Dealing With the New Normal: Economy, Markets and Business Performance

Economy, Markets and Business: Anticipating and Preparing for the New Normal

Llinlithgow [email protected]

January, 2010.

Economic Situation , Market Outlook and Business Performance Requirements

Economy +Geo-Politics

Industry

Business•Strategy

•Operations

mailto:[email protected]

Strategy without execution is fantasy. Execution without Strategy is thrashing. And without a Management System

both are improbable

Business is facing a decade of severe performance pressures ….…. And it’s not clear that many are prepared or preparing!

y = 0.63x - 0.00R2 = 0.62

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)Employment vs GDP: 1960-2009 Real GDP growth of

4.0% is required for breakeven employment growth of 2.5%. Expected growth of 2.5% leaves us short. We need 46 million jobs in the next decade but will probably get 20 million at best.

Many businesses were surprised by the depth of the downturn and not well-prepared.Now they are struggling to recover.Few are prepared or preparing for a sustained period of strains and challenges.


both are improbable

The “New Normal” will not return to the old “business-as-usual”Companies whose growth depends on the inclination and ability of the American consumer to spend are under pressure. Americans remain deeply pessimistic about the economy's current state, … But consumers do not see themselves simply trimming on a temporary basis. One in three (33 percent) strongly agree that changes to their lifestyles are most likely permanent. (GQR Research. Fall, 2009).How long will it take the unemployment rate to go back down to 5 percent? A rough estimate can be obtained by looking at the rate of decline in the unemployment rate after recent recessions: … , or almost 7 years. (Mark Thoma, Economic professor. Dec.,2009)We have not been on a sustainable economic track and that has to be changed. But those changes don't come overnight, they don't come in a quarter, they don't come in a year. You can begin them but that is a process that takes time. (Paul Volcker, Der Spiegel. Dec., 2009).Seven years later, what are the lasting lessons of Enron? There were two or three. This was a very young and inexperienced management team, and I think both management—and possibly the board—thought the good times could never end. That's one lesson: the good times do end. We're going through that right now. (William Powers, Enron CEO. Newsweek, October, 2009).Plenty of lessons can be learned from the glut of businesses that have fallen under the swift sword of a merciless recession. There are a number of mistakes being made, but the number one cause of failure is misguided strategy—not sloppy execution, poor leadership, or bad luck. (Paul Caroll, Business@Emory. August, 2009).Volatility is here to stay. What this does is force managers to harmonize two critical capabilities: on the one hand, strategic clarity and consistency; on the other, agility and resilience in operations. This may seem counterintuitive, but organizations can handle extreme change only when they can address it within a clear strategic framework. (C.K. Prahald, Businessweek. September, 2009).Although it is true that most companies do not explicitly articulate an operations strategy, the decisions made by operations executives ultimately produce — or erode — competitive advantage. Are you certain that your operations managers know the right choices to make — or are they mindlessly pursuing “best practices”? (Tim Lasseter, BCG. December, 2009)

mailto:Business@Emory


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We’ve cycled thru a sequence of reactions, judgments and fears …and there’s still a lot of confusion, uncertainty and doubts

Reading clockwise from the upper left

1.An already weak and slowing economy was tipped over into near collapse by the breakdown of the financial and credit markets

2. Which resulted in widespread panic – which was not out of line with possible realities. It was a “near-run” thing

3. The collapse and consequence was taken as the “Death of Capitalism” but that was exaggerated

4. If anything we’ve returned prematurely to complacency with too little attention on deep risks

5. And are facing a great deal of confusion and puzzlement about what’s next.


both are improbable

Two major sources of confusion – assuming a calm economy is the normal state and being surprised by storms.

- and not appreciating the underlying patterns!

The Economy follows the same recurrent patterns, driven by the same forces and governed by the same relationships but the actual behavior varies considerably. The challenge is to understand the structure and relationships and monitor the changes in the forces to anticipate what’s coming.


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ConsumerConfidenceConsumerConfidence

ConsumerSpending

EconomyBusinessInvestment

Hiring

BusinessBusinessExpectations

CREDIT

CREDIT

The GreatEconomic

Circle of Life

Consumer-ledInvestment-driven

Policy-managed

Business Cycles: Consumer-led Normal vs. Investment-driven Speculative

Economic Cycle1. Any developed economy follows a

linked cycle where the core engine is the Consumer driving the rest of the Economy (65-70% in the US – historically high).

2. Businesses respond by producing what they can sell now and, IF demand is growing hiring more workers and investing in equipment and structures.

3. Part of their decision-making process is a multi-part “Credit” evaluation of outlooks, risks, financing and expectations.

4. Going round consumers perform a similar evaluation based on jobs, wages, expectations, uncertainties and asset/wealth & financing value

• The last two bubbles were NOT based on wage or job growth but were artificially stimulated by leveraged asset-appreciation

5. As the Economy moves around the cycle the result over time is a wave pattern with repeating structures, relationships, timings, etc. that depend on how hard the “wind” is blowing

• A Normal cycle is led by Consumer spending

• A Boom is driven by speculative Investment (Tech, Real Estate)

• When excesses correct the impact can be years on the bottom without public spending


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The economy has bottomed and is starting to “recover” but employment lags and will lag for many reasons


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The current state results from the links between the US and World economies, credit and equity markets and Housing

The LUV Outlook & Risks1.The US Economy will have weak

growth (U) and poor job creation2. while Europe is facing a slower

and weaker outlook (L) and3. the developing countries are

likely to be more V-shaped with4. some major structural challenges

– China in particular• China needs 6% growth for labor

breakeven and is• facing the structural change in an

export-led economy5. US Housing remains weak6. Credit markets are self-repairing

but credit isn’t flowing because of bank balance sheet damage, lower demand and economic risks

• Small businesses are vulnerable• Consumer demand is constrained

7. We think equity markets are over-valued on a $ carry trade and are exposed

• PE Ratios are abnormally high• Economic growth will NOT be as

good as priced• Earnings outlooks optimistic• Likely priced beyond perfection


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GDP vs. Consumption vs Employment (yoy%)

Real economic data looks startlingly like the patterns we showed …. Telling us a lot about the future

1. GDP & Consumption have followed the cycle since 19502. Both have turned up but are still very weak – a post WW2 record3. Growth this decade was WEAK4. The long-term trend slowed and cliff-dove in the Great Recession

1.GDP follows PCE but Employment follows GDP

2. Employment has NOT turned yet

3. It also shows a steady downtrend since 1980.

4. Employment growth was weaker each decade


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Capital goods orders are encouraging though a directional change shouldn’t disguise remaining weakness

1.Durable goods orders and orders x-Aircraft sharply improved tough still negative and indicate better potential for investment spending

2. DG Orders and xAC are still near –10% YoY. Things are much less bad, not growing.

1.Economic activity (GDP) drives Industrial Production drives orders drives capital spending in a typical cycle.

2. The order pickup is a sign of improving capex potential.

3. BUT …. Capex lags as much or more as Employment so equipment and tech demands are limited.


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1.The US economy has created ZERO private jobs in over a decade, since 1999Q2.

2. It is the worst post-war jobs performance on record

The key to real growth, a healthy economy and future prosperity is JOBS, period.

1. Labor force growth means we need about 150K/month +/- to stay even.

2. Net New jobs is the difference between new jobs and 150K.

3. A rolling total since 1980 shows extremely poor performance

4. We entered the Recession in the hole.

5. We are now –12.2 million in the hole.

6. We estimate 46 million jobs would be prosperity but anticipate getting 20 (BLS says 15!)


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Consumption vs GDP:1960-2009

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Output vs Investment:1995-2009

To understand the performance outlook follow clockwise around the economic life cycle and read off the line…

Consumption growth of 2.5-3.0% implies GDP growth of 2.0-2.5%, the outlook for next year. 2.5% GDP growth means Employment growth of <2.0%; really need 4% GDP growth. This is a weak and atypical recovery ( typical post-war recovers are 6% real growth) but means that Employment growth will be poor and Unemployment stubbornly high. Especially given that long-term forecasts (OMB/CBO) call for growth in the 2.2-2.5% for the decade. Investment (real estate and business) won’t pick up without strong growth, though residential tends to lead a recovery it’s weakened and in repair mode for a long time. To see a surge in Investment spending would require GDP growth north of 4%, or better. So not only Employment will be weak so will Investment and Capex spending (implying weakness in the Tech and Equipment industries).


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Mythologies to the contrary economic performance ultimately drives profits, earnings and markets

1. These charts show normalized rolling (cumulative) growth in the SP500, Profits and GDP from 1960 thru 2009Q3.

2. That the markets went thru two major aberrational bubbles in one decade is clear. You have to question whether another is possible.

3. Adjusted for inflation SPX performance has not recovered (matching ~1998). More than a Lost Decade. But also not showing very good performance in prior decades cumulatively.

4. It is clear though that the SPX followed corporate profits- more closely in the 60s/70s, diverging in the 80s, bubbling in the 90s and re-aligning in the 00s.

5. It is even clearer that Profits grew with GDP, on the whole. Again very closely earlier.

6. ECONOMY PROFITS MARKETS


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At any moment markets are being driven by multiple factors across multiple timeframes and have differential impacts on different asset classes.

1. A decision to invest in a particular asset is a bet on the four factors at the time you execute – explicit and deliberate or NOT.

2. The Four Factors are Structural, Fundamental, Technical & Psychological

• Structural = long-term changes in basic relationships (globalization, emerging markets) Current: C/C-, better but jittery

• Fundamental = business cycle phase and asset performance (for equities business performance) Current: C/C-, improving

• Technical = are existing trends in the market and (oddly) actually capture investor psychology. Current: B/B-, deteriorating

• Sentiment = investor perceptions, myths and beliefs. Current: B/B-,dropping

3. The allocation among asset classes should reflect the state of the factors, the outlook, personal situation and shifts in understanding.

• Too many US investors aren’t exposed long-term to the right balance of foreign investments

• Allocations should be based on strategy. Active management should see those adjusted relatively frequently rather than held constant.

• Traditional weightings are 60/40 Income/Equity but a better strategy is risk weighted

Structural Fundamental Technical Sentiment

Immediate

Short-term

Intermediate

Long-term

Structural Fundamental Technical Sentiment

Cash & Equivalents

Income Assets (Bonds) - Domestic - Foreign - Emerging - ETFs

Equity Assets

Special Assets - Real Estate - Commodities - Hedge/ PE

Key Factor

Asset Class

Timeframe

Key Factor


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Markets have gone thru a lot of turbulence this year as last year’s disruptions began to be stabilized, though we’re still not at “normal”

1. Markets went thru several phases this year

• Another near collapse as fears of bank failure mounted

• A relief rally as the Stress Test and earnings rescinded the argument

• A flat market as the long-term outlook was questioned

• The beginnings of another, milder rally based on a long list of myths and a Dollar carry trade funded by low Fed rates

• Another Flat market at the end of the year

2. The question is what drove things after August?

• From August on the number of arguments from Hyperinflation to China saves us to Dollar collapse, to Gold, and so on and so on were a long list.

• The Fed is maintaining historically low rates which means liquidity for speculation is widely available.


both are improbable

Dollar, Gold and Exchange rate comparisons in two timeframes …. 1. Gold (& Equity/Asset)

Markets spent the entire year largely going up as the Dollar went down and visa versa

• The behavior was similar across all markets – that is they are highly correlated. Telling us fundamentals aren’t driving.

• There was a return flight to the $ as sovereign debt fears under-mined complacencies

2. The $ has had a long downtrend this decade as the result of trade imbalances and $ outflows.

• This was interrupted by the flight to quality fears last Fall

• It was based on US consumers borrowing abroad to continue spending

• As the world economy re-balances and US consumers re-build their balance sheets this will not continue

• The $ will remain the dominant reserve currency for years or decades

• It’s probably reached the bottom for now


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1. Markets were in a normal bear when the crisis hit, creating chaos that almost collapsed them last Fall.

2. And again this last Spring. Chaos is when things are completely unpredictable while Turbulence can be analyzed but remains uncertain.

3. We are still in turbulent markets with serious risk factors and an uncertain economic outlook

4. The recent rally has just touched the upper bound on the downtrend channel and has also retraced the 50% limit of the Fibonacci indicator from the Oct07 highs to the Mar09 lows.

5. Significant improvement from here will be based on

• Upside surprises in the Economy, especially Employment

• Continued trading and speculative activity

• Which depends on worldwide Central Bank policy in general and the Fed in particular

Despite all that the markets remain in a downtrend


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The notion of a lost decade is widespread (now) but in fact we’ve been in a range-bound market since 1997/1998 (which coincided with the topping out and relative flattening of GDP growth)

1. A Fibonacci indicator test from the start of the 90s bubble to the 2007 peak shows us back at roughly the 62% resistance level – matching the intermediate term analysis.

2. A horizontal resistance that trims the 98/99/00 bubble also trims much of this last several years and also defines another source of resistance being approached. That coincides with the Fib levels.

3. Taken all together we’re going to be in a range-bound Trading Market, are in one now, and, if you believe the Economic analysis, will be in one for a long-time.

4. Which puts a premium on analyzing the factors driving markets, assets, valuations and performance.

5. And active investing strategies and asset allocation management


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There are two keys to understanding likely investment performance in this market: valuations and returns. Which define a 3rd – the Margin of Safety, or the difference between what you pay and what you’re CERTAIN it’s worth.

1. From S&P’s long-run historical PE data (1936-2008) the avg. for 36-08 is 15.5 but 36-90 (pre-bubble) is 14.3 an 8.4% difference.

2. From 36-99 the difference between the avg. and the actual tended to net out to zero, over the course of the business cycle. As of 2008 it is as high as it’s ever been by a phenomenally large proportion (2009 data NA).

3. Over almost any period of time market returns are highest when initial PE’s are in the bottom decile. Implying that the likely returns at these levels are poor, at best.

4. In a range-bound market income investments (bonds) often out-perform equities. But there are market-cycle ebbs and flows

5. An an active asset allocation and selection strategy is called for. Which requires understanding the performance outlook of the asset.

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LT Value Trends:PE Avg vs Difference

Diff is the difference between the 3MoMA of trailing PE and the 1936-1990 average. Note that until this decade it w as self-correcting but now has overshot significantly.


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Equity performance is driven by profits (and the economy) – and needs to be broken down into Finance and non-Finance industries.

1. GDP (lhs) vs. sector profits show Non-Fin & Finance (rhs) in $B from 1950 to 2009Q3.

2. Relative performance using a rolling (cumulative) normalized scale shows Non-Fin tracking GDP until the late 60s then lagging badly. It then surged during the Tech boom and bubble this decade.

• The NonFin bubble resulted from restrained hiring, under-investment and financial engineering (buybacks) to maintain short-term stock prices (bonus consciousness?)

3. Finance growth was steady but lagging until the late 70s but, after a major drop, accelerated dramatically from 83-00, largely as the result of de-regulation. Beginning in 00 Finance profits bubbled spectacularly.

• From 07 thru 08 the Finance Industry destroyed the cumlative profits back to approx. 1990.

• Over half of those losses have been recovered in the last three quarters, largely on proprietary trading.

• Regulatory reform is not likely to tolerate a continuation of excess Finance profits.

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BCG Research found a large majority of major worldwide enterprises were caught flat-footed by the downturn and protected profits by arbitrary cost-cutting. Recent research indicates companies are still focused short-term.

1. Agile and resilient enterprises would anticipate the downturn, act early and prepare to take advantage of the upturn.

• Non-agile enterprises were slow to react after being caught un-prepared.

• They also appear to be counting on a vigorous upturn to avoid more serious re-thinking of strategies and operations.

• Deeper restructurings require improved controls and management systems as well as new initiatives.

2. The focus of cost-cutting has largely been on short-term trimming of existing operations

• Cost-cutting should NOT be evenly spread across all operating functions. Instead it should analyze and weigh each function separately and as part of the total enterprise.

• Performance goals and cost and investment decisions should be based on the short- and long-term performance potential of each function.

3. In the business environment we will be facing there will be major profit and performance differences between enterprises.


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A Business Enterprise exists to create and deliver value in the Market … it must have the right focus, strategy, ability to sell, deliver and execute to create value. And it must do so for today and tomorrow simultaneously.

1. Enterprise Performance starts with understanding the gaps between customer needs and solution

• Defines products and service• Business strategies and models• Operating strategies• Fundamental Value Proposition

2. It must be able to sell what it makes as it Goes-to-Market (G2M).

• Marketing is the process of understanding the market and making the market understand you

• Sales is the process of direct contact• Service is the management and

delivery of an order

3. It must be able to Deliver what it promises – whether it’s making (Mfg), moving (Distributor) or Selling (Retail)

• Operational effectiveness has deteriorated more than any other capability

• Operations are NOT best practices they are choosing the right ones, running them efficiently (cost) and effectively (enterprise value)

4. Management Systems are generally weak to extremely weak

• Establishing real goals with real resources and measuring delivery against plan is the heart of performance.

Problem and Value Focus

Key Operating Functions• Mfg, Logistics, Procurement, etc.• Efficient locally•Effective

• Linked x-function• Enterprise aligned

Marketing, Sales, Service• Same Value message• x-linked• Efficient (operations)• Effective (business)

Management System•Budgeting•Operating Plan• Compensation•Infrastructure

VALUE

Operational Delivery G2M Perf

orman

ce

EXECUTION

Enterprise Performance

AndValue Delivery


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Initiatives & Focal Areas

Business performance improvement results from understand and assessing each function by itself, in the context of the enterprise and balancing decisions across functions based on overall performance contribution and potential contribution.

Strategy Markets & Products Problem & Value Profit/Business ModelManagement System Metrics & Controls Change Management Environment & Culture Communications + IncentivesOperations Marketing & Sales Customer Service Procurement Logistics Core Operations Product Management Planning & SchedulingSupport Areas Technology Finance HR

Actions StatusResources

$ Staff Capital1 3 5 7 9Assessment

Each enterprise needs to 1) assess the current performance situation then 2) development a short-term improvement plan based on that stress test. Next it needs to 3) develop a longer-term strategic plan which 4) incorporates investments in new strategies and innovation initiatives. The number of firms actually doing this would appear to be limited – promising rather poor short-term and long-term performance outlooks.

Magic is not in the shopping list but in the blueprint

1. Knowing the functional specifics

2. Knowing how to integrate them for leverage

3. Orchestrating all the moving parts into a whole

4. And in setting the right goals realistically

5. And putting real operating plans in place


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The key questions to ask of executive leadership are what is your strategy and business plan and how are you going to deliver against it? What should we look for in 10 months? 10 quarters? 10 years?

Initiatives & Focal Areas

Strategy Markets & Products Problem & Value Profit/Business ModelManagement System Metrics & Controls Change Management Environment & Culture Communications + IncentivesOperations Marketing & Sales Customer Service Procurement Logistics Core Operations Product Management Planning & SchedulingSupport Areas Technology Finance HR

Actions StatusResources

$ Staff CapitalPhase 1: Strategies & Objectives

Operating Plan

Managem

ent System

Activity C

ontrols

Strategic & B

usiness PlanEach stakeholder (employee, customer, supplier, business partner, investor) in any enterprise owes it to themselves to understand what the current performance outlook is for every enterprise in which they have an interest. They also need to understand how well that aligns with the requirements of the “New Normal”, what the company is doing to meet those challenges, how it plans to get from here to there and (most especially) how it plans to manage execution of those plans.


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Every enterprise will face an extremely challenging environment and needs to prepare for it. Such preparation appears to be lagging requirements. - Stakeholders should be asking key questions to test the performance outlook.

SUMMARY1. We are facing a weak

recovery Poor job creation Weak demand growth Rapidly developing economies dependent on export-growth will be especially challenged

2. Markets appear to be anticipating an immaculate V-shaped recovery

Valuations are extremely high Top PE decile returns are poor and bottom decile returns are the best performers Investors need to adopt a more active investment management and asset allocation strategy.

3. Businesses are struggling to prepare4. Investors need to focus on the

performance outlook

How do we make, deliver and support ?Suppliers ? How many ? Manage ? Connect ?What moves ? Best way/mix ? Service Levels ?Best layout ? Workflow ? Skills ? Lean vs Bulk ?What features/functions for what markets ?How do we synchronize the moving parts ?

OperationsProcurementLogisticsCORE OPERATIONSProduct ManagementPlanning & Scheduling

Right Story to Right People Right Way ?What targets ? Messages ? Methods ?Find ? Prospect ? Develop ? Close ?Order ? Process ? Deliver ? Settle ? Support, Sustain and Grow ?

Go-to-MarketMarketingSalesCustomer Service

What are we all about ?What value do we create ?Is it sustainable or temporary ?Who are we going to sell what ?What’s it worth ?How will we make money ? Product, services, finance ?Subscription, Package, Per Ride ?

StrategyProblem & Value

Markets & Products

Profit/Business Model

Critical QuestionsKey Areas of Focus

How do we make, deliver and support ?Suppliers ? How many ? Manage ? Connect ?What moves ? Best way/mix ? Service Levels ?Best layout ? Workflow ? Skills ? Lean vs Bulk ?What features/functions for what markets ?How do we synchronize the moving parts ?

OperationsProcurementLogisticsCORE OPERATIONSProduct ManagementPlanning & Scheduling

Right Story to Right People Right Way ?What targets ? Messages ? Methods ?Find ? Prospect ? Develop ? Close ?Order ? Process ? Deliver ? Settle ? Support, Sustain and Grow ?

Go-to-MarketMarketingSalesCustomer Service

What are we all about ?What value do we create ?Is it sustainable or temporary ?Who are we going to sell what ?What’s it worth ?How will we make money ? Product, services, finance ?Subscription, Package, Per Ride ?

StrategyProblem & Value

Markets & Products

Profit/Business Model

Critical QuestionsKey Areas of Focus

Dealing With the New Normal: Economy, Markets and Business Performance

Business

Transcript of Dealing With the New Normal: Economy, Markets and Business Performance