THE ECONOMY: HOPE FOR THE BEST; BRACE FOR LESS

As the other end of the economic looking glass becomes murky, managers will find some clarity and wisdom in the words of this regular Ivey Business Journal contributor.

It is economic-forecasting season again. Executives should be paying particular attention. Economists are bullish and worried at the same time. “The economy will be strong unless things go south” is a tough forecast to plan a business around. The antidote to economic uncertainty is always the same: good management practices. Understand the risk agenda; offset those risks that can be offset; get properly compensated for risk that cannot be offset; constantly reassess; be sensibly bold; do not be afraid to change. In short, hope for the best; brace for less.

Few important business decisions are not materially affected by economic conditions. How fast the economy is likely to grow is crucial to production, investment, employment, inventories and receivables. Inflation expectations play on product pricing, compensation, contract length and supplier arrangements. The outlook for capital market variables like interest rates and stock prices affects everything to do with the balance sheet. Where the dollar is likely headed affects location, export pricing, hedging and the timing of transferring funds. The economy matters and it matters a lot! Executives who ignore the economy do so at their peril.

My “best guess” for this year is this: about three percent economic growth; decent, but certainly not robust job creation; inflation in the vicinity of two or three percent; a Canadian dollar in the range of 80 to 85 cents U.S. (with about 85 percent of our exports going to the U.S. and so many of our commodities priced in U.S. dollars on world markets, the U.S. dollar exchange rate is the only one that really matters to us); a solid current account surplus; slowly rising short-term interest rates and relatively stable long-term interest rates; reasonable growth in corporate profits; an okay stock market.

My “best guess” is in the ballpark of many economists. This alone should make executives wince. Economists do have a way of making sheep look like independent thinkers and the more they herd, the less the likelihood they will get it right. Oh well, to err is human, to get paid for it divine!

Notwithstanding, my relatively bullish “best guess” is supported by current economic data, emerging trends, developing momentum and economic logic. Canada is on a bit of a roll. For example, we are the only major country with both a current account surplus and a federal fiscal surplus.

Under normal circumstances, a “best guess” outlook like this should be all executives need to press on and make hay. But these are not normal circumstances. The spread about my “best guess” is considerably wider than normal and especially on the downside. There are a number of wild cards.

First, oil prices. High and rising oil prices have a nasty and quite unerring history of leading to economic slowdowns. Reference the oil-price-driven slowdowns accompanying the 1973 Yom Kippur War, the early 1980s Iranian Revolution and the 1990 first Gulf War.

High oil price/economic slowdown logic is straightforward. The gasoline, heating oil, aviation fuel, heavy oil, asphalt and petrochemicals that are refined from oil are so essential to our way of life that we have no choice but to pay almost any price for oil. In economist’s jargon, the demand for oil is inelastic with respect to price. The trouble is that as we pay more and more for oil, we have less and less available to pay for things like homes and cars, the things that create jobs and economic activity.

Rising oil prices have very much the same effect on an economy as a tax increase. Economists do not agree on much but there is little disagreement that few things will slow an economy faster and with more certainty than a healthy tax increase.

Figure a slowdown in the global economy of about two thirds of one percent for each sustained ten dollar increase in the price of oil. The key word is “sustained.” There is no doubt that my “best guess,” bullish outlook for Canada would be in serious difficulty if oil persisted at 50 to 60 dollars a barrel or higher. Right now, I’m betting that oil will behave, but when the price is so dependent on stability in the likes of Iraq, Iran, Indonesia, Nigeria, Russia, and Venezuela, who really knows? Tell economists what the average price of oil will be for the next two years and they are a good way to telling you what the economy will look like.

Second, the U.S. current account. The current account is the difference between what a country sells others and others sell the country. A deficit must be financed internationally, meaning foreign savings must be imported and international debt added. So long as current account deficits are moderate and offset periodically by surpluses, there is no particular concern. That is not remotely the U.S. current account situation. The current account deficit of the world’s biggest economy is pushing an astonishing six percent of GDP, meaning that the U.S. is adding six percent of its GDP to its international debt every year, with debt servicing costs also increasing accordingly.

The risks in the U.S. current account situation are as straightforward as they are extreme: if foreigners, especially Asians, become unwilling to keep funding the U.S. current account deficit, interest rates in the U.S. will rise significantly, taking ours with them; at the same time, the U.S. dollar will decline against the Canadian dollar, and for that matter most other currencies, making it harder for us to export goods into the U.S.; the falling U.S. dollar will come right out of the U.S. standard of living, exacerbating our U.S. export difficulties. Rising interest rates and a declining U.S. currency are not a recipe for prosperity for countries like Canada that have so tied their economies to U.S. exports.

The U.S. current account situation is not sustainable; it must be reduced dramatically; the only issues are whether the reduction is orderly or disorderly and how far and how fast interest rates and exchange rates move; we have a huge interest in an orderly and a not-too far, too-fast reduction. There is a huge jeopardy for Canada in the U.S. current account situation.

Third, the U.S. federal government spending deficit. At close to five percent of GDP, the U.S. spending deficit is arguably as unsustainable and worrisome for us as the American current account deficit. Because Americans save so little, their spending deficit over time, if uncorrected, will put serious upward pressure on U.S. interest rates; again, where their interest rates go, ours will more or less go too. At the same time, international investors will show their discomfort with the U.S. spending deficit by pushing the U.S. dollar down, further hurting our U.S. export situation.

Financing the U.S. spending deficit requires a lot of world capital that could be more usefully employed elsewhere. Causes of the U.S. spending deficit include aggressive tax cuts, rising entitlements, the war in Iraq, weak job creation and an economy that needs to grow faster. Similar to the U.S. current account deficit, the U.S. spending deficit gets at Canada with interest rates and a dollar that move in directions that damage our economy.

Fourth, the U.S. consumer. The engine pulling the Canadian economy and, to an extent, the world economy, is the willingness of U.S. consumers to spend, spend and then spend some more. Up to their ears in debt, over-stocked with consumer durables like cars and appliances and spending almost everything they take in, U.S. consumers, like energizer bunnies, just keep on ticking. If the U.S. runs out of spending gas, look out! The economic fallout here will be huge and immediate. Remove the U.S. consumer’s insatiable appetite for Canadian exports out of Canadian growth, and our economy will look pretty anemic pretty quickly. There is no way of gauging just when U.S. consumers will dial it back but it could be abrupt.

Fifth, China. China is the world’s number two economy on a purchasing-power parity basis. It is also incredibly overheated – a fact recognized by the Chinese authorities who are using monetary and credit policies to slow things down in an orderly fashion. The goal is a “soft landing” but if instead, China gets close to recession, that will be bad news for the big commodity countries like Canada. It is Chinese demand that is behind the price increases in oil, copper, lead, zinc, and aluminum that have so benefited the Canadian economy. A “hard landing” in China will hurt Canada. It will similarly hurt countries in Asia like Japan, Taiwan, South Korea and Australia that have become so dependent on Chinese exports. What the Chinese economy has accomplished in such a short period of time is nothing short of a miracle. It has also sowed the seeds of economic jeopardy for Canada and others.

Sixth, inflation. Inflation is benign at the moment, held down by productivity growth, excess labour and plant capacity, low-cost Chinese production, and brutal competition among producers. But lurking beneath the surface is the enormous monetary expansion of the past few years, the pent-up wage demands of workers and the rising prices of commodities. Each has a history of stoking inflation. If inflation significantly rises, then our authorities will have little choice but to aggressively push interest rates up in response. That would slow our economy. Rising inflation and its effects on interest rates is a risk for the Canadian economy.

Oil, the U.S. current account deficit, the U.S. spending deficit, interest rates, exchange rates, the U.S. consumer, China and inflation. Each factor in its own way creates uncertainty for the Canadian economy. If enough break the wrong way, the Canadian economy could get into trouble. Literally overnight, our economic outlook could deteriorate dramatically. I would rate the probabilities fairly low but I sure do not rule it out.

My bet, therefore, is that nothing really unpleasant happens at least through the next year. With that said, it is a wise enterprise that runs its affairs as if it might.

To wit:

  • Revenues are the lifeblood of an enterprise. They are what customers pay for the goods and services the enterprise provides. That puts customers at the top of the corporate food chain. Treat them accordingly; do not take them for granted. This is especially the case when the economy is struggling. That is when customers often have the most bargaining power and are most susceptible to the overtures of competitors.
  • Whatever problems an enterprise has magnify with each additional dollar of debt. Interest and principle obligations associated with debt must be discharged as contracted. The weaker the economy, the more pressure on revenues and hence, the harder it is to meet fixed commitments. Excessive debt is always unwise but particularly so when the economy is weak.
  • When interest rates and the dollar are uncertain, it is important to match cash inflows with cash outflows by date and currency. For example, if you know today you have to make a one-million dollar U.S. payment in 30 days, make sure you will have the one million U.S. in 30 days. If unable to affect a proper match, then use financial derivatives like futures, options and swaps to provide a hedge against untoward interest rate and exchange rate movements.
  • Products are what enterprises sell to customers. In a rapidly changing world, products can become dated overnight. A questionable product shelf is a bad way to enter a tough economy. Make sure that the product shelf is competitive across the board, including especially price and quality.
  • An enterprise is as good as its employees. Enterprises especially need the best efforts of their employees when the economy is down. Employees willing to go the extra mile can make all the difference. Make employee morale, commitment and satisfaction priorities.
  • Control spending. Difficult economic conditions are bad enough without the additional burden of dealing with profligate spending. A weak economy will expose poor spending control fast. Sometimes, enterprises cannot recover.

Things look pretty good for the Canadian economy this year. But it is not as if there are not some large risks. A case can be made that they are larger than normal. Executives should be preparing their enterprises now for the downside. Good management practice is never out of style.