Inflation Continues & The Opportunities for Entrepreneurs Increase

Consumer prices continue to rise, the U.S. labor market shows no sign of slowing down, bank insolvencies, and the Fed is signaling more interest rate increases. “What does this all mean for entrepreneurs?”

Below we’ll walk through the sources of inflation, primary changes in the economy, impacts in the financial markets, and how the dynamic is presenting opportunities for entrepreneurs.?

It’s important to walk through the sources of inflation. First, The COVID-19 pandemic resulted in historically significant U.S. fiscal stimulus of $1.9 trillion, and households jumpstarted consumption with purchases of stay-at-home goods to make quarantines more comfortable. Think home gyms, streaming services, and consumer electronics. Arguably this stimulated demand-pull inflation as these additional dollars started chasing a relatively limited amount of these goods, resulting in prices that were “bid up.”?

Second, this American demand for consumer goods hit the world’s supply chains, which were already constrained by COVID protocols. Delays and shortages of many goods (remember $100 sheets of plywood?), particularly microchips, translated into price increases. Ships started backing up in seaports. Cost-push inflation meant that suppliers were charging higher prices to firms downstream. These costs were pushed to many retailers, other small businesses and consumers, eventually bleeding into rents and services pricing.

Third, there has been an ongoing demographic shift with Baby boomers aging out of the workforce, and the pandemic sped up the process as people retired-out early or otherwise left. This imbalance has added to the upward pressure on wage levels, as employers have been forced to raise wages to attract and retain staff. This dynamic is unlikely to slow any time soon, as firms still need core employees for mandatory jobs, and have no choice but to pay prevailing wage rates.

Fourth, energy prices are particularly volatile and inelastic, meaning when prices go up there is relatively little that consumers can do to avoid the expense, at least in the short term. Energy prices were already rising because of the aforementioned pressures, and were then worsened by Russia’s invasion of Ukraine. Resultant sanctions have created new supply constraints, which further increases pricing. Thankfully a relatively warm winter has helped to limit European demand, and has helped mitigate this effect.?

The good news is that inflation is easing (CNBC). The idea that inflation was transitory has been disproven, and the Central Banks’ responses have eased the upward price pressure. Housing price increases remain high, there is still strength in U.S. demand, national industrial policy and supply chain resilience is coming into focus, some people have returned to the workforce, and energy prices have begun to normalize despite the war.

Policymakers have responded by raising interest rates and working to reduce the money supply, not just in the U.S. but across the OECD (Economist). This helps reduce inflation to the target 2% rate, so savers are not penalized by higher prices. The risk is a resulting recession, and this risk is increasingly making financial assets look overpriced.

Economy - Mixed News

• “The U.S. economy expanded at a 2.7% annual rate from October through December, a downgrade from the 2.9% forecast” (Bureau of Economic Analysis).
• Government debt as a percentage of Gross Domestic Product declined between 2020 and 2022 in almost 65% of countries (Brookings), yet “China’s debt overhang far exceeds the burdens facing the United States,” with their relative debt-to-GDP burden 40% higher than the U.S. (Forbes and Statista).?
• U3 unemployment stood at 3.4% (St. Louis Fed), and? jobless claims continue to fall as competition for workers remains fierce (Reuters).?
• Wage growth has remained strong and February private payrolls rose by 242,000 jobs, outpacing expectations and led by hiring in leisure & hospitality (CNBC).
• PCE and Consumer Price Index (CPI), are core measures of inflation - both are still running hot. Including food and energy, the annualized CPI rate stood at? 6.0%, including food and energy, not seasonally adjusted (Bureau of Labor Statistics).
• In response the Federal Reserve is signaling further, and potentially faster, increases to its core Fed Funds Rate, currently 4.5 - 4.75%. This is the rate at which depository institutions lend reserve balances to other banks on an overnight basis (Reuters and CNBC).
• The Fed has also ended quantitative easing (QE) policies which involved purchases of Treasury and mortgage-backed securities; and resulted in a peak balance sheet of $9 trillion. By not purchasing new securities to replace maturing bonds, we’re seeing a reduction to the bond portfolio of $95 billion per month (Richmond Fed and US Bank).

Asset Prices - Valuation Concerns Continue

• The rising interest rates have been felt directly in fixed income markets, where rate increases raise the specter of a hard landing: “A Bond Market Recession Signal Is Getting Even Louder” (Barrons) and “...the rout in bonds is coming your way.” (Reuters).?
• Increases in “shelter prices” are continuing a fast clip. A dip in real estate transactions, is a natural result of interest rates increases, and “Mortgage demand drops to a 28 year low” (CNBC).
• There's a corresponding drop in the dollar index, “Pullback in US Treasury bond yields,” and the DXY loses ground at 105.00 (FX Street).
• Some analysts are expecting another drop of 20-25% in public equities, with a worsening of economic indicators, expectations for continued interest rate increases, and related deterioration in consumer sentiment (Seeking Alpha).

• The Sharpe ratio is a measure of relative risk-adjusted returns. “The average annual Sharpe ratio of the traditional 60-40 stock and bond portfolio was three times more in the last ten years than it was from 1900 to 2011,” and there’s an increasing likelihood the period of high returns ends with a regression to the mean (Institutional Investor).?
• The Shiller P/E, or CAPE, is a measure of the S&P 500’s overall price-to-earnings, and it has a historic average of 15.87, with the 30.38 reading indicating a potential bubble in share prices (Motley Fool).
• It will continue to be a tough 2023 for private equity, both for fund managers and entrepreneurs raising capital (Pitchbook), and VCs have become more conservative, with a focus on funding their existing portfolio, seeking smaller profitable firms or industries of greater national “strategic interest” (Economist).

Opportunities

What does it all mean for entrepreneurs. First, all of our previously reported recommendations still hold true for existing business owners:

• Build cash reserves;
• Delay angel and VC rounds when possible, expect "down-rounds;"
• Recognize the difficulty in some sales environments;
• Continue to re-examine pricing - increases may be needed to stay within the competitive range; and
• Investigate allocations in 401k and other retirement accounts.

Second, note that there are an emerging series of entrepreneurial opportunities, both in the areas of reaching new customers as well as opportunities to develop new offerings. The starting point is understanding where the industry growth trends intersect with the particular advantages of a given region. Investigate the structural demographic, immigration, geographic and regulatory advantages for your patch.

Here in Central Virginia we benefit from proximity to the Chesapeake Bay, related cost advantages for logistics to population centers along the Atlantic coast, an eclectic cultural mix and design community, location relative to state and federal policymakers, as well as technology and product development centers.

Third, explore how these trends are impacting the sectors already experiencing the most growth, and where the inflationary pressures are playing to sellers’ advantages. Some firms enjoy stronger pricing power, while other products become commoditized. Porter’s Five Forces is a great way to think through opportunities, and the ways in which a particular industry is changing. For example, labor intensive models may be under increased pressure to find employees. Demand for precious metals sourced from conflict zones, could result in new supply chain risk (e.g., electric vehicles, battery storage).?

Our analysis in Central Virginia revealed a series of high growth, and regionally aligned sectors: creative and professional services, advanced manufacturing, life sciences, healthcare technology, engineering and product development, and social innovation.?

Fourth, when pursuing an opportunity in an attractive industry (i.e. growth sector that plays to regional advantages), bear in mind that the difficulty-of-entry will fall along a range. This range is dictated by the “barriers to entry.” This includes the following concepts:

• Economies of scale
• Brand loyalty
• Capital requirements
• Cumulative experience
• Government policies
• Access to distribution channels
• Switching costs

The lower the barriers, the easier it is to set up shop and start making sales. The higher the barriers, the more that industry relationships and commercialization collaboration is likely needed.

Finally, identify the innovations that are re-shaping that industry, and the role you could play. For example, the Whitehouse list of Critical and Emerging Technologies lays out the areas of national strategic significance, and therefore those likely to attract government grants and/or subsidies.?

For More Information

Please feel free to contact me at [email protected]. RVA Works? is a 501(c)3 tax-exempt nonprofit, registered as a Virginia Public Charity with a mission to help more people become business owners. Open Trellis? is a supporting technology developed by, and wholly owned by, RVA Works Enterprise Support, Inc.