The economic cycle has turned and the piper needs to be paid.

Warren Buffet once commented that when the tide goes out, you find out who has been swimming naked. Skinny-dipping has been rampant.

The economic cycle has turned and the piper needs to be paid. Inflation is rampant. Taming inflation is not growth (think business revenue), margin, or asset price friendly. Night follows day just as day follows night. We are already seeing asset prices correct.

Here comes the margin squeeze too. Unless we unlock a productivity miracle, or cost push inflation such as pressure on wages dissipates (unlikely), business margins are in the firing line, one implicit sacrificial pawn to containing inflation. Inflation is a thief that hits households, and businesses. Your revenue or household income line looks ok, but costs erode the bottom line.

That is the story of 2022 and 2023.

Businesses need to be proactive and not reactively manage it. Margins are the epicentre of business health. If cost increases outstrip revenue lifts, then the bottom line gets hit. Many businesses will now be pulling together Budgets for the coming financial year. Cost increase letters are doing the rounds thick and fast. Never have I seen such a spate of price increases. Ouch, if you do a budget (many do not) and see the consequences.

The initial stages of inflation including COVID challenges are easier to absorb when you have a strong economy and something to blame, such as COVID.
But inflation is now extensive. Construction costs have soared. Wages are rising rapidly. Rents continue to push up. The New Zealand dollar has fallen, and while that is good for exporters and the farming sector, consumers are facing higher prices. Blaming COVID is set to wear thin quickly.

There is growing realisation, the spate of cost increases is not temporary. It is looking more persistent. Household budgets are being squeezed with inflation now outstripping wage growth, and interest rates on the ascent (which are not included in inflation).

It is inevitable we will enter a push-back phase. To assume otherwise is saying inflation will continue to rise in line with costs unchecked. Firms continue to pass cost increases on. We’ve seen that playbook before. The cost-push inflation spiral needs to be broken. It means higher interest rates to curb demand and get us into the check and push-back zone from the end consumer.

The latest producer price statistics (which measure price movements across the business sector) reported a 9.8% rise in non-labour input costs and an 8.8% annual rise in output prices. Producer inflation is rising faster than general consumer inflation of 6.9%. Output prices rose 2.6% in the March quarter whereas input prices rose 3.6%.

Input costs rising faster than output prices represents deteriorating margins. Margin compression is typically when the economy enters the adjustment or pay the piper phase and we are starting to see it now.



All is not lost. Margins are everything to state the obvious. Productivity is the primary offset. Is it time to pull that technology investment lever? How much complacency has crept into the business during the good times?

Businesses need to focus on business basics. Improving working capital means making the cash flow cycle as short as possible; aka high inventory turnover and collecting debtors fast. Remove unnecessary costs. Work out the contribution of every marginal dollar spent and the productivity or efficiency of it. Make sure the debt structure matches the business asset profile and cash flows appropriately.

Waiting for the next cost increase letter is not a strategy. Maintaining margins requires a revenue and pricing plan. Many businesses understate their products and service value. Long-term relationships that can deliver are increasingly of value and should be more appreciated in the current supply-chain mess. Make sure you are on top of your finances and extracting value from finance providers. They have likely seen a cycle or three.

Buckle up though. Cycles turn. There are good times and other times. Many will have seen it all before. Ironically, it is often the other times that present the best opportunities, if you are able to take them.

*While Bagrie Economics uses all reasonable endeavours in producing reports to ensure the information is as accurate as practicable, Bagrie Economics shall not be liable for any loss or damage sustained by any person relying on such work whatever the cause of such loss or damage. The content does not constitute advice.

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