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Monthly Economic Letter

October 2019
Feature article

How to prepare your business for a slowing economy

The global economy is showing the effects of more than a year of intense trade conflict and many economists are predicting more trouble ahead.

Already, economic growth has slowed in Canada as it has in the United States, Europe, China and India. Forecasters have shifted their global growth outlook downward over the past few months as uncertainty weighs on global trade and investment.

The International Monetary Fund revised its estimate for global growth to 3.0% for this year—the slowest pace since 2009, and a downward revision to U.S. growth was a significant factor. The U.S. economy is likely to grow 2.4%, down from 2.6% in July.

Canada’s economy is expected to grow by just 1.5% this year and 1.7% next year.

During the first half of 2019, growth in consumer spending slowed to 1.6% and business investment contracted by 3.6%. Although, export growth of 2.5% carried the economy during the period, that momentum is unlikely to be sustained as foreign demand for Canada’s exports is expected to decelerate.

In this slowing economy, what should you do as an entrepreneur to increase the odds your business will not only survive the downturn but thrive?

Act before your business starts to weaken

Often entrepreneurs wait until revenues start to fall before taking steps to shore up their business. It’s best to get ahead of the curve by acting now in the following four areas.

  • Improve your operational efficiency.
  • Diversify your sources of revenue and your suppliers.
  • Take care of your financing needs.
  • Keep your employees engageds.

Improve your operational efficiency

There are three critical steps to improving your operational efficiency. The first is to benchmark your performance against competitors. Use key performance indicators. Audit your processes and determine how you measure up. The next step is to eliminate waste—anything that does not add value for your customers. Some common areas to consider are:

  • Inventory—Manage your inventory such that you have enough on hand to meet short-term sales or produce based on customer demand.
  • Over-processing—Consider how many people are involved in an activity, and whether they are all needed.
  • Over-production—Ensure your employees are producing what is needed when.
  • Downtime—Is everyone working at full potential? Or are there bottlenecks building up as people wait for approvals or parts?

Lastly, monitor and manage your performance with dashboards and regular meetings.

By cutting waste and continuing to monitor your performance, you’ll increase productivity and profits, and be in a better position to handle a slowdown. BDC offers many valuable tips here.

Diversify your customer base

When a client represents 20% or more of your revenues, you face client concentration risk. Having too few clients leaves you vulnerable to seeing your business devastated if you lose a big one. Even if you don’t lose a major client, dependency leaves you with less leverage to negotiate, especially in a downturn.

A BDC study found the most diversified companies—in terms of number of clients, product lines or geography—experienced by far the fastest growth in revenues and profits. Even businesses with a modest degree of diversification were more likely to have stronger revenue growth than undiversified companies.

However, about 30% of Canadian firms concentrate their business with just one or two partners, a much higher share than firms in other countries, according to the Organization for Economic Cooperation and Development.

…and your supplier base

Just as you should diversify your sources of revenue because you never know when a customer may disappear, you should also purchase your inputs from multiple sources. By diversifying your suppliers, you reduce the risk of disruptions and encourage competition on price and quality. What’s more, research shows that when you broaden your supplier base to include diverse and inclusive firms, you’ll get a much higher return on investment—133% higher, according to the consulting firm Hackett Group.

Secure long-term financing now

During recessions banks contract credit. In the great financial crisis, many firms were caught without enough access to credit. It took time to rebuild their balance sheets. And banks disbursed credit at a slower pace until the financial situation of businesses improved.

While it’s important to maintain a prudent level of debt, it’s a good policy to act early to secure long-term financing for your future projects. Currently, credit conditions remain quite favourable with the latest survey by the Bank of Canada showing lending conditions as positive for borrowers, especially in regions outside of the Prairies.

And remember if you do get into difficulty, be up front with your banker. Seek expert advice to develop a restructuring plan and rearrange your financing. For more tips on restructuring, check out this article, featuring one of BDC’s top bankers.

Keep your employees engaged

As always, you want to have your employees working to their full potential. But in a downturn, this is even more critical. To keep up morale, productivity and loyalty among your employees, your best bet is to have an innovative human resources management plan in place.

After you’ve ensured all the processes are working efficiently, you’ll want to ensure that each employee is doing value-added work. Identify the skills that people need for each position and be sure the right people are in the right jobs.

A downturn could be the right time to provide your employees with training and development opportunities to keep their skills up to date so they are ready when things pick up. But it might also make sense to let some of your poor performers go.

For the people you retain, recognize their work to keep them motivated.

Engaged employees will be more likely to pitch in and help find solutions during a downturn because they share a common sense of purpose. And when the economy improves, you won’t need to recruit.

Overall, having an innovative HR plan is a cost-saver because you will retain institutional knowledge, increase productivity and reduce recruitment costs.

Learn more about human resources best practices in this BDC report and how to create an effective HR plan here.

Bottom line

The slowdown is here. If you aren’t already prepared, there’s no time like the present to act.

Canadian economy at a glance

Slower growth ahead amid weakening consumer and business spending

Much like the rest of the world, Canada’s economy is slowing down. While last quarter’s data showed strong growth, it was driven by exports, not domestic demand.

Instead, domestic demand—that is, households’ and governments’ consumption plus business investment—contracted. Lower household spending and shrinking business investment were the culprits.

Slower consumer spending despite rising incomes

Consumer spending slowed to a pace of 1.6% in the first half of this year—about one percentage point lower than the historical average. And households didn’t seem to be in the mood to shop in July (the last data point for which data is available) either as real retail sales were flat compared to a year ago.

The slowdown in consumer spending contrasts with the improvement in household income, which grew by 4.5% compared to a year ago. Households chose to save more rather than spend. But there is another factor, debt service costs are eating into disposable income.

Debt service costs—the combination of principal repayments and interest expenses as a share of disposable income—have reached an all-time high in Canada of 14.9%. That means for the average Canadian, out of every $100 in disposable income, $14.93 goes to pay debt. The reason debt service has risen so dramatically is because the level of household debt is very high, and interest rates moved up quickly over a relatively short period.

Rising house prices unlikely to perk up consumer spending

The housing market has picked up in several cities. Resale activity has been increasing since March. And in August, the average Canadian house price was up 3.5% compared to a year ago, according to the Canadian Real Estate Association. The reduction in household borrowing rates since March as well as the Bank of Canada’s decision to lower the minimum mortgage qualifying rate from 5.34% to 5.19% in July is helping home buyers.

The improvement in house prices spurred an increase in new dwellings and renovations in the second quarter. And housing starts and residential building permits picked up in July and August. However, it will take some time for the construction sector to return to the strong growth seen a couple of years ago.

Also, it is doubtful that the pickup in house prices will translate into an improvement in consumer spending in the short term. The “wealth effect”—the notion that you feel wealthier and are more inclined to spend when your assets appreciate on paper—usually doesn’t translate into a pickup in consumer spending until two years later, according to Bank of Canada research.

Overall, household consumption is likely to remain subdued, and retailers are likely to continue having a tough go selling their goods and services.

Exports slowing down

While exports propelled growth in the second quarter, it seems unlikely they will continue to post such strong results. Energy and metals products have been doing well, but industrial products—chemicals, rubber, machinery—and consumer goods appear to be slowing. Slower global growth is a risk for Canada’s exports.

Bank of Canada expected to hold steady

With inflation just below target—at 1.9% in August—the Bank of Canada is likely to keep its policy rate at 1.75%. As noted in last month’s article, the Bank is weighing high household debt against a global slowdown. Should the bank perceive that global downside risks are outweighing concerns about high household debt, it may decide to lower rates, but probably not before the end of the year.

What does it mean for entrepreneurs?

  1. Consumers are likely to continue to slow their purchases of big-ticket items, so retailers may need to enhance the value of their product offering to make these sales.
  2. Uncertainty is unlikely to go away anytime soon. Check out this month’s lead article on tips to handle a slowdown.
  3. The construction sector is slowly improving, which should provide support to related industries, such as lumber manufacturers and building supplies wholesalers.
U.S. economy at a glance

Lower interest rates support the American economy

Faced with a slowing economy and concerns the trade war with China could take an even a greater toll, the Federal Reserve took out some insurance. It lowered its key interest rate twice this summer to 2% from 2.5%. GDP growth was 2% in the second quarter as lower investment was a brake on the economy.

Lower interest rates helping the housing market

From December 2015 to December 2018, the U.S. Federal Reserve raised its policy rate 2.25%. This clearly had an impact on the housing sector. Investment in residential housing contracted over the past six quarters.

However, the recent interest rates cuts appear to be helping the sector. Housing starts increased by 12% in August, compared to July, hitting their pre-crisis level for the first time in over a decade. Housing permits were also 8% higher than the July reading.

Lower interest rates may help business investment

The recent contraction in business investment was due largely to lower spending in the oil and gas sector. By contrast, equipment purchases and investment in research and software continued to grow.

Last year, investment in oil and gas was strong. It accounted for over a quarter of the growth in business investment according to the Federal Reserve Bank of Dallas. Back then, investment made sense with oil prices averaging US$67 a barrel in the first nine months of 2018.

This year, however, oil prices have been trading roughly US$10 a barrel lower. The break-even price that producers need to profitably drill wells is between US$48 and US$54 a barrel, according to a survey by the Federal Reserve Bank of Dallas. With the price of West Texas Intermediate trading around US$57 a barrel, the pull back in investment is not surprising.

Although the decline in business investment can be attributed in part to lower oil prices, the cost of capital also increased during this period, pushing companies to rein in investment spending. Oil and gas firms have been increasingly pressured by investors to generate cash. Whether the Federal Reserve’s interest rate cuts will be enough to stimulate more investment in the sector or allow for a higher return on invested capital remains to be seen.

Interest rate cuts could help confidence

As the trade war with China deepens and resolution appears a dim possibility, U.S. business confidence continues to slide lower. According to the Organization for Economic Cooperation and Development’s index, U.S. business confidence has dropped every month for the past year. Uncertainty regarding tariffs and the impact they are having on supply chains are creating havoc for businesses, especially in the manufacturing sector.

According to the Conference Board’s index, consumer confidence dropped nine points in September. New tariffs on consumer goods came into effect on October 15 and more are expected on December 1. They will likely hit consumer confidence again.

Job market slowing

With historically low unemployment rates across most of the country, net job creation has been slowing, from about 200,000 a month on average between 2012 to 2018, to 160,000 so far this year, but still above the level needed for growth.

Job creation in the manufacturing sector though has seen a big decline, slowing to just 16,000 a month this year, from an average monthly pace of 52,000 last year. Service sector job growth has slowed as well, but not as dramatically.

The trade war may be responsible for the weaker job growth in the manufacturing sector. As companies pivot operations away from China and toward other markets, such as India, Bangladesh and Viet Nam, manufacturing activity may need to pause until new locations are established.

Overall the U.S. economy is slowing down, but it’s still not near a recession. The market is pricing in at least one more interest rate cut by December, given the unresolved trade war with China and the impact it’s having on the manufacturing sector.

What does it mean for entrepreneurs?

  1. Despite a slowing economy, the U.S. market continues to grow, and offers opportunities for Canadian exporters.
  2. The Canadian dollar’s depreciation against the greenback provides exporters with an advantage over other countries’ exports, many of which now face tariffs.
  3. Interest rates in the U.S. could fall lower over the next few months, meaning borrowing costs could drop further.
Oil market update

Oil markets weaken after a geopolitical shock

The recent attack on Saudi Arabia’s oil facilities spooked oil markets, sending prices sharply higher. Suddenly, the geopolitical risk premium had returned to oil prices after being absent for many months.

Since then, however, prices have fallen as weaker global demand weighs on the market.

The September 14 attacks on the world's largest oil refinery, Saudi Aramco’s Abqaiq, and Saudi Arabia’s second-largest oil field in Khurais, temporarily removed close to 6% of global oil supplies—5.7 million barrels a day (mb/d)—the equivalent of half of Saudi Arabia’s production.

Oil prices spiked on September 16 with Brent moving up nearly US$12 a barrel in intraday trading and ultimately closing the day up US$9 a barrel. The price of West Texas Intermediate closed US$8 a barrel higher and even Canada’s Western Canadian Select increased over US$6 a barrel.

The amount of oil removed from the market was the largest in recent history, exceeding the loss of output experienced in August 1990 when Iraq’s Saddam Hussein invaded Kuwait, and in 1979 during Iran’s Islamic Revolution, according to the International Energy Agency (IEA).

Saudis move to calm situation

Saudi Arabia’s oil minister attempted to calm the markets by saying oil production would be back to normal by the end of the month. In addition, he said that the country would meet all contracts by drawing on existing inventories and using crude from other fields.

Initially, markets were skeptical, and prices remained $3 to $5 a barrel higher than prior to the attack.

But by September 25, Saudi Arabia had returned its operations to full capacity—and prices subsequently fell. Currently, prices are trading below where they were before the attacks.

Weaker demand weighing on oil prices

Oil prices are dropping because demand is waning. Demand growth forecasts have been declining for the past few months as global economic growth weakens. The IEA forecasts oil demand growth will slow to 1 million barrels a day in 2019. But the U.S. Energy Information Administration is more pessimistic, anticipating just 0.9 million barrels a day for 2019.

An important source of oil demand comes from international trade—making goods in factories, transporting them overseas in ships and then by truck within countries. Global trade in goods has been slowing since last autumn, according to the Netherlands Bureau for Economic Policy Analysis.

The latest trade data are for July and, therefore, don’t reflect the most recent escalation in the U.S.-China trade war. U.S. tariffs were imposed on more goods—largely consumer products—in September and on October 15 duties on the initial US$250 billion slice of Chinese imports increased from 25% to 30%. These distortive taxes, which is effectively what a tariff is, will further slow global trade and growth.

Bottom line

Global oil prices are likely to fall further as global demand weakens.

Other economic indicators

The key rate likely to stay put

The Bank of Canada is expected to maintain its policy rate at 1.75% later this month. While the trade war between China and the United States poses a threat to the global economy, to date the impact on Canada has been limited. See September’s main article for more discussion.

The loonie is down slightly

The Canadian dollar appreciated less than 1% against the US dollar during the month of September. Slower global economic growth could threaten Canadian exports and put further pressure on the loonie.

Confidence declines slightly

SME owners' confidence declined slightly in September. The CFIB Business Barometer Index fell just over one point to 59.3, down 60.6. It is below the 60-point mark (an index level of between 65 and 70 means the economy is growing at its potential). The increase is broad-based, affecting 8 out of 10 provinces. The most optimistic provinces remain Quebec (68.8) and Nova Scotia (68.5) with each moving up by one point. Confidence of SME owners in the resource-heavy provinces (Newfoundland and Labrador, Alberta and Saskatchewan and British Columbia) weakened. In terms of industries, professional services, health and information sectors are above the national average, while transportation, agriculture, retail and construction are below.

Effective rates were stable in September

Interest rates for households and business remained relatively stable during the month, reflecting stability of the Bank of Canada’s policy rate and in Government of Canada 5-year bonds.

Key indicators—Canada

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