I've got to say the global outlook seems rather bleak. Are we heading towards another "perfect storm"?
Fears of a repeat of the global financial crisis we witnessed in 2008 continue to dominate markets amid concerns of the EU contagion spreading, continued US slowdown and a worse than expected slowdown in China and the rest of Asia. In the short term, we expect most corporates and financial institutions to brace themselves for continued volatility and uncertainty. The additional challenge of Basel III capital and return implications for banks and consequential cost implications flowing to the broader credit markets are also going to be a key consideration in the next couple of years.
A McKinsey & Company report estimates that based on second quarter 2010 balance sheets, by 2019 the banking sector in Europe will need about €1.1 trillion of additional tier-1 capital and US Banks will need an additional $870 billion. While most rated Asia-Pacific banks are in a better position to meet the higher capital requirements under Basel III, high-growth banking systems such as China, India and Indonesia, may face pressure to replenish capital.
Having said this, there are key differences between these current times and 2008. Firstly, banks on average are holding a third more capital than they did in 2007. And unlike sovereigns, corporations today have stronger balance sheets than they did back in 2007. Liquidity levels are much higher, leverage levels are relatively low and corporate earnings have improved since 2008. Many companies have kept their employment levels flat, so these improvements in margins are the direct result of improvements in productivity. In general, corporate fundamentals are stronger; companies are better positioned today than they were at the start of the crisis and many have solid cash reserves.
What should CEOs and CFOs be focusing on now to brace for the troubles ahead?
Corporate executives need to increasingly manage capital decisions and deliver growth, whilst dealing with increased volatility and finding ways to fund new investment opportunities. They also need to proactively design financial policies, manage investor expectations and take actions that accommodate longer recovery periods and deeper equity declines. Given the current bearish economic outlook, risk aversion continues to increase and corporates should expect tightening liquidity in credit markets, increasing risk premium in general with an increasing flight to quality bias. Effective liquidity planning is critical; an optimal capital structure with the right balance between leverage and free cash flow can provide flexibility in volatile markets.
What can corporations do to optimise their capital structures and to stay ahead in these uncertain times?
Firstly, continued focus on liquidity management is essential. Corporate executives need to examine their liquidity positions, pay close attention to the covenants, and ensure that there is an adequate buffer after incorporating high volatility scenarios into their liquidity stress testing. They also need a forward looking approach in reviewing their cash flow estimates, taking into account lower growth projections and the plethora of probability adjusted downside scenarios in their own businesses.
Secondly, corporate executives should evaluate their liability structures. For example, they can extend the debt maturity profile through early refinancing, extension trades and opportunistic funding.
Are you advocating the bond market right now?
With corporate bond yields at an all-time low, one of the ways they can stay ahead is by being opportunistic in accessing the debt markets. CFOs could also consider hybrid-capital or convertible bonds, where pricing is more favourable during periods of high volatility. They should focus on all-in yields, rather than spreads over historically low Treasuries.