Daily Consumer #28 - Trying To Understand The Macro
Some thoughts from a few weeks of playing part-time macroeconomist.
Trying to Understand the Macro
Thank you for bearing with me and my lack of writing these past few weeks. It’s been a hectic time in the venture capital world with the macro environment changing the way it has. I’ve spent the last few weeks trying to form the “story” that I believe about the world. I haven’t reached a final script, but I wanted to share some of the current thinking.
In short, a consumer demand shock is occurring driven by inflation. Inflation means that the cost of goods is rising and, as a result, the dollars you’ve saved are going less far. You used to fill up the gas tank for $50 and it now costs you $100 but you’re getting no more gas.
The hypothesis is that the massive Covid-driven stimulus gave people more spending power. Meanwhile, Covid, the Ukraine crisis, labor shortages, and other complexities significantly impacted the production of goods. More dollars than before + less goods than before = prices rise. I’m not a macroeconomist, but that’s my summary.
The Federal Reserve is finally admitting that this is a problem. Supply shocks are correcting with Covid easing, but prices are still rising. This isn’t good as the hard-earned dollars in your bank account are getting stretched and prices are rising much faster than people’s incomes are rising. This situation is quite urgent. The Fed needs to control price inflation before people start demanding commensurate wage increases to afford goods, which could start a never-ending spiral that has tormented countries like Argentina for decades.
The Fed is now trying to constrain demand in an effort to balance out supply and demand. Their method to do so is to raise interest rates, which makes credit more expensive for anyone trying to use it. Since credit accounts for most of an economy’s transaction volume, more expensive credit should drive down demand. For example, some consumers would be willing to buy a $30K car if they could get a 5% interest rate car loan ($1.5K of annual interest payments) but not if the loan costs 10% ($3K of interest).
Rising interest rates should combat inflation but are generally also bad for the economy. Consumer demand tends to retrench to staples as has been mentioned in several retailer earnings calls over the past weeks. Companies see revenue get adversely impacted. Company valuations fall, in part due to declining earnings but also due to the fact that investors can theoretically earn a return investing in bonds instead of stocks. Investors in stocks demand that companies focus on profitability and layoffs tend to follow.
The hope is that the Fed can thread the needle on rate rises. Inflation needs to be controlled but hopefully this can be done without massive rate rises that could drive a big spike in unemployment. The Fed is now walking the tightrope and the world is become uncertain again, especially as it’s unknown how much rates need to rise for inflation to fall back to the target range of 2-3%.
What does all of this mean for you as an individual? It will likely be a volatile next few quarters as the Fed makes additional interest rate decisions and as monthly inflation readouts are printed. The hope is that inflation falls sooner rather than later. If so, the stock market may rebound more short-term and the cost of credit will stabilize. If above-target inflation persists, we will see continuous rate hikes, the stock market will likely continue to sell off, and the cost of credit will continue to rise.
What to do until the picture becomes more clear? The conservative approach may be to sit on cash and to preserve it. An alternative would be to invest in stocks that can pass through inflated prices like producers of consumer staples (think Procter & Gamble) or utilities. Consumers still need to eat and power their homes after all. This cash + select equities approach is the camp that I’m in personally. The risk-on approach may be to start buying growth stocks if you believe inflation will get reined in sooner rather than later.
What if you’re running an unprofitable company? It will almost certainly be harder to raise equity capital in this environment as investors are struggling to come up with the “fair price” for any asset. Look at the last picture in the graphic below for more on this topic. The prudent thing to do would be to make sure your company has enough cash to weather the next 4-8 quarters until the macro situation progresses. There is no guarantee the macro situation gets better but the hope is that it may at least become more certain. If above-target inflation continues to persist despite multiple rate hikes and more supply of goods opening up, then we may realize that we are unfortunately in a longer economic cycle. In this case, you will be glad that your company preserved its cash and you will likely have to chart a path to true profitability in the ensuing years. Prudence with cash is something that we are touting to all of our portfolio companies at Index Ventures.
I’m including some pictures to accompany the story. I’ll also close by saying that I’m not a macroeconomist. Should you have some thoughts or feedback, I’d love to hear it!