In this writing, the first of a five-part series, we will examine economic factors impacting business in 2017 and beyond.

Within our strategy practice, we have a client who always says, “A growing company is a thriving company.” Yet our economy appears to be a blend of the haves and the have nots, with many companies starving for growth. In an economy that has been flattened like a pancake, even stronger companies are forced to make build vs. buy decisions in an effort to increase enterprise value.

The mergers and acquisitions market is a barometer for this sentiment. After the market softened in Q1, multiples for mid-market companies skyrocketed again (up to 9.7x EBITDA), demonstrating once more that organic growth is hard to come by.

The 2016 GNP is expected to grow only 1.8% and rise to 2.0% in 2017. Ho hum. GNP, a measure of the broad-based economy, is a horrific indicator for most businesses. A more granular view of GNP demonstrates that economic stagnation is ubiquitous. GNP is really a combination of four indicators:

  • Personal Consumption +2.1% (Q3)
  • Private Domestic Investment +3.1%
  • Net Exports +10.0%
  • Government Consumption +0.5%

Kiplinger predicts the following for Q4 and 2017:

  • GDP Growth 2%
  • 10-year T-Notes 1.9% by the end of 2017
  • Inflation 2.4% in 2017
  • Crude Oil $40-$45 per barrel on January 1, 2017
  • Housing +6% in 2017

So, 2017 looks like it will produce similar output. Beware of the following trends for 2017 and beyond:

Sector performance does not sync with the economy.

Every entrepreneur needs to be aware that their business is actually a reflection of several converging cycles, including the economic cycle, monetary cycle, industry cycle, and company life cycle. Consider the construction business in the southwestern U.S. While some markets in California and elsewhere have recovered, the housing markets in Nevada and Arizona have not returned to their previous luster. This implies that a sector in a geographic market can be entirely disconnected from the economy as a whole. Residential building in the U.S. was down 1.86%, even with very low interest rates, full employment, and an uptick in consumer spending.

In Q3, sector performance (vs. preceding period) included:

Winners

Motor Vehicles +16.0%

Recreational Vehicles +12.6%

Housing and Utilities +11.9%

Health Care +11.3%

Losers

Transportation equipment (-11.6%)

Residential (-9.4%)

Equipment (fixed) (-7.2%)

Though consumer spending is a boon for business-to-consumer companies, the lack of business-to-business investment is ominous for capital-intense industries such as heavy equipment. Government spending is actually in decline. In the wake of the presidential election, many point to catastrophic consequences if there is not investment in our infrastructure. It is likely that there will in fact be spending to support construction including roads, bridges and the like. Aerospace and defense companies already face a backlog, and their long industry cycles will provide protection well into the future.

Globalization has hit a wall. 

Foreign direct investment is down 40% from before the liquidity crisis. Protectionism is not only the message of a single presidential candidate, but the rage around the world. In fact, the Brits beat us to it (through Brexit), and the appetite to close borders is permeating Europe. The Euro itself may not be sustainable.

U.S. relations are strained with large trading partners like Russia and China. China, facing a severe economic slowdown, has de-escalated initiatives designed to promote trade. China’s inconsistent enforcement of its stated currency polices is deepening distrust from other governments. The Trans-Pacific Partnership appeared to be dead on arrival.

Preceding the recent U.S. election results, an annual survey of global 1000 CEOs revealed worry that the U.S. economy would eventually lose its appeal to foreign direct investment.

It is time for Energy to rally. 

OPEC’s September 28th announcement of tighter production is driving a rally. The depressed U.S. energy sector is in desperate need of a resurgence. One premise of the Trump campaign advocated for American energy independence. The U.S. Energy Information Administration projects crude oil at $49.91 per barrel in 2017, as well as an increase in natural gas production.

We haven’t learned anything from the liquidity crisis.

The Fed’s infamous dot plot graph was supposed to be a predictor of future interest rate action. However, recent Fed announcements have not aligned with their own predictions. An HBR article by Michael Lewis earlier this year made the claim that the Fed (and other central banks) have not changed their behavior, and that banks are still motivated by perverse incentives that could spark another monetary crisis. According to Lewis, banks have incentive to take risks in the form of bad loans, but do not participate in the downside (if they are in fact too big to fail). This is a house of cards that will eventually result in higher borrowing costs (probably about .75% higher in 2017).

Zero interest rates are a short-term fix.

Many banks in Europe have negative interest rates. While this may seem convenient for the consumer, sustained zero (or sub-zero) interest rates will drain pension and retirement plans, leading to dire economic consequences. Central bankers know this, and are chomping at the bit to raise rates before deflation sets in further. Election uncertainty delayed the 2016 interest rate normalization process. Still, analysts are expecting a hike in 2017.

The strong dollar may reverse course.

The dollar is higher due to prospects of increased interest rates that have not materialized. This strains U.S. exports, causes downward pressure on commodity processes, and puts the brakes on growth in emerging markets such as Brazil, Russia and China. Personally, I don’t feel bad for any of them.

Wage increases will be short-lived.

The hot labor market and minimum wage increases are giving a boost to wages, but wage rates will eventually normalize. It may be an inconvenient truth, but U.S. wage rates (especially in manufacturing) are depressed as a result of global competition and robotics. On average, it costs roughly the equivalent of $3 per man hour to operate a robot, and new automation technologies will only improve their applicability and performance.

Health care costs will continue to rise.

Health care is becoming a priority for the new presidential administration. President-elect Trump has expressed his intentions to repeal and replace the Affordable Care Act, though 2017 may only see a handful of modifications to the plan. Trump would still like to preserve two of its most popular benefits, including one that requires insurers to cover people with pre-existing health conditions and another that allows children to be covered under their parents’ plans until age 26.

There is a recession in our future, but no one knows when.

Many economists are predicting a recession in 2018 or 2019, and the Fed’s reluctance to raise rates demonstrates their concern that they could spark one. Any number of flashpoints, from South America’s political unrest, to terrorist attacks, to deflation or currency fluctuations, could be the final straw that pushes our economy into decline. China’s real estate bubble may be the most damaging of global economic threats.

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So what should you do about it? The answer is to be proactive in planning for the future.

Manage industry cycles. Markets such as construction are in an up-cycle. Pricing for construction companies should be stronger, although new professional procurement practices on the part of builders will deflate value. It is critical for companies experiencing such volatility in their markets to carve out very specific niches where they can win.

Rethink your global strategy. Businesses have come to realize that free trade will not be free. Worldwide distribution remains difficult to execute, with varying systems, regulations, economic partners and transportation costs. The key to international success is having relationships on the ground, in the form of distributors, brokers, direct salespeople or alliance partners. For example, one of our clients who opened fast food facilities in China found it much cheaper to offer a regional franchise to a Chinese national who could mitigate local politics.

Be wary of placing all your bets on acquisitions. Danger, Will Robinson, danger. There are many businesses starving for growth that have decided to pursue “an acquisition strategy”, which is code for “we don’t know how to grow organically.” This is a trap to be avoided at all costs, because if a company cannot articulate a value proposition that resonates in the marketplace, bolt-on acquisitions (in a similar business) only extenuate the problem.

Consider vertical integration as a growth strategy. Amazingly, many management teams spend most of their time thinking about how to grow horizontally (across their existing markets), and spend virtually no time thinking about how they can expand their position in the value chain. Download our Value Chain Exercise guide at https://optimizeinc.net/white-papers/.

Brace for impact. Our clients that have performed well in past downturns have managed the blocking and tackling very well. Ensure that your company:

  • Has a clear strategic plan with 3-year and 1-year objectives, updated quarterly to adapt to changing market conditions.
  • An operational plan that cascades goals and clarifies short-term objectives.
  • A budget process driven by the management team (not just Finance and Accounting).
  • A forecasting system (such as a 9+3) that allows you to constantly reevaluate your financial condition.
  • Low fixed cost and the ability to pivot quickly to reduce direct costs.
  • A performance management system and feedback loop that engages employees.

While these tools are basic, they are key to keeping your team on plan and anticipating whatever changes the economy has in store.

 

[i] US Economic Outlook for 2016 and Beyond- The Balance

[ii] GDP: Economy Bureau of Economic Analysis

[iii] Globalization on the Skids by Talley and Mauldin- The Wall Street Journal

[iv] World faces shock as China devalues yuan at accelerated Pace by Ambrose Evans-Pritchard- The Telegraph