Managing macro financial risks

One of the most fundamental characteristics of the economy is the business cycle, that is, the considerable fluctuations of GDP around its long-term growth path.

by Professor Ole Risager, Copenhagen Business School, Denmark

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We call it the business cycle because it is associated with large fluctuations in companies’ earnings and turnover. The business cycle is also associated with considerable movements and shifts in other macro variables like interest rates, stock prices and commodities, including oil, gas, metals, grain, and so forth. Correctly positioning a company in the cycle often makes the difference between good and bad performance. Moreover, evidence also shows that the right management of business cycle risks, including the right timing of investments and acquisitions, is important for CEO and company reputation, and in some cases even for the survival of the top-management team.

LEADING INDICATORS AND EARLY WARNING SIGNALS

It is therefore important for most companies to try to spot significant changes in growth including turning points in the business cycle. There are by now also a large number of economic indicators that can be used in forecasting the cycle. Table 1 briefly reviews a short list of indicators that are useful in predicting the US business cycle. The first indicator, and probably the most important, is the term structure spread. The signal arising from a decline in long-term interest rates relative to short-term rates prior to recessions has been a useful early-warning indicator prior to the 2001 and 2008 recessions. This is also true if we go further back in the history of the US. Figure 1 shows that spikes in the term structure have preceded the majority of recessions since 1960. Careful monitoring of the term structure is therefore a ‘must’ in macro risk management, but experience also shows that one should ‘listen’ to a whole battery of indicators since there is seldom one variable that tells the whole story. I have therefore also listed a sample of other indicators that are used in forecasting cycles. However, while leading indicators offer useful guidance on where the economy is likely to be heading, indicators are unfortunately not right all the time.

READING LEADING INDICATORS: BE AWARE OF THE PSYCHOLOGICAL BIASES

Risk managers, including top-management and the executive board, who on a regular basis address key risks, will therefore always have to engage in discussions on the validity of the signals from these and other indicators. In this context, it is important to be aware that many studies in behavioral finance show that decision-makers often have expectations that are too optimistic if the boom has lasted over an extended period. In such an environment, individuals tend to make simple extrapolations of expectations and hence believe that the party will last for a long time, if not forever. Signals from leading indicators are therefore often ignored. And people who issue skeptical views about the sustainability of the boom are often considered to be out of touch with the modern world and addicts to outdated paradigms. The rhetoric is often like “this time is different – is it not?”

This explains why many businesses tend to repeat the same mistakes business cycle after business cycle. The pig-cycle is a famous model that explains this all too well. The model originates from agriculture but is equally relevant in construction, in real estate, in shipping, in banking, and in many other businesses. The story is simple: in good times with high prices, business leaders think that markets will continue to be strong going forward. Companies therefore often engage in ambitious expansion strategies through organic growth or through acquisitions. Such strategies are also facilitated by strong cash flows and therefore easy to get through the executive board. In many cases companies do not properly analyse the consequences for the whole market of massive investments. So what could be a good idea for a single company often turns out to be a disaster for the industry because the market gets flooded with too much capacity with a strong negative effect on market prices and returns. And the more so if the downturn of the market goes hand in hand with a deep recession in the macro economy as is the case right now.

RISK MANAGEMENT IS ALSO ABOUT IDENTIFYING OPPORTUNITIES

Because a thorough understanding of leading indicators and macroeconomics in general requires experience, companies that are significantly exposed to macroeconomic risks should not only allocate junior staff to this task. Competent risk management requires experienced staff also because business cycle analysis should be accompanied by a thorough knowledge of markets and economic history, including an understanding of what is ‘normal’ and what is not ‘normal.’ Moreover, it is also important that risk management is undertaken in close cooperation with top-management because risk management is not only about identifying all the bad things that could happen but also about identifying opportunities, cf. below. Unfortunately, in many companies risk management is associated with routinely, often quarterly, ‘bad risk’ identification exercises plus some discussion of mitigation possibilities. However, since risk also entails upside risks, risk management could potentially be much more rewarding. To facilitate a balanced treatment of upside and downside risks, top-management could take the lead in the internal company risk meetings.

WORK WITH EXPLICIT SCENARIOS AND TRY TO DO SOME NUMERICAL CALCULATIONS

Sometimes business leaders argue that because macroeconomists and finance gurus can never with certainty tell whether we will have a recession or not, we should not spend time on such exercises. In my view this is wrong because the business cycle is not a random event; recessions and recoveries can to some extent be predicted though seldom with complete accuracy.13 Many companies can therefore do much better if they try to get ahead of the curve.

To be more concrete, suppose leading indicators are telling us that it is likely that we will have a recession or a significant downturn within the next 12 to 24 months. The first scenario we therefore start to characterise is the recession scenario. To this end we make assumptions about the depth and length of the downturn. Next we stress test the current strategy against this scenario and try to report likely quantitative effects on sales, earnings, and so forth. How much will we lose if we maintain business as usual and how can we mitigate the downturn? What can we do in terms of capital budgets, hiring decisions, loan facilities, and so forth? Which actions could we take now? How can our company get ahead of our rivals in the industry? Following this, we also start thinking about opportunities in case the recessionary scenario actually materialises, as downturns normally are associated with bargains, that is, investment opportunities that do not exist at the peak of the cycle. Which of our rivals could get into serious trouble and hence become bargains? And can we otherwise benefit from the downturn? The recession scenario does not only have to deal with downside risks; it entails a lot of opportunities for those who carefully plan for it.

ECONOMIC HISTORY IS INFORMATIVE ABOUT LIKELY SCENARIOS

Since we cannot be sure that we will have a recession we also outline other scenarios. In this process we should also assess probabilities of different scenarios. On the basis of this analysis, top-management including the executive board can decide what the appropriate strategy should be given all the information we have at this juncture. Suppose the company is convinced that a recession is likely, moreover, suppose the company decides to adjust its strategy to make it compatible with this scenario. In this case the company is running the risk that the leading indicators could have sent a false signal. However, it is important to bear a number of simple facts in mind: First, booms are always followed by recessions. It is possible to get the timing wrong, but a long upswing is always followed by a downturn. History teaches us that ‘this time is never different’. Second, the length of a typical cycle, defined as the time from trough to trough or peak to peak, is about five to six years. This is a simple yet important piece of evidence that should help anchor our expectations and hence prevent us from flying away from macroeconomic realities. Because we had the last recession in 2001, this tells us that we should have watched out for a recession in 2006 or 2007. And that was also what serious macroeconomists started to do but most companies did not take much notice. Instead, many firms actually maintained business as usual and some firms even geared up for more aggressive investments. Now we know that in most cases it would have been wiser to have changed course and prepared for a slowdown. I am not saying that we could have forecast the magnitude of the current recession in 2006 or in 2007 but it is not surprising that a downturn was just around the corner. And in some sectors of the economy this was pretty obvious.

THE CURRENT CRISIS IS NOT GOING TO LAST FOREVER: BE PREPARED FOR A RECOVERY

Likewise it is important to realise that the current deep downturn eventually will come to an end. A recovery is therefore bound to happen. A trough is reached when housing prices have stabilised and when the banking sector has been sufficiently recapitalised.9 It is likely that it will get worse before it gets better, but some recovery will take place when the stimulus packages start to work. At that time it will be important for companies to start thinking about the likely nature of the recovery. In which parts of the world will it come first? Which industries will lead and which industries will lag? What is the outlook for interest rates and the cost of capital? Is it likely that interest rates will increase to new plateaus in response to current massive government borrowing to fund the stimulus packages? And should this affect our company’s scheduled funding strategy including the company’s capital structure policy? The current very difficult macroeconomic situation and the high uncertainty as regards the timing and nature of the recovery pose lots of important questions to company risk management that we should not forget to address. In other words, at this juncture companies should not only focus on cost cutting and efficiency gains but also devote qualified manpower to address important future business issues.

 

Ole Risager (Ph.D.) is professor at Copenhagen Business School, Department of International Economics & Management. He has extensive experience on monitoring and managing macroeconomic risks from his previous positions as Senior Economist at the International Monetary Fund, USA, and as Vice President - Chief Economist at AP Moller – Maersk, Denmark