Soaring prices since Q2’21 have let to increasingly intense debates on the transitory vs. persistent nature of particularly high levels of inflation, along with the existence of a Tech bubble and the associated risks of correction or bursting. Inflation (CPI – Consumer Price Index) reached more than 7% and 5% in Dec.21 on an annual basis, for the U.S. and E.U., respectively. During Jan.22, the NASDAQ (-100) – where most of the largest tech companies are listed – fell by (8.5)%, compared to +27% for FY21, amid concerns of expected interest rate hikes by the U.S. Federal Reserve (the “Fed”) to curb inflation in the coming months.
Since the probability, amplitude and timing of potentially more significant corrections in the valuation of Tech stocks (whether listed or non-listed, through lower valuation in capital raising) are particularly difficult to estimate, we propose to examine – in order to put these subjects into perspective – the relation between inflation and technology, in the short and longer term.
A. The sources of inflation and their impact on Tech dynamics:
(a) CPI (Consumer Price Index) evolution (annual rates), Jan.2017-Dec.2021
- The “post-Covid” rise of some prices and their impact on Tech companies’ dynamics and profitability.
One of the most significant price increases in the “post-Covid” period (say since the end of major lockdowns in 2020) affecting Tech companies pertains to semiconductor chips, which rose by 15% in FY21, mainly due to insufficient production capacities (higher raw material prices, supply chain bottlenecks, geopolitical tensions between the U.S. and China over Taiwan, unfavorable extreme weather conditions, delayed investments in new foundries…) and higher than expected demand (electric cars, 5G, graphics cards…), which grew by 25% in FY21. Though chip companies generated high revenues and profits in FY21, the price increases directly (when representing a direct production cost component of a company) and indirectly (through the tension exerted on other industries’ prices) impacted the margin rates of other hardware companies, especially those that could not entirely pass the increases on their customers, and to a lesser extent software companies (higher costs for IT equipment – like computers…- and in some cases IT hosting services). Tensions in the semiconductor sector are expected to persist in the coming months, but should gradually ease by the end of FY22, as most of the major chip players have planned major investments in their capacities, and provided that geopolitical tensions over Taiwan, which operates the most significant international wafer foundries (the company TSMC accounts for more than half of the market), do not escalate further. Overall, and all things being equal, we do not expect any significant impact on Tech software companies’ long-term profitability and valuation.
Substantial increases in Energy price increases contribute to most of the inflation since Q2’21 (directly or indirectly), rising by more than 20% on an annual basis in late 2021. The increase appears to have little to do with the transition to clean energy, but more with higher-than-expected demand (due to a rapid global economic recovery recovery, a colder and prolonged 20-21 winter in the Northern Hemisphere…) and lower-than-required supply (due to a decline in oil and gas investments in recent years as a result of price collapses in 2014-15 and 2020, delayed maintenance work in 2020, logistics bottlenecks, and geopolitical instability).
(b) Energy CPI evolution (annual rates), Jan.2007-Dec.2021
Though ambitious carbon reduction objectives might result in structural tension on prices in the long run, the current surge in energy price since 2021 appears to be cyclical. Therefore, we do not expect it to remain at this level of growth for a long time (prices may remain high in the coming months, but the rate of evolution should slow down, as evidenced by future crude oil contracts). As far as Tech companies are concerned, the surge in energy prices may adversely impact FY21 and H1’22 profit margin rates for hardware (mainly with higher manufacturing costs) and to a lesser extent for software (hosting costs…), at least when their ability to pass them through to customers is limited. However, higher energy prices in themselves should not have a significant and direct impact on the growth outlook of software companies in particular.
Increases in semiconductor and energy price increases may impact the growth and profitability of Tech companies (especially hardware), but there are some levers to mitigate their effects in the coming quarters. On the other hand, fiercer competition to attract and retain technology talents may continue to exert more structural pressure on personnel wages, profitability and growth, with overall inflation reinforcing the trend (with greater demand for wage increases). Wage increases in Tech software companies may in itself have limited effect on overall inflation. Particularly in SaaS or marketplace companies, the nature of the business models and scaling configuration may not necessarily result in a pass-through to pricing. Also, wage growth – though fuelled by historically low unemployment rates in the U.S. and E.U. – may turn out to be an insufficient driver of talent growth, and should be combined with other non-financial considerations.
Indirectly, the three effects we have chosen to underscore – semiconductors, energy and wages -, combined with the favourable fiscal and monetary policies since 2020, should expedite decisions to increase interest rates to address higher inflation.
2. Inflation, expected rate increase and their impact on Tech valuation.
Inflation trends are quite similar in the world’s major economic regions. Still, it is interesting to note that the increase in the E.U. has lagged that in the U.S. for several months, with a lower magnitude too (both being driven by energy and food) (see graph (a)). As of early Feb.22, the U.S. Federal Reserve plans to increase its interest rates several times over the course of FY22 to fight inflation, whereas the European Central Bank (E.C.B) is not considering doing so, because of differing economic recovery cycles and economic situations among Eurozone members (some of which are particularly indebted).
Whether the E.C.B. increase or not its rates, the Tech industry as a whole should be impacted by the Fed decision, as financial markets reactions already showed. As higher interest rates result in (i) lower expected discounted cash flows (all things being equal, the discount rate increases due to higher interest rates and thus weighted cost of capital) and (ii) lower investment (for the same reasons, with a higher opportunity cost), the stock valuation of Tech companies listed on stock markets dropped in Jan.22 (as discussed when referring to the NASDAQ; see above). Within such a configuration, financial markets favor value vs. growth stocks, which has been illustrated especially by the convergence of the performance of Berkshire Hathaway funds (Warren Buffet) and ARK Innovation ETF (exchange traded fund) (Cathie Wood) over the Dec.19-Jan.21 period (2).
The evolution of the stock valuation of Tech-listed companies might not necessarily impact directly and to the same extent non-listed ones (backed by venture capital or growth funds especially). Still, should lower valuation in stock markets and higher interest rate expectations remained, the subsequent fundings shall be carried out at lower valuations and investors shall be much more selective on their targets (even though dry powder remains high) (please refer to the interesting article on Tomasz Tungusz’s blog (3)).
We saw that higher inflation may impact Tech growth dynamics, profitability and valuation on the short and long term, with effects notably depending on expectations as regards to interest rates evolution. In the meantime, technologies and innovation may provide structural disinflation forces to the economy.
B. The structural impact of technology and innovation on inflation.
- The Moore Law and the structural decrease of chip prices.
According to the empirical Moore Law, every 18 to 24 months, semiconductors chips would get twice as powerful for the same cost (or to put it more precisely, the number of transistors doubles at constant cost). Though impacted by supply chain disruptions over FY20-21 (with a visible effect on prices in FY21), the positive contribution to disinflation from smartphones, laptops, computer prices etc. should remain over time (though potentially at different paces).
2. Unlimited economies of scale in SaaS.
In most cloud-based Software as a Service (SaaS) business models, the companies are benefitting from limited variable costs and increasing returns to scale. As MIT professors A.McAfee and E.Brynjolfsson said, the digital disruption has been driven by the economics of free, perfect and instant: “The marginal cost of an additional digital copy is (almost) zero, each digital copy is a perfect replica of the original, and each digital copy can be transmitted across the planet virtually instantly” (4). The production can then scale efficiently and almost unlimitedly to rapidly meet additional demand, wherever it comes from. These forces can be strengthened by machine learning as well as network effects, contributing to additional productivity gains driven by larger markets, users and data. Nevertheless, machine learning and network effects have a tendency to favor the emergence of winner-takes-all actors with higher pricing power, which ultimately could mitigate the positive effect on disinflation stemming from the scaling potential of software companies.
3. Marketplaces and market efficiency.
Allowing more transparency and comparisons between prices and offers, combined with more intense competition between sellers / buyers / workers, digital marketplaces contribute to a more efficient matching of supply and demand and more efficient markets. Notwithstanding the side-effects of an unbalanced relation with some platform behemoths in some cases, marketplaces exert a positive influence on inflation in limiting – most of the time – the pricing power of its participants.
4. Manufacturing and supply chain productivity gains.
As shown with the previous effects resulting from decreasing chips costs and the scaling potential of software companies, the positive contribution of technologies and innovation essentially lies in their ability to foster productivity gains in tech-related and non-tech-related industries, increasing the growth potential of worldwide GDP (Gross Domestic Product).
Enumerating the list of all the innovations that could significantly improve productivity is not the aim of the present article. Still, the potential of emerging technologies appears to be very promising on manufacturing and supply chains especially. Fueled by artificial intelligence / machine learning tools, automation should leap in the coming years, driven by more efficient robotization and autonomous vehicles. Also, the production of electricity based on renewable energies and lower costs as regards to batteries (the costs of lithium-ion storage dropped by (19)% p.a. over the 2010 decade (4)) should contribute to lower further production and transportation costs (4).
5. Information abundance.
The measure of inflation (and GDP) draws a veil over the wealth provided by the abundance of information the internet provides to us. Today, everyone can have access – for a very reasonable price – to data and knowledge that used to represent a non estimable amount of money in the past (and that was not even available, whatever the price). This information enables us to better understand a specific field of knowledge, to improve our professional skills, to share our thoughts with people all over the world, and enjoy music and videos with the almost the sole constraint of time. Obviously, this do not directly impact food or housing prices (nor the time constraint of a 24h day). Still, we should never forget how rich we are thanks to digital innovations, and how the potential to use this knowledge could provide us with a more sustainable growth.
Relevant sources / notes:
- (1) OECD (The Organisation for Economic Co-operation and Development): https://data.oecd.org/price/inflation-cpi.htm
- (2) Market insider – Warren Buffett outperforms Cathie Wood as tech stocks tumble and safer assets – https://markets.businessinsider.com/news/stocks/warren-buffett-berkshire-hathaway-cathie-wood-ark-innovation-tech-stocks-2022-1
- (3) Thomas Tungusz – Venture Capitalist at Redpoint – Blog (06/06/2021): https://tomtunguz.com/10-year-yield-and-venture-capital/
- (4) Azeem Azhar – Exponential, How accelerating technology is leaving us behind and what to do about it; Penguin Random house business, 2021
- Rana Foroohar, Financial Times – Why Innovation could stop inflation https://www.ft.com/content/57bccc8f-e75d-4be6-a92e-96470aa7e7de
- Universidad Nacional del Sur – Inflation and innovation value: How inflation affects innovation and the value strategy across firms, https://www.redalyc.org/journal/5723/572365672006/html/