Companies in an economic downturn

Is Australia headed for a recession, and what does that mean for my company?

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What our economy looks like in the next year

After the Covid-19 pandemic, countries all over the world are trying to revive their economy and fill the financial void it has left. Many countries are already on track and doing well.

Australia performed strongly in the fourth quarter of 2021, beating most predictions that it would not perform well.

Australia also faced the consequences of the pandemic, but they were mild compared to other countries. After the drop of 2.5% in 2020, Australia’s GDP projected 4% growth in 2021 and is expected to grow at 3.3% in 2022. Even though Australia lost its most important trade partner China, Australia successfully managed to fill its place with other nations.

Historical Events in Australia’s Economy

The pandemic has shaken Australia’s economy more than any other calamity in its history. A country with more than 40 percent of its GDP dependent on trade was put to the test. Yet, Australia did exceptionally well by showing positive economic growth in the last quarter of 2021.

With the lockdown announcement in March 2020, Australia’s economy fell 0.3% in the March quarter. This resulted in 66% of businesses reporting a reduction in turnover, 64% of companies reporting a decrease in demand, and 48% of companies reporting impacts on their operations due to the restriction put in place to fight the Coronavirus.

In May-June 2020, Australia imposed even stricter social distancing measurements, resulting in less income reporting by over 72% of businesses, while only 7% reported increased revenue.

As a result, in early June 2020, Australia’s GDP fell by a record 7%, dropping for the second quarter in a row. During this period, 2 out of 3 businesses reported decreased revenue. Among these, the most impacted industries were education, accommodation and food, and information media and telecommunication, each reporting 87%, 84%, and 80% decreased revenue, respectively.

In July and August, unemployment in Australia peaked at over 7.5%, which was the highest in over 20 years. During this time, the industries most likely to experience difficulty were accommodation and food, transport and warehousing, and arts & recreation services.

After the decrease in March 2020, Australia’s economy started to recover around September 2020 with the announcement that vaccines would be available in November. In October 2020, businesses began to show signs of recovery. And in December 2020, Australia’s economy was on the upswing, with GDP rising by 3.1%. With the start of 2021, things started to continue improving, with employment recovering to almost 93%.

The real change in Australia’s economy was visible from January 2021, when almost 93% of the job losses due to the pandemic were restored to the Pre-COVID level. Aside from the pandemic’s strictly financial characteristics, many experts compared this crisis to other recessions like 2008 and the Great Depression of the 1930s.

In the December 2021 quarter, Australia’s Growth Domestic Product was reported to have increased by 3.4% compared to the September quarter. As the pandemic restrictions started easing up, states like New South Wales (6.7%), Victoria (3.7%), and the Australian Capital Territory (1.9%) showed the most substantial growth even though they were the most affected by the Delta wave restrictions.

The strength of the Australian economy

Throughout the pandemic, Australia proved to be a resilient economy performing better than other countries. In addition, the Australian government’s cautious approach to the COVID outbreak turned out to be beneficial to the country’s economy.

Below are some of the things Australia did to contribute to its resilience:

• As a part of the $100 billion bond purchase program, the Reserve Bank announced that it would purchase bonds that the Australian Government had issued. The Reserve Bank continued to do so until February 2022. This helped to lower the whole structure of interest rates and support Australia’s economy through a standard transmission mechanism of monetary policy.
• Australia suffered a sharp drop in visitors (especially short-term visitors like tourists and international students) following the closure of international borders. From April to September 2020, there were approximately 4.1 million fewer short-term visitor arrivals than during the same period the previous year.
• Global goods trade fell by a historically high 18.5% in the first half of 2020. Despite the 11% drop in Australian export volumes, the fall in import volumes was much more significant due to weak domestic demand, as revealed in the National Accounts of the June quarter. As a result, GDP growth for the June quarter was 2.5% points higher due to net exports.

The Reshaped Housing Sector After the Pandemic

Decisions made during the pandemic—whether it was to close the country from the outside world at the beginning of the pandemic or cut interest rates to low levels, or inject stimulus into the economy—led to high property prices.

Between April and September 2020, the housing values continuously declined by 2%. As the Reserve Bank cut interest rates to historic lows, billions of dollars in the stimulus were pumped into the economy, which increased household savings. Such cheaper financing made it easier for borrowers to access more credit.

According to CoreLogic’s Home Value Index, housing prices jumped to over 24.6% from April to February 2022. As a result, residential real estate values increased from $7.2 trillion to $9.8 trillion.

By the third quarter of 2021, the household debt-to-income ratio reached a record high of 140% and increased real estate values. All of these factors combined affected the rental housing market as well. As a result, rental rates have increased from $30 per week to $470 per week since March 2020.

The current struggles of the Australian economy

Apart from the global pandemic, another recent struggle that the country is facing is the Australian bushfires of 2019/2020. It began in September 2019 and destroyed millions of properties and businesses. It also claimed both humans and wildlife in large numbers.

The short-term impact of the fire on the country’s GDP includes the fact that businesses, tourism, transportation, manufacturing processes as well as farming-related activities would be affected negatively.

Another effect is a further reduction of Australia’s confidence in recovering (especially since the country is still yet to recover from the pandemic’s effect). The unemployment rate is highly likely to drop even further with a resultant negative drop in the number of small businesses in the country.

An article by the Guardian speculated that the country would have to spend even more than the amount spent to recover from one of its past fire-related setbacks in 2009. During the Black Saturday of 2009 in Australia, about 450,000 hectares were affected. This is nothing close to the 8.4 million hectares that were affected by this recent 2019/2020 bushfires. The costs of these struggles will arise from health demands, daily disruption, insurance claims, and other sectors.

The U.S.

"When America sneezes, the world catches a cold" – as the old saying goes.

It's only been two years since the COVID-19 pandemic began, but economists are already speculating about when the next recession could happen.

The United States will fall into recession in late 2023 because its central bank, the Federal Reserve, will hike interest rates too quickly.

Deutsche Bank is predicting, "We no longer see the Fed achieving a soft landing."

Deutsche Bank economists led by Matthew Luzzetti wrote in a report to clients "Instead, we anticipate that a more aggressive tightening of monetary policy will push the economy into a recession."

Another major bank, Goldman Sachs, is forecasting a 35 per cent chance of a US recession in the next two years.

'Significant' risk of hard landing

With increases to the cost of living surging to a 40-year high in America, there's a strong argument that the Fed now has to rapidly hike rates to cool the economy down.

Money markets are betting the Fed will announce outsized rate hikes (0.5 of a percentage point) at its next few meetings – and that its benchmark interest rate will soar to 3.2 per cent in a year's time.

That's an extraordinarily rapid pace when you consider that US rates are currently near record lows (between 0.25 and 0.5 per cent).

"The Fed doesn't have a great history in terms of interest rate hikes," AMP Capital senior economist Diana Mousina told ABC News. "There is definitely the risk that this time round inflation is so elevated in the US, and the economy is running so hot, that the Fed may think it's way behind the curve and take interest rates too high. When you see a big downturn in the largest economy in the world, there's obviously negative impacts for major trading partners like Australia in terms of lower demand for exports – so it does create a downturn in global trade. But in the short term, I think that there is still further upside for the US economy and for share markets as well."

Recession risks growing in Australia

Money markets are betting that Australia's cash rate will surge above 3 per cent by the end of next year.

Considering the cash rate target is currently 0.1 per cent, that would mean a dozen rate hikes over the next year-and-a-half.

Markets are expecting the RBA to hike Australia's cash rate aggressively. (Refinitiv)

Whether the US economy falls into recession or not, Australia has its own problems to deal with.

The Reserve Bank recently forecast that if it were to lift rates by 2 per cent, property prices could drop by a massive 15 per cent.

A fall of that magnitude would certainly make consumers feel a lot poorer – causing them to cut back on spending, and therefore slowing down the economy.

"I think there's a pretty decent chance of Australia going into recession," said Angus Coote, co-founder of Jamieson Coote Bonds. "One of the things that certainly worries me about the Australian economy is that we've got a tremendous amount of people that wisely took out fixed rate loans at very low interest rates, sub-2 per cent. Now those two-year fixed rate mortgages are going to be rolling off into much higher interest rates by the fourth quarter of next year, and you're going see a margin squeeze on the household sector."

That's why some economists believe the RBA will only hike rates gradually (compared to the US, New Zealand, Canada and many other central banks).

However, the danger is if the RBA does not hike rates quickly enough, inflation could surge even higher, especially as the Australian dollar sinks.

If that situation were to arise, Australia's central bank might have to follow the US's lead, by hiking rates aggressively – risking a "hard landing" and another economic downturn.

How to Survive a Recession and Thrive Afterward

In early 2000, a five-year-old online bookseller called Amazon.com sold $672 million in convertible bonds to shore up its financial position. One month later, the dot-com bubble burst.

More than half of all digital start-ups went out of business over the next few years—including lots of Amazon’s then-rivals in e-commerce. Had the bubble burst just a few weeks earlier, one of the most successful companies ever might have fallen victim to that recession.

Recessions—defined as two consecutive quarters of negative economic growth—can be caused by economic shocks (such as a spike in oil prices), financial panics (like the one that preceded the Great Recession), rapid changes in economic expectations (the so-called “animal spirits” described by John Maynard Keynes; this is what caused the dot-com bubble to burst), or some combination of the three. Most firms suffer during a recession, primarily because demand (and revenue) falls and uncertainty about the future increases. But research shows that there are ways to mitigate the damage.

In their 2010 HBR article “Roaring Out of Recession,” Ranjay Gulati, Nitin Nohria, and Franz Wohlgezogen found that during the recessions of 1980, 1990, and 2000, 17% of the 4,700 public companies they studied fared particularly badly: They went bankrupt, went private, or were acquired. But just as striking, 9% of the companies didn’t simply recover in the three years after a recession—they flourished, outperforming competitors by at least 10% in sales and profits growth. A more recent analysis by Bain using data from the Great Recession reinforced that finding. The top 10% of companies in Bain’s analysis saw their earnings climb steadily throughout the period and continue to rise afterward. A third study, by McKinsey, found similar results.

The difference maker was preparation. Among the companies that stagnated in the aftermath of the Great Recession, “few made contingency plans or thought through alternative scenarios,” according to the Bain report. “When the downturn hit, they switched to survival mode, making deep cuts and reacting defensively.” Many of the companies that merely limp through a recession are slower to recover and never really catch up.

Decentralized firms were better able to adjust to changing conditions

How should a company prepare in advance of a recession and what moves should it make when one hits? Research and case studies examining the Great Recession shed light on those questions.

In some cases, they cement conventional wisdom; in others, they challenge it. Some of the most interesting findings deal with four areas: debt, decision making, workforce management, and digital transformation.

The underlying message across all areas is that recessions are a high-pressure exercise in change management, and to navigate one successfully, a company needs to be flexible and ready to adjust.

Deleverage Before a Downturn

Rebecca Henderson (of Harvard Business School) likes to remind her students, “Rule one is: Don’t crash the company.”

That means, first and foremost, don’t run out of money. Because a recession usually brings lower sales and therefore less cash to fund operations, surviving a downturn requires deft financial management.

If Amazon hadn’t raised all that money prior to the dot-com bust, its options would have been much more limited. Instead, it was able to absorb losses in its investments in other start-ups and also launch Amazon Marketplace, its platform for third-party sellers, later that year. It further expanded during and after the recession into new segments (kitchens, travel, and apparel) and markets (Canada).

Companies with high levels of debt are especially vulnerable during a recession, studies show. In a 2017 study, Xavier Giroud (of MIT’s Sloan School of Management) and Holger Mueller (of NYU’s Stern School of Business) looked at the relationship between business closures and associated unemployment and falling housing prices in various U.S. counties. Overall, the more housing prices declined, the more consumer demand fell, driving increased business closures and higher unemployment. But the researchers found that this effect was most pronounced among companies with the highest levels of debt. They divided up companies on the basis of whether they became more or less leveraged in the run-up to the recession, as measured by the change in their debt-to-assets ratio. The vast majority of businesses that shuttered because of falling demand were highly leveraged.

“The more debt you have, the more cash you need to make your interest and principal payment,” Mueller explains. When a recession hits and less cash is coming in the door, “it puts you at risk of defaulting.”

To keep up with payments, companies with more debt are forced to cut costs more aggressively, often through layoffs. These deep cuts can impair their productivity and ability to fund new investments. Leverage effectively limits companies’ options, forcing their hand and leaving them little room to act opportunistically.

The extent to which high levels of debt pose a risk during a recession depends on various factors. Shai Bernstein (of the Stanford Graduate School of Business), Josh Lerner (of Harvard Business School), and Filippo Mezzanotti (of Northwestern University’s Kellogg School of Management) have found that companies owned by private equity firms—which often require the companies they finance to take on debt—fared better during the Great Recession than similarly leveraged non-PE-owned firms. Companies with lots of debt struggle in part because access to capital slows to a trickle during a downturn. PE-backed firms emerged in better shape, the study suggests, because their owners were able to help them raise capital when they needed it. Issuing equity is another way companies can avoid the burden of debt obligations. “If you issue equity in the run-up to a recession,” Mueller says, “the problem of defaulting will be less pronounced.”

The reality, of course, is that many companies have some level of debt going into a recession. Mueller’s study found that the average debt-to-assets ratio among firms that had increased debt levels in the run-up to the Great Recession was 38.3%. Among the group that had deleveraged, it was 19.5%.

Although there’s no magic number, modest levels of debt aren’t necessarily a problem, research shows. Nonetheless, Mueller suggests that if a company thinks a recession is coming, it should consider deleveraging. McKinsey’s recent recession research supports this: Firms that emerged in better shape from the Great Recession had reduced their leverage more dramatically from 2007 to 2011 than had less successful ones.

When it comes to deleveraging, it helps to start early, says McKinsey’s Mihir Mysore. That means reducing debt levels before it’s clear the economy is in recession. “You need to take a hard look at your portfolio,” Mysore advises, because shedding assets can be a way to reduce leverage without necessarily cutting core aspects of operations.

We shall wait and see...