By Rich Wagner, Prevedere CEO
Economists, politicians, and business leaders alike are attempting to make sense of the current crisis, basing economic forecasts on precedents set by other recessions. No two recessions are exactly alike, but there have been enough patterns and correlations in the economic data throughout previous downturns to provide insights to develop accurate models that can accurately forecast quarterly and annual outcomes.
But the current economic downturn is an unprecedented anomaly. A true “Black Swan.” As a result, economists are rewriting their “recession playbooks” and companies need to adapt their traditional forecasting methods for the current economic situation. While there should be an expectation that businesses can return to traditional forecasting methods next year, the reality is that business leaders must replace economic forecasting with dynamic scenario planning.
What’s so different about this recession?
There are numerous examples of economic indicators that have experienced historic drops. Unemployment has reached its highest level since the depression. US Manufacturing PMI, one of the most accurate indicators for industrial production, dropped to an all-time low in April. Perhaps most concerning is the fall of consumer confidence, which was nearing an all-time high during the first few months of 2020. Then the health crisis hit, and March saw the greatest drop in consumer confidence in 50 years, only to be followed in April by the largest drop ever for this typically reliable economic indicator. Not only are the changes in these economic indicators historic, the “lead up” to these drops have been unprecedented as well.
During previous recessions, there were a significant number of reliable indicators that pointed to slowdowns in the market and likely recessions. Unlike those situations, the current economic downturn was caused by a health crisis, which poisoned an economy that was showing healthy economic indicators just a few months ago.
While the historic changes in these reliable indicators have gained much attention, there are greater anomalies that are occurring and further complicating the ability to accurately forecast economic trends.
Abnormal Economic Correlations
In order to build accurate business forecasts, modern economists, data scientists, and financial planners rely on identifying patterns and correlations across economic data that has been collected during the last 50 years. This economic modeling, which is becoming increasingly used by business leaders, accurately forecasted the “great recession” in 2008 and 2009, and industry-specific ones during the last decade. While there are no exact replications of specific scenarios, there are enough correlations to provide accurate indicators.
The rapid change in the current economic climate has led to changes in correlations that have existed for decades. For instance, during the last 50 years there has been a strong correlation between the unemployment rate and the deficit as a percentage of US GDP. Simply put, when unemployment rises so does the deficit. But in the last few years, these two indicators have started to diverge. Despite the fact that the US experienced record lows of unemployment, the deficit continued to rise. Now, the deficit will most surely rise given the current state of employment, coupled with the exceptional amount of government spending to curtail a total collapse of the economy. As a result, the correlation between these two economic indicators will need to be reevaluated.
Another correlation that is worth noting is the relationship between the consumer and the price of oil. There have been many instances that consumer sentiment has been linked to oil prices, especially during severe economic shocks. As examples, US consumer sentiment dropped significantly in 1980 and 1990 when oil prices rose. The current economic situation has yielded the unusual combination of record lows for both consumer sentiment and oil prices. While there is a single logical cause for these results, it is still an atypical economic happening that adds to the complexity of developing accurate forecasts for any company.
The New Normal for Business Forecasting
This is an unprecedented global experience and there is no certain way to predict when the health crisis will truly pass and the economy will be fully open. It is impossible to accurately forecast how long it will take for consumer confidence to rebound, manufacturing demand to return or employment rates to rise. All of which will be dependent on scenarios that include the impact of Covid-19 on emerging markets around the world, continued government restrictions, and even whether unemployed Americans will choose to return to work based on the benefits they are receiving from unemployment.
For the rest of 2020, business leaders will need to evolve their traditional forecasting process into dynamic scenario planning. This will include building models that take into account a range of fluctuations in the economy to accurately identify the most likely scenarios. As companies plan for each of these situations, they will need to choose economic indicators that identify early inflection points and quickly adapt to new economic conditions––an ability that will be vital as we adjust to the “new normal.”