The U.S.-China trade war has been sucking all of the oxygen out of the room. With a phase 1 deal seemingly behind us, we can turn our attention to an equally significant, if not longer-term, tug of war occurring in the economy and markets at the moment. Pulling on one side is productivity, which is being reported as extremely low but by our research is much higher than indicated and likely to move higher still over coming quarters. Pulling on the other side is populism, a global movement that has resulted from, among other things, productivity itself. Sitting at ground zero of the intersection between these two forces is the technology sector, an area of the market that we still see as offering opportunity despite a 45% run in 2019.
The concept of productivity is one that is incredibly important as a driver of long-term economic growth but we find to be under-appreciated and generally misunderstood by the investment community. In the simplest terms it is output per hour worked. That seems easy enough, but in today's technology-dependent world it is anything but.
Consider internet search. Google is the leader in the ad-driven search market, and they offer it free for consumers. In the third quarter of 2019 Google collected $28.6 billion in ad revenue from its various divisions including search, maps, Gmail, and YouTube (all of which, by the way, are free for consumers). However, various studies, including one from McKinsey in 2009, estimated that the ad revenue collected vastly understates the total economic value to consumers. We suspect that is still the case roughly a decade later. In other words, technology-dependent companies like Google, Uber, Netflix, and others are essentially subsidizing the consumer and under-reporting their full economic value in GDP. By extension, this means the tech economy is also understating productivity.
The economics of understated productivity matter greatly for investors, as it suggests better-than-expected growth, lower-than-expected inflation, and a stronger consumer – a recipe for an elongated economic cycle (barring a shock from a trade- or politics-related event). There are few places where the implications of this virtuous cycle are more positive than the tech sector, which is relied upon by almost every business to supply the chips, software, and cloud storage demanded by today's consumer.
Productivity is a great thing for the broad economy, but that does not mean it's a great thing for every worker. A combination of globalization (i.e., outsourcing) and automation may be leading an underground productivity boom, but it is also resulting in displacement and discontent within certain areas of the workforce. It is no wonder that populism has taken shape on both sides of the U.S. political aisle.
Technology is once again front and center, as evidenced by the collateral damage tech stocks have become in the wake of the U.S.-China trade war and the use of protectionist tariffs. The tech sector is also threatened by the numerous anti-trust cases opened by the Department of Justice and Federal Trade Commission into the "big four" technology companies: Facebook, Google, Apple, and Amazon. Full disclosure: I am not a legal scholar or specialist in what constitutes an improper monopoly. However, there appears to be concern that we could be embarking on a multi-year process to break apart or reduce the influence of what has been a key engine of the stock market in recent years.
In our view, populist headwinds to the tech sector are reshuffling, with trade risks receding and antitrust threats taking their place. There could be a "cloud" hanging over technology companies for some time related to antitrust investigations, and the cases against Amazon, Google, Facebook, and Apple are all very unique so really should be taken one by one in a manner that goes beyond the scope of this commentary. Keep in mind, though, that antitrust cases have historically aimed first and foremost to protect the consumer. For each of the technology companies in question, they have built their respective empires by offering products, services, and platforms at low or no cost to the consumer. The bar tends to be higher when trying to prove that measures were taken in an illegal manner to prevent competition.
The tug of war between productivity and populism described above is likely to play out over multiple quarters or even years, so a long-term view is warranted. In this context, we think productivity is going to win out over populism when it comes to technology.
The populist threats to tech are real. A phase 1 trade deal reduces the imminent risks associated with further tariffs, but a second-term Trump administration could see tariffs rear their head again as a major headwind to the economy broadly and the tech sector specifically. As it relates to antitrust investigations, this is likely to garner more attention on the 2020 presidential campaign trail, but our base case at the end of the day is that the tech companies involved are likely to make it through relatively unscathed with fines or increases in regulatory oversight (which, by the way, almost all of the big tech companies are arguing for and trying to be involved in writing, as larger companies generally have a resource advantage over smaller startups when it comes to managing regulatory burdens).
We still see a great deal of opportunity within the tech sector, notwithstanding elevated valuations based on next year's earnings estimates and some crowding in the fastest-growing companies, and in October we moved it to an overweight in our sector strategy. This by no means implies a straight upward trajectory for tech stocks, particularly if we find ourselves in a recession at some point over the next few years. There are sure to be cyclically and politically induced bumps along the way, but we would view near-term pullbacks as buying opportunities, with the longer-term structural supports for the tech sector making it worth the ride.
Meghan Shue is senior investment strategist at Wilmington Trust and a CNBC contributor.