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CHAPTER 1
THE SUPPLY-DEMAND IMBALANCE
The one hundred top-selling retailers and restaurants averaged a 12 percent loss in market value between August 2015 and October 2016, according to the National Retail Federation. Amazon's stock rose nearly 45 percent during that period. This is just the beginning.
We like the earthquake metaphor because we believe developed economies around the world are experiencing a seismic shift, driven by an underlying collision of too much supply and too little demand for traditional products (mostly things like apparel, food, toys, electronics, household goods, and shoes). The net result is good news for consumers — a proliferation of choices and better prices — and bad news for retailers and manufacturers: rapidly falling prices and declining profits. This oversaturation is an almost inevitable consequence of companies' seeking perpetual growth. Constant growth demands constant increases in capacity combined with efficiency gains, which in turn drive down costs. This dynamic also results in the commoditization of goods and services — that is, products that have no real differentiation among brands, leading to significant competition on price. If consumers can't tell the difference between two items or services, they will almost always choose the less expensive or more convenient one.
This process has been going on for a long time, even if the cracks have only just begun to show. The International Monetary Fund reported, "There has been a downward trend in real commodity prices of about 1 percent per year for the last 140 years." Our ability to use less, produce it more efficiently and create alternatives has driven the cost of inputs down and down. Even the recent oil price decline is a result of this, as innovation in fracking techniques has increased supply. Every manufacturing and information technology process has had a sustained learning curve, creating evermore efficiency in the production of goods and lower prices over time. For example, in supercomputing, in 1968 one dollar bought you one transistor. In 2002, one dollar bought you ten million transistors — and today it buys you close to one billion!
Examples exist everywhere. Compare the cost and quality of the color TV set you purchased only ten years ago to what is available today. Now look further back, to the early days of television. In today's dollars a 1939 RCA TV would cost $10,539, ten times more than a modern TV with features like 3-D viewing and Internet readiness. If we drill down on this one example, we see lower commodity costs for things like metals, plastic, and glass, and accelerated learning curves for technology companies and ever more manufacturing capacity (with countries like China, Japan, and South Korea continuing to churn out ever- greater numbers of sets). Add to this an ever-increasing number of distribution points (retail stores, websites, delivery vehicles, and more), and it's clear how lower prices have increased the supply of every material thing. Indeed, the long- term trend for material goods is approaching a price tag that says FREE! We know this sounds crazy, but this is the trend (obviously, in any given year the possibility of disruption as a result of political activity, strange weather, stock market volatility or any other unknown factor may cause prices to rise, but it will not break the long-term trend). However, it is worth thinking about the consequences of a world in which the price of many material possessions is essentially free. In this world consumers' attitudes and desires for material possessions, ownership and brands — to name just a few things — will all change.
It's important to note here that the only elements of the retail ecosystem that cannot be commoditized are experiences. Starting in chapter 7, we will explore this point in depth.
So we begin our story with this supply-and-demand thesis.
What Caused the Imbalance and When?
The imbalance in supply and demand began full force with the rise of globalization and the movement of manufacturing to low-cost countries. This has combined with a dramatic decrease in the costs of both global distribution and local fulfillment.
In the first nine months of 2016, China produced 170 billion feet of clothing, or roughly twenty-one billion t-shirts, and that's despite many companies' turning toward lower-wage countries. To put that in perspective, with roughly five hundred million people in the world's developed economies (we assume some of this clothing will be consumed by China's growing middle class), each of them would have to buy roughly 350 feet of clothing every year, or almost forty t-shirts, for China alone to sell everything it produces — never mind any of the other dozen or so clothing-producing countries. And all this new clothing needs to find a place in a crowded wardrobe that contains last year's 170 billion feet of clothing. The same is true in footwear, household goods — nearly everything we wear or use on a daily basis.
Indirectly, the move toward higher wages in China has generated even more supply, as manufacturing gets pushed to more and more lower-cost locations. A World Bank analysis suggests apparel exports from South Asia to the United States will increase 13 to 25 percent for every 10 percent increase in Chinese apparel prices, while exports from Southeast Asia will increase 37 to 51 percent as a result of the same Chinese price hike — so as labor in China becomes more expensive, manufacturing moves to lower-cost countries, which then send the West even more products. Supply keeps increasing despite the true level of demand. Yet there's often nowhere for this massive supply to go. For example, the global auto industry manufactured 72 million cars in 2016, or roughly one for every one hundred people on the planet, even though nearly half live on less than $2.50 a day.
There is no end in sight for this productivity explosion. By the time China starts to confront labor shortages, Indonesia, India, and Malaysia will fill the void, and after them the massive populations in Africa and South America will be available to continue the perpetual cycle of lower costs and deflating value. Capital will flow to build low-cost manufacturing capacity wherever it can be found. For as far into the future as we can see, the proliferation of supply against stagnant to decreasing demand will continue.
It's important to note here that a logical question is: If demand is decreasing so that suppliers are not able to sell all their products or services, won't suppliers cut their production and retailers reduce their inventory? Wouldn't supply and demand thereby regain some equilibrium? The logical answer is yes. However, lumpy investment decisions (big factories are built years in advance in many separate geographies), unforeseen demand changes, technological innovations that increase efficiency, and incredible access to capital all mean that capacity will keep increasing. A globally efficient market in equilibrium will take a long time to arrive — if ever.
The illogical pushing of more and more stuff out into a marketplace that with insufficient demand to consume it all is perpetuated by the captains of commerce, all of whom are committed to infinite growth. And, of course, the ever-decreasing costs of production allow them to continually decrease their prices, which needlessly revs short-term demand.
Exhibits 1.1 and 1.2 provide a closer look at the underlying country data behind this macro trend and reveal how this process has led to an incredible growth in income in China and, to a lesser extent, in India and the rest of Asia, and in Latin America and the Caribbean, while growth in the United States has remained mostly stagnant. Exhibit 1.2 also shows the next location of great middle-class wage growth: India and the rest of Asia, and sub-Saharan Africa.
It is also important to remember that the costs of distributing and moving goods have gone through their own productivity explosion. During the twentieth century the real cost (inflation adjusted) of moving goods fell by 90 percent. The cost to fly, float, or drive all sorts of food, drinks, clothes and everything else we use on a daily basis around the world has fallen dramatically. We no longer find it funny or unusual when our waiter in a nice New York restaurant says tonight's special is fresh fish from Turkey.
The really interesting question is this: What happens when everything moves close to free?
We are often asked whether the current antiglobalization, anti–free trade movement will decrease global production, fueling a corresponding decrease in global supply. For a variety of reasons, we do not expect this will happen. The biggest reason is that the current flows of global capital have already created the infrastructure for more supply in many developing countries. The productive capacity is already built. Unless we have a full-on trade war, these goods will reach the developed economies. Even a trade war will not change the picture because trade barriers will create unemployment in developed markets and further depress demand — sustaining the imbalance. Further, the trend toward on- shoring production in developed economies (to reduce lead times and now to counter political pressures) will increase supply. For "fast-fashion" items, items that are not labor-intensive to produce and those that sell better with a MADE IN THE USA tag, the expansion of sources of production is under way. Finally, 3-D printing will not only increase the amount of supply but will move a lot of production to local markets, even to individual homes (more on this later). This technology has the potential to revolutionize our production processes and global distribution.
The key takeaway here is that even if countries pursue more protectionist policies, global demand will not keep up with perpetually increasing supply. As the imbalance continues to widen, the impact on the strategic and structural models of all consumer-facing businesses will be enormous.
So who buys all this excess supply? The short answer is nobody. Much of it just gets wasted. In fact, the US Environmental Protection Agency says we throw out roughly 12.8 million tons of textiles, such as clothing and shoes, every year — or more than eighty pounds per person.
Despite this monumental waste, Western consumption-driven economies, with their easy credit and spending power, do their best to cram more and more goods into closets and kitchens and garages. The United States leads the way here by a significant margin. Controlling for purchasing power, Britons consume only 85 percent of what Americans do, while people in Germany, France and Japan buy only 70 percent as much. This is a big reason for our trading imbalance. "They" produce and "we" consume. But the problem is "they" can now produce more and more, at lower and lower cost, than even "we" can or want to consume.
Our consumption fails to keep up with production (or supply) for several reasons we have already noted; a few more are worth highlighting.
First, a number of major trends that supported demand have now ended. While the growth in production was occurring (both in developed economies and in the early days of offshoring to Asia), an increase in dual-income households was increasing spending power. From 1960 to 1990 the number of dual-income households rose from about 25 percent of US households to 60 percent, where it remained at least through 2012. With more women in the workforce and more consumers feeling pressed for time, more income and more demand were chasing consumer household products — especially those products that saved time or otherwise made life easier. But the growth of this trend leveled off and can no longer be counted on to fuel even bigger growth in consumption.
Another one-time trend occurred in the late 1990s and early 2000s. Baby boomers hit their peak spending years, and with their large numbers — seventy-six million Americans — they drove even more demand. Buying more clothes, getting the second house equipped and the first remodeled, and buying multiple cars to transport all members of the family to their various daily activities propped up demand, keeping it reasonably aligned with increasing supply. Closets grew in size and number, and storage locker rentals boomed.
In this environment, businesses found it relatively easy to stimulate or create demand for their products. The focus on classic creative advertising and marketing, lifestyle branding, and new product development and proliferation increased and helped drive consumption. The constant push for growth led companies to create more and more, intensifying competition across every category. Porsche and Coca-Cola started selling clothing, Ross and T.J. Maxx began filling their checkout lanes with candy and snacks, and Oreo introduced a Peeps-flavored variety (one of more than one hundred iterations of the classic cookie), moves that were emblematic of the lengths to which companies would go to drive growth.
But by 2016, boomers were still feeling the sting of the Great Recession and, with retirement looming, had stopped their rampant spending. Much of their disposable income shifted to spending on travel, leisure, entertainment, health, and welfare. They didn't need or desire more stuff,
Real income growth (as a result of productivity growth in the 1990s) also maintained reasonable levels of consumption. Now, however, labor productivity is slowing down around the globe, further eroding the growth in living standards. In the United States, labor productivity grew just 1.3 percent from 2005 to 2016, compared with 2.8 percent over the previous ten years. This has been happening across dozens of advanced economies, at a loss of $2.7 trillion loss in GDP since 2004. Few economists predict any near-term increase in productivity.
If anything, economists are pessimistic that global productivity will ever again (or at least in the next few years) reach historic levels. The Princeton economist Robert Gordon has argued convincingly that technology is actually leading to declining productivity growth. To state the argument simply: When electricity was first being harnessed, dark evenings and nights became productive; high-rise elevators changed how people lived; factories became automated and developed new production methods; trains, cars, and planes changed how goods and people moved from place to place; much backbreaking labor disappeared; and all sorts of major household labor-saving devices emerged. The impact of that innovation and three other factors (urban sanitation, chemicals, and pharmaceuticals) fueled growth between 1870 and 1940 that drastically reshaped lives to a degree not seen since. While people today would find a 1950s household relatively livable, conditions in 1900 would be far from tolerable to a modern traveler. Before 1900, for example, parts of New York's Financial District were seven feet deep in manure. In comparison the Internet's impact on economic growth and living conditions in the West is relatively muted (at least to date), largely affecting how we shop, order taxis, and entertain ourselves. We are actually optimists about the long-term impact of technology on health, longevity, and knowledge formation, but we do not see significant short-term growth in productivity.
When productivity growth and incomes slowed, consumption was initially buoyed by easy access to credit through home equity loans, mortgage loans, and ubiquitous credit cards. Consumers mistakenly believed they could support real increases in their standard of living with credit, not income. Financial institutions, with complicit central banks, supported this lie. In 2008, the bubble burst, causing the Great Recession, and the music stopped. As depicted in the movie The Big Short, the housing crisis and recession made a fortune for many, but it changed a generation's attitude toward and desire for credit. The notion of using debt as a cost-free route to living above your means had been thoroughly discredited.
It is clear that recent years have seen no substantial growth in demand for almost all consumer products in the developed economies. Desperate attempts to stimulate demand with monetary policy have been marginally successful (the bubble costs of this policy are not yet clear), but all the underlying drivers of demand have slowed. If anything, demand has been in a gradual decline.
The Internet, Technology, and the Smartphone
Another critical element to the seismic shift is the massive increase in both the number of points of distribution and their increasing level of fluidity (more on this idea later).
Major retailers and brands have been able to control the flow and distribution of goods for large parts of the buildup in supply that we have described. Everyone knows there has been a relentless and sustained increase in retail square footage during the last five decades. From 1983 to 2009, US retail square footage per capita shot up 30 percent. It's slid 3 percent since then: the seismic shift's first victims have started to fall through the cracks and shut their stores.
(Continues…)
Excerpted from "Retail's Seismic Shift"
by .
Copyright © 2017 Michael Dart and Robin Lewis.
Excerpted by permission of St. Martin's Press.
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