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The Years Ahead

The Years Ahead

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Published by Roy Tanner
Boston Consulting Group considers four scenarios going into 2012, and addresses what can be done to prepare
Boston Consulting Group considers four scenarios going into 2012, and addresses what can be done to prepare

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Published by: Roy Tanner on Jan 08, 2012
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CollateralDamage
WhatNext?WhereNext?
WhattoExpectandHowtoPrepare
DavidRhodesandDanielStelter
January2012
 
TheYear(s)Ahead
Astheygointo2012,businessleadersneedtoprepareforadifficultyear,andperhapsforseveraldifficultyears.Theyshouldconsideratleastfourscenarios:
 
SuccessfulMuddlingThrough.
Governmentsandpoliticianspartlyaddressglobalimbalances,generatemoderateinflation,restructuredebtwherenecessary,andstabilizetheeurozoneandthefinancialsystem.Furtherrecessionisavoided;theWestexperiencesalongperiodoflowgrowthanddeleveraging,whileemergingmarketsreorienttheireconomiestowardmoredomesticconsumption—andtherebyenjoycontinuedreasonablegrowth.
 
RecessionwithDeflationaryPressure(“Japan”).
Muddlingthroughcouldeasilyfail.TheOECDalreadysaysthatthereisasignificantriskofrecessionin2012.Thiswouldincreasethepressureondebtors,leadingtoevenlowerdemandandsotomoreausteritymeasures.SuchascenariocouldreplicatetheJapaneseexperienceofthelasttwodecades,butthistimeitwouldaffect41percentofworldGDP.
 
SignificantInflation.
Thelongertheeconomyremainsinrecessionandthemorecentralbankstrytosupporttheprocessofdeleveragingwithaggressivemonetarypolicies,thehighertheinflationrisk.Sofar,monetaryeasinghasindirectlyeffectedinflation(throughhighercommodityprices).Iftheeconomystartstorecoverorthepublicstartstolosetrustinmoney,wecouldseeasuddenspikeininflation.Evenrelativelymoderateinflationof5to10percentwouldhavesignificantimplicationsforcompanies.(See
WhyCompaniesShouldPrepareforInflation,
BCGFocus,November2010.)
 
BreakupoftheEuroZone.
Giventhesignificantdownsiderisks,companyleadersneedtoaddressthisscenario,too,takingsensibleprecautionarymeasurestoprepareforsuchaneventuality.
WhatShouldCompaniesDotoPrepare?
ACEOrecentlysaidtous:“Itwouldbeverysurprisingifanywell-runcompanywerenotpreparingitselffortheworstscenarios,howeverremotethoseeventrisksmaybe.”Sowhatexactlydoesthatmean?Let’slookatarangeofscenarios.
Scenario1:Japan.
IftheexperienceofJapan—whichbenefitedfromstrongexportsinaboomingworldeconomy—wasrepeated,wewouldfaceaprolongedrecessionandaveryslowrecoverythatcouldtakeyearstorebound.Today,thiswouldrequirethecombinedfast-growingbutstillsmallereconomiesofAsiatotakeuptheburden.Butconsumptioninthedevelopedworldisstillfourtimesgreaterthanintherapidlyemergingeconomiesoftheeast.Economicallyandsocially,wewouldseethefollowing:
 
Acontinuedbalance-sheetrecessionwithlow(orevenzero)interestratesandamassiveoversupplyofmoney.Inthosecountriesstillenjoyingtrustinfinancialmarkets,wewouldseeincreasinggovernmentdebt.Monetarypolicyloseseffectivenessinadeleveragingworld—asJapan’slongstandinginabilitytopreventpricesfromfallingshows.
 
Fallingpriceswouldincreasetherealburdenofalldebts,leadingtoaviciouscycleofdeleveragingandeconomiccontraction.
 
This,inturn,wouldcausemanybusinesses,factories,andsupportingsectorstoclose,resultinginrisingunemploymentandfallinglivingstandards.
 
Increasedsocialtensions,politicalradicalization,andprotectionism.TherewouldbemanyimplicationsforcompaniesifaJapan-styleLostDecadetookhold:
 
Manysectorshavealreadyexperiencedfallingpricesduetoincreasinglaborproductivity,competitionfromemerging-marketplayers,andtechnologicalprogress.However,moresustained,morewidespread,andstrongerpricedeclinesposeadditionalchallengesbecauseconsumersdelayspendinginanticipationofevengreaterbargainslater,leadingtoweakconsumptionandslidingprices.
 
Corporateprofitswouldsuffer,especiallyifcostswerenotreducedinlinewithfallingprices.Adeflationaryworldisoneofsingle-digitearningsgrowthandmeagerstock-marketreturns.
 
Liabilities(borrowings)wouldincreaseinrealtermswhilethevalueofassets,includinginventories,woulddecline.
 
Theproblemofexcesscapacityandsupplyofallkindsofgoodswouldbeaggravatedasemergingmarketsdevotedmoreresourcestobuildingupexportindustries.
 
 
Businessandpersonalbankruptciescouldsoarasdebtburdensbecameincreasinglyonerous.
 
Lessvulnerablefirmswouldnotbeimmune,forexample,ifcriticalsupplierswentoutofbusiness,disruptingthevaluechain,orifbigcustomerswentbankrupt,therebycrystallizingcreditrisk.
 
Possibleincreasedprotectionismcoulddisruptsupplychainsandimpaircompetition.Insuchascenario,managementshouldemphasizecostsandefficiency,whilelookingforgrowthopportunitiesinemergingmarketsandthroughinnovation:
 
Buildasustainablecostadvantage.
Whenpricesgodown,acompanymustensurethatitscostsgodownaswell(relativetocompetitors,thatis).Theyneedtoreassesstheircostbasefromscratch.It’snotenoughtomakeacross-the-boardcuts;whatisneededisathoroughreengineeringofthecostbasethroughouttheentirevaluechain.SomeJapanesecompanieshavebeenabletoslashcosts—andthereforeprices—byasmuchas50percent.
 
Rigorouslymanagepricing.
Besidessimplyloweringcostsandprices,companiesneedtounderstandthewaysinwhichdeflationchangesconsumerpsychology—andbefarmoresophisticatedinsettingprices.Forexample,acompanycanreduceperceivedpricesbysimultaneouslydecreasingpricesthroughsmallerpackagesizes,unbundlingproductsandservicesinordertoofferthelowestpossiblebaseprice,attractingcustomerswithaninitiallowofferandfollowingupwithadditionalservicesandfeatures,settingpricestomitigatecustomerriskoruncertainty,orcouplingpriceincreaseswithanincreasednumberofdiscounts.
 
Reengineerthepricingfunction.
Atmostcompanies,thereisconsiderablepricingvolatilityandleakageviadiscounting.Ingeneral,pricingdecisionsaretoodecentralized—andsalespeoplehavetoomuchautonomyincuttingspecialdeals.Instead,companiesneedtomanagepricingmorecentrally,inanintegrated,end-to-endfashion,ratherthaninthesiloedmannerthatistypicaltoday.Considerappointingachiefpricingofficer.
 
Focusoninnovation.
Fundamentalinnovationswillbethefoundationofnewindustries,whichwillgeneratemoregrowthinthefuture.Andeveninthetoughesttimes,innovationhelpsdifferentiateandattractcustomers.Thiswastrueinthe1930s,inJapansince1990,andalsoduringtherecessionof2009.CompaniesshouldthereforerelativelyoverinvestinR&D(anapproachsupportedbymanyinvestorstoday).Companiescanalsofightpricedeclinesbycreatingnewcustomerneedsandservingthemwithnewproductsandservices.JustlookatApple.
 
Lookfornewgrowthoptionsbeyondthehomemarket.
Inordertoavoidthe“toplinecliff”ifdomesticdemanddeclinesonthebackofdeflation,lookforgrowthoptionsabroad,especiallyinemergingmarkets—organicallyorbyacquisition.Ofcourse,sowillmanyofyourcompetitors.Thekeyistoactdecisivelyandaggressively.
 
Makedecisivemovesthatchangethegame.
Inadditiontobettermanagementofbothcostsandprices,companiesshouldbeconsideringboldstrategicmovestofightdeflationaryheadwinds.Justasthebesttimetoinvestinthestockmarketcanbeduringadownturn,adeflationaryenvironmentmaybethebesttimetomakeaggressivecorporateinvestments.Thinkaboutacquiringastrugglingcompetitorinordertoconsolidatetheindustryandtherebyprotectpricesandmarginsinthecorebusiness.Alternatively,investinmarketinginnovationtomaintaincurrentpricepoints.
Scenario2:Inflation.
Manybusinessleadersunderestimatetheimplicationsofinflationinthebeliefthatdeflationwouldbemuchworse.Inourview—andastheexperienceofJapanshows—milddeflation,althoughunwelcome,canbedealtwithrelativelyeasily.Inflation,ontheotherhand,hasasignificantimpactonprofitabilityandfree-cashflow.Inaddition,mostoftoday’smanagershavehadnoexperiencewithinflation.Inthefollowingparagraphs,wesummarizewhatwehavesaidpreviouslyaboutrespondingtoinflation.
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Seniorexecutivesshouldstartnowtothinkthroughtheconsequencesofinflationfortheirbusiness,tounderstandtheircompany’sexposure,andtoprepareforaninflationaryscenariothatmaymaterializesoonerthantheyexpect.Therearethreebasicsteps.First,assessthepotentialimpactofinflationonyourcompany’sprofit-and-lossstatement.Whetheracompanycanavoidseeingitsprofitsseverelyharmedbyinflationdependsontwofactors:thedegreetowhichitcanlimitpriceincreasesbyitssuppliersandthedegreetowhichitcanimposepriceincreasesonitscustomers.It’snotenoughtoknowyourownexposuretoinflation;youmustknowtheexposureofyoursuppliersandcustomersaswell.Soreviewthedesignofyourcompany’scontracts,estimatethepricesensitivityofkeycustomers,andanalyzethebalanceofpowerintheindustrytodeterminewhoislikelytobeabletoimposethecostsofinflationonothers.Theintensityofcompetitionandyourcompetitivepositionwillgreatlyinfluencetheimpactofpricingdecisions,sothesefactorsmustalsobeassessed.

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