The Three C’s of Surviving a Cash Flow and Credit Crunch

A cash flow crunch can be like a freight train, you see the danger from afar, and you try to stop it but it has an inertia of its own.  A crisis can endanger a company, it is enormously time-consuming, and often put a company out of business.  On a personal level, like any crisis, it stresses out the owners, the employees, and emotionally drains everyone involved.

However, there are several actions that can be taken to reduce the tension and save your company. First, calm down and try to stay positive. The situation is what is.  Angry or self-pity emotions cloud your thinking and reduce the energy that should be directed to the problem.

There are three steps that can help owners survive a liquidity crunch, I call them the three C’s of crisis management.  They reduce stress and emotions, help you focus, and possibly resolve problems to allow your business to survive.

1.      Calm

2.      Calculate

3.      Communicate

Here are some exercises that can help:

·        Use “square breathing,” breath in for 5 seconds, hold the breath for 5 seconds, breathe out for 5 seconds, and then refrain from breathing in for 5 seconds.  The time can vary based on your breathing capacity, but don’t physically stress yourself.

·        Sit and stand erect, don’t let the gravity of the moment affect your posture. Many studies show that posture affects emotions and your self-image.  If you let your body posture reflect the stress, then you could enter a spiraling emotional decline.

·        Slow things down some, do not attempt to do everything at once. Instead focus on the key, critical tasks.

With a focus on critical tasks, it is time to calculate.  Calculate the amounts owed and the deadlines.  Some bills can be postponed, even though you must pay a penalty.  Other vendors offer no leeway.  Figure out where you have leeway and make a sequential list.

Vendors with some possible leeway:

·        Net 30-day invoices

·        Some credit cards

·        Insurance payments

Vendors with little or no flexibility:

·        Utilities

·        Phone service

Finally, communicate with your vendors and creditors.  Don’t just let the phone ring when they call.  Engage with them, explain the situation, and ask to negotiate.  Better yet proactively call them and work a payment schedule.  Smart vendors and creditors realize that getting their money a little late is better than not being paid. Then recalculate and execute.

Going through a liquidity crunch is no fun, it is absolutely exhausting.  However, follow these tips and you should be able to work things out and survive. 

Fifty Percent of Business Startups Fail within Five Years: Most Fail for No Reason

Vernon Budinger, CFA, CAIA, QuickBooks ProAdvisor

October 15, 2022

Neural Profit Engines has developed the “Neural CFO” © business track to guide businesses through rough times.  The motivating factor is that all businesses will face an event or a series of events that will threaten their viability sometime during the life of the business.  New business owners need to understand that companies that thrive over decades may not be the company with the best product; however, they had plans and skills to survive unnecessary pandemics, economic turmoil, or disruptive new technologies.

U.S. Bureau of Labor Statistics data confirms that, on average, 20% of new businesses will fail after 1 year (orange arrow) and that 50% of businesses fail in their first five years (blue arrow).

Figure 1: Business Survival by Year Started

The source of this information is the U.S. Bureau of Labor Statistics Business Employment Dynamics Database, which identifies new business startups by the year that they were formed and tracks them over their lifetime based on this information. This provides incredibly useful information about business success versus failure.  The first graph tracks business success by cohort.  The second graph tracks each year’s cohort over time.

While the probability of a new business succeeding ramped up after 2013/2014, the overall time series has been remarkably stable (see Figure 2).  This suggests that it is not the business environment that determines the success or failure of a small business, but the internal processes that new businesses follow seem to be flawed.  In other words, new businesses don’t learn from previous failures of business owners and follow the same bad practices year after year even though the business world generally knows that these practices lead to failure.  This is something that is theoretically unacceptable in modern capitalist society.

Figure 2: Cohort transition over time

New Business Fail Because They Repeat Bad Habits

A Google search finds hundreds of articles that list thousands of reasons that most businesses fail.  Here is a condensed list.

1)     No vision: Laura Cowan finds that most successful business owners have a clear vision for the future of their business and failing business owners don’t.

2)     Bad management skills: small business owners must take on more responsibilities than the owners of more established companies that can hire managers for specific areas such as finance and human resources.  As a result, new business owners often zig when they should zag or cannot deal with a critical issue because they are burdened with a special project for their company.

3)     No niche:  Many businesses choose the wrong niche or no niche for their target market and thus do not deliver the product that potential customers want. 

4)     No business plan: In reality, #1, #2, #3, and #5 are the results of poor planning.  An effective business plan helps the founder evaluate the market opportunities, understand the need that the business’s products will satisfy, and establish a route for launching the business and building a strong clientele.

5)     Insufficient funding – Small business owners often finance their business with personal savings and don’t anticipate how cruel the business world can be when business turns bad, or complications develop.

6)     New business owners often underestimate expenses, especially in today’s inflationary environment.

7)     Low-profit margins: Low profit margins are a killer, especially deadly during inflationary periods. Many firms do not even know their profit margins.

8)     No marketing plan: Business owners who build a business plan usually create a marketing plan.  Furthermore, if you don’t have a marketing plan, you probably do not know what market niche needs your products.

9)     No action: Cowan feels that many new business owners fail to act because they try to be perfectionists. However, many new owners do not have the information network set up and fail to see the signs of trouble early enough.  In critical situations, critical events unfold rapidly and they demand quick action.

10)  No commitment to learning

11)  No follow-up: Business owners are perceived as inattentive or unprofessional because they fail to follow through on promises. 

12)  No consistency

Sources:

Laura Cowan: Eight Common Reasons Small Businesses Fail (forbes.com)

George Meszaros: 10 Unforgivable Reasons Why Small Businesses Fail – Business Tips & Advice (successharbor.com)

Melissa Horton: The 4 Most Common Reasons a Small Business Fails (investopedia.com)

NPE Evaluation

While these authors are all correct, further analysis reveals that there are only a few core factors that drive business success.  One tool for understanding the REAL problem is the “5 Whys” method; ask the question “Why?” at least five times and look at that answer or ask until the same answer repeats.

For instance, “Why didn’t a business have enough cash to survive?”  The answer is most likely that the company did not put together a budget and financial forecast.  Then ask, “Why didn’t the business create a budget with a financial forecast when it is part of a strong business plan?”  The answer will most likely be that the business did not put together a plan. Then ask, “Why didn’t business put together a plan?”  The most likely answer is that the business owner did not have the discipline to write a plan.  Finally, “Why didn’t the owner have the discipline to write a plan?”.  The answer is that the owner was not the right type of person to start a business – this is the reason the business failed.

The same answer generally results from going through the same process when asking “Why?” about marketing plans, market niche or market served, creating a product that did not fill customer needs, bad management style, and underestimating expenses.  These items are all part of a strong plan that comes from the company’s vision for satisfying the needs of the public.

The “5 Whys” process leads to a shorter list of reasons for business failure:

1)     The new business owner is not a good manager because they did not have the discipline needed to organize and run a business.

2)     The new business owner did not write a good plan to serve as a roadmap to deal with unexpected problems because they were not familiar with the components of a good business plan.

3)     The new business owner faced a perfect storm of critical events that dealt a death blow to the company.

The solution to #1 and #2 is obvious: develop the skills and discipline necessary to run a business – the subject for upcoming papers.  However, factor #3 is a tough one.  Navy SEAL training has an exercise to deal with this; it’s called the “sugar cookie.”  Recruits are targeted during training to go through the “sugar cookie” drill.  The drill instructor inspects the recruit’s uniforms and will pick a few for failing inspection, even though their uniforms are perfect.  The selected recruits then need to run to the ocean, dive into the surf and then roll in the sand.  They must then work the rest of the day in a sand-coated uniform – which looks like a sugar cookie.  The exercise is designed to teach SEAL trainees that war is unpredictable (as is business).  You can do everything perfectly and still fail.  You can’t spend time fixed on the past and all the what ifs.  You must focus on the future and move forward.

This is where the plan is essential.  The plan and the plan’s budget establishes performance targets and identifies the business performance necessary for success and, as a result, failure.  The entrepreneur with a plan will be able to pivot and shut down more quickly.  In the words of John Calvin Maxwell, American author, speaker, and pastor, “Fail early, fail often, but fail forward.”

Neural Profit Engines offers planning and budgeting services. Our experience has been honed through years of investigative investing; reviewing plans, building plans, calculating the budget that meets the plan’s goals, and implementing the tracking needed to accomplish the plan’s objectives.  Use this link to access our website and schedule a free consultation.

Schedule a free consultation.

Vernon Budinger

Owner, Neural Profit Engines

www.neuralprofitengines.com

vernon@neuralprofitengines.com

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A Summary of the Inflation Reduction Act of 2022: A Five Minute Read

The Inflation Reduction Act of 2022: You can’t spend your way out of inflation or tax your way out of recession.

One must wonder about this legislation when Bernie Sanders, the liberal torchbearer for the nation, promptly takes the Senate podium to announce that the plan will have little effect on inflation. As one unknown Republican Senator commented: “You can’t spend your way out of inflation or tax your way out of recession.” However, that is what President Biden and the Democrats seem to have planned

The measure is now on its way to the Democrat-controlled House of Representatives after Chuck Schumer and the Democratic leadership of the Senate needed Vice President Kamala Harris’ vote to pass The Inflation Reduction Act of 2022. Here is a summary of the bill.

Source: U.S. Senate Democrats

The following analysis comes from the U.S. Senate Committee on Finance

Ranking Member's News | Newsroom | The United States Senate Committee on Finance

Individual Income Taxes

• Extends the required holding period for carried interest to be taxed as a long-term capital gain from three years to five years for taxpayers with an adjusted gross income equal to or greater than $400,000.

• Extends the expanded health insurance Premium Tax Credits provided in the American Rescue Plan Act (ARPA), including allowing higher-income households to qualify for the credits and boosting the subsidy for lower-income households, through the end of 2025.

Corporate and International Taxes

·       The proposed 15 percent minimum tax on corporate book income is the most economically damaging provision in the bill, reducing GDP by 0.1 percent and costing about 23,000 jobs. The tax increase on carried interest also eliminates about 5,000 jobs.

Other Modeled Tax Proposals

• Modifies, extends, and creates a variety of tax credits for green energy and other efforts primarily through 2031 or 2033.

• Raises the Superfund tax on crude oil and imported petroleum to 16.4 cents per barrel (indexed to inflation) and increases other taxes and fees on the fossil fuel sector.

Significant Tax Proposals Not Modeled

·        Expands IRS enforcement funding by about $80 billion over 10 years with the goal of hiring 87,000 new workers.

Remember, this legislation is brought to you by the same folks who wanted to spy on every bank account over $600.  This will double the size of the IRS once the hiring is completed and catapult the agency into 4th place in the Federal Government in terms of number of employees.  Approximate 280,000 Americans make more than $1 million a year.  Do you really think that the folks at the IRS need 160,000 workers to investigate those 280,000 returns?

This is a breakdown of the expected “no tax increase for folks that earn under $400,000:

·        40-57 percent could come from taxpayers making $50,000 or less;

·        65-78 percent from those making less than $100,000; and,

·        78-90 percent from those making less than $200,000.

·        Only around 4-9 percent could come from those making $500,000 or more.

BOOK MINIMUM TAX

MYTH: The book minimum tax (BMT) does not raise taxes; it closes loopholes by making large companies pay at least a 15 percent minimum tax.

FACT: The BMT is a $313 billion tax increase, with half of the increase falling on manufacturers, according to the nonpartisan Joint Committee on Taxation.  Despite proponents’ claims, the book minimum tax does not close tax loopholes.  The BMT is calculated based on financial statement (“book”) income, which is a different set of rules established for an entirely different purpose than taxable income. 

Claims that the BMT closes loopholes ignore the fact that the provisions resulting in different book and tax treatment were specifically enacted by Congress for sound policy reasons.  For example, the treatment of capital investments differs for book and tax purposes, in part to encourage companies to invest in capital assets in the United States.  As the left-leaning Tax Policy Center acknowledges, the BMT would discourage investment.

 According to a study by the National Association of Manufacturers, in 2023 alone the effects would include:

• A real GDP reduction of $68.45 billion

• 218,108 fewer workers in the overall economy

• A labor-income decrease of $17.11 billion

Further, the BMT will not prevent large companies from paying zero tax.  The energy tax provisions included in the “Inflation Reduction Act of 2022” would permit companies to receive those tax credits in excess of their tax liability.  In other words, not only will companies in Democrat-favored industries - such as automakers, utilities, and lithium refiners - be able to pay zero tax, but some will also even be able to receive taxpayer-funded subsidies in excess of the tax due for engaging in an activity that has been picked for government handouts. 

The Facts about Raging Inflation and a Possible Recession: Usable Information for Small Businesses

The July 13th announcement that inflation climbed to 9.1% seems to have stunned many in the finance industry. As a Wall Street veteran and a Finance Professional for over 40 years, I am surprised at the level of confusion regarding the state of the economy, the dangers of inflation and the probability of recession.   

The major driver of the confusion has been Mainstream Media’s politicization of the economic story; MSM is selling the Biden Administration’s story instead of honestly reporting the factors driving the U.S. economy. Then there are the Nobel Prize-winning economists (Paul Krugman for one) who mislead the public and journalists to promote their politics.  This blog presents the facts and logic so that small business owners, who are struggling with inflation and horrified at the chances of a probable recession, can understand the U.S. economy and evaluate management options for their small businesses. 

Note: to keep this blog at a reasonable length, I have left out the debate on the Biden Administration’s oil policy because it is not necessary to demonstrate that government policies are responsible for the dire economic scenario.

Three recent economic studies in the past 2 months directly address the key issues driving inflation and a probable recession.  The first, from the Federal Reserve of San Francisco, directly links the Biden Administration’s aggressive fiscal stimulus to the current persistent inflationary trends.  This ends the greedy corporation and evil Putin gaslighting.

The second study, a working paper for the National Bureau of Economic Research coauthored by Harvard University’s Lawrence Summers, concludes that the inflationary pain felt by today’s consumers is equivalent to the damage done in the late 1970s and early 1980s. This study clearly demonstrates that Federal Reserve Chair Jerome Powell and the current Fed governors will need to administer some strong economic medicine given that Fed Chair Paul Volcker used extreme interest rate hikes in 1980 and 1981 to exorcise inflation and send the economy into a deep recession.

Third, the University of Michigan released a gloomy Consumer Sentiment Index for June 2022 that shows that U.S. consumers are becoming very wary and drastically curtailing spending plans.  This is bad news for the GDP equation.

Paper #1: Federal Reserve of San Francisco - “Why Is U.S. Inflation Higher than in Other Countries?”

The S.F. Fed paper, authored by Oscar Jorda, Celeste Liu, Fernanda Nechio, and Fabian Rivera-Reyes, unites basic economic theory and sound statistical techniques (from previous peer-reviewed papers) to prove that the aggressively stimulative U.S. Government fiscal policy financed by almost uncontrolled printing of money is driving today’s inflation spiral.  The paper leaves no doubt that inflation is going to be persistent and difficult to correct with only monetary policy.

https://www.frbsf.org/wp-content/uploads/sites/4/el2022-07.pdf

To set the stage for the SF Fed’s paper, the graph on the next page illustrates the inflation talking points that most economists and journalists use for their analysis.   The key is the grey line showing U.S. Gross Domestic Product (GDP).  This graph clearly shows the correlation between GDP growth, the growth in U.S. Federal Debt (top blue line), growth in the U.S money supply (orange), and the U.S. Federal Government Spending (bottom yellow line). While this graph seems to clearly illustrate the forces driving the economy, and therefore inflation, the relationships are correlation not causation. However, it does show that the dramatic increase in government spending and federal debt were financed by printing money.

Source: St. Louis Federal Reserve Fred System

Note: Money = M2 = currency, checkable deposits, traveler’s checks and savings deposits

A link to inflation needs to tie GDP growth from government stimulus to inflation. The SF Fed paper uses an innovative study to determine causality as explained in the following quote:

Though many of the pandemic distortions are common to other countries, we show that U.S. inflation has risen more quickly and increasingly diverged from inflation in other OECD (Organization for Economic Cooperation and Development) countries.

First, the authors show that inflation is clearly much higher in the U.S. than in other OECD countries. True, some OECD countries are experiencing U.S.-like inflation, however, the authors address this in the second section of the paper.

The authors then show that U.S. direct fiscal transfers were also higher than the average OECD country. (Note: I use “fiscal transfers” or “fiscal stimulus” to refer to U.S. Government spending and “monetary stimulus” to refer to Federal Reserve operations.) 

Rather than trying to track and sum all the various fiscal stimulus programs adopted round the world, the authors directly measured disposable income in each country. Many journalists and politicians have made the argument that the U.S. fiscal stimulus - $1,200 per person and $500 per child plus $600 a week for unemployment – was not enough to substantially change the finances of U.S. consumers.  However, the SF Fed data shows that this was not true.  This was substantial fiscal stimulus not seen on average in other OECD countries.  The two peaks in the U.S. data “reflect the CARES Act, signed into law on March 27, 2020, and the American Rescue Plan (ARP) Act of 2021.”

The key connection: “Did excess disposable income drive inflation?”

The authors then applied the Phillips Curve analysis to the data. Phillips Curves express inflation as a function of the unemployment rate. As the authors explain: “inflation reflects a combination of the public’s views on future inflation, inflation inertia, and how hot the economy is running.  Because the array of policy measures introduced during the pandemic to counterbalance the economic effects of lockdowns, common labor market statistics, such as the unemployment gap, are not reliable.”

The authors designed an ingenious method to measure the Phillips Curve effect: they compared inflation in countries that used aggressive stimulus measures to inflation in countries that were more passive.  “Using the Phillips Curve logic, we can reasonably compute the effect of pandemic support of measures on the inflation forecast. The idea is to compare the countries that, like the United States, introduced aggressive support measures, which we call the policy ‘active’ group, versus the less aggressive, or policy passive group before and after the pandemic.”   

Figure 3 clearly shows that inflation would have been much lower without the aggressive stimulus. The authors use Core CPI (without food and energy), which clocked in at roughly 5% at the time of their study. They predicted that the Core Inflation rate would have been roughly 2% without the stimulus.

The green shaded area displays the uncertainty around their statistical forecast.  Think of the green area as a series of bell curves with the maximum for each curve located over the green line.  The shaded area grows because the forecast becomes more uncertain as it is used to predict farther ahead in time.  Bottom line: the study shows that there is strong evidence that excessive fiscal stimulus drove the elevated inflation experienced in “aggressive” countries.

To address the persistence of today’s inflation, allow me to sneak one more SF Fed paper into the mix.  This paper, titled “Untangling Persistent versus Transitory Shocks to Inflation,” measured the persistence of inflation relative to the transitory factors.

https://www.frbsf.org/economic-research/publications/economic-letter/2022/may/untangling-persistent-versus-transitory-shocks-to-inflation/

Quote:

At the end of the data sample in March 2022, the shock volatility ratio is around 2, which means that persistent shocks to inflation are about twice as volatile as transitory shocks. This result implies that persistent shocks are the more important driver of recent inflation movements. The higher shock volatility ratio in recent data also implies that the optimal forecast should place more weight on recent elevated inflation readings, reflecting an increased likelihood that longer-run inflation has drifted up. But it is important to note that the FOMC’s decision in March 2022 to begin an “appropriate firming in the stance of monetary policy” would be expected to influence the future behavior of inflation.

 In other words, inflation is driven mainly by government spending, and it is persistent – not transitory.

Paper #2: “Comparing Past and Present Inflation,” Marijin A. Bolhuis, Judd N. L. Cramer, and Lawrence Summers.

https://www.nber.org/system/files/working_papers/w30116/w30116.pdf

The significance of this paper cannot be overstated.  First, Lawrence Summers is the Charles Elliot University Professor at Harvard.  Second, he is not a right-wing Fox News or Breitbart shill.  Summers is a true-blue Democrat. He was the Secretary of Treasury under Bill Clinton and the Director of the National Economic Council for Barak Obama. If Summers is warning about inflation, we should listen.

The paper’s introduction states:

As concerns about US inflation have grown, the Consumer Price Index (CPI) has come under closer scrutiny. The CPI grew 8.3 percent in the twelve months ending in April, down slightly from the previous month but still well above any other period since 1981. While a worrying figure, this remains far below the official March 1980 peak of 14.8 percent. That the headline number had already fallen to 2.5 percent by July 1983, following the policy decisions of Federal Reserve Board Chairman Paul Volcker, has served as the exemplum of the power of hawkish monetary policy (Goodfriend and King 2005). Since much less of a decline is needed to return to trend today, some commenters have suggested that policymakers might be able to decrease inflation towards desired levels without large macroeconomic consequences (DeLong 2022; Krugman 2022). Yet, methodological changes in the CPI over time make drawing conclusions from these types of intertemporal comparisons fraught.

The author’s findings state:

Our estimates suggest that the current inflation rate is closer to the peak of other cycles than the official CPI data suggest. …  We draw two sets of conclusions. First, our observations imply that the current inflation regime is closer to that of the late 1970s than it may at first appear. In particular, the rate of CPI disinflation engineered in the Volcker-era is significantly less when measured using today’s treatment of housing. In order to return to 2 percent core CPI today, we need nearly the same 5 percentage points of disinflation that Volcker achieved.

Note that even Larry Summers is calling out Krugman for gaslighting the American public in an NBER paper!  However, let’s focus on these frightening findings and put this work in perspective with a historic graph of interest rates and inflation.

To make sure the reader understands the importance of Summers, et. al., they are reporting that the consumer pain felt in 1980 and 1981 (when inflation was at 14%) is EQUAL to the consumer pain felt now because the 1981 inflation data needs to be adjusted for the basket of goods and services in 2022 and computational changes in measuring housing.  Once this is done, the authors conclude that the current inflation is about the same as in 1980.

As we can see from the graph above, the Fed Funds Rate, the main Federal Reserve tool for controlling economic activity, peaked at 19.1% in July 1981; inflation had peaked over a year earlier in March 1980 at 14.8%.  Basically, Volcker and the Fed needed to increase interest rates ABOVE the inflation rate for an extended period to control inflation. 

The reason? Before the Fed took control, investors could borrow at interest rates below inflation – that means that they were being paid to borrow since they were paying back with dollars that had devalued more than the interest rate they paid – in other words, they were paid to borrow.  Then investors used funds from the loans to invest in fixed assets that appreciated at the inflation rate.  This is the arbitrage that wealthy families used in Germany in the 1920s hyperinflation to become incredibly wealthy.  Savvy investors are doing the same today, that is one reason that the real estate market continues with strong positive performance.

Look at the current relationship between inflation and the Fed Funds Rate – the Consumer Price Index clocked in at 8.3% in May 2022 and updated Fed Funds are sitting at 1.5% to 1.75% (this paper was being released just as the Department of Labor released the 9.1% number for June).  As Summers and crew explain, the Fed will need to inflict some strict monetary tightening and nasty economic medicine to control the current economy.  However, the economy is not expecting the Fed to increase interest rates above 4.0%.  If 1981 serves as a guide, the Fed will need to push rates to 8% or 9%.

The risk to my 9% Fed Funds forecast is the possibility that the Fed does not need to raise interest rates above inflation because of “quantitative easing” tools.  In previous economic downturns, the Fed relied on the overnight rate to steer the economy.  However, during the Great Recession of 2008, the Fed started practicing “quantitative easing”; they bought market securities with longer maturities to inject liquidity into the economy.  This tool was especially effective in 2008 and 2020 when short-term interest rates dropped to almost zero.  Similarly, the Fed could tighten liquidity by selling these longer maturity securities.  However, that would still remove liquidity from the economy, slow economic growth, and risk a recession.

Bottom line, there is no doubt that the U.S. Federal Reserve will need to administer more monetary tightening than the market is expecting.

Paper #3: Michigan Index of Consumer Sentiment Drop Ties the Lowest Levels Ever Measured

To understand the importance of the Michigan Index of Consumer Sentiment – a graph that you are about to see - you need to understand this Gross Domestic Product (GDP) equation.

GDP = Consumption + Business Investment + Government Spending + Net Exports

Terms:                                               Contribution to GDP

C = Consumer Spending                           70%   

 I = Business Investment                         18%

G = Government Spending                      17%     

E = Export minus M = Import                  -5%

Note that Consumer Spending contributes a whopping 70% to the GDP.  When you see the Consumer Sentiment Index drop dramatically as seen in the chart below, then you know that that our economy faces some difficult times since it has nearly 4 times the weight of the next most important component of GDP. 

Source: University of Michigan Survey of Consumer Confidence

This is the statement from the University of Michigan:

The final June reading confirmed the early-June decline in consumer sentiment, settling 0.2 Index points below the preliminary reading and 14.4% below May for the lowest reading on record. Consumers across income, age, education, geographic region, political affiliation, stockholding and homeownership status all posted large declines.”

Inflation continued to be of paramount concern to consumers: 47% of consumers blamed inflation for eroding their living standards, just one point shy of the all-time high reached during the Great Recession.

Many economists and journalists react to these numbers with the hope that consumers will reach into their savings accounts and spend down savings.  Oh yeah, I haven’t posted the trend for the Personal Savings Rate, have I?

This is probably why consumers are so scared; they have already drawn down their savings.  This Personal Savings Rate graph is what led Jamie Dimon, CEO of J.P. Morgan, to predict a severe recession (an economic hurricane). We can see the two income spikes that were in the SF Fed study; the Personal Savings rate reached an unheard-of level of 33.8% in April 2020 and spiked again to roughly 26.6% in March 2021.  J.P. Morgan reported that the average personal checking account held $1,500 at the end of 2019 and that had risen to $7,500 in 2021. Now personal savings have plunged to 5.4% in May 2022.  The low was 2.1% in July 2005, so consumers have some room to go, but not much.

Now, when we consider the rest of the GDP equation, Business Investment is the only variable that has been contributing to positive economic growth.  This could change with the increases in interest rates – we have seen the fallout in the Cryptocurrency market from Crypto firms that were dependent on zero interest rate policies.  Hopefully, Crypto problems will not spread to other business sectors.

Government spending is also falling, as can be seen in the first chart.  The government is spending less as the spending for employment supplements and other COVID stimulus packages expires.

Additionally, Net Exports are also likely to be a drag on GDP growth as the Fed pushes up interest rates, the dollar has strengthened and will continue to strengthen (it just traded at par with the Euro).  This makes exports more expensive and imports cheaper, which leads to a growing trade gap and reduces GDP.    All in all, it looks like a perfect storm for the economy.  Did we mention the war in Ukraine?

Inverting Yield Curve

This is a bonus section (since it has been in the headlines recently) because an inverted yield curve is a very reliable predictor of inflation.  Investors subtract the 2 Year Treasury Yield from the 10 Year Treasury Yield to calculate the slope of the yield curve.  As of Thursday, July 14, 2022, the 2 Year was yielding 3.12% while the 10 Year yielded 2.94% for a negative 18 basis point curve inversion.  While this is not a good sign, an inversion of more than 15 basis points has a 100% accuracy record in prediction recessions.  (Recessions are the gray bars and the curve is inverted when it dips below the black horizontal line.)

Conclusions and Implications for Small Businesses

Inflation will continue at elevated levels into the foreseeable future and imperil U.S. economic growth.  This is not transitory; inflation will persist even if the inflation-adjusted economy stops growing - stagflation.  Inflation alone is enough to threaten economic growth as consumers curb spending because they need to spend more of their fixed budget on necessities.  However, the Fed’s economic medicine will most likely be more damaging since the Fed has already lost control of the economy.  The Fed will need to become much more aggressive and we are not talking about exact science with precise doses of economic medicine that will allow the Fed to safely land this economy at 2% inflation.

Conclusion 1:

Inflation is the result of financing aggressive government stimulus with growth in the money supply – printing money.  This inflation was expected, is not transitory, is not the result of the war in Ukraine, and will persist for the foreseeable future. The US printed money to finance this spending and the easy monetary policy financed the nearly uncontrolled spending – now we are paying the piper.  While monetary growth has fallen from the 12% year-over-year gains seen in 2021, it is still above average for the U.S. economy.

Implication 1 for Small Businesses:

1.      Accept inflation as the new normal for now.  Become aggressive in learning to deal with inflation.

2.      Understand the importance of pricing and expense control. 

3.      With respect to pricing, ignore the profits reported in GAAP accounting.  Prices need to be adjusted now to reflect future price increases for inventory, not when you buy inventory or equipment in the future.

Conclusion 2:

The level of inflation is as economically painful as it has ever been in modern financial history.  Those who lived through the late 1970 and early 1980s can tell you that it was a very difficult period. We are currently going through the same pain and the economic medicine needed to bring inflation down to the 2% long-term target will taste nasty.

Implication 2 for Small Business:

For the second time - get moving if you are postponing action to address inflation! Most of the probability distribution around future inflation is on the upside, as can be seen in Figure 3 from the Federal Reserve of San Francisco paper.  This means that the inflationary trend will most likely continue and there is little chance that inflation will drop dramatically in the short term.

1.      Look at your pricing options; where can you safely increase prices?

2.      Maintain good relationships with your clients, especially your biggest clients. 

3.      Use social media to communicate with your clients and potential clients.

Conclusion 3:

There will most likely be a recession and it could be one of the deeper recessions.  While the Fed correctly points out that jobs are still strong and the economy is still pressing ahead, administering the monetary medicine needed to bring inflation to 2% will be difficult and the financial markets are underestimating the doses needed to slow economic growth.

Implications for Small Business:

1.      Go for price increases now where possible.  Don’t wait for the economy to collapse.

2.      Understand your cash flow – profits don’t pay bills.  Cash pays bills. The first thing that finance and investment professionals do is tear apart the profit and loss statement to understand the future cash flow picture.

3.      Talk to your bank about a line of credit or other financings now when you don’t need it. If you can SAFELY (meaning that the amount represents a risk-adjusted small portion of your business) borrow money at a 1- or 2-year rate now to purchase inventory or other assets - buy now before prices increase further and pay the money back with dollars that are worth 5% to 10% less than today.

4.      Look at expenses to bring them in line with revenues.

5.      Eliminate unprofitable or low-margin product lines and introduce new products that diversify your income stream.

Check out the Neural Profit Engines website for more papers regarding the dangers of combining GAAP accounting and inflation.  Contact us for more insights into positioning your company to thrive in today’s chaotic business environment.

Vernon Hamilton Budinger, CFA and CAIA

Neural Profit Engines

Position Your Company to Survive through Grow

www.neuralprofitengines.com

vernon@neuralprofitengines.com

The India-China Border Conflict Summed Up in One Word: Water

June 22, 2020

The recent deadly skirmish on the India/China/Kashmir border on Monday, June 15th, has everyone talking and most pundits puzzled. If you haven’t heard, tensions along the border have risen dramatically in the last few weeks with 20 Indian deaths and additional Chinese deaths in the Galwan Valley just that one day. This conflict could become a global conflict because there is more at stake than control of a desolate, largely uninhabited patch of earth at 20,000 feet.

On Monday, according to IndiaToday, Indian soldiers on patrol found a Chinese tent pitched on Indian territory. The Indians tore the tent down but were suspicious of Chinese intentions. They then marched onto Chinese territory to check their suspicions and IndiaToday reports the Indians encountered a larger group of Chinese combat troops not regularly found in this border region and three separate brawls took place. The second brawl caused most of the casualties and lasted about 45 minutes. The Indian Military provided a picture of some of the weapons used (See below). India maintains that its military thwarted a pending invasion of the region by China.

IndiaToday  https://youtu.be/y7YNo1YyOFQ

All the pundits see this skirmish as a further escalation of complicated global political tensions resulting from China’s ongoing aggressive campaign to acquire new territory on many borders, ranging from the India/China border in the Kashmir Region to the South China Sea. However, the answer is very simple — the game is about water.

I know because I may be one of only 100 non-Chinese who has been close to the Galwan Valley. I traveled through the Aksai Chin Zone in 2010 as part of a photography trip. My journey took me from Kashgar, through the Kunlun Mountains and along the spine of the Himalayas to Lhasa, the capital of Tibet.

The Galwan Valley is located on the border of the Chinese region of Aksai Chin. I have traveled through Sub-Saharan Africa, vast reaches of Alaska and the desert southwest of the United States: I never been in a region so remote, so desolate, and so uncivilized. The region has no trees and very few plants. Most of the towns exist solely to serve truckers and are logically placed to provide fuel at strategic points. All the lodges or rooms are dirty shacks with no running water or toilets. Some of the towns serviced the Chinese Military with prostitutes and liquor. You generally had to do your daily personal business directly in an open area or open pit behind the lodging. I picked up fleas and lice. It is a very tough, demanding region.

So, why is the water in this god-forsaken region so important? South and east of the Galwan Valley lie the headwaters of the Ganges River. To the north and west lie the headwaters of the Indus River. The Siachen Glacier lies just inside the Indian-administered region of Ladakh and next to Aksai Chin and is the source of the Nubra river. Imagine the Colorado River, but instead of Colorado, Utah, Arizona, and California with some semblance of law, you have three hostile countries armed with nuclear weapons and anxious to maintain recent economic growth.

Source: BBC

Most Europeans and other folks from the Western Hemisphere are not familiar with the Siachen Glacier. Wikipedia informs us that the glacier is in the Karakoram Mountain Range, which is part of the Himalayas. Siachen is 47 miles long and is the second-longest glacier in the world’s non-polar areas. Per Wikipedia, “The Siachen Glacier lies immediately south of the great drainage divide that separates the Eurasian Plate from the Indian subcontinent.”

The Siachen Glacier system covers about 700 square kilometers when you include all its tributary glaciers. While the Siachen Glacier is the crown gem of the Karakoram Region, this entire drainage area is extensively glaciated and is sometimes called the “Third Pole.” It provides water to India, Pakistan, and the Xinjiang Autonomous Region of Western China.

https://en.wikipedia.org/wiki/Siachen_Glacier

India and Pakistan fought over this region in a conflict that started in 1984 when India captured the glacier in Operation Meghdoot. The two countries reached a ceasefire agreement in 2003. In addition, this is the region that India stripped of its special status in October 2019. India shut down the internet and phones in the region, deployed more troops to the area, and placed public figures under arrest.

India strips Kashmir of special status and divides it in two
Delhi has formally revoked the disputed state of Jammu and Kashmir's constitutional autonomy and split it into two…www.theguardian.com

The strategic importance of this region is growing because of global warming; the loss of ice in the Himalayan glaciers has doubled during 2000–2016 relative to 1975–2000 studies. However, this shrinkage is patchy and uneven. In fact, a few glaciers have been growing in size.

The glaciers in the Siachen area are shrinking much faster because of military activity. The Siachen Glacier has come under assault from the Indian Army as it builds high-altitude camps to establish a permanent military presence above 20,000 feet. Both Pakistan and India have been building base camps and training centers in the area, but India has been particularly aggressive in building bunkers by cutting and melting the glacial ice with chemicals. This shrinkage is in direct contrast to falling temperatures and expanding glaciers in the neighboring Gilgit-Baltistan region where there has been no military activity.

https://advances.sciencemag.org/content/5/6/eaav7266

https://www.thenews.com.pk/archive/print/621835-melting-of-siachen-glacier-%E2%80%94-don%E2%80%99t-blame-global-warming#:~:text=Siachen%20is%20the%20only%20Glacier,area%20and%20not%20global%20warming.&text=The%20infrastructure%2C%20including%20several%20bunkers,of%20glacial%20ice%20through%20chemicals.

It is truly amazing that Indian Forces have been so reckless with the glacier given its importance. The rivers fed by the glacier have become polluted and difficult to control as the ice melts at an accelerating rate. The troops have been firing munitions, dumping non-biodegradable waste, and dangerous chemicals into the glacier (see the Wikipedia reference above). Some estimate that the Indian Army is dumping about 1,000 kilograms (1.1 tons) trash a day on the glacier.

This conflict is about the control of water for food, energy, and the livelihood of the vast populations in South Asia. It is about the future growth of three countries with nuclear weapons. This conflict is not going away and will only escalate as China sides with Pakistan and Kashmir to acquire more water for its growing economy and its plans to mine strategic minerals in Tibet. The situation has all the ingredients to become a major armed global conflict.

https://www.indiatoday.in/india/story/exclusive-satellite-images-of-galwan-valley-clash-india-chinese-troops-in-ladakh-1689900-2020-06-17

Vernon H. Budinger, CFA, CAIA

Owner

Neural Profit Engines

Vernon@neuralprofitengines.com

www.neuralprofitengines.com