Managing Volatile Times

Sunday, April 1, 2012 - 12:30

As the world teeters on economic chaos, business leaders need to plan ahead to weather the storm. Leon Gettler reports.

The new hyper unpredictability of uncertain times and a shaky global economy has been reflected in the Australian stock market. It defied the predictions of market commentators, who at the beginning of 2011 predicted the Australian stock market would put in a strong performance. Commentators were gob-smacked by the volatility.

CommSec economist Craig James, who has seen many turbulent times in the market, was taken aback by the global anguish caused by the GFC and the speed at which it happened. No one, he says, was expecting it.

"It shows what can happen in the interconnectedness of the global markets,'' James says.

"The speed this time around was a whole lot quicker in terms of the events and the way they affected each day.

"Nowadays, financial markets won't give you an inch. Unless you act quickly, you will have a mess on your hands."

In an interview with Bloomberg, Morgan Stanley's Asia chairman Tom Keene gave a blunt assessment of the volatility. "Over the last 25 years, we had an average of one crisis every three years.

"The gap this time is 18 months. The scale is bigger. And now we have product contagion from subprime to mortgage-backed securities, back to cross-border contagion within the eurozone. This interplay between cross-border and cross-product contagion is very difficult to unravel."

With Europe teetering on the brink of deep recession and indications China's economy may also be slowing, commentators expect the volatility to continue. Stock markets worldwide are gyrating; consumer and business confidence is down; industries such as retailing are being hit by seismic structural changes; and there is political uncertainty about issues such as the NBN and carbon tax.

Added to that is the basket case, otherwise known as the eurozone; the likelihood of more bailouts and possible defaults; the US credit rating getting downgraded; and shaky US economic fundamentals.

Future Fund chairman David Murray told reporters this level of volatility is likely to continue for at least 20 years.

Debt levels worldwide, he says, will not be resolved in weeks, months or even years. He says investors should be conservative. The same would probably apply to managers.

Economic drivers of volatility include global competition, unpredictable capital markets and rapidly evolving business models. But other sources of instability come from areas far outside economics: government regulation and deregulation, undisciplined government spending, political risk, disruptive technologies, new media, the effects of the 24-hour news cycle, energy shocks, terrorism, political upheaval in developing countries, and so on.

Banks are right at the centre of this volatility and their ability to withstand financial shocks will be put to the test by the International Monetary Fund (IMF), which has announced Australia will be one of 18 countries it will target this year amid fears Europe's sovereign debt crisis could cause a repeat of the 2008 meltdown of global markets. The IMF says Australia was included in the first lot of countries to face increased scrutiny because of its large and interconnected financial sector.

Relatively speaking, Australia's banks have shown better risk management than their overseas counterparts. They have little exposure to Europe, with government bonds from the nations most at risk of default - Greece, Ireland, Italy, Portugal and Spain - accounting for only 0.2 per cent of Australian bank assets.

Australia also has limited trade exposure to Europe with only 4 per cent of Australian merchandise exports going to eurozone countries.

Furthermore, Australian banks moved to control bad debts earlier than most and Guy Debelle, assistant governor of the Reserve Bank of Australia, has said Australian banks' funding structures are "considerably more resilient to periods of stressed markets than they were previously". Still, there will inevitably be a spillover from Europe's volatility.

Australian banks are now under pressure. In December, Standard & Poor's downgraded the four big banks one notch to AA-minus, the fourth-highest credit rating on S&P's scale.

The second big ratings agency, Moody's, has warned Australia's banking system faces "crucial challenges" over the coming year, saying global investors might shun the banks as funding costs climb and the world economy slows.

Moody's has warned the health of the system likely hinges on "how severe and how protracted any contagion from the European sovereign crisis may be".

Australian banks are raising interest rates independent of the RBA to both protect their margins and credit ratings.

That is effective management in the face of volatility and doing the groundwork to withstand the shock waves. Furthermore, Australian banks still have a rating higher than European banks which have been downgraded to A-plus. Australian banks are a good example of managing volatility.

By keeping exposure to Europe and the US subprime market low, they have prepared for the worst-case scenarios.

This in itself is challenging management models. Traditionally, management was about continuous improvement, outsourcing, cost-cutting and managing budgets. The aim was to leave the organisation faster and more efficient. This has not changed.

But now there is a greater focus on management innovation. Managers now need to watch trends closely so the organisation is not swept away. It's about catching the next wave. This is a big challenge for managers. They can price risk, but pricing uncertainty and volatility is more difficult. Douglas Dow, an associate professor of business strategy at Melbourne Business School, says managers should get used to the volatility because they can't avoid it. He says they need to consolidate during stable periods, but plan for constant change and creative destruction by watching market trends.

"Some people say companies need to be in constant change, but the problem is human beings don't deal with constant change that well,'' Dow says.

"You can't co-ordinate. You can't be in a constant state of change, you would have a dysfunctional organisation unless it's just an organisation of two people.

"It's almost a game of leap frogging. Once a firm gets into a strong position, they would want to resist change for good reason. So they have got to look for these periods of stability, but keep an eye on how long they can maintain that to see when they should jump."

Companies should have scenario-mapping teams that report to the board and work with suppliers and customers to identify potential threats.

Twenty-first century risk-management is not about predicting the future. It is about systems and relationships that create an organisation agile enough to withstand volatility and respond appropriately. Twenty-first century management is about creating organisations more prepared for the unpredictable.

Be aware, be prepared

In his latest book, Great by Choice (Random House, 2011), management writer Jim Collins joins co-author Morten T. Hansen, a management professor at the University of California in Berkeley, in saying volatility has always been with us, it's not a 21st-century phenomena.

"The premise behind this work is that instability is chronic, uncertainty is permanent, change is accelerating, disruption is common and we can neither predict nor govern events,'' they wrote. "We believe there will be no 'new normal'." There will only be a continuous series of "not normal" times.

The writers identify that resilient companies have certain traits in the face of volatility. Successful leaders and managers are not necessarily great visionaries, but figure out what works, why it works and build on those foundations.

They have a fanatical discipline, do the research and groundwork first, rather than leaping into action and have what the writers call "productive paranoia" where they examine all possible dangers, and prepare themselves.

As the writers note: "Whether we prevail or fail, endure or die, depends more upon what we do than on what the world does to us."