When Something Seems Too Good To Be True It Usually Is

​I remember around the middle of last year, Gorilla Post Production, the company that I founded in 2009, hit an extremely busy period. It was by far the busiest period we’d ever had in 13 years since we started. In the final two quarters of 2021 our revenue almost doubled compared to the same period a year earlier, and was 35% higher compared to the same period in 2019 before the pandemic. Over all, our revenue in 2021 and 2022 will be roughly 25% above pre pandemic levels on an annualised basis. 

Like so many other businesses in recent years, demand for our services skyrocketed. While our costs increased significantly, higher volume ensured we remained profitable. The past two years will be our best by far by any measure in over a decade. And that’s what has me worried. 
 
I wrote here in January and discussed in my first podcast that despite impressive economic growth for most developed countries since 2021, I felt that the rebound was temporary and would precede another downturn. The sudden surge in consumer demand was bound to be short-lived, as was the historic level of government spending and provision of subsidies. Abnormal profits and soaring share values were just some of the tell-tell signs of a classic bubble. Over-hiring and obscene wage demands in some cases reflected the irrational exuberance that often accompanies an overheating economy. The laws of diminishing returns are rarely betrayed, however, and so it came to pass in recent weeks. The mass redundancies in Big Tech is an astonishing case of misjudgement of the economy by some of the brightest minds in business.
 
Aside from falling profitability, share values in these large tech companies have come under severe pressure since inflation and higher interest rates. When interest rates are low, the cost of capital falls and stocks rise. When the tide turns, higher interest rates reduce investment and drag down share values. Tech equities and risk assets such as Crypto are first in the firing line.
 
But even in my own line of work, in the TV and film industries, streamers have started downsizing and are turning to ad revenue in a desperate bid to tackle rising costs and boost share values. Post lockdown demand for content has significantly fallen from its high in 2020 leaving a glut in expensive programming and fewer subscribers. In an increasingly competitive market, and in an environment with higher interest rates, a reduction in spend is the obvious response. Investors now expect film studios to provide more value added to their consumers and a higher return on capital. The race for content in the ‘golden age of television’ has likely come to an end.
 
While equity markets rebounded on the back of a 0.5% monthly fall in inflation between September and October of this year, rate hikes are far from over. Speculators beware. Monetary policy will remain tight until central banks believe inflation is on a sustained downwards trajectory towards their 2% targets. At best the Fed will pause indefinitely at the so-called "terminal rate" of around 5% next year to keep inflation at bay. While not overly restrictive by historical means, 5% is still a significant jump bearing in mind, for instance, that mortgages could get re-priced at 7% or 8% after factoring in bank margins. Pivoting too soon, though, would be a huge mistake by central banks which history  reminds us of. 
 
In 1974 US inflation and interest rates hit 11.04% and 10.51%, respectively. The following year the Fed reduced rates to 5.81% thinking inflation was under control but by 1980 it had jumped even higher to 13.5%. Soon afterwards Paul Volcker, the then chairman of the Federal Reserve, quipped, “even a little inflation is still too much inflation.” In 1981 he took no chances and raised interest rates to 18% which eventually crushed prices and caused a deep recession.
 
Jerome Powell makes no secret of being a huge fan of Volcker’s and has regularly signalled to markets that rates will keep rising until “we get the job done.” Getting the job done means a considerable cooling down of labour markets and causing a rise in unemployment. Incidentally, there has never been a time when inflation has fallen back to target without a recession.
 
The ECB announced this week too that it would continue raising interest rates despite worsening economic conditions in the Eurozone. Average inflation is currently 10.7%, much higher than the US reflecting the Euro’s relative weakness against the dollar and higher gas prices. Reducing inflation to 2% will require even tougher decisions by the ECB. The deposit rate at the ECB is still only 1.5%.
 
While real wages adjusted for inflation have fallen over the past 12 months, demand for everyday goods and services has remained extremely robust. Although no one likes it, most consumers will put up with a few extra euro added to their grocery bills each week or 5 cents to their cappuccinos. The real pain will come from higher mortgage repayments which are inevitably coming.
 
The OECD estimates that Ireland’s economy will grow at less than 0.9% in 2023 and 2024. This compares to 5% forecasted for 2022 and 15% in 2021. This is a significant fall in economic output despite the strength of our multinational sector. Indeed, a general fall in corporate earnings is now likely the next phase in the economic cycle, meaning further pull backs in stock markets and rising unemployment over the next 2 years. For bullish investors hoping that the end of 2022 is a ‘buy the dip’ moment, the reality is it's probably not.
 
I came across an interview with Robert De Niro the other night when scrolling through YouTube. In it he says “when things are going well just be calm. Don’t think you’re on top of the world and don’t get ahead of yourself. No one is indispensable.” I immediately thought of Ellon Musk and the recent chaos in Big Tech. I also thought of my own business. When something seems too good to be true it usually is. Buckle up. Leaner times are ahead.