The Cross-Sector Solutions:
Cost pressures should make companies accelerate investments in automation and productivity-enhancing technologies. Many of these technologies are inherently deflationary. Within this note, we provide a shopping list of “deflation enablers.”
Persistent inflation in areas such as labor, supply chain/procurement, and energy give rise to transformational investment across industries. While cyclical forces tend to deter investment in an uncertain macro environment, we believe structural changes in demographics, energy policy and security, and an aging capital base make technologies focused on cost reductions and productivity
Focusing on stocks that enable this productivity and cost reduction through automation, efficiency, or their own declining cost curves while maintaining strong barriers to entry and attractive equity risk/reward, we created a Deflation Enabler shopping list.
(1) In an inflationary world, we believe companies that have developed deflationary products/services will become increasingly valuable, (2) as long as those companies have significant
barriers to entry with respect to those products/services. (3) We have developed a global shopping list of Overweight-rated stocks that provide such deflationary solutions for customers.
How do we define Deflation Enabler? We examine stocks that produce tangible cost savings for their customers where costs themselves are rising due to inflation (e.g., labor, energy) or scarcity (e.g., semis, materials). In many cases, the costs of the product itself has also come down through technology or economies of scale, benefitting the purchaser and therefore adoption on both lower costs to implement and higher cost avoidance through use.
From an equity strategy standpoint, we see two key insights from our prior work that should be supportive of this corporate push to accelerate investments in automation and productivity enhancing technologies. The first is the potential for structurally higher wages in the US, which poses a longer term risk to US corporate profitability (see What the ‘Workers Economy’ Means for Margins and Markets).
The second is a lack of productivity-enhancing fixed capital investment in the US over the past couple of cycles, a dynamic that has contributed to a multi-cycle decline in productivity growth. With infrastructure now at the forefront of the political landscape, and the cost of labor and capital on the rise, corporate investments are likely to pivot toward productivity-enhancing capex and technologies that can lower the cost of doing business and improve profitability.
As detailed in What the ‘Workers Economy’ Means for Margins and Markets, our economists see a structural rise in wage growth as employee bargaining power returns and labor compensation catches up with the historical productivity gains we have seen.
At the economy-wide level, this poses a secular risk to profit margins, though as we detail, the risk is idiosyncratic across sectors. In response to these dynamics, we think corporates will increasingly engage in efforts to mitigate exposure to rising labor and other costs. Automation and digitization should be front and center, and as detailed in this report, many of the opportunities on this front are inherently disinflationary.
We also believe that there has been a lack of productivity-enhancing capex over the last several cycles. In fact, the average age of private fixed assets in the US is at the highest level since the 1950s. Partially as a result, productivity growth has been in a 20-year decline. The positive spin from a productivity standpoint is that underlying drivers of this trend are shifting:
All told, we believe the incentives are now in place for companies to re-focus their efforts on automation and productivity-driving technologies. As discussed at the stock level in this report, corporates that can deliver such solutions for customers are more likely to profit from the higher nominal GDP, albeit more volatile environment we expect over the next decade. As a result, such companies can offer a relatively attractive risk/reward investment proposition.
With Covid-induced supply chain bottlenecks, rising geopolitical tensions, and greater focus on energy security, the decades-long deflationary narrative has been upended. Even as demand destruction leads to some moderation in recent sharp inflation prints, the fear of higher-for-longer inflation continues to be the big debate of the moment.
In that context, we believe companies that provide innovative and/or cost effective solutions will see heightened demand and greater competitive advantages in their respective industries
As corporates consider and adapt to the implications of higher-forlonger inflation on their cost bases, C-Suite’s necessity to explore cost-saving tools and technologies should in turn drive higher volume for companies providing deflationary-enabling products and services.
These range in form and function, from automation tools designed to reduce increasingly expensive headcount in organisations, to cost-saving booking software for airlines who must find ever-more innovative ways to offset rising jet-fuel prices.
The Cross-Sector Solutions:
While our analysts cite specific examples of deflation-enablers in their respective sectors, we consider there to be 3 major deflationary technologies which permeate across sectors and which are at long term inflection points in their importance for both enterprise and consumer: AI & compute; Clean Energies; Energy Storage & Mobility implications.
(1) AI is proving relentlessly and increasingly deflationary. This cheap and increasingly powerful compute has allowed training for AI models that are not now growing at the rate Moore’s Law would have projected, but instead far in excess of this rate. The history of investment in AI is usually told as a story of booms and busts, but that is not reflected in the historical trend of compute used by learning systems.
Most recently, GPT-3 set new records with its 175 billion parameter ML language model only to have the top spot quickly usurped in 2021 by China’s “Wu Dao” – which at 1.75 trillion parameters is 10x larger than GPT-3. The race for AI superiority – driven in part by desires for national and corporate innovation superiority – is accelerating at pace.
Software is a “Deflationary Technology in an Inflationary World”.
“The case for digital transformation has never been more urgent or more clear. Digital technology is a deflationary force in an inflationary economy. Businesses, small and large, can improve productivity and the affordability of their products and services by building tech intensity.
The Microsoft Cloud delivers the end to-end platforms and tools organizations need to navigate this time of transition and change.”— Satya Nadella, CEO of Microsoft.
The fundamental purpose of software is to optimize business and consumer processes, automating them to be more efficient and effective. So in a larger sense, one can make the argument the entirety of the enterprise software industry serves the purpose of driving efficiencies within business to fight inflation (as Satya Nadella noted above).
For the purposes of this note, we’ve tried to narrow the focus to vendors whose software targets a specific inflationary cost pressure being seen in the market today.
C3, Palantir, Snowflake – Enabling More Efficient Supply Chains and Logistics with Better Use of Data. Consolidating multiple data sources and making it usable to solve some of the most difficult problems facing organizations and governments is the core functionality of all these vendors. In the context of this report, all three have talked to a significant use case within their customer base of driving logistics and supply chain efficiencies with their software.
To focus on one vendor in particular, Palantir’s core Foundry data platform accelerates the integration of data, allows simulations against that data, enables real-time alerting for any potential disruptions in the data which allows customers to optimize and find efficiencies in supply chains and logistics.