The Real Risk of Persistent Inflation on Shareholder Value
While everyone in the northeast has been warily keeping an eye out for the cicadas about to emerge after seventeen years of silent underground operations, it was another phenomenon—dormant since the latter part of the aughts—that recently speared ahead and raucously dominated the headlines: inflation.
Both the PPI and the CPI are up in April from a month and a year ago. The figures announced last week were significantly higher than expected and caught most investors by surprise. The reason markets turned downwards earlier this week shows that this was not priced in.
Inflation impacts shareholder value in a couple of areas: the first is on a firm’s profitability. Some companies are able to pass on the cost increases from inflation to their customers, while others cannot. Those that can will see an increase in costs in the future, but a similar increase in revenue will offset the impact on their future profitability. Others are not that lucky. The unlucky ones may be forced to keep prices flat due to competition or customers’ price sensitivity, and their future profitability will decrease, reducing their share prices and hindering shareholder value.
The second area, the increase in the risk-free rate, impacts all firms. When the inflation figures were announced, the ten-year bond yield—the rate that most investors call the “risk-free” rate—increased to 1.7%. While still low by historical terms, it nevertheless represents a 200% increase from where it was in July of 2020.
The risk-free rate impacts the cost of capital, which measures the return expected by shareholders for providing firms with funds to run their operations. The higher the riskless alternative is, the higher shareholders’ demands from their riskier investments. If those demands are not expected to be met, shareholders will take their funds elsewhere, potentially depriving firms of the resources to fund future growth opportunities. This puts extra pressure on those firms that are unable to pass on the cost increases to their customers, which is why some firms were “punished” more than others.
The good news is that there is a possibility that this spike in inflation will be temporary and has a lot more to do with the fact that last April—in the uncertainty that accompanied the first few months of the COVID lockdowns—some costs were relatively low as firms like airlines, hotels, and restaurants cut prices to survive. You may recall as well that energy prices were significantly lower, with WTI futures dipping below zero in April 2020.
The second piece of good news is that the risk-free rate is still very low. While the 200% increase from last July is worrisome, the anxiety resides more in the speed of the increase than in the current yields. In 2008 and 2009, the last time inflation was a cause for concern, the yield on these treasuries was mostly between 3 and 4%, significantly higher than now.
Nevertheless, more trouble lies ahead. President’s Biden infrastructure plan calls for significant spending that could easily translate into more inflation. While these government outlays are supposed to be distributed over multiple years, the overall size of the plan and the high likelihood that some of the projects will be unfinished when the purse runs out (and will require additional funds), may make the possibility of persistent, long-term inflation much more likely. This could drive the risk-free rate to 4% or above, which means that a value-accretive project in late 2021 or 2022 would need to provide a return that is 3 or 4% more than it would have needed to in 2019 0r 2020. This is no longer a rounding error but a potentially significant hurdle that will crowd out a lot of privately driven investments, the type that tends to be more efficient and less wasteful.
With the prospect of increased, persistent inflation on the horizon, President Biden should resist the call for excessive “empire building.” The focus should instead be on more targeted private–public investments in key infrastructure and a reduction in regulation. With a lower cost of capital, unhindered by high inflation, private enterprise can come in and fill in the gaps.