The most dangerous words regarding investing are, “This time, it will be different.” The same words often occur when planning for a recession. But, quite possibly, this time, it will be different. Why do we at Everest Group believe it may be different for the looming recession we now face? Because there is a confluence of trends that are different from past recessions.
Typically in a recession, companies postpone or cancel their discretionary spending, talent demands cool, and labor wages come down. But we are already in the midst of a globally constrained labor market because of the acute shortage of engineering and IT talent that cannot meet the high demand for these skills to build and run software-defined operating platforms. This situation likely will get worse as we move forward. We base this belief on a confluence of two trends.
Trend 1: Skilled Labor Supply Is Diminishing
The reality in the US and Western Europe is that more people are leaving the workforce than are coming into it. Further exacerbating this problem is the fact that universities are not graduating enough qualified people with engineering and IT skills that are so critical to meet the demand for building software-defined operating platforms.
Furthermore, immigration policies continue to restrict immigration in both the US and Europe for engineering talent.
Trend 2: Demand For Skilled Labor is Increasing
As I explained in several recent blogs, companies are quickly becoming more dependent on engineering to build and evolve software-defined operating platforms. These platforms create a dynamic relationship that requires the tech stack constantly adapt as the organization constantly evolves.
These platforms yield substantial benefits in creating new value and competitive positioning. They require persistent teams that stay in place to evolve the platforms; in fact, the numbers of team members increase over time. Thus, there is a constantly growing demand to invest in developing the platforms.
Many companies have already moved significant portions of what historically would have been discretionary spending on engineering IT into essential spending. It is necessary to continue to invest in these value-producing operating platforms, regardless of economic conditions.
Are Labor Markets Cooling?
Labor demand is rising faster than supply. This will lead to a new floor that rises every month, every year. That is not to say that demand will not cool. Some portions of spend that are still discretionary and can be postponed or eliminated will create some cooling of the labor markets. But it will not be nearly to the extent of historical precedent. Therefore, we likely will still face a constrained labor market for engineering and IT.
We already see companies pulling back on hiring, trying to rid themselves of excess. Clearly, that will create some marketplace relief. But given the ongoing increases in demand, it will not be enough to move out of a constrained labor market.
This poses a substantial challenge to companies that are preparing for a recession.
Strategies And Resulting Problems
Strategy 1: Outsource
One strategy is to outsource and use contractors, particularly in short-term contracts. Although they would prefer to hire skilled individuals to do the work in-house, companies do not want to be saddled with too many employees in a recession. Outsourcing and contracting are a short-term remedy during a recession, providing labor and cost savings. We can clearly see these short-term contracts are driving a hot demand marketplace right now.
At first glance, it seems prudent for companies to do this. This strategy creates some flexibility so a company may not have to undertake significant layoffs as would otherwise be necessary.
Problem: Simply put, there will still be a constrained labor market. It is not as constrained as it has been; however, although attrition has come down over the last two years, it is still well above historical norms. This indicates there is still a constrained labor market, even with layoffs and reduced hiring.
Keep in mind that third-party service providers likely will need to continue to raise wages for engineering talent.
Outsourcing for the short term is easy for companies that want to move quickly to reduce costs. But with a high demand flow in this environment, companies could easily find themselves without sufficient capacity in their contracting supply chain.
Strategy 2: Contracting For Cost Savings
Looking to pivot to cost-saving strategies in view of a coming recession, many companies put pressure on their service providers to deliver cost savings.
Problem: Companies are less likely to realize those planned cost savings because the service provider must increase wages for their employees due to the constrained marketplace.
Strategy 3: Portfolio Rationalization
For the last two years, the constrained marketplace drove companies to try to rationalize their portfolio of service providers and give more work to some providers with the intent of achieving lower costs from those providers.
Problem: At this time, the strategy proves to be very difficult because the providers are not able to fulfill the demand in a constrained labor market. We at Everest Group see some contracts being written for this cost-saving strategy. But we are not seeing providers that win those contracts being able to fulfill them with the requisite level of talent.
My advice: Be very careful before you decide to go through portfolio rationalization. On paper, it may look like your company achieves savings, but you likely will constrict the ability of your business to continue to evolve its tech stack at a time when the ability to do so has shifted from discretionary into essential spend because platforms are needed to run your business.
Service Provider Reset Trend Presents Dilemma
One implication of software-defined operating platforms we observe is that it causes a reset of third-party service providers. Some will move to the value providers segment.
Value Providers. It is essential that companies maintain the same teams for software-defined operating platforms. These teams have the best people doing the work continually as they understand the internal environment as the tech stack evolves. In each platform team, there will be one or two value players that have this deep relationship. Companies must pay more for this value – whether it is internal employees or a service provider and its employees.
Value providers commit to investing in growing a company’s platforms and in keeping team members in place.
Best-of-Breed Partners. Besides shifting some service providers to relationships that are in the value segment, companies will continue to contract with best-of-breed providers. These relationships will have contracts based on RFPs for the best capabilities and lowest price. Companies will treat these providers in a more arms-length arrangement.
In a recession, the best-of-breed providers likely will be in the discretionary spend component. The value segment providers will be in the essential component, which likely will continue to increase even in a recession.
The challenge for purchasing organizations is twofold. They will need to be able to differentiate between best-of-breed and value situations. Then they will need to develop new contracting vehicles for the value providers because the existing contracting vehicles focus on best-of-breed relationships.