How to Hedge Against Inflation in Today’s Volatile Market

Inflation. It’s a word—and harsh reality—that no one welcomes. But it’s undeniable: inflation is here, and it’s become a huge problem with no end in sight. This leads us to wonder, how can we possibly hedge against inflation in today’s volatile market?

There is no enjoyable way to say it: A recession is looming. The globe has watched skyrocketing inflation rates that we haven’t seen since the 1980s. Yet, despite evidence of the intense situation, procurement functions are still expected to bring cost savings to their organizations and hedge against incoming inflation.

It’s quite a high bar—one that seems to require almost heroic skills and keen economic and business acumen. The good news is that we’re here to help, offering you some helpful risk management information. We take an in-depth look at some ways you can hedge against inflation and invite you to our upcoming FORGE Dollars and Sense event, where you can learn even more.

What Is Causing Inflationary Pressure Today?

The reality of global inflation is not new by any means. And when we look at the state of global supply chain inflation, it makes sense. Think about it: All the signs were/are there. You can even see many of them in the recent ISM® Report On Business®, covering economic indicators of the direction the overall economy is going.

Specifically, we’re seeing signals such as:

• Economic growth and stimulus
  
  
• Labor shortages
  
  
• Lifting COVID restrictions, paired with an influx of consumer demand
  
  
• Low interest rates on loans and mortgages
  
  
• Shortages and subsequent stockpiling (panic buying) of goods
  
  
• Fear of incoming recession

Even though we can see these signs and signals as they hit the scene, it’s difficult to plan strategically to hedge against inflation and successfully mitigate all these factors. Those procurement departments that can successfully plan for inflation will be the highest performing organizations long term.

And isn’t that where we all want to be? So, let’s explore how to make it happen, which begins with step one: identification.

How to Identify Inflation Risks and Hedge Against Inflation

You can’t successfully solve a problem before knowing what’s causing it. In this case, you must first identify inflation risks. An excellent tool in your arsenal that you can use to help you achieve this is what is known as the PMI index.

The PMI index is tied to economic trends and clearly shows commodity costs in different areas. How does this help? By simply watching and accessing these trends, procurement and finance teams can use that data to make an educated best guess at what is coming next.

In a perfect world, guesswork wouldn’t be necessary, and the answers would be dangling before us with warnings of what’s to come. However, we don’t live in a perfect world, and despite being an excellent resource, PMI reports tend to only show us what is already upon us, not necessarily what is coming. So, we must read between the lines and predict what’s next.

Start by looking at end-to-end supply chain and sub-tier suppliers to understand potential risks and where the next shortage or price hike will come from. This will be the key that unlocks your potential for prediction. Another piece of advice: Focus on categories tied to commodities with large amounts of spend, and that cannot have price increases passed on to consumers.

You can’t underestimate that your organization’s current contract terms have a massive role in hedging against inflation.

For example, if a category of spend is facing inflation, locking in terms ahead of time for upcoming terms and defending terms will make a significant impact. However, with increasing reports of supplier hostility and resistance to agreeing to such terms, this is becoming increasingly difficult.

Procurement Nerve Center’s Exposure Matrix

McKinsey released an excellent resource for hedging against inflation. An inflation Kraljic matrix explains the best defensive and offensive tactics for navigating an inflationary environment. McKinsey’s procurement nerve center’s exposure matrix helps guide responses to suppliers.

McKinsey describes its reasonings for creating this matrix: “In this era of upheavals, procurement leaders have an opportunity to reinvent their function and broaden their mandates to promote greater resilience. To fulfill this broader mandate, procurement needs an end-to-end operating model that promotes the creation, preservation, and enablement of value .”

Enter the nerve center exposure matrix, which the company created to help companies address immediate challenges by “launching inflation nerve centers that illuminate supply-chain risks, control spending, and accelerate collaboration—all in comprehensively addressing exposure in critical categories.” According to McKinsey, “The approach helps guide decision making so that rapid responses can focus more on strategic implementation and less on firefighting.”

Hedging Against Inflation Strategic Areas

There are three main areas to focus on to hedge against inflation: contracts, strategic sourcing, and financial hedging. Let’s take a closer look at each of them.

Contracts and Inflation Management

Contract negotiations are going to be big for renewal terms. But increased supplier hostility is being reported more these days, so procurement must tread carefully. To add even more pressure to the mix, alternative suppliers are becoming difficult to come by. So, it’s important to consider if a supplier is reliable and delivers on time and in full (OTIF) when in negotiations.

Carefully reviewing contracts while looking at the specific terms and conditions to see what can be adjusted—like contract duration or price adjustment limits—can help hedge against future inflation.

Strategic Sourcing and Inflation Management

The next step can be summed up in two words: supplier relationships. In a volatile environment like 2022, your supplier relationships need to be solid.

You must have good relationships with suppliers you trust and can depend on. For this reason, relying on long-term relationships (suppliers who have proven themselves over the long haul) is emerging as a critical strategy to protect against inflation.

Now is not the time to strongarm suppliers, nor is it the time to try to adjust payment terms from a net 30 to a net 90. The last thing you want to do is place yourself in an even more vulnerable position by turning off—and possibly risking losing—steady suppliers.

Use your sourcing strategy to set your function up for longer-term benefits.

• If you can find alternate suppliers, do so.
• If you can find suppliers that are low risk due to being closer, bring them on board.
• If you can find suppliers that can take on multiple contracts and items, it might be wise to do that, too.

Consider all these factors and weigh each step of the strategic sourcing process for risk and potential inflation.

Financial Hedging to Manage Inflation

The buy and hold strategy has been a popular tactic since the onset of COVID-19, and if space allows, it has been proven to be impactful. According to Investopedia, “There is statistical proof that a buy-and-hold strategy is a good long-term bet, and the data for this hold up going back for at least as long as investors have had mutual funds.”

Proxy hedging, or substituting one ingredient for another, is a tactic that can also be used in some cases. For example, the meteoric rise of canola oil prices has caused some organizations to look at other oil sources. In such a real-life scenario, the question would be: Can sunflower oil be substituted or something else?

As for hedging through contracts, this can be done with multiple suppliers, and the new terms even out expenses. You can also look toward using price caps in your contracts—but again, be careful to remember that now is not the time to strongarm suppliers.

FORGE Dollars and Sense – Procurement’s Conference to Hedge Against Inflation

At Procurement Foundry, we’re dedicated to empowering you on your journey. Hedging against inflation will be a major topic at our upcoming FORGE Dollars and Sense event.

Join us for innovative thinking on how and where dollars are being spent, risk vs. cost, and how to use procurement data for better profit. Speakers will dive deep into topics like how future-state procurement supports the business, better spend, data, and suppliers to drive positive change.

Ready to learn more? Reach out to us today and join us at the FORGE Dollars and Sense conference.