While US inflation is showing signs of moderating, it’s still higher than it has been in four decades. To cool down the economy, the Federal Reserve has raised interest rates three times so far this year. But if policy makers brake too hard, it could send the economy into recession. It’s a tough balancing act that companies also must play between battling inflation while fortifying against recession.

During a recent webcast on the economic challenges, Oliver Wyman partners Chaitra Chandrasekhar, Rory Heilakka, Til Schuermann, Vanessa Webb, and Hunter Williams shared their perspectives on the impacts of inflation — an economic phenomenon that affects every company and person — on retail and consumer goods companies, travel, financial institutions and private equity firms.

Below is a summary of their observations.
 

The benefits of inflation for retail

Consumer spending had been resilient over the last 18 months, supported in part by stimulus during COVID-19 stimulus money and the unleashing of pent-up demand as pandemic restrictions eased. High consumer demand and supply chain disruptions caused by the pandemic, a tight labor market, and the Russian invasion of Ukraine have been one of the drivers of inflation.

Not surprisingly, consumers are starting to respond to the higher prices with cutbacks in spending. US retail and food services sales looked to have remained flat in July versus June, adjusted for seasonal variation and holiday and trading-day differences, but not for price changes. The relief came primarily from declining gasoline prices. Even so, July was still 10.3% above July 2021.

So far, the slowdown has been concentrated primarily in purchases that can be postponed, require financing or are geared towards lower income consumers, rather than broad-based. This trend is most likely connected to July’s unemployment rate which was the lowest in 50 years. The higher interest rates are likely contributors to the pullback as consumers become more reluctant to use credit to make purchases. Because of the higher rates, consumers are likely to “shift down” their spending habits — reducing their dining out and takeout and shifting to home cooking. This can be good news for grocery stores.

Within the grocery store, consumers are likely to look to cut spending by switching from name brands to private label. Retailers wanting to engage their customer base need to offer ways for shoppers to stretch their budgets and still enjoy a nice meal.

The outlook for travel

Despite the extreme operational challenges airlines have faced this summer, Americans just seem to want to keep traveling — one of the clearest manifestations of pent-up demand from COVID-19.

Even with higher fares and the wave of delays and cancellations, the outlook for air travel remains positive through the rest of the year. Still, the industry faces potential obstacles to recovery.

Labor issues have been and remain a challenging constraint across travel industry. They are driving up wages and operational costs, and the inability to hire enough workers is prompting airlines to cut schedules. The higher prices for jet fuel are also pushing up costs for airlines at a time when capacity is constrained. Supply chain woes and material prices are also impacting aircraft production. The airline sector also remains behind desired utilization levels, which are key to managing costs in a downturn.

In other parts of travel, companies are facing similar challenges. Hotels are also facing labor shortages and have limited occupancy in response. Rental car companies have been unable to restock their fleets after selling off vehicles at the height of the pandemic.

High prolonged inflation could start to temper leisure demand. As the pent-up demand dissipates, more price conscious consumers may decide that this discretionary category of spending should be postponed.

Why inflation is less of a problem for banks

Banking is one of the few industries where inflation is usually a net positive. As interest rates rise, loans reprice at the higher levels. While interest paid on deposits goes up as well, it will not increase as fast or as much, which means higher rates favor the banks. But if the economy tips into a recession, those benefits could be more than wiped out. In a downturn, borrowers may have a harder time paying back loans, as unemployment rises. Demand for credit is also likely decline as the economy softens.

For banks, a lot rides on the Fed’s hopes for a soft landing from high inflation. Planning for different scenarios will be key to keeping the financial services industry resilient.

Recession-proofing your private equity portfolio

With low interest rates and rising equity values, the last two decades, and particularly the last five years, have been a good environment for private equity firms. While the first half of 2022 remained strong, some major challenges lie ahead. Firstly, interest rate uncertainty and fear of impending recession is having an immediate impact on the cost and availability of credit for M&A activity. Secondly, portfolio companies themselves are being hit by inflationary cost increases, diminishing return on investment for PE firms. Still, real assets tend to outperform in inflationary environments as valuations rise. Additionally, many infrastructure-related assets have an explicit link to inflation through regulations, concession agreements, or contracts, giving them natural inflation protection. This is particularly true for companies with defense or government contracts.