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Managing end-of-cycle economic risk

When and how to plan for the next downturn

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Managing end-of-cycle economic risk It seems like an odd time to worry about the economy. GDP grew at 4.2 percent and 3.5 percent for the second and third quarters of 2018, respectively, and could top 3 percent for the year. The December 2018 job numbers also point to continued economic strength. At under 4 percent, unemployment remains near historic lows. The report also showed year-over-year wage growth of 3.2 percent—the highest in nearly a decade.

But there are reasons for concern. While longevity alone is not a measure of risk, at 116 months and counting, this is already the second longest economic expansion in the post-war era and will almost certainly become the longest early this year. No expansion lasts forever.

Storm clouds gathering? In her most recent edition of Economic Currents, Grant Thornton’s Chief Economist Diane Swonk points to a variety of storm clouds on the horizon, including a strong dollar, weakening growth abroad, mounting corporate debt, a slow-down in housing and the ongoing havoc that tariffs are wreaking on global supply chains. Swonk predicts that real GDP growth will slow from 2.9 percent to 2.5 percent in 2019 and that the fourth-quarter to fourth-quarter change, which is a better measure of momentum, will drop dramatically, from 3.1 percent for 2018 to 2 percent for 2019. She has moved up her prediction for the beginning of the next recession by six months, to the first half of 2020.

“I grew up in the Midwest, where storms and tornados are a fact of life,” said Swonk. “Even while basking in the sun of an aging economic expansion, I start to check the shadows and look for places to seek shelter for when the storm eventually arrives.”

Interest rates and corporate debt After holding rates at nearly zero for almost a decade, the Fed has raised rates nine times since December 2015. After the most recent hike in December 2018, the federal funds rate is now at 2.5 percent. On January 30, 2019, the Fed changed course slightly on previous signals that it would continue rate hikes in 2019, with Fed Chairman Jerome Powell saying it would be “patient.” But, should inflation start rising, rates likely will as well.

While rates are still in historically low territory, one of the byproducts of a decade of near-zero rates has been an unprecedented explosion in corporate debt. As this recent column in the New York Times demonstrates, many are beginning to wonder what will happen as rates continue to climb and companies need to refinance record levels of debt.

The yield curve is another metric worth watching. Inverted yield curves, where rates on short-term bonds are higher than those on long-term offerings, have preceded the last five recessions. While the yield curve is not yet inverted, it has very nearly flattened.

From China to Brexit, international concerns Internationally, a number of economies raise concerns. China’s rapid growth has been a vital driver for the global economy in the decade since the Great Recession, but burgeoning debt, currency concerns and uncertainty stemming from its ongoing trade war with the U.S. have slowed China’s growth considerably and raised concerns about a possible contraction. Great Britain, the world’s sixth-largest economy, continues to be rattled by the prospect of a no-deal Brexit as the March 29, 2019 deadline looms. As of the beginning of the year, Prime Minister May has yet to be able to secure a Brexit deal. The ramifications of a hard Brexit would extend throughout the EU and the world. Adding to global uncertainties, Germany, EU’s largest economy, contracted by 0.2 percent in the third quarter of 2018.

Stock market woes In the U.S., despite solid economic fundamentals, investors have reacted negatively to growing global uncertainty and to political turmoil at home. The S&P 500 index finished 2018 down by 6.2 percent—its worst performance since the economic crisis began in 2008. And it was not alone. For the year, the Dow Jones Industrial Average was off by 5.97 percent and the NASDAQ by 4.38 percent. And the new year has not started off any better. On January 3, 2019, largely because of disappointing sales in China, Apple downgraded earnings estimates for the first time in almost 20 years, driving down not only Apple shares, but pushing continued weakness in the technology sector. The same day, Trump administration economic advisor Kevin Hassett, appearing on CNN, said he anticipated that a “heck of a lot” of U.S. companies could be facing earnings downgrades because of slumping sales in China.

Internationally, stock markets fared even worse in 2018. The FTSE All-World index, which tracks stocks in more than 3,000 companies and nearly 50 countries around the world, dropped 12 percent for the year. Markets in China took the biggest hit, with the Shanghai Composite Index down by 25 percent.

Six steps to plan for what’s next Scott Davis, a partner in Grant Thornton’s Strategic Solutions practice, works with companies that are restructuring and with others that are planning transactions. “We’re seeing a lot of warning signs, especially overseas,” says Davis. “It’s a global economy, everything is connected. Something like a sloppy Brexit could trigger serious ramifications. A major slowdown in China could really rock the global economy.”

Davis believes now is the time for businesses to plan for the next downturn. “This has been a really long expansion. Expansions always end. There are a lot of companies with people in senior positions who haven’t been through a downturn. Things have been good for so long that it can be hard to break away from that mentality.”

Davis points to six key steps businesses should consider now.

  1. Think strategically: This is the time to take a hard look at how your company is performing. Segment operations by product and service line, geography, customer and other key metrics to see where performance is strong. “During this long expansion, a rising tide tends to lift all boats,” says Davis. “But which ones are likely run agound first when conditions get worse?” By identifying underperforming or non-core assets now, you can sell them while conditions are strong and you are likely to secure a better return. You can then use that capital to pay down debt, provide a financial cushion and build a war chest to seize opportunities once the recession hits. Davis points out that recessions are times of tremendous opportunity for the prepared. “Companies that plan ahead and have the resources can often buy out troubled competitors or make other moves at bargain prices during a recession,” Davis says. Strategy also includes looking at your product mix and marketing strategy for approaches that might work in tighter conditions. “How can you market to focus on value during a downturn?” Davis asks. “This is a good time to look at your affinity program. Is it driving real value? It could become more important as conditions worsen.”
  2. Watch long-term commitments: With most economists now expecting a recession by the end of 2020, this is the time to start thinking carefully about any long-term commitments, from new leases to capital expenditures to new supplier and customer relationships. “Consider long-term commitments through the filter of how they would impact your business should conditions tighten,” Davis says. “You’ll want to maintain some flexibility.”
  3. Plan your debt: “If you know your business will need new capital or if you have a refinancing coming up in the next year or two, act on that now,” says Davis. Currently, businesses can secure debt on relatively easy terms, with very few covenants. “Having low covenant financing in place at favorable terms is a real advantage during a downturn,” Davis notes. Once conditions have tightened, the cost of debt shoots up, covenants get restrictive and the overall availability of capital can go down, sometimes sharply.
  4. Manage inventory and supply chain: The ongoing trade war with China and, to a lesser extent, other markets, is already complicating supply chain issues for many companies. Now is a good time to evaluate what you need, where it is sourced and how much you really require. What are you long in today that you may not want to be? What don’t you want to get longer in? This is also a good time to consider the long-term viability of key suppliers and develop back-up plans should any fail.
  5. Get serious about forecasting: Disciplined forecasting is always a good idea, but is particularly important during tight conditions. Focus on liquidity. Davis recommends that all businesses keep a rolling 13-week cash flow forecast and analyze the results weekly. Watching the variances can give you the early warning to need to keep problems under control.
  6. Consider your exit strategy: For closely held business owners who are close to retirement or otherwise considering an exit, the end of a business cycle is a critical juncture. “If you’re planning to sell in the near term, then sell now,” Davis advises. “No one wants to have to sell during a recession.” Otherwise, have plans in place to ride out the downturn, profit where possible, and position your business as an attractive target when conditions rebound.

The next recession is always a question of when, not whether. Evidence is mounting that when is sooner than many where expecting. Plan now to succeed then.

Contact:

Scott Davis Scott Davis
Partner
Strategic solutions
T +1 707 632 3540