De- / In- / Biden- / Stag- / flation – what’s in a prefix?

August 2022

This article considers the impact on corporate treasuries of changes in the general level of prices, such as deflation and inflation, and, just as importantly, of the policy responses of central banks and Governments who are trying to manage price changes to modest inflation targets. The author concludes that corporate treasuries should differentiate between transitory and persistent drivers of inflation and adopt a strategic perspective to cut through the noise of day-to-day transactional volatility in interest rates, FX rates and commodity prices. The author also makes the case that the current implementation of ESG is inflationary and will remain so until ESG transitions from enterprise risk to enterprise value frameworks.

Be careful what you wish for

It was not that long ago that central banks and Governments collectively proclaimed to be waging the good fight against the pernicious effects of deflation. This fight was notionally waged for us. It was for our benefit that central banks and Governments unilaterally exercised their powers to implement extremely aggressive policy responses to combat not only deflation, but the mere absence of inflation. The impact of the effects on us, has not been described, explained, or quantified, to us. Nor has it been articulated how their respective policy responses alleviate the effects on us without causing harm to us. The policy silence has been deafening.

Since monetary and fiscal policy levers were aggressively and coincidentally pulled with the sole intention of creating inflation, I am surprised and bemused at the widespread shock that followed the realisation of inflation. After all, there was nothing subtle or nuanced in the policy responses. Central banks and Governments swung for the fence, saturation bombing the breadth and depth of the economy with extremely expansive monetary and fiscal policies until they got what they wanted. Or what they thought they wanted.

Be careful what you wish for. The very high levels of inflation these policies caused are equivalent to large and regressive taxation on voters, none of whom voted for it. In American colonial history, taxation without representation was called ‘tyranny’. C. S. Lewis observes that:

“ . . . a tyranny sincerely exercised for the good of its victims may be the most oppressive. It would be better to live under robber barons than under omnipotent moral busybodies. The robber baron’s cruelty may sometimes sleep, his cupidity may at some point be satiated; but those who torment us for our own good will torment us without end for they do so with the approval of their own conscience.”

My views, expressed briefly in the article Normal, New Normal, Next Normal – A Corporate Treasury Perspective, are that monetary and fiscal policies are crude, blunt and lagged instruments, and that central banks and Governments have much less understanding of, let alone control over, economies than they think. Economics is a social science with few laws, abundant art, limited and imperfect information, complex dynamic relationships between variables, and increasingly confused objectives. At the risk of understatement, aggressive policy responses with crude, blunt and lagged instruments based on limited and imperfect information to hit a poorly defined moving target are, not surprisingly, difficult to execute successfully in practice. The result is that they got so much of a ‘good’ thing that it became a ‘bad’ thing, and the panic to increase inflation turned into panic to decrease inflation. They let the genie out of the bottle, and the way they propose to put it back – pause for effect – is aggressive policy action in the opposite direction! Plus ça change.

It is ironic that in trying to achieve modest price increases, central bank and Government policies oscillate from one extreme to another, from quantitative easing, near zero interest rates and expansive spending, to large and frequent interest rate increases and spending packages to protect against the pernicious effects of inflation. The policy responses seem to me to be less about ‘waging the good fight’ and more like ‘wagering economic futures’, and, in Governments’ case, with other peoples’ money.

The traditional perspective

For the first time in a decade, corporate treasuries are managing financial risks in an inflationary environment. The effects of inflation are many and varied. While a detailed exposition is beyond the scope of a short article, the effects of inflation typically include:

• an increase in the level and slope of the yield curve;
• step-changes in spot and forward foreign currency rates (and volatilities); and
• downward pressure on corporate operating margins.

Therefore, corporate treasuries are exposed to an elevated risk of higher liquidity and working capital funding costs, and higher term debt funding costs through existing floating rate debt, debt refinancing and new issuances and loans. Higher debt costs increase the weighted average cost of capital, increasing hurdle rates for capital investments. Downward pressure on operating margins through lower sales and/or higher input costs that cannot be passed on to customers, including from adverse foreign currency rate movements, reduces return on invested capital. Lower returns on, and higher costs of, capital mean that enterprise value and hence the capital funding capacity of the company are reduced, making the company less resilient to business cycle downturns and adverse economic conditions (such as a global pandemic). The stakes are high for all stakeholders.

In meeting financial risk management challenges, corporate treasuries consider the main drivers of inflation, whether they are transitory or persistent, and precisely what inflation expectations the market has priced into yield curves, foreign currency rates and commodity prices. For example, consideration is given to:

• international and geopolitical frictions such as wars, sanctions, tariffs, carbon policies, Covid responses;
• natural disaster impacts on crops and State and Federal Government budgets;
• energy costs;
• supply chain constraints; and
• labour shortages.

Corporate treasuries are aware that central bank and Government policy responses have half-lives in capital markets. At some point, the market will judge the efficacy of the same policy response to pass from desired to detrimental. We have already seen evidence in the market, such as the inversion of yield curves, that markets are concerned that central banks and Governments have overcooked their policy responses to such an extent that recession is a real prospect. Unfortunately, overcooking is common. It is rare for central banks and Governments to do too little.

Texas tea and ESG

Consider cost-push inflation from higher oil prices triggering higher costs for other products and services, which has been keenly felt of late. Higher oil prices act as a tax on business, reducing cash flows for consumption and investment. Higher oil prices also act as a tax on individuals and the tax is regressive – it affects the poor most. Corporate treasuries will consider whether this inflation driver is transitory or persistent, and what expectations the market has priced. Has the market over-reacted? Will high prices reduce demand by a lot or a little, quickly or slowly?

The challenge for corporate treasuries is increased by the fact that the drivers of inflation change over time. I remember ‘peak oil’ – the concern that the global economy would effectively run out of oil, with resultant high prices and the search for substitutes. This turned into being so awash in oil that spot and forward prices traded at negative levels, and the surfeit of supply was so great that tankers were used as floating storage instead of transport. A subsequent change in government in the USA lead to the withdrawal of support for domestic exploration and production from both conventional and unconventional sources, increasing prices substantially (i) before they increased further owing to the war in the Ukraine. The same product at different points in time needs different treasury risk management actions, and hence treasuries need to be alert to market developments and agile and measured in their responses.

It has been posited that the large inflationary increase in oil prices is actually a silver lining because it will compel economic agents to transition away from fossil fuels faster. This transition, more of a green than silver lining, is a nice segue to ESG which, if you have been living under a rock for a few years, stands for Environmental, Social and Governance. ESG discussions tend to be binary – polarised opinions of believers and non-believers rather than discussions in the true sense of the word. To avoid going down that rabbit-hole, I make the following disclosure: I believe ESG principles are laudable, but implementation in practice is seriously flawed. If this is true, we need to re-think how to manage capital allocated to ESG before the large allocations already made to ESG are depleted.

I believe ESG in its present form is inflationary. Companies are acting on ESG, either because of the actions of financiers (which include banks, and the impact on debt and equity capital markets of credit rating agencies and proxy investors) and insurers, or because everyone else is doing it. I understand the impulse. If banks, ratings agencies, proxy investors and/or insurers take their bats and go home, companies are in a predicament. However, only a very small subset of our largest leading companies acted early and were able to attract, and can retain, the most able ESG experts. Every other company is effectively building an ESG bureaucracy by, if not scraping, then trawling, the bottom of the talent barrel, as there simply are not many ESG experts to go around. There are many pretenders but few contenders. This will change over time but does not help now.

This situation is flying-under-the-radar because C-suite and Board ESG focus is on enterprise risk, where resource allocation and conduct of activities is proffered as achievement. In the current environment, media releases announcing ‘we have doubled our ESG team’ or ‘we have spent 25% more on ESG this year’ are beneficial to the personal reputations of C-suites and Boards. It does not follow that it is good for their companies. Doubling the ESG team or spending 25% more increases the cost base, and capital allocated to activities needs to deliver outcomes that increase value for the allocated capital to be replenished and grown for future deployment. Without value-accretion, capital is depleted and ESG becomes another overhead recouped from customers (directly or eventually), shareholders, etc., which is inflationary.

Since ESG is fundamentally about sustainability, and only value makes sustainability economically sustainable, I am curious whether ESG will transition from enterprise risk to enterprise value frameworks. To-date, the jury is out.

All things to all people

Earlier in this article I described monetary and fiscal policy responses as crude, blunt and lagged instruments. This is relatively uncontroversial. I also said that economics has increasingly confused objectives. This is likely to be controversial.

What is a company’s role in Western capitalist democracies? Not long ago, the role of company’s was to focus on what they do and on doing it well, and, in doing so, delivering strong returns to shareholders. Shareholders subsequently direct their personal wealth and/or income towards ventures that appeal to them – philanthropic, commercial, cause, family or otherwise. As a result, diverse endeavours are funded, and hence enabled, by strong corporate returns. While Western capitalist democracies have their shortcomings, they also have the best health, education, safety, and wealth outcomes in the world. No mean feat.

In contrast, companies are now expected to be all things to all people. Shareholders, also known as owners, are individuals with different, divergent, and conflicting opinions, wants, needs, etc. Companies simply cannot be all things to all people, and if they try, they will be pulled from pillar to post. While our democracy rightly celebrates differences, divergences and conflicts, if they result in economic frictions and inefficiencies in our corporate sector, they will produce inferior economic outcomes which negatively affect all stakeholders, including individuals (employees, shareholders, taxpayers), businesses (creditors, investors, debtors, taxpayers) and Governments (tax collectors).

Consider ESG again. Corporates are allocating large amounts of human and financial capital to ESG. Since capital is finite and limited, it is being diverted away from other productive opportunities. This is a statement of fact, not an opinion on whether the allocation / diversion is warranted or not. If financial capital allocated to ESG is not at least replenished or preferably grown, less capital will be available for other ventures both now and in the future, including future technological innovations for ESG that we do not know about yet. As an investor, I expect companies to make value-accretive investments, even if that investment is in ESG. And before I get pigeon-holed as an old-school capitalist, everything I have read and heard about ESG is that it is not one-and- done or set-and-forget, it is a continual, ongoing investment with increasingly binding contractual commitments. If this is true, the continual, ongoing demand for capital from ESG investments can only be met if capital is replenished and preferably grown for future deployment.

Like corporates, Governments are intensely focused on ESG. Again, this is a statement of fact, not an opinion on whether the focus is warranted or not. However, other crucial issues affecting economic performance (and hence economic agents), such as tax reform, labour market reform, competition policy, etc. have vanished from political and business agendas, despite these issues individually and collectively acting as a substantial handbrake on the economy.

I think there is an opportunity to kill two birds with one stone. More funding can be made available to fewer Government initiatives by reducing Governments’ economic footprint. The government sector now accounts for a large proportion of Western capitalist democracies, which stifles the animal spirits upon which the system depends. Unfortunately, I am not aware of any central bank, Government or regulator who is willing to reduce their economic footprint, reach, power and therefore cost in favour of, and to release, the animal spirits of economic agents. This is what leads to the preposterous situation in Australia of taxpayers funding massive Federal budgets for Health and Education, when there are no Federal patients and no Federal students. The economic friction caused by bureaucratic duplication and inefficiency of this scale is of great concern to me.

Handbrakes and friction retard economic growth and slowing economic growth during periods of high inflation are two of the three (ii) elements for stagflation.

Denouement

Inflation was deliberately created by central banks and Governments. Their extremely aggressive policy responses resulted in very high inflation rates, which currently act as regressive taxes on voters that no voters voted for. Since policy responses are oscillating between the extremes, corporate treasuries will need to look through the headlines to differentiate transitory from persistent effects, and to understand the expectations that markets have priced. Do not just scratch the surface. Be strategic by elevating and extending – elevating to a company-wide focus and extending to a long horizon – which both help to cut through the noise of day-to- day transactional volatility.

For example, when yield curves are low and flat, it is attractive to term out through physical fixed rate debt. This leaves capacity in shorter maturity buckets and in CVA (iii) exposure should yield curves increase and/or steepen. That is, incurring higher rates on long term debt when the term premium is low, preserves the capacity to utilise cheaper shorter-maturity debt later if yield curves increase. In doing so, treasuries can smooth the peaks and troughs of the rates market and keep the weighted average cost of capital low and stable. The goal should be to expend more effort into finding 150-200 basis points of strategic value not 15-20 basis points of tactical value.

There is also an opportunity to be strategic in managing corporate debt portfolios with interest rate swaps. A swap rate is the fixed rate that effectively equates the impact of the amount, frequency, and timing of rate hikes on the floating rate. If you believe that hikes will be smaller or less frequent or not as fast, then floating rates will outperform fixed rates. This is often the case for the anticipatory reversals in yield curves as leveraged accounts exit en masse. In this environment, not chasing the swap market keeps your powder dry for later. If the yield curve flattens and especially if it inverts, forward swaps can provide opportunities while forward points are very low to retain floating rate outperformance in the short-term and to fix rates synthetically for future periods.

I recently heard an economist call ESG the moral issue of our time, immediately prior to imploring the new Federal Government to do all in its power to mend the fractured relationship with a major trading partner. Let’s be diplomatic and simply note that Australia generates a lot of wealth from trading partners who are not renowned leaders in ‘E’, ‘S’ or ‘G’. If it is a moral issue, it is at the very least morally dubious to fund ESG with immoral money. If we are prepared to black-ball a supplier for not meeting a particular standard, shouldn’t we apply the same standard to a nation-state? This would of course be crippling to Australia’s economic wealth.

I do not think ESG should be managed in a moral framework. Our economy and its economic agents cannot afford value-destruction, and especially when capital allocation to ESG is large now and is expected to have a growth profile. Corporate treasurers are experts in capital management – sourcing, structuring, and allocating capital – and are positioned at the pointy end of enterprise value and ESG. I believe that corporate treasurers can provide leadership to companies to make ESG economically sustainable. This will not only provide the ongoing capital required to meet increasingly binding contractual commitments, but it will also provide more wealth and income to individuals to allocate their capital to causes they believe in.

I want to make my choices. I am confident that the choices that I will make will be better than choices made for me. There is no reason for me to believe that the lived-experience of C-suites, Board members and proxy investors correspond to my own, nor that they share my values and what I find valuable. I do not want the tyranny of unrepresentative and privileged decision-makers making decisions for my own good. I want to make my own choices and be accountable for them.

i. Colloquially known as Bidenflation.

ii. The third is high unemployment.

iii. Credit value adjustments.