Stagflation Poses a Serious Threat to US Entrepreneurs, Says Middle Market Advisor

Photo: Nicholas Tell

As supply chain disruptions and increasing inflation continue to impact the US economy, one of the most vulnerable segments that could be at risk is middle-market companies. Often forming the backbone of the US economy and a primary driver of jobs, small and mid-size companies are feeling much of the brunt of increasing prices (which they struggle to pass along to customers) and the fallout from labor and supply shortages. Nicholas Tell, the CEO of Armory Group, an investment banking and advisory firm specializing in middle-market companies, has seen many of these factors playing out firsthand.

Tell advises that entrepreneurs should be paying close attention to the capital needs they may have over the coming months and to prepare for a possible distressed cycle in credit markets. We caught up with him for his insights on what risks stagflation poses to mid-sized companies and what it means for the economy.

You have spoken recently about stagflation and its threat to middle-market firms. Are you seeing the prospects for stagflation become more imminent?

Nicholas Tell: Stagflation generally means that there is relatively high inflation during times when economic growth slows or stalls. This seems like a paradox but has occurred when there are external shocks that cause inflation, outside the typical economic cycle of supply and demand. We saw this in the 1970s when OPEC curtailed crude production causing prices of crude to skyrocket.

Today, we are experiencing a number of external shocks that I believe will lead to persistent inflation even as economic growth continues to stall.

These shocks are related to: 1. supply chain disruptions caused by COVID related shutdowns; 2. wage inflation-related, in part, to substantial government subsidies adopted in the wake of COVID; 3. increased severity of storms in the gulf coast due to climate change impacting crude production in the US and refineries and 4. food inflation due in part to drought conditions in the western US due to climate change. The Fed continues to “hope” that these inflationary pressures are “transitory” but I believe that it is only a matter of time until they acknowledge that inflation above their 2 percent target will persist for a number of years.

On the economic growth side, we have recently seen a slowdown in the economy attributed to the uptick in COVID cases from the Delta variant. There is optimism that this threat is subsiding as Covid cases are starting to fall again. Time will tell. Last year, prior to the vaccine, cases also fell and then came roaring back during the winter months. I believe that growth will continue to stall even if COVID cases continue to fall for three reasons: 1. Significant consumer demand has been pulled forward by the historic subsidies by federal and state governments over the past 18 months; as a result, the rate of growth will inevitably slow. 2. Reduced political will for additional federal subsidies. 3. Fed reaction to high inflation once it acknowledges that it is persistent.

What is the biggest threat that it poses to entrepreneurs and middle-market companies?

NT: The biggest threat is margin compression, causing the weakest middle-market companies to go out of business. We are already seeing signs of this. For the first time in years, the spread between the CPI and the PPI went negative in January. Currently, the PPI annualized rate is in excess of 8% and the CPI annualized rate is around 5%, resulting in a negative 3% spread. That means that companies are unable to pass along as much as 40% of the increased costs related to this “external shock” inflation. That only gets worse as growth continues to stall. Companies are then hit twice, by reduced revenues and by substantial margin compression. Middle market companies are typically hit the hardest as larger companies tend to target smaller competitors during times of economic stress to grab market share.

Can you describe what impact a stagflationary environment will have on the cost of capital for small and mid-size companies and the ripple effects of that?

NT: 80% of the debt of small to middle-market companies is floating rate, typically LIBOR. LIBOR is the most interest rate-sensitive index. As rates increase due to Fed pressures to rein in inflation, LIBOR will spike. At its heights, LIBOR can be as high as 4%. Today, it is .25%. I believe that the uncertainty around the transition to SOFR will increase this volatility even more.

One ripple effect stems from increases in raw material prices due to “external shock” inflation. There is an increased need for debt for increased working capital associated with the increased raw material prices. That debt has now become more expensive, resulting in further margin compression. More impactful, many smaller companies will not be able to have access to liquidity to fund these increased working capital needs. We are already seeing that with many of our middle market clients.

What do mid-sized companies need to be doing in order to ride out the next economic cycle?

NT: Although we are starting to see some signs of slowing economic growth, the overall economy remains very strong. It may seem counterintuitive but during these times of healthy top-line growth, mid-sized companies need to focus on margins, on cutting costs by being more efficient, on investing in automation or software to reduce labor costs. In our experience, mid-sized companies start focusing on margins as they start to get into trouble, which is too late. Also, to the extent, mid-sized companies can raise additional liquidity today, even if they don’t need it. They will not have access to it later as the economy weakens when they need it most. Finally, mid-sized companies should fix their interest rate either through issuing fixed-rate debt (the market for small issue high yield debt, called “baby bonds”, is developing) or by hedging their floating rate debt, even if that is more costly today.

The preceding post was written and/or published as a collaboration between Benzinga’s in-house sponsored content team and a financial partner of Benzinga. Although the piece is not and should not be construed as editorial content, the sponsored content team works to ensure that any and all information contained within is true and accurate to the best of their knowledge and research. The content was purely for informational purposes only and not intended to be investing advice.