As 2020 came to a close, Thompson Research Group (TRG) in our 2021 Investing Themes and Outlook report predicted that inflation would be a key driving force in 2021. Early in 2021, we had economists pat us on our heads, advising that we stick to our knitting and leave the big thinking to economists.
Inflation will continue but it should be better in 2022
By mid-2021, those very economists were shouting from the mountain tops about the perils of inflation. Overall, we have all seen significant inflation throughout 2021 on a wide range of consumer and industrial products, from aluminum to RVs. The question, however, remains how much is driven by supply chain issues versus an increase in fundamental demand versus other external forces. Ultimately, it’s a combination of a variety of factors.
The cost of construction goods has accelerated since the begin of the pandemic.
In TRG’s opinion, inflation will remain a factor in 2022 in all forms (products, labor, insurance, etc.). If the pace of inflation moderates, the year-over-year comparisons (YOY comps) will ease, which should allow for more positive price/cost and likely higher margins. But what are the implications and how to manage in a sustained inflationary environment? Here’s how we are thinking about 2022:
- Pace of inflation moderates—We believe the pace of inflation will moderate in 2022 for many commodity-type products such as aluminum, steel, etc., as YOY comps in 2022/21 are higher than 2021/20.
- What likely won’t change—Value-add products likely won’t see any inflation relief in 2022 (e.g., any product that requires microchips, etc.).
- Previously implemented pricing yet to benefit results—Many companies have already implemented pricing in the second half of 2021. That said, given backlogs are higher than normal (for production challenges or customers not yet ready to receive product), higher pricing has yet to fully impact P&Ls. We expect this to support sales and margins in first half of 2022.
We believe the pace of inflation will moderate in 2022 for many commodity-type products such as aluminum, steel, etc.
- We believe further price increases will (mostly) go through successfully—Given a strong demand outlook, we believe pricing actions from a wide array of building products and materials categories will continue to be successful. This period should continue to benefit distributors, a business model that typically thrives in inflationary periods. Pricing actions from second half of 2021 will carry into the first half of this year.
- Pricing up + higher volumes + inflation up less = higher margins—Should pricing flow through on increasing volumes, and the pace of inflation moderate (or turn negative), this should drive higher margins in fiscal year 2022. The one caveat we would add is companies/industries that have a higher labor component as a percentage of cost of goods will be more challenged fully to offset cost increases. Feedback from a wide range of TRG industry contacts points to combined labor cost increases in 2021-2022 could average anywhere from 15% to 20%.
- Catalyst for M&A–Against this backdrop, we expect increased merger and acquisition activity as companies look to enhance their scale for greater purchasing power.
There is no one scapegoat for inflation, and ultimately, this has been years in the making with COVID effectively the tipping point.
Going back to the labor cost component, China’s climb to global economic dominance has in part been driven by being a country where everything has been made for less money than other countries. Costs for goods didn’t increase because the emerging entrant in the market (China) provided a seemingly never-ending supply of low-cost goods, which kept inflation at bay. China has grown into a developed country and as part of that progression, a key cost element has also increased: labor. The bottom line is, while inflation may be relatively better in 2022, it’s still a theme to be managed for many months.
Kathryn Thompson is a founding partner and CEO of Thompson Research Group, Nashville, Tenn. In addition to managing and setting the direction of the firm, Thompson also serves as director of research. She brings more than 20 years of experience analyzing, modeling and advising mutual funds, hedge funds, pension funds and private equity investors.