Deflationary Times12th January 2015

Imagine running a business when your selling price plummets by 42% in the course of a year, and you can do absolutely nothing about it. This, when your input prices have risen 6%, or how about 156%? Well some businesses are already facing just that. Such is life if you produce Brent Crude in the UK[1], pay for your supplies in dollars[2], or even worse if your business is based in Russia.[3]

Now combine that with reduced access to investment capital to achieve change and less working capital to maintain daily cashflow, and this is a tough squeeze. Does it represent falling prices or some deeper malaise? Real world volatility is alive and kicking, and however remote this may seem in the UK (unless you already work in Aberdeen’s oil industry) it is part and parcel of a deflationary environment. Everything gets a bit smaller and just a bit harder.

Could it happen here? Well it already is. In November both RPI and CPI were in negative territory over the month. December’s announcement will reinforce the trend. Sustain that over a year and both RPI and CPI will fall 2.7%. That may seem like a modest trickle, but what will the impact be when our country is so heavily indebted (both state and individuals) and we run such a high current account deficit?

Falling prices will come as quite a shock for those businesses used to steadily escalating prices year after year after year. Rising prices are a useful ‘get out of jail free’ card, smothering a host of trading and investment errors over the years. Compound 2.7%pa over say 5 years, and it becomes a 12.8% drop. It could be a lot more than that. Now what will that do to your margins, your return on investment, and just how flexible and reactive are your overheads to cope with this change?

History tells us how this can work out when deflation goes wrong. In 1929 the supposedly strong Austrian Bank Creditansault was forced by its Government to assume the liabilities of one of the country’s largest and troubled Industrial groups. As a result within 2 years the bank was bust, triggering a global financial crisis, The Great Depression and the launch pad for political extremism. Such is the potential for wealth-destroying monetary deflation, which nowadays includes the risk of bank bail-ins as your bank deposits are compulsorily confiscated. For more on that please refer to my previous article here and here.

But now lets also look on the bright side, with the more socially acceptable price deflation. Many consumer-facing businesses have been used to managing tight pricing for many years now, and for consumers this is great news. So the point where prices move from modest disinflation (falling inflation where prices are still rising) to deflation (where prices actually fall) should be manageable provided the right steps are taken early enough.

You will hear media pundits, politicians and economists telling of how deflation must be avoided at all costs. Yet price deflation is a natural and positive consequence of capitalism as producers compete to provide users with better or cheaper products to buy. Prices also fluctuate up or down with demand and supply. But deflation is an all-pervasive influence, which can take hold for years. The current threat of deflation is a consequence of the abuse of our financial systems by the State and Central Banks in whom we place our trust, who have brought us such huge monetary inflation for so many years that it is long overdue a correction. For a background in banking, central banking and the state please refer to my series of five articles I, II, III, IV and V.

Where deflation becomes ugly is when too much debt is involved. Governments, businesses and homeowners must suddenly pay back real debt with real pounds, a much tougher proposition than when debt is inflated away. So Government loves to proclaim the evils of deflation, when in fact price deflation generally suits the citizen. It is only when monetary deflation gets out of hand (usually as a result on inappropriate state interference) that we are all in trouble.

We can’t know precisely when and where deflation will hit hardest, but we need to be prepared. So having romped through some basic background (and there will be much more on this topic over the year), what do businesses need to plan for?

Falling sales values:
1. Businesses risk a reduction in both sales volumes and prices. One economic belief is that people buy less if they think that it’ll be even cheaper next week, next month or next year. But generally people are buying because of need (and so are unable to defer purchases) or want (where the desire for the latest product offsets any desire to wait). So focus more than ever on meeting needs and wants.
2. Review your customer mix. How will their spending power and confidence be affected (for example reduced employment opportunity and lower house prices?)? Think about how can you help these customers buy from you rather than your competitors. And can you reach into other markets to help maintain or grow your market share?
3. Consider your product or service. How unique is it, and will it, like the price of oil, be seen as just a commodity to be bought anywhere, or can it be seen as “unique” or “special” to carry its own or premium pricing in the marketplace. Consider fresh approaches to product, packaging and marketing to stimulate ‘wants’.
4. Don’t just look to protect prices. There will be an optimum point of price and volume which maximizes your sales, which could mean offering lower prices in return for higher volumes, or higher prices for lower volumes. Try various price tests to help find this optimum point, and explore numerous pricing structures if your business is seasonal.
5. Maintaining your selling prices is a great start to tackling deflation. So consider offering longer-term contracts to your customers to help to ‘lock-in’ current prices and protect your sales value from deflation.
Margins under pressure:
1. Whilst optimizing sales volumes and pricing, the other aspect of Gross Profit is better purchasing and less wastage. Do not expect your suppliers to come to you offering price reductions. Get ahead of the curve, and seek them out yourself. If they are not forthcoming offer them a ‘win-win’, for instance where they can expect more of your business in return for keener pricing.
2. Don’t lock yourself into purchase volume and price deals, as falling prices may soon turn them uncompetitive. You must remain free to move your buying terms down with the marketplace.
3. Examine wastage in your direct costs. If you use raw materials (whether you run a printing-press or a commercial kitchen) check every production run for accuracy and unwanted surpluses. If you supply to tolerances check that you are doing so most effectively. Ensure that you minimize shrinkage through damage, age, theft or mishandling, and if you offer a returns service these must be handled cost-effectively. If you offer a service, check how you buy your essential costs in meeting that service, from sub-contracting to travel to communication. The aim is not necessarily the lowest possible costs, but ensuring the greatest efficiency of cost (for instance ensure that your staff have the tools to work whilst travelling can be a positive outcome).
Lower labour and other costs:
1. In a marketplace of lower total sales you need to keep a lid on staff costs. With compulsory pension enrolment your staff costs may already be on an upward trajectory, and that needs to be tackled.
2. If your staff are used to annual pay rises or automatic salary progression within a pay grade structure then you’re in for a shock! You cannot enter deflationary times with escalating costs like this. Deflation will hurt wages, so look to renegotiate contract structures early, carrying your staff with you. Remember that in deflationary times they should be able to buy more with the £s in their pocket.
3. Reducing nominal salaries will be a tough ask, even in deflationary times. Try offering flexible working hours or extra unpaid holiday, provided the ‘voluntary holidays’ suit both staff and the business. Or can you control the business better with fewer layers of management? Often the best business has fewer chiefs just giving great direction, and plenty of good Indians. Aim for better communication and a can-do culture where staff know what is expected of them, and why.
4. It is kinder to be early in culling unwanted staff in order to protect the majority for the future. Ideally this can be achieved through natural wastage as staff leave or retire, whilst raising the flexibility of those remaining with training, skills and knowledge development. If redundancies or lack-of-performance departures do occur, act now, as this will not only protect your business and its continuing employees, but also help those who do leave to find another job more easily than when deflation really takes hold.
Inventory, Stock & Work-In-Progress issues:
1. You may be used to times when stock rises in value as it sits on the shelf, as the next batch that you buy always costs more. Those days will be gone. Get used to the fact that stock sitting around will fall in value, and try to buy it in just in time, ordering smaller quantities in shorter cycles to take advantage of falling prices.
2. Whilst limiting your stock-holdings, do it in a way that is consistent with what your customers need and expect. Tie this in with your purchasing decisions so that stock is capable of being bought keenly when needed.
3. Rotate stock well. If you are left with old stock it will become increasingly hard to shift at sensible prices, especially if your competitors are slashing prices to clear their surplus stock. Better to turn it into cash sooner rather than compete with the crowd later.
4. If you have funds tied up in a production process, whether house-building or processing or order to delivery/invoice time, look at ways to shorten the timescales.
Premises & Investments:
1. If you own your premises or other assets these may be about to be devalued. Consider the impact this would have on your balance sheet, and the knock-on impact on any borrowing.
2. If you lease premises, avoid upward only rent reviews and seek to negotiate market rent reviews (including downwards). Be prepared to take professional advice from agents who will value your long-term business.
3. If you hold assets in investments, or surplus cash in a particular manner, have a plan ready to react to bank downgrades and other changes in the market. Know what the trigger-point is, and if that trigger is flicked, react very promptly to protect your assets.
4. If you are about to commit to an investment, whether property or an acquisition, consider just how deflation could impact your risk and expected return on investment, and adjust your plans accordingly.
Innovation and Productivity:
1. Prepare to be disrupted by innovative competitors. Better, cheaper ways of delivering wants and needs will always be found, so ‘think outside the box’ to deliver these fresh approaches yourself.
2. As businesses fight for market share and prices fall, some competitors will go to the wall. This may eventually enable a growth in margins, but only if you search for the better ways of doing things and deliver those improvements.
3. Innovate internally. Consider the efficiency of every process through the business, from sales to order processing to product/service delivery to administration. Is everything done to add value and minimize time/cost at each point, or because it has always been done that way?
4. As the cost of technology falls, use it not just to reach your customers in better ways, but also to make your business processes more productive, streamlined and cost-effective.
Working capital management:
1. If all businesses are under pressure then you can expect greater challenges in collecting payments. So look at revising your credit terms and/or credit limits and ensure that you and your customers adhere to them. Be prepared to wave goodbye to customers who cannot pay their bills on time, and don’t ignore early warning signs.
2. Access to bank facilities will be constrained as the profitability and cashflow of business, and the security of banks themselves, comes under pressure. Cash is king, so aim to ensure that you keep enough of it in the right place to control your own destiny.
3. Expect to pay higher deposits on leasing and HP deals, including replacement vehicles that you may not have factored into your budgets. Consider whether you can keep such assets going for longer rather than sticking to the same replacement timings as before.
4. Aim to maintain your reputation and credit rating so that your suppliers and customers view you as strong, reliable and the best place to do their best business. Communicate with customers, suppliers & funders to ensure they retain confidence in you.
Debt in deflationary times is bad:
1. Not only can debt facilities be withdrawn, but the assets acquired with debt can fall in value. This is how negative equity occurs. Can borrowing terms be changed or extended now in order to make your access to finance more secure?
2. Look to be totally on top of your debt commitments, and review the assets that you borrow against. Do you really need that debt? Do you really need to replace leased assets?
3. Interest rates may appear to be low, but if the value of what you borrow is mal-invested then borrowing will be very costly indeed.
4. If everyone is looking to repay debt, this may prompt significant moves in currencies, such as the US$ in which much debt is denominated. Demand for dollars to repay debt will rise, impacting other currencies. So depending upon the intrinsic strength of your currency, interest rates could become volatile or very low (even negative). If this is important then protect yourself against rising rates, but do so whilst rates remain low (the price of protection rises significantly if everyone is already expecting rates to rise) and take regulated professional advice.
Keep an eye on Socionomics, strategy, tactics and detail:
1. Business cycles move in line with ‘social mood’ rather than whatever the Government of the day thinks is best to do. Socionomic change will become the buzzword rather than raw Economic figures.
2. Listen to your customers and not the traditional media for the real facts on demand, and manage your response accordingly. If consumers are looking for reassurance in their lives then comfort and tradition can become strong marketing factors.
3. Besides planning ahead, ensure you really understand the levers in your business to be able to set strategy and tactics to respond to events.
4. The devil is in the detail. Analyse your business thoroughly now so that you truly understand the factors that will make a compelling difference.
Don’t panic, but don’t expect it to go away:
1. Prepare a Plan A, and act on it early. Aim to take positive advantage of deflation in a way that your competitors don’t.
2. Prepare a Plan B should changes in the marketplace be more severe than anticipated. Remember that some of what is in Plan B may be easier to achieve if done early, in which case make it part of Plan A.
3. Do not expect deflation to affect business sectors equally. There will be many losers, but the odd winner too. Aim to stay on the winning side.
4. Be alive to the greater risks of monetary deflation. If hording of money occurs across the economy you’ll need a Plan C.

Above all, surviving deflation requires good information, the confidence to act, and to do so decisively at an early stage.

If you’re looking for support in meeting the challenges of deflation then do give us a call. We’ve experienced in handling early-stage deflationary planning through to tough survivorship cases in industries hit with deflation, all with positive outcomes.

[1] 42% fall in Brent Crude oil priced in £, twelve months to 30^th December 2014.

[2] 6% fall in £ sterling versus US Dollar, twelve months to 30^th December 2014.

[3] 61% fall in Russian Rouble against £ sterling, twelve months to 30^th December 2014, equivalent to a 156% price rise for Russian importers.