July 6, 2022 | Ron Sege, Partner, BGV
In this paper I argue that a recession is inevitable and that a recovery may well take several years. I conclude with some takeaways for early-stage tech ventures.
I started my career as an analyst in the Wages, Prices and Productivity section of the Division of Research at the Federal Reserve Board in 1979, under Federal Reserve Chair Paul Volcker. This was the last period when inflation ran as rampant as it is running today, and monetary policy was used to ultimately tame the inflation as well as the inflationary expectations. My job, among other things, was to tend to the econometric model (which was written in FORTRAN and run on an Amdahl v4 mainframe) that connected wages, prices, and productivity into a predictive model (early “AI!”).
A recession is the point
Of course, it is human nature to pattern match, and I see many similarities between the period of the late 70s and early 80s, and now. Some differences are visible as well, which we shall get to.
But first, the similarities, which all amount to an economy that is running hot, due in large part to very accommodative monetary policy, aggressive fiscal policies, and supply-side shocks. In the 70s a recession emerged due to the accommodative monetary policy (perhaps due to political pressures) pursued by Arthur Burns, then Fed Chair, an oil supply shortage in the mid 70s that was brought on by the OPEC cartel, and significant fiscal stimulus to fund the Vietnam war. Today, again, it is due to an accommodative monetary policy (initially due to the need to increase the inflation rate*, and then due to pandemic-related demand shortfalls), aggressive fiscal stimulus to counter pandemic-related hardships, and broad-based supply issues resulting from the pandemic and the war in Ukraine. The numbers are familiar and frightening:
*Having inflation and interest rates run too low, as was the case for much of the 2010s, limits the Fed’s ability to respond to economic downturns.
consumer wealth which drives consumption
To address the combination of strong demand, ongoing supply shortages (including the supply of labor) and increasing consumer expectations of ongoing inflation, the Fed, under Jerome Powell, is taking strong action via increasing interest rates and reducing the stimulus the Fed had been providing via the policy of QE, or quantitative easing. Both actions are designed to fairly quickly reduce demand to balance with the supply of goods, services, and labor. Or, as William McChesney Martin once said, “to take away the punch bowl just as the party is getting started.” In the end, to bring on a recession, which is defined as a fall in Gross Domestic Product (GDP) for two quarters in a row.
Since supply generally cannot be increased quickly, a recession is the quickest way to bring demand and supply into balance.
It seems it will last quite some time
So, why can’t supply be increased quickly, and more generally, how long might this all last?
The answer to the first question has two related reasons: A war in Ukraine with no end date in sight, and the time it takes to reconfigure global supply chains to respond to dramatically changing geopolitical dynamics, especially to reduce dependency on China. The former significantly affects food supply, and the latter manufactured goods.
The answer to the second question, unfortunately, is ‘perhaps a long time.’ Looking back on the last strong (hyper?) inflationary period from the mid-70s to the mid-80s, it took several years for Paul Volcker’s drastic contraction in monetary accommodation to tame inflation and bring the economy back to full employment. This was in part due to the feedback of wages into prices (cost of living adjustment clauses, or COLAs, were common in labor contracts of the time) and in part due to inflationary expectations across the economy’s actors.
relative to the size of the economy
In addition, for the last 20 years or more the world economy has received the benefit of globalization, which improved efficiencies, especially in manufactured goods, and kept a lid on prices. We are now entering a period of “deglobalization,” which will have the reverse effect – less efficiencies and more price pressures. In addition, deglobalization will likely mean supply shortages for some time, until geopolitically “safe” supply chain elements are re-optimized. How much and how long remains to be seen, but I would not expect this phenomenon to play itself out quickly. For example, tech companies that are relocating manufacturing from China to “politically safe” countries like Vietnam are finding shortages of skilled labor, immature transportation infrastructure and component suppliers that are still anchored in China.
For these reasons, I expect the Fed will need to keep interest rates high for some time to keep demand dampened, both to break the wage-price spiral and to match demand for goods with adjusting supply chains. Again, back to the 70s-80s, look how long real interest rates had to stay above their longer-term average to bring inflation under control.
Although the above chart does not show the most recent period, by historical standards real interest rates are still quite low – too low to significantly reduce real demand. Here is a somewhat technical chart showing interest rate swaps minus inflation expectations, indicating that the market believes real rates must rise by perhaps another 1.5 percentage points to get back to even recent averages.
What are startups to do?
The swing from ‘growth at any cost’ to ‘profitable growth’ is clearly one rational answer to the current situation. Another is to focus on value propositions that help customers manage their costs and adjust their supply chains. ‘Climate change’ ventures that target solutions to the likely long-lasting high cost of fossil fuels (EVs, wind power, solar power, conservation techniques) should also benefit, since we can presume that Russia will not be a source of oil and gas for the foreseeable future. The trick on the last point, however, is to find ventures that have a reasonably short payback period (or government subsidies) since the cost of capital has gone up, and will continue to go up, for the future.
Finally, especially for startups that have raised money at high valuations, shepherd the existing cash until you have clear signals regarding product market fit in the new environment, as well as proven go-to-market models. What worked before 2022 is likely not to work in the next 3-5 years.
Conclusion
We are entering an inflationary period not unlike the one in the 70s and 80s. Back then there were built in inflation expectations (COLAs, etc), fiscal largesse and supply shocks (OPEC). Today there are labor market dynamics (shortage of willing workers), pandemic-related government spending and supply shocks (war, deglobalization). These trends could inspire a several-years effort by the Fed to dampen demand. Startup exec teams should gird for this eventuality by conserving cash, finding new applications for their solutions and adjusting PMF and GTM.
