A 20-year period in the European Union (EU) that can be dubbed the ‘Great Moderation Phase’, which lasted from the late Eighties through to 2007, was characterised by low and stable inflation, and consequently falling yields. European governments and the European Central Bank (ECB) also laid the foundations for a new type of currency union in the euro area during this era, but the ECB is now following and ultra-loose and interventionist policy to mitigate the Eurozone crisis. In the long run there will probably be a high price to be paid for ECB president Mario Draghi’s success in calming market fears about sovereign debt.
The help from the ECB and other European Monetary Union (EMU) countries has significantly reduced the incentive for peripheral countries to undertake necessary reforms, especially in labour markets. While some progress has been made, for example in Spain and Portugal, much more will be needed from other countries in order to speed up their productivity gains and to regain price competitiveness. Therefore some member states of the EMU will lag behind their peers for a long time.
As a consequence there will be significant pressure on the ECB to mitigate these problems via an expansionary monetary policy, resulting in higher inflation and a weaker euro similar to that experienced by Italy in the Seventies and Eighties. The European economy’s recovery should go hand in hand with higher lending growth and the ECB will have to act fast in order to limit the increase in broad money supply. If it fails to do so, inflation pressures will surely increase. The Eurozone currency area could end up being the ‘Italian Monetary Union’.
What ‘Italian Monetary Union’ Means for Europe
This Italian model will initially feel very good for European companies. Lax ECB policy will probably kick-start a strong upswing in some countries’ fortunes during the second half of 2013, if the sovereign debt crisis really does abate and firms feel more certain about the future of the euro and their own business. Falling unemployment will strengthen trade unions’ bargaining power and wages should rise rapidly, with pensions following suit. Real estate prices in the cities are likely to continue to rise.
Normally, the ECB would react to increasing inflation risks by hiking interest rates. Unfortunately, this time around the ECB is limited in how far it can tighten monetary policy as a response to higher economic growth and higher inflation, as it still has to deal with the sovereign debt crisis. Therefore, there is a real danger that the ECB will do too little too late. Consequently, inflation is likely to rise in 2014 and ultimately exceed the 2% central bank target. European corporates, particularly those in certain sectors, are in real danger of being harmed .
Using eurozone consumer price index (CPI) inflation, to identify the correlations between companies’ revenues and costs and inflation, Commerzbank studied four periods: from before and after the late Nineties ‘dotcom bubble’ to date, and from before and after the dotcom bubble to before the 2008 financial crisis. This data was used to develop an inflation framework to allow companies to make an accurate assessment of the form of inflation risks that apply to them. Further to this Commerzbank developed a cost inflation sensitivity metric, to distinguish between companies that are cost rather than revenue-sensitive, and attempted to capture a company’s exposure to labour and fixed costs especially.
Industries which have been especially cost-sensitive historically are automobiles and spare parts; construction and materials; industrial goods and services; technology; and telecommunications. Those that are particularly revenue sensitive – on a net basis – seem to be basic resources: construction and materials; industrial goods and services; oil and gas; travel and leisure; and utilities.
Across sectors, most companies were shown to be positively correlated with inflation both on the revenue and cost side. In the case of large caps, only the healthcare sector – with companies such as Merck and Novartis as examples – had negative revenue and cost side correlation with inflation, and were accordingly removed from the study as no inflation-linked products would necessarily be appropriate in such a case.
Figure 1: Cost Sensitivity of European Industry Sectors.
Cost pressures from inflation are particularly magnified for small to medium-sized enterprises (SMEs), unlike larger companies which are likely to be more diversified in their cost base, particularly in their exposure to labour costs through emerging markets. This can be seen in Figure 2 below which compares eurozone large cap companies to German medium-size (MDAX index) companies. The percentage of fixed costs of total costs is, in general lower for the majority of the large cap companies compared to those in the MDAX. These findings are likely to apply not just to Germany but to other medium-sized companies across the eurozone and the UK.
Figure 2: Comparison of Costs between Eurozone Large-Cap Companies and German Mid-Caps.
How can Corporates Protect Themselves?
Companies with exposure to defined benefit pension plans typically hedge against salary increases or inflation- linked payouts through inflation swaps that mimic the increased costs. Alternatively, they invest in inflation- linked bonds where the payout increases with inflation.
Companies with rental costs can create a pay-out in the inflation swap that exactly matches the inflation increases set by their landlords through the rental contracts. Those with the prospect of unbearable wage cost increases can enter into inflation swaps or caps on CPI (with the notion that CPI will not exactly match the wage inflation but be more like a proxy hedge). Companies with clear inflation linkage on their revenues, such as utilities for example, can offset the potential volatility in revenues either via paying inflation through inflation swaps in an exact and opposite manner to linkage in sales contracts, or by issuing inflation-linked bonds where the debt payments would offset volatility in sales revenues in some manner.
Even those companies with no exposure to inflation can issue inflation-linked bonds in order to access an investor base keen to receive inflation linked coupons and to benefit from discounted coupons when such conditions exist in the market place. They can then swap the inflation exposure away, being left with nominal interest rates to pay only and keeping the investor base and/or discount.
What is certain is that inflation cannot be ignored by risk-conscious corporates. Those able to successfully tackle the risks from it are those that use this method to understand where their own inflation risks sit -whether through costs or revenue. As a result, they will be far better-positioned than companies which sit on their hands.
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