Recession: When is it coming? How do we prepare?

These are questions we have heard frequently from our clients over the last quarter. Owners and CEOs are wondering when will the economy enter another recession. Good questions given the geopolitical uncertainty caused by Brexit and trade tariff wars, as well as partisan politics whipsawing that led to the longest government shutdown and legislation stalemate.

So, when is the recession coming? Honestly, no one has that good a crystal ball. But we can share some findings on how best to anticipate a downturn. Many executives and investors look to equity markets to shed light on long-term economic trends. But history shows (McKinsey & Co. research) that equity markets have a poor track record in predicting downturns. Credit markets are the more effective indicator, as they have triggered most financial crises and downturns in recent history. Unlike equity markets, credit markets don’t always function well when economic conditions get tough, making them a better leading indicator of the economy’s future direction. It is the credit market’s operating model that is the major causal factor for economic downturns. Here are some of its characteristics:

• Extremely illiquid market. Debt is rather sold than bought, we only buy debt when there is inventory to be sold. This illiquidity makes it difficult for banks or investors to sell credit assets at a fair price.
• The banking system and many investors (e.g. hedge funds) rely on the spread between long versus short credit assets to generate profits. If this formula is disrupted it can cause credit markets to freeze-up and trigger selling credit assets at distressed prices.
• The credit market system suffers from group think. If a strategy is successful, everyone piles on, which can lead to credit excesses (sub-prime mortgages), that cannot be counter-balanced without a market correction or government intervention.
• If credit markets expect a government bailout, investors will lend at rates that don’t reflect the true risk of the debt.

As you can see from the credit market operating model, if conditions are in place, a crisis will evolve. It generally takes several years, but a downturn is inevitable. Your best bet is to look for the following signs that an economic crisis is developing:

• Loose Lending standards – during the 2005 U.S. real-estate bubble, buyers with little or no credit worthiness were given loans to purchase a house.
• Unusually high leverage – This can be for any sector (Companies, Financial institutions, governments or individuals).
• Financial transactions that don’t create value – An example would be the collateralized debt obligations that contributed to 2008 crisis, which create a lot of fees for institutions but usually don’t create value.

Heightening your awareness of the workings of credit markets is one answer to the question, “how do we prepare?”  Yet, as the saying goes, “Don’t let a good crisis go to waste.” What else should you and your leadership team be considering to be more competitive after a downturn. Being strategist, and not economist, we offer the following three behaviors that will help you weather, as well as take advantage of, the economic storm:

• Be more flexible in planning – due to the level of uncertainty you and your organization will be facing, consider more than one course of action. Based on how events evolve, having options already in place accelerates decision making.
• Be more aware – developing better business intelligence promotes faster, more effective decision making. Business intelligence strength can also surface opportunities you can take advantage of during these tough times.
• Be more resilient – challenge structures and behaviors that may be holding back productivity and effectiveness. This can lead to making better decisions, lower fixed costs, free up capital, and reduce business risk.

The best advice we can offer is to accept that a downturn will be in our future and take advantage of these good times to prepare your organization to be flexible, aware and resilient to successfully navigate new levels of uncertainty that a downturn will toss your way.

“I think the most important factor in getting out of the recession actually is just the regenerative capacity of American capitalism.” – Warren Buffett

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