A CHANGE IS GONNA COME

by Paul Cormier, President, Cormier Strategy Advisors Inc.

January 2009

“It’s been a long, a long time coming, but I know a change gonna come. Yes it will.” So say the words R&B singer Sam Cooke wrote in 1963. Barack Obama paraphrased these words in his Chicago election night acceptance speech and the more I have been studying and contemplating the economic and political times we are in, the more these song lyrics have run through my head. A change gonna come.

How did we get here?

We are in one of the worst economic crisis since the Great Depression. Whether this is worse than the inflation and high unemployment of the 1970s or than the post-war production collapse of 1946 is debatable and in many respects inconsequential. Figuring out how we got here, however, tells us a lot about what to expect going forward.

The 1980s and 1990s were unusual in the sense that the United States and Canada stopped having much in way of recessions. Economic growth in North America continued largely unabated from 1983 to 2001 (apart from a fairly short recession in 1990/1991 in the US). Prior to this unprecedented run, the US economy was in recession about 20 percent of the time between 1946 and 1982. So what changed?

Around 1982, baby boomers hit their prime spending years. Although there is some variation on what dates the baby boom took place, it was roughly 1947 to 1966. So in 1983, boomers, who constituted the largest segment of the population, were between 17 and 36 and entering their peak spending years for houses, cars, furniture, etc. By 2001, this group was between ages 35 and 54 and the older part of this demographic group’s consumption began to slow.

The boomers’ accumulative phase is very evident from the dramatic drop in personal savings rates from around 12% in 1982 to around 1% by 2001. And they didn’t have to save. Their asset values rose as the stock market reflected strong profits driven by their consumption and real estate values increased reflecting their own demand for housing.

In the 1983 to 2001 period, central banks also became pretty good at figuring out how to smooth the economic cycle through active monetary policy. By reducing the cost of money (interest rates), they could stimulate spending by the boomers on large ticket items like houses and automobiles. So every time the economy began to slow, central banks could cut interest rates and the boomers would start buying again and rescue the economy. But as 1990s came to a close and the new century began, the older boomers started getting close to retirement and the traditional “accumulation” phase of their lives began to come to an end and here is where the problem developed.

When there were fears about the impact of the Y2K computer issue and then again when the economy slowed in 2001, central banks led by the US Federal Reserve went back to the tried-and-true method of stimulating the economy through interest rate cuts. Initially the monetary stimulus only had limited success as boomers weren’t that interested in spending so the Fed lowered interest rates to historically low levels and here the two initial mistakes came:

 The Fed failed to recognize that demand would naturally drop due to aging of the boomer population and that long-term GDP growth projections needed to decline as a result.

 The Fed did not worry about the inflationary impact of reducing interest rates because inflation was low (or so they thought). In a recent article, market commentator Jim Jubak makes a strong case that government-calculated inflation numbers are misleading for several reasons including the use of hedonics (where new product features are not considered part of inflation), use of substitute products in calculations, use of rents instead of costs of housing and the ignoring of asset inflation. This has meant that misleading inflation and real GDP (which strips out perhaps the wrong inflation amount) numbers could have created and compounded monetary policy mistakes.

The Fed’s efforts eventually did stimulate the economy but these low interest rates created three of the primary effects that led to the current crisis:

 Excess housing demand which created higher real estate prices to the point it became a bubble. This was supported by very low unemployment which gave people a false sense of security about repayment, a false public perception that real estate prices never declined, changes to banking laws which brought down the wall between banking and investment banking, facilitating banks ability to dramatically increase the degree to which mortgages were securitized and the creation of derivative markets for these assets, incredibly high risk tolerance among investors, dependence by mortgage lenders upon refinancing and easier lending standards to drive revenue growth and a Federal Reserve and US government that was unwilling to require tighter lending standards among mortgage lenders for fear of slowing the economy.

 Excess consumption by the consumer sector leaving insufficient long-term savings to finance retirement.

 Excessive speculation in financial assets driven by excessive use of leverage by hedge funds, sovereign wealth funds, private equity funds and investment banks.

 There were plenty of dominos in the chain, but it started with a lack of understanding that as the boomers aged, economic growth expectations should decline. In trying to hit previous growth targets, we essentially stole from future growth, creating inflation and setting up the economy and financial markets for an inevitable collapse, which happened in 2008.

It is important to understand the circumstances that led to the current crisis because it tells us there is no quick fix solution. It tells us that it will take several years to unwind the excesses of the past and that we can expect lower growth during that period.

A secular bear and a deep recession, but no depression

From a market perspective, it is important to provide a larger context to the recent stock market declines. It is my opinion that we are in the midst of a secular bear market that began in 2000. The recent declines set new lows for these bear markets, weekly lows very similar to those set at the bottom in October 2002. The tops achieved in July 2007 and October 2007 were very similar to the top achieved in March 2000 when the secular bear market began. Secular market trends typically last for approximately 17 years, meaning we are around half way through a market that is likely to be range-bound between 800 and 1550 on the S&P 500. Luckily, if you still have cash, we are towards the bottom of that range, potentially presenting a decent buying opportunity for long-term investors.

In the end, the message of stock and bond markets and leading economic forecasting firms such as the ISI Group and the Economic Cycle Research Institute is that the US is in for a recession that will last throughout most of 2009 and that will be quite severe in nature. ISI Group is predicting a contraction of 3% in US GDP in 2009 and if the recession lasts past April 2009 it will be the longest since the Second World War.

Up until recently there was a real risk that the recession could turn into a depression, a much longer, more severe downturn. There are a number of reasons I no longer believe that a depression is a likely outcome. These include falling mortgage rates which should allow the housing market to begin to recover, plunging oil prices which is effectively a tax cut to the US consumer, the actions that have been taken and that are likely to continue to be taken by the Federal Reserve and the fiscal stimulus that will be provided by the US government, mostly on infrastructure and tax relief. Up until recently US bond markets were predicting a period of fairly severe deflation for the next five to seven years, which would have been consistent with a depression scenario, but around the beginning of December bond markets began to predict a significantly reduced risk in this regard. It appears the most likely scenario is the longest, deepest recession since the Second World War, but one that will end later in 2009.

What change can we expect?

Bill Gates has said “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten. Don’t let yourself be lulled into inaction.” This economic crisis will drive a lot of change, some of it in the next two years, but a lot of it with impacts that won’t be seen or understood for several years to come. I have tried to identify some of those coming changes in regards to the economy, finance, government & public policy and global issues in the short-term (next two years) and the longer-term (two to ten years) and how that will impact the corporate world in the years to come.

The Economy

Short-Term

 Economic activity will bottom in late 2009.

 US government will use its borrowing power to underwrite mortgage and car loans to stabilize the credit markets and revive the housing and automobile sectors.

 US will pass a $1 trillion stimulus package aimed at infrastructure and low income tax cuts.

 There will continue to be high levels of risk aversion making acquisitions and new projects difficult to finance.

 Many retailers and shopping centers will go bankrupt.

 The US housing market will bottom in 2009; however the inflated housing markets of Western Canada will severely correct in 2009.

Longer-Term

 Economic growth will be slower than the last decade.

 Many baby boomers will postpone retirement.

 Savings rates will increase substantially.

 Personal debt levels will decline significantly.

 Consumer credit standards will be much tighter.

 Consumer discretionary spending, particularly in the luxury segment, will be reduced.

 Goods/services price inflation will be near zero.

 The price of oil and other major commodities will not return to 2006 to 2008 peak levels for the foreseeable future.

The biggest theme in the economy will be a return to greater personal responsibility. Aging boomers who don’t have enough for retirement will have to save a great deal more and will be paying down personal debt. You already saw this in 2008 as fiscal stimulus in the US was used to repay consumer debt (as opposed to buying goods). This will lend to the slower economic growth rates over the next ten years. However it will probably keep interest rates and inflation low, which should drive improved business investment which will ultimately set up the economy to be in a good position going forward. Demographics will also begin to help around the year 2015 as the majority of the children of baby boomers will enter their peak spending years (similar to 1983). Commodity prices will go back to historical long-term trends as the 2006-2008 peak prices were more the result of financial speculation rather than economic fundamentals.

Finance

Short-Term

 There will be significant risk aversion, leaving in place above-normal yields on corporate bonds, REITS and higher hurdle rates for investors and businesses (these risk premiums will gently ease).

 In the risk-averse environment, with the consumer segment reducing debt and increasing savings rates, governments will be able to access low cost capital to invest in infrastructure.

 Governments will continue playing a role to facilitate lending in mortgage and consumer markets.

 Monetary policy will remain very accommodative to protect against deflation.

 The US dollar will show strength in the short-term as the US continues to be seen as a safe haven.

 Merger and acquisition activity will remain subdued as financing remains unavailable.

Longer-Term

 Income taxes are likely to rise longer-term in order to pay off some of the debt being accumulated to provide short-term economic stimulus.

 The secular bear market for equities should extend until around the middle of the next decade, after which a secular bull market should begin.

 The US dollar’s strength and position as the dominant currency will continue to deteriorate vis-à-vis other currencies as the US government’s enormous debt burden and future liabilities are appreciated in currency markets.

 Sovereign wealth funds will reduce their international exposure and increase domestic exposure as governments will focus on using these funds for domestic economic development.

 The financial industry will not learn from this crisis and there will be another financial crisis around 2017 (financial crisis has hit almost like clockwork in ten-year cycles in the last half-century).

The demand for financing from the consumer sector will decline which should free up money which will be accessed by government to provide short-term economic stimulus and infrastructure funding in the short-term. The secular bear market for stocks will end around the middle of the next decade as demographics drive stronger demand, and corporate productivity investments yield strong benefits.

Government & Public Policy

Short-Term

 Government’s primary focus will be on reviving the sagging economy through focused tax cuts and infrastructure spending.

 US and Canadian governments will run very large deficits.

 There will be increased focus on the effectiveness of government spending efforts.

 The economy will become the only major political issue for the next two years – parties will need to be seen to have a plan to address economic issues.

 Protectionist sentiments will rise in political dialogue, but will be beaten back.

 Currently there is a greater than 50% chance that the BC Liberals fail to win a third term in British Columbia and are replaced by an NDP government.

Longer-Term

 Income taxes will rise, especially on higher tax brackets, to address fiscal shortfalls.

 There will be significant health care reform in the United States, including adoption of a national universal health care insurance program. This will occur primarily for economic reasons.

 A major priority of the US government will be energy independence. This will be sold as a national security priority (more than an economic or environmental one).

 Environmental issues will diminish in stature due to the slow recovery from the recession. The one exception will be clean water conservation, which will emerge as one of the biggest environmental priorities.

 US immigration policy will be loosened, especially for investors, as a means of increasing economic growth potential and shoring up housing demand.

 The mechanisms used to exert US foreign policy will shift from large-scale military operations to greater use of diplomacy, intelligence and smaller-scale tactical military operations.

 Social activism will rise as there are increasing demands on limited government resources.

In the short-term, most government and political attention will focus on attempts to alleviate the global economic crisis, at precisely the time that trust and confidence in existing institutions will be declining. However, as the cloud of the current crisis gradually lifts the consequences of the factors that led to the crisis as well as the solutions to the crisis will shape government policy for years to come. Taxes will rise to pay service charges on the debt incurred to solve the crisis. Health care reform will occur in the US as more and more companies cut employee benefits or declare bankruptcy to avoid retirement liabilities. The United States will not be able to afford to continue occupying Iraq, but their inability to finance foreign occupation will force a movement to US energy independence. The repercussions will go on for years.

Global Issues

Short-Term

 The economic crisis will spur significant social unrest in China. Rising unemployment and the lack of a significant social safety net will lead to protests which will grow louder over the coming months.

 Russia will also face a significant political crisis as its resource based economy is deeply affected by the world economic downturn and its financial sector continues to suffer.

 The US government will move to extract its forces from Iraq on a faster timetable, but will have to add to its forces in Afghanistan.

 Pakistan will continue to destabilize and will become a prime area of concern for fear that a nuclear state will fall into the hands of a radical Islamist government.

Longer-Term

 Terrorist activity will increase. While radical religious groups will continue to be the prime perpetrators, advocates of other social causes may also become more violent.

 There will be increasing risk of terrorist cyber-attacks, particularly targeted at critical infrastructure.

 There will be a weapons of mass destruction terrorist attack within the next 10 years (it will most likely be a biological attack).

 Tensions between Pakistan and India will rise and will pose the greatest threat to international security over the coming decade.

 US stature will increase in the world due to a different approach to foreign policy.

In the short-term, the economic downturn is likely to lead to political unrest in a number of countries including China and Russia. China faces devastating mass unemployment which has historically been the impetus for political revolt in that country, especially once the intellectual class joins in (which they have started to do). It is currently difficult to predict what changes may result in China. The consequences of recent economic changes will also contribute to an increase in terrorist activity as disillusionment tends to increase association with radical ideologies among youth. Political instability in Pakistan is very troubling due to its status as a nuclear power and the United States and other world powers will feel obliged to get involved due to the potential consequences of an unstable or unfriendly government in Pakistan.

Impact on the Corporate World

The most important lesson most companies can learn is that they are facing a new long-term reality – that the adjustments that need to be made today are not just temporary cyclical adjustments; they are long-term structural adjustments.

The new reality involves reduced and more careful consumer and business discretionary spending, increased competition for the customer’s dollars, reduced pricing power on the part of sellers, greater consumer sensitivity to price and product features, far less trust in companies and institutions among the general public, lower commodity prices (compared to what we have seen over the last three years), increased bankruptcies among customers, suppliers and competitors, less ability for companies to employ creative financing techniques, and shifts in governments towards the left of the political spectrum with rising taxes and more regulation likely.

This new reality will mean that attracting the consumer’s attention will be more difficult. Product development and marketing will be the top priorities for most companies. Focus will be on increasing market share and creating new markets as price increases will be difficult to achieve. In an extremely competitive environment, companies will need to be structured to be creative and nimble. Corporate bureaucracy will need to be ruthlessly attacked and there will be little tolerance for non-performers. Productivity will be a key focus area and process improvement in operational and administrative functions will be pursued with greater vigour. Costs in many industries will benefit from reduced input costs as commodity prices stay at more reasonable levels. However, companies will seek further cost savings to attempt to restore margins severely impacted by diminished demand and pricing.

Many companies are likely to seek reduction in employee benefit obligations by reducing or eliminating employee benefits. Opposition to such moves may strengthen the power of organized labour, whose influence has been generally diminishing in recent years. Those companies that still have defined contribution pension plans will find that these plans are severely under-funded as the markets take time to recover. Also, many individuals who were planning to retire may decide to delay retirement due to diminished investment holdings, reducing the level of attrition many companies were planning on over the next ten years.

Reputation management and government relations will be critical as companies attempt to rebuild trust among their stakeholders and to address the calls for increased regulatory scrutiny which will befall many industries.

Contingency planning will be crucial as cyber-terrorism and terrorist plots that target public health become more likely. In addition, with many more companies sourcing support services and production globally (in places such as India and China), global conflicts and political instability have the potential to disrupt basic company operations and services and contingency plans will need to be developed or revisited for such potential disruptions.

Calls for corporate governance reform at the shareholder level will also likely get louder, especially as corporate profits diminish.

I have outlined what I believe to be some key changes we will see over the next ten years. It is time for all corporate managers to assess their company’s plans in the context of our changing environment. Assessing organizational capabilities and structure for the long-term will be paramount. A change is gonna come. Are you ready?

Paul Cormier is President of Cormier Strategy Advisors Inc., a firm which provides clients with strategic consulting, project management and short-term management services.