Be Asset-light and Cash Flow Efficient ahead...

We can sense the very "animal spirits" forces, coined by economist John Maynard Keynes, that once helped trigger the dot-com bubble to burst during the 2000's crisis.

The FED (Federal Reserve) has so far failed at one of its two mandates tremendously -price stability, by allowing rampant inflation while preaching it was transitory, to record levels not seen since 1981 (well over 11% if adjusted using the same measuring model of the time, then the highest inflation in history). This is mainly because it was them who caused it in the first place, by printing their way out of the 2008-09 crisis at extremely low and negative nominal federal fund rates, while bagged trillions of dollars of questionable debt. This only worsened in 2017, and by 2020, when the world's economy came to a halt due to Covid, the 'smart' solution (or so they thought) was to stimulate workers to not work at all and still get paid through government debt and other stimulus, due to a complete lockdown of the labor force and a halt of the world's economy. Some quarters after and we now deal with an inflationary catastrophe the size most of us have never experienced in our life times. Many millennials who occupy senior leadership roles today never experienced an inflation storm of this magnitude before, nor do they understand their dynamics.

The FED kept calling it "transitory inflation" so no one really asked more complex questions, just a handful of us unfortunately noticed what was going on and preached about it for well over a year now, making no difference though. The result: the FED is now so behind the inflationary wave that all they can do is either nothing at all -avoiding to upset the markets- but letting inflation destroy the middle and lower classes in America further, and for generations to come, or forcefully cooling the Economy down with a shock treatment, which this late in the game most probably translates into quickly rising rates .50bp to .75bp all they way up to 5%, while trimming its balance sheet, Paul Volcker style. This, although necessary, would dangerously push the economy into recession. The problem is that the economy won't stand 5% (it couldn't digest 3% in 2018!) addicted as it is to credit and debt. How do you let air out of a soap bubble without bursting it? What a difficult situation to be in...

You see.. at these current price levels (both consumer and producer) and with bubbles in pretty much every single asset class in our economy today -some of a size we have no experience with- record private and public debt and deficit levels, and lack of savings, along with economic sanctions that will hurt ourselves more than they will hurt Russia, the only way for the FED to resolve really, as some of us have said for well over a year now is, raising interest rates and trimming the balance sheet as quickly and meaningfully as possible. But they didn't, did they, so more than a year later here we are with historic high prices.

Why is this key and didn't require me to have a crystal ball? Somehow similar but opposite to the Law of Scarcity, Deflation is the term. The more there is of something we all have and/or want, the lower its intrinsic value, and in the case of money, its resulting purchasing power. This is why inflation is commonly coined as a "tax".

Let's chat Hospitality!

• Mortgage rates have began climbing higher quickly, even before interest rates (Federal Funds Effective Rate) actually do! and many hospitality businesses are already feeling the higher borrowing cost just like our guests are. Many having gone into business making themselves and their investors beautiful promises and setting unachievable performance milestones -borrowing was cheap after all, why bother about reality anyway, in a quest to make proformas look good. These illusions often result from Keynesian ideologies incentivized by central banks, which argue that fixing every sickness of the economy via artificially low interest rates and printing new money out of thin air, is the right treatment, often luring the economy into absorbing new debt they would not do so otherwise in a true free market where you would work with your own savings, and channels capital to the wrong asset classes (stocks for example, most specifically tech stocks of companies that still remain to prove profitable, yet saw a record increase in valuations as a result).

| By-The-Way Note | The Interest Rates we all hear and talk about on the news, are not our common mortgage or credit card rates -a common confusion among consumers. These refer to the so called Federal Funds Effective Rate. In basic terms, it is the rate at which financial or depository institutions (banks) trade federal funds, or in other words, banks deposit and borrow funds from the Central Bank at an interest. These funds are then used for things like loans and mortgages, heating or cooling the economy, along with its expansion or contraction -hence the confusion.

... as we were...

• Commercial Real Estate is promptly heading towards a bumpy road, as lending and leasing costs continue to increase and tenants begin to tap out, some probably will soon realize that demand was inflated and their business had no space in a true free market economy. Rent has gone significantly up for businesses and employees alike, along with credit card fees -something consumers greatly depend on in the US. The restaurant sector is a clear example of artificially inflated demand, via low borrowing costs, which has led to new restaurants opening left and right during the last decade. If they belong, they will survive, we will soon see.
• New hotels and restaurant projects have also already noticed a significant increase in the costs associated with construction materials, labor and FF&E, which could potentially jeopardize many projects on the books or make those already ongoing a lot more costly to keep afloat, not being able to remodel nor keep up with maintenance costs... supply-chain constrains aside. Blind-sided by the FED's "transitory inflation" rhetoric... no one thought about advancing FF&E purchases, neither provisioning capital for difficult times like these, but I hope balance sheets are lean enough at least. For many hotel operators and management companies, which exponentially grew in weight via loading their balance sheets with large numbers of real estate assets and M&A in some cases, all because low borrowing costs made it possible, this will soon prove critical.
• Almost every cost of operation has gone up, particularly in F&B and full service hotels, and we now pay significantly more for services and products we need in order to operate, and to keep our employees working too! Wages keep climbing along with benefits, and the cost of living but remain behind inflation, eating away any income before it turns into savings.
• Luxury and lifestyle hotels, restaurant and other services alike may be a temporary hedge against inflation, provided inflation remains moderate, which is no longer the case. This is due to the wealthier customers ability to cope with higher prices, and to corporate travel still having funds to spend in their current budgets, but at these levels, them too will soon start to cool down. 2023 will certainly be a much different year.
• Most businesses that lacked the economic acumen, did obviously not foresee inflation coming in this high, and therefore did not purchase and store supplies in advance at lower costs for example, or renegotiated supply agreements whenever possible, or provisioned so called 'emergency funds' (the pandemic did not make it easy either for this to be available), neither did they work on planning performance improvements for their teams, or the ability to cut expenses quickly without hurting customer service when time comes. We are often more reactive than proactive these days. A significant number of leadership positions in hospitality were filled with younger executives as a result of the rapid expansion our industry recently experienced; a generation that has never lived through nor operated businesses in a very high-price-and-constrained environment like the one unfolding, let along a recession right after a world pandemic that brought us all to our knees. If many can't understand its implications (some still don't understand inflation dynamics), how could they prepare for something they don't understand and saw coming?

This is what I refer to as the "grey pause or period": a silent yet painful transition time between a problem and its solution, when all of our operating expenses go up at the same time that borrowing costs do (renting an apartment is expensive but buying a home is too), typically, right before your customers and revenue stop coming. And just like a sudden 'Short Squeeze' destroys unhedged market investors overnight, a recession has the same effect; it just happens.

With Operating Expenses and COGS already increasing significantly as margins shrink, while the FED prepares to enact the -cool down- of our artificially-inflated economy, it only gets worse from here on before it gets better. At some profit margins that we are about to see in many hospitality asset classes, it would not be a surprise if it ends up being more productive for investors to place their capital away from volatility and hospitality and real estate, and into safer treasury bonds, at least for the next few years while things calm down again, (if they ever do). How strong will the medicine given be is up to the FED but avoiding a "hard landing" requires a level of precision and finesse the FED has repeatedly failed to show in recent opportunities.

2yr-10yr and 3mo-10yr yield spreads have already signaled recession ahead, more than once this quarter -considered the best and most precise signal that a recession follows within 6 to 11 months after; UMich's Consumer Sentiment dropping -5.4% MoM and -30% YoY! and Consumer Expectations -8.6% and -31.9% respectively; the Housing Market deflating back to reality; Used-Car Sales popping for the third month straight; ISM's Manufacturing and New Orders index growth weakening; (Manufacturing) Inventories growing sharply; Weak Q4 Earning season, most probably weak Q1 earnings ahead (Update: Netflix and JP Morgan already popped); Credit spreads in Corporate Debt (particularly C-rated bonds) getting uglier by the week; War, and nations applying economic sanctions that only hurt those who participate in the global economy... are all signaling a possible recession ahead. Is the latest Freight Truck Sales fall signaling US growth possibly in jeopardy as well? (Drops like this have been associated with recessions in the past as well). Rapid drop in unemployment does too believe it or not. The unemployed did not return to work because we asked them to or we paid them more, but because they couldn't continue to cope with such higher costs of food, rent, gas, utilities, etc.. they obviously did not prepared themselves in advance either because savings in America are mystical creatures; some would rather buy $1,000 phones. The confirmation to this would partially be if Consumer Staples and Retail like Shopify, Etsy, Amazon, Pinterest, Pinduoduo, Ebay, Paypal, etc... report missed Q1 earnings or weak guidance, for many of our former employees tried being entrepreneurs online during and after the pandemic, contributing to the coining of the term "great resignation". But history has many lessons... and the trouble ahead will catch many enslaved to financial debt and with little to no savings. The "grey pause"..., remember?

Speaking of hedging against economic storms... weeks before the famous 2000's crash or 'Dot-Com Crisis', a fairly new digital company that was selling books online at the time called Amazon, decided to sell $672 million in convertible bonds to shore up its financial position, even when credit institutions raised all sorts of concerns about such move. Just a month later, out of nowhere, the dot-com bubble burst, bankrupting more than half of all digital start ups, including many of Amazon's competitors. Had they not provisioned capital like they did (maybe unaware of what was coming), weeks before it all suddenly collapsed, they would not exist today and I would have not been able to enjoy Amazon Prime like I have!

So the golden child ahead is cash, and the questions we should all ask in hospitality should sound more like... Are we successfully hedging our businesses against the possibility of a recession in 2023, or at least, the weakening of the economy? Do we know how to? Critical questions every hospitality executive should be asking themselves right now, but I'll leave you with a quick thought that comes to mind these days particularly... Be Asset-light and Cash Flow Efficient ahead.

Interest rates increasing is a savings lesson we all need from time to time.

Disclaimer: I am not a financial advisor nor an advisor of any kind by trade and this is not financial advice, just an experienced hotelier with a passion for economics, who enjoys research and data analysis. I post my personal opinion on these topics only. Therefore, the information I share should never be observed and accepted as any type of advice, implied or not, nor used to make any financial or other decision whatsoever, as I make no warranty nor representation about the information, including its completeness, accuracy, truthfulness or reliability, and I disclaim, expressly and impliedly, all warranties of any kind, of such information I share.

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