From 2020 to 2022, we experienced unprecedented macroeconomic conditions: low interest rates, cheap capital, and a work from home consumer base that drove up demand. Supply chain managers also bulked up inventories over this period, as unexpected supply chain failures would cause unpredictable shortages.

In 2023, we now find ourselves within a drastically different dynamic — rapid interest rate tightening, normalized freight costs, and deflationary pressure in China.

Considering these changes, businesses must be aware of the critical factors that may result in severe margin compression and learn how to navigate this shifting landscape proactively.

Uncertainty and excessive spending defined the COVID-19 economy 

The COVID-19 pandemic triggered a coordinated fiscal and monetary response by all governments to prevent a lockdown-driven economic collapse. Government expenditure reached levels not seen since the Second World War. Many of the G7 countries saw an increase in their net debt-to-GDP ratio. In Australia, state government debt issuance increased more than two times from the average levels before COVID-19 to 2023. Equally supportive monetary policy enabled this spending, with interest rates dropping to 0% and many central banks committing to depressed rates for an extended period.

Stimulus checks, debt relief, and free money inevitably drove perverse incentives for many operators. Supply chain managers received a blank check to stockpile inventories to avoid stockouts at almost any cost. Capital was cheap, the expenditure on goods was growing rapidly with consumers stuck at home, and previously unimaginable supply chain failures were driving unpredictable shortages with spiraling prices. All of a sudden, paying global freight rates seven times higher than the norm of the previous 18 months seemed uncomfortable but acceptable. 

2023 saw a complete paradigm shift

For many of the world’s leading economies, there was a sharp U-turn in 2023. Most central banks started a historically fast interest rate tightening cycle from mid-2022, hoping to bring inflation rates down to the 2% to 3% target range. Major central banks have signaled more rate rises are coming.

This policy shift has challenged and contracted consumer and business demand in much of the OECD. Freight and shipping costs have already returned to pre-pandemic levels. Since April 2022, there has been an 80% reduction in shipping rates between Asia and the west coast of the US. The challenges in China are even more dire as the world’s second largest economy is already exporting deflation; in July 2023, China’s Consumer Price Index fell to -0.3% year-on-year, while the value of its exports decreased by 14.5% despite a minimal change in export volume.

Three unavoidable pressures point to severe margin compression ahead

1. Higher interest rates are draining consumer spending capacity

Higher interest rates are placing pressure on anyone who pays rent, mortgage, credit card debt, or personal loans. From 2023 to 2024, about 1.3 million Australian households will move from fixed rate mortgages to variable ones. These changes have also impacted the rental market, with rental rates up 27.6% in the first half of 2023. Households have withstood cost of living pressures so far, thanks to record household savings during COVID-19. However, this buffer has been eroded with the rate of savings per household at a 15-year low of 3.7%, down from just under 20% in 2021.

National Australia Bank noted a 6% year-over-year decrease in consumer retail spending from 2022 to 2023. Business earnings have also been hit, with small-to-medium business insolvencies at an eight-year high, and Australian Securities Exchange-listed retailers including Harvey Norman, Baby Bunting, and Best & Less downgrading earnings expectations prior to reporting for fiscal year 2023.

2. Costs remain sticky and wages are rising

Input costs in the real economy remain sticky and may not reduce to match the lowering demand. The most pernicious of these costs are wages. Real and award wages are rising faster than inflation in Australia, but this is happening with a backdrop of declining productivity, presenting a critical challenge for businesses striving to maintain financial viability. Nominal wages have been increasing at about 5% per year since 2021, much higher than the 10-year average of about 2%. Wages are notoriously sticky, so these increases will become painful if the descent towards deflation continues.

The difficulty in effective cost management was evident during the latest Australian earnings report season, with profit forecasts for fiscal year 2024 lowered by 5.7% on average. This problem is magnified in commodity-focused businesses — iron ore miners are now facing margin pressure from declining commodity prices, due to reduced construction activity in China and higher energy prices and real wages.

3. Inventory write-downs and deflationary pressures are likely with reduced consumer demand and excess stock

The sudden contraction in demand has caught many leaders flatfooted by the buildup in inventory levels, especially in the context of the significantly higher cost of capital. While we agree it is important to plan for global uncertainty, we should not ignore cost efficiency. Businesses have become accustomed to overstocking inventory to de-risk supply chain uncertainty. If consumer demand continues to decline, the supply gluts within the economy will become more apparent.

Leading indicators show contraction will persist. This dynamic is underappreciated by pundits, as the mix of plummeting demand and excess inventories means inventory write downs are a likelihood for many businesses, which will further worsen margins and by extension deflationary pressures.

How to tackle the risk of margin compression proactively

• Invest in a robust multi-scenario plan that rethinks organizational performance more broadly
  Sticky operational costs in a deflationary environment are not just a margin compression challenge, they present an opportunity to reassess and optimize organizational performance to create a competitive advantage. A comprehensive strategy that anticipates and effectively mitigates margin compression risk is critical. Investing now in a robust multi-scenario plan to future proof businesses will position organizations to be more resilient and better prepared for the challenges that lie ahead.
• Develop a dynamic supply chain cost optimization program
  Developing a dynamic supply chain cost optimization program is crucial for mitigating the risk of margin compression. By continually analyzing and adjusting supply chain expenses, businesses can respond to market fluctuations with agility. This allows for the better management of input costs and inventory levels, safeguarding profit margins in volatile economic conditions.
• Be quick to act as early responders will fare better than their peers
  Businesses face a perfect storm of declining demand, cost base pressures, and excess inventories. Successful leaders will take a proactive approach to weather challenging conditions and seize opportunities ahead of their peers. Time is of the essence; those who act quickly and decisively are more likely to maintain healthier margins compared to competitors that are slower to respond , and almost twice as effective in delivering more innovative products and services compared to their peers.

Additional contributors Suzy Torta, engagement manager, and Phoenix Love, associate.