The big long

• Three key structural trends are gaining momentum, partly boosted by the behavioural response to Covid-19. First, a pickup in spending on research and development (R&D). Second, rising capital expenditure on intellectual property products and, eventually, non- residential physical infrastructure (often with a ‘green’ twist). Third, faster spreading of innovation across countries and industries.
• The confluence of these trends has the potential to at least begin to reverse the productivity decline of the past few years, especially in the US, and to accelerate automation and digitalisation around the world. These trends could also continue to boost job creation for non-routine cognitive roles and tasks, mainly in knowledge-based companies.
• Much of what’s happening has to do with the rising importance of intangible assets. Some are included in the macro statistics, such as software, data, R&D and content. Many others aren’t, such as brands, marketing, design, organisational and financial innovation, and networks. They are particularly important for the US, UK and northern Europe.
• An asset’s intrinsic value comes from the firm’s earnings power. Valuation approaches relying mainly on company accounts treat many intangibles like ‘expenses’. But if these intangibles can generate future cash flows, and are what makes companies what they are in the eyes of their customers, then earnings and book value may both be understated.

Spending on R&D as a share of GDP has been rising since the mid-1990s – mostly due to the increased role of the private sector. More recent, less comparable information shows a further pickup in private-sector spending. What’s new is that public spending on R&D, which has contracted for years, is now showing signs of stabilisation across many countries.

The success of the ‘messenger RNA’ approach behind the Pfizer-BioNTech and Moderna vaccines, and of bespoke antibody treatments, shows how science continues to transform medicine and genetics. Artificial intelligence is finally displaying significant progress in a range of promising fields, from predicting the shapes of proteins to natural-language recognition and driverless vehicles.

One view is that the age of ‘great inventions’ – things like the internal-combustion engine, electrification, plumbing and the like – is behind us. Any further step is likely to be more incremental: moving from the internal-combustion engine to electric motors in order to drive vehicles is one thing; moving from the horse to the car is another. We don’t believe this view explains productivity trends very well. It’s true that overall growth and productivity lag R&D outlays by quite a while. However, it’s also true that accelerating R&D during the 1980s and from the mind-1990s coincided with faster productivity. The only exception is the most recent decade, which has been characterised by several crises. However, over the past five years, on average, the trend points upwards.

What are intangible assets and how should investors think about them? Two points are relevant here. First, intangible assets aren’t just about digitalisation and technology. It’s that too, but it really is about intellectual property, networks, design, marketing and advertising, relationships and many other things that aren’t included in the official statistics. Basically, statisticians simply don’t know how to accurately estimate many of these things and so they leave them out. Figure 11 shows a classification by the European Investment Bank, along with what’s included in the macro statistics and what not. The variation in assumed capitalisation and depreciation rates reflects the unique nature of each type of intangible investment. For example, advertising has a shorter life than software.

The second point is a broader one. The key structural trends highlighted in this report mean that, in today’s service-led economies, what makes companies valuable isn’t their ownership of physical assets. Rather, the value increasingly is in intangibles: assets you can’t touch and see, but of huge value because they’re what makes a company unique. Take a smartphone. Its value is mostly in its software and multi-media applications, not in its production, as this is done by contractors assembling components made by third-party suppliers worldwide. Markets are volatile as investors constantly re-evaluate the price of an asset versus its intrinsic value. The price of a stock shifts up and down depending on greed and fear. Its intrinsic value comes from the firm’s earnings power.

This approach relies mainly on company accounts: valuation is based on a multiple of future profits and the book value of the firm’s assets. Of course, profits are revenues minus costs. If a chunk of costs is not current expenses like electricity or rent, but spending on intangibles that will generate future cash flows – such as advertising or R&D – then earnings and book value may both be understated. Intangibles can be used repeatedly and are often characterised by network effects: the more people use a firm’s services, the more useful and cheaper they become to other customers. This is why industries become dominated by a small number of big players.

But intangibles tend to generate bigger synergies than tangible assets more generally: with increasing economies of scale, a firm that rises quickly will often keep on rising, as ideas multiply in value when they are combined with each other. Figure 12 shows how the way of doings things (the ‘paradigm’) is changing across sectors. One way or another, this has to do with technological innovation first and foremost, but the concept is broader than that and has to do with the rising importance of intangibles, a greater use of digitalisation and automation, and organisational innovation. While quantifying any boost to economy-wide productivity, inflation and ‘equilibrium’ interest rates is rather difficult, the opportunities this generates at the sector and company level are clearer.