Newport LLC, an Advisory Firm Serving Middle-Market Companies, Issues a Warning of Economic Storm Clouds on the Horizon

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Prepare your company for a turbulent 2020.

A recent survey conducted by Duke University concluded that a recession was looking “likely.” 82% of the executives surveyed are of the opinion that a recession will happen by the end of 2020.

With the U.S. stock market on a roller coaster ride with daily swings of hundreds of points in each direction and several of the world economies facing economic downturns (Germany, China, U.K. and others) economists are re-evaluating the chances of a U.S. recession in 2020. The latest signs of a potentially weakening economy were strong enough to help persuade the Federal Reserve to lower interest rates recently-for the first time in nearly a decade.

Despite record employment, there are signs that the U.S. economy is weakening and that an economic downturn, perhaps not at the recession level but the near recession level, is approaching.

A protracted trade war between China and the United States and a deteriorating global growth outlook has left economists apprehensive about the end to the longest expansion in American history, now entering its 11th year.

The recent rise in U.S.- China trade war tensions has brought forward the next U.S. recession, according to a majority of economists polled by Reuters.

Trade tensions have pulled corporate confidence and global growth to multi-year lows and the announcement of more tariffs have raised downside risks significantly, Morgan Stanley analysts said in a recent note. Across the U.S. various sectors are already approaching recession levels such as agriculture with farm bankruptcies increasing due to export issues with China.

Bank of America Merrill Lynch economists said they see odds for a recession at a 1-in-3 chance in the next 12 months, and Goldman Sachs economists lowered their forecast for fourth quarter growth to 1.8% and said fears of a recession are growing because of the trade war. (source Bank of America and Reuters)

The spread between the 3-month Treasury bill and the 10-year note has been inverted with the 3-month bill yielding about 35 basis points more. The benchmark 10-year note yield has been falling as global interest rates decline in a flight-to-safety play and on worries about economic growth. The dreaded 10/2 year inversion occurred in early August. In at least the last 4 recessions, a recession immediately followed this interest rate inversion.

A recent survey conducted by Duke University concluded that a recession was looking “likely.” 82% of the executives surveyed are of the opinion that a recession will happen by the end of 2020.

But how can a recession happen when our economy is experiencing record GDP increases and we have full employment?

Interestingly, a full employment economy can contribute to the likelihood of a recession. Businesses that are labor constrained cannot grow as rapidly and they encounter a “growth ceiling.” Political policies such as immigration curtailment will also effect the labor supply, further reducing growth. Additionally, a very large proportion of our working population (43%) makes less than $15 an hour, the so-called “working poor” who have not benefited from the economic expansion. https://fortune.com/2015/04/13/who-makes-15-per-hour/

But what if the economy in 2020 begins to weaken as the Duke survey predicts? Extreme pessimists are usually wrong-but so are extreme optimists. A downturn, caused by the natural ebb of the economy or by a shock such as a geopolitical crisis, is always a possibility, bringing back conditions we remember all too well from the years after 2008: declining revenues and margins, excess capacity, anxious employees and restless investors. Even if a recession doesn’t come to pass, your company might have its own downturn this year, caused by a new competitor or new substitutes for your products and services.

Why not start with a resolution to do some contingency planning for the possibility of a downturn later this year? Below are 4 steps to take to manage your way through a potentially very challenging year.

1. Manage profitability
Most companies have a relatively narrow margin for error. A 10% decline in revenue could wipe out the entire bottom line of your company. Having a contingency plan to produce marginal, short-term profit despite a drop in revenues can make all the difference.

Consider doing the following:

  • Develop forecasts based on optimistic, realistic and worst-case revenue scenarios.
  • Formulate contingency plans. Make sure your top managers are on-board with the plans, and are ready to act quickly if revenues decline.
  • Agree with your management team on early warning signals, such as a shrinking back log, a downturn in customer-market indices, or a worsening sales pipeline.
  • Be willing to adjust discretionary spending at more frequent intervals; for example, quarterly, or even on a rolling basis.
  • Be ready to keep bankers and investors appropriately informed in case of a downturn and to communicate the actions you’re ready to take to limit the damage.

2. Identify and maintain your strengths-and your best customers
Identify the strengths that have enabled your success to date, and those that will be important in the future. Which capabilities and skills are most critical? What distinguishes your ability to serve customers effectively?

Identify your highest-margin customers, and understand what you are doing right for them. Develop a game plan, in the event of a downturn, to protect and build on the strengths that have allowed you to be indispensable to them. In the event of a dip in business, rather than cutting costs across the board, be ready to shift resources to retain these high-margin customers.

Continue to be creative in how you can add value for your customers without increasing your costs. Example: a professional services firm adds regular briefings to client executives to monetize its intellectual capital.

3. Be ready to decide what you can stop doing
Companies that create enduring value typically excel at discontinuing what no longer adds value. Be ready to make changes in cost structure that will least damage your strengths and will hone your value proposition down to what customers really value.

Comb through your cost structure to create a contingency plan for what you would cut. Identify what’s inefficient; what’s nice to have but dispensable; what’s there because of history, inertia or wishful thinking; what may have worked in the past but doesn’t anymore; what isn’t creating value as it used to.

Realize the challenges you would face in cutting costs. Most organizations aren’t adept at taking costs out quickly as revenues decline, and margins suffer. Even your most hard-headed managers will try to protect their own people first. As your company has grown, your operations have probably become more complex. Be ready to take a knife to any complexity that isn’t compliance-required or value-adding. Consider outsourcing non-strategic company functions such as human resources, accounting and even finance.

4. Manage liquidity as hard as profitability
A downturn might force you to deal not only with negative growth but also with liquidity constraints. Trying to maintain liquidity on a smaller revenue base can be crippling.

You would need a plan to turn over every balance sheet dollar faster to contribute to working capital. You’ll need plans to:

  • Maximize cash flow by narrowing the timing between sales and outlays for costs you incur in advance, such as inventories.
  • Collect from customers faster. Consider offering discounts for paying promptly or require deposits from customers.
  • Take advantage of increased supplier willingness to share risk and to provide favorable terms.
  • Monitor your receivables against your payables and reduce your Cash Conversion Cycle days (time it takes for money to come in from customers against the days when your supplier payments are due).

Be ready to shrink to survive

The list of things a CEO needs to do to plan to survive a downturn is long and can seem daunting. You would need to avoid disassembling what has made you successful while accepting the necessity of shrinking it for the near-term. Managing through the crisis may require some skills that have been rusting in your managerial tool case.

In the event of a downturn, you’ll no longer be insulated by growth. Disciplined decision making will be essential. You’ll need to lead with the right proportions of cost-conscious frugality and bold innovation.

Michael Evans is a Managing Director in the Newport LLC, an advisory firm serving middle-market companies.

This article was updated from one written by Michael Evans earlier in 2019.

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