Feeling the Squeeze

Treasury Implications of Inflation’s Extended Run

Corporate treasurers are starting to feel the heat in their cash management policies as heightened inflation levels persist. Understanding the driving forces behind the current rates globally is key to gaining an insight into how long the situation may persist and whether treasurers need to be making short- or longer-term plans to manage the impact on corporate cash.

Inflation emerged as one of the key financial concerns facing corporate treasurers, central banks, and society as a whole towards the end of 2021. While not threatening to reach the runaway levels of the 1970s, inflation is currently elevated, particularly in the US, UK, and Europe.

Average inflation in the US since the 1920s has been in the region of 3%, while US Bureau of Labor Statistics data for January 2022 showed it had hit 7.5%. Although not quite as extreme, a similar story has played out in the UK and Eurozone. Since the 1920s, UK inflation has been at an average of 2.5%, while the Office for National Statistics’ data for January 2022 saw annual inflation at 5.5%, a rate that’s likely to increase in the first half of 2022. While the Eurozone has a lower historical average of 1.3% inflation, its January 2022 reading saw inflation hit 5.1%, according to data from Eurostat.

Drivers of inflation

The initial rise in inflation last year had been anticipated, as the extraordinary circumstances caused by the onset of Covid-19 in the spring of 2020 skewed the year-on-year data comparison in 2021. Many central banks repeatedly described the rise in inflation as “transitory”, anticipating that as the annual data worked through the monthly reports, inflation would fall as naturally as it had risen. However, by Q4 2021, it became clear that this was not the case. The elevated level of inflation was not going away in a timely manner as anticipated. Federal Reserve Chair Jerome Powell even told the Senate Banking Committee in November 2021 that “it’s probably a good time to retire that word [transitory]…”

Jim Fuell
Head of Global Liquidity Sales, International, J.P. Morgan Asset Management

“Inflation has persisted longer than we had anticipated,” explains Daniel Farrell, Director, International Short Duration Fixed Income, Northern Trust Asset Management (NTAM). “A large part of it is that we thought one of the biggest contributors to inflation – supply chain issues – would have been resolved by now. This is an ongoing issue, with governments globally tackling new Covid variants in very different ways. For example, China’s ‘zero-Covid’ policy is a very different way of looking at this than in the UK or the US. But while it has taken longer, those supply chain issues are beginning to ease in Q1 2022.”

Along with the extended supply chain disruption, the year-on-year base effects on inflation introduced by the pandemic – such as government fiscal support measures – lasted longer than anticipated. Actions such as VAT relief for specific sectors and products impacted prices and were often renewed beyond their initial period. These measures, such as the temporary VAT reduction in Germany for example, are now starting to tail off. Events in the labour market have also contributed to prolonging inflation. Throughout 2021, as economies around the world were reopening in a more meaningful way, companies were faced with higher wage bills.

“Firms were having to attract workers with higher wages, which has been a big factor in this disruption,” recalls Farrell. “Looking at the granular detail, some of the fiscal support that we saw, such as the relief being paid through stimulus cheques in the US, meant that it was attractive for workers to stay at home. That caused a decrease in the number of workers moving back to employment. The lower supply of workers increased demand, which is going to mean higher prices being paid for those workers.”

Daniel Farrell
Director, International Short Duration Fixed Income, Northern Trust Asset Management

Finally, energy has emerged as another critical factor in the extended run of heightened inflation due to spiking wholesale prices and geopolitical factors. Beccy Milchem, Head of EMEA Cash Management, BlackRock, notes: “Geopolitical risk is a key theme, particularly in Europe, as we speak. That risk potentially threatens the energy supply, which has a knock-on impact on inflation. Additionally, the transition to net zero will lead to further price pressures in certain areas of the economy, particularly around energy.”

Indeed, the pressure being exerted on inflation from the energy sector looks likely to have a particular impact on the UK, which is bracing itself for an eye-watering price rise.

Marcus Wright, Senior Economist, NatWest, explains: “We know there’s more to come, we’re not yet in the eye of the storm for inflation in the UK. The peak is expected to be around April, as UK energy regulator Ofgem announced in February that the price cap would rise in the order of 54% from 1 April 2022. Along with clothes price inflation, hospitality VAT, and goods prices, energy is conspiring to push inflation up in the coming months. The Bank of England [BofE] estimates the peak will be around 7.25%.”

A new challenge in the perpetual low- rate environment

With most central banks concluding that the heightened level of inflation is not transitory, the issue then becomes one of predicting what actions they might take to address the situation. One interesting wrinkle that makes this scenario unique is that it is happening in a time of prolonged low, or even negative, interest rates. The longer inflation remains elevated, the more pressure central banks will be under to pump interest rates back up.

James Waud, Head of Banks and Transaction Services, NatWest Group, explains: “The dual impact of low interest rates and inflation forces intervention. At the time of writing, the Bank of England has raised rates from 0.25% to 0.50% which, while welcome for savers, naturally impacts the cost of borrowing.”

The pace of any rate movements from central banks is particularly under scrutiny as, while they strive to limit inflationary pressures, they do not want to threaten any fragile post-pandemic economic growth. Jim Fuell, Head of Global Liquidity Sales, International, J.P. Morgan Asset Management, comments: “The challenge for central banks is when they need to cut rates and there’s no room to cut. Given the current environment, central banks have tools to address inflation; the discussion point is whether it’s short-lived or long- dated in nature. The last thing they want to do is to put the brakes on post-pandemic growth prematurely if inflation works itself out in six months.”

For corporate treasurers, the prospect of managing both inflation risk and interest rate risk in these turbulent times could be a little daunting, particularly when it is not always clear what the central banks are likely to do next. This was emphasised by the BofE in the final two months of 2021.

In November, markets anticipated the bank hiking rates but it did not, while in December the markets expected no change of rates, in part due to the Omicron variant emerging, and yet the BofE pushed through a 0.25% rate rise regardless.

“In an environment like this, where there’s a level of uncertainty, do not take too great a level of interest rate risk,” advises Fuell. “Avoid the temptation of moving your investment duration out along the curve to achieve greater returns. You don’t want to be surprised by a central bank move that wasn’t anticipated by yourself as an investor or the market as a whole, which will then wipe out the gains that you thought you had created. Stay cautious with your overall investment, despite what looks like an erosion in performance on a true net basis, because it’s not necessarily clear as to where central banks are going.”

Corporate cash management responses

All of this uncertainty has posed several cash management questions. Corporate treasurers will face choices in balancing borrowing costs with looking for greater yield on their cash.

“Working capital management again becomes a key focus, determining whether to pay down debt with excess cash or maintain a strong liquidity position, all the while focusing on increased return on capital,” notes NatWest’s Waud. “Looking for cash management efficiencies in this environment will be critical.”

Treasurers are also scrutinising current investment policies to ensure they are fit for purpose. “We’ve certainly seen, over the past couple of years, more conversations around cash segmentation strategies, looking at products that take a little bit more duration, or more credit risk and a laddering out of portfolios of cash,” reflects Blackrock’s Milchem. “The added challenge that people need to be mindful of is that, while we expect central banks to be more tolerant of inflation going forward, the policy rate path is only heading in one direction – interest rates moving higher. Managing interest rate risk in your cash holdings should be the key focus for treasurers.”

Beccy Milchem
Head of EMEA Cash Management, BlackRock

With interest rates now starting to be hiked by some central banks, understanding the reaction that different financial instruments have to these rises is vital for treasurers, as certain investment strategies can react quicker to the changing environment.

NTAM’s Farrell comments: “There is a risk that treasurers look to longer-term bonds or risk assets to try to negate some of the inflation pressure they’re seeing, only to suffer losses. From an operational cash perspective, MMFs still provide the best option for investors. MMFs can respond to interest rate hikes quicker than fixed deposits and similar types of instruments. Even current accounts don’t necessarily respond in the same magnitude to interest rate hikes.”

BlackRock’s Milchem agrees that MMFs are primed to be more responsive to rate rises, partly due to a slow response by banks to pass on the rate changes to their customers. “The last time we saw central banks embarking on a rate-rising environment, banks were slower to pass on the rates than historically had been the case. Also, due to the pandemic, we’ve seen many banks build up non-operating deposits, which they don’t really want because of the regulations in play. Therefore, they might be slow to reprice their deposit books in order to reduce those balances naturally. This means that MMFs might outperform deposits because they are positioned to absorb the rate increases a little bit quicker,” she says.

Another consideration facing many corporates is the supply-side issues, which conspired to drive up inflation, have also impacted their own supply chains and that, in turn, might be causing them to currently hold more cash, according to Milchem. “Some treasurers might be thinking that they need to allow for inventory costs going higher,” she says. “Because of supply chain issues, they might be building higher inventories or be locked into some existing contractual arrangements. You might therefore see some treasurers holding more cash at a time when it might not seem like the optimal thing to do. Cash flow forecasting is critical in ensuring you have a better view of what effective cash investment strategies there might be for you.”

NatWest’s Waud concurs: “Treasurers will want to look at the yield curve and engage their banking and other partners to help plan key predicted financing moments against their forecasted cash positions, not seeing them as mutually exclusive. Diversification will be key as well as targeting yield above the rate of inflation and ensuring reasonable liquidity access, all the while monitoring the fragility of their supply chains.”

James Waud
Head of Banks and Transaction Services, NatWest Group

The potential for lower margins is an additional risk facing corporates due to a combination of cost pressures. In the UK, for example, there is the expectation of inflation growing until at least April, with the costs of various goods still rising and the British Government’s intention to raise National Insurance contributions that will hit employer and employee alike. Corporates face a decision of how best to manage these increasing costs. If inflation does decrease in the second half of the year, they need to decide if they can absorb these additional costs or instead pass them on to customers, which may reignite inflation.

“In some respects, corporates are going to have to scrutinise their own cost base and see what’s driving those expense rises,” J.P. Morgan’s Fuell comments. “To the extent that they’re labour intensive, it certainly begins to feel like a more permanent change when you’re starting to increase wages, as that can’t typically be rolled back with ease. Responses could vary, depending upon the type of industry that the corporates are in.”

For NatWest’s Wright, there is some cause for optimism. In the UK, for example, while upward pressure on wages compared with the recent past is unavoidable, there is good reason to believe those rises will remain grounded rather than skyrocket uncontrollably.

“If we look back at the past 10 to 15 years, companies have managed to hold the line on pay rises reasonably firmly,” Wright says. “That supports the view that we won’t end up with a 1970s-style wage-price spiral,
as wage growth across the board remains contained. That particular pressure, while building from where it was, is more likely to remain pocketed rather than pervasive.”

What the future holds

The $64,000 question, or perhaps the million-dollar question, accounting for inflation, is where this trend is heading as we move through 2022. The past year has shown how changeable the markets can be, and how unpredictable the central banks’ responses are at times. However, data still suggests that the heightened inflationary environment is most likely a short-term risk for treasurers to manage.

“We think that supply and labour disruptions will fade in 2022 and inflation numbers will revert to more normal levels, albeit higher than the pre-pandemic lows,” predicts NTAM’s Farrell. “In fact, inflation may still be above the target of 2% held by the likes of the Fed, BofE and ECB throughout 2022, but it won’t be maintaining these current elevated levels. Inflation in both Europe and the US is expected to peak in Q1, so we should start to see a downward trend. For the UK, it is best to anticipate there are a few more months to go, peaking in late Q1 or early Q2.”

If these indicators in the data continue pointing in the right direction, the second half of 2022 could look very different from an inflationary perspective. However, certain elements could challenge this outcome.

“There are some key risks to our views for 2022,” continues Farrell. “One risk to this outlook is the zero-Covid policy in China, where future shutdowns of cities or ports could further seize up the supply chains that are currently loosening. We have already seen the impact that can have on the global economy. Another risk to our inflation outlook for the year, which has more recently emerged, is the current geopolitical tension around Ukraine, which could impact inflation through higher energy prices in Europe.”

Marcus Wright
Senior Economist, NatWest

Of course, even when inflation does move towards a downward trend, it doesn’t mean that it is no longer a risk to corporate cash management. The effects can take time to be felt and to subside. NatWest’s Wright warns that even if inflation does peak in April, the challenge will go on long after that. “Inflation isn’t felt instantaneously, and the reaction of businesses and consumers isn’t instant. That noticeable impact on finances, both commercially and to the household, is something that builds over time. So even when inflation is in retreat, this will remain an issue that has consequences through 2022, and even into 2023.”

However long the heightened inflationary environment lasts for, its rapid emergence in the past year has again underlined the need for treasurers to build flexibility and agility into their cash and risk policies, to be able to respond to every challenge.

“I remain hopeful,” BlackRock’s Milchem says. “In a zero or low interest rate environment, there can be a bit of inertia around proactive cash management. Having something to talk about from a yield perspective can focus the mind on cash as more of an asset class again, and inflation does that as well. It should be an interesting year as people get back to offices and conversations kickstart again around cash management strategies.”

NatWest’s Waud also has some words of encouragement for corporate treasurers managing the current situation: “The upside is clearly the proven resilience of certain sectors, testament in part to the preparedness and ongoing regular calibration that corporate treasury departments have become used to undertaking in this environment,” he concludes. “In a world where a generally positive outlook prevails after a protracted period of ‘hyper care,’ companies will again turn to growth strategies, new products and new markets to consider. The ability to beat inflation at its own game in the short term will be the key to success.”