Economic Outlook

The Pendulum Has Swung

The balloon has popped. The bubble has burst. Someone left the door open and the chickens have fled the coop.

After a prolonged and very robust period of growth, the U.S. economy has finally taken a turn for the worse. The stock market has plunged precipitously and can’t seem to sustain any kind of meaningful comeback. Dot-com companies continue to implode at warp speed. Large layoffs have become regular front-page news as companies begin to tighten their belts. Several macroeconomic leading indicators have either flattened or reversed their direction.

Perhaps the surest sign of all that we’re about to experience a painful correction? Alan Greenspan and the other conservative members of Federal Reserve Board have lowered interest rates four times (for a total of 200 basis points) this year in an effort to jumpstart the floundering economy. The board has intimated that it will implement further reductions if needed.

If the U.S. economy hasn’t already entered a recession (officially defined as “two consecutive quarters of negative growth”), most experts believe it soon will. The question for CEOs and business owners is how deep will this downturn cut and how long will it last? That depends on who you talk to.

Vistage speaker Brian Beaulieu , an economist with the New Hampshire-based Institute for Trend Research, projects a fairly mild recession with a very strong recovery. Vistage speaker Ed Freiermuth , a Los Angeles-based consultant and business strategist who specializes in working with financially challenged companies, foresees a slightly more painful economic adjustment and a milder recovery. Despite their divergent outlooks, however, both agree on one thing — while many companies and industries will struggle during the coming downturn, it also represents a time of opportunity for well-managed companies.

An Over-Leveraged Economy

According to Freiermuth, the economic downturn began in late 2000 and will continue through 2001 and likely into early 2002. He sees it as a repeat of the 1973-74 recession, but hopefully without the subsequent return of virulent inflation that required an equally strong antidote.

He also believes that the shape of the rebound will more likely resemble a “U” than a “V,” meaning that it will take a while for the economy to bounce back. This could increase the anxiety level among corporate decision makers and consumers, which could prolong the recession and postpone the return to positive growth. Should this scenario unfold, CEOs and business owners who delay implementing corrective actions because they see the downturn as short-lived will have to make continual adjustments in their workforce and other operating costs. On the other hand, those who batten down the hatches and prepare their companies for a longer, rougher ride have an opportunity to come out on the other side stronger than ever.

Freiermuth attributes the current downswing to several related factors:

• Huge amounts of consumer and corporate debt. Currently, trillions of dollars worth of junk loans, junk bonds and consumer debt are dragging on the economy like a two-ton anchor. This huge debt must get resolved before the economy can resume full-speed.
• Bad loans from over-leveraged transactions. Many of the highly-leveraged mergers and acquisitions that occurred during the recent boom have started to unravel. With top-line growth rapidly shrinking, these companies can’t service the principal and interest on their debt.
• Bank stress. Sooner or later, banks will have to acknowledge the huge amount of problem loans. This will cause them to tighten credit and cut off access to capital for poorly-performing companies.
• Private equity sources are drying up. Many of the more than 300 private equity sources that helped finance the over-leveraged transactions are now in trouble themselves. Companies that get cut off by their banks will have nowhere else to turn.
• Major credit crunch. Together, these factors will combine to produce a major credit crunch for corporate America. Well-managed and well-capitalized companies will still be able to obtain credit. Lesser-performing companies will struggle to retain liquidity and access to credit.

“Banks and asset-based lenders have already tightened up significantly,” notes Freiermuth. “And unlike the stock market, lenders can’t solve their problems with one good day. It takes time to restructure and work out large amounts of bad debt. As a result, banks have cut way back on the number of new loans and have toughened the standards on which they make them. For this reason, I believe it will take longer to come out of the recession.”

A Sectoral Recession

Beaulieu agrees that we stand on the threshold of recession (if we haven’t already entered it). However, he believes it will unfold as more of a “sectoral” than an across-the-board correction. The overall economy may not slide into recession, but certain sectors will definitely experience negative growth. Beaulieu suspects mature manufacturing (such as autos, industrial machinery and plastics) and high-tech industries will get hit the hardest. Newer service-oriented industries should feel less pain, but will still experience a slow-down mode.

Macroeconomic signs that point to a recession include:

• The Federal Reserve index has declined for the past few months.
• The 3/12 rate of change has dropped below the 12/12 rate of change.
• New orders for durable goods are declining while inventories are growing. As new orders soften, production will likely soften.
• The U.S. composite leading indicator has been declining since January 2000.

“At best, we’re looking at a sectoral slowdown similar to 1995,” explains Beaulieu. “At worst, it could devolve into a 1990-91 situation that impacts industries across the board. I believe we’re headed for a light to moderate downturn, with some industries feeling it harder than others. I see this more as a pothole in the midst of prolonged prosperity, not a major derailment.”

Reacting to the Downturn

When faced with the specter of recession, the first instinct of many CEOs is to race to the woodshed, sharpen the ax and start cutting. Beaulieu recommends a slightly less dramatic approach.

“Don’t panic or overreact to the situation,” he cautions. “At the same time, don’t stick your head in the sand, thinking you can skate through untouched. Nobody can predict exactly what will happen with the economy, so it pays to adopt a defensive posture.”

To prepare your company for the next two to four quarters, Beaulieu recommends the following:

• Set conservative budgets so you don’t hemorrhage cash.
• Build in as much financial liquidity as possible.
• Work with your lenders to get as much credit as possible, striving to maintain a 10 percent margin for error with your financial covenants.
• Prepare a comprehensive cash flow forecast that includes best- and worst-case scenarios.
• Scrutinize every job in the company to determine which ones are essential to the core business and which can be cut if needed.
• Once you have these defensive strategies in place, start thinking about how to position your business to take advantage of the next economic upturn.

“Despite the gathering storm clouds, now is the time to start looking at whether you have the resources (capital, people, machinery, etc.) in place to capitalize on the next rising trend because it will be a very long and strong one,” says Beaulieu. “If you can get in front of your competitors by providing the goods and services businesses and consumers will demand in 2002, you can gain market share without having to sacrifice price. Gaining market share in a downturn positions you for even greater growth when the economy rebounds.”

Despite his gloomier outlook on the recession, Freiermuth concurs with the opportunity for well-managed firms.

“Without question, the economy has taken a turn for the worse, and it will last a while,” he admits. “But that’s bad news only for the companies that are ill-prepared to handle it. For well-managed companies that anticipate and prepare for the recession, it represents a fabulous opportunity to acquire assets at rock-bottom prices.”

Let the Good Times Roll

Freiermuth predicts a fairly moderate recovery. He believes that relatively new investors who have suffered significant financial losses in the recent stock market correction are unlikely to speculate as much as they have over the past few years. Some will avoid the equity markets altogether. Others will sell into rallies and move funds to safer havens. In addition, financial institutions will continue having problem loans with businesses and consumers, and it could take another year for lenders to acknowledge, identify and begin solving the problems. As a result, corporate America may not have access to enough capital to stoke the fires of a rapid expansion.

In contrast, Beaulieu forecasts a very robust and long-lasting recovery, one that will exceed the boom of the past seven years. His research indicates that the U.S. economy will grow at 3.8 to 4.7 percent a year for the next 10 years — not exactly a “gloom and doom” scenario.

“My advice to business owners is, ‘You ain’t seen nothing yet,’” says Beaulieu. “If you think the coming decade will look like the last one, you underestimate the future. All signs indicate that we’re heading toward even stronger growth than we experienced over the past 10 years, and the time to start planning for that growth is now. By taking advantage of other people’s pessimism and mismanagement during the slight downturn, you can reap the rewards for years to come.”