Compass Points

Economic Commentary

Storm Clouds Looming?

by Denise A. Harrison

Just when many had been lulled into thinking that the world economy had fundamentally changed; storm clouds appeared on the horizon. But wait, many predicted that the future would hold fewer and shorter dips in the economy. What is causing the turbulence that may put an end to eight years of expansion?

In Japan, the first economy to fall, checks and balances between lenders and borrowers do not exist. As times got tough, financial institutions continued lending to customers who were not credit worthy so that they would not have to take large loan write-offs. These interdependencies created a financial bubble which burst with devastating consequences for the Japanese economy. Japan, the former economic miracle, is a victim of its own excesses. After many years of consistent but unrealistic growth, Japan is about to complete its second year of economic contraction. Insolvent borrowers continue to receive credit so banks can avoid write-downs while good borrowers are denied loans because there is little left to lend. Financial institution loan portfolios are still valued at the stock price at the date of purchase rather than the current deflated stock prices. Japan must take some bitter medicine before it will be in a position to lead the rest of Asia out of its economic crisis.

After a long period of expansion, the remaining Asian countries found that credit customers could not meet their financial obligations and financial institutions imploded when the loans, negotiated on a handshake, resulted in default and an ensuing significant loss of capital. Many years of irrational exuberance in Asia, where excess capital led to easy money and poor investments, came to a crashing halt. People sought high returns without weighing the accompanying risks associated with those returns.

Much like Japan, the financial institutions throughout the rest of Asia found it difficult to say no to large industrial entities. They continued to throw good money after bad. While we look aghast at their predicament we only have to look at the US during the 1930’s and again during the S&L crisis in the 1980’s to find that we are capable of the same mistakes. During these times the US saw the seeds of destruction sown when financial institutions and their credit customers, joined at the hip, made loans on the basis of relationships rather than credit worthiness. The crop of bankruptcies which followed were a major cause of the long period of economic stagnation during the 80’s and the Depression in the 30’s. This borrower/lender interdependency was one of the major reasons for the economy’s downward spiral to a depth where recovery during the 1930’s was measured in years rather than months. During that time period new legislation was passed by the US government to define strict boundaries for financial institutions and their customers. Now the Asian countries need to take the bitter medicine of defining boundaries between financial institutions and their customers. Treasury Secretary Robert Rubin comments that problems in Asia took a long time to develop and there is no reason to think that they will come to quick resolution.

In Russia, the failure of communism was deemed proof that capitalism is more effective in raising the standard of living. However, the simple desire to move to a market-based economy did not result in a cure for all ills. Gorbachev began a slow, but orderly transition from communism to capitalism. He wanted to develop the building blocks and infrastructure necessary to move to a market-based economy.

Yeltsin, after wresting the power from Gorbachev, quickly sped up the transition. This accelerated speed led to increased risk and correspondingly heightened the chance of fatal injury. Pushing down the accelerator of a car manufactured in an environment without proper infrastructure might cause the wheels to come off. The Wall Street Journal reports that the Russian standard of living has eroded so that nearly one in three is living below the poverty level. There is no prediction of speedy recovery here. Luckily, Russia’s economy is the size of the Netherlands and therefore should not have a significant impact on most US-based businesses.

South America
South America was the next region to feel the turbulence. Still, South America took bitter medicine back in the 1980’s as inflation raged throughout many of the Latin economies. A strong dose of this medicine put many of the checks and balances required for financial stability in place and ensures that South America will recover at a faster rate than either Asia or Russia.

United States
So what is the temperature of the United States? While the United States is currently enjoying the benefits of lower commodity prices, low inflation, and high employment, there are caution signals flashing on the horizon.

Inverted Yield Curves
Inverted Yield CurveWarning signs appeared early this fall as the stock market experienced roller coaster gyrations. One of the early indicators of trouble ahead is when an inverted yield curve is present in the marketplace. What constitutes an inverted yield curve? When the yield on short term rates exceeds that of longer term rates. More specifically, it is when the yield on the 3-month T-bill brings less than the 10 year T-bond. In a normal economy longer term rates are perceived as more risky so the yield or reward is higher. Based on economic models developed by the Cleveland Federal Reserve the inverted yield curve foretells of a recession in the next 12 to 18 months. The last time the inverted yield curve appeared was in the early 80’s and what a fun time that was! While the economy is not suffering the high interest rate and commodity stress that occurred in the previous decade, the inverted yield curve indicates that all is not well.

Index of Leading Indicators
During our seminar, Simplified Strategic Planning for Small to Mid-Sized Companies, members of the CSSP team encourage participants to watch the index of leading indicators. When the index of leading indicators turns down for three or more months one can expect a recession during the next twelve months. A recession is formally defined by two consecutive quarters of negative growth.

What is included in this index of leading indicators?
Unemployment claims
Orders for consumer goods
Slower deliveries
Plant and Equipment orders
Building permits
Interest rate spread
Stock prices
Money Supply
Consumer expectation

This index is developed by the Conference Board and appears monthly in the Wall Street Journal and other new publications. During the early phases of this economic expansion this indicator moved continuously upward. Recently this positive trend has been interspersed with negative months indicating an economic slowdown. Should the storm clouds become more ominous, what can your company do to reduce its exposure?

What can you do to cushion your company during a period of economic instability?
Use lower commodity prices to build customer loyalty (Figure 1). Many companies have seen a significant decrease in basic commodities. One way to build customer loyalty is to rebate back part of the savings to customers. The benefits include:

  1. Goodwill among customers and a feeling that you are being “fair”.
  2. Customers who no longer want to renegotiate their contracts, thus enabling you to go back to your original prices if the commodity prices increase.
  3. More flexibility to determine your pricing policy while you evaluate how long prices will stay at low rates.
  4. An ability to re-negotiate longer term contracts, thus increasing volume, that will see you through an economic downturn.

Capital Investments
While interest rates are at low levels companies need to guard against the desire to take on too much expansion. In Asia cheap capital and easy money resulted in reckless investment decisions. Companies should avoid higher leverage during times when an economic downturn is possible. By avoiding over expansion now your company will be positioned to make the investments when the forecast of a brighter future illuminates the horizon.

Assumption Review

  1. Are any segments counter-cyclical or more likely to sustain volume through an economic downturn?
  2. Are there any segments that are currently suffering from the global economic crisis? The semiconductor industry has been particularly hard hit, for example.
  3. Are any segments going to be severely impacted by the global economic crisis?
  4. Conversely, are any segments more likely to benefit from the global crisis?

During your quarterly strategy review discuss the impact of an economic down-turn in each of your market segments. Discuss how a recession will impact your opportunities.

Whether this is an economic slowdown, downturn or recession, it is time to cut back on fatty growth.
During times of prolonged prosperity companies often relax financial guidelines. Companies start to put on weight in areas that do not directly impact customer satisfaction and shareholder value. With signals of economic downturn flashing, your company needs to think about cutting back on the fat and reinstituting or establishing stricter financial controls.

Planning ahead for an economic down-turn allows for more flexibility when it actually materializes and guards against a knee jerk reaction in the decision making process. A company that is positioned to weather the storm will often emerge with a stronger market position as weaker, less-prepared competitors are forced to abandon ship. Good economic times enable many marginal players to exist and it is these players who fall by the wayside during an economic downturn. Let’s use the strategic planning process to develop a plan for weathering the storm.

© Copyright 2007 Center for Simplified Strategic Planning

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