Inflation is at its highest level in more than 40 years. Although the Federal Reserve has been raising interest rates to combat inflation, the results so far have been negligible.
Michael Guckes began his career in construction economics as a leading economist for the Ohio Department of Transportation. After nearly a decade, he transitioned into manufacturing economics and served as Chief Economist at Gardner Business Media. In 2022, he joined ConstructConnect’s economic team and shifted his focus to the civil and commercial construction markets.
In our first Discerning Distributor episode, Guckes joined our host Alex Chausovsky to dig into inflation, interest rates and what distributors can expect in the face of a potential economic slowdown.
Alex Chausovsky: There have been a lot of discussions recently about whether or not the U.S. economy is in a recession. The answer to that question largely depends on what definition of “recession” you use to qualify economic data.
Do you think we are headed for a recession in the near future? What does this all mean for distributors?
Michael Guckes: That’s a great question. There is a lot of data out there, and not all that information is actionable. When we consider what is happening with the GDP, we need to remember that, to some degree, we are like a canary in a coal mine. What we experience is eventually going to roll down and affect the consumer.
When we think about where the GDP is, many of us hear major news outlets saying, “GDP is down 0.6% in the second quarter and 1.6% in the first quarter.” Those measures look at one quarter right next to the other, and then they seasonally adjust the results and magnify them to an annualized rate.
So what you’re doing is taking two points and pretending that, essentially, if the economy moved that way for an entire year, that’s where we would end up. But, if you look at the absolute dollar amounts for GDP over the last four or five quarters, you’ll see that we have created an apex, and now we’re simply coming off of it. So if you look at longer measures of GDP growth, they’re much more encouraging than if you just look a the most recent quarters and magnify those to be annualized.
But, I don’t recall there ever having been a time in history when we’ve had two consecutive quarters of declining GDP, as we’ve discussed, without it being considered a recession. Of course, NBER, the National Bureau of Economic Research, has its own way of defining whether we are in a recession or not, and it’s more complicated than just two consecutive quarters of negative GDP growth. But, the way NBER works, they take their time. It can take months for NBER to announce that we have been in a recession.
Chausovsky: In essence, you can’t oversimplify it. For instance, GDP is driven primarily by consumer spending. If you operate in a B2B space, there are better metrics that measure B2B performance, such as industrial production or new orders. Wouldn’t you agree?
Guckes: I would, and, to your point, every recession is sparked by something different. This time, it’s probably more complicated than anything we’ve seen before. We have unprecedented government intervention with things like changes to debt payments and the $7 trillion in funding doled out over the past few years.
I would say that we’re probably more on the recession side than not. People will say, “We can’t possibly be in a recession. Look at how low the unemployment rate is.” But there’s a lot more going on there. We also need to look at the labor force participation rate and unit labor productivity. What is keeping people out of the workforce? How much production is each person adding? If you go back through history all the way to the early 60s, each time we have a decline in unit labor productivity, we end up with a recession.
Distributors need to be looking at industry-specific data to make the best distribution and supply chain decisions for their companies. For example, look at the automotive industry versus the energy industry. They couldn’t be more different at this point, right? Auto unit production is still millions of units per year below where it should be. That looks very different from the energy markets where, if we could double the size of the U.S. energy infrastructure tomorrow, that would be fantastic.
Chausovsky: I often see you talk about the need to pay attention to unit data rather than top-line dollars. Revenue often feels the most significant impact from inflation, while units have a secondary reaction to what’s going on in the inflationary environment. In my opinion, though, units are a better way to measure your business performance in periods of high inflation. What are your thoughts on that?
Guckes: That’s absolutely true. One of the great challenges many firms face is that if you grow revenues by 7%, but your costs double, your operational margins will be severely compressed. One of the ways to monitor what’s going on is to look at bid prices – the amount that someone is selling a finished product for compared to their material and labor costs. Over the last two years, we’ve seen that the cost of production has, in some cases, greatly outpaced the ability of firms to raise prices.
Firms, especially on the supply chain side, need to be very careful about how they write their contracts. We need to ensure we’re not making a year-long price guarantee when our own cost might be monthly. We saw those kinds of horror stories coming out of the manufacturing side in 2020 and 2021, where firms had made year-long commitments when they suddenly couldn’t get product. They were simply underwater because of how they had priced things three, six and nine months prior.
We have to be very careful of how we look at revenue and understand that it is only the first part of the picture. You also need to look at EBITDA, operating margins and things of that nature.
Chausovsky: In a high inflationary environment, materials and other input costs, as well as labor, will put pressure on your margins and your bottom line. You’re not trying to increase profitability; you’re trying to maintain profits at a stable level. So when prices go up, customers will have to pay more. If prices go down, they will have to pay less. Everyone will benefit if pricing is done more neutrally and impartially and is driven by data rather than emotions.
Guckes: Right. It can become problematic when everything is about price. We assume that availability is a given, but we’ve all learned the very difficult lesson that it is not. You can no longer have one supplier and assume they will provide everything you need at a great price when you need it. So, many firms are finding that they need to reinforce their supply chains by having two or three suppliers for any given part.
One of the conversations I hear again and again is the idea that it’s okay to ask for a little bit of a price premium if you can assure availability. For instance, determine what your customer is willing to pay to ensure their own operations can maintain a peak level of efficiency. It expands the conversation that a supplier or distributor can have with their customer because now, price is only part of the total picture of the value created by a supplier or distributor.
Chausovsky: Let’s talk a little about why the federal government is doing what they’re doing in terms of managing interest rate policy and what the implications are to the distribution community.
Guckes: Currently, the federal reserve is continuing to raise the federal funds rate. If you’re a business that wants to borrow money, you have some risk premium associated with your loan. That is because, unlike the federal government, you could default. So, you have to pay a premium, which is some amount above the base interest rate. If we look at what’s happening with corporate interest rates, we see that they are going up because of this compounding, layering effect.
The idea behind the government raising interest rates is that, ideally, higher interest rates would mean fewer investment projects would have the rate of return needed to make them feasible. The idea is that this would slow down the economy and grow GDP. The challenge with that strategy is that we’ve dumped $7 trillion into the hands of consumers and businesses. There are also over a trillion dollars sitting in the Federal Reserve. There’s too much money in the system, and we don’t know what to do with it.
I’m not convinced that traditional monetary policies like playing with interest rates will solve this problem. If you wind down the demand for investment spending to offset inflation, you’re going to put the country in a very difficult spot.
We need infrastructure. How often do we hear about crumbling bridges and roads that need investment? If you don’t have good infrastructure, it will affect you in the long run. You want to have a country that is investing in its infrastructure and can invest in new products and ideas and be adaptive to the needs of consumers.
As we think about inflation and interest rates, there need to be other ways to solve these problems.
Chausovsky: What would your recommendation be to the distribution community regarding borrowing money? Should they borrow, even at slightly higher rates of return? Or use the cash they have on hand?
Guckes: A lot of rates are under 9%, which means you can borrow money for less than the cost of present-day, broad-level inflation. So there is an opportunity for firms to continue to borrow. On the flip side of that, we do want to make sure we are conserving cash.
One of the things I’ve been looking at is data on new and unfulfilled orders. We’re seeing growing inventory levels and work in progress in construction and other industries. When you’re committing to building an asset or product, there’s a certain risk to it. There’s a risk that someone will cancel their order or that they might default. Then, suddenly, you could be holding a lot of inventory that has depleted your free cash.
In this type of environment that we find ourselves in, we want to have free cash. When you look back at the Great Recession, firms that could preserve free cash came out much better. Most importantly, the firms that went through the last recession and were able to hold onto their employees were able to rebound more quickly. That was the most challenging asset for those companies coming out of recession. If you don’t have people, you can’t submit bids, grow revenues or grow your business.
Given that, preserve free cash and hold onto your best employees. If we go through a hard time, we have to find a way to maintain those two things. If it comes at the cost of having less inventory than we’d like, that’s the risk we have to take.
If you look at new order data in real, inflation-adjusted terms, it’s eroding. Looking at the last several recessions, every time we had a recession in the last 20 or 30 years, there was divergence where you would have more unfulfilled orders than new orders. It’s like the kid who’s running too fast and trips over his own feet. So, make sure you’re looking at data in real terms compared to data from years ago.
We’ve seen new order numbers come in below a level of 50, with 50 being the no-change line. That means that production is slowing. We’re seeing weakness in new orders. If you’re not tracking new order activity in your industry, you need to start because it impacts everything else down the road. If you can determine the level of production your customers will be committing to in the next three, four or five months, you can begin to prepare today.