How PE learned to stop worrying and love inflation

The current debate about whether the inflation spike we are seeing is ‘transitory’ should be reframed as ‘reflation vs sustained inflation’, according to Commonfund’s Ryan Driscoll.

While some, including Blackstone’s Jon Gray, see inflation as a major risk today, some amount seems inevitable as the deflationary effects of covid-19 unwind and the economy picks up momentum.

In a blog post last week, Commonfund Asset Management director Ryan Driscoll examined the confluence of pandemic recovery inflationary pressure with forecasted sustained long-run inflation as a result of the Federal Reserve’s pumping trillions of dollars into the economy.

Headline inflation in the US accelerated to 4.2 percent in April, the highest mark since 2008, due to a 0.8 percent monthly increase in the Consumer Price Index, over a consensus of 0.2 percent.

The current debate about whether the spike we are seeing in inflation is “transitory” should be reframed as “reflation versus sustained inflation,” according to Driscoll. “Just like many other economic data points (ISM, confidence, employment) the recent inflation measures represent a resurgence from the mid-pandemic lows and a positive sign of economic recovery. We believe it is also short term and should not be misconstrued as the long-run intention of the Federal Reserve’s actions.”

The April inflation report highlights a combination of supply issues and economic reopening: used car prices shot up 10 percent (thanks to shortages and stimulus checks); increased personal mobility lifted hotels nearly 9 percent and airfares 10.2 percent.

Traditional measures of inflation may no longer be appropriate given how lifestyles have changed to adapt to covid, Driscoll added.

“Headline inflation data is likely not capturing what the consumer is experiencing,” he wrote. “The basket of goods used for CPI suffers from lack of substitution and does not represent all production and consumption in the economy.”

Accelerated labor costs (wage inflation), particularly in inelastic low-skilled labor, could present economic hardship for businesses trying to recover, Driscoll also noted.

Private equity managers concentrated in sectors like industrials and manufacturing will feel the brunt of that acceleration, Private Equity International reported last week. Rising raw material prices will test the ability of businesses to pass those increases on to the consumer. Pricing power will be a big theme if the inflation persists.

GPs invested in business-to-consumer companies will be more vulnerable with regards to pricing power, though this depends on the product being sold.

Technology, and particularly software, could be insulated from that effect as it provides much greater value than its price in the market, contended Thoma Bravo co-founder Orlando Bravo during the Global Boardroom digital conference on 5 May.

It is worth keeping in mind that private equity, and the American economy, haven’t had to deal with systemic, persistent inflation since at least 1990, when the inflation rate hit 6.1 percent with the prime rate at 7 percent.

Commonfund believes the Fed will continue to focus on the employment half of its dual mandate (rather than price stability). Driscoll’s post explained: “As chairman Powell noted in his last press conference, ‘payroll employment is 8.4 million below its pre-pandemic level, and this figure understates the shortfall in employment as participation in the labor market remains notably below pre-pandemic levels.’”