Companies must battle the beast of stagflation

SIMMERING GEOPOLITICS, outright war, a global pandemic: anyone who has led a business through the ups and downs of the 2020s so far probably feels like they’ve seen it all. Now they must prepare to battle another foe—the two-headed monster of high inflation and economic stagnation. This fearful stagflationary beast last made an appearance in the 1970s, well before most of today’s senior executives had even set foot on the career ladder. How should they respond?

Companies are already having to deal with soaring inflation. Share prices tumbled in 2022 as first one firm and then another warned of eye-watering cost squeezes. Ford reported that its costs in the third quarter of the year were $1bn higher than it had anticipated, for instance—an overshoot equivalent to about 25% of its adjusted operating profits in the second quarter. In the euro area, producer prices rocketed at annual rates exceeding 40% on the back of jaw-dropping increases in energy prices. Yet even as costs surged, consumer demand remained strong, still sustained by generous fiscal stimulus enacted during the pandemic. That helped American businesses’ profits, as a share of GDP, reach a record high during the year.

In 2023 managers will face the daunting task of defending these sky-high profit margins from two sources of pressure. The first is still-elevated costs. Though energy prices may stop rising quite so quickly, they will remain at high levels, as will wages and other costs. And the “gigantic corporate tapeworm of inflation”, as Warren Buffett, a celebrated investor, once described it, risks gobbling up dollars that were meant for investment, too. Companies will be forced to shell out more on inventories and receivables simply to maintain a given level of production, to the detriment of capital spending.

The best-placed companies will be those with strong pricing power

The second squeeze on margins will come from faltering demand. Although governments in Europe are trying to cushion the blow from the energy shock, consumers will buy less as they lose purchasing power. In America rising interest rates will start taking a toll on the economy. No wonder, then, that 39% of chief financial officers surveyed by Deloitte, a consulting firm, in August 2022 said they expected America to be in a period of stagflation in 2023, and 46% expect a recession.

As they head into battle with the stagflationary monster, bosses will deploy a mix of strategies. More of them will seek to pass cost increases on to customers. In 2022 McDonald’s raised the price of its cheeseburgers in Britain for the first time in 14 years, for example, and other firms will follow suit. That is never comfortable: customers may react badly to price rises, causing a firm to bleed market share and revenue. The best-placed companies will be those with strong pricing power, either because they sell essential products for which demand is generally sturdy—think, say, of the consumer goods churned out by Nestlé—or because they have brands that customers trust and value. “A brand is a wonderful thing to own during inflation,” Mr Buffett once noted, perhaps thinking of his own investments in Coca-Cola.

Not all firms are blessed with such pricing power; and in any case, there are limits to just how high prices can go before customers start turning away. Some companies will resort to the ruse of “shrinkflation”—making chocolate bars smaller, for example, while leaving prices unchanged. Others will seek to hold down costs through efficiency gains. Already, higher energy bills in Europe have started to reshape some companies’ supply chains: BASF, a chemicals giant, is making more energy-intensive ammonia for fertiliser in America and Belgium, for instance, rather than at home in Germany, where the exorbitant cost of natural gas makes it uneconomic.

Perhaps the trickiest attempts to hold down costs will involve workers’ wages. With labour in short supply for much of the pandemic, bosses tripped over themselves to court employees, sprucing up their offices and encouraging remote work. But with costs rising and demand wobbling, managers may shift from suitors to adversaries. As the cost of living soars, unions in America and Europe have been demanding big wage increases. But pay rises will be harder to agree on as demand flags, and the threat of lay-offs will begin to loom. Even in mid-2022, half of American businesses surveyed by PwC, another consultancy, said they were planning to reduce headcount.

As with the other challenges that have been faced in recent years, some companies will emerge in better shape than others. Bosses who preside over spiralling costs and collapsing market share will be booted out by unhappy investors. But those who emerge victorious from this latest corporate struggle will find their reputations enhanced. Let battle commence.■

Rachana Shanbhogue: Deputy business affairs editor, The Economist

This article appeared in the Leaders section of the print edition of The World Ahead 2023 under the headline “Battling the beast of stagflation”