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Since our last review in August of 2022, we are beginning to see the realization of our forecasts. The hiring environment has begun to show promising signs; however - inflation - despite the Fed's best efforts, remains stubborn.
According to a speech given by Jerome Powell on November 30th 2022 at the Brookings institute in Washington, DC:
“There is considerable uncertainty about what rate will be sufficient, although there is no doubt that we have made substantial progress, raising our target range for the federal funds rate by 3.75 percentage points since March. As our last post-meeting statement indicates, we anticipate that ongoing increases will be appropriate. It seems to me likely that the ultimate level of rates will need to be somewhat higher than thought at the time of the September meeting and Summary of Economic Projections.”
Chairman Powell’s comments indicate that the Fed will continue to increase interest rates drastically, until inflation has been tamed; in turn, implying that a recession is inevitable. Since Fed policy has a lagged effect, many economists (1) argue that the magnitude of the rate increases should be smaller (potentially making a future recession less severe).
According to the Bureau of Labor Statistics (BLS), yearly CPI inflation for all items is 6.5% in December, which is way above Fed’s target of 2%. Food prices increased 10.4% in December (on an annualized basis), but the increase has been steadily slowing since May. Energy inflation has been steadily declining since July to an annualized 7.3%. On the other hand, shelter is now 7.5% more expensive and shows no sign of slowing down (2). While housing sales were down 7.7% in November, interest rates are making mortgages more expensive. Existing homeowners are less likely to consider financing a new purchase. With new development now more expensive because of elevated interest rates, capital costs, etc..., housing demand will likely continue decreasing which will lead to lower inflation.
Many of the inflationary catalysts that we have discussed in our previous thought leadership pieces have subsided. Many sources imply that supply chain issues have been easing (3). Yet interest rates have grown sharply. Growth in money supply, a factor that generally leads to inflation, has also fallen dramatically as is evident from the graph of M2 below:
Despite all of this, inflation still remains high. Have you purchased eggs recently from a grocery store? The following are three of the main reasons for ever-persistent inflation:
The economy always takes time to respond to monetary policy – it is never immediate.
Un-cooperative fiscal policy. Government spending is a part of aggregate supply – every dollar increase in government spending is multiplied through the economic machine and ends up having more than a dollar impact on GDP. In December the House voted to approve a $1.65 trillion spending bill. According to WSJ, (4):
"The omnibus legislation includes $858 billion in military spending, $45 billion more than the White House had requested and up about 10% from $782 billion the prior year. It also includes $772.5 billion in non-defense discretionary spending, up almost 6% from $730 billion the prior year. The overall discretionary price tag works out to about $1.65 trillion, compared with $1.5 trillion the prior fiscal year.”
This certainly will not help reduce inflation.
Anything that increases the amount of money (or the future expectation thereof) in consumer’s pockets increases aggregate demand and fuels inflation – inflation relief checks and student loan forgiveness are great examples.
Labor market tightness. We have previously discussed the reasons behind the labor market’s supply and demand imbalance. Many of these reasons are still valid and the predictions we’ve previously made are still unchanged: worsening economic conditions will lead to loosening of the labor market and more and more employees will become available for hire. To an extent, we are already beginning to see this come to fruition. The restaurant industry was one of the hardest hit sectors during the COVID lockdowns and many restaurant employees didn't return - at least not until now. According to the BLS, “leisure and hospitality added 88,000 jobs in November, including a gain of 62,000 in food services and drinking places”. Their report continues to state that leisure and hospitality is, nevertheless, still “below its pre-pandemic February 2020 level by 980,000 or 5.8 percent” (5).
The two most important questions for any decision making at this point is 1) how long will inflation last and, consequently, 2) how long will the Fed continue increasing the rates. Looking at various markets can help one glean some insights into what the “smart” money is expecting.
One way to see the market’s inflationary expectations is by looking at the yields of Treasury Inflation-Protected Securities (TIPS). Yields and prices are negatively correlated, just like two ends of a seesaw - when prices go up, yields go down. Prices, in turn, go up when demand increases. Demand for TIPS increases when the market is expecting high inflation as everyone is trying to protect their principal amount. Below is the graph of yields-to-maturity of 5-year TIPs due 4/15/24. It is very clear that markets were expecting high inflation in all of 2020, yields were negative for the most part, until August of 2022. Now market expectations have clearly changed, and the TIPS market seems to think that inflation is going to decrease.
There is also a way to quantify these expectations. The Federal Reserve Bank of Cleveland reports inflation expectations over various time horizons. They use a sophisticated model which looks at Treasury yields, inflation data, inflation swaps, and survey-based measures of inflation expectations. The graph below shows market expectations, using the Cleveland Fed’s model, for the rates that inflation is expected to average over 1, 2 and 5 years. In December of 2022 these expectations are below 3%.
Again, there is a huge psychological aspect to inflation is psychological - a large part of what drives it is reaction to anticipated or perceived price changes. If market participants believe that costs will be stable, they stop increasing them and inflation comes under control.
As to the projections of the interest rates - below is a median projection of the Fed Funds Rate from the Federal Open Market Committee (FOMC). Clearly rates are projected to continue increasing through the end of 2023 - after which they will begin to decline again.
These economic conditions will clearly have an effect on many businesses – below are the expectations for EBITDA margins from McKinsey and Co:
According to these predictions, in the near-term, inflation will continue to decrease. Interest rates will keep rising, all of which will result in a low or even negative GDP growth (i.e. recession). There are a few areas where businesses can think of protecting themselves from recession related turbulence:
Leverage
First of all, let’s talk about debt. Interest rates are rising, so obtaining new debt financing will obviously become more and more expensive. The same is true for any existing adjustable rate loans. While the cost of new debt is the obvious elephant in the room, there is a slightly less obvious 800-pound gorilla hanging out here too – as cash flows become more volatile - and generally fall in recessionary times - service of existing debt becomes more challenging.
Research of companies during the great recession suggests that firms with higher leverage were less successful (6). According to this study, higher levered firms were more likely than their lower levered peers to incur significantly larger employment losses during declines in local consumer demand. The problem ahead of us now is that aggregate demand is slower during recessions, cash flow problems are more likely to occur – all making it all the more challenging to pay principal and interest. Refinancing, however, will be very expensive due to higher interest rates. Re-assessing your firm’s balance sheet and deleveraging to the extent possible is one potential answer.
Further research shows that companies owned by private equity firms performed better during the 2008 financial crisis compared to their peers. This indicates that access to private equity funding can loosen some financial constraints (7).
Investment in technology
Another possible way to deal with recession is to reduce overhead by investing in technology solutions. In many cases, more efficient technology can drastically reduce costs of operations. In times of financial turmoil, many changes in business processes are expected. Better technology increases flexibility, accuracy, and enterprise-reaction speed. In addition, in times of lowered aggregate demand many firms operate at less-than-full capacity. This gives firms an opportunity to implement technology with fewer workflow disruptions.
Managing company performance
In inflationary times, looking at company performance can be challenging. For example, when a company is looking at potential capital investments, they will reflect current and future prices, but depreciation is based on past prices. Inventory accounting may also be seriously impacted. All of this has to be taken into account when analyzing performance or building budgets. One way to handle it would be to look at free cash flow rather than EBITDA. Key performance indicators and key risk indicators should also be inflation adjusted.
Thank You!
Rita George
Managing Partner
Clement George
Managing Partner
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Footnotes:
1: Mankiw, Krugman, and others
2: Federal Reserve December 2022 Monetary Policy Report
3: Speech by Chair Powell on Inflation and the Labor Market
4: WSJ. "House Approves $1.65 Omnibus Spending Bill. 12/23/2023.
7: Bernstein, Lerner, Mezzanotti. "Private Equity and Financial Fragility During the Crisis". Harvard Business School.
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