Perspectives Taking Deflation Seriously
Taking Deflation Seriously Two years after the biggest downturn in world stock markets since World War II, business executives need to take seriously the prospect of deflation. No one can predict with certainty that the world economy is entering a period of continual crises in financial markets and sustained economic contraction. But neither can the risk of a deflationary recession or even depression be ruled out. Even if the probability is low, the impact of such a scenario would be enormous. Few managers today, if any, have lived through a period of radical deflation. Few organizations have the mindset, the managerial systems, and the decision rules in place to adapt to and survive this most difficult of macroeconomic environments. Prudence dictates that every company prepare for the contingency by understanding the potential impact of deflation on its businesses and by establishing a comprehensive program of preventive crisis management. The Deflation Scenario To understand why deflation remains a plausible scenario, consider the following: The United States stock market remains highly valued. The exhibit below charts the ratio of stock-market values to underlying fun-
damental values for the Standard & Poor s 400 from 1926 to October 2002. It shows what similar analyses of price-earnings ratios and long-term trends also confirm: that despite the considerable drops in stock prices over the past two years, the United States stock market remains highly valued, with market valuations outpacing fundamental values by approximately 25 percent, on average. This number probably underestimates the gap because the calculations for fundamental values are based on the very accounting practices that investors have come to mistrust in recent years (nor do they include the huge costs of stock-option programs because those costs are not captured in the profit-and-loss statement). So there is reason to believe that the stock market has considerably more room to fall. Every period of overvaluation is followed by a period of undervaluation. The historical data in the exhibit also make clear that for each period of relative stock overvaluation, a period of undervaluation of similar magnitude followed. If this dynamic holds true for the current cycle, one could expect the Standard & Poor s 500 to drop from its current level of around 900 to roughly 400. But the actual outcome could be even worse. In the wake of such tremendous financial losses, it is unlikely that companies could maintain their current levels of fundamental performance
thus setting off a vicious cycle in which the stock index could drop even lower. The major world economies are experiencing record-high levels of debt. At the same time that financial markets are weak, there is considerable weakness in the real economy. For example, all the major world economies are facing record-high debt levels as a percentage of gross domestic product (GDP). In the United States, total debt as a percentage of GDP reached nearly 300 percent last year. In 1929, it was at 200 percent. Even in the depths of the Great Depression in the 1930s (when nominal GDP nearly halved), it reached only 260 percent. Current levels of consumer spending are unsustainable. This situation is especially dangerous given the importance of consumer demand to the overall U.S. economy. For the moment, consumer spending has propped up the economy. But given the high levels of consumer indebtedness, savings rates that are low to negative, and a likely decline in housing prices, it is only a matter of time before this spending spree comes to an end. Widespread overcapacity has created an investment overhang. Corporate investment is unlikely to fill the gap. On the one hand, corporate debt is also at record-high levels. On the other, the economy still has not digested the major bulge in investment brought on by the combination of Y2K, the new economy,
cheap money, and consumer demand. Most industries face serious overcapacity. As long as capacity utilization does not increase significantly, additional investment is unlikely no matter how low the U.S. Federal Reserve pushes interest rates. Traditional economic-policy tools are increasingly ineffective. If traditional monetary policy is unlikely to be effective, neither is traditional Keynesian deficit spending. As the example of Japan demonstrates, government spending to stimulate demand won t work as The Historical Relationship Between Market Value and Fundamental Value, 1926 2002 Market value Fundamental value % 200 210 268 180 160 140 120 100 80 60 40 20 0 1926 1931 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 Market high Market low Average SOURCES: Moody s Manual of Investments; BCG ValueScience Center; BCG Value Creators Report, 2002. NOTE: The sample for 1926 1949 consists of 40 S&P 400 companies; the 1950 2002 sample consists of 376 S&P 400 companies, with 2002 data running only through October.
long as debt levels remain high. In the absence of major write-downs of outstanding debt, deficit spending s only effect is to increase public debt and further burden the real economy. No single region of the world is likely to serve as a near-term engine for growth. After the crash in the Japanese stock and real estate markets, Japan could still participate in global trade and benefit from the economic expansion in the United States. Today no country or region is likely to play a similar role. Japan still is in deflation with record-high debt levels. South American countries such as Argentina and Brazil are in financial crisis. The euro zone is hobbled by rigid economies like Germany s, which seem incapable of reform. And China, the one country where economic growth is strong, is also the biggest exporter of deflation through the price pressure its cheap goods exert in industry after industry. Preventive Crisis Management For all these reasons, the deflation scenario represents a huge risk. But it also represents an opportunity for some companies. Many of the world s biggest companies first gained dominance during the Great Depression by winning share from competitors that were going bankrupt or by acquiring financially weakened companies. By understanding the potential impact of deflation on its businesses,
a company can prepare today to take full advantage of the situation, should it occur. The first step is to develop a rich understanding of just how vulnerable your industry or businesses will be in a crisis. How vulnerable to price and volume decreases are the businesses you operate in? What factors influence their susceptibility to crisis? How crisis-resistant are your various business units? How does your own vulnerability compare with that of competitors? Liquidity is key in a crisis, so pay particular attention to cash position and cash management. What are the operational drivers of future cash inflow? How are they likely to react in a crisis situation? Define the measures you need to take to stabilize cash flow under extreme scenarios, and develop the management systems necessary to track cash flow on a daily basis should a crisis occur. These initial steps will put you in a position to develop what we call a recession portfolio, which sorts a company s business units both by strategic importance and by likely vulnerability during a crisis. A company can use this portfolio to set priorities for where to invest, divest, acquire, or restructure, and where to put scarce cash flow during a period of severe crisis. The portfolio helps decision makers act quickly if the negative scenario develops. Finally, a company needs to make sure that the organizational structures and manage-
ment systems that will need to be activated if an economic crisis occurs are in place. In a severe deflationary period, a company cannot operate according to business as usual. It will be necessary to create a companywide task force, armed with the right data and metrics, to get the organization through the crisis period. Companies should be designing this infrastructure now so it will be ready if economic circumstances call for it. Such an exercise in preventive crisis management will be useful, even if deflation does not occur. It forces companies to explore aspects of the business that they have never explored before; it can reveal hidden costs and key structural problems, but also new opportunities and capabilities. A company s management team will come out better prepared, no matter what scenario develops. Daniel Stelter Lars-Uwe Luther Daniel Stelter is a vice president and director in the Berlin office of The Boston Consulting Group and leader of the firm s Corporate Development practice in Europe. Lars-Uwe Luther is a manager in BCG s Berlin office. The authors can be contacted by e-mail at: stelter.daniel@bcg.com luther.lars-uwe@bcg.com The Boston Consulting Group, Inc. 2003. All rights reserved.
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