The efficient digital economy will exert increasing downward pressure on inflation and employment demand globally, as illustrated by Amazon’s automated warehouse distribution fueling lower costs. Low cost Chinese goods via eCommerce platforms like Amazon and eBay began the revolution in a relatively fringe portion of western economies. But in the past 2-3 years we’ve reached a tipping point
The digital economic revolution is transforming every aspect of our lives, including the way we invest. The rules have changed – the economy and financial markets will no longer be driven by historical measures. You can witness the impact on seasoned investment pros by reading the press after any of the recent jobs or wages data, “unemployment is very low…, yet wages aren’t rising…, and inflation is stubbornly low”. Economists are puzzled by the market.
However it is only puzzling if you are trying to use old economic models to understand today’s changing economy. There comes a time when enough fundamental factors have changed permanently that those old models have to be thrown away.
The dramatic changes in the way that products are now manufactured, sold and distributed, typically with multiple layers of handling removed, means the loss of millions of jobs (around 6.4m jobs globally by 2020 according to the World Economic Forum), and lower costs for most manufactured items. Similarly, the sharing of underutilised assets such as housing, cars, equipment, bicycles, art, pets and finance brings down the cost of services such as transport and accommodation.
Online sourcing of project resources, more bandwidth and lower communications costs mean more flexible labour mobility around the world (for example, my assistant lives in Manila!).
While the economic implications are obviously wide reaching, the topic for this article is inflation. In short, we care about inflation because lower inflation has long meant that rates are likely to remain lower, not to mention the specific impact on the price inflation linked bonds represent good value.
Low inflation is likely to persist and lead to a very low interest rate environment globally until the digital revolution has run its full course.
What if there was high demand and low inflation?
Central banks use fixed inflation targets as a proxy for a healthy balance between supply and demand; when inflation is below target, this suggests there is insufficient demand to put upward pressure on prices, and vice versa. Where inflation becomes a poor measure of excess demand in the economy is when there is a fundamental change to the price of goods that isn’t linked to demand.
We’ve often cited Australia’s tobacco excises as a great example. Inflation is being semi-permanently increased by rising taxes of tobacco despite the demand for tobacco products halving in the past 10 years. Similarly the digital economic revolution has fundamentally changed the “rules” in a permanent manner. Prices of many goods, typically those sold on Amazon, have been falling over the past few years, despite demand rising faster than economic growth. The price of goods sold by Amazon and its peers is lower than the same goods sold in retail outlets, meaning that the more the consumer spends online instead of in shops, the more inflation falls.
On top of the trend in the first wave of products sold online, the lower cost structure of companies like Amazon and their willingness to reinvest in growth by aggressively competing on cost, means that other sectors will soon be attacked by the online giants. Amazon just announced a US$13.7bn bid for Whole Foods Market, a high end grocer. The move to online grocery distribution will force other grocery chains to improve value to hold off competition and keep loyal clients. WalMart, for example, just launched a program offering discounts on 10,000 items if they are purchased online and picked up from the store. Despite that initiative, WalMart’s share price fell 5% on the announcement of the Amazon move.
The lower cost Amazon model has already savaged the two largest book retailers, Borders (bankrupted 2011) and Barnes & Noble (sales down 15% in past three years alone), along with RadioShack (closing 1,000 of its 1,072 stores) and Circuit City Stores (once #2 in consumer electronics, bankrupted 2008), and even the once dominant Sears, which announced earlier this year that they were concerned that they were no longer a viable going concern.
This can be summed up in one oversimplified, but pointed illustration. If a central bank lowered interest rates in response to low CPI, to try and stimulate the economy, they could find that the consumer responds by spending more on online goods and services, which typically have negative inflation (or deflation), and so the central bank would ironically have lowered inflation by lowering interest rates. This is more than enough to confuse economists stuck in the past. When online spending was less than 5% of total spending, this would have been entirely theoretical, but US online spending is already 17% of total retail discretionary spending. In Europe and Asia this figure is even higher.
What is the Amazon Inflation Index?
The Amazon Inflation Index, or AII, is an index of the prices of the goods sold on Amazon. It is a proxy for the price of goods and services sold online. We have identified those goods and removed them from the CPI basket, effectively separating the CPI into two baskets: online (AII) and offline (CPI).
The AII includes the following goods, chosen because they can be separately identified in inflation data and a meaningful percentage of their total sales is online:
- Personal care goods
- Household furnishings and textiles
- Household appliances
- Communications (excluding phone)
- Recreation products
As shown in Figure 1, the AII has increasingly diverged from the CPI over the past 10-15 years and has rapidly widened to be a massive 2.7% apart today (non-Amazon CPI at 2.1% vs Amazon inflation at -0.6%) Prices of these goods have been in a deflationary cycle since 2006, with short periods of positive inflation but an overall downward trend.
Figure 1: Amazon Inflation Index, US
Source: Amazon, Bloomberg, FIIG Securities
In that time, Amazon alone has gone from sales of US$0.6bn to US$135bn and online spending has gone from 0.1% of total spending to 17%. Once online sales passed 10% of total retail discretionary spending, the permanent nature of the change became more apparent – 15,000 store closures between 2015 and 2017, counting the announced closures for this year. That’s more closures than the worst three years of the GFC (2008-2010). In the first three months of 2017, US retail outlets shed 60,000 jobs. Australia is heading for a similar pattern here, albeit a few years behind as Amazon and Alibaba haven’t really launched here yet.
With the online share of retail spending estimated to rise to more than 30% over the next decade, the impact on inflation is set to rise as well. The AII already has a deflationary impact of around 0.45% pa or around 0.30% per 10% share of retail spending taken up by online spending. If price trends continue, the deflationary impact could increase to 0.70 – 0.80% pa over the next decade, a substantial hit to the US Fed’s 2%pa inflation target.
For Australia, calculating the AII is a lot harder due to the dramatic swings of the AUD and our reliance on imports for so many goods. Intuitively however it isn’t hard to imagine a similar pattern to that seen with the US market when we already have higher online share of retail spending than the US, before the major e-retailers like Amazon set up permanent bases here.
China’s impact on the AII
It is very hard to separate the impact on prices between China’s low cost manufacturing versus the digital economy. The fact is that the two work hand in hand. Many goods these days are sourced by entrepreneurs able to go directly to the manufacturers in China and have them delivered into their own country, cutting out several layers of middle men. It is reasonable to assume that the earlier declines in the AII rate, say around 2002-2005 were due to China’s arrival on the world manufacturing scene, but more recent years’ price impacts are far more likely to be caused by online purchasing.
There is clearly a fundamental shift in global commerce – whether it is the digital revolution or China matters little. Between 2017 and 2020, global online retail spending is expected to jump from 9% of global sales to 15% and continue to well over 30% over the next decade. As seen in the US where retail spending online is already at that level, the deflationary impact will be at least 0.40-0.50% per annum, having major long term implications for interest rates.