Have you heard there’s a recession coming? Don’t panic, it won’t be tomorrow or next month, but according to many economists, it is getting closer.
The good news is most economists agree we won’t have a recession next year. Former Federal Reserve Chair Janet Yellen said at the Annual Mortgage Bankers Association Conference in October that, “the economy’s stellar run can make it through at least 2019”. Yellen went on to say she doesn’t see any outstanding financial imbalances right now. The only thing she said worries her is that the economy could overheat due to strong employment growth.
The issue with labor is certainly something we are experiencing in the construction industry. This is having a significant effect on residential building, as the increased labor cost, rising commodity prices for building materials, and higher mortgage rates have all reduced affordability for homebuyers. This has slowed down the pace of new home building, which is still well below prior peak highs.
Yellen’s views are consistent with a forecast I saw last week by Anirban Basu of Sage Policy Group. According to Basu, 2019 looks solid but the picture gets a lot murkier after that, and he projects there will be a mild recession in 2020 or 2021.
In addition to the inflationary pressures noted above, Basu points to several factors that will lead to a recession. One reason is that debt has reached an all-time high in part by all the debt taken on by public corporations and private equity firms. In addition, Basu believes the US equity, US bond and commercial real estate markets have all gotten overheated.
We all know the recession will eventually come and it is only a matter of “when”. The question then becomes what to do to prepare in the meantime. Here are a few strategies we see implemented by our clients along with some advice I have personally received from advisors.
1. Reduce debt – Many of our contractors have a plan to pay off the fixed portion of their equipment debt in the next year or two in order to free themselves of the fixed expense should they need to reduce overhead.
I would further encourage contractors to reduce and ultimately eliminate any reliance on their bank line of credit. Banks are fickle when it comes to the construction market, and we’ve already heard of some that are reducing their exposure to contractors. This puts contractors in the undesirable position of being “surprised” when the bank pulls the rug from underneath them right as they need the line of credit most. However, contractors shouldn’t be surprised, as it will most certainly happen just like it has many times before. Therefore, the best thing contractors can do is avoid the issue altogether and implement a plan to pay down their bank line over the next year.
2. Avoid big purchases (for business or personal use) – As many contractors see their incomes peak, it makes it very tempting to use all of that cash to make a big purchase. Perhaps, a commercial building, that home they’ve been eyeing, or any number of toys. Many of these purchases not only drain cash, but they also add an ongoing stream of debt that will continue long after the music from the good economy stops (see number one above). Those same items for purchase can be purchased after the recession, and they might even be on “sale”. It pays to wait.
3. Create a proforma – It is not uncommon for contractors’ revenues to decline by 30-50% during a recession depending on the severity and segment of the market they operate in. I was advised several years ago to always have a proforma income statement showing how a significant decline in revenue of this magnitude would affect the company’s earnings. It’s easy to do by simply taking your last fiscal year-end financial statement and reducing the earnings and gross profit by the percentages you think are appropriate. Then I would encourage you to ask yourself if your company could survive that kind of hit.
A second step to the exercise is to identify those nonessential expenses that can be cut. I tend to categorize the expenses in steps or phases. My first phase is the least essential like sports tickets, for example, and each successive phase gets a little deeper.
Planning for a downturn is not high in most people’s desired things to do. However, it can take some of the emotion out of the process, as it is never easy, especially in the moment. The fact is, it’s part of operating a lasting business, and as Rick Mears, one of the Indianapolis 500 winners once said, “To finish first, you must first finish.”