How Is Inflation Affecting Capex Decisions?

Whether it’s a carton of eggs or a tank of gas, prices are up in just about every corner of the economy. And while the implications for consumers or businesses at large are discussed night and day, there is less of a narrative around what it means for capital planners.

 For them, trying to decipher how long this bout of inflation will last, how severe it will be, how the central banks are likely to respond, and whether there will be a recession makes the task of planning and budgeting that much more difficult.

On one hand, the rising cost of capital associated with interest rate increases can make it more difficult to fund projects. Add high current costs of labor, difficulty acquiring certain machinery, and shifting consumer preferences to this mix, and delaying project investments until the inflationary storm has passed can be tempting. If a recession comes about, those with extra cash reserves will be happy they saved for a rainy day.

Conversely, in the face of these obstacles, many businesses find themselves flush with cash. Finding a way to deploy it productively instead of watching it inflate away can be a high priority. Investing in capital projects with high potential ROI now can be a smart move before prices rise even further.

Beware the self-fulfilling prophecy

The dynamic of trying to stay ahead of one’s competitors can create an unfavorable outcome. If businesses believe that inflation is here to stay, they’re likely to pull forward purchases to lock in lower prices, exacerbating the problem.

 Shortages throughout the economy make the outlook even murkier. Even if leaders want to pull Capex projects forward to lock in prices that they expect will increase, difficulty in sourcing necessary people and parts can jeopardize their plans. A recent Finario survey, for instance, found that many current and prospective customers have more projects in the pipeline than they can complete due to these shortfalls. With the floor shifting beneath their feet, capital planners must constantly be reevaluating projects in progress, and take all these factors into account when evaluating future projects.

So, how are businesses making sense of the shifting landscape? For context, here first is a refresher course in the types and causes of inflation.

Cost-push vs. demand-pull inflation

Inflation arises for two main reasons: demand outpaces what the economy can supply, or shortages drive higher input costs, resulting in higher prices.

 The current flavor in the U.S. economy seems to be a mixture of both. Geo-political conflict has sent oil and wheat prices upward, and supply chain snags have produced shortages of goods from computer chips to baby formula. Higher input costs as a result of these shortages point to cost-push inflation.

 There has also been a historic amount of money injected into the economy by the Fed since 2020. All of that cash sloshing around without a place to go, in the context of ultra-low interest rates, is an indication of demand-pull inflation.

 While some companies have benefited from rising prices, high-growth tech companies have seen their stock prices crash as rising interest rates indicate a lower present valuation. These firms have had to endure a painful wave of layoffs, while energy companies are enjoying higher margins due to price increases.

 With both types of inflation, the Fed’s main mitigation tool is hiking interest rates. In June 2022 it raised its key short-term rates by 75 basis points, and more increases in 2022 are likely on the way.

A key worry among investors is that the Fed is raising rates at the worst time, when the economy is showing signs of weakness. Further hikes could trigger a recession in the name of taming inflation.

Amid these complicated dynamics, how are capital planners responding?

A Capex spending spree?

Historically, changes in short-term interest rates have proved to have minimal effects on capital investment.  Rather profit levels have historically had the highest correlation with Capex. Even though the cost of funding projects goes up with rising interest rates, interest rates also tend to rise when the economy is running hot and profits are high. Basically, even though project costs go up, companies usually have the requisite cash to fund them.

Despite a horrific start to the year for the U.S. stock market, for example, the data shows that capital planners are unfazed. Significant Capex expansions were a theme from Q1 earnings, with nearly 200 S&P 500 companies reporting large increases year-over year. That’s an optimistic sign, as businesses wouldn’t make these investments unless they felt confident about realizing a healthy return. 

Since inflation can be thought of as a ‘tax on holding cash,’ it would make sense for businesses to put that cash to work in productive investments, all else being equal. The question becomes whether business leaders believe that interest rate hikes will bring down inflation appropriately, without triggering a painful recession. If it’s able to thread the needle, then increasing investments now would be a wise move. If they overcorrect and trigger a severe downturn, businesses may wish they had extra cash to weather the storm.

Physical vs. digital investments in the current environment

Not all capital projects are created equal. Obviously, if there aren’t attractive opportunities, businesses shouldn’t make investments just for the sake of putting cash to work.

Other than project quality, required inputs are an important element to consider. The tight labor market and continued supply chain challenges have made projects requiring a lot of labor and components hard to execute. On the other hand, software and tech investments that don’t have these constraints can be much easier to complete, increasing their relative attractiveness.

When looking through a backlog of projects, capital planners should consider these limitations. Even if a software investment has a lower NPV than other industrial projects in the backlog, it might make sense to purchase the software (and requisite hardware) now, and wait for the labor and component constraints to ease before funding other projects.

 Don’t sit on your hands, but save enough for a rainy day

Trying to time exactly when inflation will peak is a fool’s errand. Even central bankers admit that it’s an imperfect science at best, due to the countless variables involved.

The path ahead is uncertain. Nobody knows for sure whether the economy is headed for a crash-landing recession, a softer landing, stagflation, or something entirely different. With so much uncertainty on the horizon, remaining flexible may be the ultimate strategy. Real time reporting, rolling forecasts, and better risk-adjusted ROI calculations can help businesses achieve the agility they need to navigate the choppy waters. For a look at how Finario can help you implement these best practices, click here.

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