Let me start by reminding you what I said in April: no one can accurately and consistently predict the future. However, what you can do is successfully prepare for the uncertainties ahead.
Now, having said that, here are some of the specifics from my remarks last April:
- The credit crisis was the worst since 1929.
- Although the National Bureau of Economic Research (NBER) had not yet called it, I believed the U.S. economy was already in recession, and had been since about November of 2007.
- The American housing market was in free fall, but that unless there were nasty surprises, the American economy should begin recovering by the end of 2009. However, you should have a Plan B in case the American economy fell hard and splashed everyone else.
- The Canadian economy would not suffer as much as the American, but because more than 70% of Canadian trade is with the U.S. it would be hurt by the American recession.
- The Canadian dollar was overvalued at par, but longer term would remain strong compared to the greenback because of the demand for resources.
I also offered the handbook I have prepared for my consulting clients on scenario planning, and suggested that because of the inherent uncertainties of the then-current situation, it was a perfect time to use scenario planning in order to have a Plan B ready in reserve.
So, how did I do?
- The U.S. economy has now been declared by the NBER to have been in recession since December of 2007.
- There have been nasty surprises in the financial markets, and the US economy is falling farther, and harder than anyone, including me, expected, even though I was notably pessimistic last April.
- The Canadian dollar has fallen hard, and is now almost certainly undervalued, because people believe that now is the time for safety, and they also believe U.S. treasury bills and bonds are the safest things to own. Although it’s never possible to be sure, I believe the Canadian dollar is probably worth somewhere between 87-90¢, not 80¢ or less. However, as Keynes pointed out: ‘Markets can be irrational longer than you can stay solvent’ if you bet against them.
But my best call was the need to have a Plan B, and that you should be using scenarios to help you structure your strategic planning. We are in a period of high uncertainty, and trying to guess right is not only futile, but dangerous.
What I’m going to try to do here today is first, brief you on where we are, and what it means. Next, I intend to paint the possible scenarios I see going forward, and again encourage you to create your own scenarios for fun and survival. And finally, I will offer some suggestions on how to be creative in a difficult marketplace, along with an explanation of why you should bother
The dangers ahead: Where we are today
The U.S. economy is pushing the global economy into recession. American consumers are, by some estimates, coming off of 25 years of over-consumption, having used their homes as ATMs, and buried themselves in too much debt. This was aided and abetted by U.S. tax code, which made mortgage interest tax deductible, providing a very strong incentive to keep borrowing on your house, especially when real estate prices were rising. As well, it was the official policy of the U.S. government to subsidize home mortgages, principally through Fannie Mae and Freddie Mac, which were official, unofficial arms of the U.S. government.
Then add to this the policy errors of the U.S. Federal Reserve coming out of the dot.com bubble in the early 2000s. The Fed was worried about deflation, appropriately so, and so flushed the system with liquidity, but then neglected to mop up the excess liquidity when the time came. This fed the housing bubble. The Fed did this primarily because they were worried about deflation – ¬and those worries were valid, up to a point, because deflation can be a far more dangerous problem than inflation in most circumstances.
To explain why, let’s look at deflation for a moment. By definition, deflation is an environment of persistent and widespread declining prices. However, there are different kinds of deflation, and it makes a difference which one you are experiencing. There is the deflation we have experienced from the increased competition caused by the emergence of the global economy. This is OK, because increased competition produces lower prices through higher efficiency and better use of resources. There is the deflation that occurs because of improved efficiency due to computers, communications, and automation. This is OK, too, because it reflects increased productivity. Finally, there is the deflation that occurs because of a lack of consumer confidence, and a strong decline in overall demand. This is not OK, because it can become self-perpetuating, and it was this kind that the Fed was concerned about in 2000 and thereafter.
If you think you can buy a car next month for $500 less than you can today, then the sensible thing to do is to wait. But if next month, you think you can save another $500 by waiting, then you are probably in a self-propagating vicious cycle, where consumers stay out of the market because there is an incentive to do so, and demand remains weak because everyone is waiting to buy. This is an enormous potential threat to the economy, because it can take a mild recession, and turn it into a severe one. This is what happened to Japan in their ‘lost decade’ of the 1990s.
But the combination of tax incentives, government subsidies for mortgages, and unreasonably high liquidity produced a perfect storm of unsustainably rising housing prices and caused American housing (and housing prices in other jurisdictions, such as the U.K. and Australia) to boom. Then, the financial industry (often referred to somewhat inaccurately as ‘Wall Street’) got involved through securitization and asset-backed securities, which made credit even easier, further accelerating the boom. This has been described as being caused by a lack of proper regulation, and while there is some truth to this, financial innovation will always outrun regulation. We would have had problems regardless of deregulation – although it would not have been anywhere near as bad. As it is, the financial industry, including many Main Street banks, have put the stability of the entire global financial system at risk through lack of prudence and due diligence in issuing loans. The classic example were so-called ‘NINJA’ loans, where NINJA meant: No Income, No Jobs or Assets; in other words, lending to people who had no business in borrowing. And this ultimately led to the major short-term risk: that we won’t just see the collapse of individual banks, or banks in one specific country, but of the entire global financial system, leading to a 1930s-style global Depression. This is what we have experienced so far, and brings us to the range of major risks ahead: deflation, a liquidity trap, then renewed inflation.
Liquidity Trap
A liquidity trap occurs when central banks flood the system with liquidity in order to stave off bank failures, and to jump-start the economy, only to find that it doesn’t work. This is happening right now: people are taking the extra money being pumped into the system, and sitting on it instead of spending it because they’re afraid they may need it if they lose their jobs. And commercial banks are doing the same thing: building cash reserves as protection against a possible run on the banking system. They haven’t even been lending to each other, let alone consumer and commercial borrowers.
The best way to gauge how confident the banks are feeling about the banking system of which they are a part is by watching the so-called TED spread, which is the difference between the 3 month U.S. T-bill rate and the ED, or Eurodollar futures contract. In effect it’s the difference between what the U.S. government pays for three-month loans, and the amount banks pay each other for short-term loans. Normally, the TED spread has been 20- 50 basis points (a basis point is 1/100th of a percentage point, so 50 basis points is 0.5%, or half a percent). At the worst of the financial crisis, the TED spread was about 10 times that level, close to 5%. This indicated that the world’s major banks didn’t believe that the other major banks were solvent, which also reflected their worries about their own survival.
The liquidity trap the U.S. is now experiencing, where people and businesses save instead of spend, is forcing the U.S. economy into a much steeper decline than would otherwise have happened. Indeed, one of the classic macro-economic prescriptions for weak demand is a tax cut – but in this environment, people will just either use the tax cut to pay off debts, or save it in case they lose their jobs. As a result, the major government policy tools – lower interest rates, tax cuts, and so on – don’t work, which is why this is called a trap. And, with consumers sitting on their wallets, the economy goes into the dumpster, producing a much worse recession than would otherwise have been the case.
In turn, this hurts government tax collections, and pushes up government expenses for things like unemployment and welfare, so that governments are pushed into deficits, with the result that they try to cut back spending and raise taxes, especially governments, like states in the U.S. or cities in Canada, that are not supposed to run deficits.
As well, falling demand means corporate earnings plummet, which knocks the props out from under stock prices. And, of course, stock markets are also frightened by uncertainty: if a company is rumored as being at risk because it doesn’t have enough cash, then it doesn’t matter what its earning prospects are – no one wants to own the stock.
Finally, focusing on the stock market as the most sensitive indicator of the future of the economy, there are the three keys to the future of stock prices: interest rates, corporate earnings, and investor psychology. The outlook for interest rates is currently positive because central banks, led by the Fed, will at worst be flat, and may continue to fall. This is usually quite positive for stock prices. The earnings outlook is clearly negative, which is very bad for stock prices. And investor psychology is also clearly negative, which is also very bad for stock prices. And yet, it may be that investor psychology isn’t as negative as it currently seems. I’ll come back to this in a moment.
What's the Key?
So, what’s the key? What brings us back from the edge of the precipice, or pushes us off it? Confidence. When consumers start to believe that things are going to get better, that they’re not going to lose their jobs, and that they are not going to be thrown out of their homes and have to live in the street – that’s when they’ll start spending again. So, when we look at our prospects today, the key questions we need to focus on are: What will affect consumer confidence?
First, the investment markets and financial markets have to settle down for confidence to recover. We are going through a gradual calming period, and if no further major crises emerge, the markets will begin to settle down, and stock prices will begin to recover. We’re not entirely out of the woods yet, as there are still nasty surprises that could emerge. For example, if there’s another run on a major bank, or the unexpected bankruptcy of a company with no relationship to the financial markets, that would be further blow to confidence, and the markets would dive again.
A run on the Big Three North American automakers, or their outright collapse, could further shake confidence, and, unfortunately, that is all too possible. Nor is it entirely the fault of lazy car companies with stupid managements: How would you like to see demand for your products fall by about 40%, and financing for your sales to evaporate? That’s what car makers are facing, so it’s not just that they’re arrogant or incompetent. So this is one of the major scenarios you should develop: What happens if there is another nasty surprise, such as a major bankruptcy that catches people off-guard?
But if there are no more major shocks, then things will start to settle down, and the stock market will start to get a bit bolder. Again, watch the TED spread – it’s not back to where it normally lives, but it has dropped a lot from the highs of just short of 5% to about 1.7%. That’s a good sign. Now we need stock market volatility to settle down: days with big changes, up or down, are a sign that the market doesn’t know what the economy’s prospects are – i.e., it reflects uncertainty, which is automatically bad for the market. So the next thing to watch for is smaller market moves, preferably in double digits instead of triple. Once it looks as if the market is beginning to settle (or ‘bottom out’ in stock market parlance), there are literally trillions of investment dollars just sitting on the sidelines, waiting to jump in and ride a recovery. These dollars won’t be adventurous because every time someone has tried to pick the bottom of the market so far, they’ve been massacred. Indeed, there’s a stock market saying about this, that you shouldn’t try to catch a falling knife – i.e., buy into a falling market.
Here's What I Expect
And I expect that December is going to be bad for the stock market for 3 primary reasons: First, people will sell for tax losses so they can get money back from the taxman for capital gains paid in earlier years. Second, companies are going to want to dress up their balance sheets before their December 31st year-ends, which means they will dump positions that aren’t working out to avoid the embarrassment of having to show their mistakes on their balance sheets. This applies to mutual funds, hedge funds, banks, and, to a lesser extent, publicly traded non-financial companies. All of this will put downward pressure on the markets. And finally, when people get their year-end investment statements, they are not going to like what they see. As a result of these three things, Santa Claus is probably the only one bringing good news this month. January may be better, but then, as I said at the outset, no one can predict the future, and the markets could make a fool of me, as they do everyone sooner or later.
But if the market settles down, and the economy stops worsening, then investors sitting on the sidelines will start to get greedy, and begin nibbling on stocks. Once it looks like it’s safe to do so, others will start to come in, not wanting to be left behind, which will trigger a gold rush, pushing the stock market way up, very quickly. That won’t solve the economic problems immediately, because the stock market leads the real economy by at several months at least, and in this environment, maybe by a year or more. But, a stronger stock market increases consumer confidence, and allows companies to raise capital, which begins the process of rebooting the economy. So, right now, the two key indicators you want to watch are the TED spread, and stock market volatility. The better they look, then the more likely the stock market is going to recover, leading the way for the economy several months later.
Of course, this doesn’t answer the central question: How long until confidence returns? And even though I’ve already told you nobody knows what will happen, here’s what I expect:
The U.S. housing market has not yet hit bottom, although it may be approaching it. I expect bad news, especially on rising foreclosures and falling prices, will continue for a while yet, but it will gradually get better – especially as what look like real bargains appear and start to be nibbled at. For example, there are reports that interest in properties in Las Vegas and Florida is starting to perk up. Since these were some of the most overheated markets, that’s a sign we may have seen the worst in those markets. Perversely, the U.S. federal government is trying very hard to soften the impact, which could cause stretch out the time to recovery because a soft landing takes longer than a hard crash. Remember that it took years for this problem to develop, and so it’s going to take time for all the bad news to come out in U.S. housing, but we’re getting there.
Next, the domino effect of bad corporate earnings and layoffs is not finished yet: we probably have months of horrible reports yet to come since the reports lag the reality. It’s going to take time for government stimulus to have an effect, especially if it takes the form of infrastructure spending – and the new American administration can’t even start to do anything until January 20th. President-elect Obama is, though, setting up to hit the ground running.
Watch for These Danger Signs
Then there are risks you need to keep your eyes on, starting with trade protectionism. Protectionism was one of the major reasons why the Great Depression was as bad as it was. Global trade dropped by more than two-thirds in the four year period from 1929 to 1933, which dramatically compounded the economic difficulties of the period. You don’t hear a lot about this, but protectionism was a critical mistake at the time, and one we may be about to repeat, because protectionism is a knee-jerk reaction for legislators, especially in hard times. The benefits or free trade are spread widely, but are relatively small, like saving $200 on a television set. The costs in lost jobs are concentrated in a few highly motivated and vocal groups of people, like the auto workers, and get a lot of attention.
For example, although no one has even breathed a word about it, U.S. aid for the Big Three automakers would be a subsidy, and clearly in violation of World Trade Organization (WTO) rules. So watch carefully to see if the incoming U.S. Congress and President Obama are as protectionist as they sound, because that would be bad news indeed.
Also in this context, watch China. They have in the past, and are again, keeping their currency artificially low in order to keep selling to the States. This is creating the global financial imbalances that were a major contributing factor to the global housing and asset bubble, as Chinese savings largely financed American overspending and the U.S. housing bubble. China is keeping their currency low, and subsidizing exports to the U.S. because they need high rates of employment growth to avoid political instability or even open revolt. They recently added new export subsidies and a further competitive devaluation of their currency against the Euro, both of which are not only against WTO rules, but tremendously unhelpful in this environment. So, watch to see whether China acts as a team player, or pursues beggar-thy-neighbor policies, as it seems to be doing.
Next, watch for a faster-than-expected recovery in the U.S. housing market, or a major upward market move (30% or more) in the stock market. Both would be a surprise, but both markets are notoriously volatile and could surprise us on the upside as they caught us off-guard on the downside. If that happens, it likely means the economy will recover sooner than I expect. This, in turn, could lead to a re-emergence of inflation. The liquidity flooding into the system right now is not a problem – as long as consumers stay out of the market. But if consumers come back faster than expected, and the central banks don’t mop up the liquidity because they are afraid that the economy is too fragile, we could see yet another asset bubble, leading to yet another bubble collapse. And each time that excess liquidity produces an asset bubble, the subsequent collapse gets worse.
Moreover, in many of the critical commodities that were pushing to new highs even earlier this year, the bottlenecks that caused the price increases are still there. For example, at $40, oil is now too cheap. This causes all the investments made in expanded capacity, new drilling, and alternative energy sources to look like bad investments, which will now be shelved or cancelled. This is what happened after the oil price spike in the early 1980s. But when the global economy starts picking up steam again, the bottlenecks that led to $147/barrel oil will re-emerge, and the price of oil will jump again.
With all of this as background, let me offer my best estimates of the four scenarios that represent the future we are most likely to face.
The Expected Future (Most likely: 45% probability)
There will be a recession in the States that runs through all of 2009. There will be a gradual recovery after that – much like Canada in the early 1990s. No major new bankruptcies or financial disasters occur. The Canadian economy mirrors the U.S., although not to the same depth of recession, and recovers more quickly. Consumers return cautiously to the marketplace, starting late in 2009. Housing starts begin to recover in Canada in 2010 or late 2009. Commodity prices recover gradually in 2010, then more quickly after 2012. The Canadian dollar begins to strengthen against the greenback late in 2009.
The Next Great Crash (Least likely: 5% probability)
A major, unexpected bankruptcy causes a financial panic, leading to a chain reaction of other bankruptcies. Credit markets seize up, and governments exhaust their ways of getting things moving again. Stock markets go into free-fall around the world. The resulting recession is deep, and provokes trade protectionist policies that leads to a trade war, lead by China fighting with the U.S. Economic depression results, with high unemployment and a falling global economy through 2010. Negotiations reverse protectionist actions in 2011, but recovery remains slow. President Obama is defeated in his re-election bid in 2012. Canada follows the U.S. into a protracted recession, and housing starts remain low everywhere, not just in the U.S. Commodity prices remain low, harming western Canada. The manufacturing industry continues to get slaughtered in central Canada, although slightly cushioned by the continuing weakness of the Canadian dollar.
Short and Shallow (Possible: 35% probability)
U.S. housing prices begin to firm as bargain hunters start buying up resale housing. Stock markets start a mild rally (up 20%) in January, 2009, kick-starting the re-emergence of consumer confidence. Consumers re-enter the marketplace in the second half of 2009, and Christmas 2009 sales are better than dismal results expected. Housing starts in Canada begin to recover in the second half of 2009. Canada outperforms the U.S., and the Canadian recovery begins in the 3rd quarter of 2009, aided by the low Loonie. Commodity prices begin firming in early 2010, which helps western Canada.
Re-igniting Inflation (Unlikely: 15% probability)
The first half of 2009 is slow, but the stock market begins moving up faster than anyone expected. The housing market in the States begins recovering in the worst hit markets first. China resumes strong economic growth, leading southern Asian economies to stronger than expected global growth. This feeds back into the North American economy, and commodity prices start to firm by mid-year. Central banks are reluctant to raise interest rates too quickly for fear of choking off the recovery. Inflation begins to perk up, and oil rises towards $80 a barrel by the end of 2009. Long-term interest rates begin rising faster than anyone expects because of the specter of renewed inflation, harming the bond markets, and taking some of the steam out of the stock market, which begins moving sideways. Housing starts in Canada bounce back, recovering much of the decline of 2008 by the middle of 2010. By 2010, the global economy is beginning to look stronger, and inflation is becoming a concern. Central banks begin tightening more rapidly, but given the lags in policy actions, inflation continues to move up towards 5%, and oil moves over $100 a barrel by the end of 2010. The North American economy is recovering well, particularly Canada, led by natural resource exports. By 2011, the Loonie is approaching par again, and exporters are complaining about the currency again. Commentators begin to talk about a commodity price bubble provoked by too much liquidity.
Do I expect one of these scenarios to come true? No. Although you do your best when creating scenarios to anticipate what might happen, reality always catches you by surprise in at least some ways. For example, last April I expected the Canadian dollar to fall from par – but not below 80¢, which is what actually happened. But the important thing is not to predict the future with great accuracy, but to be prepared to react faster than your competitors no matter what happens, and to respond with more constructive actions. Developing alternative future scenarios puts you in a mindset that is more flexible, and where you have considered what might happen, and how you might respond to it – and that’s the real value of any strategic planning. It does, in short, allow you to improvise with greater intelligence. Once again, I’m making available to today’s conferees the handbook that I’ve developed over the years for my consulting clients about how to use scenario planning.
What to Do While Waiting for the Recovery
What do you do in the meantime to weather the storm we are undoubtedly facing? First, be different: this is a not a time for doing the same old things. This is an environment that no one working in business today has experienced, so don’t plan on using the strategies you’ve used in past economic slow-downs. As well, consumers don’t quite know how to behave. Not only is this new, and unnerving territory for them, but the boomers are looking at a rapidly receding date when they can retire. That will tend to compound their desire to save instead of spend. In fact, one of the strategies I would adopt, were I in your shoes, would be to start every appeal to consumers with the implicit (or explicit) statement: ‘Here is how we’re going to help you reduce your living costs, increase your savings, and still enjoy life…’, because that’s what’s on their minds.
Next, be creative. Recessions are the best time to innovate because most of your competitors go into hiding, like frightened groundhogs. You have to make do with less resources – and, as the saying goes, ‘Necessity is the mother of invention.’ And recessions were when many innovative companies were born, such as FedEx (1973), CNN (1980), and USA Today (1982). In this environment, you should substitute creativity for cash to find ways to improve efficiency, raise customer satisfaction, increase marketing clout, and boost sales.
Find a reason for the consumer to get off the sidelines. It’s not just about selling stuff cheap and cutting prices, because everyone will do that. Instead, look for other, more constructive reasons. Brainstorm using techniques like lateral thinking, as propounded by Edward de Bono. For instance, ask provocative questions, and then insist on finding some kind of answer, whether it makes sense at first or not. One example might be: How could you give things away and still make money? If that sounds nonsensical, keep in mind that Google did just that and nearly became the world’s first company to reach a market capitalization of a trillion dollars, before the market collapsed. And don’t think of each idea as a finely-formed strategy. Think of it as a way of coming up with novel ideas, or ideas that can spark novel ideas, or ideas that can spark ideas that can spark novel ideas. So, working through this example: How could you give things away that consumers would find valuable, and yet make money doing it? Or, another example: How could you double your prices and still increase sales? What could you do or sell at a premium price point in this environment that consumers would find more valuable than the things you sell at your current price points? Or, to approach it from a different perspective: What would a premium offering have to do for consumers that would make it irresistible?
As well, I would encourage you to use The Opportunity Matrix, which is a technique I use with my consulting clients to help them come up with 200-300 new ideas, and then to select 5-10 that they want to work on first. Then come up with another 200-300 new ideas, and select some more ideas to work on. But keep doing it. This isn’t a one-time thing, but a continuous process of innovation and kaizen (continuous improvement) with a steady stream of minor improvements, rather than waiting for the one, great, golden idea that will solve all your problems. Such a single idea probably doesn’t exist.
The way forward: How do we cope?
Clearly this is a time when you need to plan for the worst, yet hope for the best. This implies knowing what the worst might be, what the best might be, and how you would respond to each one. Consider questions that might occur in this environment, even if you don’t like them. It might, for example, make sense to define a point beyond which you won’t go, but will wind up your business for dissolution. Or you might define a situation where you would be willing to take the risk, in this environment, to buy out a competitor, supplier, or client. In other words, consider what kinds of things might happen, and what would be your best responses to possible situations and scenarios – but don’t get trapped into assuming you can only do in the future what you’ve done in the past. The situation ahead of us may offer both the greatest danger you have ever faced, and the greatest opportunities of your career, and the only way to deal with either is by being mentally, financially, and commercially prepared to behave in new ways.
If you would like to talk to me about how to use any of the tools I’ve described, or others that I use in strategic planning, feel free to come up and talk to me later, or contact me through my website. I’m happy to offer further insights if they can be useful. My motto is: ‘Advice is free, but sweat costs money.’ You may also want to bring in an outside facilitator to help you work with novel concepts like brainstorming or scenario planning. It’s easier to break new ground if you have a guide who has done it before.
Alan Kay, one of the great technological visionaries of our time once said that the best way to predict the future is to invent it. I’ve said that before, but if there were ever a time when this was true, it’s now. And I wish you good luck, and God speed. Thank you.
© Copyright, IF Research, December 2008
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