The Rules Will Change but That’s (Probably) OK

By John Mauldin

“But the emperor has nothing at all on!” said a little child.

“Listen to the voice of innocence!” exclaimed his father; and what the child had said was whispered from one to another.

“But he has nothing at all on!” at last cried out all the people. The emperor was suddenly embarrassed, for he knew that the people were right; but he thought the procession must go on now! And the lords of the bedchamber took greater pains than ever, to appear holding up the robes although, in reality, there were no robes at all.

—“The Emperor’s New Clothes” by Hans Christian Andersen

When you write about controversial topics for hundreds of thousands of readers for 20 years, you develop a thick skin. Virtually anything I say will upset someone.

So, when people say something like, “John Mauldin wakes up sucking lemons and then moves onto something sour,” as happened after last week’s letter, it doesn’t bother me. (It actually made me smile.) I write what I believe is correct. Those opinions change over time as I get new information.

I’m not the only one who changes. Laws and policies that may seem etched in stone are often more flexible than generally thought. In last week’s Japanification letter, I described how no one anticipated the various extreme measures taken in the last crisis, from TARP to QE to NIRP. Yet once those ideas were in play, they happened quickly.

I think the next crisis will bring similarly radical, sudden changes. We will think the unthinkable because we will see no other choices. That means the range of possible scenarios may be wider than you think.

To think this may be so is not necessarily bearish.

Fiscal Insanity

As of now, my best guess is the US will enter recession sometime in 2020. I may be off (early) by a year or two, but it’s coming. We know two things will happen.

  • Tax revenues will fall as people’s income drops.

  • Federal spending will rise as safety-net entitlement claims go up.

The result will be higher deficits. Keynesian economics advocated running deficits during recessionary and economically difficult times and surpluses the rest of the time. That’s not what we did.

Last year (fiscal 2018) the “official” budget deficit was $779 billion. The national debt went up $1.2 trillion. The “small” $421-billion difference was more than half the official budget deficit. That is the off-budget spending that Congress doesn’t count. It includes the revenue and spending of certain federal entities that Congress wants to isolate from the normal budget process. Lately it has run in the multiple hundreds of billions of dollars, every year.

Below is a graph showing the projected budget deficits for 2019 and 2020 from a website called The Balance. You can find similar numbers all over the internet. I’m using the US but the situation is similar in most developed countries (though hopefully not yours).

Now, add another $400 million to each of those numbers. What is called the “unified budget” is now $1.5 trillion.

Next, let’s go to a very handy website called The US Debt Clock. (Scrolling around you can find the debt for your own country and state and other useful data.) We see that halfway through fiscal year 2019, the debt is already well over $22 trillion. It will be $23 trillion before the end of this year. By the end of 2020, Trump’s first term, it will be approaching $25 trillion. And that doesn’t include state and local debt of $3 trillion plus their $6 trillion unfunded pension liabilities.

And as I pointed out before, all that is without a recession. The unified deficit will easily hit $2 trillion and approach $2.5 trillion in the next recession. Within 2 to 3 years later, the total US debt will be at least $30 trillion. Not including state and local debt or unfunded pension obligations (more on those later).

Recognizing that simple arithmetic is not being bearish. It’s recognizing reality.

There are calls for a 70% tax rate on incomes over $10 million. Experts quoted in The Washington Post estimated it would produce about $72 billion a year. And you can guarantee that people will work their income statements to get below that. And in the face of a $2.5-trillion deficit? It doesn’t do very much, let alone pay for any new programs.

The simple fact is that raising income taxes on whatever we think of as the wealthy doesn’t get us close to a balanced budget. But what about actually doing a wealth tax? Like 1% of total net worth on the 1% wealthiest in America? Helpfully, The Washington Post article calculates that for us (my emphasis):

Slemrod, of the University of Michigan, said in an email that the wealthiest 1 percent of Americans own roughly one-third of the $107 trillion in wealth in America. This group collectively holds about $20 trillion in wealth above $10 million per household.

From there the calculation of wealth tax is simple: a 1 percent wealth tax on the wealthiest 1 percent of households above $10 million could raise about $200 billion a year, or $2 trillion over 10 years. Tedeschi, the former Obama official, found a 0.5 percent wealth tax on the top 1 percent could raise at most $3 trillion over 10 years.

But this, too, would probably change Americans' behavior and perhaps lead them to try shifting their wealth overseas, and the economists say the actual amount of revenue is likely lower than their estimates suggest. And this is assuming there are no exemptions to what is considered wealth, such as housing assets.

Again, a few hundred billion a year is nothing to sneeze at, but at the rate we’re going would make only a small dent in the deficit.

The real problem? Unfunded entitlement spending. The CBO is projecting literally trillion-dollar deficits in the latter part of this next decade simply because of unfunded entitlement spending. And then there’s the pesky little fact that we spent $500+ billion last year on interest payments.

In a recession and bear market, the $6 trillion of unfunded pension liability on state and local balance sheets could easily rise to $9 trillion, a number most cannot meet. Either firefighters, police officers, teachers, former government workers, etc., would not get their agreed-upon pensions or state and local taxes would have to rise precipitously, or the federal government will have to step in.

All of this will happen in an environment in which the Federal Reserve will be fighting a recession and a slow-growth economy, trying to move those asset prices back up to help the pension funds. So for me to suggest that the balance sheet of the Federal Reserve could grow to $10 trillion by the middle of the next decade and $20 trillion by the end of the decade is not entirely outrageous. And we haven’t really approached Japanese territory yet.

This analysis is not “bearish.” It is simply looking at the numbers, doing the arithmetic, and observing that we’ll have to borrow a great deal of money to meet our obligations.

I might be wrong if politicians from either party run and win with a platform of “I’m going to cut your Social Security and Medicare, slash the defense budget, and zero out a lot of little other pesky expenditures that you probably like.” I feel sure that won’t happen.

Avoiding the Windshield

The Emperor isn’t wearing any clothes. Maybe I’m that naïve little boy who isn’t smart enough to see the beautiful cloth in which our national budgets are arrayed, and how easily we can raise more taxes from invisible sources.

And like the Emperor in the above story, we just keep walking and telling ourselves that nobody will notice.

The bulk of that debt will end up on the Federal Reserve’s balance sheet, just like the bulk of European debt will end up on the balance sheet of the European Central Bank, the Bank of England, and so on.

Exactly the path the Bank of Japan has already gone.

Let’s examine how that worked for them. From one perspective, it has done quite well. From another, they have paid a cost. Is it worth it? I think many Japanese, likely a big majority, would say yes.

The Bank of Japan has more than 140% of Japanese GDP on its balance sheet. Its laws let it buy equities not just in Japan but all over the world and it has. Yet the currency is roughly the same value as it was when the Bank of Japan got busy with that project.

I am personally well aware of that because I was the one who called Japan “a bug in search of the windshield.” Just like I am predicting that much of the US deficit will end up on the balance sheet of the Federal Reserve, I said the same thing would happen to the Japanese. I also said it would devalue their currency. I actually put real personal money, not just token money, on the prediction. I bought a 10-year yen put option. That trade has not worked out so well. I don’t even want to open the envelopes from J.P. Morgan containing that information.

But I learned a lesson and I had a great deal of company. Many hedge fund managers and other investors made the same bet. In essence, we said that Japan is going to print money and the same thing will happen to it that happened to every other country in the same situation: The currency will lose value.

Instead, it brought one of the most surprising macroeconomic outcomes that I could imagine. Talk about thinking the unthinkable back in 2008. What happened is unthinkable to me, and to a lot of other people.

First, let’s realize that Japanese debt-to-GDP has risen to 253%. Notice in the graph below that the increases are much smaller each year. That is a (surprising!!!) point I’m going to make next.

For the last two decades, the Japanese have been promising they would balance their budget in 7 to 10 years—and they’re actually beginning to make progress. Their fiscal deficit is in fact smaller every year in terms of GDP and actual numbers of dollars. Good for them.

The deficit should fall even further as they have a small sales tax increase kicking in the fall of this year. It is, of course, controversial whether they will actually implement the tax, but I expect them to eventually do so. And sometime in the next decade, it is entirely possible that Japan will actually have a balanced budget, and then a surplus that lets the government begin paying down that debt.

Of course, they have to navigate global recessions, and all the sturm und drang and vicissitudes of life, but they are clearly trying to move in the correct direction. Kudos to Abe and Kuroda-san.

The Cost of High Debt

All this has not been without cost. It brought severe financial repression on savers. If you could somehow buy a new Japanese government bond, which is almost impossible because the BOJ buys everything that isn’t nailed down, you would get negative yield. That’s one reason Japanese savers are not selling their bonds. Even 1–2% on bonds bought “back in the day” is a lot more than they can get now.

The Japanese government bond market was once one of the world’s most liquid. Now it trades by appointment. Here is the JGB yield curve right now. Notice it is negative out to 10 years. So if somehow you had bought a 20-year bond 10 years ago, which makes your Japanese bond now a 10-year bond (effectively), you would have a nice capital gain. But then where would you put the proceeds if you sold? That’s why there are very few actual sales in the Japanese bond market.

As Lacy Hunt will demonstrate to us at the SIC (get your virtual Pass here), massively increasing debt actually reduces interest rates, productivity, and GDP growth, exactly as we see in Japan. They ran massive government debt, bringing future consumption into the then-present, and now must live in a world where that future consumption doesn’t happen, GDP growth is negligible if not negative, and investors have to live by new rules.

To some degree, we already see the first evidence of that in the US. My good friend Ben Hunt notes that the S&P 500 companies have the highest earnings relative to sales in history.

Source: Ben Hunt

Quoting Ben:

This is a 30-year chart of total S&P 500 earnings divided by total S&P 500 sales. It’s how many pennies of earnings S&P 500 companies get from a dollar of sales… earnings margin, essentially, at a high level of aggregation. So at the lows of 1991, $1 in sales generated a bit more than $0.03 in earnings for the S&P 500. Today in 2019, we are at an all-time high of a bit more than $0.11 in earnings from $1 in sales.

It’s a marvelously steady progression up and to the right, temporarily marred by a recession here and there, but really quite awe-inspiring in its consistency. Yay, capitalism!

Ben goes on to say many people think that is because of technology. He argues it is the financialization of our economy and the Fed’s loose policies. I agree 100%. If you think they haven’t changed the rules since the 1980s and 1990s, you aren’t paying attention, boys and girls!

It goes without saying that those profits are not going to labor, and the same monetary policies that were supposed to enhance the economy have contributed mightily to wealth and income disparity. When you muck around with the markets, don’t be surprised if you get unintended consequences. We have them in spades, and everybody wants to blame “the rich” rather than the incentives the government and Federal Reserve created.

New Rules, or Moving the Goalpost

I don’t think it is bearish to notice the political and arithmetic implications of our budget process. I want to help my readers understand that the rules are going to change. That is not necessarily a bad thing. It is just what it is.

The massive increase in debt, huge quantitative easing programs, and increased financialization of the investment process are going to change the rules of investing we have lived under for the last 50 years.

It is going to be difficult, more difficult than now, to get a positive return on your bonds without taking significant risk. And your returns are going to be lower. Think Japan. Think Europe. For that matter, think the US.

If somehow the gods of American football changed the rules so you needed 12 yards for a first down, the field was now 120 yards long, and gave a few advantages to receivers, the nature of the game would change. It would still be recognizable as football but it wouldn’t be the game we know.

That’s not unprecedented. Football in my father’s day was significantly different from now. I’m sure there are people nostalgic for the way it was. I just want to watch the game as it is today. And when it comes to investing, if I have to change my style and look for different opportunities, it is just acknowledging a rule change.

I am not being bearish when I say there is the potential for future rule changes. I am simply pointing out what I see.

I think I am truly the most optimistic man in the room. Everywhere I turn I see opportunities. But then, I’m looking beyond my Bloomberg or business TV.

The world is changing around us and we have to adapt. Many won’t notice the changes and end up like the dinosaurs. That is very sad. What will happen to people who are counting on pension funds is also going to be very sad. Or we taxpayers are going to have to step in and bail them out. As a taxpayer, that is also sad.

Is there a way out of all of this? Absolutely. We can overhaul the tax system like I wrote two years ago, actually balance the budget, fund all the entitlement spending, and watch GDP growth once again become part of our national conversation.

But it will take a crisis before we consider that. In the meantime, let’s pay attention to how the rules are changing and adapt.

Now, how is that bearish?

The rules really are changing and past performance is not, and will not be, indicative of future results.

Dallas, Cleveland, Chicago, Puerto Rico, and Washington DC

Travel just seems to happen to me. I have to go back to Dallas to have my root canal checked and get a new cap, then run to the airport to get to Cleveland to have my eyes checked because of the cataract surgery (which seems to have gone well), then run to another airport to get to Chicago for a speech, some meetings, and a dinner the next night, then back to Puerto Rico and finish next week’s letter before flying off to Washington DC to do a video with my friend Neil Howe.

Almost every day I have one if not two conference calls with speakers who will appear at the Strategic Investment Conference, going over what they will say and how the panels will interact. It is hard for me to curb my enthusiasm. There will be so much important information conveyed that will help you understand the changes that are coming. We will discuss China, Europe, geopolitics, debt, central bank policy, all sorts of market and market opportunities, real investment ideas, and much more. And hopefully have a lot of fun while we are doing it. If you can’t make it (get on the waiting list if you think you might be able to change your schedule), then you really should get the Virtual Pass. It’s the best deal out there.

One of the best things about going to Dallas is that I will get to see some of my kids. Maybe even catch an action movie with the boys. And a few friends have time slotted as well. Sunday will be a full day. You have a great week!

Your calling it as I see it analyst,

John Mauldin
Chairman, Mauldin Economics

Precious Metals Give Traders Another Opportunity

Chris Vermeulen

We know many of you follow our research posts and have been waiting for the Gold/Silver setup we predicted would happen near April 21~24, 2019 back in January 2019. Well, it looks like our predictions were accurate and the current downward price rotation in Gold/Silver are the opportunities of a lifetime for precious metals traders.

Our original research regarding the predicted Gold price rotation and breakout initially posted in October 2018 and was updated in January 2019. You can read our updated post here.

This research suggested, back in October 2018, that gold would rally above $1300, then stall and setup a momentum base near April 21~24, 2019. Currently, we are actively seeking entry positions in Gold, Silver and many other stock market sectors related to the metals and miners.

We’ll start by highlighting the Gold to Silver price ratio. When this ration moves well above 80, it is generally considered a long term buy trigger. The reason for this is that this ratio attempt to reflect the price of Silver to the price of Gold. When this level reaches above 80, it traditionally reflects an extremely cheap price ratio for both Gold and Silver and usually prompts a big price advance in the near future.

Taking a look at historical price moves for both Gold and Silver, we fall back to the big upward price advance that began after the 2009 market crash. One thing that all traders and investors must understand is that, currently, Silver presents an incredible opportunity for bigger returns than Gold. Yes, Gold will likely rally higher and provide an incredible opportunity for upside gains. Yet, historically, Silver begins to move a bit later than Gold does and the upside potential of Silver tends to be 40~70% greater than the upside potential for Gold.

Take a look at this comparison chart, below, of the 2009 to 2011 price move. Gold shot up nearly 100% – as shown on the chart. Silver shot up over 150% when the breakout move happened a bit after the Gold move started. We expect the same type of price advance pattern in the near future. We expect Gold to begin the move higher and Silver to lag behind this upside move a bit – possibly for a few months. Eventually, Silver will break to new multi-year highs and could rally 130% to 220% above current levels – possibly higher.

Over the next few months, we believe increased volatility in the US stock market may drive prices a bit lower as price rotates near all-time highs. We believe this rotation, coupled with foreign market concerns (think Brexit, Europe, China, South America) as well as the US Election cycle may cause the markets to enter a period of stagnation and sideways trading. These impulses may become a catalyst for precious metals to break recent highs and begin an upward price advance as a general increase in FEAR settles into the global markets.

We do believe Gold and Silver will likely move a bit higher over the next 30+ days as the US stock markets continue to push higher towards new all-time highs. Yet, if the volatility increases, as we expect, and a bigger price rotation takes place (see the chart below), we believe Gold and Silver may experience another price drop to near or below current levels before a massive upside breakout move begins. Historically, the price of Gold contracts throughout the initial price correction phase of the S&P500 and begins to accelerate upward near the end of a correction phase. This is because investors and traders are typically shocked to see the correction take place and move into a protective mode as true fear sets in. When fear subsides, traders move out of precious metals and back into stocks.

Our current expectations are that Gold will continue to push lower, below $1275, in an attempt to establish our April 21~24 momentum base. This base should be at or near ultimate lows for the price of Gold and we would expect a pennant or sideways price channel to complete this bottoming formation. Ideally, any price move below $1250 is a gift for skilled traders. We’ll just have to wait to see where this bottom sets up before we know just how low Gold will fall before the next leg higher.

We believe the next upside price leg in Gold will push prices above $1400 initially, likely in May or June 2019. After that peak is reached, we believe a period of rotation and a potential for a price decline is very real. We believe this next leg higher will really to levels above $1400, then price will stall and retrace – possibly retracing back to levels below $1300 again. It would be at that point that skilled traders should consider this the last opportunity for long entries before the bigger move to the upside.

Our research into this move, which initiated back in October 2018, has called these rotations almost perfectly. If our newest research is correct, you will have at least two opportunities to enter fantastic long trades in Gold and Silver, one setup hitting between April 21 and April 28 and another setup after the initial upside price rally retraces (likely in June or July 2019). After that last retracement, we believe the bigger upside rally will begin and both Gold and Silver will initiate a rally that could be an opportunity of a lifetime for skilled traders.


The wisdom of José Carlos Mariátegui

The Latin American left should rediscover the Peruvian thinker’s pluralism and creativity

HE DIED AGED just 35, disabled for his last six years by the amputation of a leg. But in his short life José Carlos Mariátegui managed to become Latin America’s most influential Marxist thinker, at least until Che Guevara came along.

Barely known today outside Peru, he also played a significant role in Latin American culture in the late 1920s, a period when artists and writers were trying to establish national identities based on the recognition of mestizaje (racial mixing) and of workers and peasants. An exhibition, currently at the Reina Sofia museum in Madrid and then bound for Lima, Mexico City and Austin, Texas, introduces Mariátegui to a broader audience while establishing him as a cosmopolitan figure at the hinge of revolutionary politics and artistic vanguards. It offers lessons for the region today.

The child of a mestiza mother and an absent aristocratic father, Mariátegui was an autodidact who became a journalist and writer. Exiled by Peru’s authoritarian regime, he lived in Europe from 1919 to 1923, mainly in Italy and Berlin. He attended the first congress of the Italian Communist Party and was influenced by its founder, Antonio Gramsci, whose thought was a bridge between liberalism and Marxism and who stressed the importance of culture. Mariátegui was introduced to a profusion of European artistic movements, including Italian futurism, Dada and surrealism.
He returned to Peru “with the idea of founding a magazine”, he wrote. That idea came to fruition in 1926 with Amauta (“wise one” in Quechua), a political and cultural journal. Mariátegui was never dogmatic or narrow in his interests, and he wanted Amauta to analyse the problems of Peru “in the world panorama”. The first issue contained articles by Sigmund Freud and George Grosz, a German artist, as well as reports on political developments in Spain and Mexico. It included illustrations by Emilio Pettoruti, an Argentine cubist, and José Sabogal, a Peruvian artist who created Amauta’s modernist design.

In his writings, Mariátegui developed a distinctive revolutionary vision, which he briefly tried to put into practice when he founded the Peruvian Socialist (ie, communist) Party in 1928. Peruvian (and Latin American) socialism should not blindly copy European models, he thought. Rather, it should put the “problem of the Indian”, and thus land reform, at its heart. He believed that the Amerindian peasant communities of the Andes contained the germ of socialism.

This romantic view set him on a collision course with the apparatchiks from Moscow, who took over Latin American communist parties shortly after his death. But Mariátegui was right in stressing indigenous peoples, popular religiosity and culture in Latin America’s political identity. He was unusual, too, in counting many women among his collaborators.

The exhibition highlights the loose continental network, with ties to Mexico and Argentina, to which Amauta belonged. It includes art by Diego Rivera and other Mexican muralists. But the visual highlight is the work of Peruvian “indigenist” artists, such as Sabogal and Julia Codesido, who painted portraits of Amerindian elders and scenes of Andean community life. Indigenism was seen as archaic compared with the revolutionary commitment of Rivera. But it endowed its subjects with dignity, and Mariátegui defended it. “The emergence of indigenism represented a radical upheaval that is hard to imagine today,” writes Natalia Majluf, the exhibition’s co-curator and the outgoing director of Lima’s Museum of Art.

Mariátegui was wrong about big things. It is capitalism, not communism, that has freed billions from poverty. But in the aftermath of the first world war and of the Russian and Mexican revolutions, and having seen the failure of liberalism to prevent Italian fascism, he was not to know that. What he saw was that in Peru a century of political independence and creole capitalism had not freed the Indian from near-serfdom.

Mariátegui was a committed socialist who also managed to be a free thinker. That makes him valuable today. Much of the Latin American left is blindly obedient to the failed models of Cuba and Venezuela, or still beguiled by populist caudillos (for whom Mariátegui had no time). It desperately needs some of the original thinking of the 1920s. For the right, “Gramscian cultural Marxism” is a new bugbear. They should recognise that Latin America suffers unacceptable inequalities based on sex and race, and needs more tolerance.

Look for Gray Rhinos, Not Black Swans, in China’s Financial Zoo

The main risk to the country’s financial system is the threats everyone knows about

By Mike Bird

Widely known flaws such as excessive leverage and mispriced risk are thundering toward policy makers.
Widely known flaws such as excessive leverage and mispriced risk are thundering toward policy makers. Photo: biju boro/Agence France-Presse/Getty Images 

Rhinoceroses are getting rarer everywhere in the wild—everywhere, that is, except in the wilds of China’s financial system.

Wang Jingwu, the Chinese central bank’s financial stability chief, listed this week a number of “gray rhinos” threatening the country, including the large pile of local government debt, more bond market defaults and banks’ high level of exposure to the shaky real estate sector.

Unlike Nassim Nicholas Taleb’s black swans, gray rhinos aren’t unpredictable events with catastrophic consequences. The term, popularized by American author Michele Wucker in a 2016 book, refers to highly visible and potentially devastating challenges that policy makers often elect to ignore, rather than dodge.

Mr. Wang is using the right framework to communicate what ails China’s state-led financial system, where highly unpredictable events aren’t the real threat. Rather, it is widely known flaws such as excessive leverage and mispriced risk that are thundering toward policy makers.

Not that black-swan events don’t happen. The 2015 blowup in the equity market and the collapse of several Chinese peer-to-peer lending platforms in 2018 are good examples of surprise shocks to the system.

But China’s core problems, as adumbrated by Mr. Wang, are well understood by analysts.

With far more control over the financial system than most Western countries exert, Beijing has shown that it can keep periodic eruptions under control, for instance by clamping down on capital flows out of the country.

But keeping that control comes at a price: the gray rhinos get larger and larger. Facing little external pressure, policy makers find it hard to resist the temptation to keep the economy afloat simply by increasing the country’s debt—even if each round of stimulus sparks less growth than the last.

So if Chinese policy makers are well aware of the underlying problems that cause such events, why don’t they act?

Easier said than done. This week, the Chinese Academy of Social Sciences noted that debt in the real economy fell from 244% of GDP in 2017 to 243.7% in 2018. For all the discussion of the deleveraging campaign and the economic pain it brought, the needle barely budged.

Neither aggressive stimulus, nor paring down debt levels are attractive options for Chinese policy makers. As long as that remains the case, expect those gray rhinos to keep piling on the pounds.

Can Amazon Reinvent the Traditional Supermarket?

Wharton's Barbara Kahn and Columbia's Mark Cohen analyze Amazon's plans to open supermarkets in major U.S. cities.

Amazon’s plans to launch physical grocery stores this year is just the latest affirmation that, ironically, bricks-and-mortar stores are crucial to the e-commerce giant’s future growth. Amazon may launch as many as 2,000 supermarkets in major U.S. cities, according to a recent report in The Wall Street Journal. It will be Amazon’s sixth physical retail format after Whole Foods, Amazon Books, Amazon Go, Amazon 4-Star and Amazon Pop-Up.

Amazon’s plans are likely to rattle major grocery purveyors such as Kroger’s and Walmart, whose shares fell on the news. But the expectation is that Amazon will introduce a different business model — one that merges bricks-and-mortar and online experiences, then powering it with data analytics, according to experts at Wharton and Columbia University who spoke about Amazon’s grocery-store strategy on the Knowledge@Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)

“It was a natural next step,” said Wharton marketing professor Barbara Kahn. Opening supermarkets makes sense for Amazon because its business model is to offer low prices and convenience, which is what shoppers look for when getting groceries. “If you look at their bookstores or Amazon Go (fully automated convenience stores), they’re fine stores, but they’re not beautiful stores. They’re the kind of stores where you can get what you want at a cheap price, fast and convenient,” she said.

Amazon’s expansion of its grocery business — it already has Prime Pantry, AmazonFresh and Whole Foods — also lets it collect consumer data more frequently since people shop for food regularly and prefer to do it in person. “Their game is data and they need to have frequency. What’s really attractive about grocery is not really the margin; it’s the traffic,” Kahn said. “When you go into an Amazon store, you have to log in with your app and everything you do in that store is then connected with everything online.”

The Journal said Amazon’s supermarkets will take up about 35,000 square feet compared to 60,000 square feet for a typical grocery. Talks reportedly are underway to open stores in Seattle, Philadelphia, San Francisco, Chicago and Washington, D.C.

It’s About Data

Whatever retail store format Amazon uses, it “would be built upon this tremendous capacity they have to gather, analyze, understand and use what customers are saying to them every day,” said Mark Cohen, director of retail studies at Columbia University who had been CEO of Sears Canada. “Amazon is proof-positive of the value of big data and the way in which you collect it and the way in which you examine it and use it.”

Cohen cited the smart use of data by 7-Eleven, the convenience store chain. “7-Eleven has enterprise-wide systems that enable it to manipulate, modify or not modify its assortments to be extremely relevant and also extremely efficient so that not only is the right brand on the right shelf at the right depth, but it’s in a place in the store where customers expect to find it.”
Amazon’s opening of physical grocery stores also could solve some hurdles to growth. “Amazon has a fundamental barrier to its organic growth, and that is that there are may be millions of customers who can’t participate in e-commerce either outright or who find it inconvenient,” said Cohen. “That’s largely because they don’t have a place a package can be delivered because no one’s home and they’re not comfortable or in any way or willing to have something left on a doorstep.”

Physical locations are helpful also for folks who cannot buy online because they don’t have or cannot get credit cards — or don’t want to use them. “Having a network of locally convenient places with which to interact with those customers like an Amazon grocery convenience store that will accept cash would give them access to an enormous number of customers who very well might want to do business with Amazon but who can’t at the moment.”

Testing Bricks-and-Mortar

Amazon’s supermarket plans follow other forays into physical stores, the biggest of which thus far was its June 2017 purchase of Whole Foods for $13.7 billion. It gave Amazon nearly 470 stores, including about 20 in Canada and in the U.K. Six months ago, the company launched Amazon 4-star stores that carry the most popular products from its online store, including consumer electronics, devices, toys, books and home items.

In January 2018, it opened Amazon Go convenience stores where consumers take what items they want and leave without seeing a cashier or checkout counter. Sensors track their purchases, which are automatically charged to their Amazon accounts. There are now 10 Amazon Go stores with more to open soon. In addition, the company has opened 17 Amazon Books locations. Amazon also has Pop-Up stores in malls, Whole Foods and Kohl’s, but it is closing all 87 of them because the format didn’t work out.

As for its coming supermarkets, Amazon could redesign the traditional grocery format. Typically, staples like milk purposely are placed in the back so shoppers will spend more time in the store. Kahn said Amazon CEO Jeff Bezos could have a different design in mind. He could say, “Let us design the store so you can find what you want as fast as you need to find it and get in and out of there,” she said. “I bet once they start working on it and use their data, they will change things that make sense from the customer perspective. So that’s going to be pretty cool to see.”

The Journal said Amazon’s supermarket concept strongly resembles ideas from a 2013 report by former Deloitte consultant Brittain Ladd, who now works for AmazonFresh. That report sees Amazon’s supermarkets combining its discounting strategy with online capabilities, adding drive-through grocery pick-up and placing Amazon Lockers inside. The goal is to create “an ecosystem of channels centered on food and groceries capable of meeting the needs of all customers through all available channels,” he wrote.

As for concerns that Amazon is entering a low-margin business, Cohen said it doesn’t have to be problematic. “They view that as an opportunity in many cases,” he said. “At the end of the day, I think this is [about] creating more and more of an efficient connection to customers, especially those who they’re not doing business with, who would like to do business with them.”

Dynamic Pricing

Kahn said one of Amazon’s dilemmas in selling groceries is how to manage the costly effort of delivering to each home and business, the so-called ‘last mile.’ Amazon has to deliver because until it purchased Whole Foods, it didn’t have a lot of stores where people can shop, unlike traditional supermarkets. Walmart got into the grocery business and handled the industry’s thin margins by focusing on “operational excellence” to lower its costs. “They are a low-cost supply chain master,” she said.
Amazon’s priority is customer convenience. But deliveries can be quite costly because they’re inefficient, Kahn said. Therefore, opening more physical grocery stores could work so there will be more places for customers to pick up their orders. “They need it because their model is so different from a typical operationally-excellent grocery business,” Kahn added.

Moreover, Amazon will find it tough to convince competing bricks-and-mortar retailers to let it open one of its Lockers in their stores. Amazon has been “aggressive in trying to place those lockers throughout the realm. Many stores just don’t have room for them and some don’t really want Amazon delivering through a locker [the same products] they’re trying to sell,” Cohen said. “Amazon is not likely to convince Target to install Amazon Lockers, unless some incredible combination occurs.”

By opening its own stores, Amazon also gets control over pricing and margins. Kahn pointed out that it already uses “dynamic” pricing. At Amazon 4-star stores, prices are in digital form and match the ones on its website. However, the prices “can change as things happen,” she said.

Similarly, at Amazon Books, no prices are displayed. Instead, customers have to open up the Amazon app to find how much the books cost. This way, Amazon could play with the pricing too, perhaps setting different prices for Prime and non-Prime members. “In both of those ways — with ‘price’ and ‘place’ — Amazon is redefining the model,” Kahn said