Nov 13 2019
While companies have the ability to control internal factors of their operations, they have little control over external factors such as supply shocks or trade wars. To be successful, businesses must make decisions with these risks in mind. Industry developments can significantly affect company operations, with exogenous economic or political factors typically driving change.
By following trends that pose potential threats to industry performance, companies can minimize losses in risky business environments. While companies typically tend to change their operations in favor of seeking growth opportunities or efficiency, the onset of an economic slowdown poses a question many businesses have not had to grapple with for some time: How can we effectively manage risk?
With the US economy firmly in the late-cycle phase of the business cycle, macroeconomic indicators are pointing toward a worsening economy. The Federal Reserve has a dual mandate to maintain full employment and steady inflation, with monetary policy being its primary tool to achieve these goals. Recently, however, inflation has failed to materialize, and previous expectations for interest rate hikes in 2019 have proved incorrect; the Federal Funds Rate has now been cut to a target of 1.75% to 2.0% following the Fed’s September meetings, the second such cut in 2019. This decision was an expected response to increasing uncertainty in the US and global economies, but it has done little to quell said uncertainty.
While shifting toward dovish policy is a potentially viable strategy for stimulating the economy, economic indicators have not reflected an accommodative business environment.
To maintain employment levels and continue to attract new talent, businesses have significantly increased wage levels, representing an increased cost for their bottom-lines. Additionally, construction spending, a typically leading indicator of business investment, has failed to materialize alongside the Fed’s interest rate cuts. Businesses tend to spend more on construction projects when they believe they would be profitable, so the current lack of investment could be a worrying sign. Furthermore, geopolitical tensions over trade relations with China have negatively affected international trade flows and financial market performance. These trends have coalesced into a spike in overall uncertainty for businesses, leading to even more speculation of market decline.
Short-term risk outlook
The economy’s shaky position is reflected by increasingly bleaker industry prospects, as risk has increased significantly with respect to the short-term outlook. In fact, the only sectors where total risk, a function of structural, growth and sensitivity risk components, has not increased are the Utilities (IBISWorld report 21) and Construction (report 23) sectors. While structural risk, the risk associated with operating conditions such as barriers to entry and competition, tends to shift gradually over time, growth and sensitivity risk are subject to greater change.
Although growth risk, the risk businesses face operating in industries with varying levels of demand growth, has contributed to the overall higher risk environment, sensitivity risk trends in particular have had the greatest impact on driving up industry risk ratings. Sensitivity risk is the risk associated with an industry’s sensitivity to macroeconomic indicators that are largely exogenous and uncontrollable by businesses, thus having considerable influence on performance. For instance, indicators such as the world price of crude oil, the world price of steel, consumer spending and domestic trips by US residents are all projected to trend negatively in 2020.
While these sensitivity risk trends affect many industries, their impact is heavily concentrated in certain sections of the economy. Durable goods manufacturing industries such as Automobile Engine & Parts Manufacturing (report 33631), for example, are expected to endure a heightened level of risk in 2020 than in 2019, as their operations are affected significantly by oil and steel prices. Both commodities have been subject to considerable geopolitical uncertainty, as disputes with Iran and steel tariffs, respectively, have ratcheted up the risk associated with these drivers.
Sensitivity risk is also amplified in the Accommodation & Food Services sector (report 72), as domestic travel and consumer spending are key to its demand growth but both are expected to decelerate. The effects of increasing risk can be tracked through supply chain linkages, as well; for instance, sensitivity risk in Refrigeration Equipment Wholesaling (report 42374) has increased significantly due to tougher conditions in a food services and drinking places, a subsector of the Accommodations & Food Services sector.
On the horizon
Amid these negative trends comes the increasingly likely chance of a recessionary period in the near future. Yield curve inversions, which represent short-term investment instruments yielding higher return rates compared with long-term counterparts, have historically been a reliable predictor of a looming recession within the subsequent 15 to 18 months. Yield curves have now inverted. As a result, now more than ever, prudent risk management is necessary to stave off the potential effects of such a recessionary period. Nationally, new regulations such as Current Expected Credit Loss (CECL) are being instituted to prevent an economic collapse akin to the Great Recession. While steps like this are being taken at the regulatory level to protect businesses and the overall economy from downside risk, it is crucial for businesses to act in a similar manner and incorporate proactive risk analysis into their decision-making process.
For more information on why industry risk matters and how IBISWorld can help you manage risk for your business, check out our Risk Rating System white paper on Industry Insider!
Edited by Kieran Newton, Lead Editor