The year ahead will likely be a pivotal one for the world economy and most corporations. Themes of low interest rates, weak US dollar and sluggish growth in the United States dominated much of the discourse post-2008 financial crisis. However, market expectations that 2017 will be a turning point in these areas has been the dominant theme since last November’s US elections.
Market consensus on some of the highlights of 2017 are significantly higher interest rates, a much stronger US dollar, a new US tax regime and a potential pickup in commodity prices across the board, due to increased demand in North America from robust growth and infrastructure spending. Given these themes, a key function of corporate treasurers in the first quarter of 2017 will be to review corporate plans in the light of this new and evolving market consensus. Key strategies for corporate treasurers to pursue are discussed below:
High interest rates
Since the 2008 financial crisis, interest rates have been at historic lows and corporate debt issuance at historic highs. The stock of long-term floating and fixed rate corporate debt is at an all-time high as companies have taken advantage of low interest rates. There is market consensus that 2017 will be the beginning of significantly higher interest rates. Indeed, interest rates across the yield curve have already increased by an average of 70bps in the past couple of months since the US election outcome.
As such, corporations that have issued floating rate debt either as bonds or bank loans should consider hedging the risk of rising interest rates. This can be done via swaps, options or exotic swaps embedding optionality to better match the risk-benefit profile of the corporate hedger. In an environment of upward-sloping yield curves, corporates typically find swapping their floating rate debt into fixed rate carries an embedded cost, since the swap fixed rate payer incurs a higher cost of debt on a periodic basis than if the debt remained floating. Strategies such as range floaters or collared swaps can substantially reduce this perceived cost of swaps.
Conversely, corporations that have issued fixed rate debt and simultaneously entered into floating rate swaps to take advantage of near-zero floating London Interbank Offered Rates (Libor) – reigning since the 2008 financial crisis through most of 2016 – should consider unwinding their swaps. With the increase in short-term rates, corporations will be incurring higher interest costs and negative mark-to-market (MTM) on their swaps. This issue is ever more salient for corporates that have swapped their long-term fixed rate debt. Negative MTM on long-term swaps can be substantive for the corporate fixed rate receiver in an environment of rising rates.
While there is market consensus that the general direction of interest rates across the yield curve is on the rise, there is considerable uncertainty and volatility in interest rate markets. Corporates that have debt on the books must undertake a deep analysis of the overall corporate debt profile in conjunction with corporate budgetary planning.
This analysis, together with the board of directors’ view on the direction of short- and long-term interest rates, will help determine the optimal strategies for managing interest rate risk of the corporation. Corporate treasurers will have to analyse various interest rate hedging and debt profile conversion strategies in order to meet the board’s objective of a given cost of debt and risk tolerance.
Strong US dollar
The US dollar (USD) has strengthened significantly over recent months. Given the prospect of further increases in USD interest rates and improved US economic growth, market expectation is for further strengthening of the USD against all currencies. There is, however, continued uncertainty surrounding the policies of the incoming Trump administration towards the USD as members balance various growth strategies. This added element of uncertainty is bound to increase USD volatility.
Corporates with exposure to foreign exchange (FX) volatility must undertake a thorough review of that risk and any current and potential future hedges. Corporations with USD as their base currency and which have FX hedges to protect against a weak dollar must carefully review their position in conjunction with analysis of their budgetary plan, with a view towards potentially unwinding some – or all – of these hedges.
Similarly, any hedges to protect against a strong foreign currency should also be analysed with a view towards potentially unwinding, or significantly paring back, such positions. Conversely, companies with exposure to weakening currencies must consider putting on hedges against such weakening. Barrier and digital options are among the strategies that treasurers can consider, with a view towards reducing the cost of vanilla FX options.
Commodity prices will pose an interesting challenge to corporate treasurers. While demand pickup typically puts upward pressure on commodity prices, structural market characteristics need also be considered, especially in the oil and gas sector.
Market expectations of stronger US growth and demand will put upward pressure on commodities across the board. Metals will specifically be impacted, given the market expectation of the Trump administration’s large infrastructure spending in the US. This upward pressure might be tempered with potentially sluggish growth globally in the light of several factors: the slowdown in China, a strong USD depressing global competitiveness and hence demand, and the expectation that many US companies will shift manufacturing and production from overseas to back home in response to the new president’s avowedly protectionist stance.
Treasurers of companies with exposure to commodities will be tasked with continual analyses of changes in commodity prices and a continuous rebalancing of hedges in place to protect against commodity price risk. Given the uncertainties surrounding commodities prices, treasurers can devise a portfolio of very short-term and mid-term commodity hedges once they have decided on the optimal hedge ratio of their commodity exposure.
Tax planning and overseas cash reserves repatriation
The US tax code is poised for an overhaul under the new Trump administration. Not only is the corporate tax rate expected to be brought down dramatically, but also the many loopholes in the US tax code are expected to be removed.
Tax planning is strategically used by many corporations as a means of shifting income globally to low tax jurisdictions. Corporations minimise their tax base globally and domestically via strategic tax structures that take advantage of various loopholes in tax codes. Companies in 2017 will need to undertake a thorough review of their tax structures and tax planning in the light of the upcoming new US tax regime to ensure their tax burden meets corporate objectives set by the board of directors.
The Trump administration, moreover, is expected to give companies incentives to repatriate their overseas cash reserves without incurring tax penalties. Deployment of repatriated cash will be an important strategic initiative for most US corporations, and corporate treasury’s role in optimal cash management in expectation of the deployment of cash reserves will be highly visible.
FX risk management of the cash targeted for repatriation will be a key risk that treasurers will need to manage. Given the current strengthening of USD and market consensus that it will continue, all conversions to the currency must be strategically timed to the market on order to minimize the conversion costs incurred.
Uncertainties in commodity markets and the US tax regime will be key risk drivers for US corporations in 2017. While there is market consensus over the general path of interest rates and FX, risk management of each will be of paramount importance – especially following the record debt burden assumed by corporates over nine years of unprecedented low interest rates since the 2008 crisis. FX risk arising from the vast stock of overseas cash held by US companies that will be repatriated under the Trump administration will also pose challenges to corporate treasurers.
Whether responding to questions from other stakeholders or seeking to monitor the effectiveness of their risk management processes, treasurers and FX managers in growing companies with expanding foreign currency exposures need solid analytics to support their decision making.
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