ECONOMIC FORECASTS: EXECUTIVES BEWARE

With this issues of Ivey Business Journal, we close a year, a decade, a century and a millennium. Because there was no year zero when counting started, decades, centuries and millennia actually end on the last day of years that end in a zero, not a nine. Undeterred by that minor technicality, last year’s New Year’s revellers put on the party of the millennium anyway. Imagine what the party will be like this year when it is legitimate!

If ever there was a time for an economic forecast, a once-in-a-thousand-year occasion is surely it. Executives are undoubtedly already deluged. They should take this round of economic forecasts with an even bigger grain of salt than normal. The case that forecasting is becoming more difficult and uncertain is compelling; forecasts may not be as good as they once were. The timing is unfortunately terrible because perhaps never before has an accurate economic forecast been more important to the successful operation of an enterprise. There are a few steps executives can take to improve their forecasting odds and outcomes.

The best approach to economic forecasting is one that works from the top down. The economy is forecast, then the industry, and then the firm-specific environment. Beginning with the big picture provides grounding, structure, context and discipline. When an executive group can agree on the emerging economic environment, it is a good start to getting a consensus, as focus narrows to crucial planning and decision-making parameters. As well, revisiting the economic forecast at regular intervals such as each quarter provides an ongoing reason to review planning and decision-making that no one need take personally. The economy is a far better and more constructive adversary than members of the same executive team.

Only luck can consistently save planning and decision-making that are based on a flawed view of the emerging economy. The key components of an economic forecast will vary from enterprise to enterprise and industry to industry. However, they usually include real growth, consumer and investment spending, inflation, employment productivity, the balance of trade, corporate earnings, interest rates, the Canadian dollar and equity markets. A few examples illustrate why economic forecasting matters: a wrong view on real growth and consumer and investment spending can lead to bad production, plant, machinery, equipment, hiring, inventory and receivables decisions. An incorrect interpretation of inflation can lead to bad pricing, compensation and labour relations decisions. Misreading interest rates and the Canadian dollar can lead to bad financing, investment and currency-conversion decisions, while a poor analysis of equity markets can lead to a badly constructed pension portfolio ad bad acquisition, merger and disposal decisions. Good economic forecasting is not sufficient on its own to assure the success of an enterprise. But over time, good economic forecasting is necessary.

Speed and competition are what make good economic forecasting so especially important today. Virtually instantaneous communications, the Internet, breathtaking technological advances, staggering debt and worldwide financial-market integration are driving a speed of change in business conditions that may be unprecedented. The faster conditions change, the more important an accurate picture of the emerging economy is to planning and decision-making. Being late to the realization that important economic variables were reversing was one thing in the more leisurely paced 1960s and 1970s; it is quite another matter today. The example of Asia-dependent enterprises that were as little as a few weeks late responding to 1997’s “Asian contagion” debacle illustrates how quickly the costs of misreading the economic environment can mount.

Competition exaggerates the jeopardy attached to weak economic forecasting in a time of rapid economic change. The more aggressive the competition, the greater the consequences of missing turning points in important economic variables. Globalization has given a whole new meaning to the concept of aggressive competition. With globalization, everyone is everyone else’s competitor; no market is safe from encroachment; being the best in a city or even a country is no longer a guarantee of success; consumer loyalties are measured in a minute few pricing points. Falling trade barriers, declining transportation costs, the Internet and intense investor pressure for profits assure the globalization phenomenon will only accelerate from here.

Today’s missed economic trend is tomorrow’s falling market share or squandered opportunity. Speed and competition are a lethal cocktail. A rapidly changing economy and competition will expose forecasting ineptness in a hurry; a leisurely pace of economic change and limited competition hides a multitude of management sins. Executives will not go wrong if they assume a future with ever more competitors ever more willing and able to pounce on any serious blunder. This is a grim but bracing reality.

There is no shortage of reasons why executives should be increasingly wary about economic forecasts. First, an absolute must for reliable and consistent economic forecasting is an underlying theoretical model of how the economy fits together and works. A forecast not rooted in at least a semblance of credible theory is closer to wishful thinking and fortune telling than useful science. This is not to say that executives may not find a trip to the astrologer or card reader comforting and/or entertaining from time to time. The point is that forecasts not rooted in sound theory will be correct over time only by accident, and are of no help in separating cause from effect. Hence, they should not be relied upon.

The problem is that the economy is too complex and variable for it to be described by a single theoretical model. It only makes things worse that complexity and variability are increasing. The consequence is a hodgepodge of models with varying, and too often, contradictory views on what determines what. Each model excels on some variables in some circumstances while failing miserably on other variables in other circumstances. No theoretical model comes close to working across all variables, all the time.

The poor economist—Peter Drucker’s observation that “there has never been an economist who had to worry about where the next meal would come from” comes to mind—is left to pick the entrails of Keynesian, post-Keynesian, classical, neoclassical, monetarist, rational expectation, supply-side and public-choice theory for relationships that might be appropriate for the forecasting focus of them moment. For example, if the focus is on growth, Keynesians advise concentrating on aggregate demand, monetarists on the money supply, and supply-siders on incentives and disincentives in the tax system.

The holy grail of economic forecasting is a single, integrated, intertemporal model that perfectly explains the causes and effects of everything from growth and inflation to the balance of trade and interest rates. At the moment, we do not seem to be getting any closer and are probably moving farther away. Until we get there, economic forecasts should be viewed with considerable suspicion.

Second, a number of anchor economic relationships that are key to forecasting have had a tough time of late. What is clear is that many important relationships are not as reliable as they once were; what is not clear is what should replace them. Some examples:

  • The Keynesian view that income explains consumption needs to be updated to incorporate wealth
  • The monetarist view that inflation is related to excessive monetary expansion needs to be updated to incorporate rampaging productivity and fierce global competition
  • The financial economics view that share prices are determined by earnings and discount rates needs to be updated to accommodate cash flows and technological change
  • The Keynesian view that inflation and unemployment tradeoff has been mugged by reality-record job creation and stable prices
  • The capital markets view that the economy and the financial markets are headed for big trouble when short-term interest rates get significantly higher than long-term interest rates has also been mugged by reality; the latest inverted yield curve seems to be stoking a boom
  • The Keynesian view that savings must equal investment needs to be updated to explain record investment spending with no domestic savings.

Third, it does not help economic forecasting that so many fundamentals of the Canadian economy are in such a state of flux. Shifting fundamentals play havoc with the reliability of quantitative relationships that are crucial to good forecasting. Examples of fundamentals that are changing fast:

  • One-third of our economy consists of exports to the U.S. versus one-fifth in the early 1980s; that one-third represents 87 percent of our exports
  • Managed assets are replacing deposits and certificates as the preferred way to save
  • The economy is now dominated by services and high technology, not the old standbys of agriculture, manufacturing and resources
  • The economy is less sensitive to interest rates
  • Unions are not as powerful as they once were.

Fourth, around-the-clock trading in financial instruments, unprecedented trades volumes, lightening trading speeds and deregulation have combined to greatly increase financial market volatility. Because financial markets have such a great impact on modern economies, the more volatile the financial markets, the more difficult they are to forecast.

Fifth, workplace and product technologies are advancing in breathtaking, but also highly unpredictable, fashion. The consequence is a sea change for key economic variables like productivity, unit labour costs, investment and the stock market. This cannot happen without making economic forecasting more difficult.

Sixth, through trade, technology and communications, the world is interconnected as never before. This is good for growth, output, efficiency and standards of living. But it also means that everyone is increasingly dependent on everyone else. The more the world is interconnected, the more things there are that affect the performance of an economy, and, hence, the harder it is to predict. As well, the more the world is interconnected, the more unpredictable is the impact of out-of-the-blue events like 1998’s Russia default crisis and OPEC’s 1973, 1979 and 1990 oil-price shocks.

Seventh, the greater the debt, the more vulnerable and unstable an economy and, hence, the harder it is to forecast. Consumer, mortgage, business and government debt in North America is unprecedented.

Finally, the influence of government on economies is huge but rapidly changing and possibly declining. Government is a force of stability in economic affairs. As government influence changes and possibly declines problems in forecasting arise.

Forecasting the economy is not going to be getting any easier anytime soon. It will probably get more difficult. That said, executives should consider these steps:

Good management practice is always the best antidote to an uncertain and unpredictable but at least it is the same for everyone. Over long periods of time, the effects of luck come out in the wash and, inevitably, the most successful enterprises, regardless of the economy, are the ones that are best managed. Being indefinitely among the best managed is no small challenge for an enterprise; but good management is not at all complicated. Good management is customer satisfaction, innovative products, high quality, effective cost control, a sound balance sheet, a prudent risk agenda, wise diversification, motivated employees, disciplined planning, and unquestionable and unshakeable ethics. Because the future is uncertain and unpredictable does not mean it is unmanageable.

The enterprise that understands how it is specifically exposed to the economy is also ahead of the game. Not all economic variables affect all enterprises the same way. The greater the unpredictability, the more an enterprise will benefit from studying the details of its relationship with the economy.

There are always some who are better at forecasting than others. A given enterprise, having determined its exposure to the economy, will find value in identifying those forecasters with the best record of forecasting those variables that matter most to it.

Another avenue is to increase the resources devoted to forecasting. That the economy may be becoming more uncertain and unpredictable does not mean that more resources effectively targeted will not increase the probabilities of getting the economy right.

Finally, it may be a tough hump to get over, but executives should be encouraged to see an increasingly uncertain and unpredictable economy as an opportunity and challenge, as well as a threat and nuisance. For skilled executives, difficult business conditions are just what the doctor ordered when it comes to beating mediocre competition. Difficult business conditions bring out the best in the best.

It is the rare enterprise that is not profoundly affected by the course of the economy. Regrettably, forecasting the economy accurately may be getting harder. Executives should view all economic forecasts—but especially those for the longer term—with considerable suspicion. The good news is that because the economy is the same for all, the greater the uncertainty and unpredictability, the greater the opportunity for good executives to shine.