It’s tough being caught in the middle, especially when it comes to inflation.
The pandemic caused a significant shift in demand toward goods and away from services and shattered the stable supply-demand balance that had spawned two decades of inflation averaging just above 2%. This abrupt change in demand patterns sparked pricing shocks that basically divided companies into winners, survivors and losers on inflation.
The last group will be playing catch-up on price increases, which is why inflation will most likely prove to be more stubborn than many people expect. To help cool inflation faster and return to an economy anchored by balanced supply and demand, some businesses will need to pull back on the price increases they have already passed through to customers.
When the supply-demand imbalance struck, some companies were well-positioned to take advantage with outsized price increases, which widened profit margins. Maritime shipping was the best example. Cosco Shipping Holdings Co. and AP Moller-Maersk A/S raked in the profits during the pandemic because volume surged and capacity was constrained, leaving price as the only mechanism to deal with the crush of goods the US was importing. Consumer packaged-goods companies, vehicle makers and logistics providers also experienced more demand than they could handle and leaned on price to swell their profit margins. (A measure of aggregate profit margins improved in the second quarter to 15.5%, the most since 1950.)
Survivors had some power to push through cost increases, especially if the companies were large. If they fell short of keeping price gains in line with inflation, then cost cuts and improved efficiency helped close the gap. Big retailers like Walmart Inc. come to mind. Even larger manufacturers like Honeywell International Inc. and Eaton Corp. fall in this group. Some used ingenuity, such as designing products that need fewer semiconductors, to keep par with the price-cost equation.
And then there’s the group that ended up on the losing end of inflation. These companies aren’t poor operators, they’re just stuck between large original equipment manufacturers, which don’t readily accept price increases, and the rising costs of the raw materials that they need to make their products. The profit margins of these middle-market companies have been squeezed, and they will eventually need to correct the imbalance in the price-cost equation. The thousands of companies caught in this middle-market squeeze are one reason that inflation will linger well into next year even as the economy begins to lap last year’s elevated commodity prices.
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Thomson Plastics Inc. is one of those companies. The company, named after its hometown in Georgia, makes injection-moulded parts for autos, lawn mowers and all-terrain vehicles among other customers in three factories. The company pushed through its first price increase of about 7% in January and is planning to boost prices again in October.
“The bottom line is we certainly have to pass these through,” Steve Dyer, the chief executive officer of Thomson, said in an interview about the accumulated costs his company has absorbed. Thomson’s operating margins have tumbled more than 40% even after cutting costs and taking measures to increase productivity, said Dyer, whose company employs about 400 people. “I’ve eaten all I can eat.”
Thomson will need to keep raising prices as the squeeze continues. Dyer said he would have to boost employees’ salaries at the beginning of next year because food, gasoline, rent and almost everything they buy are eroding their wages.
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The increase in costs, mostly from commodities, wages and freight, was the biggest issue on the minds of small producers surveyed by the National Association of Manufacturers, said Chad Moutray, chief economist for the trade group. The small companies get pinched the most, Moutray said in an interview.
“They just don’t have the scale and scope to be able to absorb costs the way that some of their larger counterparts are and the ability to pass those on,” he said.
To help inflation unwind, the cycle for raising prices needs to end for some industries that enjoyed margin expansion built on price. Maritime shippers should have a hard argument for raising prices after margins ballooned and container costs remained elevated. AP Moller-Maersk, the Denmark maritime shipping behemoth, increased its operating profit margins 14 percentage points to 41% in the first half of this year from the same period in 2021. Keep in mind that the maritime shipping giant eked out operating margins of only 4.4% in 2019 and less than 1% in 2018.
Those companies that were able to tread water by raising prices at the rate of inflation should now be decelerating those increases and resist the temptation to pad margins with price. The market knows where exactly companies rank on this price-cost equation as executives argue over price, and the pushback should be harder on those industries and companies that are ahead of inflation on price.
The quicker the supply-demand balance is restored the quicker the Federal Reserve can put away the interest-rate club it’s wielding with a force not seen since the 1980s. Until there’s a clear deceleration of inflation, Fed Chair Jerome Powell will lead an indiscriminate destruction of demand by raising the cost and availability of capital that will finally halt the ability of companies to increase prices. It won’t be pretty and could tip the US into recession. Cooling inflation and maintaining economic growth should be in the interest of all industries, and that will be up to companies, especially those that have benefited the most from the pandemic-induced imbalance of supply and demand.
