Fugazi

With the global rise in commodity prices and incremental supply chain challenges caused by the invasion of Ukraine and covid outbreaks in China, the notion that global inflation will disappear on its own in the short term is fugazi.

Unfortunately, central banks’ track record of taming inflationary shocks is not comforting. In ‘Systematic Monetary Policy and the Effects of Oil Price Shock’ (1997), Ben Bernanke concludes that ‘an important part of the effect of oil price shocks on the economy results not from the change in oil prices, per se, but from the resulting tightening of monetary policy.’

With no significant inflation period in developed economies since then, it is difficult to imagine that the Fed and its peers would beat ominous odds. A hard economic landing is an eventuality.

Mid-term inflation expectations are already substantially above 2% in the U.S., as highlighted in the February NY fed survey published last week. Coupled with inflation rates peaking in Q2, expectations could derail. Panicked, the Fed would ostensibly react and thus overreact to rein them in. A U.S. recession would ensue, impacting 2023.***

The work of more than a generation of central bankers is at stake (see ‘Inflation Toxicity.’) From a financial and price stability perspective, the risk of a recession is worth incurring, which only increases the risk of its occurring. Whether that risk is fairly reflected in the financial markets is subject to a passionate debate, with many like Bill Gross or John Authers echoing the brilliant U.K. rock band Marillion (1984): ‘Do you realize, this world is totally fugazi.’

An economic slowdown is never propitious for financial transactions (incl. M&A and IPOs). Indeed, the bid-ask spread widens during times of economic uncertainty.

Inflation may further complicate the matter. On paper, inflation is not ‘real.’ It is fugazi, too. All other things being equal, it only affects the nominal value of companies since their cash flows and value are unchanged in real terms. There is no real win or loss for anyone, which is why equities are generally seen as providing some hedge against inflation in the long run.

But assets are still valued in nominal terms, which requires that the impact of inflation on financial forecasts, from pricing and revenue growth to free cash flows, be assessed. Inflation, until now a fixed variable, may become variable again. Below I have drawn a non-exhaustive list of questions to illustrate the challenge of determining a company’s normative growth and profitability levels under these circumstances.

If inflation expectations were de-anchored, they would contribute to a further widening of the bid-ask spread. Deal-making would need to rely on new skills. They start with laying the issue on the table.

*** In Europe, a recession may happen independently from the ECB intervention driven by a loss of confidence, in particular in Germany (check the latest IFO survey from Friday which shows a collapse in sentiment)

DUE DILIGENCE QUESTIONS RELATED TO INFLATION (sample)

• To what extent has the time lag between cost inflation and pricing measures impacted cash flows in any given period?

• What do pricing policies say about pricing management capabilities and pricing power?

• What is the long-term pricing power of the company under due diligence?

• Could a structural price change affect the long-term competitiveness of its product and services?

• Has cost inflation led to the temporary abuse of pricing power, resulting in unsustainable margins?

• How to treat depreciation, a proxy for normalized annual capital expenditures, related to pre-inflationary times since understating operating expense?

• Have margins and related cash flows benefited from input cost hedges? If so, how will cash flows evolve once these hedges expire?

• What is the actual value of the inventory (and its implications for normative gross profit margins) and other balance sheet items?