IN THE SPOTLIGHT
As Supply Chain Normalizes, Signs that Inflation is Moderating
The global supply chain logjam, precipitated by constrained capacity paired with hyper-stimulated demand, has necessitated continual and often exhausting adaptation over the last two-plus years. Inflation has compounded the situation.
When is relief coming? Relief is already starting, but improvement is uneven and may be hard to detect amongst the barrage of negative news. The Global Supply Chain Pressure Index is moving lower, although it is still elevated. This is not just a one-off tick down but six months of downward movement in the monthly value have translated to decline in the annual trend, which is a decidedly strong signal.
Weaker global demand is contributing to easing pressure. The quarter-over-quarter growth rate dropped to 0.7% in China industrial production and -3.7% in Japan. European Union quarterly growth slowed to 0.7%, as it contends with war in Ukraine and trade restrictions with Russia. Thus far, North American countries show softening quarter-over-quarter growth in industrial production (Canada at 4.8%, US at 4.6%, and Mexico at 2.9%), but they are stronger than Europe and Asia. While disruptions could resume at any time, supply chain tangles are expected to continue to unwind through the remainder of 2022 and into 2023, as leading economic indicators signal waning business cycle momentum in the quarters ahead.
As supply improves and the initial volatility of the war in Ukraine has subsided, prices for commodities (including oil, copper, and steel) have started to move lower. While producer price inflation is still on the rise, the rate of rise in the Core Consumer Price Index, which takes out volatile components of food and energy prices, has moved lower for three consecutive months. Disinflation (a lower rate of rise in prices) is expected, with multiple commodity prices plateauing. Actively managing your margins will remain key, but do not get stuck using past trends to plan your business. Tides are shifting.
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A Closer Look at
The Macro — The Market — Your Business
What you need to know: Some markets will experience slowing growth; others, decline
The rising trend in annual US nondefense capital goods new orders (excluding aircraft), on a deflated basis, has slowed noticeably. The annual growth rate stands at 5.1% and is in slowing growth phase. Quarterly new orders are a thin 0.3% above this time last year. The slowdown may lead some to believe there is a recession around the corner. The chart below shows that annual new orders can in fact move lower without a corresponding decline in GDP. The essentially flat trend in annual new orders does not mean there will be a recession. Analysis suggests that annual new orders will be essentially flat through the rest of 2022. On a positive note, quarterly new orders are the highest they have been in just under three years.
Analysis of inventories and unfilled orders suggests that we are not at a tipping point that would cause a macro recession. Some are concerned that there is a lot of ‘water’ in the new orders trends, that the macro slowdown will result in a quick evaporation in new orders, and that industry will need to work down inventory levels before resuming a normal order pattern. The levels of orders, unfilled orders, and inventories are likely to result in the deceleration many have been forecasting, but the data does not support a full-on macroeconomic recession, but a technical mild second-quarter decline in GDP. A technical decline in GDP is unlikely to be the result of business activity, declines in retail sales, or job losses. Rather, it would be a result of things that, most likely, do not impact your business, such as a decline in government spending or an increase in the trade deficit.
There are many markets that will experience only a slowing rate of growth in the second half of 2022 and into 2023. Others may be negatively impacted because there was a surge in inventory levels that is now followed by dramatic slowing, or even decline, in demand.
Your company could find itself in the more comfortable, slower-growth environment where disinflation (a slowing in rate of inflation) is the norm. Your top line will likely move higher in unit and dollar terms under these conditions and, if you carry inventory, you will likely realize a slow reduction through time as you balance sales against inventory replenishment. The situation is a bit different if you participate in a market where inventories are a concern and price deflation is likely. The inventory build-up could cause suppliers to see a dramatic reduction in orders whether it is justified or fear driven. Market participants will be faced with price reductions to move inventory and maintain cash flow. This situation may see sales move lower in the latter half of the year as prices decline. Here are some things to keep in mind:
- A decline in sales does not necessitate an equal decline in EBITDA. Sales dollars decline with deflation, but so do some of your input costs. Careful cost management and previously implemented efficiency gains should help.
- Volume may not decline, even as dollars do. It is easy to make decisions based on a top line trend when we have been living in a no-inflation environment for years and, more recently, in an inflationary environment. Deflation causes a shift in focus to units or throughput where possible.
- Cash becomes the greatest concern in a firm dealing with inflation-valued inventory and deflationary pricing pressures. Use of lines of credit or strategic reserves could become necessary.
- Do not assume the deflationary trend will last. Straight-line forecasting is always dangerous. Stay abreast of anticipated price changes at least one year out.
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How do I know which of my end markets will perform better as the economy slows down?
You are right that some industries will continue to grow throughout this macroeconomic slowdown, while for others activity is forecast to flatten or even mildly decline. There are a few things to keep in mind.
First, did any of your end markets largely benefit from the pandemic? While overall US total retail sales is growing, we are starting to see corrections in certain segments that boomed during the earlier parts of the pandemic — furniture and appliance sales, for example. If your markets benefited from consumers being confined to their homes, do not be surprised if a correction begins or is already underway.
Second, is the market considered discretionary or a staple? While consumer financial health is stable, they are feeling their purchasing power diminish in this elevated inflationary environment. If the market is viewed as discretionary, you may begin to see activity dwindle or a substitution effect occur. If the market caters to businesses, keep in mind that while businesses are in a strong financial position, their demand for new goods is typically still rooted in consumer activity.
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High inflation is on everyone’s mind. Consumer inflation reached 9.1% in June, the highest in 40.5 years. Producer inflation, at 18.6%, reached the highest level in 47 years.
On the producer side, prices are rising faster for intermediate-demand goods and services as opposed to final-demand goods and services. However, we are just beginning to see some easing of pricing pressures on commodities used for intermediate goods. Following early 2022 commodity price surges, US crude oil prices have tentatively peaked and both US copper futures prices and US steel scrap producer prices dropped dramatically from May to June. Further declines for most commodities are not anticipated and prices are expected to remain generally flat through the next few quarters, which will likely ease some pricing pressures on producers.
On the consumer side, the high levels of inflation are largely being driven by energy prices. In June, the energy-specific Consumer Price Index was up 41.6% from June 2021, and the gasoline Consumer Price Index was up 59.9% from June 2021. Recently, however, gas price national averages have begun to decline mildly. Consumers may see some additional relief at the pumps in the near term.
While the current inflation numbers can be worrisome for both consumers and businesses alike, macroeconomic fundamentals signal that the rate of rise in prices will begin to slow by the end of this year and continue to slow into 2023. Despite the disinflation trend, be prepared for higher levels of inflation in the coming years relative to what was experienced in recent decades.
While elevated prices are eating into the purchasing power of consumers and businesses, both are still positioned well to drive future growth in the economy, just at a slower pace of rise. The labor market is on the side of the consumer, with about two job openings per unemployed person. Credit delinquencies remain low, and real personal income (excluding transfer payments) is rising. Both corporate cash holdings and corporate profits are elevated, and business bankruptcies are near record lows.
Note that some of the projected growth in retail sales and business-to-business spending will be due to elevated pricing — volume will be a different story. While there is concern amongst many about whether GDP will go into recession or not, it is more important to focus on your business. How are your margins doing? It is important to watch your margins in this high inflationary environment — you do not want to be caught in a period of economic growth, but declining profitability. Ensure you are consistently monitoring your margins.
Arrows indicate 12-month moving total/average direction
- US total retail sales in May 14.1% above year ago
- Retail sales growth slowing; indicators suggest growth will slow more early 2023
- Soft landing anticipated, aided by stable consumer financials & elevated inflation
- Annual US total wholesale trade in May came in at $7.721 trillion, 23.0% above the year-ago level
- Rise in wholesale trade reflects rise in consumer & B2B spending; all at record levels
- Growth this year & first half of 2023 will move lower as macroeconomic activity cools
- N. America light vehicle production 10.3% lower in May than year ago
- Despite being down, annual production rising
- As global economy growth slows, automakers will face less competition for inputs, allowing production to ramp up to meet strong demand for light vehicles
- US total manufacturing production in 12 months through June 4.6% above year-ago
- Indicators & utilization rates signal slowing growth in manufacturing
- Soft landing expected in overall manufacturing; markets that received a boost during COVID shutdowns have an increased risk of contraction
- Quarterly average US rotary rig count rose to 498 in September, nearly double 2020 level
- Quarterly US oil & gas extraction production is still 10.3% below the record high and has been slow to recover, contributing to higher prices
- Crude oil prices averaged $71.65/barrel in September and >$80 mid-October
- Annual US nondefense capital goods new orders (excluding aircraft) in May totaled $852.0 billion, 12.0% higher than year-ago
- Some rise in New Orders driven by rising prices, but volume likely to grow in coming quarters
- Annual defense capital goods new orders 1.4% below year-ago
- Following revision to data by US Census Bureau, annual US total nonresidential construction was $826.8 billion, 1.2% below year-ago
- Despite robust growth in 2021, construction rise sluggish, likely due to shortages in materials & labor
- Corporate finance trends & prior growth suggest accelerating future growth
- US total residential construction in 12 months through May 23.0% above year-ago
- Indicators suggest contraction in homebuilding as incomes unable to keep pace with affordability
- Dollar-denominated construction less likely to contract as inflationary pressures keep spending elevated