For the leaders of America Inc, high inflation is undesirable. It is also unknown. Warren Buffett, 91, the oldest boss in the big companies’ S&P 500 index, last warned of the dangers of rising prices in his 2011 annual shareholder letter. The average CEO of the index, just 58, he had not started a university in 1979 when Paul Walker, the main enemy of inflation, became chairman of the Federal Reserve. By the time the average boss started working, the rise of globalized capitalism ushered in an era of low inflation and high profits (see Chart 1). Their shares rose between the 2007-09 global financial crisis and the covid-19 pandemic, a decade of lowest inflation.
Inflation will remain high for some time to come. On June 7, the World Bank warned that “several years above average inflation and below-average growth now seem likely.” A new study by Marijn Bolhuis, Judd Cramer and Lawrence Summers found that if you measure inflation consistently, today’s pace is almost as high as it was at the top in 1980. As the past creeps upwards into the future, stagflation is a concern for offices. Today’s leaders may think of themselves as battle-hardened – they have survived a financial crisis and pandemic. However, the stagflation challenge requires a variety of tools that borrow from the past and also include new tricks.
The main task of any management team is to protect the margins and cash flows that investors prefer to revenue growth when things get tough. This will require a stronger struggle in the trenches of the income statement. Although rising margins, when inflation first rose last year, led politicians to condemn corporate “greed,” post-tax profits tend to fall as a share of GDP as prices continue, based on everyone’s experience. American companies since 1950 (see Figure 2). To create value for shareholders in this environment, companies need to increase their cash flows in real terms. This means a combination of cost reduction and passing on cost inflation to customers without reducing sales volumes.
Reducing costs will not be easy. The prices of goods, transport and labor remain high and most companies take the prices in these markets. Supply chain constraints have begun to ease somewhat and may continue to ease in the coming months. But the interruptions will almost certainly continue. In April, Apple complained that the shortage of computer chips across the industry is expected to set a “limit” of $ 4 billion to $ 8 billion for the iPhone maker this quarter.
The most important bosses can control the work. After months of fierce hiring, companies are trying to protect margins by getting more from their workers or getting the same amount from fewer. The labor market remains tense: in America, wages are rising by more than 5% on an annual basis, and in April the cuts reached a record low. But in some corners, the pandemic hire scam is being tackled to meet accumulated demand.
American bosses have once again shown that they are less disdainful of layoffs than their European counterparts. In a note sent to employees this month, Elon Musk revealed plans to reduce the number of employees at Tesla, its electric car company, by 10%. Digital pets, many of which thrived during the pandemic, collectively laid off nearly 17,000 workers in May alone. After the temptation of workers with increased pay and benefits, in the last three months of revenue calls, more and more American CEOs are talking about automation and work efficiency.
However, in the current climate, persistent (and stubborn) cost control will not be enough to maintain profitability. The rest of the cost inflation must be passed on to customers. Many companies are about to learn the difficulty of raising prices without reducing demand. Companies that own this superpower often share several qualities: weak competition, inability of customers to slow down or avoid purchases, or inflation-related revenue streams. A strong brand also helps. Starbucks boasted in a profit call in May that despite rising caffeine prices for its beverages, it was struggling to cope with the “relentless search”.
But recent data suggests softer consumer sentiment. This makes it more risky for companies to introduce frequent price increases. Amber lights are flashing, from McDonald’s, which speculates on “increased value sensitivity” among burger lovers, to Verizon, which has found “slowness” in customers in the last quarter. The ability to push for price increases while customers tighten their belts requires careful management. Unlike the last era of high inflation, managers can use algorithmic real-time pricing, constantly experimenting and adjusting according to consumer response. Nevertheless, all companies will need to have a longer-term view of how long fast prices will last and the limits of what their customers will tolerate. This is something with a finger in the wind.
Even if they keep their revenues and expenditures under control, CEOs are discovering what their predecessors knew all too well: inflation is wreaking havoc on the balance sheet. This requires even tighter control of working capital (the value of inventories and what is owed by customers minus what is due to suppliers). Many companies have misjudged the demand for their products. Walmart lost nearly a fifth of its market value, or about $ 80 billion, in mid-May after announcing a shrinking cash flow caused by excessive stockpiling, which rose for the third year in a row. On June 7, its smaller retail competitor, Target, issued a warning that its operating margin would fall from 5.3% in the last quarter to 2% this year as it cuts goods to clear surplus stocks. Payment cycles – when a company pays suppliers and is paid by customers – also become more important as the purchasing power of money delivered tomorrow dries up in the midst of inflation.
All this makes the work of the business more difficult to assess. For example, calculations of return on capital seem more impressive with an inflated numerator (current return) and denominator (capital invested in the past) in old dollars. Between 1979 and 1986, during the last bout of high inflation, American companies were required by law to report income that was adjusted for rising prices. This decree is unlikely to be revived. But even when bosses boast higher nominal revenue growth, investment and compensation decisions must take such artificial winds into account. Just ask Mr. Buffett. In a letter to shareholders in 1980, he reminded them that profits must increase in proportion to rising prices without increasing capital investment, so that the company does not start “chewing” investors’ capital. His message to investors in 2023 may need to carry the same message. ■
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