January 2018

During the fourth quarter, the stock market, as measured by the S&P 500 Index (the S&P 500), rose another 6.64%, propelling its full year 2017 total return to 21.83%. This reflects the continued low inflationary economic expansion, rising corporate profits and a very clear pro-business agenda in Washington. Whatever else one can say about the Trump administration and the Republican Congress, it is undeniable that the current regime has rolled back many regulations that business found onerous and has passed historic tax legislation that favored business by lowering the corporate tax rate from 35% to 21%.

The first order effect of a lower corporate tax rate is to increase companies’ after-tax profits. Since higher earnings reduce the market’s price-to-earnings ratio, the market is less expensive than before the tax cut. The second order effect will likely result in increased dividends and stock buybacks. The third order effect may be greater capital spending, but this will likely take time to play out. Finally, since taxes are a cost of doing business, a fourth order effect will be to lower corporate costs, thereby allowing companies to compete more aggressively by lowering prices.

This final point brings us to our favorite economic topic of the day, namely: How can inflation remain so low with an expanding economy and falling unemployment? Why are there not shortages driving up commodity prices, and why doesn’t labor have the power to demand higher wages? The answer lies in the combination of globalization, and more importantly today, technology.

Globalization has opened labor markets such that when U.S. workers demand higher wages, companies are able to move production to countries with cheaper labor costs, such as China. Likewise, as a company seeks to reduce labor costs, it can also replace workers with capital. This used to mean a machine but today more likely refers to a robot, artificial intelligence or some other device or process powered by information technology.

The growth of information technology has transformed the U.S. economy and is, in our opinion, the principal reason that inflation remains low. Because of the way the national accounts are calculated, it is hard to decipher exactly how pervasive information technology has become. This reflects the fact that tech is a combination of hardware or tangibles (e.g., computers) and intangibles (e.g., software), which companies can buy or develop themselves. To the extent it is developed in-house, software does not show up in the national accounts and so total tech spending is thus understated. While we, therefore, cannot get a clear picture of just how widespread tech has become by studying gross domestic product data, we can get a proxy by looking at how tech has grown as a percent of the stock market: The technology sector represents about 25% of the value of the S&P 500 today, up from 5% in the early 1990s, a 5-fold increase! In the U.S., intangible investment, which you can think of as a proxy for high tech spending, first exceeded tangible investment in the mid-1990s, smack in the center of the dot-com boom, and has continued to grow faster ever since. Technology has become pervasive.