Upside Down: The Yield Curve Means It’s Time to Manage Economic Risk
By John Pasinski, June 4, 2019
If you’ve been following the financial news lately, you have likely seen a number of headlines about the yield curve inversion. Although this may not mean that diva-scale drama and discord in the economy is certain, an inversion in the yield curve is a potent warning sign of possible trouble to come.
The inverted yield curve occurs when investors start piling into the bond market in search of safe havens, which drives long-term interest rates down below short-term rates. As a reference point, the last time the yield curve inverted this much was in 2007, just prior to the Great Recession. Furthermore, yield curve inversions have preceded the last seven recessions.
With the specter of a trade war between the US and China, political volatility in Europe, and rising tensions in various regions around the world, there seems to be plenty of cause for concern about the global state of affairs and the economy.
Managing Risk in an Economic Downturn
Although it is too early to say whether an economic downturn is unavoidable, the time is certainly ripe to take stock of how you are managing economic risks. For businesses, economic changes may manifest themselves in a variety of ways. Here are four examples:
Price Sensitivity: Consumers may become more price sensitive, placing more importance on lower prices or value when making decisions between alternatives. This can change the dynamics in markets for necessities, shifting attention towards lower-priced alternatives. Such price sensitivity changes may also render price elasticity analyses obsolete.
Market Compression: Consumers may defer making purchases or forego them altogether, compressing demand in the market. This means that to maintain sales levels, growth in market share is required to offset a shrinking market.
Changing Churn Dynamics: Consumers may start paying more attention to the competition, examining competitive offers as the market shifts. Consumer expectations may evolve as the landscape shifts.
Evolving Consumer Preferences: As market conditions change, consumers may place more value on how products compete on fuel efficiency or energy efficiency if gas and energy prices fluctuate.
There are two common threads in each of the circumstances listed above. First, understanding consumer behavior is crucial in order to properly assess the situation. Second, competitive market dynamics play a significant part in driving the likely outcomes.
The Consumer-Centric View
Taking a consumer-centric, market view of the landscape is an effective way to manage economic uncertainty, and that is exactly what Concentric Market® (shorthand for Consumer-centric Market) does. Concentric is a market simulation software company that provides organizations with a capability to better manage their risk by providing a platform to help answer “what-if” questions.
This improved risk management is a function of a number of capabilities Concentric Market provides. First, market simulation enables integration of various types of information and intelligence that are typically examined in isolation. These data sets include information like sales, marketing, consumer research, competitive insights, and macroeconomic factors. Incorporating this breadth of insight in one model allows for a fuller understanding of market dynamics and risks. Market simulation’s flexibility to include a variety of inputs allows for its faithful representation of real-world economic dynamics. It is possible to construct such a simulation, even when data does not extend back through the economic cycle.
Next, Concentric allows for the testing of unlimited what-if experiments. This empowers organizations to forecast likely outcomes across different possible economic scenarios and various competitive gaming situations. Most importantly, organizations can test different strategic levers within their own market simulations to project their likely impact under various circumstances. Having the ability to test product, marketing, positioning, and pricing ideas in the market simulation before going live with a strategy reduces risk.
Finally, Concentric provides confidence intervals around every forecast it produces. Risk managers understand that planning based on point estimates can lead to sub-optimal decision making as outcomes rarely go precisely as expected. Because market simulation is a probabilistic approach, it naturally accounts for uncertainty and produces a distribution of possible outcomes through Monte Carlo simulation.
Answering Your What-If Questions
with Market Simulation
At Concentric, we have worked with a range of companies looking to answer questions related to macroeconomic impacts. Here are a number of use cases related to the four examples above:
Price Sensitivity: A large CPG organization used market simulation to manage their portfolio of competing products, hedging their risk across economic scenarios. Certain products performed better if consumers became more price sensitive, while others performed better when consumers became less price sensitive.
Market Compression: An appliance company used market simulation to forecast the impact of changes in the housing market. They identified cost-effective approaches to preserve sales volumes if the market shrinks.
Changing Churn Dynamics: A local bank used market simulation to inform how to set interest rates on savings accounts as short-term market rates climbed and competitors began raising their rates. They found a marketing and pricing strategy to balance net interest margin with customer retention as customers started seeking out higher rates.
In addition, a media company used market simulation to determine how their pricing and content strategies should evolve in the event of an economic downturn. They derived a content-based approach to retain subscribership despite prices that were above market. Evolving
Consumer Preferences: An automotive company used market simulation to understand how changes in gas prices affect the importance of Fuel Economy to car buyers. They were able to more accurately forecast their volume of hybrid sales and adapt their product development and pricing strategy to increase their fleet fuel economy.
It’s probably best not to wait around to see if this yield curve inversion leads to a recession or is just an inconsequential aberration in the markets. If you are interested in exploring market simulation as a capability to better prepare your organization to manage economic risks, we would be happy to share more.
Note on the author: John Pasinski is the VP of Analytics at Concentric. He advises customers on how to most effectively leverage market simulation to answer their pressing what-if questions. He also applies market simulation at Concentric to guide its own planning processes. Prior to joining Concentric, John worked in quantitative risk management at Bank of America, leveraging models to understand macroeconomic sensitivities in their consumer credit portfolio and the capital markets.
He is also a fan of Diana Ross.