OUR BLOG

THE REVENGE OF DISCIPLINE

• 12th September 2022

Introduction

In the last six-to-twelve months pundits have been sounding alarms about the return of inflation and the prospect of an ensuing recession. The US monthly consumer price index moved to 6.2% for the first time in 39 years as early as May 2021, preempting the same movement in other parts of the world, including the EU and the UK. This sharp and sudden inflation was initially confined to energy prices, because of an agreement between OPEC members to not increase oil output when economic activity picked up after COVID-related lockdown measures were lifted. Other geopolitical events added fire on the burner in 2022 and ghosts of the past started to resurface; for the present generation of entrepreneurs, a past learnt through history books.

Major central banks did what their instruction manuals advised them to do, they raised interest rates to bring inflation down, at any cost, to a considered acceptable 2% annual level.

Whatever changes are being precipitated in the economy in quarters to come, no startup entrepreneur must remain indifferent.

1. Why is Inflation a Peril?

What it is

Inflation is, first, the manifestation of the inability of the supply of goods and services to meet the level of the demand, driving an increase in prices. This is the case for goods with a high price elasticity. Second, inflation may occur when the labor market is so tight that increases in wages and salaries are greater than productivity gains. Third, inflation may be recklessly provoked by government action that pours an excess of money on the market to fund unproductive programs (unproductive in both short-term and long-term).

How it takes a turn difficult to reverse

As soon as statistical data show a slight inflationary movement, uncontrollable psychology effects accelerate the phenomenon, as consumers fear to lose their purchasing power. This behavior in turn gives wings to some distributors and retailers who tend to pass on to consumers more than the excess cost they are subjected to. To make matters worse, the media exacerbate that fear. When emotions lead expectations, there is no limit, and panic, such as the one in Germany in 1922-1923, replaces a minimum of balance. The currency loses its value. Some economists liken it to a virus (Pascal Blanqué, Amundi Institute, 4/20/2022).

The role of the central bank

Today central banks react quickly with a set of monetary tools, mainly by increasing interest rates to calm the price overheating. The effect is however neither immediate nor automatic. Bringing back confidence in the value of the currency once it was lost implies to take drastic measures. Such measures make the cost of funding higher for corporations and potentially reduces the supply growth of goods and services. The shock therapy may temper the demand. The risk then is of a recession. What matters to the central bank is that the currency has been protected. This is especially true when the currency is a reserve currency (5 currencies represented together 92.4% of total reserves in the world in Q2 2022, according to the IMF: the US dollar, the Euro, the Japanese Yen, the British Pound and the Chinese Yuan). The finesse in dealing with the measure is to assess properly how low the confidence in the economy is. Underestimating it leads to a succession of rate increases, as the central bank tries to play catch up with inflation. Overestimating it brings a severe disruption that will need to be reversed.

2. Its Impact on Startups

If inflation is a scourge for households, it is also a peril to businesses, mature businesses as well as startups. Businesses with high margin and a healthy balance sheet are better protected against inflation. Startups unfortunately either are still depending upon capital to survive or are generating cashflow that may not be sufficient to fund cost increases. Startups generally spend more of their resources in developing intellectual property with a good R&D team than spending in material and consumption of goods. However sophisticated equipment indispensable to develop their products may become temporarily unavailable or more costly. As a rule, it really depends where in the investment cycle (as in capital expenditures) the startup stands to determine the effect of inflation.

For those early startups relying on investors, in principle investors are more cautious in periods of inflation, more so now because almost all are in uncharted territory, having never before experienced significant changes in price level. Hence, startups are in even better position than in normal times if they have recently closed a round of financing than if they are seeking funding.

The 2022 inflation case

The present world inflation is due to the conjunction of a geopolitical event, a response to a sanitary crisis, climate change, a shortage of raw materials in fast increasing demand, and other less spectacular factors. There is a quasi-certainty that these factors are going to be dealt with and their impact will progressively recede, some in a matter of months, others in a matter of years. In a risk analysis, one should always brace for the worst and prepare for a long period of inflation, unlikely in double digits, and very likely above 5% per annum.

3. Recession

What it is

In economic theory, recession is part of the economic cycle. Recessions have generally been defined as a period of two or more successive quarters of GDP declines. However, in the U.S. the National Bureau of Economic Research (NBER), considered the authority in the matter, does not use this criterion. Its attention is on depth -a significant decline is necessary-, transmission across all the sectors of the economy, and duration -at least a few months. Recessions in the US therefore are officially declared long after they have started, and often when they are over.

A recession is the result of a loss of confidence in the economy by consumers. What is at the origin of a loss of confidence in the economy? Not only an unwarranted optimism on economic perspectives denounced by investors, but often unanticipated external shocks, or more specifically, the perception of a negative aspect of an event, often amplified by the media. It trickles down to businesses whose orders are shrinking, and to investors who anticipate a retreat in profitability due to the response time from businesses to adapt their capacity to the new reduced demand.

Recessions can start by a disconnection of the stock market from the real economy. It is triggered when asset bubbles burst, which they inevitably do. Investors flip from euphoria to panic in a matter of days. To burst a bubble. it takes only one savvy influencer who finally declares some assets overvalued. The oddity is that an attempt by clear-sighted investors to infuse wisdom to re-position the market in harmony with the real economy has a quick, unwanted, impact on the real economy the expansion of which stumbles. The psychology of stock market investors creates an unnecessary amplifier.

Last, a recession can also be the result of central bank policy measures to stop the overheating of the economy at the tail of an expansion period. By reducing money supply, a recession takes place. The real estate sector is generally hit the hardest, making it the best indicator of a coming recession. The most followed indicator however in the US is the Treasury yield curve inversion -when short-term interest rates become higher than long-term interest rates-. Such inversions have occurred in the 12-to-18 months before all recessions of the last 50 years.

Depth of a recession

According to the World Bank, in the last 150 years, only four times did the world GDP retracted by more than 5% in a year, the last time being with the COVID disruptions. However, on a country-by-country basis, since 1945, tens of countries in all continents have experienced significant decreases in GDP. Some were very short (two to three months) while others lasted two years or more. A long, deep recession, such as the 1930-32 recession becomes a real economic crisis with record unemployment. Historic references are brandished by pundits to compare a situation they anticipate with a past recession, jumping to quick conclusions as to the sequence of events one can expect. I would recommend caution in embracing such expectations. Today’s world may have many similarities with previous decades, yet it is a different world.

Attempts to contain it

Governments have a vested interest in rapidly turning the economy around. Fiscal incentives to enterprises to develop emerging sectors and to households to give an impetus to the demand, together with monetary measures applied by central banks, essentially reducing interest rates to incentivize borrowers and loosening bank reserve ratios to incentivize lenders, are the spectrum of traditional tools at their disposal. A great finesse is required however to avoid a succession of stop and go cycles, such as those the United Kingdom went through in the 1950s and 1960s.

Signs announcing a potential recession in 2022 or 2023

Eeconomists point to “the war in Ukraine’s impact on commodities, including energy, as well as China’s zero-COVID strategy… It puts downward pressure on output [and] upward pressure on prices." (Pr Rogoff, Harvard University, 7/28/2022). Theoretically, all this is true. Yet dynamics are different from one continent to another.

Is a recession a necessary evil in the economic cycle?

It allows to reallocate capital to investments bringing higher productivity with a more acceptable level of risk, setting the basis for a new growth period. The price to pay varies. The number of bankruptcies affecting the least healthy businesses increases, their workforce is out of employment, healthy companies grow less or even stop growing due to an anemic demand. In the meantime, new technologies are invented and new opportunities emerge. It takes anywhere from 6 months to 3 years in average for the economy to rebound, stronger.

Impact on Startups

It is common knowledge that the greatest businesses were created during recessions. Savvy entrepreneurs, undeterred by a dire economic situation unearth new business opportunities and manage to reach their milestones with less capital. Their mission is not deeply affected by the timing of their product launch in the economic cycle.

Whatever will happen in 2023, investors’ attitudes have changed: they suddenly concern themselves more with profitability and return, away from the bliss of 2021. As stock markets stumble, valuations of private rounds of financing take a hit, starting by late stage rounds progressively reaching Series B, then Series A and finally, as of today early-stage funding.

4. Can a Recession Be an Opportunity for DeepTech Startups?

In principle DeepTech startups should not overly concern themselves with inflation or recession, because they are at least one-degree remote from consumers, and their focus is on the long term. Still the purchasing power of their potential clients might be affected, prompting prudent delays in considering any technology acquisition, a decision they often regret. Inflation will affect all startups in increasing the cost of wages, a paramount expense. It will therefore increase the burn rate and reduce the “safety period” before running out of fund.

What to do?

Basic measures will go a long way to protect startups, all pertaining to one simple idea: to extend the life of existing cash by reducing the burn rate.

• Privilege cash protection vs. unfettered growth. Make sure your cash in bank, at constant burn rate will last at least 15 months.
• Seek customer financing wherever possible.
• Seek “low-cost” revenue opportunities.
• Focus on business models that minimize the cost of marketing and sales.
• Last, do not stop hiring talent. Recessions are the best opportunities to find new talent.

Conclusion

A recession is a salutary correction in most cases. It reinstates discipline in business and investment practices after years of unbridled high-risk expansion, annihilating the bad roots and the rogue actors. Fundamentals become back in favor, companies’ valuations more in line with their future earnings capabilities. Genuine entrepreneurs set to build sustainable businesses are celebrated, progressively carrying the banner for a new period of expansion on a sound basis.

“As businesses fail, talent and capital will return to the pool with a renewed outlook, and industry participants will be more likely to do the right things for the right reasons.’ (Griffin Parry, CITY.A.M., 8/9/22)