By the most commonly used definition of a recession — a decline in gross domestic product (GDP) for two or more consecutive quarters — it's impossible to identify one until it's already begun. Be that as it may, those who toil near or inside the world of finance often prefer their own set of field-tested barometers when it comes to getting a read on the economy.
Spreads between various investments are increasing, indicating a likely recession, says James Hamilton, professor of economics at the University of California, San Diego. For instance, the spread between 30-day A2/P2 and AA nonfinancial commercial paper jumped from fewer than 20 to about 100 basis points between mid-2007 and early 2008, according to the Federal Reserve Bank. “The historical rules of thumb have changed,” Hamilton says. So, a treasurer who's used to borrowing at, for instance, 25 basis points over treasury notes may find this no longer doable.
The upshot? While it may take a few months to determine whether the economy has met the technical definition of a recession, it makes sense that treasurers act with the tightening economy in mind. As a starting point, given that credit is likely to remain constrained — according to the Federal Reserve's January survey of senior bank lending officers, about one-third of banks had tightened standards for firms with revenue of $50 million-plus — treasurers will want to maintain a healthy buffer of cash and cash equivalents, says Asha Bangalore, vice president with Northern Trust Global Economic Research, Chicago.
Already, many financial executives appear to be reordering their investment priorities, says Scott Horan, vice president and group product manager with PNC Financial Services Group. Until six months ago, treasurers were focused on yield, with liquidity and then safety at the bottom of the list. “Risk creep” occurred, with companies moving from, for example, money market funds to enhanced cash funds, which can include investments with longer maturities. “Now, safety is a high first,” Horan says. Corporate investors that had been invested in money market funds, for instance, now are shifting to treasuries.
Of course, no reasonable person is going to argue against safe short-term investments. However, a sort of “herd mentality” appears to be at work, with some organizations eliminating entire asset classes from their investment parameters, says Horan. Rather than move from one investment extreme to the other, treasurers and executive teams should step back and rethink their investment approach.
First up is identifying the organization's risk tolerance and its preferred investment vehicles. Next is considering investment styles. Does the company have the expertise and resources to actively manage all of its investments, or would it be better off turning over some of these responsibilities to an outside firm? At the same time, to reduce the risk that their firms belatedly find themselves exposed to securities that they wouldn't normally buy — such as subprime mortgages — treasurers need to “demand transparency in short-term investments,” Horan adds. Finally, the treasurer and CFO need to think through the way that they will monitor investments on an ongoing basis and regularly compare them to their company's investment policy and investment benchmarks.
Fortunately, the news isn't all doom and gloom. Businesses, as well as households, stand to benefit from the economic stimulus package assembled by Washington. The provision for “bonus depreciation” on investment expenditures allows businesses to accelerate depreciation, primarily on assets ordered and delivered during 2008, says John Sands, senior vice president with PNC Equipment Finance. The bonus depreciation means that less of a company's income will be subject to taxes.
While the bonus may provide the economy with a badly needed shot in the arm, on a longer-term basis, treasurers and other financial executives need to get back to basics. This means following their own investment policies and asking questions when they don't understand a potential investment. One reason that the credit markets have tightened, notes Horan, is that “the right questions weren't asked.”
Does the tightening economy mean that corporate financial jobs are likely to be at stake? So far, this doesn't appear to be the case, says Ellen Williams, senior client partner in the financial officers practice with Korn/Ferry International. “You don't need to fear for your lives,” Williams says, noting that she and her colleagues continue to work on filling top treasury and financial positions. Moreover, the placements have been for normal reasons, such as internal promotions.
This is not to say that no changes are under way, however. Treasurers can expect more scrutiny and a bit more pressure, as executives focus on successfully navigating the downturn. “We're moving to an environment where cash is king,” Williams says. This is likely to put treasury in the spotlight, offering opportunities to treasurers who can take a leadership role in working with other departments to most effectively manage their company's cash flows.