For those who lived through the 1970s the word ‘stagflation’ conjures memories of oil price shocks and 3 day working weeks. Until the Russian invasion of Ukraine the Bank of England was expecting inflation to peak at 6% this spring before falling back to a more reasonable level. With oil and gas as well as food commodity prices spiking sharply since mid February (Ukraine is known as the bread basket of Europe and Russia is also a major exporter of grain and corn) the immediate expectation is that inflation will accelerate rather than reduce.
Does this mean we now need to prepare for stagflation?
The description of stagflation is ‘economic stagnation alongside high and persistent inflation’. The resulting pressure on household budgets increases the risk of a consumer driven recession with more money needing to be set aside for ‘essential’ spending reducing what is available for ‘discretionary’ items. On the positive side, with the exception of those businesses directly affected by the COVID pandemic (e.g. travel and leisure), the UK economy is currently in decent shape. Whether we see the picture change rapidly for the worse could well depend on how long the war in the Ukraine continues for: if it ends soon and trade ties are restored with Russia, we would hope to see both oil/gas and soft (food) commodity prices fall. If it drags on, ruining the summer Ukraine crop harvest and ensuring that oil & gas prices remain elevated, we could see the squeeze on consumers ripple fast through the global economy.
Whilst its important to stay optimistic and take a long term view, appreciating that this current uncomfortable period will pass, the phrase ‘hope for the best but prepare for the worst’ is an apt one for every business owner to have at the forefront of their mind.
What can businesses do to prepare for a stagflationary environment?
Maintaining gross margins is absolutely key to successful survival in a stagflationary environment: companies that have pricing power (for example those producing B2B goods or services that are ‘business critical’) should be able to increase prices in line with inflation.
Companies that don’t have this pricing power need to be very careful to focus on eliminating any ‘non-essential’ costs (in particular reviewing contracts that might auto renew or require a full year lead time to disengage) and where possible opt for variable over fixed costs. For example, hiring a contractor for a specific project rather than a full time employee or taking serviced office space on a contract that can be easily terminated or renegotiated lower in the event of recession, rather than a multi year lease. Even if, in the short term, the costs for the variable options may be higher, the flexibility to cut costs at short notice could prove invaluable in the not so distant future.
The impact of high and persistent inflation on working capital management also needs to be thought through: if you don’t invoice promptly and fail to enforce your debtor terms the value of what you invoice will be significantly lower in real terms by the time you receive the cash into your bank account. Good working capital management is important in any economic environment but it is essential in a stagflationary one.