Supply Chain Venture Capital in a High Interest Rate Environment

Overview

A topic of growing prominence inside Dynamo is the high interest rate environment we will be investing and operating in for the foreseeable future. We have reflected on the impact a higher rate environment has on labor markets, consumer and business savings and spending, as well as the broader credit markets. Combined, we then reflect upon its impact on the supply chain and how we think about pre-seed and seed investment.

It is fair to say that this article represents a snapshot of the data readily available to us at the time of writing in mid-October 2023, and our views are likely to evolve as more information becomes known.

Background

Following massive influx of supply side capital to support the economy during the COVID-19 pandemic, the US Federal Reserve (the Fed) has been battling with inflation for the last 24 months.  Many argue that the Fed reacted too slowly which has led to them increasing the Federal Funds Rate (FFR) 11 times since March 2022 to its current rate of 5.50%, that is the highest it has been since 2001.  The general sentiment is that rates are getting close to their peak, but what is unknown is when they are likely to decline and how quickly.

While the Fed has been pumping the brakes, policy makers have had their fiscal foot on the accelerator. Fiscal policy has seen >$5.5T of stimulus enter the system via the COVID-19 Relief Programs, the CHIPS Act, IRA, student debt relief, and various other social programs. These diametrically opposed positions have muddied the water and certainly made it more challenging to dampen demand and inflation.

While we appreciate that the Consumer Price Index (“CPI”) (inclusive of food and energy) is a more realistic measure of cost of living for everyday citizens, the Fed focuses primarily on Personal Consumption Expenditures (“PCE”) reading (exclusive of food and energy) with CPI as a supplement when it determines monetary policy. CPI in the US has increased significantly over the last 36 months, reaching a 41-year high of 9.1% in June 2022. This is the highest inflation rate since December 1981. It has since declined to 3.7% in Sept 2023, but there is a material risk that the rate of decline slows (or flatlines) as the Fed targets bringing inflation back down to a rate of 2%.

And let’s be clear, inflation as it pertains to the consumer (CPI) is not under control. The Fed’s aim with raising interest rates is to reduce demand for goods in order to dampen inflation. This in turn will slow economic growth. To be explicit, this means causing people to buy fewer cars, spend less on our credit cards, and to build fewer factories.

Consumer Savings & Interest Income

We will first focus on the impact of higher rates on the consumer who is the locus of demand for supply chains. Increased rates flow through to consumer credit products with floating rates - credit cards, auto loans, and certain mortgages and home equity lines. On the flip side, deposit accounts are also yielding higher rates (consider Vanguard Money Markets are generating APRs of >5%.) However, as can be seen below, household interest payments as a percentage of interest income are at their highest level since 1959 with an enormous spike in the 18 months.

Source: Apollo Global’s Academy

Alongside this, auto loan rates from commercial banks have similarly spiked to their highest level since 2008.  This will clearly have an impact on the sale of new vehicles and potentially EVs (that are ordinarily more expensive than the average vehicle) and therefore the recently reshored battery supply chains that have emerged following the Inflation Reduction Act.

Source: Apollo Global’s Academy

In parallel to the rapidly accelerating cost of credit for consumers it is worth highlighting the massive decline in excess savings that were accumulated during the pandemic by US households, as can be seen below.  These excess savings might help to explain why spending and inflation has been prolonged and difficult to get a handle on.

Source: Apollo Global’s Academy

Finally, student loan payments restarted on October 1st, 2023 which will affect half of the 44M people who currently have loans, with an average loan payment of $200 per month.  This will subtract roughly $5B from consumer spending every month, or roughly $60B a year. This again further reduces overall consumer spending alongside all the factors described above.

Labor Markets

Another major factor that has a material influence on inflation and interest rates is the labor market for which there have been several contradicting factors.  As can be seen below, there has been an increase in the percentage of permanent job losses since the increase in interest rates.

Source: Apollo Global’s Academy

However, contrary to popular belief, immigration continues to increase with the number of foreigners in the labor force increasing by more than 3M since April 2020.  

Source: Apollo Global’s Academy

Also contradicting the job loss report, the most recent employment numbers from the September jobs report saw an increase in jobs by 336k and the jobs numbers for July and August were revised upwards by 119k which goes against the norm where previous revisions are typically downwards. We note that the underlying labor participation rate has also been relatively constant.

Lending & Credit Spreads

The cost of capital has not just affected consumer loans, but it is also feeding through to businesses in two key ways: 1) a rationalization of capex and 2) increasing working capital costs that are inherently inflationary as they tend to be passed on to buyers.

As can be seen below, there has been a gradual slowdown in capex spending since the Fed started increasing rates. We have also heard corporates including Pitney Bowes and FedEx making remarks that financial officers are limiting capex as they recalibrate hurdle rates inside of their corporate budgeting processes. 

Source: Apollo Global’s Academy

Additionally, at our annual “Hub + Spoke” event, about one-third of the 20 corporates in attendance voluntarily remarked at how their opex is under scrutiny and they’re in a world of “margin preservation” for the foreseeable future. In the same breath, it was noted that leadership teams are open to major technology investment that can help deliver this. We noted that privately held businesses have less of a “whipsaw”.  They are instead able to invest consistently in capex and opex as their investors have a longer time horizon and are less worried about the vagaries of trading in public markets.

Moving ahead, when thinking about lending, what is less obvious is the impact the SVB (and First Republic) crisis has also had on the credit spread for lending over the last 6 months.  As you will note, since the SVB crisis, underlying credit spreads are up approximately 100 basis points.

Source: Apollo Global’s Academy

As identified below, the combined squeeze on interest rates with the increase in the credit spread, has led to bank lending growth to rapidly slow since the SVB crisis.  According to Goldman Sachs, during 2024, corporate debt of $790B will mature and a further $1.07T in 2025. Most of this debt was financed at rates well below the current market rates. 

Source: Apollo Global’s Academy

The bottom line is that even if the Fed choses to reduce the base rate, it doesn’t control credit spreads and the cost of capital in the commercial environment. This is trickling into higher costs of working capital which we see part-and-parcel to supply chain operations. Ironically, this will perpetuate inflation as cost increases are passed on to the end buyer.

So What Does This Mean For Our Investment Approach?

While there’s early signs that the demand-side might be slowing as warehouse rates are creeping up, last mile carriers are cutting shipping fees, and holiday staffing demand is lower than in prior years. Contrary to that, there is some buoyancy with unemployment numbers still coming in lower. 

We also note that 2024 is an election year in the US which further complicates matters. The incumbent party will not want to see higher unemployment and lower economic growth on their watch (or at least until after the election). This uncertainty is likely to push a prudent Fed into squeezing the brakes on the economy further by increasing interest rates again before the end of the year with no obvious signs when a reduction of interest rates is likely to happen. We’d guess that there could be a further 25 bp increase in the FFR next year.

It is simply not clear that inflation is under control and with some many different factors at work, we do not see a “soft landing” as likely to manifest. We believe 2025 is likely to bring a “hard landing” to bear with the Fed remaining more sensitive to inflation requiring a hawkish stance for longer than most expect.

In light of the above, things we’re being mindful of going into 2024 with dry powder:

• Consumer demand is going to weaken over the next 12-18 months before it gets stronger. While eCommerce sales as a percentage of retail sales is increasing, this is part of a longer term secular shift away from offline retail and less about growth or robustness of consumer spending. Both startups and investors need to be thoughtful about the exposure they have to the consumer and how they compete to take share in a market with stagnating volumes
• “Nice to have” technologies (aka vitamins) will make way for “mission critical” solutions (aka painkillers) with a particular focus on those which can deliver cost reductions and increased productivity in relatively short periods of time
• Teams who can stay “lean-and-mean” while finding product/market fit will be sought after. With the bar higher for Series A-eligible companies, this is especially important given that seed rounds sizes are unchanged at $3-3.5M according to recent data from Carta - one must do more with the same resources
• Solutions that require significant upfront investment and longer payback periods will be delayed until more favorable conditions with lower cost of capital. This is likely to lead to a slowdown in the implementation of industrial automation (robots) particularly if there is an increase in unemployment and greater availability of labor in the short to medium term. Note that several large retailers and 3PLs in our network are pausing robot purchases for the next two-to-three quarters as directed by the CFO
• Market conditions are also likely to lead startups to expanding their “middleware” footprint to one that is more of a “full stack” approach. B2B customers will be more inclined to adopt a solution that is “plug and play” and does not require significant engineering time to implement but delivers tangible results quickly. This will also result in business models that might have a bit more “hair” on them than the traditional SaaS businesses VCs are predisposed towards
• While there is significant hype around GenAI in venture capital today, we believe that its timeliness in an economic environment where cost reductions will be sought after will accelerate its adoption.  This will be most evident in functions such customer service, sales and office support which are not specific to supply chain solutions.  However, we have started to see GenAI being developed in a “full stack” format for specific industry verticals to help accelerate its adoption. Listen to our one of our recent podcast episodes with Steve Sloane of Menlo Ventures on the subject of using GenAI for internal operations
• Investment in climate technologies does appear to be slowing with later stage investors wanting more commercial traction - namely, LOIs before investing large sums.  However, we do have concerns whether potential customers will defer spending in this sector during a recession when cost savings remain important.  This is more likely to be applicable in the US versus Europe where climate technologies are being prioritized. One major cold chain logistics provider told us their investments are largely focused on efficiencies barring California and Europe where they are deploying meaningful sums of capital in sustainability given the incentives and penalties, respectively
• It is widely accepted that climate solutions are a massive opportunity in the medium to longer term, however, these startups might struggle to find business use cases in the short term that will bridge them to these larger markets in the longer term.  For those startups who have exposure to technologies supported by supply side subsidies of the Inflation Reduction Act this might not be an issue. We also have heard some investors suggest the idea of “green subsidies” around certain lending products which were previously less meaningful given the low interest rate regime we are in
• We note that the venture markets are markedly different from years prior where rounds do not “just happen” as they seemed in 2020 and 2021. Instead, both seed and Series A investors are requiring businesses to demonstrate meaningful revenue traction with the latter also once again pressure testing: the repeatability and scalability of sales, the feasibility of raising follow-on capital, and better charting a path to building a durable business model
• Lastly, a high rate environment resets valuations across asset classes. With a new fund, the general statement people make is that “there’s no better time to have capital to invest.” While this is true, we have not seen seed valuations meaningfully reset and will continue to prioritize pre-seed where we think: 1) there is an attractive risk/reward profile and 2) ability to build strong ownership to the tune of 12-15%. Equally, this allows us to remain pragmatic in our underwriting that does not rely on unicorn-type outcomes to “return the fund”.