Six ways the prospect of higher inflation could affect your business

While coronavirus, and to a lesser extent Brexit, have been hogging headlines recently, a lot of our clients are now telling us that they’re becoming increasingly concerned about something that hasn’t been on their radars for several years: inflation.

We see inflation creating a range of issues and risks for businesses

Inflation hasn’t been that much of a concern for clients in recent years, or rather excessive cost increases haven’t. A lack of inflation has, on some occasions, been troubling to businesses, raising questions over investment decisions and the prospect of diminishing potential returns from them. It has also raised concerns over debt levels, which might remain larger over time against flat earnings returns.

Yet as the global economy starts to recover from the pandemic, alarm bells have begun to ring – and in conversation with NatWest Markets clients, one concern stands above the rest: the prospect of higher inflation.

  1. Labour cost and supply issues: labour shortages, evident across a number of industrial, construction and services businesses, have prompted some wage inflation. The same businesses expressed concerns that supply problems and wage inflation may prove persistent.
  2. Commodity prices: as measured by the Commodity Research Bureau (CRB) index, commodity prices have doubled since reaching their lows during the pandemic and now sit over 7% higher than at the end of 2019.
  3. Freight costs: shipping costs have risen sharply in the face of container shortages and rising transport costs. The Baltic Exchange Dry Index, which reflects dry bulk shipping costs, rose almost 240% between the end of December 2020 and early May 2021.
  4. Additional pandemic-related costs: extra debt, pandemic-related social distancing measures, minimum wage increases, the end of rent and rates holidays, and the prospect of higher taxes to finance generous government support all translate into higher costs for businesses.
  5. Supply chain disruption: supply chain disruption due to the pandemic and Brexit have become more common, as are rising input costs – but we’re also seeing a degree of speculative price increases being fed in. Meanwhile, the potential need for multi-jurisdictional supply chains to overcome Brexit and pandemic-related trade friction could impose additional supply chain pressures.
  6. Retail demand and demand-pull inflation: The UK headline retail sales volumes index from the Office of National Statistics (ONS) rose to 113.6 in April 2021. But it’s unclear whether this is just pent-up savings and demand meeting with easing lockdown restrictions and price discounting, or a sign of more longstanding behaviour and spending patterns shifts – which may prompt demand pull inflation.

What do these risks mean for businesses?

Shortages of skilled labour create significant risk. In manufacturing, construction, health and social care, and in parts of hospitality, the third lockdown has led to labour shortages. This may prove a medium to longer term problem, according to businesses we’ve spoken with, rather than a short-term issue. Whilst the increase in unemployment has not been as significant as feared, the drop in labour force participation, albeit only 1%, is feared to reflect a more permanent change in the domestic labour supply.

The years that followed the global financial crisis (GFC) may be particularly instructive on the risk posed by rising commodity prices. The global economy has become fairly accustomed to cost push-inflation (when overall prices increase due to higher input costs) since the global financial crisis of 2008-09, when a significant bout was observed. Having hit multi-year lows in 2009, the CRB index, which reflects the price of a broad basket of commodities, rose over 75% in the space of under 2.5 years. That rise in commodity prices was in part speculative, rather than due to shortages. So signs of commodity price inflation seen more recently – the doubling in commodity prices since March 2020, according to the CRB index – are not wholly unexpected. In this case though it may in part be supply side driven, rather than purely due to demand side ‘speculative’ activity.

Freight costs are rising, making supply chains more expensive. The Baltic Exchange Dry Index rose from just over 1350 at the end of December 2020 to a peak of 3266 in early May 2021.Why? The past six to nine months have seen a growing shortage of shipping containers in Asia, used to ship goods to the West. With limited transit of goods from Europe to Asia, the UK and Europe have accumulated a surplus of containers – making shipping from the Far East more difficult and expensive. The short-term solution has been to incorporate the cost of shipping the empty containers back to their port of origin into the cost of shipping goods. This may become a longer-term solution unless more goods are shipped from the UK and Europe back to Asia.

Additional pandemic-related costs need to be navigated. Businesses that have been forced to close during lockdown for long periods have taken on additional costs. The costs associated with becoming more coronavirus-secure, taking on extra debt to stay afloat, delaying rent and rates payments, as well as reduced capacity limits lowering business income are all likely to lead to higher prices (and already has in some areas of services).

Supply chain disruption is becoming more commonplace in the wake of Brexit and the pandemic. Businesses in construction, manufacturing and wholesale have repeatedly mentioned supply shortages, with a variety of materials and semi manufactured goods seeing demand outpace supply. This is evident in the pace of producer output price inflation, although this has, so far, accelerated more quickly in the US and the Euro Area than the UK.

In construction and some parts of manufacturing, material prices have risen sharply as a result of shortages and some speculative price hikes (to take advantage of the supply/demand imbalance). We can see how producer price inflation has spiked in the chart below. It’s important to note that it’s not the level of producer price inflation that’s the issue – it’s the speed of the swing from deflation to inflation, which has been far faster than anything we’ve seen over the past decade. Nevertheless, in conversation with businesses in these sectors, those that face materially higher input costs note that their clients seem to be less resistant to the prospect of raising their prices than expected.

Producer output price inflation, % year-on-year

Source: Refinitiv

We’ve also heard businesses discuss setting up multi-jurisdictional supply chains in the face of uncertainty around fulfilment from existing suppliers – something many explored in the immediate aftermath of the Brexit referendum in 2016. The prospect of additional suppliers in different regions increases the likelihood of higher costs for businesses, as a more widely spread-out supply chain reduces potential efficiencies in production.

A longer-term shift on the horizon?

The disruption for businesses caused by the pandemic, Brexit, and a sizeable change to global demand dynamics may have created conditions that support a more sustained rise in cost-push inflation than initially anticipated by fiscal authorities and central banks.

Cost-push inflation has leaked into some wage inflation and demand-pull inflation, albeit in a limited way, clients say. There are signs that consumer spending remains targeted more towards goods versus services, not just in the UK but also the US, compared with pre-pandemic levels. Is this the consumer just playing catch-up, reacting to a more limited basket of goods and services available to consumers, or signs of a notable long-term shift in consumption?

It is unclear is whether economic conditions will continue to exist such that demand outstrips supply more permanently, creating a more sustained pick-up in consumer price and wage inflation, If that were to be the case, central banks would likely have to respond with monetary policy tightening in excess of what markets are currently pricing in. A rise in borrowing costs would further impinge on profit margins or increase inflationary pressures. Is there anything businesses could do in mitigation of a potential further rise in costs associated with borrowing?

To learn more about the implications of rising inflation on your financial strategy, get in touch with your NatWest Corporates and Institutions representative or contact us here.

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