Just when one thought bonds yields could not fall lower, the yield on Australian 10-year government bonds briefly hit 2.15 per cent this week. That implies investors expect inflation, and by association economic growth, to remain weak for some time.
The breakdown between interest rates and global economic growth is puzzling economists. Record-low interest rates should spur a recovery in business investment and growth and lead to higher inflation – or so the theory goes. But low rates, even negative rates in some countries, are having little effect on growth.
Theories abound for the faltering relationship between interest rates and growth. Some observers point to secular stagnation, with oversupply and weak demand featuring in more industries. Others nominate debt and its effect on bringing forward years of consumption. Both theories are plausible.
Then there’s expectations: companies, expecting persistent weak demand, are reluctant to invest. And consumers, expecting lower future prices, are reluctant to spend. Consequently, investors extrapolate low interest rates far into the future.
I believe technology is the big X factor in all of this and something that economic models cannot accommodate adequately. Just as technology is disrupting industry, so too is it disrupting economies. Technology is exposing workers who do not add enough value, relative to their salary – just as it exposed intermediaries or middlemen in industries who took a fat fee for doing little. Technology is crunching white-collar job security, which in turn is weighing on confidence and spending for more consumers.
Record low wages growth, not unique to Australia, is a symptom of this trend. Companies have rarely had as much bargaining power over white collar employees, given the potential to replace more of them with software algorithms or lower-cost overseas workers.
The upshot is wages growth remaining depressed for longer than most expect, which in turn will constrain inflation and interest rate rises. That what’s the 10-year Australian goverment bond is telling us.
Chart 1: Australian 10-year government bond
This trend has huge implications for investors: what happens when a 5 per cent return is hard to achieve without taking extra risk?
Companies, too, are greatly affected. The lack of inflation and sluggish consumer demand make it harder to raise prices. A growing concern, as I have written for The Bull, is deflation or falling prices, which encourage consumers to defer purchases. Deflation still looks unlikely in Australia at this stage, but central banks worldwide are finding inflation stubbornly hard to lift.
Investors should search for companies with two key traits: genuine pricing power and/or an ability to reduce investment if demand weakens, without hurting overall growth too much. The power to lift prices – or even maintain them in some industries – has never been as valuable.
Pricing power and sustainable competitive advantage go hand in hand. Companies with a genuine ‘economic moat’ have greater capacity to lift prices when demand weakens. Consumers pay more because the company offers a superior product or service, or because it has other attributes, such as high ‘switching’ costs, that make it hard to leave and join competitors.
True pricing power hard to find
Genuine pricing power, or the ability to lifts prices without adverse consequences, is rare. Monopoly assets, such as Sydney Airport, have pricing power, but growing public pressure could limit their ability to keep lifting prices. Utilities, too, often have constrained ability to lift prices because government authorities regulate their revenue. Leading healthcare companies have pricing power, but it is not always easy to exploit it.
Pricing power can fade. Coca-Cola Amatil, for example, used to have reasonable pricing power: consumers would pay more for their beloved can of Coke. Not anymore. The same is true of Fairfax Media many years ago when print classified advertising still ruled.
Pricing power can also underpin high valuations. REA Group arguably has more pricing power than most ASX-listed companies. Its dominance in online property advertising means property sellers have to wear price rises if they want to access is popular platform.
Previous REA price rises were accompanied by a few grumbles from agents, but it was soon business as usual and REA stock kept heading higher. That is the power of genuine sustainable competitive advantage and the ability to exploit it through higher prices.
Chart 2: REA GroupSource: The Bull
Domino’s Pizza Enterprises also has strong pricing power, courtesy of a sustainable competitive advantage derived through scale and innovations in ordering and delivery technology.
Domino’s provides exceptional value in its basic pizza: $5 for a freshly cooked pizza large enough to feed two people or one hungry person. I suspect customers would not hesitate if Domino’s lifted that price to $6 or more if sales volumes weakened in a sluggish economy.
Chart 3: Domino’s Pizza EnterprisesSource: The Bull
Accounting software provider, Xero, is another with pricing power. Although its industry is highly competitive, Xero benefits from a highly ‘sticky’ product. Customers who use its accounting package find it hard to leave. I’ve heard several users rave about the simplicity of its service; Xero could charge a little more in time without noticeable customer attrition.
Xero also gets ticks in the second category mentioned earlier: an ability to trim investment if volumes growth slows. One the great strengths of Seek, REA Group, Carsales.com or newer tech businesses, such as Freelancer, is an ability to reinvest a little less in the business if demand weakens, to support short-term earnings growth.
Chart 4: Xero (ASX)Source: Google Finance
The problem, of course, is valuation. The market knows that these companies have strong competitive advantages and latent pricing power and has valued them accordingly. Xero and REA still look okay value for long-term investors; Domino’s appears fully valued after exceptional share-price gains over the past few years.
Tony Featherstone is a former managing editor of BRW and Shares magazines. This ideas in this column are not stock recommendations or financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at June 8, 2016.