Market Memo: Investors and the Industrial Revolution 3.0

11-29-2017

The first industrial revolution transformed an agrarian economy into a manufacturing-based economy; the second transformed the manufacturing-based economy into a service-based economy. We now are in the midst of a third major industrial revolution—the digital revolution, which is bringing an analog economy into the digital world. And as with the first two, this revolution is having profound effects on the way we live, work and conduct business.

Technological progress by design is disruptive. Think of the wage-income inequalities that arise as wealth spawned from new technologies and processes almost always flows first to their creators, be they the Rockefellers, Vanderbilts and Carnegies of the first Industrial Revolution or the Gates, Bezos and Zuckerbergs of the current digital revolution. Or of the demographic disruption that comes as work shifts from rural areas to the cities, again be it from farmers heading to factories during the first Industrial Revolution to the knowledge workers and techies who tend to concentrate in and around university towns and research centers.

Misplaced fears
But history has shown that, over time, the rise of these new industries also has brought with it increased employment opportunities, improved productivity and higher standards of living. In many ways, it is the story of our economy. Innovate, adapt and adopt, repeat. Sometimes the benefits are quick to come; sometimes they can take decades. There is little doubt, for example, that this current revolution is generating a lot of fear about displacement. It’s estimated that half of the activities people engage in at work can be automated with currently demonstrated technology. However, a McKinsey & Co. study also concludes that less than 5% of all occupations can be completely automated. Similarly, it’s also true that some wages may remain under near-term pressure as the growth and assimilation of new digital technologies drive down the demand for labor faster than new employment opportunities arise.

As large companies automate and standardize, however, we would expect that good-paying employment opportunities will arise, both within the industries where these technologies are being created and elsewhere. This always has been the case during past periods of technological disruption. And we anticipate the biggest shift will see job growth come from smaller businesses offering more customized goods and services. We already are seeing this in the beer industry, where a few global, highly automated macro brewers now control 87.5% of the market. Craft brewers, on the other hand, are growing in number at a rate of 20% per year, according the Brewer Association, and now employ more than half of all brewery workers in the U.S. Similar patterns can be seen in other industries, including financial services.

It’s all about earnings
For investors, the benefits of technologically driven improvement are clear. S&P 500 profits have tripled and overall corporate profits have doubled as a share of GDP since 1973, a period that saw productivity grow 74.4%, according to a 2015 Economic Policy Institute study. Coming off the 2015-16 earnings recession, S&P earnings have rebounded strongly this year and, we think, are on track to reach $145 in 2018 and $155 in 2019, in part on productivity gains as this Industrial Revolution 3.0 takes root. Many advances in automation, robotics, artificial intelligence and quantum computing are just now making their way into our daily work and home lives. There’s always a lag between the introduction of a new technology and its impact on productivity—the first mass-produced PCs hit the market in the early 1980s, but peak productivity growth from their use didn’t materialize until 1995-2005, McKinsey says.

In the simplest form, the value of an equity market is determined by earnings of its constituent companies and the P/E multiple the market is willing to pay for those earnings. Given this latest wave of technological advances and their growing impact on production efficiencies, labor costs and access to global markets, we expect to see higher profits, abetted in future years by a new wave of investors—the millennials, who are just now starting to hit the market. Research by Merrill Lynch, Bankrate.com and Legg Mason shows that contrary to popular belief, millennials are avid savers, are inclined to invest in stocks as they get older and, relative to older generations, are more bullish about the market in the coming year. Adding to this potential tailwind for equities is an estimated $30 trillion transfer of wealth in coming years from baby boomers to their Generation X and millennial heirs. In this environment, the risks for the long-term equity investor remains skewed to the upside.