Companies may now be more resilient to inflation shocks

Milton Friedman famously declared that inflation is always and everywhere a monetary phenomenon. While this is undeniably true, no policymaker can afford to overlook the behavioural dynamics that are part and parcel of the inflationary process.

In confronting an energy price shock it would be helpful, as Huw Pill, chief economist of the Bank of England, implied in a podcast last week, if companies and households stopped trying to maintain their real spending power by passing energy costs on to customers and bidding up wages.

Yet the real question is simply how income losses will be shared between capital and labour after supply-side disruptions such as those arising from the Covid-19 pandemic and the war in Ukraine.

Judging by company news this week, capital is doing pretty well in the battle. Nestlë, the food group, raised prices by almost 10 per cent in the first quarter, close to the fastest pace for more than three decades, at the cost of minimal loss of sales volume. Among other consumer goods groups, Procter & Gamble, PepsiCo and McDonald’s have all found consumers ready to accommodate sizeable price increases.

In the meantime, banks in today’s higher interest rate environment have passed on little of their increased loan interest to depositors, with positive impact on margins. And oil companies, predictably enough, have enjoyed a Ukraine-related bonanza. In contrast few workers have managed to maintain real living standards.

European Central Bank president Christine Lagarde worries about a “tit-for-tat” dynamic where the mutually reinforcing feedback between higher profit margins, higher nominal wages and higher prices produces so-called second round effects that cause an upward price spiral. This process goes a long way to explaining why inflation remains so high.

Against that background it is surprising that there has been little discussion of the need for inflation accounting. In the inflationary 1970s, Martin Gibbs, a partner in stockbroker Phillips & Drew and one of the most influential voices in the inflation accounting debate, argued that when inflation reached anything like 10 per cent it was essential to find ways of measuring companies’ real, inflation-adjusted profits.

Traditional historic cost accounts had become a meaningless mixture of “pounds” of different dates and of differing real values when expressed in terms of today’s pounds. More specifically, amounts set aside for depreciation of plant and machinery were, in a period of inflation, completely inadequate to provide funds for the replacement of those assets.

Similarly, profits are overstated where the replacement cost of stock is soaring across the board. Nor does historic cost accounting allow for the decline in the real value of cash or the cost of borrowing arising from inflation.

How, then, to explain the non-debate on inflation accounting?

The short answer is that the policy framework back then was very different. In addition to corporate taxes being levied on artificially inflated historic cost profits, companies were squeezed by price controls and strong unions. In effect, British industry was going bust, which was reflected in a two-and-a-half-year plunge in the FT All Share index of 72.9 per cent between May 1972 and December 1974.

At that level, the dividend yield on the index was 12.7 per cent while the price/earnings ratio on the 500 shares in the industrial index was just 3.6. Only when the then Labour chancellor Denis Healey introduced a tax break for stock appreciation could the equity market recover. Inflation finally peaked in 1975 at 27 per cent on the retail price index.

Today, the structure of the advanced economies is very different, with a strong orientation away from manufacturing towards technology, intangibles and finance. That means less vulnerability to rising replacement costs — witness the numbers reported by Apple this week showing that the combined total of its property, plant, equipment and inventory of $49.8bn was less than the value of its net cash and securities pile of $56.1bn.

Globalisation and efficient inventory management through cross-border outsourcing also reduces vulnerability to inflation. And, of course, the financial sectors of the US and UK, much bigger than in the 1970s, have no supply chain bottlenecks. The implication is that while company accounts may now be distorted by inflation, the squeeze on corporate cash flow is more bearable.

All of this casts interesting light on the downgrading of Big Tech since the tightening of monetary policy. The present value of future earnings has shrunk because those profits are discounted at higher interest rates.

Yet stubbornly high inflation highlights the defensive merits of such growth stocks as Apple, Alphabet, Microsoft and Meta, which between them have net cash and securities in the balance sheet of close to $250bn. In a world of renewed inflation, pricing power plus a super-facility for cash generation makes for a great combination of growth and value.

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