Investors Focus on Tech Disruption Risks…

On my latest roadshow around Asia, the macro implications of new technologies were a key presentation theme and topic for debate as much as China’s leverage unwind, and indeed tech has been a sustained overweight and the subject of several notes over the past year, including the ‘Rise of the Machines’ looking at the next wave of automation published last April. On that topic, I suggest that every investor reads “The Second Machine Age” by Erik Brynjolfsson and Andrew McAfee of MIT, which I finished on my travels (and “The Zero Marginal Cost Society” by Jeremy Rifkin covers the same ground, albeit with a more utopian bias). They posit that advances in computer technology, robotics and artificial intelligence mean that an algorithm driven automation wave will erase many job functions over the next decade. It will also slash the profitability of many consumer facing sectors, as we’ve seen already from music to mobile operators, by crashing entry costs and margins. In Shibuya in Tokyo, I visited a café with 3D printing machines for hire for instant prototyping (mostly for Kawaii trinkets, from what I saw, but this technology is now going mainstream for niches like biomedical implants), an early sign of a very different future for mass manufacturing and the associated global supply chain. I met a hedge fund manager who is so paranoid about being eavesdropped that he uses the highly secure Telegram app for his instant messaging, and a proxy web server that hops around a dozen countries for everything else – I didn’t ask if he’s taking his fees in Bitcoins. Meantime, Alibaba bought a controlling stake in ChinaVision to launch a Netflix style content streaming business and a stake in a US messaging app to combat Tencent’s mobile threat ahead of its landmark US listing (which will likely ring the bell on the increasingly frothy wider social media/mobile web subsector near-term – note the selloff in equally heated US biotech).

The integration of neuroscience and software to give say a factory robot the intelligence to ‘learn by doing’ i.e. rewriting its own software code by simply repeating a task, would have profound implications. Indeed the topic of machine learning and its macro consequences are critical for investors to understand – one point I’ve made repeatedly is that the ‘cognitive threshold’ for a job in terms of its automation vulnerability is rising very rapidly now, and given the immutable IQ bell curve a substantial proportion of the population will simply become surplus to requirements. There are of course plenty of signs of this already, including high levels of graduate unemployment globally – about 3m Korean graduates are ‘economically inactive’ in an academically obsessed country, while US graduate underemployment is becoming entrenched. This looks quite different from the industrial revolution that began 150 years ago and which saw a huge migration in Europe and then the US from farms and country to factories and cities, driving a virtuous urbanisation/productivity cycle as repeated in recent decades in China. A trend I’ve highlighted is the growing concentration of household and corporate wealth and cash flows, the latter focused on the tech sector which is leading the overall economy toward a growing ‘dematerialization’ i.e. we need less capital and labour input for every increment of GDP and corporate revenue (and China will belatedly make that same shift, as its own tech giants begin devouring SOE margins). Think for instance of the implications of all those taxi booking apps proliferating from the US to China – by matching supply and demand more precisely and adding private limo supply (and in Uber’s case removing fixed pricing), they reduce redundancy and the overall fleet of vehicles required to serve any given population – Airbnb is doing the same to hotels by adding private spare bedrooms as a competitor.

Sophisticated data analysis reduces capacity slack in the system (as airlines have known for many years) but huge chunks of the global economy are now becoming subject to similar optimising ‘yield management’ software. If Amazon can generate a million USD of incremental turnover with a tenth of the labour and even less real estate overhead of a WalMart, the only rational response of the latter (and Tesco etc.) is to restructure their business model as margins get compressed. Having a large legacy workforce and real estate assets to restructure and downsize as new online entrants cherry pick your client base is a looming threat – there will however be a first-mover advantage for those adapting business models early.

Where Have Six Million Missing US Workers Disappeared To?

18th September 2013

Are the unemployment statistics giving a seriously misleading indication of the timetable for Fed policy normalization? Back in the 12th June weekly on this topic, I noted that: ‘The Fed has no idea how many of those workforce exiles have left for structural/demographic reasons rather than cyclical ones; if the latter is the key factor, then unemployment would probably rise in the initial stages of an accelerating recovery, as discouraged potential workers began actively looking again, and thus prolong easy policy. We won’t get a clear answer until y/y employment growth accelerates to 3-4% for several successive months, and then see if there is a strong participation rate response.’  The head of the SF Fed has recently pointed out that the unemployment rate has consistently been the best single measure of slack in the labour market for many decades, and that it remains very closely correlated with alternative measures derived from other sources such as private employment surveys/job openings etc. As it likely tests the 7% level by early 2014, the  Fed’s hand will be forced on exiting extreme monetary stimulus…

While markets have been cheered by Larry Summers having dropping out of contention as the next Fed Chairman, inspiring hopes for a slower QE exit, the bigger issue is the underlying state of the employment market and whether it will prompt the Fed to lower its 6.5% unemployment threshold for a rate hike, which on current trends looks likely by H1 2015. A key issue for global investors to watch is the falling participation rate but also rapidly slowing workforce growth. If the same percentage of adults were in the workforce today as in January 2009, the measured unemployment rate would be 10.8%, and the Fed would be launching QE4. Over the past three months, the US has averaged 148,000 new jobs, a slower pace than the previous six months and yet the unemployment rate dropped to 7.3% in August, the lowest since December 2008, because over the summer a further 312,000 people dropped out of the workforce.

Between 1960 and 2000, the proportion of Americans in the workforce surged from 59% to a peak of 67.3% of the population before dropping to the current 63.2%, driving overall economic growth and household incomes. That was largely due to women entering the labour force while improvements in healthcare allowed working lifespans to be extended.  For the Fed and investors, the question is how much of this downshift is cyclical (the still weak employment market discouraging potential workers) versus structural (i.e. demographic trends).  If the same trends in employment/population growth were in place as pre-recession, total employment would by now be about 6m higher.

The employment/population ratio has hardly changed at all since 2009, implying that the whole of the decline in unemployment has been due to a decline in the participation ratio. Since 2000, the labour force growth rate has been steadily declining as the baby-boom generation has begun retiring and under-25s enter the workforce at a later age. Bureau of Labour Statistics and Chicago Fed researchers have forecast the participation rate to trend even lower by 2020, regardless of how well the economy does in the interim. The extent to which this workforce shift is cyclical rather than structural has huge implications for trend US wage inflation, productivity and GDP growth.

According to the February 2013 CBO estimates, potential growth of the labour supply has been slowing from 2.5% annual growth from 1974-1981 to only 0.8% from 2002-12 and is projected to slow further to only 0.6% over the next five years. At current levels, working-age population growth is at multi-decade lows. Part of that decline in working-age population growth reflects lower immigration to the US as a massive post 9/11 increase in border security spending since 9/11 has curtailed Mexican illegal immigration, and tougher visa rules have slowed legal migrant flows.

The CBO has estimated that the non-inflationary unemployment rate (NAIRU) has risen for temporary reasons to 6% of the labour force, but in the long term it will drop back to 5.5%. At the rate of jobs market progress seen recently, this implies that slack will be wholly eliminated in about 24months, implying a fairly rapid exit from the Fed’s aggressively easy monetary stance. The standard way of estimating the number of people who have temporarily  withdrawn from the jobs market until it improves is to compare the actual participation rate to that predicted if the demographic composition of the workforce had remained unchanged after 2008. This method implies that about 1.3% of the labour force has dropped out since 2008, but should come back if the jobs market improves and that the amount of slack in the labour market might be at least a percentage point higher than implied by the unemployment rate. However, for several important demographic groups, there appears to have been a long term downtrend in participation rates for structural reasons unconnected to the economic cycle, while the potential supply of labour is now constrained, leaving a lot less lack in the system than many assume.