Feeling the Pressure: Examining the Effects of Inflation on Equipment Finance
by Gary W. LoMonaco Vol. 48 No. 6 2021
The U.S. economy is feeling inflationary pressure as the recovery from the downward trend created by the COVID-19 pandemic continues. Gary LoMonaco of The Alta Group looks at the sources of inflation and how they are affecting different types of businesses while providing some important considerations for equipment lessors.
Gary W. LoMonaco, Director, The Alta Group
Despite some setbacks in containing the spread of COVID-19, the U.S. economy has made strides toward a “new normal.” As a result of the rapid shutdown and reopening of the economy, significant inflationary pressures have had and will continue to have profound impacts on equipment finance companies and their clients. It is critical for the industry to prepare for the risks and seize opportunities arising from this inflationary environment. In fact, we should use inflation and rising rates to promote a sense of urgency with our clients and vendors.
Why Are We Experiencing Inflation?
Some inflation was expected as the recovery commenced because of the distortion created by comparing a period with weak prices to a period of growth. Early in the pandemic, fuel prices, transportation costs and non-essential goods were depressed by low demand caused by rising unemployment levels and government-mandated shutdown orders. Fuel producers reduced crude extraction and refining capacity, shippers had lower demand for containers, suppliers to restaurants had to shift to a consumer model or shut down entirely. The shutdown also interrupted just-in-time inventory models, which caused shortages of gasoline, lumber, semiconductors and other goods until production resumed to normal levels. Policy decisions, such as Canadian lumber tariffs and termination of the Keystone XL pipeline project, have also played a role in shortages and inflation.
Labor shortages have also emerged, as displaced workers (i.e., restaurant workers, food producers, manufacturers and others) have elected not to return to available positions in their industries due to fears of exposure to COVID-19, a lack of childcare and extended unemployment benefits provided that provide a disincentive to return to lower paying jobs.
When combined, these factors led to inflation in the range of 5% and higher in the first months of the recovery. While economists disagree over the expected magnitude and duration of the inflationary period, published reports predict it lasting anywhere from the end of the year to through 2022.
The Alta Group believes that a short-term resolution is unlikely. History shows that once inflation arrives, it is usually a multi-year problem that comes with a host of issues, some of which we’ll discuss in this article.
Guidance from the Past
Although it is difficult to find a modern equivalent, economists have been looking at past pandemics to determine the likelihood of prolonged inflation as the economy recovers from the effects of COVID-19. In an April 2021 study by Goldman Sachs, researchers found that there was very little correlation between pandemics and subsequent inflation. After the Spanish Flu, inflation was driven more by the destruction of capital assets during World War I than by the pandemic, whereas following the Black Death, the incredible loss of life among working age people caused shortages and price increases.
Historically, there has been a greater correlation between pandemics and extended periods of low real interest rates. The current outbreak has a number of differences that could make interest rates increase, however. The current low interest rate environment and Fed management thereof leaves rates with little room to go but up. In addition, the unprecedented levels of economic stimulus during this pandemic leave the potential for overheating if the economy recovers as rapidly as forecast.
The SMB Client Experience
Small businesses may feel the effects of inflation differently depending on the nature of their business and the shape of their recovery. Small businesses that sell to other SMBs and consumers have to address how their clients have fared during the pandemic, for example. A number of economists expect a “K-shaped recovery,” in which the upper tier of the economy — manufacturers, technology companies and large-cap firms — experiences a relatively quick, strong rebound while the lower tier — SMBs and service-based and cyclical businesses — has a much slower, more shallow recovery curve.
Some of the ways smaller businesses will need to address inflation include:
Businesses that downsized staff during the beginning of the pandemic are finding it difficult to replace workers, causing wage inflation as companies compete to attract the best staff in a tight market. This labor situation may make it an opportune time to invest in automation.
Potential rising interest rates can work with inflation to price small businesses out of needed new equipment. Equipment finance can help clients mitigate those risks by spreading payments over time and utilizing fixed rate financing as a hedge against a rising rate environment.
Selling to other businesses experiencing shrinking margins limits a company’s ability to pass along increasing costs. Equipment finance companies can provide benefit to these companies by allowing them to conserve working capital.
The Effect on Larger Borrowers/Lessees
Inflation is also an issue for larger firms despite predictions of a steeper recovery curve, which bodes well for longer-term success. Wall Street has reported record profits, as many firms have been able to pass along price increases to consumers and have thus far been able to avoid the wage inflation seen in smaller businesses. Generally, revenues have been up significantly and this steep growth is putting demand on working capital regardless of business size or industry. Many firms deferred investment in needed infrastructure only to find that if equipment is available, it is being sold at inflated prices.
Other concerns for larger clients include the following:
The recovery and its attendant inflation will have unforeseen consequences and opportunities. As is true with smaller firms, larger businesses will need to be agile to take advantage of the recovery.
Companies that source globally are being affected by COVID-19 infection rates in other countries. Of particular concern are chemicals, pharmaceuticals and components sourced from Brazil, Vietnam and India, all of which are seeing labor disruptions due to low vaccination rates and high infection rates.
As with smaller businesses, equipment financing affords clients the opportunity to pay for equipment with future dollars utilizing current interest rates, creating an effective hedge against inflation.
For businesses that sell outside the U.S., inflation rates in other jurisdictions will vary depending on the local economic climate and pace of recovery, which will, in turn, drive currency fluctuation. These companies will need to pay close attention to exchange rates and take advantage of risk hedging opportunities.
What to Know
On one hand, inflation and the potential for increasing interest rates makes leasing and financing options much more attractive means to acquiring the equipment necessary to take full advantage of the opportunities of economic recovery. On the other hand, it requires diligence to make sure that any business is being added profitably and sustainably.
Some issues to be aware of include the following:
Rising equipment prices will necessitate increased diligence when setting residuals. Assumptions will need to be adjusted to make sure future values are in line with business profitability goals. Some examples of increasing prices:
Used steamship container prices are up 120% year over year.
Average used construction equipment prices are up 20% year over year.
Average used Class 8 semi-tractor prices are up 50% year over year.
For those considering M&A activity, the value of portfolios is being affected by the volatility of equipment pricing. It is important to understand target market segments and to project values into a more normalized economy.
Rising prices for new equipment will translate into increased collateral values and profitability at the end-of-lease stage.
Each customer will have its own set of issues to address, and it will be more important than ever to be a strong financial partner to your lessees and vendors by listening and structuring around such issues when possible.
Equipment finance companies need to be diligent in managing float risk between quote and close, particularly those that depend on discounting as a means of funding new business.
As equipment prices and (potentially) interest rates rise, marginal credits will be seeking longer terms and lower down payments, increasing credit default risk. Lenders will need to pay attention to inflation’s effects on risk-reward.
For those equipment dealers struggling to obtain new inventory, creating or enhancing a used equipment rental fleet could help satisfy client demand and enhance near-term profitability.
Margin compression is likely to continue due to the high degree of liquidity in the market.
One of the hallmarks of our industry is that we have been able to turn uncertainty into opportunity by listening to our clients and providing them with financing solutions that help their businesses grow. The current economic reality may have come about differently than in the past, but the risks and opportunities remain the same. It’s important to mitigate the risks while also reaping the rewards, using inflation and rising rates to create a sense of urgency with our clients and vendors. In doing so, we will continue the legacy that built our nearly $1 trillion industry.
Gary W. LoMonaco is a director of The Alta Group who primarily works with the consultancy’s Strategy & Competitive Alignment Practice. His areas of expertise include captive and vendor finance and credit management.