Navigating the headache of inflation | Cash flow and risk
In recent months, the rise in prices has impacted our daily lives. The cost of everything from cars and food to lumber and plane tickets has increased over the summer, given supply chain issues and a shift in consumer spending. following the pandemic.
While we doubt a full-scale crisis is imminent, inflation and the resulting supply chain disruption will create challenges for treasury teams for some time to come.
Don’t go back to the 1970s
To many, today’s inflationary pressures are reminiscent of the stagflation crisis of the 1970s. Headlines have sometimes sparked flashbacks to the painful oil shortages of the time. Likewise, the fiscal and monetary stimulus measures have, for some, recalled the accommodative financial policies that helped lead to wage-price spirals and double-digit inflation five decades ago.
However, we think things are very different today. The current low interest rate policies and aggressive quantitative easing by the Federal Reserve are unprecedented in magnitude, in nominal terms. However, measured in real terms, financial conditions were noticeably looser in the 1970s.
We determined this by examining the interest rates paid globally by government, businesses, consumers, and mortgagees (see Figure 1).
The composition of inflation is also different. Inflation today is mainly due to rising prices for âflexibleâ goods like used cars, airline tickets and hotel rooms. In the 1970s, it was motivated more by âstickyâ goods and services, such as the cost of rent (see Figure 2).
This is why the Federal Reserve has called the recent wave of inflation âtransientâ rather than âpersistentâ. The message is that the Fed expects inflationary pressures to moderate as supply chains normalize and price distortions related to the pandemic are not factored into annual inflation calculations. .
Nonetheless, we believe inflation will stay above target for some time, and may even exceed 5% for a few more months, keeping it well above the Federal Reserve’s 2% target. The latest central bank economic forecast also shows that inflation will stay above target until the end of 2024. So the Fed expects inflation to be transient, but not short. We believe inflation will remain relatively high over the next year.
There is also a risk that the “stickier” components of the Consumer Price Index (CPI) will start to rise over the next few months, especially since the last two monthly CPI readings have shown a decline. modest but constant acceleration of the ârentalâ component of the index. This will exacerbate the risks of persistent inflation. Treasurers cannot afford to be complacent.
Supply chain issues contributing to inflation
Much of today’s inflationary pressures are due to supply chain issues, which have a direct impact on treasurers. These supply chain problems originated in sectors of the economy such as the chemicals sector.
In this sector, many companies reacted to the onset of the pandemic and the resulting economic uncertainty by immediately liquidating their inventories. When a confidence measure returned in early 2021, chemical companies began to resupply. However, in February, freezing weather and the ensuing energy crisis in Texas shut down a large percentage of North American chemical capacity. This has blocked the supply of raw materials throughout the value chain, impacting the sourcing of almost all inedible chemicals, from paints to packaging to paper. Now, slowly but steadily, the chemical factories have come back on line and the resupply effort is resuming. However, the 2021 hurricane season created more headwinds, wiping out gas and oil production in the Gulf of Mexico.
These supply constraints have made inventory more expensive for this sector. And some companies struggle to deliver products to customers on a timely basis, which can lead to unforeseen costs. For example, a chemical company in Q2 / 2021 encountered logistical problems in shipping paint to its automotive customers. His contractual obligations were inflexible, leaving him little choice but to absorb the excessive cost of doing whatever was necessary to get his product to his buyers.
The specifics of supply chain challenges vary by industry, but distortions similar to those we see in the chemicals industry are forcing all kinds of businesses to need increasingly large cash reserves. The need has been particularly acute for companies near the end of the supply chain. Those who depend on four or five links in the supply chain are particularly vulnerable to working capital problems.
In the longer term, this situation can cause many companies to abandon just-in-time inventory management. The conventional belief has been that tying up money in inventory is an inefficient use of capital. However, as treasury groups understand that their supply chains are more fragile than they previously imagined, they determine that they might not be able to call factories overseas for a next day delivery to North America in the event of peak demand. .
Will COOs look to keep larger inventories, invest in production facilities closer to their customers, or integrate vertically by buying or merging with their suppliers to gain more control over their supply chain? ‘supply ? These questions remain open. Companies can also finance inventory differently, for example by demanding faster payments from customers or by delaying payments to their suppliers. Either way, the short to medium term will be the time for businesses and treasurers to put more emphasis on cash management.
How to do more with cash management
As the world enters a period of relatively high inflation and record cash reserves for businesses, every basis point of performance will make a difference. Consider that for every $ 100 million an organization holds in cash, an annual return of 0.01% equals $ 10,000 in additional revenue per year. This return could certainly add to the cash cushion, but it could also be reinvested in the business. Technology, subscriptions, training and other human capital improvements could potentially offset inflation costs through productivity gains.
Basically, the challenge is to make sure treasurers don’t sacrifice the security and cash flow they need when they take more basis points out of their cash. Money is currently earning close to zero. Short-term investments pay more and incremental returns on investment are vitally important right now, but come with a tradeoff in terms of liquidity.
Strategically, therefore, treasury teams may decide to diversify their cash funding profile, taking into account assets such as debt financing, commercial paper issuance and letters of credit. Once a company has an adequate reserve of liquidity, the optimal allocation of these funds between cash and short-term investments becomes crucial, whether investment decisions are made in-house or outsourced to a third party. investment advisor.
Traditionally, treasurers have tended to base their allocation decisions largely on cash flow forecasts. Forecasting is definitely needed, but adding sophisticated portfolio analysis to the process can potentially help treasurers improve their allocations further.
For example, an analytics tool can use a treasurer’s risk tolerance and investment policy as central data to create custom risk metrics such as “take risk tolerance” and “risk tolerance. balance â. These metrics measure, respectively, the potential resilience of a liquidity portfolio to declining investment markets and the proportion of assets that will potentially not need to be called. Such metrics can be powerful tools for treasurers in optimizing daily, operational and cash reserve allocations. They allow treasurers to meet specific liquidity needs without leaving valuable returns on the table.
Treasurers will have to factor in inflation for a while
A generalized inflation crisis may not be in the cards, but relatively high inflation (above the Federal Reserve’s target) can be a feature of the investment world for months or even years to come. Since the 1980s, inflationary pressures have steadily abated, making the prospect of a period of even short-term inflation and supply chain bottlenecks a potential new challenge for treasury teams. today.
At the same time, businesses needed more cash. Perhaps it is time for treasurers to consider sustainable innovations in cash management, in a world where every basic point has become more valuable.
Jason celente is a senior portfolio manager at Insight Investment in New York, overseeing short-term and personalized investment strategies.
* The opinions expressed here are current opinions of Insight and are subject to change without notice. This document is provided for general information only and should not be construed as investment advice or recommendation. Consult your investment advisor to determine if a particular investment strategy is appropriate.