In A Stagflationary Environment, Today’s Entrepreneurs Have No Idea What To Do

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The last twenty years, ever since the Dotcom bust, were a Goldilocks environment for entrepreneurs (excluding the Great Recession, of course). Interest rates were low, making borrowing historically cheap. And inflation was nowhere to be found. The Fed, ECB, and Bank of England all kept their rates at or below zero, yet prices didn’t rise. Technology and international market integration were a rare saving grace.

Now, though, things are a little different. Headline inflation in most major economies, including the U.S., is above 8 percent. And growth appears to be faltering. Many commentators and politicians are pointing to the 1970s as a historical analogy of what is likely to happen next. Because of high energy prices and asset bubbles, consumer goods are feeling the brunt. Prices are rising even as wages remain stagnant, leading to dramatic falls in real living standards. 

While there may be some entrepreneurs around who lived through the 1970s, they are few and far between. Even old stalwarts, like Bill Gates, are barely old enough to remember that era. And that means that the new environment is going to throw today’s crop of business leaders out of kilter. They simply won’t know how to react. 

Cheap Borrowing May Come To An End

Nobody is quite sure how the current set of circumstances will play out. Financial plumbing is complicated. However, it appears that inflation has become embedded, contrary to the predictions of central banks that previously called it “transitory.” Price rises are no longer in the energy sector alone, but also in other areas, including consumer goods, food, and professional services. 

Because of this, central banks will have to raise rates to protect their currencies, even if that means more economic pain. Citizens will then strike and protest, putting immense pressure on politicians to do something about the situation. Unfortunately, they will be between a rock and a hard place. If they compel central banks to ease monetary policy, then new money creation will flow straight back into assets. The rich will become richer, and inequality will worsen. On the other hand, if they allow central banks to raise rates, that’ll destroy growth and cause living standards to plummet. Businesses will fail due to a lack of demand and high input costs.

At the moment, businesses are looking at the prospect of higher inflation or higher interest rates, and probably a combination of both. And that’s not something most have ever seen before. It’s now forty years since the last time that happened to any significant degree. 

Ultimately, this means that cheap borrowing will probably come to an end, at least for a time. Entrepreneurs won’t be able to get access to the same level of credit as they did in the past from mainstream institutions. Hence, venture capital is likely to become a more important part of the mix. 

Inflation Could Become Rampant

At the same time, it isn’t clear if central banks will actually get inflation under control. The costs of doing that could be enormous, and the real economy might suffer tremendously. Raising rates would contract demand and cause a recession. Unemployment would rise and the cost of servicing government and household debt would also go up. 

When governments increased rates in the 1970s and early 1980s it was painful, but debt levels weren’t as high. Today, that’s not the case. Governments, households, and businesses could all fail if real rates return to historical norms, even for a short time. 

Because of this, sustained high-interest rates seem like an unlikely policy choice. Instead, it seems much more probable that governments and central banks will resort to money-printing to prop up economies and financial markets. And because real goods are in short supply, inflation could pick up even more. 

Entrepreneurs simply aren’t ready for this kind of environment, either. They don’t have any training in it. Thanks to the extreme volatility in prices, many are using a laptop for trading on the side, but they don’t understand what it means for their businesses fundamentally. And that could lead to a wave of startup failures going forward.

How Can Entrepreneurs Succeed In This Environment?

To really thrive in today’s market, entrepreneurs need to have a clear picture of which way the economy is heading. From the above discussion, it seems like there are two choices from today’s vantage point:

1. Low growth, low-interest rates, and high inflation
2. Recession, high-interest rates, and low inflation

Which of these two paths plays out in the long-term depends almost entirely on central bank policy. However, given that human beings tend to prefer pain in the future rather than pain today, option number one seems more likely. 

In inflationary environments, most consumer discretionary businesses perform poorly (particularly when inflation is commodity- and central bank-driven, as it is today). Wages remain flat, and consumers simply can’t keep up with spending, as they did in the past. A rotation occurs into utilities and consumer staples, such as food, as we are seeing right now.

For entrepreneurs, succeeding in this environment is difficult. Business failures in the 1970s were also high, particularly following energy shocks. However, there are things that can be done. 

• Reduce the luxury component in products and move towards “value” or “staple” appeal
• Cut back on expansion plans but keep core product quality high until conditions improve, potentially in 2024 once inflation is under control
• Rotate into inflation-hedge assets temporarily to provide ongoing capital until the consumer economy recovers
• Raise prices to preserve margins

None of these courses of action are particularly appealing. They all involve some sort of pain. But it is important to understand what happens during inflationary episodes. In all cases, there is a transfer of wealth from some groups in society, to others. 

At present, homeowners, cash holders, and most discretionary businesses are losing. At the same time, energy producers, extractors, and resource-based firms are winning. As an entrepreneur, you want to be on the winning side of the equation, which means aligning yourself with these groups as much as possible and reducing exposure to at-risk sectors.