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“The other biggie”

Third Quarter 2019

Download PDFCapital Investment Services Third Quarter 2019 Perspective - The Other Biggie

“If you can get a job at Motorola or Sears, your career will be golden.” —A Chicago father’s advice to his son

When the advice was offered, Sears and Motorola were not just titans of business in Chicago, but ‘world class’ companies.

Cartoon: Have the world’s growth batteries gone dead?

A cartoon showing a dilapidated rabbit too tired to beat the drum of global growth

Motorola had earned an impressive corporate pedigree. It developed the first car radios as autos became a mass market, later produced best-of-breed TVs as consumer demand for television exploded, and was a mobile phone pioneer.

However, it’s now a shell of its former self, having essentially been “sold for parts” awhile back. Phones from Nokia and (soon after) Research In Motion’s Blackberry handsets were deemed by the marketplace as superior to Motorola’s offerings. Motorola lost and never regained its edge. (The latter two companies’ own “time in the sun” didn’t last very long, of course, as consumers mass migrated to the iPhone and Android devices).

Today, Sears is circling the drain towards oblivion, but back when the father offered his career advice, two-thirds of US consumers shopped there and an estimated one-half of U.S. households had a Sears’ credit card.

Perhaps, as a symbol it thought befitting its stature as an industry giant, Sears constructed the (then) tallest building in the world to house its Chicago headquarters and some of its 350,000+ employees—many of whom, no doubt, did enjoy “golden” careers at Sears (up to that point).

Success in credit cards and selling insurance through its Allstate unit emboldened Sears’ management in the early 1980s to think ‘bigger’ and expand its experiment beyond retail. In a push to become a ‘financial supermarket,’ it bought the real estate brokerage firm Coldwell Banker and the stock brokerage firm Dean Witter.

Their strategy was to cross-sell financial services to its vast customer base. “Customers can now buy their stocks where they buy their socks” was its informal mantra. With dreams of conquering new markets, retail goods were no longer the centerpiece of Sears’ focus.

Alas, the financial supermarket strategy didn’t deliver the hoped for results. Meanwhile, Walmart’s “everyday low prices” strategy was becoming a huge hit with consumers, and a distracted Sears failed to effectively respond. As Walmart, and later Target, Best Buy, Home Depot, and Amazon all transformed the retail market, Sears continued to bumble, and its market share (and stock price!) plummeted.

Ants are always attracted to picnics

Our point is absolutely not to disparage well-intended parental advice. (The author of this edition of Perspective treasures his parents, but is also happy that career interests took him in a direction different than that suggested in his father’s advice quoted earlier!)

Nor is the point to pick on Sears or Motorola. Other corporate titans like Kodak, Xerox, Blockbuster, Toys R Us, IBM, and General Motors—to name just the ones that immediately come to mind—all also experienced erosion of seemingly insurmountable “market power” positions over time.

And while the particular stories charting the erosion of each company’s former position have their own nuances, it’s important to note that it wasn’t economic recessions, or the impeachment of a sitting president, or antitrust tangles that triggered erosion in their businesses.

The key point is that the common denominator is that they each suffered competitive defeats in the markets for their goods and services.

Why did they suffer defeats? Because other companies figured out a way to “up the competitive game” and better serve customers.

Just as ants are attracted to a picnic, potential competitors are constantly seeking ways to win over customers by providing a product or service of superior value to the potential customer.

Today’s titans—even as their past successes make them appear to some as invincible “monopolies”—are not immune to this same dynamic. Despite handwringing by policymakers (and policymaker wannabes) about corporate concentration of power, the very success of today’s titans makes them particularly juicy targets for the ants of competition.

Moreover, as the Sears and Motorola examples above suggest, the relative speed at which companies, industries and the economy itself can be altered by surprising shifts in the competitive landscape is nothing short of amazing.

The two biggies shaping the economic future

For many months the investment markets have been fixated on the possibility of a recession, the next Federal Reserve (‘Fed’) policy move, and the China trade issue.

These current events are not unimportant of course. We offer our assessments in the appendix.

But as we have noted previously, these events are largely being shaped by other very powerful trends with investment implications that may well span several decades into the future.

Just as tectonic plates beneath the earth’s crust are slowly, incessantly shaping the planet’s surface in ways only time reveals, two trends…the two “biggies” reshaping the world economy are demographics and technological innovation.

Last quarter’s Perspective: Sub 2.1 = Running on Empty? focused on demographic trends. We’ll provide a quick review of demographic trends, and then we’ll turn our focus to the other “biggie”—innovation.

The great defining event of the 21st century…?

Chart 1: Big changes ahead (Source: Morgan Housel)

A column chart titled estimated percentage change in working age population 2019-2050 showing the United States having the only positive plot among all major economies.

To briefly review the demographic trend; birth rates continue to collapse to sub-par replacement levels around the world. There’s credible evidence that the population bomb is giving way to a population bust.

Demographer Darrell Bricker and researcher John Ibbitson in their book, Empty Planet: The Shock of Global Population Decline, write:

“We face…a relentless, generation-after-generation culling of the human herd. Nothing like this has ever happened before. The great defining event of the 21st century—one of the great defining events in human history—will occur…when the global population starts to decline.”

Chart 1 above reflects the implication for countries’ labor forces in the years ahead.

It’s hard to grow an economy with a contracting workforce. It’s doubly difficult when populations decline as appears in store for a number of countries within the relatively near future. (Note that U.S. demographic prospects stand in contrast to much of the world, a point we’ll return to soon).

Population growth is not the only factor that can power economic growth. Innovation is even more important.

Innovative dynamism

The fall of Sears and rise of its competitors is an example of the process longer-term readers will recognize as what economist Joseph Schumpeter called creative destruction. This process has been a recurring feature of the U.S. economy.

As we’ve discussed on previous occasions (see for example, What-dun-it?), it’s the primary force responsible for the remarkable economic advancement and the rise in the standard of living that’s occurred over the past two hundred years (see Chart 2).

Chart 2: For most of our existence, people were desperately poor; life was “nasty, brutish and short.” Things began to change in a major way as human ingenuity was released upon the world.

A line chart showing the rapid near vertical growth of global GDP plotted in 1990 international dollars that began circa early 1900s and continued into the year 2000.

Its benefits have continued to ripple across humankind in more recent decades as repressive governments have become less so (Chart 3).

Chart 3: A very favorable under-the-general-radar trend

A line graph titled share of world's population living in poverty 1981 to 2015 depicting a falling line that began at 42.2 percent in 1981 and ending at 10 percent in 2015.

For those questioning the need for economic growth, we point to the mass flourishing which results when human ingenuity is allowed to work its magic. There are many more human problems that remain unsolved!

We’ll admit the word destruction in Schumpeter’s creative destruction phrase is off-putting. It’s hard to think anything good can come from destruction. We believe the underlying process Schumpeter identified is better understood by the term, innovative dynamism offered by economist Arthur Diamond.1

Innovation reflects the power of applied human ingenuity, the evolution of new ideas and advancement. Dynamism implies constant motion of competitive pressure and the human drive to improve one’s life and/or the lives of their family.

So here’s how innovative dynamism works:

Innovative dynamism leads to market tested betterment

Periodically, clusters of innovation erupts that enable creative entrepreneurs to displace the current way(s) commerce is done in some industry or industries. The innovations could be in the form of a new product or service, or a better production process or means of delivery. (Recall our earlier Sears discussion.)

Diamond explains what comes next:

“Once innovative dynamism creates a new good or service, it is soon within the reach of everyone. Before innovative dynamism creates a new good or service, it is within the reach of no one.”

The innovators and the businesses they steer are the agents of not only economic change, but economic advancement.

The benefits are considerable:

  • Innovative dynamism enables “common folk” to live better than the richest and most powerful from prior generations.

    As a master innovator himself (in the oil industry), John D. Rockefeller is estimated to have been one of the wealthiest Americans in history. Yet he couldn’t sit back and watch a color TV while enjoying air conditioning, was limited to primitive dental and medical care, he didn’t have easy access to almost all accumulated knowledge of human kind as we do with that smartphone in our pocket, couldn’t get the out-of-season fresh fruit or enjoy the ‘endless shelf’ of goods the internet provides us today.

    U.S. Presidents are generally considered among the most powerful people in the world. One (Calvin Coolidge) couldn’t save his son from dying of an infected blister because penicillin wasn’t yet available. (Rockefeller’s wealth also couldn’t save his cherished grandson from childhood death for similar reasons, by the way). Another President (FDR) suffered from polio—which now is preventable.

  • Mass flourishing is enabled.

    Besides the availability of more desirable goods and services, innovative dynamism enables mass flourishing. Life spans have been expanded, jobs are safer, less back-breaking and deemed by many as more mentally challenging in a favorable ways. The cost of basic needs like food and energy require an ever declining portion of incomes.

Economist Diamond points out that with basic needs more easily satisfied and leisure time increasing over time, people have the opportunity to pursue endeavors, which address what psychologist Abraham Maslow called our higher needs. In today’s digital world, access to almost any music, literature and entertainment is at our fingertips.
A pyramid depicting the famous hierarchy of needs pyramid created by famed psychiatrist Abraham Maslow.

Of course, heaven on earth does not exist. Job losses at disrupted businesses are a painful element within innovative dynamism. Some people and towns don’t recover when they’re impacted by disruption of the then-present economic status quo.

But net new jobs have always flowed from innovative dynamism. New businesses and entire new industries are typically created. Some worry that with robotics, artificial intelligence (AI) and deep computer learning this time will be different with respect to job creation.

Similar worries have always dogged innovative dynamism. Luddites smashed looms, an early sewing machine was withheld from the market out of fears about what it would due to employment, and President Kennedy worried about “automation replacing workers” back in the 1960s.

Recall the declining labor force chart shown earlier in Chart 1? We’re going to need robots to augment human employment!

Augmented technology will likely be just another in a long line of tools developed for increasing productivity. Consider; a computer may be able to beat a human chess master, but the master playing tech augmented chess dominates.

What are the new employment opportunities and what new industries will be created? Only with the benefit of hindsight will we know. This too has always been the case. Who could have foreseen for example, the multi-billion dollar professional sports industry that sprung from the invention of the now mundane lawn mower?

It’s always been a bad bet to underestimate human ingenuity at solving problems. We believe it’s still a bad bet.

Speaking of problem solving, let’s take a look at innovators and businesses as agents that help distribute innovative dynamism across the economy.

Innovators

Innovation does not spring forth from a predictable formulaic process. As a result, it doesn’t readily lend itself to analytical study and is not well understood.

In his book Diamond2 describes the research on shared traits of innovators. It’s easy to see why a cookbook for innovation does not exist.

Diamond states:

“Through insight, courage, or hard work, innovators see what others do not. The focus of their thoughts, their habit of mind, leaves them more open to innovation than others.”

“The innovator entrepreneur often has less theoretical (formal) knowledge than scientists, managers or ‘experts’. They do possess however, a great deal of hard to articulate informal knowledge of observed general patterns or how to do something that is hard to articulate.” (In much the same fashion that those who know how to ride a bicycle find it difficult to articulate how to do so.)

The research indicates that innovators are by and large, “rebels with a cause”. They are discontents, question convention and have a penchant to “think outside the box” of accepted wisdom.

Their motivation is typically much larger than monetary rewards. Steve Jobs is reported to have told Pepsi’s John Scully when Apple was recruiting him for the CEO position years ago, “do you want to sell sugar water, or come here with a chance to change the world?”

Perhaps because they are less bound by current theoretical knowledge, they (to quote Diamond once again):

“…are less prone to what Nobel laureate Daniel Kahneman calls ‘theory-induced blindness’ that leads us to see what currently accepted theories predict, rather than what is actually in front of us.”

“Successful innovators are those who can avoid or overcome the blindness—to see the dissonant, the unexpected, or the hard to see.”

The rebel with a cause characteristic is tolerated if not celebrated within the U.S. Other countries are much less tolerant of rebels, those that question the status quo, or want to change the world. This, we assert, is why so much of the world’s innovation occurs in the U.S.

Think China can become the next tech innovation hotbed? We have our doubts. Consider that the recent Hong Kong protests began when China wanted the island to extradite those questioning authority to the mainline for (no doubt) “re-education”. Not exactly an encouraging environment for rebel innovators out to change the world!

The role of business: a “thank you-thank you” proposition

At its essence, the role of businesses is to serve customers. They fulfill this role by solving some customer problem or satisfying some customer desire in a manner that is both valuable to the customer and allows the business to earn a worthwhile return for its efforts.

Don’t have a green thumb or know how to grow food? Of course, there’re businesses that will do it for you. You go to the store (or nowadays, they’ll come to you if you prefer). You pick out what you want, hand over valuable currency (that was also probably earned from serving others) and, likely, tell the store employee, “thank you” as you do so. The store willingly exchanges the food for the currency and likely tells you, “thank you for shopping with us”.

Both parties are made better off by the transaction, hence it’s a “thank you-thank you” proposition.

Want apples but it’s the middle of winter? No problem. Some businesses have figured out how to make the remarkable routine. Do you want a Granny Smith, or how about a Honeycrisp? The variety is simply mind blowing. (As we discussed earlier, the richest man in history—John Rockefeller—couldn’t enjoy this routine activity that’s now easy to take for granted!)

Yearning to see a loved one that lives across the country and yet can’t travel? No problem, you can Facetime or Skype them because some businesses figured out how to make this happen. And you don’t even need to have a clue about the underlying technology to benefit from its magic!

Similarly, you don’t have to know how an internal combustion engine or the electric vehicle motor in your car actually works. All you need to know is how to operate it…and soon that may not even be required.

Of course, businesses have to fulfill their role by operating within the laws, rules and customs of the land. Some businesses will be run by unscrupulous people. Such people have always existed and–unfortunately, likely always will.

The good news is that other businesses have made inroads to solving the problem of assessing beforehand the quality of the goods or service provided by specific businesses. In today’s digital economy, shysters and poorly run businesses will be exposed faster than ever as adverse online reviews “go viral”.

Competition drives businesses to constantly “up the bar”. In doing so, businesses are essentially running constant experiments to see what exactly wins in the marketplace. In turning magic technology or crafting incredibly complex global supply chains, they enable commerce that’s easy to take for granted. As such, they are vital agents of change in the innovative dynamism process.

Meanwhile, you and I as consumers hold the power of judge and jury of businesses’ continuous experiments aimed at solving our problems. It’s a remarkable and virtuous dynamic.

What about big tech, monopoly power and privacy issues, you ask? As history and the Sears example from earlier suggests, the ants of competition are coming for them. It is only a matter of time, and the clock speed in the world of computer bits moves much faster than in the physical world of atoms.

The privacy matter is an issue to be sure. But we also think history once again shows the way. New technologies and innovative dynamism run ahead of the status quo and that includes laws, regulation and societal norms.

The latter will “catch up”. For example, Grand Rapids, Michigan is experimenting with autonomous-driving car services.3 They note, “This is way more of a sociology experiment than a technology experiment”.

As innovative dynamism is distributed in an economy, the “new” eventually becomes the accepted way we do things as rules, regulations and society also undergo innovation.

Growth-starved, low-inflation world

Many of the world’s economies are characterized by poor prospects for the “two biggies”. Innovative dynamism is lackluster and significant demographic challenges loom. Growth is highly prized and likely to remain so in a growth-starved world.

Cartoon: Super heroes to the rescue? They can’t create growth.

A cartoon depicting European Central Bank president Christine Lagarde, Federal Reserve chairman Jay Powell, and Bank of Japan governor Haruhiko Kuroda as super heroes.

We suggest that the negative interest rate structure around much of the globe is a signal of their lack of dynamism with poor prospects for a turnaround anytime soon.

Many policymakers keep doubling down on a playbook of more monetary “loosening” and increased government spending. This playbook hasn’t reversed Japan’s stagnation over the past 30 years. It’s not likely to work elsewhere for it does little to stoke the source of economic growth—innovative dynamism.

The good news is that U.S. has much more favorable demographics and, most importantly, another cluster of innovative dynamism underway.

Lots of innovation in the pipeline

Our “ear-to-ground” research approach continues to “hear” of many innovative developments in the pipeline as the digital (computer bits) and physical (atoms) economy meld.

These innovations (see partial list below) have moved beyond just the proof of concept stage and are increasingly being deployed within the economy. We have investments in many companies that are providing the digital “tools” that provide problem solving solutions to help other business avoid the fate of Sears as industries and the economy itself undergoes its structural changes.

Cartoon: “Necessity isn’t the mother of invention. You are!” Kevin Ashton

A cartoon showing a wife asking her husband who knocked on their home's front door with the husband responding opportunity but it had the wrong address.

A partial innovation list includes:

  • Internet of things (IOT)
  • 5G
  • digital commerce
  • cloud computing
  • software simulation
  • software as a service
  • AI/AR
  • unscaled customized consumer goods
  • direct digital manufacturing

We continue to believe the implications are both significant and favorable for productivity growth and the spread of another significant phase of innovative dynamism. One of the profoundly important developments is the increasing democratization of innovative dynamism. Now anyone with a good idea can access increasingly sophisticated software and massive computing power via the cloud and with relatively low cost subscriptions. More minds than ever are working on solving problems.

We’ll conclude this Perspective with some worthwhile perspective from (yet) one more economist. Ed Yardeni recently noted:

“One of my favorite songs is “We Didn’t Start the Fire” (1989), by Billy Joel. The lyrics include brief, rapid-fire allusions to more than 100 domestic and global headlines during the Cold War, from 1949 through 1989. Many of them refer to troublesome events during that period.

Today, Billy Joel would have no trouble updating his list of troublesome events: Red China, North Korea, South Korea, vaccine, Ayatollah’s in Iran, foreign debts, homeless vets, China’s under martial law, impeachment, negative rates, deflation, inverted yield curve, and many more. Actually, the first eight items were in Joel’s original lyrics from 1989.”

Lots of problems exist. Always have, always will. But there are also lots of solutions ahead. The volatile ride along the way will, at times, be tiresome and probably even scary. But if investors get the investment implications of the “two biggies”—innovative dynamism and demographics—even approximately correct, the investing rewards will be worth it.

Appendix

“Today was the worst decline since the February decline you don’t remember anymore.” Morgan Housel

“Stocks plunged to levels that a decade ago would get you locked up for suggesting we’d ever get half this high.” Morgan Housel

Since this economic expansion began, it’s been dogged by fears that recession is right around the corner.

Trade issues have been a nasty wet blanket on President Trump’s pro-growth tax cuts and deregulation efforts. Despite the slowdown in measured economic growth, we do not think recession is in the cards.

Here’s an update on our dashboard of leading indicators for growth and inflation. Data provided by the Federal Reserve of Chicago.

Growth prospects remain steady (but slow).

A CFNAI-M3 line chart showing value changes as they relate to recessions from the mid-1960s to 2019.

Notes: Shading indicates official periods of recession as identified by the National Bureau of Economic Research. Following a period of economic expansion, an increasing likelihood of a recession has historically been associated with a CFNAI-MA3 value below –0.70. Conversely, following a period of economic contraction, an increasing likelihood of an expansion has historically been associated with a CFNAI-MA3 value above –0.70 and a significant likelihood of an expansion has historically been associated with a CFNAI-MA3 value above +0.20.

The financial plumbing underlying the economy remains in good shape, with no signs of a threatening credit crunch unfolding.

A line chart showing value changes of the National Financial Conditions Index from 1970 to 2019as they relate to recessions from 1971 to 2019.
The National Financial Conditions Index (NFCI) and adjusted NFCI (ANFCI) are each constructed to have an average value of zero and a standard deviation of one over a sample period extending back to 1971. Positive values of the NFCI have been historically associated with tighter-than-average financial conditions, while negative values have been historically associated with looser-than-average financial conditions.

Similarly, positive values of the ANFCI have been historically associated with financial conditions that are tighter than what would be typically suggested by prevailing macroeconomic conditions, while negative values have been historically associated with the opposite.

No signs of threatening inflation either.

A CFNAI-M3 and inflation line chart showing value changes as they relate to recessions from the mid-1960s to 2019.

Notes: Shading represents periods of sustained increasing inflation. An increasing likelihood of a period of sustained increasing inflation has historically been associated with values of the CFNAI-MA3 above +0.70 more than two years into an economic expansion. Similarly, a substantial likelihood of a period of sustained increasing inflation has historically been associated with values of the CFNAI-MA3 above +1.00 more than two years into an economic expansion.

We remain focused on understanding the current trends in fundamentals because it gives us the best probability for investment success.


 
Sources & Notes

1 Arthur Diamond, Jr., Openness to Creative Destruction (copyright 2019), Oxford University Press
2 ibid
3 “Grand Rapids dips its toes in the driverless vehicle market”, Financial Times, September 25, 2019