Navigating the Inflation Headache
Inflation has emerged as one of the key concerns of business leaders. Grappling with rising prices may require innovations in cash management.
In recent months, higher prices have impacted our daily lives. The cost of everything from cars and food to lumber and airfares surged over the summer, given supply-chain issues and a re-orientation of consumer spending as a result of the pandemic.
Although we doubt that a full-blown crisis is imminent, inflation and related supply-chain disruption will create challenges for treasury teams for some time to come.
Not Going Back to the 1970s
For many, today’s inflationary pressures are reminiscent of the stagflation crisis of the 1970s. Headlines have sometimes sparked flashbacks to the era’s painful oil shortages. Similarly, fiscal and monetary stimulus has, for some, harked back to the loose financial policies that helped drive wage-price spirals and double-digit inflation five decades ago.
However, we believe things are very different today. The Federal Reserve’s current low-rate policies and aggressive quantitative easing are unprecedented in scale, in nominal terms. However, when measured in real terms, financial conditions were materially looser in the 1970s.
We determined this by looking at interest rates paid in aggregate by the government, corporations, consumers, and mortgage-holders (see Figure 1).
The composition of inflation is also different. Today’s inflation is mostly being driven by rising prices of “flexible” goods like used cars, airfare, and hotel rooms. In the 1970s, it was driven more by “sticky” goods and services, like the cost of rent (see Figure 2).
That’s why the Federal Reserve has been characterizing the recent spell of inflation as “transitory” rather than “persistent.” The message is that the Fed expects inflationary pressures to moderate as supply chains normalize and the price distortions related to the pandemic fall out of the annual inflation calculations.
Still, we believe inflation will remain above target for some time, and may even print above 5 percent for a few months yet, keeping it well above the Federal Reserve’s 2 percent target. The central bank’s latest economic forecasts also show inflation staying above target all the way to the end of 2024. So, the Fed expects inflation to be transitory—but not brief. We believe inflation will remain relatively elevated for the next year.
There is also a risk that “stickier” components of the Consumer Price Index (CPI) will begin to rise in the coming months, particularly as the last two monthly CPI readings showed a modest but steady acceleration in the index’s “rental” component. This will exacerbate risks of persistent inflation. Treasurers cannot afford to become complacent.
Supply-Chain Issues Contributing to Inflation
A large degree of today’s inflation pressures have derived from supply-chain issues, which directly impact treasurers. These supply-chain issues stemmed from areas of the economy such as the chemicals sector.
In that sector, many companies responded to the onset of the pandemic, and the ensuing economic uncertainty, by immediately liquidating inventories. When a measure of confidence returned at the start of 2021, chemicals businesses began restocking. However, in February, the freezing weather and ensuing power crisis in Texas shut down a large percentage of North American chemical capacity. This blocked the supply of feedstocks through the entire value chain—impacting the supply of almost every non-edible chemicals-based product, from paints to packaging to paper. Now, slowly but surely, chemical plants have come back online and the restocking effort is resuming. However, the 2021 hurricane season created more headwinds, knocking out gas and oil production in the Gulf of Mexico.
These supply constraints have made inventory more expensive for this sector. And some businesses are having trouble delivering products to customers in a timely manner, which may result in unexpected costs. For example, one chemicals company in Q2/2021 suffered logistics issues in getting paint to its customers in the auto sector. Its contractual obligations were inflexible, leaving it little choice but to absorb the excessive cost of doing whatever was necessary to get its product to its buyers.
The specifics of supply-chain challenges vary by industry, but distortions similar to those we’re seeing in the chemicals sector are causing all kinds of businesses to need increasingly large cash buffers. The need has been particularly acute for businesses toward the end of the supply chain. Those reliant on four or five supply-chain links are particularly vulnerable to working capital challenges.
Longer term, this situation may lead many companies to move away from holding just-in-time inventory. The conventional belief has been that tying up cash in inventories is an inefficient use of capital. However, as treasury groups come to understand that their supply chains are more fragile than they previously imagined, they are determining that they may not be able to call up overseas factories for next-day delivery to North America in the event of a spike in demand.
Will COOs look to keep larger inventory positions, invest in production facilities closer to their customer bases, or vertically integrate by buying or merging with their suppliers to have more control over their supply chain? Those remain open questions. Businesses may also finance inventory differently—for example, by demanding quicker payments from customers or delaying payments to their suppliers. Either way, the shorter- to medium-term will be a time for firms and treasurers to place a greater emphasis on cash management.
How to Do More with Cash Management
As the world enters a period of relatively high inflation and record-high corporate cash reserves, every basis point of return will make a difference. Consider that for every $100 million that an organization holds in cash, an annual return of 0.01 percent equates to an additional $10,000 in revenue per year. This return could certainly add to the cash buffer, but it could also be reinvested in the company. Technology, subscriptions, training, and other human capital improvements could potentially counteract inflation costs through productivity gains.
Crucially, the challenge lies in making sure treasurers do not sacrifice the safety and liquidity they need when squeezing out more basis points from cash holdings. Cash currently earns close to zero. Short-term investments earn more, and incremental investment returns are vitally important right now, but they come with a trade-off in liquidity.
Strategically, therefore, treasury teams may decide to diversify their cash funding profile, considering assets such as receivables financing, commercial paper issuance, and letters of credit. Once a company has an adequate cash buffer, optimally allocating those funds between cash and short-term investments becomes crucial—regardless of whether investment decisions are made in-house or outsourced to an investment adviser.
Traditionally, treasurers have tended to base their allocation decisions largely on cash-flow forecasting. Forecasts are undeniably necessary, but adding sophisticated portfolio analytics to the process can potentially help treasurers enhance their allocations further.
For example, an analytics tool may use a treasurer’s risk tolerance and investment policy as central inputs in creating customized risk measures such as “drawdown risk tolerance” and “balance risk tolerance.” These metrics measure, respectively, a liquidity portfolio’s potential resilience to falling investment markets and the proportion of the assets that will potentially not need to be called on. Such metrics can be powerful tools for treasurers in optimizing daily, operating, and reserve cash allocations. They enable treasurers to meet specific liquidity requirements without leaving valuable returns on the table.
Treasurers Will Need to Consider Inflation for a While
A full-blown inflation crisis may not be in the cards, but relatively high inflation (above the Federal Reserve’s target) may be a feature of the investment world for months, even years, ahead. Since the 1980s, inflationary pressures have consistently dwindled, making the prospect of even a short-term spell of inflation and supply-chain bottlenecks a potentially new challenge for today’s treasury teams.
At the same time, corporates have found themselves needing more cash on hand. It may be time for treasurers to consider lasting innovations in cash management, in a world where every basis point has become more valuable.
* Opinions expressed herein are current opinions of Insight, and are subject to change without notice. This material is provided for general information only and should not be construed as investment advice or a recommendation. Consult with your investment adviser to determine whether any particular investment strategy is appropriate.