The Corporate Tapeworm: How inflation creates shortages and devours businesses
“Inflation acts as a gigantic corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism. Regardless of a company's profits, it has to spend more on receivables, inventory, and fixed assets to simply equal the unit volume of the previous year.”1
- Warren Buffett
Inflation has taken financial media by storm. Talking heads and “experts” are suddenly aware of the problem normal people noticed for quite some time: life is getting more expensive. Stuff is getting harder to come by with bare shelves for everything. This is what inflation delivers.
As Milton Friedman pointed out, inflation is always and everywhere a monetary phenomenon. The engine of inflation is the nation’s central bank—the Federal Reserve System. The monetary phenomenon of running a printing press into overdrive is manifesting in higher prices.
December 2021 Consumer Price Index
On Wednesday, the Bureau of Labor Statistics released its December 2021 Consumer Price Index (CPI). This is the official government measure of inflation with its own inherent flaws of calculus. The verdict? The highest inflation rate in 40 years: a 7% CPI.2
This may be already apparent or old news to some. I won’t dwell on the typical inflation debate—there’s plenty of online literature as-is. Instead, I thought it better to focus on another aspect; one where many have questions and await a suitable answer. What are the business implications and when will the shortages end? I will offer my own view that hopefully addresses some of the confusion.
The Tapeworm
Warren Buffett said it best: inflation is a corporate tapeworm. The lifeblood of any enterprise is its cash flow. Money is injected into the firm through revenue-generating activity—sales. Dollars are shed as they navigate through financial statements until what’s left is paid out to shareholders or retained by the business.
Sandwiched within those financial statements is arithmetic reflecting expenditures: the costs of doing business. This is where inflation-incubated tapeworm eggs hatch and thrive. Excessive money printing circulates through the economy, bidding up prices for goods and services. These nagging price increases work their way into cost of goods as companies compete for the same inputs.
Margin compression takes hold as operators hope the rising costs are indeed “transitory.” As time passes, the realized net income or profit begins to lag comparables—the same business underwhelms previous quarters.
Cash-intensive businesses begin to struggle. Their costs soar eating up residual savings. They then must throttle back activity, preserving liquidity. Output slows and new investment stalls. Expansion becomes harder to justify.
This trend repeats and is magnified across the economy. Inflation saps vitality out of business growth. The byproduct is further shortages of goods and services as new capacity is impractical.
Profitable investments become few and far between. Return on capital becomes a return of capital. It’s analogous to walking up an escalator the wrong way with the speed ramping up. More effort is exerted to achieve the perceived gain, but end up going nowhere at a faster rate.
The reason for this is the hurdle rate for investment climbs with inflation. If the acceptable hurdle rate is set for a new project yielding a 15% internal rate of return (IRR) in a 2% inflation world (13% real IRR), to achieve the same 13% in a now 7% inflation reality, the nominal rate must be 20%. This squeezes out acceptable projects to undertake choking business activity and by extension, growth.
Unfortunately, the commentary today attributes inflation to pandemic-induced supply chain issues. No doubt this is a factor, but will be a distractive boogeyman in the future. Going forward, we can expect inflation itself to actually drive the shortages further. The very reasons were listed above:
Higher hurdle rates - Fewer projects exist in an inflationary environment that replicate historical IRRs.
Cash Burn - Cost increases compress margins. Inputs like commodity prices have to be accepted. Your end-product may not be by consumers if you must raise prices.
Status Quo vs. Growth - Staying afloat becomes the survival instinct at the expense of expansion.
When will it end?
The only practical way out is for contractionary monetary policy. The Federal Reserve must raise rates aggressively and shrink its balance sheet. The primary issue is too much money chasing too few goods (and services). When a central bank sells assets, it mops up liquidity. Money is pulled out of the economy and retired. The problem is such policies are incredibly painful.
The first casualties of a contractionary monetary policy will be high-flying growth stocks and speculative assets (see Bitcoin). Catastrophic losses and bankruptcies follow with margin calls and broad market sell-offs. Years of fiscal profligacy end up coming home to roost for individuals and businesses. But this is the only way.
As the Fed pulls back liquidity, they will be contending with a leery investment climate. Businesses will be more conservative than ever to preserve their enterprise as a going concern. By fighting inflation, the Federal Reserve will see sharp downturns in business activity further shrinking the supply of consumer goods. It becomes politically untenable, but the only solution. Otherwise, chronic inflation lingers.
Paradoxically, raising rates to quell inflation will also create an element of inflation as well. The US economy is hyper-addicted to credit and a higher federal funds rate flows into the broader cost of credit markets. While the Fed battles inflation with higher interest rates, the cost of borrowing will increase for every market participant. Those with debt on a floating variable rate will pay more to service that debt. Any new debt assumed, or rolling debt maturities into a new term will also face these higher rates. This particularly strains the US federal government who “rolls” expiring Treasuries into new notes on a regular basis.
The Fed’s current stance is indeed problematic. They are continuing to expand their balance sheet in the face of this crisis. Fed Governor Loretta Mester indicated we can expect a rate hike two months from now.3 The lack of urgency is alarming.
That’s my take on the macro, anyway. Feel free to comment and let me know what you think!
Mohamed, Theron. November 14, 2021. Warren Buffett called inflation a 'gigantic corporate tapeworm.' Here's the investor's classic warning about rising prices. https://markets.businessinsider.com/news/stocks/warren-buffett-berkshire-hathaway-warned-inflation-prices-tapeworm-investors-businesses-2021-5-1030456755
Cox, Jeff. January 12, 2022. Inflation rises 7% over the past year, highest since 1982. CNBC. https://www.cnbc.com/2022/01/12/cpi-december-2021-.html
Derby, Michael. January 12, 2022. Fed’s Mester Says Economy on Track for a March Rate Rise. The Wall Street Journal. https://www.wsj.com/articles/feds-mester-says-economy-on-track-for-a-march-rate-rise-11642007358