Weathering the financial market storm

2016 is off to a rocky start as concerns mount about international financial market stability. Dr Andrew Charlton discusses the factors expected to contribute to market volatility and considers how directors should respond to these challenges.

Fears are growing about the health of the global economy and the possibility of further market instability throughout 2016. Dr Andrew Charlton, co-founder of strategy and economics advisory business AlphaBeta, considers how directors should respond.             

Global stock markets have recorded their worst start to the year in living memory, with nearly three trillion dollars slashed from the value of equities around the world in the first few weeks of 2016.

Many Wall Street veterans are fond of the saying, “As goes January, so goes the year,” and while this old adage may sound glib, fears for continued volatility in 2016 are widely shared. According to a new survey from US bank, Wells Fargo, nearly 75 per cent of respondents expect market volatility to continue for much of 2016.

Three factors are expected to contribute to volatility in 2016.

First, the Chinese economy is worrying markets. A series of policy missteps in the last few months have undermined confidence in Chinese authorities and precipitated heavy falls in local equity markets. China is facing a trifecta of economic challenges including an extremely unbalanced economy, chronic over-capacity and high debt. Already China’s economy has fallen to its lowest pace of economic growth in 25 years, and the outlook is highly uncertain.

Second, markets are also being spooked by the possibility of rising US interest rates. For the last several years, low interest rates have boosted asset prices. But the Federal Reserve has signalled up to four rate increases throughout this year, potentially spelling more pain for equities.

Third, the rising US dollar is creating instability around the world, especially in emerging markets. In recent years, many companies in emerging markets have dramatically increased their dollar-denominated debts. Now companies holding these debts are being hit by the double whammy of rising interest rates and the rising dollar. "Emerging markets were part of the solution after the Lehman crisis. Now they are part of the problem," said William White of the OECD.

Advice for directors

So how should directors respond to the possibility of further market instability throughout 2016? A few principles are important to keep top of mind:

1. Confirm the soundness of your balance sheet: In the recent turmoil, companies with weak balance sheets have been hit hardest. Directors should ensure their CFO has reviewed risks to their balance sheet. That means keeping a close watch on debt and creditors. The unfortunate case of Dick Smith should be a warning to directors: it took less than a year for the management team to accumulate debts which ultimately brought down the company.
   
2. Ignore the noise: While keeping a close eye on market developments, directors shouldn’t overreact to the constant stream of news. Much of the daily fluctuations in financial markets are simply noise. This can be distracting and push management teams to act irrationally and not in the best interests of shareholders long-term goals. It is essential to stay focused on what matters and remind your management team they are in it for the long term.
   
3. Understand your exposures: Directors need a clear view on their exposure to sources of volatility, such as currency exposure, commodity prices, trade creditors or key customer risks. Work through scenarios that could expose your business or its counterparties to sudden weaknesses and put policies in place to address those risks.
   
4. Re-evaluate business strategies: John Maynard Keynes famously said: “When the facts change, I change my mind.” Major business decisions including capital investments, acquisitions and significant changes in strategy should be re-evaluated in the context of changing market conditions. This isn’t a time to throw the baby out with the bathwater, but it is important to adjust business cases to reflect significant changes in market conditions such as a sharply lower currency, lower economic growth, and stalling asset prices.
   

Volatile conditions call for calm judgement. Directors should be carefully considering new risk factors as they emerge, but not overreacting to them.