After a period of little or no inflation in many of the world’s leading economies, it appears we could now be approaching the point where prices finally begin to tick higher. What type of inflation environment can we expect going forward, and how should corporates analyse and quantify their explicit and implicit inflation risk? In this article, experts from banks and leading risk consultancies discuss these and other important questions.
“We think inflation right now is at a nadir,” says Adam Chester, Head of Macroeconomics, Commercial Banking at Lloyds Bank. That’s right. After many long months of subdued inflation across the most G7 economies, signs that change is now afoot are now being picked up.
Concerns over disinflation – or even deflation – are beginning to ease in America. By late April, the US ten-year “break-even” rate, which measures average market expectations over the same time period had recovered from a 1.53% low in January to 1.92%, its highest point since November 2014, and a reflection of the higher core inflation now being recorded in the US.
Meanwhile in the UK, price indexes may, despite the recent slip into negative inflation, also be about to move higher. In the past year plunging energy prices, combined with aggressive high-street discounting and a period of sustained strength in sterling weighing on imports have together produced months of flat headline inflation figures. But the significance of these factors is now waning. Brent crude is back up at around $65 a barrel. There is too some evidence that high-street discounting is starting to slow compared with the frenetic pace we saw in 2014. Exchange rate movements have been more mixed – sterling bounced back slightly post-election – but dollar/sterling is still well below where it was in the early part of last year.
“The falling out of the base effects of those three things will I think cause inflation to move higher as we move into the second half of this year,” says Chester. “We have headline inflation at the end of this year back at 1%. In the medium term, the key driver will be the underlying dynamics of the UK economy, and in particular how wage growth materialises. There are some tentative signs that wage pressures are starting to emerge as the labour market tightens, and we think that will continue.”
Then there is the Eurozone. Just a few months ago, we were hearing talk (unfounded though it seemed) that the single market may be entering a deflationary ‘lost decade’ akin to what Japan is only now gradually emerging from. But even here the picture is changing. At the end of April four months of declining prices in the euro area was officially declared over. Inflation in the Eurozone now stands at an annual rate of zero, a sub-target level that highlights the fact that there is still some way to go. However, with the European Central Bank’s programme of quantitative easing set stimulate prices further up until its conclusion in the autumn of 2016, it would be tempting to conclude that a corner has now been turned.
One does not need to be an investor or central banker to understand that this turnaround represents good news for the global economy. Inflation is not intrinsically good or bad. But like GDP growth and industrial production increases, a moderately higher rate of inflation can be taken as a sign that a recovery is under way. For businesses the contrary scenario, as recently played out in Japan, would have been very harmful. Deflation drives up the real cost of debt, depresses asset values and, ultimately, defers consumer consumption. Whatever business you are in, everyone west of the Urals should be relieved that scenario no longer looks likely to play out.
However, the return of inflation also raises risk management questions for corporates. In this still uncertain environment, corporate treasurers – even those at companies without any direct linkages to inflation on the balance sheet – should consider defining an appropriate strategy to understand the risks they are facing and reduce the impact on their business of uncertainty related to market movements and central banks actions. Perhaps it’s time to recap on the basics.
The answer to the question of what higher inflation will mean for corporate risk managers ultimately hinges upon the company and the nature of the business they are in. While inflation impacts all companies to one degree or another, the impact tends to manifest itself differently across sectors. How it does, precisely, will often determine both the feasibility and usefulness of risk mitigation strategies.
Firstly, there are those with direct linkages to inflation. This category includes companies, like utilities firms, who have tangible linkages to inflation in both revenues and the asset base. It could also include any commercial real-estate owners, companies with commercial offices or indeed retail outlets on long-dated leases that are also linked to inflation.
These two broad groups of corporate clients, because they have an explicit link to inflation in their business, tend by virtue of that to be the main users of inflation-linked hedging products. Like any hedging exercise the objective here is to foster greater stability in cash flows and the balance sheet. “An investment into a utility company is akin to investing into an index-linked bond in that the return is 100% inflation linked, to the extent that the corporate doesn’t hedge any,” says Aled Patchett, Director, Financial Risk Advisory at Lloyds. “As a result of that linkage they tend to hedge a large proportion of their inflation risk.”
Understanding the implicit
Then you have the other – much bigger – set of companies, those that have exposures that are more implicitly linked to inflation; that is revenues or costs that broadly, but not exactly, track inflation over time. Hedging inflation risk is difficult for these types of companies and because of that many opt to simply ignore the risk. There are a number of reasons why it is difficult, beyond the obvious point that it is harder for companies to work out precisely which costs are linked to inflation, which revenues are linked to inflation and where there might be a natural offset or hedge within the business.
The first relates to the accounting treatment of any potential hedges. “It is not straightforward for them to hedge their implicit exposures because won’t get good hedge accounting unless they can point to an explicit underlying inflation contract,” explains Patchett.
Hedging inflation exposures with certain types of derivatives might prove dangerous if ones projections are not spot on. Hedging is simpler when a company has something that is contractually linked to inflation, all one has to do is purchase an inflation swap linked to the performance an index like the Consumer Price Index (CPI). But try to use an index to hedge an exposure that is only implicitly linked to inflation would expose themselves to basis risk, that is the risk that the inflation hedging strategy will not experience price changes entirely matched (eg opposite directions from each other) to the underlying inflation exposure.
“If I have a cost base that roughly tracks inflation, but not perfectly, I will have basis risk between how the cost actually moves and how the inflation index moves,” says Ivan Harkins, Director of Debt and Hedging at risk management consultants JC Rathbone Associates. “That would be quite important in the building trade, for example. In recent years, particularly in London there has been huge inflation in building costs that has completely outpaced the consumer price index.” Harkins points out that companies with risks of this nature would be advised to consider their hedges very carefully before proceeding. “Hedging exposures, where there is a significant basis risk, with an instrument like a swap can be dangerous because you can incur a liability under the hedge that does not match the underlying you are trying to hedge.”
For these reasons, those that hedge implicit linkages to inflation are few in number relative to the utilities and energy companies who tend to dominate the inflation linked derivatives market. Even those treasurers who decide not to actively hedge inflation risk still need to be mindful of their company’s exposures, however, especially given the fact that a changing inflationary environment often reflects changes in other financial exposures.
“What is really important to understand is that the three main factors which will drive higher inflation – energy prices, aggressive discounting, and the strength of sterling – means that for a much broader set of companies who historically think that inflation is not their biggest risk, the drivers of higher inflation can be very meaningful to them in terms of their exposures to financial markets,” says Yuri Polyakov, Head of Financial Risk Advisory, Lloyds Bank. “For a treasurer looking at the dynamics of inflation, they really need to be thinking about what the direction of oil prices or the weak sterling means for their business, for example.”
Cost or revenue sensitive?
Determining what types of exposures one has, explicit and implicit, is the first step. The next is determining where the exposures reside and quantifying them. One method that Commerzbank’s corporate solutions team uses to assist clients with this employs an inflation sensitivity matrix; on one side sits a cost sensitivity metric and on the other side is a revenue inflation sensitivity metric. Companies that exhibit a high correlation of sales to inflation may benefit from monetising their exposures through for example, issuing inflation linked debt, while firms that demonstrate sensitivity to cost inflation would typically benefit from executing hedges against higher inflation.
“Hedging inflation is the final part of a process,” says Satu Jaatinen, Head of Corporate Solutions at Commerzbank. “To figure out a company’s exposure to cost inflation is not always completely straightforward.” How Commerzbank approaches it is by using a mix of measures that they believe denote cost inflation sensitivity for a corporate. One of these is comparing EBITDA growth to inflation growth, with a negative correlation between the two indicating cost sensitivity. Others include the inverse of EBITDA margin and percentage of fixed costs of total costs. As Jaatinen explains the EBITDA margin can be helpful in determining where the more significant exposures reside. “If you have a very low EBITDA margin, you are more exposed to for example, wage inflation moving higher than if you have a high EBITDA margin. We use this mix of measures (“cost inflation indicator”) also in our pension exposure analysis to see how much inflation cost exposure companies have already before the additional inflation exposure stemming from pensions.”
Again it is important to note that there is a sector angle to this. Precisely where a company appears on Commerzbank’s inflation risk matrix will to some extent be determined by the business they are in. One can imagine how utilities companies’ revenues are naturally linked to inflation (sometimes through an explicit inflation to price linkage) and they typically benefit from a higher inflation environment. Service sector companies however, will have a higher concentration of wages on their accounts and will be more likely to suffer from higher inflation. As such, revenue sensitive industries, as measured by the correlation between their revenues and inflation, appear to mainly reside in the oil and gas, utilities, basic resources, travel and leisure and to a lesser extent, food and beverages sectors. Meanwhile, companies that seem to be more cost than revenue sensitive in the matrix (applied to Eurostoxx companies) are more likely to be operating in the telecoms, technology and automobile industries. The matrix sometimes reveals individual companies’ dislocations compared to industry average too as exposures do vary from company to company.
As an interesting side note on Germany, when the cost sensitivity is measured by fixed costs as percentage of total costs, only one industry in the DAX – technology and telecommunications – was deemed to be more sensitive to cost than revenue inflation. Within MDAX however, a whole lot more industries (eg healthcare, industrial goods and services, chemicals, oil and gas, retail and technology) showed up as being more cost- than revenue-sensitive to inflation. This could be explained by a higher percentage of domestic labour force as well as higher operational leverage in the MDAX vs DAX industries, Jaatinen explains.
Finding the right hedge
Identifying whether your business is cost or revenue sensitive is of crucial importance when it comes to evaluating the suitability of different hedging strategies. For example, companies in sectors that are more revenue than cost sensitive could see benefits from hedging their inflation exposures through inflation linked debt issuance. Inflation linked bonds offer companies a means of offsetting the volatility in their sales revenues with the cash flows incurred through debt payments. There is but one problem with this strategy. “The challenge in the inflation linked investment market is that it is finite,” says Lloyd’s Patchett. “There are a small number of investors who will buy inflation linked paper. That means a corporate cannot go to the market and issue an indeterminate amount of bonds any given year.”
Consequently, alternative strategies are sometimes pursued. One of these, Patchett explains, would be to issue a normal fixed-rate bond before embedding an inflation swap which transforms the fixed bond coupons to inflation. “The other option is to create [the inflation link] through the derivatives market,” he says. By doing that companies can obtain “cash flows that exactly match what an inflation linked bond would look like.” The other relates to the accounting treatment of any potential hedges. “As hedge accounting is really only achievable if a corporate can point to an explicit underlying inflation contract,” explains Patchett.
On the other hand, for companies with inflation exposures in their cost base, utilising the purchase of inflation linked derivative contracts is more often the better strategy. A company with exposure to inflation through rental contracts, for example, might choose to create a pay-out in with an inflation swap that exactly matches the inflation increases set by their landlords. Liquidity in this market can also be lacking at times, but it is said to have improved a lot since the market’s infancy in the early 2000s. Today, it is proving particularly useful means of hedging for companies with inflation cost sensitivities. “If you’ve got a 20 year inflation linked lease so that every year the rental payment increases by inflation obviously there is a huge amount of uncertainty around what your rental costs may be over a 20 year period,” says Patchett. “But you can forgo that uncertainty by entering into a hedge, the bank pays the uncertain component and they swap that for a known payments schedule over the twenty year contract.”
Whether one decides to hedge inflation with a derivative, monetise it with a bond or simply just decide to tolerate it, it is evident that no risk-conscious corporate treasurer can afford to ignore inflation entirely. Forecasts suggesting that inflation is ripe for a rise should unquestionably be noted by treasurers as any rise in prices will have implications for almost every aspect of their work.
Take, for example, cash management and the growing levels of liquidity on corporate balance sheets. Last year a research report, professional services firm Deloitte found that the 1,200 listed companies in the region have built up their cash reserves by €47bn over the past year, bringing total cash reserves to €963bn. This represents an increase of around €250bn on the reserves recorded in 2007.
The reserves now swelling corporate balance sheets underline just why treasurers need to be cognisant of inflation, even if it is not deemed to be a risk worth hedging. “A lot of people forget that when they hold large cash balances, for whatever valid reasons that may be, in an environment where there is high inflation those cash balances lose purchasing power to inflation every year,” says Lloyds’ Polyakov. “It is not just negative yields on corporate cash balances, it is actually how much money you are losing to inflation. So that is something corporate cash and portfolio managers clearly need to consider.”