Just as the pandemic seemed to be subsiding and the U.S. consumer products industry expected some return to normalcy, new challenges emerged or intensified including supply chain constraints, labor shortages, the delta variant, and rising commodity prices. Fortunately, so far, S&P Global Ratings doesn't think the delta variant has had much of an effect on consumer behavior--at least not enough to damage the sector's credit quality. Higher labor, freight, and materials costs, on the other hand, are pressuring margins for many issuers and we don't expect much relief in the coming year. Much of the pricing pressure is being passed to the consumer (see chart 1).

Chart 1

Our ratings reflect significant inflationary pressure at least for the next several quarters and then a gradual abatement as supply and demand return closer to historical levels. However, we're watching closely for signals that suggest inflation will become entrenched because we believe this would threaten credit quality for many consumer products companies. Here, we examine the impact of potentially greater inflation on the ratings of select consumer products issuers.

Inflationary Stress Test Assumptions

To stress test issuers that could be exposed to higher inflation, we designed a hypothetical scenario that consisted of a simple broad-based assumption of 500 basis points in additional costs for one year for a select group of issuers. We then considered two offsets that companies would likely be able to implement: reducing costs elsewhere in their operations and raising prices. On a case-by-case basis, we estimated the portion of the additional inflation each issuer would be able to offset, from either cost offsets or passthroughs. In cases where we believed passing on costs could hurt volumes, we adjusted revenues accordingly. We then compared the resulting credit metrics to the respective downgrade or outlook revision threshold to determine if a negative rating action would be likely, holding all else equal, for the issuer.

The stress test was designed to be a simple "what if" scenario that communicates our view of the vulnerability of select issuer ratings to additional inflation. For this reason, we limited the offsetting actions to operational strategies. If a similar spike in inflation became reality, we would expect many companies to pull additional levers to protect their balance sheets and cash flow; for instance, by optimizing inventory, reducing investments and capital expenditures, and pausing share buybacks.

We intentionally chose issuers that we believe could face a downgrade or negative outlook revision. For instance, issuers who are already facing high inflation, or issuers whose credit metrics are approaching our downgrade threshold. Of the 21 issuers, we rate 12 investment grade and nine speculative grade. We included six companies with negative outlooks. The sample represents most subsectors of consumer products: packaged foods, household products and personal care, apparel, durables, and one each in beverage and commodity foods and ingredients.

Stress Test Results Vary

The stress test resulted in potential negative rating actions for slightly more than half of our sample of 21 companies: seven could face a downgrade and we could revise the outlook on four to negative from stable or to stable from positive. Ratings and outlooks on 10 companies were unaffected under our stress test scenario (see table 1). Most of the hypothetical downgrades were of speculative-grade ratings. Two thirds of the issuers whose ratings and outlooks remained the same were investment grade. Of the six companies with negative outlooks, four were potentially downgraded. Of the three with positive rating outlooks, two were potentially revised to stable or negative.

Table 1

Food, Freight, And Labor Inflation Will Not Fade Away Easily For All

We believe the historically high inflation in the economy, in general, and food sector, specifically, reflects supply chain constraints including labor shortages, highly accommodative monetary and fiscal policy, a spike in agricultural commodities, and consumers' pent-up demand for goods and services they eschewed during the height of the pandemic. We believe many of these pressures will ease over time as demand gradually normalizes, supply catches up to sustainable demand levels, and labor imbalances decline due to the expiration of supplemental federal unemployment benefits. The unprecedented combination of shocks that have hit the economy and food supply chain at the same time are likely to continue to disrupt the consumer products industry well into 2022 and then gradually subside.

Food inflation doesn't appear to be widespread, and will likely be offset through price increases.   Key economic indicators that reflect the inflationary climate include the price of food and commodities, which have a direct impact on packaged and commodity food producers. Food inflation is primarily concentrated in meats, which is very volatile and subject to over-production and deflationary price cycles. The pandemic caused dislocations and plant closures that exacerbated volatility by combining limited meat supply with consumers' elevated demand as they pivoted to meals at home rather than at restaurants. We expect higher input costs for protein processors in feed, freight, and labor to remain high over the next year, and when coupled with still strong export demand could continue to heighten meat inflation, particularly in the away-from-home channel. Typically, packaged food companies can eventually pass along costs. They don't have to raise prices explicitly. Instead, they can reduce package sizes, change product compositions, or promote less. Additionally, because of the supply chain constraints, retailers are still heavily reliant on brands to keep shelves fully stocked. Still, packaged food companies have to be cognizant of the price gap between branded items and private label: if it increases significantly, consumers are likely to trade down. Consumers' financial condition is another risk to passing cost inflation on to buyers. With the expiration of government transfers, consumers may not have the financial flexibility to purchase the branded product.

The Bureau of Labor Statistics (BLS) expects inflation for meats to decline (see chart 2). Increased demand at restaurants and supply chain disruptions have also pushed up wholesale prices for meat. However, BLS predicts normalization across supply chains and consumer behavior should ease inflation in 2022 and beyond (see chart 3).

Chart 2

Chart 3

In most years over the past decade, price increases of food away from home have outpaced those for food at home. Last year was the first year since 2011 that price increases of food at home were greater than for food away from home because of the dramatic demand shift to grocers away from restaurants. We expect food-at-home inflation to ease modestly over the next year as consumers' demand for food at home continues to shift back to food away from home.

Chart 4

The consumer products and packaged food sectors are absorbing high costs in commodities, labor, and freight. We believe they'll be able to pass on a significant portion of these costs to the retailers and in turn consumers, especially while consumers are in good financial health, which we expect will extend well into 2022. However, raising prices beyond low- to mid-single digits could result in lower demand due to substituting for lower cost items or trading down to retailers' private label and consumers' return to dining out.

Chart 5

Freight inflation should ease, but not for several more quarters as port congestion and container availability remains tight.   Freight costs are also limiting consumer products companies' margins. Container dislocation, port congestion, and labor shortages are constraining the normal movement of goods from manufacturing facilities to the retailer or end consumer. According to Drewry, a provider of shipping industry research, a composite of container freight rates on major routes between the U.S., Europe, and Asia in September was more than three times higher than the same period in 2020. High port throughput (e.g., the North American ports throughput index in June was 11% higher than in 2019, according to Drewry) is causing congestion and delays. Issuers that ship product from overseas are resorting to alternative ports and shipping routes, more costly air freight, or entering contracts to charter entire container ships. All of these workarounds are appearing in margins. Eventually, the imbalance between supply and demand in freight will reverse, but we expect most of these pressures to continue in 2022.

Wage inflation may continue for longer given the current labor shortage, which coupled with ongoing supply chain constraints could trigger ratings actions.   Companies are competing for employees by making the application process easier, lowering requirements, and offering signing bonuses, retention bonuses, and other perks. The pressure on wages became evident in the 4.3% year-over-year increase reported in the U.S. Labor Department's August jobs report, up from 3.7% in July. Our macroeconomic base case assumes the labor shortage will ease beginning in September when supplemental unemployment benefits cease, which should in turn take pressure off wages and avoid triggering an inflationary spiral. Excluding transportation costs and commodity foods, consumer products companies aren't labor-intensive but that doesn't mean they wouldn't be exposed to an inflation spiral, as illustrated in this stress test.

Related Research

• Labor And Supply Chain Woes Chill Retail Spirits For Holidays And Beyond, Sept. 28, 2021
• Economic Outlook U.S. Q4 2021: The Rocket Is Leveling Off, Sept. 23, 2021