What is the Importance of Demand Destruction?
Demand destruction, in economics, is described as a permanent or sustained decline in the demand for a particular good. The decline in demand is a result of persistently high prices or limited supply of a certain good. Due to persistently high prices, consumers may reduce their purchases of such goods or try and find alternatives as substitutes. Demand destruction has most often been associated with energy commodities and related goods. For example, persistently high gasoline prices can induce consumers to purchase smaller, more gas-efficient cars or switch entirely to electric vehicles.
Today, demand destruction applies to more than just gasoline prices. As you may recall from our last newsletter:
“Free Money:
The majority of citizens who had never lost a job during the pandemic, received two tax-free stimulus checks in the first few months of 2021. This created one of the greatest booms the world had ever seen. This second round of stimulus in 2021 was like pouring gasoline on a fire. So, free money was either spent, invested, or speculated on with meme stocks (shared investing idea imitated by others). During the year, we saw each of these actions play out with a rippling effect across the economy and markets.”
Simply stated, the demand created by “free money” outstripped the supply for many goods, not just oil. There were/are other policies that have impacted pricing: government policies that have hampered drilling and transportation of oil; the Ukraine/Russia war has contributed to not only oil price rises, but food prices and shortages as well; baby formula shortages; the Chinese zero-Covid policy has virtually shut down an important source of many products; and our own restrictive and/or regulatory policies have contributed to shipping and supply chain issues.
Inflation and Demand Destruction.
In spite of undeniable inflationary evidence in our economy in 2021, the Federal Reserve (FED) continued calling inflation transitory. Now in 2022, the FED has admitted that inflation was/is persistent, they must try and fix it. There will be financial stress because it became clear interest rates had/have to rise.
The FED had decisions to make. They had two paths, only one of which could be followed. They would either favor economic growth or fight inflation. They cannot do both, and each has unpleasant consequences. If economic growth is the path, the FED would keep interest rates low and keep the liquidity spigots (quantitative easing – buying bonds which adds liquidity to the system) turned on. This would keep bailing out the markets and zombie companies – but do nothing to combat inflation. Long-term inflation is not a positive for economic growth and, it can foment civil unrest. The consumers who are considered in the 1% would keep benefiting but those hurt the most are the middle class and lower income people (considered about 40% of our population).
The second path is to make attacking inflation their primary goal – doing whatever it takes to bring down inflation. This would include “breaking” the markets and economy if necessary. This path forward meant raising interest rates, removing liquidity from the system by instituting quantitative tightening (selling bonds to reduce the supply of money in the economy), and trying to create demand destruction. The FED cannot do much about supply constraints, but it can do something about demand. Many bubbles have been created over the last 14 or so years – housing, autos, art and of course the financial markets. The stock and bond markets had risen to historically high valuations and in turn created a wealth affect – consumers feel richer and so spend their gains. To create demand destruction, the FED needs to force the markets to go down to create the reverse wealth affect – stop buying. Bill Dudley, the former President of the Federal Reserve of New York, pretty much said this in a Bloomberg TV interview a few months ago.
So, the markets have responded in kind, so far. As you may or may not know, the first half of 2022 saw all financial asset classes (except commodities) decline. The S&P 500 is off to one of its worst starts ever. The bond market is seeing a historical decline in prices (yields increase). We believe the FED is committed to bringing down inflation. The way forward is to do damage to the economy (demand destruction, company profit margin squeezes, and possibly recession). That is the only way the FED can back-off their interest rate tightening policy. Our hope is that they will not go to far and “break” something. Our hope is that the downturn is mild. The silver lining is that finally, good value is being created. We have discussed this for a few years, and frankly had thought something would have happened much sooner to bring valuations everywhere back in line. Going forward, with patience, we are ever optimistic that this will allow us to put money to work, as valuations warrant.
We appreciate and thank you for the trust and confidence you have placed in Occam Capital® Management, LLC.