Inflation risks are real, but manageable

Inflation reached 5.4% in the US in July, and in the UK August brought the biggest single-month leap since records began, to 3.2%. August also saw German inflation reach a 13-year high of 3.4%, while the rate for the euro zone as a whole was 3%. Broadly speaking, central banks in all these jurisdictions have a target of 2%.

The surge in inflation raises many questions. What is causing it? Is this a temporary spike as the world recovers from the COVID-19 pandemic, or might higher inflation be here to stay? What will central banks' reaction be, and what impact will that have on the broader economy? And how can companies manage the risks presented by inflation and the growing probability of tighter monetary policy?

The current wave of inflation is driven by a range of factors. Supply-push factors include rising raw material prices, logistics and transportation bottlenecks, and shortages of intermediate goods — such as semiconductors — and labour. The latter have become particularly acute during the pandemic, which has restricted workers' ability to do their jobs due to lockdowns, increased childcare responsibilities, and reduced mobility and migration. Tighter environmental regulations may also be contributing, while Europe in particular is being hit by soaring gas prices due to climatic, logistical, and geopolitical factors.

Opinion is divided on whether the current bout of inflation will be "transitory", as the US Federal Reserve has characterised it, or could be sustained and have a significant broader economic impact.

As the Financial Times has explained, "doves", including many leading developed-market central banks, see the surge as largely caused by short-term factors such as the post-pandemic consumer spending splurge, and spikes in the price of specific goods such as lumber, used cars, and semiconductors. They point out that budget stimulus and furlough programmes are now being tapered down. And they note that inflation dipped in August in the US, which also saw a sharp slowdown in hiring.

Hawks, however, argue that consumer price inflation has not yet seen the full effect of sharp increases in wages and rents that have occurred in some countries. They warn that an inflationary spiral may set in if companies need to raise prices to pay for higher wages, leading to further wage demands down the line. Some point out that semiconductor shortages and higher shipping costs have lasted longer than expected; central banks also seem to have been taken by surprise by the level of inflation midyear.

FM magazine spoke to experts to gauge their opinion.

"Supply chain challenges, rising input costs, logistics delays, and labour challenges are broad based, and across all sectors there doesn't appear to be a quick or easy resolution," said Jesse Morris, Houston, Texas-based executive vice-president, CFO, and COO at investment firm Main Street Capital. "With stabilising supplies and the impact of rising prices on demand, inflation will eventually stabilise, but in our view it will likely be more of a mid-to-longer-term outlook rather than a near-term resolution."

Kaspar Hense, London-based senior portfolio manager at BlueBay Asset Management, also warned that inflation will persist longer than doves expect.

"Inflation will remain high, and higher than currently priced for the next year, which means it will not come down as quickly as central banks anticipate," he told FM. "Most important here is a strongly growing economy with second-round effects and ultra-low inventory levels but remaining bottlenecks, especially on trade."

Companies navigating the uncertainty need to bear in mind the impact of both inflation and monetary tightening. The latter has been signalled in the US and in the euro zone, with announcements that the Fed and the European Central Bank will slow their bond-buying programmes, while central banks have already started hiking rates in emerging markets including Russia, Mexico, and Ukraine.

Higher rates present challenges for indebted companies, which have become used to low debt-service costs, as well as those looking to borrow to invest. The corporate debt-to-GDP ratio has soared in many economies, including the US and China, over the past decade, accelerating during the pandemic, making businesses particularly sensitive to interest rate changes.

Central banks increasing rates too slowly will lead to the current situation of negative real rates being sustained longer. This will help erode debt, but it will also eat into cash buffers and pensions investments, as Hense pointed out. He also noted that issuing companies and investors alike will need to take an active approach to fixed-income tools such as bonds, the value of which is eroded by both inflation and rising interest rates.

As a recent note by directors at Franklin Templeton's fixed-income division pointed out, some sectors are more at risk from bond repricing than others. Automotive, consumer products, and retail companies are at "elevated risk" of downward repricing. Those in industries including energy, metals, and mining will benefit from higher commodity prices and could even see an upward repricing. Overall, however, the note concluded that high-yield US corporate bonds faced only "modest downside" from inflation and supply shortages.

Nonetheless, Hense remains sanguine about the ability of companies in leading developed markets to weather the storm. "On the European and US business angle, I am not concerned," he said. "Companies will be able to pass most of these increased input costs of goods onto the consumer, who has high savings rates and is eager to spend after lockdowns."

Morris said that while most companies initially resisted passing input, labour, and logistics price rises on to their consumers, ultimately many have had to do so, even if it is just through the elimination of promotional discounting.

In an ideal world, Morris added, formal financial hedging would help companies manage inflationary periods. However, most smaller companies do not have the capacity to hedge, and even larger businesses have difficulty implementing formal financial hedging because of the complexity of finding effective hedges and the accounting implications. Therefore, the companies in which Main Street Capital invests have taken a range of actions to cushion the impact of both inflation and some of inflation's root causes in the supply chain and labour market.

These measures include consolidating vendors and increasing order sizes to obtain lower pricing. This usually entails decreasing use of just-in-time logistics, smaller orders, and less-than-truckload shipping. Morris said that shipping costs have soared to between twice and five times normal rates, demonstrating that squeezing logistics and supplier expenses can have a significant impact on the bottom line.

Most of Main Street's companies are now experiencing labour shortages and are increasing wages as well as referral and stay bonuses, among other incentives. Given that such changes in turn increase costs, some businesses are focusing on lean operating methods and performance-related pay to boost efficiency and productivity.

Meanwhile, although investments in technology may be capital-intensive, they can help reduce costs in the medium to long term. "Many of our companies are viewing the input, logistics, and labour challenges as continuing for at least the midterm, if not longer," Morris said. "They have turned to longer-term solutions including investing in process improvements, capital purchases for modern equipment with improved throughput rates, and automation investments for which current conditions have improved the return."

Finally, companies are also working to maintain margins on the customer side by increasing minimum order sizes, securing longer-term commitments from customers, and in some cases exiting unprofitable business.

The current inflationary wave — and the supply shocks and demand-pull behind it — are having a real impact on businesses worldwide, and may well be sustained for longer than expected. Yet with assiduous financial planning and strategy, companies should be able to ride it out.

— Andrew MacDowall is an independent consultant and writer based in France. To comment on this article or to suggest an idea for another article, contact Drew Adamek, an FM magazine senior editor, at Andrew.Adamek@aicpa-cima.com.