THE IMPACT OF BREXIT
Ongoing uncertainty plaguing European markets will push growth rates in the Euro region below world benchmarks, with gross domestic product (GDP) rising by 1.5% in 2017, according to October 2016 figures from the International Monetary Fund (IMF). And in the wake of Brexit, companies will behave cautiously.
According to a recent Duke University/CFO Global Business Outlook survey, an overwhelming majority (69%) of European CFOs rated the degree of political uncertainty in the region as either a “large” or a “moderate” risk. Consequently, CFOs in the European Union (EU) say that their companies will be more conservative when it comes to capital spending (58%), hiring (49%), and making acquisitions (38%). In September 2016, almost one-third of CFOs indicated that, should the United Kingdom leave the EU, their companies would shift production, operations, or both toward the rest of Europe.
Outside the EU, however, Brexit wasn’t expected to have much of an effect in 2017. According to the third-quarter Global Economic Conditions Survey of accounting professionals by ACCA (Association of Chartered Certified Accountants) and IMA® (Institute of Management Accountants), 70% of North American respondents said that the Brexit vote would have no impact on their companies, largely because only a relatively small portion of their exports goes to the U.K.
That said, for CFOs of a global company with significant exposure to exchange rate volatility, 2016 was quite a ride. Brexit resulted in a dramatic drop in the pound and euro, causing revenues denominated in local currencies to fall along with them. At the same time, the value of commercial properties in the U.K. has come under serious negative pressure. On the other hand, companies looking to acquire properties in the U.K. face limited options as sellers pull deals off the market, waiting for some indication of where prices will settle in 2017.
GOOD NEWS, BAD NEWS
While Brexit is still on the minds of many, the bigger cause of concern for CFOs in 2017 is the most recent political upset in the United States.
Although most major stock markets surged after the election of Donald J. Trump as America’s next President, it remains to be seen whether growth in the world’s major economies will strengthen this year. Economic forecasts are all over the map, and a consensus for the U.S. economy isn’t forthcoming as many analysts seem disinclined to stick their necks out anytime soon.
Pre-election estimates had U.S. GDP rising by 2.2% in 2017, according to the IMF’s October report, more than that of other advanced economies but lower than the world average of 3.4%. Emerging and developing Asia will chug away at 6.3% and is expected to remain on that path for the next four years. Japan, however, will continue to struggle at a rate of just 0.6%. Growth in Latin America is expected to get back on track after a four-year decline because of soft commodity prices, which are expected to turn around somewhat in 2017.
But on November 9, 2016, a day after the presidential election, the “Trump effect” was sudden. After an initial knee-jerk negative reaction, U.S. equity markets turned around with “irrational exuberance” in the hopes that the economy will get a Keynesian kick in the pants. Bond yields on U.S. treasuries jumped along with the value of the dollar against international currencies.
If you’re in one of the industries that will benefit from an injection of infrastructure spending or the potential repeal of the Affordable Care Act (ACA), consider yourselves lucky. Expect the boost to equity prices to carry on well into the new year, despite an increase in U.S. interest rates. But if you’re a U.S.-based company with a substantial amount of foreign income, the Trump administration is likely to impose new taxes as well as new regulations around tax inversions that may cause you to rethink your business strategy.
If you’re an exporter based in Latin America, China, or the 10 countries that make up the Association of Southeast Asian Nations (ASEAN), planning for expansion based on trade with the U.S. just became a lot more difficult in 2017. For example, Trump’s promise to unravel the North American Free Trade Agreement (NAFTA) has had a particularly unsettling effect on Latin American currencies. (Immediately after the U.S. election, the peso lost 15% of its value.) The possibility of weaker private consumption and lower fixed investments as a result of potential trade restrictions will also be particularly detrimental and is likely to derail any hope of Mexico achieving a positive growth forecast in 2017. Not surprisingly, companies in the region are worried. (For more, see the International Monetary Fund’s October 2016 report, “Latin America and the Caribbean: Are Chills Here to Stay?”.)
While the equity markets may be quick to respond to pretty much any news these days, global CFOs aren’t expected to make any big strategic moves just yet. Uncertainty around potential trade restrictions, as well as the future of the Trans-Pacific Partnership, Dodd-Frank, the Offshoring Act, the ACA, and NAFTA are all in question. As such, this year will be a time for many CFOs to reexamine their strategies under alternative risk scenarios. Some will focus on investment, cash, and liquidity issues, with expectations of higher interest rates. Others, particularly in the construction and materials sector, are anxiously looking forward to an injection of U.S. infrastructure cash to boost sales.
In China, the finance team at textile manufacturer Yongsheng Advanced Materials Company will be reevaluating many strategic imperatives in the wake of deflating regional currencies. For CFO Julian Leung, the volatility in the renminbi (RMB), China’s official currency, will be keeping him up at night in 2017. Some of his costs are exposed to the strong U.S. dollar, and “the path of the RMB is what we talk about every day,” he says. “The uncertainty around U.S. policy towards China has made it challenging for us to make investment decisions, and there is little if anything we can do to plan. It’s difficult to predict and think about how to proceed with hedging strategies.”
Large and small companies alike whose products are destined primarily for the U.S. market are also worried about the possibility of the Trump Administration slapping a 45% tariff on Chinese imports (America imports roughly US$500 billion worth of goods from China each year). Many CFOs in China are hoping President Trump will ultimately prove pragmatic. As Leung points out: “U.S. trade with China is a two-way street. Taxing Chinese imports will increase business costs in the U.S., making them [U.S. businesses] less profitable and less efficient. This would limit the U.S.’s ability to grow and will have a negative impact on employment, particularly in the manufacturing sector.”
Nevertheless, for Kai Zhu, CFO, KaVo Kerr Emerging Market, plans for 2017 remain aligned to a longer-term growth strategy. (The KaVo Kerr Group, which manufactures products for the dental services industry, is part of publicly traded Danaher, a Fortune 500 global science and technology company with more than US$20 billion in annual revenue.) As Zhu explains, “Our agenda for 2017 is typical of any public company: to show rising profits and margin expansion for the shareholders. So our focus is on funding the type of investment we need for growth.”
“Another priority,” he adds, “will be how to improve our processes to get more efficiency from the global organization and thereby help finance our expansion plans. For mature markets, making sure we have advanced technologies in place will be critical.”
THREE BIG CHALLENGES
Zhu’s concern for emerging markets in Asia and elsewhere is making sure they have the optimal distribution channels in place to facilitate growth. Also, in terms of future expansion in emerging markets, Leung points to three important challenges. “The first one,” he says, “is having the right talent in place that understands U.S. GAAP, as well as our high standard of corporate governance and control.”
The second challenge relates to market diversity. “There’s a huge difference between high- and low-income consumers,” Zhu adds. “Reaching the low-income market is especially difficult for manufacturers serving the healthcare industry in these environments.” The major problem for the low-income demographic is affordability, and although company and private insurance is growing, it remains a slow growth sector.
The third challenge has to do with legislation and tax complexity. “Brazil, for example, has a very complicated regulatory environment and very high import duties to protect national companies,” Zhu explains. “This kind of thing is a nightmare for multinational corporations attempting to enter the market, especially with goods manufactured outside the country.”
Finally, impacting Zhu’s job on a day-to-day level, as an executive of a subsidiary of a U.S.-listed company, will be implementing the Financial Accounting Standards Board’s (FASB) new revenue recognition standard—Accounting Standards Update No. 2014-19, Revenue from Contracts with Customers (Topic 606, or harmonized International Financial Reporting Standards (IFRS) 17, Insurance Contracts). Danaher was selected to be one of the pioneer companies to adopt the new revenue recognition requirement, Zhu notes, which is quite different from the one under current U.S. GAAP. “That will definitely require changes in our internal control setup system, such as pricing or invoicing processes,” he says.
CLOSER TO HOME
For many U.S.-based companies, ramping up for new production might well be on the agenda. For example, the prospects of Phonon Corporation, a small, privately held aerospace electronics subcontracting company, are tied directly to U.S. domestic policy and, more specifically, defense spending. Some 95% of what Phonon builds and sells goes to the U.S. government. “We’re largely dependent on programs funded by the U.S. Congress, and most of the contracts we service have been in play for several years and are for large defense contractors,” says Phonon vice president and CFO James Smith. Some of these programs, he adds, are 30 to 35 years old and are still going strong. “So predicting the future has been a little bit easier for us than for companies that depend on overall growth in the economy.”
Yet, for Smith, the big question for 2017 and beyond is whether or not the Trump presidency will translate into new contracts. “Once we understand a little more about what’s going to happen, we’ll have a much better picture about what that’s going to mean for our business in the future and how we have to ramp up for expansion,” he notes. “Building cost expectations into future pricing is the biggest issue we have, and [it] depends primarily on material costs and wages, as well as rising healthcare costs. All of those are a bit of an unknown at the moment.”
Increasing costs means Phonon will need to look for ways to improve productivity—to be able to do more without necessarily having to add a lot of new people. “This,” Smith explains, “will mean designing and utilizing equipment more efficiently and getting our final [product] testing time down, which can sometimes take between eight and 10 hours.”
Regulatory uncertainty will also come into play for Phonon in 2017, and for many other companies as well, particularly around cybersecurity.
“Right now we’re not sure what emerging cybersecurity regulations are going to cost us,” Smith says, “or even if they’re going to be on the table next year. The requirements are still being formulated and are moving targets. We have some long-term contracts that will be affected where we’ll have to renegotiate costs; for others, we would just have to eat it.” Another area of considerable concern, he adds, are conflict minerals clauses in contracts. “We have to find other ways to save money to offset those kinds of regulatory requirements that nobody wants to fund, and planning for these contingencies is becoming increasingly difficult in this environment.”
NEW ACCOUNTING STANDARDS
One area that isn’t shrouded in mystery and that’s likely to keep most CFOs up at night in 2017 concerns the newly inked accounting standards of the International Accounting Standards Board (IASB) and the FASB, along with the ever-expanding scope of the finance function.
The FASB’s new lease accounting standard, ASU 2016-02, Leases (Topic 842), is expected to bring dramatic changes to the balance sheets of lessees. While the December 2018 effective date is some ways off, companies are planning now, looking at the impact on systems, management accounting practices, and, ultimately, their financials.
And for those companies that will be affected by the FASB’s new revenue recognition standard, a one-year reprieve to January 1, 2018, has given some relief. The new standard affects all entities—public, private, and not-for-profit—that have contracts with customers. At the same time, it eliminates current transaction and industry-specific revenue recognition guidance and replaces it with a principles-based approach. Many companies are starting now in order to determine the implications on their control systems and financials in anticipation of dramatic changes.
At the same time, insurance companies will need to start preparing for IFRS 17, which will go into effect on January 1, 2021. This new standard on accounting for insurance contracts will have far-reaching implications for how insurers manage the liability side of their balance sheets. While the implementation period is relatively long for this standard, insurers will need that time to develop an effective operational and strategic response that addresses the complexity of IFRS 17. (For the FASB, the comment period closed on December 15, 2016, for Targeted Improvements to the Accounting for Long-Duration Contracts, and the timing of the new standard was still to be determined.)
CONFLICT MINERALS CLAUSES
And as a heads-up for our European colleagues, in November 2016, the European Parliament and the European Commission, after much debate, finally came to an agreement with respect to conflict minerals disclosure. Accordingly, the European Parliament stated in a press release that “all but the smallest EU importers of tin, tungsten, tantalum, gold, and their ores will have to do ‘due diligence’ checks on their suppliers, and big manufacturers will also have to disclose how they plan to monitor their sources to comply with the rules, under a draft EU legislation.” The regulation aims to curtail human rights abuses by stopping the financing of armed groups that trade in minerals from conflict areas.
The regulation applies to all conflict-affected and high-risk areas in the world, of which the Democratic Republic of the Congo and the African Great Lakes region are the most obvious examples. The European Commission estimates that mandatory reporting will affect roughly 1,000 out of 7,959 EU-listed companies and potentially 800,000 downstream companies—mainly small and medium-sized enterprises—at a price tag of €8.4 billion initially and €1.7 billion on a recurring annual basis thereafter. In the U.S., 2017 will mark the fourth reporting year for conflict minerals disclosure. According to a recent study by Development International, “Conflict Mineral Benchmarking Study, RY 2015,” the affected industries in America had a combined revenue of US$9.7 trillion—a little more than half of the U.S. GDP.
Finally, the purview of the finance function is expanding again in 2017 with the release of a new intangibles reporting framework. Thankfully, though, this will likely provide more food for thought for CFOs rather than insomnia. While it could be argued that it was always the management accountants’ job to measure the value-creating capabilities of their companies, reporting on intangibles has been slow to develop. The lack of a manageable framework has been partly to blame. In September 2016, however, the World Intellectual Capital Initiative (WICI) tried to remedy this situation by synthesizing the subject into a manageable and executable framework, which is now endorsed and promoted by a group of highly respected organizations and represents a step forward in consistency in nonfinancial reporting. For more, go to http://www.wici-global.com/framework.
U.S. CFOs ARE OPTIMISTIC FOR 2017
A majority of U.S. CFOs say that 2017 will be a banner year for the American economy, according to the results of the most recent Duke University/CFO Global Business Outlook. By a margin of 4 to 1, CFOs who said they’re becoming more optimistic about the U.S. economy outnumbered those who are tending to be more pessimistic. In fact, the Duke “Optimism Index” jumped to 66 from its long-term average of 60 (on a 100-point scale), the highest level in about a decade. Historically, spikes in the Optimism Index have indicated strong growth in employment and rising GDP over the next 12 months, Duke reports.
“The CFOs are telling us that they anticipate pro-business policies to be enacted in the near future—but until specific policy details are known, many are waiting to see how their own firms will navigate the new terrain,” says survey director John Graham, a finance professor at Duke’s Fuqua School of Business. Nearly 1,000 senior finance executives were surveyed.
Two of the biggest reasons for the increased optimism among U.S. CFOs are hopes for regulatory and corporate tax reform under the Trump administration, with companies in the financial, transportation, healthcare, and retail/wholesale sectors expressing the greatest confidence. U.S. firms expect increases of 2% in both payrolls and capital spending, but those modest jumps represent a change in outlook from the previous quarter’s prediction of zero growth.
In certain countries, however, the outlook for 2017 was met with much less enthusiasm. Rather predictably, in Mexico, where policies of a new Trump administration could have significant negative impacts on trade, optimism among finance executives dropped 16 points to 47 out of 100. In Canada, reflecting fears of NAFTA being unravelled, the index fell to 63, a point lower than in the previous quarter.
Back in the U.S., CFOs say they support interest-rate hikes by a 2-to-1 margin. “CFOs support the need to return to normal interest rates,” adds Campbell R. Harvey, a founding director of the Duke CFO survey. “Though Fed hikes are widely anticipated over the next year, over half of CFOs do not believe that their borrowing costs will increase in 2017. Overall, they expect average interest expense to increase by only 30 basis points. This relatively minor increase shouldn’t deter capital investment or hiring plans.”
Detailed results from the current Duke quarterly survey—as well as results from previous surveys—are available at www.cfosurvey.org.