I consult, write, and speak on running better technology businesses (tech firms and IT captives) and the things that make it possible: good governance behaviors (activist investing in IT), what matters most (results, not effort), how we organize (restructure from the technologically abstract to the business concrete), how we execute and manage (replacing industrial with professional), how we plan (debunking the myth of control), and how we pay the bills (capital-intensive financing and budgeting in an agile world). I am increasingly interested in robustness over optimization.

I work for ThoughtWorks, the global leader in software delivery and consulting.

Thursday, March 31, 2022

Crowding Out

Tech has had a pretty easy ride for the last twenty years. It only took a couple of years for tech to recover from the 2001 dot-com crash. In the wake of the 2008 financial crisis, companies contracted their labor forces and locked in productivity gains with new tech. Mobile went big in 2009, forcing companies to invest. Then came data and AI, followed by cloud, followed by more data and AI. The rising tide has lifted a lot of tech boats, from infrastructure to SaaS to service providers.

The ride could get a little bumpy. Five forces have emerged that threaten to change the corporate investment profile in tech.

  1. Labor power: workers have power like they've not had since before the striking air traffic control workers were fired in the early 80s, from unions winning COLAs in their labor agreements to the number of people leaving their jobs and in many cases, leaving the workforce entirely. Labor is getting expensive.
  2. Interest rates: debt that rolls over will pay out a few more basis points in interest rates than the debt it replaces. Debt finance will become more expensive.
  3. Energy inflation: energy prices collapsed before the pandemic, only for supply to contract as energy consumption declined with the pandemic. It takes longer for production to resume than it does to shut it off. True, energy is less a factor on most company income statements than it was fifty years ago, but logistics and distribution firms - the companies that get raw materials to producers and physical products to markets - will feel the pinch.
  4. Supply chain problems: still with us, and not going away any time soon. Sanctions against Russia and deteriorating relations with China will at best add to the uncertainty, at worst create more substantive disruption. By way of example, the nickel market has had a rough ride. And there has been increasing speculation in the WSJ and FT of food shortages in parts of the world. As companies stockpile (inventory management priorities have shifted from “just in time” to “just in case”) and reshore supply chains, supply chain costs will rise. Supply will continue to be inconsistent at best, inflationary at worst.
  5. Increase in M2: adding fuel to all of these is a rise in M2 money supply. More money chasing fewer items drives up prices.

All of these except for interest rate rises have been with us for months, and we’ve lived with supply chain problems for well over a year now. These factors haven’t had much of an impact on corporate investment so far, largely because companies have successfully passed rising costs onto their customers. Even if real net income has contracted, nominal has not, so buybacks and dividends haven’t been crowded out by rising expenses.

But the economy remains in transition. Many companies are starting to see revenues fall from their pandemic highs. While rising interest rates may cool corporate spending, it has to cool a great deal to temper a labor market defined more by an absence of workers than an abundance of jobs. With real wages showing negative growth again, it will become more difficult for companies to pass along rising costs. Rising resistance to price increses will, in turn, put pressure on corporate income statements.

Of course, this could be the best opportunity for a company to invest in structural change to reduce labor and energy intensity, as well as to invest for greater vertical integration to have more control over upstream supply, with an eye toward ultimately changing its capital mix to favor equity over debt once that transformation is complete. That’s a big commitment to make in a period of uncertainty. Whereas COVID presented a do-or-die proposition to many companies, there is no cut-and-dried transformational investment thesis in this environment.