The year is closing with a tremendous roar of market uncertainty, requiring treasury and finance professionals to think proactively about how to position their firms for success in 2019 and beyond. Increased political volatility in the form of trade wars, concerns over a declining economy and tanking equity markets are forcing companies to re-evaluate their risk management strategies. To stay ahead of the curve, savvy treasury professionals should keep an eye on changes in the marketplace with a particular focus on the following trends:
Much has been made of the length of the US economy’s growth since the end of the financial crisis. It seems inevitable that after a decade of expansion a recession should form eventually. While unemployment and inflation are holding steady, the number of new jobs created is marginally decreasing. Unemployment rates are at record lows in urban areas while many rural parts of the country are still experiencing elevated unemployment levels. Anecdotal data is starting to line up to support the idea of an impending end to the expansion as well, with plant closings and layoffs related to market changes announced by companies. Also, worryingly, recent yield curve movements have created temporary inversions that may indicate a recession is on its way if historical data proves true once more.
Action Steps: Review your risk management plan to determine how an economic slow-down might impact your exposures. Consider scheduling a Market Update and Impact Assessment.
U.S Interest Rates
The big question, of course, is what will the Federal Reserve do in the face of these challenges? The Fed’s dual mandate of maximum employment with price stability leads it to focus on two key factors: unemployment rates and inflation. Knowing that its actions impact these factors on a lagged basis, the Fed constantly tries to forecast the future and ensure smooth paths to meeting its objectives. Clearly, the Fed missed the causes of the financial crisis at the onset, though it has managed to maintain a smooth path for the economy since then. The market clearly has priced uncertainty into the Fed’s future path for interest rates. While earlier this year the Fed and market anticipated three hikes in 2019, this posture now feels far more questionable due to the data mentioned above.
Reducing interest rate volatility through interest-rate derivatives can help companies create certainty in the face of other market factors and this has been reflected in hedging activity by Chatham clients. Chatham has seen clients' total interest-rate swap notional increase by about 32 percent between August 15 and November 15 in 2018 compared with the same period last year, with the number of forward-starting swaps increasing by 38 percent. Chatham has also seen average interest rate swap maturity increase by more than 18 months over the same period.
Action Steps: Companies looking at this situation should strongly consider terming out debt prior to a recession when borrowing capacity typically worsens. This can be accomplished through either refinancing or with interest rate derivatives.
Continued Volatility in the FX and Commodity Markets
Uncertainty expands far into other markets, such as FX and commodities. Dollar strengthening was a theme for much of 2018, and US multinationals are, once again, back to blaming FX for missing earnings estimates. Investors may be comfortable with these one-time impacts, though repeated excuses on controllable items like FX are typically not viewed favorably, particularly when coupled with general market weakness due to a recession. Concerns over the impact of political actions like tariffs and trade wars can significantly impact US based multinationals, as will the uncertainty surrounding Brexit. The pound weakened over 11% against the US dollar from April through November, with uncertainty around the type of Brexit that will occur.
For those companies with exposure to oil, the rollercoaster ride has been particularly challenging this year. With prices now 30% or more lower than their peak earlier this year, it is hard to know how best to approach exposures in 2019 and beyond. For consumers, low prices represent an opportunity to lock in favorable costs relative to expectations and support earnings estimates in the years ahead. Producers, though, may be facing the prospect of locking in losses, and alternative strategies may make sense to limit the further downside of declining prices.
Action Steps: Companies should either evaluate their existing programs or develop new hedging programs based on expected continued volatility in FX and commodity markets.
New FASB Hedge Accounting Guidance
The FASB issued ASU 2017-12 last year with the objective of making targeted improvements to accounting for hedging activities. While mandatory adoption is required in 2019 for public filers and 2020 for others, significant advantages available under the new standard have prompted many organizations, including more than half of Chatham's hedge accounting clients so far, to pursue early adoption. These benefits include a reduced administrative burden for commodity hedging, more time for hedgers to perform initial prospective quantitative testing, and, in some instances, a more simplified approach to determining hedge effectiveness. Importantly, some common hedging strategies not previously qualified for hedge accounting now qualify under the new standard. There are also instances, such as commodity hedge accounting and cross-currency swaps, where a strategy previously qualified, but the accounting results under the new guidance will better align with the organization’s economic objectives. This presents an exciting opportunity for treasury teams who wish to hedge exposures while minimizing volatility recognized in earnings from the hedging relationship.
Action Steps: Assess how your hedging programs may change as a result of the new guidance. Consider proactively evaluating new strategies presented by adopting the standard. Keep in mind that ASU 2017-12 is relatively new, so regulator and auditor interpretation will continue to evolve in the years to come.
How will treasury and finance have the insight and capacity to pursue these initiatives? Executing the best strategy requires capturing the right data, aligning objectives and integrating across multiple platforms. With many teams still looking to fully staff their teams, new initiatives tend to be both energizing and draining due to capacity constraints. Technology plays a significant role in most treasury and finance teams’ day-to-day experiences and, in most cases, can be optimized to reduce time spent on tedious tasks. Removing 50 clicks a day over 250 days adds up, and companies are realizing the benefits of having specialized treasury risk management systems that automate many more of their processes. Integration costs have come down significantly over the past several years, and the most efficient teams are often running multiple systems that seamlessly integrate with single sign-on and no need to transfer data from one source to another.
Action Steps: Evaluate your treasury management system to assess how you can gain insight and efficiencies. Many Fortune 500 companies maintain treasury risk management systems alongside their ERP and TMS platforms. Consider adding risk management automation to your treasury technology stack to streamline the process of managing hedging programs.
The Bottom Line
Next year is poised to look vastly different than this past year. Recall that a year ago the US had just passed a massive corporate and personal cut to income taxes, whereas today we are headed into an uncertain economy for next year. Senior management counts on treasury and finance teams to prepare the company for volatile times such as these, and these teams count on Chatham to craft and support their solutions.
Chatham Financial Corporate Treasury Advisory
Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with organizational objectives. Our full range of services includes risk management strategy development, risk quantification, exposure management (interest rate, currency and commodity), outsourced execution, technology solutions, and hedge accounting. We work with treasury teams to develop, evaluate and enhance their risk management programs and to articulate the costs and benefits of strategic decisions.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit https://www.chathamfinancial.com/legal-notices/.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 18-0305
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