Executives do not control the economy, but they do control how they run their businesses. Which is why managers trying to divine the direction of the economy in the year ahead should look no further than how they control spending and the balance sheet, and how they treat customers and employees.
This is the fifth fall that I have written an Ivey Business Journal article on where the economy is headed and what executives should do about it. Articles of this type are more common at year-end, but they may be more useful now because Labour Day is, for many enterprises, when next year’s planning and budgeting cycle begins in earnest. My forecasting record has not been particularly impressive, but at least I am not alone—some of the company, in fact, is quite exalted. Being a forecasting economist gives new meaning to misery loving company. That old one-liner about economists providing forecasts because they were asked, not because they had any real idea, has always made me wince. Anyway, I am back!
My problem last year was that I underestimated Canada’s strength and resilience in the face of global, and especially, U.S. slowdown. Canada’s economic performance has been nothing short of remarkable. Regardless, no enterprise should regret having heeded my advice that whatever shape the economy is in, good management is never out of style and often makes all the difference. Executives do not control the economy, but they do control how they run their businesses. After blind luck, good management has always been the best antidote for a bad economy.
For the year ahead, look for Canada to regress to the U.S. mean. The balance of probabilities suggest modest but satisfactory growth with the risks weighted to the downside. There is virtually nothing on the immediate horizon to push Canadian interest rates up, but do not bet against the Bank of Canada moving the other way. For the Canadian dollar, expect it to be flat or move down. On the management front, emphasize spending and balance sheet prudence and treat customers and employees like they matter more than anything else. The watchword is caution. This is no time to be betting the company! The outlook beyond a year is more uncertain than it has been for some time.
The biggest issue by far for the Canadian economy going forward is the United States. Over one- third of our economy consists of exports to the U.S., so over time, how those exports go is how we are going to go. The NAFTA has done wonders for our standard of living, growth and job creation, but it tied our economy to the U.S. as never before. Fifteen years ago, less than one-fifth of our economy consisted of exports to the United States.
My bet is that the U.S. will bounce back from the doldrums in fairly short order. Put the probability at about 70 per cent. But if they do not, Canadian executives should brace for what could be a very bumpy ride. If, perish the thought, the U.S. goes the Japanese deflation route, we will have a lot in common with the person at the tail end of a very long line of crack-the-whip: holding on for dear life with no control, no options and no capacity to safely exit. Put the deflation scenario probability for the U.S. at 15 per cent (quite low), but I would have had it at essentially zero for my entire 40- year working life.
The U.S.’s problems are well documented: slow growth, weak production and terrible job performance. That the U.S. job market has not been this weak since the Second World War is particularly worrisome. A good job and confidence that it is secure are at the heart of each one of us consuming, saving and investing in ways that collectively produce a sustainable high-performance economy.
The causes of the U.S.’s problems are in the eyes of the beholder. They include some combination of a bad turn in the business cycle, the inevitable aftermath of a pricked stock market bubble, a big fall-off in business spending, huge production overcapacity in a host of industries, fierce competition across the manufacturing board from low-wage countries like China and India, breathtaking workplace and product technological change, arguably unprecedented levels of personal, household and corporate debt, little residual pent-up demand for high-employing consumer goods like cars and appliances, a staggering current-account deficit and a U.S. dollar that was too strong for too long against major world currencies. It is a long litany that boils down to the bigger the boom, the worse the aftermath as the excesses get worked out. Binging is fun but it always comes with a hangover. Former Federal Reserve Board chairman William McChesney Martin (1951-1970) was fond of saying his job was to take away the punch bowl just as the party was getting good. The punch bowl was out for too long in the late 1990s.
All that was then and this is now! The Federal Reserve is weighing in with the biggest dose of peacetime monetary stimulus in its history. They have taken their key interest rate, the federal funds rate, down 5.50 per cent, to one per cent. That puts rates today at 15 per cent of what they were at the beginning of 2001 and at the lowest levels in almost 50 years. If this does not get the economy moving, then arguably nothing will. But there is more: the Bush tax cut is big and far more spread out than is popularly believed; Iraq and homeland security along with the tax cuts have sent the U.S. deficit into orbit, providing a gigantic dose of classic Keynesian fiscal stimulus. Add in a materially weaker U.S. dollar against important trading currencies like the euro and the Canadian dollar, positive consumer confidence, the natural tendency for economies to improve the longer they are down, a strengthening profit picture and better stock market tone, and it would be surprising, indeed, if the U.S. economy is not accelerating by year-end. That is the view of many economists and it is my view also. Another old one-liner about economists making sheep look like independent thinkers bears noting at this point. Heaven help us all if the U.S. economy remains stuck in the mud with everything that is being thrown at it. The authorities are fast running out of stimulating ammunition.
An improving U.S. outlook for next year is not the only reason to be optimistic about Canada. First, the Bank of Canada has lots of room to lower Canadian interest rates should it be necessary. The Bank’s overnight lending rate is 3.00 per cent, 2.00 per cent above the comparable U.S. federal funds rate. Second, inflation in Canada is well contained, removing the largest single impediment to the Bank of Canada lowering interest rates. Third, SARS has devastated Toronto-area tourism, but the outlook there is encouraging as is the outlook on the mad-cow and West Nile fronts. Fourth, the Canadian economy has considerable momentum coming off a number of decent quarters. Fifth, our public-sector finances are better than they have been in years.
A big negative, of course, is the appreciation in the Canadian dollar, but if it does not rise from here, we should be fine. Much upward movement and all bets are off. That is one reason why this article does not look beyond a year. Other reasons include global economic uncertainties, the precarious U.S. recovery and problematic geopolitics.
The most important capital market variables for executives are interest rates and the Canadian dollar. Logic for where both are likely headed is straightforward. If the economy trips, the Bank of Canada will lower interest rates; with the economy hesitating, the Bank of Canada would never raise rates, especially with inflation benign. The run-up in the Canadian dollar makes Canadian exports accordingly more expensive in the U.S. There is no appetite among policy authorities for a higher currency until the economy firms and the effects of the dollar’s rise are better understood. The components of proper management practice have been developed in this space over the years. In the economic environment at hand, five areas warrant special attention.
First, aggressively control operating spending. Executives should be pressing to get down to the bare essentials. Cutting spending is a lot tougher than saying “No” to begin with. If this economy falters, competitors and financial markets will exact a very heavy toll, and very quickly, on inefficient spenders. What is different today from only a few years ago is that globalization and technological change have opened everybody’s market to any and all competitors. In this “meet the best price or lose the business” environment, the only way to run an operation is lean.
Second, put the same effort into controlling capital spending. Because capital spending only goes through the operating statement as it is written off, it can be beguiling. The trouble in an uncertain economy is that assets may have to be abruptly mothballed, but there is no mothballing the write-offs and financing costs that just keep chugging along regardless of whether there are offsetting revenues. If this is the kind of economy in which to put a special focus on controlling operating spending, then it is equally the kind of economy to go after capital.
Third, control debt. Interest and repayment charges must be made when they are due. In an uncertain economy, the last thing you want to be doing is adding debt which does not have underlying assets with a sound revenue stream. Think equity and a strong balance sheet.
Fourth, put customers on a pedestal. It has probably never been easier for competitors to reach your customers. Taking care of customers means product quality, availability, price, and service. Keeping a customer is usually much cheaper than winning a lost customer back or picking up a new customer.
Finally, put your employees on the same pedestal. Employees make the product and take care of the customers. If things get difficult, their willingness to be supportive and to sacrifice may be the difference between making it and not making it. Respect is the key.
My guess is the next year will not be too bad for the Canadian economy. But with so much up in the air, a prudent approach is wise. This economy could turn on a dime. The deflation scenario is a big concern, and while we are clearly not there, the probabilities of such are rising. What executives can do is run their enterprises well. Executives should give considerable thought to exactly what “well” means in their specific circumstances. If it does not have a lot to do with spending, the balance sheet, customers and employees, they should probably think about it again.