The crew comes back to the mic to predict how demand will respond to milk prices approaching record highs across the market.

Between widespread inflation and rising interest rates, the economy hasn’t been in a remotely similar situation since at least the 80s. The discussion touches on potential for a European recession, how interest rate increases affect nonfat trade with Mexico, milk consumption expectations and the barriers to a rapid supply response to record-high prices.

The team comes up with potential answers and a few more good questions. Ted Jr. closes out by backing T3 into holding onto a bullish position.

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T3: So, this week, joining my dad and I in the discussion is Don Street, our head of global strategy, Jacob Menge, our head of trading strategy and risk management, and Joshua White, our vice president of whey and feed ingredients, and we thought this podcast, the conversation that would be pretty appropriate would be, given the current economic environment we’re in, dairy products are 50% higher in price than they were just six months ago, and interest rates are climbing. Are the combination of those two factors going to start stifling dairy demand, and if so, how is it going to play through the system?

The old adage has always been the cure for high prices is high prices, which means as dairy prices go up, there’ll be pushback from those high prices, and ultimately, demand will go down and it’ll correct itself. Meanwhile, producers are making more money at higher prices, so they increase supply at the same time. The increase in supply, the decrease in demand tend to start getting prices to adjust. But we’re in a very different environment this time around. The kind of inflation that we’re experiencing is unlike anything I think we’ve seen in this country since the 1980s, and the interest rate response by the Fed is going to be probably unlike anything we’ve seen since the ’80s, and I think as demand will adjust this time, it’s not going to be like anything we’ve seen in the last 10 to 15 years, so I think it’s worth bearing a discussion. Jacob, how do you think high dairy prices are going to affect demand from your point of view?

Jacob Menge: I think the first and most important thing to address is, are these prices high? What is a high price? I think that’s an important part of the question to address because you said the old adage is the cure for high prices is high prices, but I think there’s a lot baked into that statement. Part of that is historically when prices are high, that’s an indication that suppliers probably have good margin baked into that number because their costs didn’t really increase that much. So, when these prices really increase, suddenly they’ve got a lot of margin. That’s an environment that can’t really stick around. I would maybe push back and say prices aren’t even that high, quote-unquote, anymore because we’ve really had the inputs increase so much, and I think that’s really an important thing to address here, is you just need to reframe what the definition of a high price is and reframe the market overall in your head. Let’s just run with it, though. The consumer’s still going to push back with the higher number. You add to the overall prices, you’re going to get pushback from consumers.

I don’t think we’re there yet. Consumers are pretty flush still with cash, just looking at consumer sentiment numbers, looking at all the numbers that we could get. We have a very good economy still, as much as it might not seem like it to the average household. You hear your good costs twice as much, but at the end of the day, if the consumer has the cash to pay for the goods, it’s pretty unlikely that they change their buying habits. So, taking this one step further, it’s then what does change the buying habits, and I think it can either be recession hits, and suddenly we don’t have the cash on hand. The consumer doesn’t have the cash on hand that they do today, and that would stifle demand, or you get pushback on the supply side, which would also, obviously, not impact demand, but result in prices moving lower. I don’t know if that answered your question, but the step-by-step process I take weighting into this topic.

T3: So, which do you think happens first, given where we are at the economy right now at the end of March? Is it more likely that we’re going to start getting a weakening economy that pushes back on demand, or do you think it’s more likely that prices are even high enough here at $24 milk that we’re going to get a supply response from the dairy farmer?

Jacob: Oh, man. That is very, very difficult because there’s two parts to that, and let’s just look at the demand piece, is I think consumers are finally at a point where their amount of cash on hand is starting to wane, and so that certainly will have an impact, but is dairy the sector of the economy, and food in general, the sector of the economy that sees that impact first? That’s the part where I’d say probably not. Does the consumer put off buying a new car because you basically are paying over MSRP if you’re going to go get a car? Yeah, I think that’s pretty obvious. Yes. But do they buy less cheese? Do they buy less et cetera, et cetera? I would say we’re not there, and I would suspect that the first pushback comes on the supply side rather than from the demand side. That’s just my guess. There’s a lot of assumptions being made in all of our statements here. I will make that abundantly clear.

Don Street: Just a thought to maybe throw into this mix is that from the supply side, because input costs have gone up in almost every category, feed, fuel, electricity, labor, you may not get a very rapid supply response. It may take multiple months of what we think of as very high milk prices to see a real change in production.

Joshua White: Yeah. Maybe even to echo on what both Don and Jake said, I love the definition of high because high implies that I feel like, or any of us who have been in the industry for a little while feel like these prices are abnormally on the higher end of the scale, and that really draws us back to the fact that many of us have never even experienced food inflation, particularly in dairy products. My entire career, haven’t experienced this. So, I don’t really have anything to reference. High prices to me means one of two things.

We’re trying to slow demand down because supply isn’t there to fulfill what people want, or we’re trying to stimulate additional milk production, and then the question or the discussion about how will supply respond, there’s a lot of other variables baked into that. Time is one of those variables. It takes time to add infrastructure. It takes time and availability of heifers to expand the herd. I mean, it takes time to make these things happen, and I think that’s what we’re all trying to digest right now, is how long will it take and how high do prices need to go in order for the situation to balance out? Because right now, we’re not expanding milk production globally.

Jacob: I really like the way Josh just phrased that. So, circling back to your first question to me, Ted, that is what gives first, do we get this extra supply or do we get consumers backing away? Yeah. If you’re betting on one, I would bet on a demand response just because of the speed at which that can happen. Really, what that’s saying, and I’m sticking my neck out there on this one, it’s saying that we at least slow the economy as a whole, if not under a small recession, before the supply response can ramp up. Again, that’s a guess. It is absolutely a guess, but if I were betting on one, that’s what I’d bet on.

T3: Jake, I agree with you on that. I think it’s much more likely we have a demand response before we have an appropriate supply response, and the trigger that I’m having trouble letting go of is the Fed has made it very, very clear they’re raising interest rates, but how does that feed through the economy, both from the supply side with the dairy farmer and cheese makers, powder, butter, et cetera, but also from the consumer? How does that increase in the interest rate start getting a pullback on the demand side of the equation, and specifically, how does it get that pullback on the cheese side? This is where I’m going to go with that question.

We went into the pandemic, I think most of the world and most supply chains and food supply chains in the world had a variation of just-in-time inventory in terms of the way they manage their inventory, and therefore, the way that the supply chain managed its throughput from original production to it finally getting bought at the supermarket shelf or at the restaurant. I think the big change we saw in the pandemic was just-in-time inventory, its flaws got exposed strongly. So, right now I would make the case there is a lot more inventory in the whole supply chain today than there was two, two-and-a-half years ago. As the Fed increases interest rates, and as banks in response increase those interest rates to companies throughout the supply chain, distributors, wholesalers, manufacturers who hold inventory, restaurant chains, et cetera, they’re going to start, just because of the financial pressure from two places, to reduce the amount of inventory you’re carrying, both because your credit lines are starting to get squeezed, and because your costs are starting to get squeezed.

So, the first thing I would argue is going to happen is the actions of the Fed are essentially going to squeeze the supply chain and get all inventory in the supply chain, not all of it, but start reducing that inventory level, maybe back towards where we were pre-pandemic, and it’s going to feel like a decrease in demand, but in reality, I’m not sure we’re actually getting end user consumer demand decreasing yet. Then the second step is if the consumer themselves, because their credit card rates are higher, because their costs are all going up, whether it’s through higher food costs, other costs, are going to have to adjust their own buying, but I think that happens later. I agree with you, Jacob. I think the economy’s running too good right now. I think if they have to make decisions of what they’re going to go without in the near term, it’s not going to be cheese, or it’s not going to be butter. It’s going to be something else. But I do think ultimately, that pushback feeds all the way through. Do you guys agree with that?

Don: I was thinking of maybe a slightly different way to look at this, which is ultimately cheese, but I’ll start with nonfat. First of all, we export 60%, 65%, 70% of nonfat production, skim and nonfat. After that goes to Mexico, Mexico was already just in time. Any way you want to look at it, there’s just not liquidity on the import side in that market, and our interest rates drive, as the Fed increases it, drives the dollar stronger, the peso weaker, so you start to see a real heavy impact on pricing in pesos in a market like Mexico. The depth of balance sheets to deal with that is simply difficult. Nestlé Mexico will be just fine, but there are a lot of distributors, blenders, even small cheese companies that buy protein directly. So, I think that’s where you can see a real rapid change in demand, but for us it shows up as protein demand, not cheese demand.

T3: That’s a good point. But we’ve also been making the case that with less milk in 2022, we’re going to miss most of that milk in Class IV, so Class IV production is what’s going to be impacted the most, but what you’re also saying is that’s where demand is going to be impacted the most by high prices as well?

Don: Yeah. I think those two can kind of offset each other a bit, and we’ll know more as we go over the next several months. I think cheese exports probably fall in the same category, particularly as what I was just describing on nonfat. Particularly if it’s cheese for further processing, that’s ultimately a low-value price point competitive product, whether in North Africa or wherever around the world. It would be under the same pressure.

T3: That makes a lot of sense.

Jacob: Just taking one further step back here, I like that Don got us off the US-centric view, if you will, because I think that’s actually really important. I’ve been talking about recession happening in the US, perhaps due to these interest rate rises triggering it. I think even more likely, though, is that the US gets dragged into a recession by another part of world entering it first, the obvious answer being Europe. I mean, there’s all kinds of warning signals flashing in Europe. With natural gas supply, the European Central Bank I believe has basically come out and said, “Hey, if the natural gas supplies are interrupted, we’re almost guaranteed to enter a recession.” How does that back into the US? While we’re fine in the US right now, I’d say, from an economy standpoint, if a major world player gets thrust into a recession, I think there’s certainly knock-on effects.

Bringing this all back to your original question, Ted, as far as how does interest rate rising impact the supply side, will purge these inventories a little bit, I think personally, I think that’s a temporary thing. You’re going to have to rebalance what a normal inventory is, and it’ll look like demand is decreasing in the short run, but I think that’s just it. That’s a short-term, rather, impact on the market. I think it does take a major macro economy move to break us out of this funk we’re in.

T3: One of the things, Jake, that you have said in some of our internal discussions has been, when I’ve mentioned that, “Hey, the Fed’s going to get aggressive with interest rates. That’s going to cool off the economy. It’s going to potentially put us in a recession,” your pushback to me has always been, “Well, it’s not going to put us in a recession if the Fed gets it right: if they raise interest rates just enough to cool it off, but not so much that we kill demand.” It almost sounds like the other part of what you’re saying is they won’t have to raise interest rates as much if a recession in another part of the world is cooling off demand as well, and then that means that interest rates won’t need to go as high as Powell seems to be talking right now.

Jacob: Yeah, I think that’s true. I mean, there are so many balls in the air. This is a heck of a juggling act by the Fed. I do not envy anybody in that position. They do have a good number of tools at their disposal, not a ton, but that’s one possibility that I’m sure they’re considering as far as, hey, if the rest of the world cools off, that buys us some time on our interest rate rising. You also got to have some faith that they’re more in tune with the indicators than anybody of the economy cooling, and they’ll do it in a very measured response on interest rate rises. I’ve seen a number of articles over the past few days mentioning yield curve inversion really being an indicator of, hey, the yield curve inverting has been a sign of impending recession. It’s predicted the last X number of recessions.

We’re kind of in a different world right now. That yield curve I would argue is largely inverted because of the corporate bond buying that the Fed took part in, I think mainly in 2021. They bought a lot of bonds in deferred, which depressed those deferred rates, and that inverted the curve itself. But that’s something they can unwind very quickly. They can unwind that bond position, and that would bring the curve right back into a deepened state. So, I think they’re good things to pay attention to, but this is a very unique situation that I can’t say the Fed’s been in before as far as the interplay with the world economy, US supply chain, and a few other unique things.

Josh: I’m trying to draw this back to dairy because I think every time I start to get down the macro economy rabbit hole of inflation, my head starts to spin. But if I think specifically about dairy, and we go back to that initial remark that milk, based on perhaps my professional lifetime, is at a high price, and all of the components right now, all of them, are at a relatively high price. What we’ve known before is that they all don’t necessarily move together, and that certain products will reach that saturation point or kill demand earlier. I was listening Don earlier, the comment on we might see certain economies hit harder, maybe even before the US economy is hit, with a food price inflation, and that’ll push back on some of our exports, and that immediately draws me think, okay, nonfat dry milk, whey powder, products like that that we export heavily.

How does all of that balance out in terms of our milk production, but then we also got to consider the fact that the other key milk production surplus regions of the world are also declining. The US is traditionally the balancing plant of world supply and demand. We fill those gaps. I’m really trying to wrap my head around, well, do higher prices… Okay. So, that pushes those products back here. I’ve heard you guys discuss on this podcast multiple times that components don’t flow back and forth between three and four that fluidly. I mean, it takes time for those structural shifts to happen. I really want to understand a little bit more of the key user of milk in the US right now, cheese. I want to understand what cheese demand does at higher prices or with inflation in the US, domestic cheese consumption. How does that change?

If we have less dollars in our pocket because we’re spending them at the gas tank, how does that change our buying patterns for food service, for eating at home, and what does that mean for cheese consumption, knowing that our milk production isn’t growing? The average middle-class person is eating out in a few different ways. They eat out at fast food facilities for convenience. They eat out at chain type restaurants for just a nice evening out, and then upscale restaurants. COVID, as I understand it talking to some people, increased cheese consumption at home. How does all that shift if you have less dollars? Does it change your eating practices, and if so, is that actually a negative for cheese consumption, or does it actually increase cheese consumption in some ways?

T3: So, I would say I’m probably the person who needs to take a stab at that answer, given my experience on the cheese side, and I would say I expect it in three ways. First and foremost, it changes on the margins. The great example of what I mean by that is there’s going to be a number of pizzeria companies that were using eight ounces of mozzarella on every large pizza that are now going to use seven ounces. They’re just going to decrease it by just the littlest bit, or Domino’s and their cheesy crust with the cheese in the crust, maybe that goes away. You’re going to get small decreases in cheese consumption at the margins, mostly in the restaurant side of the business because they’ll just change what they’re promoting, they’ll change what they’re offering, and they’ll decrease those entrees, pizzas, to get costs back in line.

Now, one of the things we’ve been saying is one of the issues this time around, Jake had basically brought it up at the beginning, was are these prices high? When all the substitutes have gone up just as much as dairy prices have gone up, switching things around doesn’t necessarily change anything. The cost is still high. You can’t switch to something else. It’ll be the classic approach that many brands have where when prices go down, they make the portion size bigger and then charge more, and then when prices go up, they keep the price the same and decrease the portion size. So, you’re going to get those kinds of adjustments at the margins.

But the other thing that’s happening, and this is definitely a result of inflation, but not necessarily a result of high milk prices, is I’m increasingly starting to hear about stresses in the specialty cheese, and specifically the packaging side of the supply chain. For example, a lot of labels are printed on a particular craft paper that right now is in such short supply that there’s a lot of talk at label manufacturers of rationing labels. Well, what does that mean? What that means is those converters that take blocks of cheese and convert it into shreds and slices and chunks, they’re going to take those high-volume packages, maybe that instead of using a paper craft paper label, use a printed film label, are going to be easier to run, and they’re going to do something like that. They’re also less labor-intensive on a per-pound basis.

So, you’re going to get this subtle switch away from some of your higher-end specialty cheeses towards some of your commodity cheeses, which almost seems counterintuitive at higher prices, but the reality is because the challenge and the reason specialty cheeses are more expensive is because they have less economies of scale. It actually means that as the cost of inflation feeds through the system, it increases the cost of low-volume items more than it does high-volume items. So, you’re going to get changes, I think, in cheese consumption, specialty packaging, specialty cheeses, things like that, more so than your core cheddar, mozzarella sales. That’s how I expect that to play through.

Don: I have a question in the cheese space. To what extent does risk management, forward-hedging, price-locking mechanisms, however that’s managed to be done, limit the impact at a consumer level in the current upside of the market so that if you’re a large retail chain, or even a large pizza company, that your costs are locked and you have all your other costs in the space, labor, utilities, et cetera, going up? Does that shield the consumer somewhat for a given period of time for the increase in the cheese price?

Jacob: The interesting thing is it’s not really shielding the consumer. It’s shielding the consumer for the very, very last little bit. So, you have pizza chain A and pizza chain B, and pizza chain A hedged all their cheese, and pizza chain B didn’t. Pizza chain B is forced to raise their price to, let’s just say, $5. Okay? Pizza chain A who did hedge is going to raise their price to $4.98 and book the rest as profit, and you see that actually in earnings statements. Across the board, there are major winners on these earnings statements of publicly-traded companies who are just booking these record-breaking profits. And typically, if I just had to guess, those are the ones that did hedge, and again, why wouldn’t they just book at as profit? Why would they pass the savings on to the consumer? It definitely doesn’t benefit the consumer in the long run.

Don: Long run, we’re all in the same boat. Right?

Jacob: Yeah.

Don: As Keynes famously said.

T3: I have to agree with that. Dad, you haven’t said anything. Are we on the right track?

Ted Jr: Yes, but I think you’re underestimating the upside potential of the situation. Right now, if you look at the math, and again, acknowledging Jake’s original question, what constitutes a high price, right now the grocery turn on cheese using the latest indices that I saw, is about $30 a hundredweight. Manufacturing charges out of that, what, $3, maybe $4? So, that would mean you have $2 or $3 upside potential in the current situation. To underwrite that, you got corn prices, which are more than doubled, two-and-a-half times, and corn is a good indices of what milk costs, input costs are. So, it’s hard for me to see how you’re going to see any degradation on the demand side before the end of the year, until such time as Europe sees the degradation. You’re right. The situation in Europe is more dire than it is here, but the first reaction on the demand side would have to be in Europe, and their production is worse than ours. It’s not increasing at all. It’s decreasing at a faster rate than ours is decreasing.

So, I’m bullish on milk pricing to the dairymen. Now, you translate that to all the various components that we have in milk, the situation’s much different than it was 20 years ago where Class I sales are reduced, and we’re selling more and more components and so on, but our disappearance keeps going up. It’s not going down. So, I think we’re in a period of adjustment right now. We have the so-called flush of the United States. That’s also going to cause a little bit of extra milk to come out, wind up into butter and cheese, powder and cheese. So, second half of the year, this thing could be quite strong.

T3: I’m literally reduced to having only one way to counter your argument, and that counter is-

Ted Jr: You’re always on the negative side. You know that.

T3: I know that. So, hear me out, and I’ve said this. It’s like, since I’m usually the bear in the room, the fact that I’m not bearish is usually quite bullish. But my only counter right now to all of these thoughts is it always makes me nervous when everybody’s on the same side of the boat.

Ted Jr: Well, I don’t hear you being on the same side of the boat. You’re worried about the same all of a sudden disappearing, and I’m saying, “What demand?” We have continuous degradation of supply. I mean, to disappear, we’re going to have to see one hell of a lot of demand disappear in order for it to make a difference on the upside, and it’s got to start in Europe, not in the United States.

T3: Your Europe comment got me thinking. I actually think it’s a really smart comment in that you’re right. Europe is under way more pressure, price pressure, than the US is. The dollar has been strong, which means the 50% increase in prices in the US is even more outside the US, and for the most part, our economy’s going really well, and most importantly, we don’t have a war nextdoor. So, between the issues that they have with the Ukraine and Russia, with natural gas prices, with all sorts of other issues, I think it’s a very fair comment to say the demand’s going to suffer first in Europe. I also think in many ways maybe Europe’s the canary in the coal mine, that if Europe really goes into a recession, that’s what the US has to worry about, and that’s the domino effect that may pull the US into a recession as well.

Ted Jr: Okay. Let’s take that. They go into a recession. What’s that mean? It means a reduction in consumer demand. Right?

T3: Mm-hmm.

Ted Jr: Right now you have what, production in Europe down 2%. That’s a pretty big number, and it’s ongoing. It’s not an anomaly. It’s ongoing. So, you’re going to have to see a big change in demand in Europe in order for them to suddenly develop surplus dairy products. So, I see our market with significant upside potential. When we were in the toilet here a year ago, the price to the dairyman was $13 or $14 because of all the problems that we had at those times coming out of COVID. I think that’s colored our thinking a little bit. I think the real price is probably about $18, $17 to $18, and we’re up from there. So, what are we up, 30%? That’s not exactly an outrageous number. So, you go up to $25, $26 a hundredweight to the dairymen, I don’t think you’ll see increase in supply until you get up into that area, and then I think anything with four legs will be left in the milking herd. But right now, I don’t think that’s the case. There’s too many other problems.

T3: Does everybody else agree with that? I’m getting a lot of heads nodding yes.

Josh: Yeah. I mean, it seems that everyone agrees that prices are moving up, inflation’s moving higher, and that prices may need to go up to slow demand because production’s not ready to respond.

T3: Well, it’s going to be interesting. I think the most interesting thing is we’re sitting here at $24 milk and we’re all still bullish. That’s just amazing to me, and it says a lot about the environment we’re in right now.