For Financial Professionals in the US

Assessing Inflation – Industrials: The Crossroads of Supply Dislocations

Matt Peron

Matt Peron

Director of Research | Portfolio Manager

Jul 13, 2022

To provide forward-looking perspective on inflation, Director of Equity Research Matt Peron and analysts from our Equity and Fixed Income Research Teams assessed comments made by listed corporations addressing the topic. In a series of articles – also available as a whitepaper – they discuss how select sectors are being impacted by rising prices and what it means for both company profitability and the health of the economy.

Key Takeaways

  • Management teams with whom we’ve spoken believe the inflationary environment for industrial inputs will persist well into 2023.
  • The headwind of higher rates, combined with supply-driven price increases, have the potential to unleash demand destruction, leading to lower revenues and shrinking margins.

Within the industrials space, companies have been able to successfully pass along higher input costs via price increases with very little pushback. In recent months, order books have continued to grow and backlogs are extending. These are signals one would expect to see during continued economic expansion. How they evolve merits close observation given the resetting of interest rates, which could place pressure on demand for big-ticket, capital goods. A sign of changing fortunes would likely be faltering conversions of orders to sales.

Within some businesses, there is a lag between pricing decisions and how inputs flow into the costs of goods sold. Given this mismatch, we expect to see some transitional pressure on margins, but over the longer term, margins would likely be defensible as long as demand remains robust. That is not to say there are no risks to margins. Supply dislocations across a range of industries have the potential to dampen sales. In these cases, industrial companies with considerable fixed costs could see margins pressured as those expenses are incurred regardless of units shipped.

Business New Orders, Inventory and Shipments
The leading indicator of new orders remains strong across the economy, but it bears monitoring for signs that orders are not converting to shipments or are failing to keep up with inventory levels as either would be a sign of economic softening.

Source: Bloomberg, as of 23 June 2022.

On the supply side, the industrials sector has found itself in the crosshairs of a series of challenging developments. Commodities and other inputs were already experiencing upward price pressure due to lingering pandemic-related disruptions. These have been aggravated by the war in Ukraine and the recent lockdowns in Chinese industrial centers and ports as the country continues to pursue a zero-COVID policy.

Industrial inputs responsible for inflationary pressure include iron ore, copper, fertilizer, anything related to the energy complex, freight and – as seen across the economy – labor. Although there are signs of easing on some fronts, such as shorter backlogs for container ships, those linked with the war in Ukraine may worsen as the full pain of this year’s curtailed planting and production will hit markets at a later date.

From a corporate perspective, it remains to be seen whether industrial companies can retain current pricing once upward pressure on input costs eases. While such a scenario would allow for margin expansion, it’s likely far down the road. Management teams with whom we’ve spoken believe the inflationary environment for industrial inputs will persist well into 2023. There is also the risk of an alternative scenario, which is the headwind of higher rates, when combined with supply-driven higher prices leading to demand destruction, lower revenues and shrinking margins as economic activity constricts.

Nondefense Capital Goods (ex aircraft) is the category of manufactured goods aimed at increasing the productive capacity of an economy and serves as a proxy for business investment in capital.

Industrial industries can be significantly affected by general economic trends, changes in consumer sentiment, commodity prices, government regulation, import controls, and worldwide competition, and can be subject to liability for environmental damage and safety.