Alison Porter, portfolio manager, discusses the background of the technology sector. This gives reasons why companies might look to prioritize digitization to offset the rising cost.
At the height of the COVID-19 pandemic, governments and businesses had to close down all forms of investment and production, effectively reducing the supply curve to zero. To manage the crisis, unprecedented fiscal and monetary stimuli had to be given. As a result, inflation has been triggered by shifts in demand and supply. This was accompanied by ongoing supply chain problems, rising healthcare costs, transport bottlenecks, higher fuel prices, and continuing supply chain problems. All this is happening against the backdrop of a growing demographic bomb.
Although goods inflation may be lessened by rising energy prices, the largest cost pressure is from services, mainly wages. This may make it more difficult for central bankers to manage higher interest rates. Economics scholars often refer to Gibson’s paradox or the Fisher effect. Global governments and central banks are trying to manage rising inflation and sustain an economic recovery after COVID. The Global Technology Leaders Team believes that technology is the science of solving problems. Over a 25-year span, the relationship between lower bond yields as well as inflation and technology adoption has been clear. The combination of technology adoption with globalization via increased productivity, lower labor costs, and integration of supply chains has historically led to lower inflation expectations and a decrease in bond yields.
The long-term trend of rising technology adoption has led to lower inflation and falling bond yields.
Why does technology have such a deflationary effect?
Technology has made products and processes more efficient, quicker, and cheaper. Gordon Moore, a 1965 mathematician, predicted that every two years, the number of microchips’ transistors would double and that prices would fall by half. Moore’s Law allowed computing power to increase exponentially while falling in costs. In addition, it made computing power more accessible – in 50 years, the NASA supercomputer of the 1960s was within reach of half the population. Although Moore’s Law has been under pressure for microchips now, the fundamental idea that technology can make products or processes more efficient, quicker, and better is still valid. This is evident in many areas. For example, hyperscale data centers are where the top cloud service providers are driving down storage and compute costs.
How can technology adoption growth help to reduce inflation?
We will discuss examples of technology that can be used to increase productivity and automate and optimize resources.
Low-carbon, low-power infrastructure
The exponential rise in power consumption is due to computing proliferation. This is a challenge to climate change and energy resources. It requires a shift to low-carbon cloud and 5G architectures. Data center electricity consumption has remained almost flat despite the explosion of data over the past ten years due to a shift towards cloud computing and hyperscalers that have super-efficient data centers. The power usage efficiency (PUE) of hyperscalers is significantly higher. Microsoft’s Azure cloud platform was found to be 93% more efficient than on-premise solutions in 2018, according to a Microsoft study. Investment in vertically-integrated solutions, such as Nvidia’s graphics processing units (GPUs) in server racks that use 1/20th of the power consumption of traditional racks or flash storage systems, can result in over 50% energy savings. Companies of hyper-scale are leading the way in using renewable energy. They have moved beyond carbon offsets to fully carbon-free electricity. Alphabet’s Google set a goal to provide electricity for its offices and data centers 24/7 using carbon-free electricity by 2030. Enterprises have been contemplating a shift towards the public cloud to improve digital transformation, flexibility, and an IT budget that is more capital-intensive. The transition is now driven by energy costs, energy security, and carbon emissions.
Problem: High energy prices
Solution: The next generation of low-carbon infrastructure
Technology and new creation
Nearly 5.4 million Americans applied for small business licenses in 2021. This is more than half the number of applicants from 2019 1. The global start-up funding total reached $643bn. This is a tenfold increase over a decade ago. Although funding and interest rates have been low, it is easy to access the funds. The core of this start-up boom has been technology. Companies don’t have to borrow millions of dollars to purchase computing power or storage, unlike in the dot.com era. Instead, they can rent it now from a cloud provider. There are no huge budgets needed for sales and advertising to reach the market, open distribution channels, and make sales. Alphabet, Meta, and TikTok offer targeted advertising options. Marketplaces such as Etsy, eBay, and Amazon provide customers with access, and the latter even offers logistics and warehousing. Invoicing, inventory management, and logistics have never been easier, thanks to payment digitization. While there have been many critics of large-cap tech companies, they have allowed many start-ups that are uniquely positioned for innovation and creativity. The ‘creator economy’ is one of the fastest-growing small business sectors. Linktree’s 2022 Creator Report found that there are currently 200 million content creators 3, which includes those who use creator platforms like Instagram, YouTube, Facebook, and TikTok to make supplemental income and monetize their content.
Resource optimization and the circular economy
Productivity can be significantly increased by being able to track and reuse items. The logistics, supply chain, and transport industry can be used to optimize the storage and transportation of goods. This will help reduce miles driven and maximize capacity. Companies in a variety of industries, including manufacturing, healthcare, aviation, and retail, can now use microchips or software to track assets. This allows them to see asset locations in real-time, which gives them a better understanding of equipment’s status and helps to plan their resource usage.
Technology is driving clean energy and sustainable transport. This technology is enabling the transition from renewable energy to sustainable transportation. How does this relate to addressing inflation? The Inflation Reduction Act, which was adopted in August in the US, is a good example. This was the most comprehensive piece of federal legislation to address climate change. This bill provided tax incentives for electric vehicles manufactured in the US. It also created a cleaner manufacturing sector and increased wind and solar energy production. Investing in technology allows solar costs to continue to decline and efficiency to improve. This makes EVs more competitive. Solar inverters and micro-inverter innovations can improve the conversion rate of solar energy and also make it more reliable and easier to integrate solar power into the grid. For EVs, power semiconductors can be used to increase battery efficiency using more environmentally friendly technologies such as silicon carbide. This can improve the range and extend the life of batteries by storing energy in a second form.
Improving labor productivity
To address skilled labor shortages, productivity and resource optimization are crucial. Technology’s role does not end with enabling online education and skill access. Smart ways to increase workforce skills are provided by robotics and artificial intelligence (AI). The software allows for better alignment with peak customer demand times and enhanced labor scheduling. Cloud software companies help many industries restructure workflows and automate responses. For example, in healthcare, robotic surgery facilitates the sharing of best practices from the most skilled surgeons.
Managing healthcare costs
In the past 25 years, consumer prices have not risen faster than healthcare inflation (prescription costs and doctor visits). Even after 2008’s financial crisis, when overall inflation fell, medical prices continued growing. Although the impact of COVID on healthcare costs has been slow, a McKinsey study found that healthcare inflation will soon catch up to overall services. Unsurprisingly, the recommendations on how governments and providers of healthcare could prepare for and offset this were technology-centric. “Healthcare organizations must fundamentally reset themselves in order to increase productivity through the use of advanced analytics and digitalization.” 4Increasing healthcare costs are being addressed by increasing administrative spending. Long-term, AI can be used to identify promising compounds faster and cut down on time it takes to develop preclinical drugs. It also reduces early-stage development costs by up to half as much. In addition, AI and massive computing power are key to lowering blood screening costs. This could help to detect illnesses early and provide cheaper treatment plans.
Tech investors must continue to place emphasis on the importance of valuation discipline.
These are just a few examples of the reasons why companies will continue investing in digital transformation even during periods of lower economic growth and higher inflation. As a result, these areas can offer great investment opportunities. However, investors must be more careful about their valuations and look for companies with solid balance sheets and strong free cash flow prospects. This means that investors must be able to navigate the hype cycle and look for ways to invest in secular themes with potential long-term growth. However, this requires that they only do so when there are reasonable growth expectations, reasonable valuations, and balance sheet strength that allows them to capitalize on their competitive advantages.
4 McKinsey.com – The Gathering Storm: The transformative effect of inflation on healthcare, 19 September 2022
References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy, or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees may have a position in the securities mentioned.
The technology industries are susceptible to obsolescence, new market entrants, falling profits and prices, and competition from other companies. Concentrated investments in one industry can be more volatile than those made in the whole market.
Foreign securities can be subject to additional risks, including currency fluctuations and increased volatility.