How Technology Is Transforming The Economic Landscape (XLK)

From BlackRock: Rick Rieder explains the economic implications of “the Amazon effect.”

Some characterize the current economic climate as one lacking demand-driven pricing power, but we think that is a misapprehension of dynamics at play today. Rather, we think we’re in the midst of one of the greatest supply-side-driven cost revolutions of all time: the critical force being largely driven by technology’s influence on the economy. Indeed, we’re watching cash flows shift at an extraordinary pace and are seeing powerful disinflationary forces at work. In brief, a large part of what’s on display here could be described as the “Amazon effect,” which holds a powerful deflationary impact on large swathes of the goods economy.

Indeed, service sectors have seen balanced growth in quantities and prices. Yet, in the goods-producing arena quantities have held up, while weakness has been driven by prices (see first graph). When taking a close look at the data, the influence of technology on some of the goods sectors is incredible, with innovation, lower production costs and added efficiency weighing on price. Of course, while a positive development for consumers’ quality-of-life, this dynamic is disrupting entire industries, weighing on corporate profits and shifting cash flows in a manner that greatly concerns investors.


This story began when Amazon started opening consumers to the long tail of books that otherwise would not have made it to market, essentially by making every title available online. That shift redistributed market share and eroded the pricing power of bestsellers, deflating the price of all books in the process. Over the years, the influence of this dynamic expanded to many other product categories. Today, premium brand value is being eroded in virtually every consumer goods sector that is subject to significant online penetration. In turn, the value of the distribution center in the traditional retail sales model (the brick-and-mortar store, shopping mall) began to be impaired due to selection constraints, the deterioration of brand value and the ease and low cost of online alternatives.

In sum, those consumption categories that display some of the highest degrees of online penetration (consumer electronics, books) are also those areas that have witnessed the greatest level of deflationary pressure. In contrast, those market segments that have resisted online penetration (for example, over-the-counter drugs and pharmacy segments), either due to regulatory or other factors, have tended to have higher rates of inflation. Still, we think it is these latter areas that are most at risk of future disruption and subsequent price deflation, and investors would do well to heed that fact.

This long-tail consumer phenomenon partly explains why generic brands have been able to surge ahead in recent years in certain product categories, relative to more established brands. As a concrete case in point, the AmazonBasics battery brand has rapidly jumped to having nearly a third of the online battery market share percentage. It has surged well ahead of better-known competitors, such as Duracell and Energizer, according to July 2017 Kleiner, Perkins, Caufield, & Byers and Amazon data. In what is essentially a highly commoditized product space, Amazon can compete fiercely on price while customer reviews bridge any perceived “quality gap” between generic and premium brands. In essence, online customer reviews can provide a literally global “word of mouth” form of advertising. Word of mouth used to be a localized phenomenon (neighbor-to-neighbor), but with online retail it becomes widespread.


Taking a step back, if we look over the past few decades, the U.S. consumption story has evolved from one in which a small number of dominant brands sold products via a network of thousands of small “mom and pop” distributors, to one in which a small number of dominant distributors sell the products of thousands of “mom and pop” brands. Many barriers to entry in the retail space have been broken down (geography, marketing, distribution) as a result of the shift toward online consumption. At the same time, switching cost for consumers is near zero. In essence, the long-tail effect facilitated by the advent of online marketplaces allows many new entrants to compete and the equilibrium price for many products has shifted lower (see second graph). At the same time demand is becoming more elastic, as the new word of mouth of online reviews levels the playing field.

The fact is that the kind of instant information available through online reviews and price-comparison apps is a major tailwind to savings (consumer surplus) and a headwind for retail profits (producer surplus). For many product categories that process is only in its infancy, so we can expect many industries to continue to see margin and profit compression. The technological revolution underway in the economy is changing the nature of systemic inflation, and that holds enormous implications for investors and policy makers alike.

Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is a regular contributor to The Blog.

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The Technology Select Sector SPDR Fund (NYSE:XLK) was trading at $58.90 per share on Thursday morning, down $0.01 (-0.02%). Year-to-date, XLK has gained 22.76%, versus a 12.92% rise in the benchmark S&P 500 index during the same period.

XLK currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #1 of 52 ETFs in the Technology Equities ETFs category.

This article is brought to you courtesy of BlackRock.