Catching the Innovation Wave
Innovation is a multifaceted concept that theory considers as a fundamental driver of economic growth. We further believe we are going through a period of intense technological innovation, whose effects will be teased out in the years ahead.
The current wave of technological innovation exhibits four main characteristics: it is disruptive, exponential, deflationary and global. It plays a big role in our expectations for economic growth and asset class returns. The impact of the current innovation wave has not done much to lift growth and productivity so far because it has simply been displacing existing industries without necessarily adding to aggregate demand.
However, a more fully ‘creative’ phase is emerging, in which new products and services based on recent innovations finally generate additional economic growth. Combined with, say, stronger and more equal wage growth, innovation could be an essential catalyst for productivity growth in the yeas ahead.
We see innovation as a source of extra returns in an enduring low-return environment. Equities can be expected to see the greatest rewards from innovation. For example, in the past 10 years, the Nasdaq index, skewed to disruptive innovation companies, has generated an annual return of around 20%, more than double that of the Stoxx Europe 600.
Investors should keep four things in mind. First, equity returns of the most innovative companies should be higher thanks to improved earnings prospects, which will transmit to the economy as a whole. Second, the current innovation wave is likely to result in inflated valuations through the corollary downward pressure it exerts on interest rates. This is relevant to equity markets, but also to outstanding bonds.
Third, the deflationary impact of the current wave of innovation should further support the valuation of innovative companies as it is increasing the relative attractiveness of fast-growing cash flows when discounted to the present day. Fourth, innovative companies are expected to fare better than their peers as they drive (rather than simply undergo) disruption.
Above-average returns often come at the expense of extra risk, however. While some degree of diversification is possible across innovation themes, each is subject to its own diffusion cycle, which means that investors must watch out for potential bubble-crash phenomena. Therefore, investment returns linked to innovation often follow a ‘camel-back’ shape, formed by the aggregation of several cycles, rather than a textbook S-curve. Furthermore, and due to the inherently risky nature of investing in innovation, diversification benefits tend to fade during global bear markets or crashes, resulting in higher drawdowns overall.
Still, truly disruptive companies tend to outperform broad markets over the long run—an attractive prospect for long-term investors, especially in the current low-yield environment, which is expected to endure.
Diversification remains paramount both across and within innovation themes. Given innovation’s inherent riskiness, we would strongly recommend investing in at least six to eight different themes to maintain a level of volatility that is as close as possible to that of the broader equity market. Somewhat counterintuitively, stock picking among various sources of innovation through a ‘best of’ approach is not necessarily optimal. Identifying winners in emerging and fast-moving industries is a difficult task, even for experts. Rather, investors should strive to achieve a good representation of innovation themes within their portfolio to ensure they ride the innovation wave(s).
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