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What a trying year 2001 was for risk managers. The markets generally performed poorly, with US equities in the aggregate down for a second year in a row, and lower grade bonds suffering as well. Yield spreads between corporate bonds and US Treasury bonds rose to the largest spread in over 20 years, as lenders became cautious. Bankruptcies rose to levels not seen in 10 years, and among the walking wounded was possibly the largest bankruptcy in US history - Enron Corporation. For me there were a few lessons from 2001 that I think are worth repeating as we head into the new year. I'd be interested in hearing from others. What did you learn about risk in 2001?#1 - The business cycle still exists The first lesson is that the time-honored recession model still works, and the economy is still sensitive to the credit cycle. The Fed raised short term rates, the Treasury yield curve became inverted, economic growth stalled, a few shocks hit the system, creditors became cautious, businesses then slashed their capital spending and .........waallaaa! Recession appeared in the US once again. #2 There are negative effects from the new information technology tooThe second lesson is that yes, the new economy is here, but that it is not all a positive. The rapidity of the changes that occur now due to the IT that businesses have at their disposal is much greater than ever before. While most observers have publicized the great gains in productivity that technology has brought to the economy, it is less well understood that technology can now also slow the economy much faster than in the past, pushing the "angle of attack" of an inventory correction and production slowdown into a steep nosedive. What became apparent in 2001 is the degree to which IT allows a business to adjust to new conditions. In effect, IT has created a situation where the rapidity of decline is much faster than ever before.#3 The global village is becoming increasingly synchronizedThe third lesson is that the global village is more synchronized and more dependent on trade than I first thought. The increasing synchronicity of the global business cycle is becoming more and more evident. Unlike 1982 and 1990, this time the US was the first major economy to move into recession and it did not take long for the rest of the developed nations to follow. Steven Roach of Morgan Stanley Dean Witter points out that there are three important characteristics of the current global economy: First, as the 1990's wore on, the US accounted for as much as 40% of the cumulative growth in world GDP in the 1995-2000 period. Once that engine of global growth slowed and went into reverse, the degree to which everything was tied to the US became very apparent. Second, global trade now accounts for a record 24% of world GDP. This has probably helped to synchronize the economies of the world. Third, global trade has gone through an unprecedented sharp transition from boom to bust, as growth in world trade went from a record +12.4% in 2000 to less than 1% in 2001.#4 Balance sheets still matterIf we are entering a new era of more volatility in markets and economies, flexibility will increasingly become the key concept for capitalization. As many businesses found out once again in 2001, covenanted debt does not leave one with a lot of flexibility if cash flow experiences any type of disruption, no matter how temporary. The number of bankruptcies in the US in 2001 was surprisingly high. With increasing leverage even a modest slowing in business can create a massive squeeze on profit margins and earnings. Indeed, 2001's plunge in corporate profits in the US was the sharpest in 50 years. Businesses used to employing operating leverage found themselves in a bind as lenders turned skittish, yield spreads soared, and credit availability contracted. In other words, many managers once again learned the lesson that there is a positive correlation between the need for debt and the reluctance on the part of lenders to lend.#5 The risk premium on US assets may have permanently increased.As the Romans built roads out to all corners of their empire, trade grew and business improved. However, the Romans eventually learned that the roads worked both ways - the roads used by the legions to expand the empire were also used by the Vandals and Goths to march to Rome and sack the city. So it appears to be with the new globalization and the US. It is not only the terrorists that present a problem either, immigration problems as well as the potential spread of Mad Cow and Foot and Mouth disease are other examples of the downside of global integration (the Kudzu problem).tr
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