Unstable Market Factors
Schleifer’s Laws of Market Dynamics
Contractors Thrive During Stable Markets
There is No Such Thing as a Stable Construction Market
Only Profitable Growth is Good
Inflation Murders Contractor Profitability
Construction is the only industry that cannot pass down inflationary pressures to the consumer. Construction services are priced in advance and fixed by contract. No other industry is constrained in exactly the same way. If the cost of wholesale food commodities goes up dramatically over time, restaurants simply raise menu prices and everyone complains about the government or the Federal Reserve. However, the bottom line is protected unless and until the inflation is so persistent or dramatic that people postpone restaurant dining.
For contractors, however, inflation is murder. Our services are priced in advance and fixed by contract. We deliver them and incur attendant costs over an extended period, often a year or more. If, during the buildout period, costs go up we have no way to adjust our selling price. The rate of inflation over the job period comes directly out of our pockets. If the inflation rate is steep and persists over the entire life of the project, the loss that a construction firm incurs could be substantial and perhaps deadly.
Inflation? What’s That?
Most of today’s construction professionals have never experienced serious inflation. They’ve heard the word inflation but have never actually seen the real thing because our economy has experienced almost 30 years of Fed-induced stability. In 1990, U.S. inflation hovered around 5 1/2%. By 1992, however, it settled back to 3% and remained around 3 to 3 1/2% until the Great Recession of 2009 where it actually dipped for a moment into negative territory before recovering to around 2% ever since. In other words, you’d have to go back more than 30 years to experience any meaningful inflation.
The 1970s – Now That’s Inflation!
In the 1950s baseline inflation was 1 – 2 %. In the 1960s economic growth was weak, which resulted in rising unemployment that eventually reached double-digits. The American central bank launched a period of easy-money policies designed to generate full employment that quickly resulted in high inflation. (Remind you of anything?) Baseline inflation in the 1960s was 4 to 5% and by the early 70s was approximately 9-10% with two periods spiking up to 12.2% and 13.3% respectively. Now that’s inflation.
2021/22 – Could be Our First Taste
In the spring of 2020, the Fed unleashed easy-money stimulus that looked a lot like the policies of the late 60s: a $120 billion per month bond-buying program designed to keep borrowing costs low and help consumers and businesses weather the economic storm. This program, and other relief measures introduced by the government, are credited with keeping the economy afloat and spurring a faster-than-expected economic recovery. At the same time, this new monetary policy tool coupled with supply chain snags and pent-up COVID-19 consumer demand is credited with causing the inflationary spike we are currently experiencing. In September, consumer prices grew by 4.4% annually, compared to the Fed’s 2% target. U.S. gas prices averaged $3.40/gallon last week, up from $2.14 a year ago. Food and energy spiking? Sounds just like the 70s.
At the beginning of the year the Fed predicted no real inflation in 2021 because of the COVID-19 recovery – STRIKE ONE!
Now the Fed is saying that this inflationary spike won’t last long. It will settle out as soon as markets return to normal – STRIKE TWO?
Contractors cannot wait to see if the Fed strikes out. With inflation already nipping away at our heels, we must begin to take market stabilization measures.
1. Bid only on work that you already have the capital and the skilled labor to complete on time and on budget. Now is not the time to overextend yourself hoping that a big bump in revenues will somehow magically produce profit.
2. Negotiate – negotiate – negotiate. Negotiate every contract. During periods of high or extended inflation, if at all possible, every contract should have some allowance for increased costs that cannot be accounted for at signing. Owners and their lawyers will resist but do not relent.
3. Do not fall in love with your suppliers. During times of cost inflation shop, shop, shop. Learn to hedge some materials by either going long or utilizing real-time inventory techniques to hedge costs as they begin to taper.
4. If you cannot formulate bids that hedge continued cost inflation effectively, go to a zero-growth policy. Zero growth does not mean no growth. It means only grow at the rate your firm is already comfortable with.
Next week we will discuss the current serious shortage of skilled labor. See you then.
For more information on inflation, read more at: https://simplarfoundation.org/?s=inflation
For a broader view on the construction market cycles, read more here: https://simplarfoundation.org/?s=markets
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