Inflationary scenario that the US is not used to causing CEOs of US companies to dust off – and update – the management books of 40 years ago
For US business leaders, high inflation is not welcome. It is also not common. Warren Buffett, 91, the oldest head of large companies in the S&P 500 index, recently warned of the dangers of rising prices in his annual letter to shareholders in 2021. On average, the CEOs of companies in the index are young men at home 58, who had not yet entered college in 1979, when Paul Volcker, the main enemy of inflation, became president of the Federal Reserve (Fed, the American central bank). When most of them got to work, the rise of globalized capitalism was ushering in an era of low inflation and high profits. The share prices of its companies soared between the 2007-2009 global financial crisis and the Covid-19 pandemic, a decade of inflation at its lowest.
Inflation will remain high for some time to come. On June 7, the World Bank warned that “several years of 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 rate is not far from the peak of the 1980s. As the past sneaks into the future, “stagflation” worries those in leadership positions in companies. Executives today can consider themselves hardened after going through a financial crisis and a pandemic. However, the stagflation challenge requires a different set of tools involving both elements from the past and new artifacts.
The primary job of any management team is to protect margins and cash flow, which are preferred by investors over revenue growth when things get risky. This will require a tougher struggle in the trenches of the income statement. While rising margins with rising inflation last year prompted politicians to denounce corporate “greed-driven inflation,” after-tax earnings tend to decline as a share of GDP when increases persist. pricing, based on the experience of all US companies since 1950 To create shareholder value in this environment, companies need to increase their cash flows in real terms. This means a combination of cost cutting and passing on cost inflation to customers without decreasing sales volume.
Cost containment will not be easy. Prices for raw materials, transport and labor remain high and most companies cannot dictate prices in these markets. Supply chain constraints have started to loosen a bit and may continue to loosen in the coming months. But it is almost certain that the troubles will continue. In April, Apple complained that the shortage of computer chips across the industry is expected to create a $ 4 to $ 8 billion “barrier” for the iPhone maker this quarter.
Brake to hiring
The input that bosses can most easily control is work. After months of hectic hiring, companies are trying to protect margins by getting more from their employees or getting the same result as before with fewer of them. The labor market remains very strong: in the United States wages have risen by more than 5% per year and, in April, layoffs hit an all-time low. But in some cases, the frenetic post-pandemic hiring to meet pent-up demand is lifted.
American bosses are proving once again that they are less reticent about layoffs than their European counterparts. In a memo sent to employees this month, Elon Musk revealed plans to reduce the number of employees at his electric car company Tesla by 10%. Many of the most beloved companies in the digital world that grew during the pandemic collectively laid off around 17,000 workers in May alone. After attracting professionals with higher salaries and benefits, in the latest quarterly earnings releases, more and more US CEOs have talked about automation and workforce efficiency.
In the current juncture, however, pragmatic (and insensitive) control of spending will not be sufficient to maintain profitability. The remaining cost inflation must be imposed on consumers. Many companies are about to learn the intricacies of rising prices without hurting demand. Those companies that put this superpower into practice tend to share some characteristics: poor competition, inability of customers to delay or avoid purchases, or sources of income linked to inflation. A strong brand also helps. Starbucks bragged in an earnings release in May that, despite rising prices for its coffee drinks, the company has struggled to keep up with “relentless demand.”
However, recent data suggests weaker consumer sentiment. This makes it more risky for companies to implement frequent price increases. Signs of caution emerge from McDonald’s, which has speculated a “growing price sensitivity” among burger fans; Verizon, which found customer “delays” in the last quarter. The ability to force acceptance of price increases while consumers tighten their belts requires careful management. Unlike the last era of high inflation, managers can use algorithmic pricing in real time, constantly experimenting and adapting to consumer reaction. However, all businesses still need to have a long-term view of how high prices will last and the limits of what their customers will tolerate. It is not an exact science.
Even as they keep their income and expenses in check, CEOs are discovering what their predecessors knew all too well: inflation devastates the balance sheet. This requires even tighter control over working capital (the value of available cash resources plus what customers owe less what you have to pay suppliers). Many companies have miscalculated the demand for their products. Walmart lost nearly 20% of its market value, or about $ 80 billion, in mid-May after reporting a contraction in cash flow caused by excessive inventory build-up, which increased for a third year. On June 7, its smaller retail rival, Target, issued a warning that its operating margin will decline by 5.3%; in the last quarter, at 2%, in the current one; as it is discounting merchandise to burn off excess inventory. Payment cycles – when a company pays suppliers and is paid by customers – have also become more important, as the purchasing power of cash delivered tomorrow weakens due to inflation.
All of this makes it more difficult to measure a company’s performance. For example, return on equity calculations look more impressive with an inflated numerator (current returns) and a denominator (past invested capital) in old dollars. Between 1979 and 1986, during the last period of high inflation, American companies were required by law to present income statements adequate for the increase in prices. It is unlikely that such a decree will be able to resurrect. But even as bosses brag about higher nominal revenue growth, investment and compensation decisions must take these artificial winds into account.
Just ask Buffett. In his letter to shareholders referring to the year 1980, he reminded them that profits would have to rise in proportion to the rising price level without an increase in the capital employed, to prevent the company from starting to “eat” the capital of the investors. His letter to investors in 2023 may have to convey the same message. / TRANSLATION OF ROMANA CACIA