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Stephen Miles' Annual Client Letter | January 2023

How to Thrive Through the Impending Global Recession and Systemic Inflation

Dear Clients:

The first question on most CEOs’ minds for 2023 is not ‘if’ but ‘when’ the global economy will enter into a recession.

As the new year begins, many signs remain surprisingly robust (e.g., unemployment, wage growth, spending, etc.), extending the bullish run further into 2023. It turns out working through more than ten trillion dollars dumped into the global economy takes a lot of work, and we are still in the process of doing so. The stock market, experiencing one of its greatest bull runs, has deep positive confirmatory bias built into it. As such, it is always looking for a shred of positive news to move upward, even when the road signs suggest it should be doing something different. But there will come a time in the coming year when the market’s positive confirmatory bias turns to negative confirmatory bias, and the end of the cycle will be upon us, revealing many ‘genius investors’ were just buoyed by an extended bull market rally.

For CEOs, rather than hunker down, which some will try and likely not survive, a recession can be an opportunity to thrive.

Most CEOs responded very well to the shock of inflation and the movement away from cheap money and the deflationary world, where many things continued to decrease rather than everything increasing. The best reacted quickly and moved pricing out of sales and marketing and into the CFO function, where there was capability to do the hard work of increasing prices. Those who were on the front foot took price early and continued to take price, as their business models absorbed the shock of inflation.
Those who were slower to act fell behind on pricing, in denial that it was not transitory. The ‘wait and see’ approach led to deep margin erosion and embarrassing levels of inventory buildup, as demand decreased while the most sensitive consumers doubled down on gas and food and moved away from merchandise.

The challenge now for many CEOs is dealing with the systemic cycle of inflation, rather than reacting to the initial shock. The effects have not yet been felt all the way up the food chain, and consumers at the top are still spending like drunken sailors, with little evidence of an end in sight.

However, it is coming, and when it comes, it will hit hard. In a systemic inflationary world, the big question is whether we enter a phase of stagflation, where we have low or no growth combined with continued price increases (e.g., Japan in the 1980s).

The crystal ball for most CEOs is blurry or nonexistent, so the companies that do thrive through the next phase of the cycle will be those that see this as an opportunity to differentiate and win. They will do this by being more flexible and agile than their flat-footed competitors, enabling them to respond to setbacks rather than be knocked down by them.

1. The Shift from a Potential-driven World to a Performance-driven World

The move to a performance- rather than potential-driven world is no more acute than in the technology sector. On an uninterrupted 21-year run, it has brought many of its founders and CEOs cult-like status for having the Midas touch, the ability to turn nothing into gold overnight. In fact, through the lens of historical business building, it has been even faster than overnight, as there are so many unicorn companies with little prospect of profitability anytime soon. They received unlimited venture funds at valuations that still would not make sense after colonizing Mars! This is not specific to one or two unicorn companies, there are herds of unicorns with immense valuations. What is different from 2001 is that there were far fewer unicorns and the funding cycle was a lot shorter then, so they were mostly ‘miniature unicorns.’ This time around the funding has been much longer and the money funding them has gotten a lot dumber, driving up valuations to levels most rational people cannot fathom. It is going to be a longer and more painful death for them as we move into a performance-driven world that is less interested in moon shots, if they do not have some sort of return on investment in a measurable period of time.

The actual tech reckoning is ahead of us, not behind us, as more and more companies look in the mirror and acknowledge they will never be profitable and their business model cannot sustain them going forward. This will also reveal the degree of dumb money that literally chased unicorns using FOMO as their due diligence, rather than understanding the fundamentals of the actual businesses.

The FTX fraud is a perfect early example of dumb money and FOMO-driven investing, where large checks were written without any due diligence. Get ready for a steady stream of down rounds and the recalculation of valuations through the lens of performance and not unlimited potential.

Elon Musk is running an experiment at Twitter for everyone to see on how few people he can have to run the company and many tech founders/CEOs are watching with a high level of intensity hoping the experiment works. There is an even larger force at work that will continue the trend of tech companies moving from a potential-driven world of hiring as many people as possible to a performance-driven world where they are focused on fewer people, who are considered ’higher density’ talent, combined with massive advancements in AI. You just have to go to chat.openai.com to quickly understand the power AI will have in the future.

This may prove another superior time for some founders and CEOs to thrive and differentiate, even as the ground is moving around them. When there is hardship and scarcity it almost always leads to invention and innovation. We will likely see many CEOs take advantage of this new world for tech and grow rather than stagnate.

2. Regulatory Focus and Enforcement

Technology and the rest of industry have a new foe, and that foe is regulation. We have experienced a period of more than 20 years of light to moderate regulation as the United States was anti-regulation and the European Union (EU) did not have a regulatory partner for a while. That has now changed, and the administration has assembled a dream team for regulation. It is likely they will lock arms with their partners in the EU and start coming after big technology for their monopolistic enterprises and block as many mergers as possible, using every weapon they have.

Many CEOs have never experienced this level of scrutiny and aggressiveness. To see something as stifling to one’s business model, look at what it was like for Microsoft when they were charged by the DOJ in the 1990s. We are likely to see a lot more action on the regulatory front across all industries in the coming year, and beyond.

3. The Decoupling of China

This is one of the biggest stories out there, and it will have massive reverberations for the global economy for years and years to come. The combination of supply chain restraints and China entering into a new phase of aggressive posturing on the global stage has sent a flare up for many global CEOs who have people and operations in China. The Covid-19 pandemic revealed how fragile the global supply chain really was and how much we had traded accessible, durable, and multi-source for global, low-friction, and single- source. It was an alarm bell for CEOs around the world when defense contractors could not build military weapons because their supply chains were shut down due to Covid-19 restrictions. The resulting actions of moving to local and dual source are deeply painful, very hard, and very expensive, and it will put a continued acute inflationary element into the world. We are moving from 30+ years of lower cost and deflation to higher cost and inflation, and we are all going to bear that price for years to come.

Even bigger of a concern with China has been their Covid-Zero policy and strict lockdowns across the country, causing supply chains and the ports that move goods to come to a grinding halt. Now that China has changed its Covid-Zero stance, many CEOs have still developed strategies to deemphasize China in their global supply chains, moving their Southeast Asian headquarters to places like Singapore and moving more production into places like Vietnam and Thailand. This is not an easy light switch fix, and it will take years and years to play out given how central China has become in the global supply chain around the world.

China’s continued aggressive stance in the South China Sea combined with a publicly stated desire to take back Taiwan, which they simply view as a territory that needs to come back closer, is putting China and much of the rest of the Western world on a collision course that could have massive reverberations for the global economy and the world order. The benefit of the past 30+ years of increasingly global supply chains with low friction was that it was a tool to bring the world closer and avoid any escalations of tension. As we head more into a world where countries are defined as ‘good acting’ and ‘bad acting,’ we are losing the peace effects of the previous model and heading into a world where conflict is much more likely.

4. Energy Transition and its Implications

The front pages of most newspapers in the Western world feature stories covering the need for faster, more aggressive energy transition. This means moving away from fossil fuels to a greener future using renewables. It also means – more than likely – the return of nuclear power, highly controversial but one of the only fuel sources that has the capacity and technology to power a world thirsty for more and more power without using fossil fuels.

The ‘Catch-22’ with government leaders is that they have moved away from any form of compromise or transition, and everything is now ‘all or nothing.’ Unfortunately to do what needs to be done, we need an energy transition strategy, and this takes time and compromise. If governments go down the path of aggressively deemphasizing certain forms of energy, we will be out of business before we even begin, as food and heat will become too expensive. Deemphasizing ahead of implementing an energy solution will eliminate the very industries we need for the future.

Wind turbines are an example. Blades and solar panels come from the chemical industry, thus the chemical industry needs a cheap supply of energy in order to make the things we need in the future for a successful energy transition. If we wipe out natural gas or make it so expensive that businesses are not viable, there is no energy transition. Europe is the singular test of this right now, as the cost of gas is so high that most heavy manufacturing companies do not have a viable business model. The question is how will they respond, and the answer is most likely in ever-increasing prices and more inflation. Or they will have to move closer to cheap sources of fuel, something that takes years and has huge country-level implications.

Another concern of CEOs, which no one seems to be writing about, is not the cost of oil, but the availability of the most important fuel source on the planet: diesel fuel. The world runs on diesel, and we have a shortage that is going to drive up the price of just about everything, as you cannot move anything anywhere without being reliant on diesel. In North America, the cost of diesel continues to rise and there are expected shortages on the East Coast. During the Covid-19 pandemic, the United States took out critical refining capacity, and when the world came back to life, that refining capacity was not added back, leading to diesel constraints and likely shortages (unless demand precipitously falls putting the supply-demand equation back in better balance).

5. ESG: Navigating Divided Governments using the Legal System to Drive Policy

A topic of great interest for many global CEOs is how to work with governments at the federal and local levels to advance legislation. The era of political parties working together towards a greater good for the population and economy is over, and now governments are deeply divided. They brand themselves on how divided and oppositional they are from their counterparties, making it nearly impossible to drive forward bi-partisan policy and legislation. The very serious joke for many CEOs in the United States is that they can be called to one part of government to be grilled about why they are worried about the environment and ESG, then the next day be called to testify in a different part of the government and be grilled about why they are not doing enough for the environment and ESG! To drive policy, many CEOs are reverting to the least efficient way to do so, using the legal system. In a divided government, the path of last resort involves the courts and using the court system to drive policy because compromise is impossible in the legislature. The key for CEOs is to form coalitions, use industry associations when they can, and look for precedent-setting cases to draw battle lines to drive policy formation.

6. The Role of the Office and the Future of Work: Employer-Employee Power Dynamics

The role of the office has been a much-debated topic with camps forming on both sides of the argument. Much of the financial services industry came out early and strong, stating that they are an office-based employer and much of their culture and learning happens in the office. Therefore, their default will be the office.

Many technology companies came out on the other side, with CEOs publicly stating that their default will be virtual, with the office becoming less relevant and even obsolete. The underpinnings for much of the work from home (WFH) argument were based on experience from the Covid-19 pandemic. To the surprise of most CEOs, that transition to virtual leadership went far better than anyone would have predicted. Most employers did not miss a beat and in fact for many it was a positive event that accelerated their business model and demonstrated how much and how fast things could get done when everyone was mobilized and prioritized.

Today, the conversation around the role of the office has begun to change for many CEOs, including those in technology who are suggesting that they underestimated how important in-person time and work was to performance management, relationship building, learning on the job, and most importantly, just getting work done efficiently. As one technology CEO said:

“We have developed thousands of processes for being in the virtual world that actually make it harder to do your job. If we were together in the office, we would not need most of these processes. We have moved from GSD (getting stuff done) to activity-based leadership, which is in service to all the processes and negatively impacts getting actual work done.”

Many CEOs have leadership team members who are exhausted and speaking of never working so hard in their careers, yet they are well off plan. There is a huge disconnect between the work that needs to get done and the processes and activities that stand in the way of getting that work done.

We have spent so long out of the office that WFH has become the ‘new normal’ for many non-frontline employees, and their expectation is that this will continue. One major North American airline CEO came out saying that ‘every weekend is now a long weekend,’ and they are seeing demand for travel continuing and outside of specific occasions and holidays for people. Companies have backed into the four-day work week and are now struggling to figure out a path forward. The historically tight labor market has exacerbated this phenomenon with employees having more power than they have historically ever had, and many are taking advantage of this power by switching jobs while only dressing from the waist up. Many CEOs have also inadvertently built deeply distributed leadership teams through the pandemic, allowing new hires to work from anywhere versus locating in a central headquarters, making the notion of ‘team’ that much harder to actualize.

As we move into a post-pandemic world that is brutal, and much harder than the pandemic, it is going to test many of the theories of virtual work, distributed leadership teams, and the role of the office, like nothing before. Our prediction is that in-person work and more co-location will have very high value for many CEOs. This will be easier and made possible by the shift back in the employer- employee balance of power in favor of the employer, and through a recessionary environment that will start with larger reductions in force. This has already been happening but more in a stealth manner, as American employers had more than 8M open positions. This capacity is being taken out of the system at an accelerated rate. Once it hits zero, we will start to see more and more layoffs of actual people, versus not filling open positions – witness Amazon’s unprecedented recent reduction-in-force.

The first step in getting the post-pandemic office up and running a few days a week is to reserve the office for in-person work instead of another place to commute to in order to sit in on a video. Many CEOs are referring to these in- office days as ‘Density Days,’ and they are intentionally ensuring that the company gets the right teams in the building. The office becomes a place to do the hard things, to edit lots of ideas into the best idea, to engage in idea conflict and tension through problem solving, to work through a business or functional review or specific milestone events. It is a place to build relationships and trust and engage in the development and growth of executives, from the intern to the CEO. It is also a place to manage performance, ensuring the company is the best in the people business. Many CEOs realize that over the course of the pure WFH years little or no performance management has happened, and even less investment and development of people has occurred. This is a trend that must be reversed, while still maintaining some employee flexibility.

7. Cyber Concerns

Cyber risk has always been a deep-seated fear of CEOs and boards of directors, as experts in the space advise that every company will experience a major cyber challenge. The separation of the world into good-acting and bad-acting countries continues to amplify state-sponsored cyberattacks, as bad-acting countries put more and more resources behind their missions, seeing this as the next frontier of undermining democracy and the companies that support it. Additionally, the Russian invasion of Ukraine and the subsequent flight of Western companies has inadvertently created a lot of cybercriminal capacity. Many who have been trained on Western technology systems at those companies have not turned in their keys, will be available to the Russian government, and turned against the Western world in the form of state-sponsored attacks. The crippling repercussions of a cyberattack – from ransom to far worse – are among the most lethal possible to a company and their CEO and board of directors.

8. Unionization

Finally, one of the biggest surprises for many people is that labor unions are having a new day, only this time they are also focused on companies no one ever believed would be unionized. Apple, Google, Starbucks, Activision, and so on, are facing pressure from organized labor. The rail unions are another example of unions’ growing influence and power, and this will lead to further inflationary effects as salaries and benefits increase another 30%.

Many of the reasons for forming a union go beyond compensation to working conditions, scheduling, sick leave, health benefits and annual leave. As we see the minimum wage move higher and higher, many employers with vast frontline workforces will be challenged on their business model’s viability. Doubtlessly, this will lead to rapid technological innovation that drastically reduces the need for as many frontline workers in many companies. Since frontline workers often do not have many other options, drastically reducing the need for their services will create hardship felt by lower income households, and serious societal repercussions down the road.

As the cycle continues, this will provide an argument for the further unionization of frontline workers, so they try to limit the degree of automation and the use of AI to drastically reduce the number of roles required. A historical example of this cycle is the tobacco industry that was once a massive employer of low-wage frontline workers. As their business models were challenged, mostly by government regulation, they moved swiftly into automation, eliminating the need for the large number of frontline workers in their business models. This is a trend we are likely to see more of in the coming years, across industries.

Many CEOs believe we are at the bottom of the labor inflation cycle not at the top, and that there is a lot more wage inflation to come. This is the key indicator for the Federal Reserve’s continued hawkish stance. The Fed’s critical indicator of inflation is wage inflation, and as we see new rounds of increases across sectors like the rail unions, followed by the airline pilots, this will set a new benchmark, or floor, for negotiations with other unions looking to capitalize on the momentum and their new-found bargaining power.

The movement today seems to be strong and gaining momentum, so if a company has a large frontline workforce, the possibility of their organizing is much higher than it was a few years ago.

Demand will have to come off precipitously in order to reverse this trend. Many CEOs were thinking this would occur in the early part of 2023, but most are now predicting late 2023 or even early 2024 because of how robust the labor market continues to be, along with spending at the medium to higher ends.

With all of these critical issues top-of-mind, and continually evolving, it is those leaders who can respond to the changing world better, faster and smarter than others who will have a distinct advantage in the coming year, and well beyond.

Stephen A. Miles
Chief Executive Officer
The Miles Group

Stephen Miles is the Founder and CEO of The Miles Group. Previously, he was a Vice Chairman at Heidrick & Struggles and ran Leadership Advisory Services. With more than 20 years of experience in assessment, executive coaching, top-level succession planning, organizational effectiveness and strategy consulting, Stephen specializes in CEO succession and has partnered with numerous boards of global Fortune 500 companies to ensure that a successful leadership selection and transition occurs. Listen to Stephen on TMG’s C-Suite Intelligence podcast, and follow TMG on Twitter and LinkedIn.