Inflation and recession, disgruntled workers, higher borrowing costs, and more — risks lurk everywhere in 2023.
By Vincent Ryan
The worst risks — the ones that cause the most harm or or loss — often catch us unprepared. Some are unanticipated because they’re unknown, and others are apparent but ignored.
For 2023, there are almost too many risks of both kinds. Below we address five significant risks that chief financial officers need to scenario-plan for, monitor, and manage in 2023. They are generally “known unknowns,” but that doesn’t mean businesses are ready to absorb these potential shocks. We present them in descending order of general awareness.
5. Macroeconomic Conditions
Plausible expectations of a recession? Ongoing inflationary pressures? CFOs are dealing with both. A year-over-year consumer price index (CPI) reading of 9.1% in June 2022 set finance executives on a new cycle of cost awareness. To help cover substantial price increases in everything from legal services to raw materials prices, they put their scalpels to work.
Now, however, the medicine to counteract inflation — the Federal Reserve’s monetary policy tightening — is giving CFOs another reason to slash the expense line. Aggressive increases in the Fed funds rate have raised fears of a recession in 2023. All of a sudden, companies successful at raising prices in the past year may start to find sales growth slowing. Raising prices by 10% in the fourth quarter (after a 9% hike the previous quarter), Procter & Gamble saw sales volume drop 6%, twice the third-quarter’s decline, the consumer giant disclosed last week.
“Although the economy is strong, there is an overarching pessimistic outlook for 2023, largely caused by uncertainty regarding how much longer and higher the Fed will need to raise rates to stabilize prices,” said Dustin Renn, CFO of purchasing platform Teampay.
The World Bank and surveys of business executives foresee weaker economic growth. The World Bank slashed its 2023 global economic growth estimate in half to 1.7% and predicted the U.S. economy would expand just 0.5% this year. S&P projected the U.S. economy would fall into a recession sometime in 2023, with yearlong GDP contracting by 0.1%. The Richmond Fed/Duke CFO survey, taken in late 2022, found U.S. finance chiefs projecting real GDP to grow only 0.7% this year, and 31% expecting negative growth when adjusting for inflation.
Companies are suddenly asking themselves, ‘did we do enough to prepare ourselves for the lean times?’ said Andrew Casey, CFO of Lacework, a cloud security platform. “One of the biggest risks CFOs face in this uncertain economy is adjusting businesses which have been focused primarily on growth to rein in spending, rethink business plans, and drive toward profitability.” Finance execs need to be ready to forecast frequently and rigorously as well as consistently manage cash flow.
4. Labor Costs and Poor Employee Engagement
This could be a lethal combination. Managements, on average, have budgeted more for employee raises this year — 3.8% for merit increases, according to Mercer’s U.S. Compensation Planning Survey, and 4.2% when promotions and cost-of-living adjustments are included. At the same time, though, CFOs are looking to cut the fat in their workforces, while executives and managers worry employees are burned out and highly disengaged.
Nearly one-third of the 256 respondents to the latest Grant Thornton CFO survey said they could potentially reduce their workforce in the next six months. Over 40% were looking to cut human capital expenses in some form. Amazon, Microsoft, DirectTV, Salesforce, Vimeo, and Google have all announced large layoffs in 2023, while other companies have frozen hiring.
Prophix Software CEO Alok Ajmera sees mounting friction arising from employer cost-cutting and “the immediate reality faced by employees, who see rising costs of goods and a still-bustling job market as justifications for salary increases,” he said in an email. “Organizations will be in a game of tug-of-war to hold onto their cash over the next six to nine months as the job market, and employees’ expectations, level-set.”
The still-tight labor market will cause finance chiefs to think twice before cutting skilled labor that’s in high demand, said Wes Bricker, co-chair of PwC’s U.S. trust solutions business. Kathryn Kaminsky, Bricker’s co-chair at PwC, sees employers “more selective in seeking out those with a unique set of skills” because of pressure to lower overhead costs overall.
The question on many minds in the C-suite is, ‘How do you excite and inspire your people, even during a downturn?’ — Wes Bricker, PwC
Stephen Miles, founder and CEO of The Miles Group, wrote in his annual client letter that some tech companies will run their companies with fewer people — “moving from a potential-driven world of hiring as many people as possible to a performance-driven world.” That world employs “higher density” talent combined with “massive advancements in artificial intelligence.”
Regardless, companies still have to deal with “the erosion of the employee experience” arising from the pandemic years, according to The Conference Board’s 2023 outlook report.
“The question on many minds in the C-suite is, ‘How do you excite and inspire your people, even during a downturn?’” said PwC’s Bricker. CFOs, CEOs, and other business leaders “will need to show that their company is innovating, creating value, and moving beyond just a dip in the overall economy.”
Part of the answer to widespread disengagement might be to bring employees together more often. Miles, whose firm specializes in CEO successions and executive transitions, said: “CEOs realize that over the course of the pure [work-from-home] years little or no performance management has happened, and even less investment and development of people has occurred. This is a trend that must be reversed, while still maintaining some employee flexibility.”
3. Higher Interest Rates
Companies will pay more to issue bonds and borrow from banks and private creditors in 2023 — new credit will be materially higher in price than it has been in a while, as will refinancings. That could put a crimp in companies’ plans for growth, even if a recession doesn’t materialize. It could also put some highly leveraged businesses in danger of defaulting on their debt. And business models that were acceptable or profitable when the Fed funds rate was near zero may not be when the benchmark rate is near 5%, said famed short-seller Jim Chanos at a conference last November.
BofA Securities research in late November found changes in capital allocation strategies at 800 high-yield and investment-grade companies, many of whom have “shifted to de-risk their balance sheet through capital preservation as they brace for potential margin pressure and recession.”
Murphy Oil, for example, has accelerated its debt reduction goals by allocating some of its free cash flow to paying down its debt load of $1.8 billion, already reduced by $646 million last year. It hopes to achieve an investment-grade rating. Even large investment-grade companies like equipment maker Deere have large amounts of debt maturing in three years that may have to be refinanced at a much higher rate.
Rating agencies and credit analysts are not expecting a torrent of defaults at large companies. BofA Securities, for example, estimates high-yield issuers will default at 6% in a recessionary scenario, a moderate increase that pales in comparison to the peak of 15% during the financial crisis. If inflation persists and the Federal Open Market Committee has to raise rates higher for longer, bankruptcies and restructurings could surge.
If businesses are not managing their covenants tightly, they will be inviting the bank to come in and collect their cash. — Alok Ajmera, Prophix
The full impact of higher interest rates and layoffs may not be seen in credit markets until the end of 2023, according to Som-lok Leung, executive director of the International Association of Credit Portfolio Managers. Many U.S. corporations have been flush with liquidity and borrowed when interest rates were low — and those loans have not yet come to maturity, shielding borrowers from the higher rates, said Leung.
Among small business clients, U.S. banks are seeing lower demand for loans, according to the Federal Reserve Bank of Kansas City’s small business lending survey. Both outstanding and new small business lending balances for commercial and industrial loans decreased in the third quarter of 2022, with new lending falling by 22.1% year-over-year. Interest rates paid continued to rise. The median rate on new variable-rate small business term loans rose by 112 basis points (to 6.25%) and variable rate lines of credit by 128 basis points (to 6.8%).
Many companies, large and small, won’t have the cash flow to reduce their leverage. So, “for highly leveraged businesses, those with any significant amount of debt, covenant management is critical in the year ahead to avoid putting the company at risk,” said Prophix CEO Ajmera. “If businesses are not managing their covenants tightly, they will be inviting the bank to come in and collect their cash.”
2. Geopolitical Stresses
World politics can seem esoteric when a CFO is buried in a financial performance dashboard or budget spreadsheet, but the risks developing on that front this year warrant vigilance. Some companies already suffered financially from Russia’s invasion of Ukraine. Aluminum packaging provider Ball, for example, sold Russian operations last year that amounted to 8% of the previous year’s operating earnings. Because new facilities in the United Kingdom and the Czech Republic are not complete, the Russia sale will be a drag on earnings from its EMEA unit, the company revealed in its November earnings call.
The geopolitical risks companies might face going forward will be on a much larger scale. The World Economic Forum’s (WEF) 2023 Global Risk Report characterizes the global political climate as “geopolitical fragmentation,” which it sees driving “increasing clashes between global powers and state intervention in markets over the next two years.”
The WEF said, “economic policies will be used defensively, to build self-sufficiency and sovereignty from rival powers, but also will increasingly be deployed offensively to constrain the rise of others.”
The contentious relationship between the United States and China is the most visible example of the heightened risk. “Strategic competition between the U.S. and China is driving global fragmentation as both focus on boosting self-reliance, reducing vulnerabilities, and decoupling their tech sectors,” said BlackRock Investment Institute in its Geopolitical Risk Indicator. “Unprecedented U.S. semiconductor export restrictions against China are set to accelerate decoupling.”
The combination of supply chain restraints and “China entering into a new phase of aggressive posturing on the global stage has sent a flare-up for many global CEOs [and CFOs] who have people and operations in China,” according to Stephen Miles of the Miles Group. The COVID-19 pandemic, according to Miles, revealed how much businesses’ supply chains had traded “accessible, durable, and multi-source for global, low-friction, and single-source.”
The move to what Miles calls “local and dual source” will have two effects, first, it will be “deeply painful, very hard, and very expensive, and it will put a continued acute inflationary element into the world.” And second, says Miles, curtailing global supply chains will remove a tool that brought the world closer and prevented escalation of tensions between nations.
“As we head more into a world where countries are defined as ‘good acting’ and ‘bad acting,’ we are losing the peace effects of the previous model and heading into a world where conflict is much more likely,” Miles said.
For CFOs and other executives facing questions from their board about geopolitics, “the challenge headed into 2023 will be figuring out how to model those risks to mitigate the impact of those challenges,” said PwC’s Kaminsky. “How do you frame these risks and distill them into a qualitative framework that allows for decision-making?”
1. Second Crisis, or ‘Risk On Top of Risk’
The last risk CFOs should be wary of this year is the circumstance of being hit by a second, unrelated risk when their company is already in crisis mode. As a trio of risk management textbook authors reminded CFO readers in 2021, organizations already in a weakened state from a prolonged crisis can develop blind spots. A surprise second crisis could represent a ‘tipping point’ “with disproportionate negative impacts on the organization,” according to the authors of “COVID-19: The Risk Management Part Is Unfinished.”
There are plenty of risks that have gone unmentioned in this list: cybersecurity breaches, labor disruptions, inflation refusing to fall to 2%, the U.S. defaulting on its debt, new onerous business regulations, the erosion of consumer demand, a sudden technology failure (see: Southwest Airlines), accusations of greenwashing, an abrupt slowing of customer payments, employee fraud, a large unexpected expense, the transition to clean energy, a new competitor that raises your target customers’ expectations, a controls failure at a trading partner.
The multiplicity of risks many companies will be exposed to this year make it imperative CFOs and risk management teams plan how the organization will cope if one of these hazards or others occur. Asked the authors: “When something new breaks, will you be able to work through it?”