positive for consumers who can obtain services and products far more cheaply. But this also has a flip side: lower turnover and slower growth, and ultimately job losses. Digitalization also heightens the competition between man and machine. Man loses out in situations where a machine can do the work cheaper and more quickly. Potential job losses are a cause of concern for Daalder. “The low and high paid jobs will remain, because there is always work that a machine can't do and someone has to construct and program all the robots, but I do predict that jobs in the middle segment of the labor market will disappear. Job losses lead to reduced purchasing power and quite possibly to social inequality. And what are all the people without jobs going to do?"
Digitalization creates competition for existing sectors in places they least expect it. Uber is running roughshod over competitors in the taxi segment, Airbnb is the new kid on the block in the hotel sector while Google and Tesla have nothing to do with the traditional automobile industry but are working on an electric, self-driving car. Here too, Daalder sees clear advantages and disadvantages of digitalization. More competition means more freedom of choice, but shareholders are deprived of growth. “The new companies are lean and mean. They often employ just a fraction of the workforce employed by more established companies," concludes the strategist. “Uber doesn't actually have any taxis and Airbnb has no hotels.”
Digitalization is responsible for the emergence of a sharing economy. People share cars (SnappCar), houses (Airbnb) and even tools (Peerby) with each other online. On the plus side, people can generate income from the things they own and the higher usage rate creates more efficiency. But in the end, this causes lower demand for products, which in turn can result in slower growth.
Daalder lists a number of potentially revolutionary trends that could rock the foundations of our economic model – self-riding cars, 3D printing, solar power, DNA-personalized drugs and blockchain, the technology behind the Bitcoin digital coin. “3D printing enables parts to be made anywhere, any time. A blockchain is a database for financial transactions that removes the need for banks and brokers as intermediaries. It is hard to comprehend what impact self-driving, electrically-powered cars could have. This will range from truck, bus and taxi drivers losing their jobs, because they are no longer needed, to a completely different infrastructure setup where cities have fewer and narrower roads, and to oil companies that see most of the market for their products just disappear. And will it be the existing automobile companies that launch self-driving cars or outsiders like Google, Tesla and Apple?"
‘Active investors can position themselves to take advantage of disruption much faster than index investors’
How can investors deal with the trend of digitalization and the disruption it causes? According to Daalder, technological changes will lead to new production and consumption processes. “We don't know how or when, but things are happening pretty quickly. Investors should be prepared for disruptions and check whether their investment policy can withstand such changes." Daalder has noticed that major investors such as pension funds are worried about this.
It is also something he is concerned about. “It’s an uphill struggle for a pension fund to predict how its participant population will change over time. A steady inflow of new pension money one minute can turn into outflow the next as new companies or sectors appear. If a fund has invested too large a proportion of its capital in an illiquid asset class that cannot be sold quickly, it can encounter some problems."
But this can also have major consequences for investment returns on a broader scale too. Daalder illustrates this using the sector weights in the US and UK equity markets in 1900. Half (UK) and almost three quarters (US) were made up of railway companies. “If you had invested in the broader index, most of your holdings would have been railway companies and that would have had a major impact on your investment performance as none of those railway companies survived. It is true that if you had invested in the broader index from 1900, you would still have generated attractive returns on equities, but it's clear these would have been that much better if you had invested less or even nothing in the railway sector. The same applies today: if you don't invest in companies that are threatened by disruption, you can minimize losses for a part of your portfolio."
As far as the bond market is concerned, the conclusion is a lot less straightforward. Lower economic growth and job losses can cause a deterioration in government financing. Less tax income and higher benefits payments, for example. On the other hand, the impact of digitalization may well result in structurally low inflation, which is generally positive for the bond market. Here too, other factors such as population aging and monetary policy play an equally important role, which makes it difficult to make accurate predictions on the direction in which capital-market rates will move.
Daalder thinks that the disruptive effects of digitalization support the argument for an active investment policy. “Indexes are full of yesterday's winners, but not those of the future. There will be a delayed reaction before a disruption in any particular sector has an impact on the index. This means active investors are able to respond to changes far more quickly."
Although digitalization has its pros and cons, Daalder doesn't want to be a gloom-monger: “Robeco believes in the strength of human ingenuity, so productivity will improve and growth will continue. And digitalization will also result in new sectors and jobs."