It has become clear that Britain’s vote to leave the European Union (EU) is a major disruption to global business plans, and its consequences clearly rise to the board level. Ongoing political chaos in the United Kingdom (UK) is having seismic economic effects and has already amplified downside political risks across Europe.
“Wait and see” is a dangerous response to a highly uncertain situation. Proactive board leaders can undertake several immediate initiatives that will minimize the damage to 2016 results in Europe and improve the resiliency of your company’s plans for 2017 and beyond.
What we know today: The UK’s economy will contract next year. Frontier Strategy Group’s (FSG) Europe, the Middle East, and Africa (EMEA) Team forecasts a sharp slowdown in UK growth in the second half of 2016, deepening into a recession of -0.5 percent in 2017. Regardless of the pace and the aim of its exit negotiations with the EU, deep splits within the UK’s major political parties and energized independence movements in Scotland and Northern Ireland guarantee governmental dysfunction and depressed sentiment among consumers and businesses.
Beyond the UK, certain economies are especially vulnerable. Ireland, Norway, and the Netherlands will be hurt quickly as UK demand shrinks. Around the world, UK and European economic woes are likely to hit Poland, South Africa, Algeria, Azerbaijan, Bangladesh, and Costa Rica especially hard in their respective regions.
What we won’t know anytime soon: As of yet, it is impossible to predict (1) whether the European Union will change fundamentally or lose additional members, (2) the political and economic effects of energized populist parties in many European countries, (3) the downside risk to the UK from regional separatism, or (4) the new destinations for foreign investment that may leave the UK. Scenarios and contingency plans are essential tools to manage risk and identify targeted opportunities in this environment.
Bolster Commercial Execution in the Second Half of 2016
Boards should expect to receive a rapid-response sales strategy review from UK executives and risk assessments for Europe overall. Is management being sufficiently proactive in managing new risks?
Prioritize risks to 2016 sales targets—In the UK, business investment is most likely to see near-term declines as companies worried about growth move to limit expenditures (hiring is sharply down in London), while consumer sentiment will be dragged down by housing-price shocks. Sterling and euro depreciation will hit specific customer segments hard. Expect management to proactively engage customers about changes to their expected spending, and redeploy sales and marketing resources to the least vulnerable territories.
Target contingency plans on talent and finance—Uncertainty about visa requirements for Europeans in the UK (and for non-UK citizens generally) is a serious engagement and retention risk. Currency effects are wiping out margins for some UK subsidiaries and should force a near-term rethink of hedging and payment terms. Expect management to document contingency plans with signposts and priority actions by function, especially for finance and human resources (HR).
Track leading indicators of changes in demand—Volatility in currency markets and commodities markets will have global ripple effects on business and consumer sentiment, and on government finances—especially in emerging markets. Ask if European management teams are adjusting their dashboards and monthly/quarterly agendas accordingly.
Stress-Test Strategic Plans for 2017 and Beyond
The next planning cycle will be more demanding than usual. Updating forecast data is a small part of the needed response. So much will remain uncertain that plans for Europe (and for markets with links to Europe) should be stress-tested for resiliency against downside scenarios. Contingency plans should be put in place for big bets.
Use scenarios to model UK and EU demand—FSG’s benchmarking found that simple scenarios are key to organizational alignment and resilience; the companies that do this best grow market share 2.1 times faster than their competition in volatile markets. My pre-Brexit vote NACD post highlights a range of risks worthy of incorporating into scenario plans.
Evaluate risk exposure in European operations and the supply chain—Profitability and pricing power for imported products will diminish if barriers to trade with the UK increase and European currencies weaken further. Scenario analysis can help evaluate potentially improved returns from localized production and supply-chain structure.
Rethink Europe/EMEA hub locations—Potential changes that affect HR, legal, regulatory, and finance teams may tip the scales in favor of revisiting the UK as a hub for EMEA, Europe, or Western Europe leadership and operations. Balance financial and political/reputational considerations along with change-management costs. Retention of European nationals currently based in the UK is becoming a factor as well.
Reassess global market-portfolio prioritization—Long-term investment plans for Europe must be rebalanced given the likelihood of a UK recession in 2017 and ripple effects varying among other European countries. Moreover, investment cases for Europe are likely to face sharply skeptical review even as EMEA leaders strive to make up the gap that UK underperformance will create. At the global level, Asia-Pacific and Latin America leaders have an opportunity to put forward more aggressive plans for 2017 and beyond. India in particular is a substantial market that remains under-penetrated by foreign companies; higher-risk big bets there may be more warmly received when Europe looks so uncertain.
When uncertainty is high, boards have a valuable role in helping management bring focus to the most important decisions rather than falling victim to firefighting and analysis paralysis. Companies that set a proactive agenda now for a mid-year course correction and forward planning will be well positioned despite market volatility in the year ahead.
Joel Whitaker is Senior Vice President of Global Research at Frontier Strategy Group (FSG), an information and advisory services firm supporting senior executives in emerging markets.
For more on the Brexit fallout and what it means for your board, join us for:
This is the first of a three-part series looking at the global economy and uncertainty in 2016. In our next post, we will focus on geopolitics and its implications for business strategy and decision making.
The United Kingdom’s vote on June 23 to leave the European Union highlights the uncertainty and volatility that companies face this year. (See my “Why Brexit Really Matters” article in Forbes.) Indeed, the sharp fall in global equities and currency markets on June 24 accentuates the rude awakening. But should the investment and business communities have been surprised? Most polling in the run-up to the vote suggested the leave campaign could prevail. Companies are now scrambling to implement their contingency plans…or to create them. Currency shifts will be the most immediate shock to manage.
According to NACD members, the greatest concern they foresee in 2016 is the global economic slowdown and how this will affect their company. This issue outranks other concerns, such as the changing industry landscape or cybersecurity. When looking at the board’s activities, NACD members say that the most important area for improvement is the board’s ability to test management assumptions underlying corporate strategy.
The Brexit vote highlights the strategic challenges directors face in today’s volatile world: How can directors make sense of increasingly uncertain economic conditions and what can they do to pressure test the validity of management’s assumptions about future growth?
A slow-growth world
Companies are facing strong headwinds in a slow-growth world. In April, the International Monetary Fund (IMF) downgraded its outlook for global growth this year to 3.2 percent—barring any system shocks. This is about the same rate as last year. The IMF downgraded the outlook for most major economies as well (see chart).
In June, the Organisation for Economic Co-operation and Development (OECD) fretted that the global economy is “stuck in a low-growth trap.” Shortly thereafter, the World Bank issued a more negative forecast, saying global growth would come in at only 2.4 percent this year, down substantially from the 2.9 percent pace it had projected just several months before.
Of significance, there are few positive country narratives. The United States is a relatively bright spot, with the IMF expecting 2.4 percent U.S. growth in 2016—the same as last year, but lower than the IMF had forecast in October 2015. The Business Roundtable recently downgraded their expectations for U.S. growth from 2.2 percent to 2.1 percent, based on concerns over impediments to trade and immigration. And, as most Americans feel, U.S. growth is neither robust nor equally enjoyed.
Europe looked like it might have been turning the corner: Business and consumer sentiment had improved, productivity had increased, and GDP growth strengthened significantly. But growth across the eurozone in 2016 is expected to come in at just 1.4–1.6 percent—barring a sustained Brexit shock.
Over the past decade or so, many companies have globalized and bet heavily on emerging markets (EMs)—sometimes dubbed “rapid growth markets.” This strategy could be easily justified by management when EM growth rates consistently outstripped those of the United States and Europe by five percentage points or more.
But these markets have been underperforming in recent years and their outlook has been consistently downgraded. This year, the World Bank expects emerging markets to grow by just 3.5 percent—about two percentage points below their average growth over the past decade.
Moreover, EM performance will continue to be uneven and uncertain thanks to poor governance—as exemplified by a massive corruption crisis that has gripped Brazil’s business and political communities. India continues to be a top performer at 7.5 percent growth, but the reform-oriented government there has made little headway tackling the myriad of bureaucratic impediments to investing and doing business there.
And while China is still doing relatively well—with its growth expected to be in the 6.5–7.0 percent range this year—this performance has come thanks to renewed stimulus and the expansion of debt, which raises more questions about the sustainability of China’s trajectory. At the same time, Western companies conducting business in China are facing increasing political and regulatory headwinds, not to mention a much more competitive business environment.
An uncertain outlook
Not only are we in a slow-growth world but we are also in an era of significant uncertainty about the future. The IMF in April described global economic activity as “increasingly fragile” and the World Bank warned in June that “the balance of risks to global growth forecasts has tilted further to the downside.”
Uncertainty is rooted in the fact that traditional cyclical drivers such as business capital investment and consumer spending seem to have lost their oomph. In short, in our chronically slow-growth world, businesses don’t want to invest and consumers don’t want to spend. Moreover, productivity, profits, wages, and trade growth are stagnant as well, and many economists believe that income inequality is exacerbating the slow-growth problem.
On top of this, the growing influence of geopolitical risks—the Brexit vote, the upcoming U.S. presidential election, refugee migration, and China—are adding new and hard-to-quantify variables to the outlook.
Given this context, the severe market volatility seen during the summer of 2015 and in January 2016 points to profound uncertainties about the future and to how easily perceptions and the markets can get shaken in our slow-growth world. A resurgence of sustained global market volatility triggered by the Brexit vote has the potential to derail global growth.
Pressure test management’s assumptions
In this uncertain and volatile world, directors should be testing management’s assumptions about growth—now and in the future.
Start by confirming the baseline: Does management’s view of macroeconomic growth for 2016 in the company’s key markets align with the market consensus?
Get your own perspective. As noted above, we rely on the views of multilateral organizations—such as the IMF, World Bank, and OECD—for a global perspective. Their economic outlooks are easily accessible and widely viewed as a reputable baseline around which to test assumptions.
The OECD has put together a handy one-page summary chart focused on advanced economies that a director can take to a board meeting as a reference. The World Bank has an easy-to-navigate website for exploring regional and country economic outlooks. Central banks also are a good source of country-level data.
Ask questions about management’s assumptions:
What data sources does management rely on?
Does management’s view differ materially from what others are saying?
What assumptions support a divergent outlook?
How does management account for political risks?
Next, test management’s view of the future. Economists have had to significantly downgrade their expectations of U.S. and global growth and the economic headwinds are not expected to diminish over the next several years.
Has management adjusted its growth projections downwards as well?
What is management’s two- to three-year view of China and other emerging markets?
Do the company’s plans reflect a slow-growth environment going forward?
Given widespread uncertainty and the risk of volatility, management should be able to present a range of alternative market scenarios.
Does management have an economic disruption scenario?
How has management sought to make the company more resilient to the uncertainty and volatility in the global market?
Many directors we have spoken with have highlighted the challenge of managing near-term foreign exchange risks.
What steps has the company taken to hedge against swings in key currencies?
If management says the company is going to significantly outperform its peers or the macro economy—especially in emerging markets—that is a yellow flag that should signal you to dig deeper and ask more questions.
NACD’s Global Board Leaders’ Summit in September, themed around the issue of convergence, will have dedicated sessions on global economic and political disruption, featuring subject-matter experts and seasoned directors.
This Thursday, the United Kingdom (UK) will vote in a referendum on whether to leave the European Union (EU)—referred to as the “Brexit.” Opinion polls have shifted sharply over the past two weeks to indicate that the likelihood of Brexit has increased substantially, but Frontier Strategy Group continues to believe that the UK will vote to remain in the EU, albeit by a very small margin. Opinion polls have been extremely inaccurate in the past two UK elections and we believe some hesitant voters will choose to remain in the EU in a conservative bias that we saw in both the parliamentary elections last year and in the Scottish referendum. Markets are also interpreting the murder of pro-EU Labour MP Jo Cox as likely to damage the Leave campaign.
A narrow win for the Remain campaign—our baseline scenario—is unlikely to alleviate the grievances of those supporting Brexit and would cause deeper tensions within the UK’s Conservative Party, raising the likelihood of early elections and another referendum in the next couple of years. While the economic impact of these trends would be relatively modest, lingering uncertainty would cause investments to underperform.
Should Brexit happen, however, multinational businesses would be affected in several key ways. Besides the initial financial volatility and somewhat weaker growth in Europe, most of the broader effects of Brexit outside the UK would be slow-moving, although their long-term implications could be significant enough to reshape the European Union. Companies need to be prepared for short-term volatility—particularly of currencies—but should Brexit occur companies can expect to be gradually adapting to its effects for at least the next two to three years.
Financial-market volatility and currency depreciation
The possibility of Brexit has already rattled currency, bond, and equity markets and this volatility will increase in the immediate aftermath of the event should Brexit occur. The British pound could depreciate by as much as another 10–20% against the United States’ dollar (USD) in the aftermath of Brexit, and the euro would also likely lose value, possibly as much as 5–10% against the USD. The scale of the losses would likely be temporary, but neither currency would be likely to recover to pre-Brexit levels. Brexit would also dampen investment confidence, softening commodity prices and causing overall financial market uncertainty. Added to a backdrop of weak global growth and deep concerns about China’s slowdown, Brexit would prompt another bout of volatility that would cloud corporate expectations and complicate 2017 planning for emerging markets generally.
Growth in Europe
Brexit would cause a slowdown in UK investment and business activity. A similar, though smaller, effect would be likely in the EU as a whole. Markets strongly linked to demand from the EU—such as North Africa, Eastern Europe, and parts of Asia—would see a softening of demand for the next 12 months that would affect industrial performance but would not disrupt growth trajectories. The demand effect for other parts of the world would likely be negligible. As corporate leaders gear up for 2017 planning, they would have to dedicate more analytical energy to identifying sources of growth in Asia, the Middle East, Africa, and the Americas to compensate for weaker performance in Europe.
Brexit would raise a host of trade issues from the future of the Schengen Area to the outlook for the Transatlantic Trade and Investment Partnership, all of which would increase uncertainty over the cost and structure of supply chains that involve the EU. Any tangible effect on supply chains, however, would likely materialize over a period of several years, giving companies ample time to respond. It would, however, raise fundamental organizational issues such as where companies’ European headquarters will be located, tax rates, distribution-chain structure, and other concerns that should be factored into 2017 and longer-range planning as well as profitability targets. Making changes earlier could yield valuable competitive differentiation for cost and talent.
Brexit’s most dangerous effect could be to galvanize anti-EU sentiment and populist parties across the EU, setting into effect a series of policy disruptions in the region that could weaken the EU, slow down EU integration, or even lead to other EU members exiting the union. All of this would undermine the EU’s economic outlook, and force multinational corporations to manage political risk in this usually stable region much more closely. While that would be unlikely to have ripple effects globally, it could contribute to greater instability in the Middle East and Eastern Europe if it coincided with increasingly isolationist foreign policy from the United States.
Overall, Brexit would put greater pressure on regions outside of Europe to deliver strong results that can compensate for years of underperformance by the UK and the EU in corporate portfolios. This may be a big challenge in the current global growth environment, requiring an even greater focus on agile strategies that emphasize strong competitive positioning, careful risk management, and a reshaping of how companies plan to win in emerging markets.
In case the UK votes next week to leave the EU, boards and executive teams should ask themselves several urgent questions to effectively prepare their response:
What is our company’s exposure to short-term currency volatility of both the British pound and the euro? How would significant depreciation against the dollar affect our overall revenue and profit targets for this year?
Have we developed alternative international growth strategies that rely less on demand in Europe?
What production and distribution disruptions are we likely to face in our European operations?
How should we adjust our long-term outlook for doing business in Europe? What economic and political risks are now more likely and more significant to our company?
Joel Whitaker is Senior Vice President of Global Research at Frontier Strategy Group (FSG), an information and advisory services firm supporting senior executives in emerging markets.