My last column argued that financial markets over the next five to ten years will be characterized by volatility. For those who accept this conclusion, this article now describes what a business owner or manager might do about it.
Volatility does not necessarily mean that all news is bad: the recent appointment of a technocratic government in Italy headed by Mario Monti triggered a dramatic fall in interest rates on 10-year Italian treasuries from approximately 7.3 percent to approximately 6.5 percent – whopping potential savings on trillions of dollars of debt! It dramatically illustrates how confidence is at the cornerstone of our financial system.
Yet the dragons of massive indebtedness (in countries like Greece, Italy, US and UK) and of lack of competitiveness (and Greece, Spain, Portugal) are far from slain. There will be many more battles before the European Union truly operates like a union – especially in the financial sense. So volatility will persist as we lurch from crisis to crisis – the gyrations may even increase in intensity.
So for those who run businesses, if you accept a scenario of volatility moving forward, how might that affect your actions?
1. Increase the equity available in your business. Most businesses are financed by a combination of debt and equity. Lowering your debt/equity ratio increases the stability of your business, and allows you to weather storms more easily. This can be done by infusing fresh equity, paying down debt, or a combination of the two.
2. Be more cautious with your investment and expansion plans. Perform sensitivity analysis as to how your new projects or expansions will perform under more pessimistic scenarios. Is the project robust enough to perform adequately even under negative scenarios?
3. Reduce your “burn rate”. What are your monthly overhead expenses? To the extent that you reduce such fixed expenses, you improve the ability of your business to survive a possible diminution of revenues. Sometimes this can be done by cutting only fat, not muscle, from your operations. Cutting fat is a “no-brainer” – it simply needs to be done. Cutting muscle must be done much more carefully, fully weighing costs and benefits.
4. Restructure short-term debt to long-term debt. To the extent that you hold short-term debt, you may be at the mercy of financial institutions who may refuse to extend or renew your debt. Switching to long-term debt diminishes this vulnerability, as long as loan covenants are observed.
5. Allocate your portfolio. If you are holding large volumes of cash or securities over the longer term, consider balancing and hedging your portfolio. Gold and other precious metals, for example, may be a useful hedge or insurance policy should the world economy become seriously destabilized, and fiat currencies lose their value.
While inflation has been generally low in developed economies, due to the large amount of free capacity in the economy (high unemployment, etc.), the alarming increase in money supply in most developed countries may eventually trigger significant inflation. So in conjunction with point four above, to the extent you are able to obtain long-term indebtedness, under an inflation scenario you would do better with fixed rather than variable rate financing.
As Larry Summers wrote: “It’s the central irony of financial crises that they are caused by too much confidence, too much borrowing and lending, and too much spending – and they are only resolved with more confidence, more borrowing and lending and more spending.” As we lurch from crisis to crisis, governments will have little option but to rev up the printing presses and print even more money. It has been remarkable how little inflation has resulted from past exercises of Quantitative Easing. One cannot discount the possibility that eventually inflation – or worse, stagflation – will rear its ugly head. And inflation is one of the more unpleasant manifestations of volatility.
