It’s no secret that the rampant inflation of the past year has harmed the global economy’s growth. Consumers are spending less, and companies’ revenue is dropping due to not being able to pass on the full price of inflation to the customer.
But a recent McKinsey report highlights the “hidden” damage of inflation - namely long term negative economic effects and challenges to value creation. Both of these are hard to evaluate in numbers but are very much a factor.
The biggest inflation problem
In order for a company to be truly healthy during inflation, they need to increase growth in both profit margins and return on capital for them to come out stronger.
But companies find this extremely difficult. In fact, most organizations would be happy to come out of inflation by staying in place.
The title of the report, “Why You Can’t Tread Water When Inflation is Persistently High”, explains it all. If you are staying in the same place, you are going backwards, because inflation will eat away at your profits from all angles.
Sales tend to fall (even on a nominal basis), and even if they don’t, profit margins and return on costs (ROC) most probably will. The report shows that during times of rising price pressure from 1970 until 1990, almost all industry sectors in the U.S. suffered declines in these areas.
Therefore, in a time where companies actually need to grow more than usual in order to be in a healthy situation, the vast majority are going backwards.
Long term effects
Although inflation has subsided ever so slightly, The Fed has made it clear that they are quite disappointed in their efforts to lower it below the goal of 2%. While high inflation is not good for the economy, persistently high inflation causes even more challenges, namely how it affects value creation.
The difference between temporary inflation and persistent inflation is that temporary is not likely to affect the stock market but persistent inflation will. That’s because persistent inflation comes along with decrease in cash flows and rising inflation, while temporary inflation usually doesn’t translate into a huge change in consumer spending (cash flow).
The McKinsey report explains: “With that insight in mind, managers should not rely exclusively on reported operating margins and returns on capital; likely, these metrics are distorted by inflation. Even if profits increase in nominal terms, they may be falling on a real basis.”
However, the harm to value creation isn’t very clear because “accounting doesn’t handle inflation very well”. Therefore the negative effects of value creation might not be realized until further down the line.
The McKinsey study found that over the past 50 years, high inflation harms the average US company by slowing growth 0.6 percentage points due to the damage from price pressures to business performance.
It’s important to note an industry with an exception to negative effects of inflation is energy companies, as they actually benefit from rising oil and gas prices. Another industry that can benefit is well established consumer staple brands, as they are able to pass on rising prices to consumers far easier than other businesses.
Conclusion
McKinsey highlights that long term inflation has more serious consequences than what can be calculated in numbers. It slows growth, changes consumer sentiment far more than temporary inflation, and causes most companies to suffer a decline in free cash flow.
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