Breaking with the Herd

By the most commonly used definition of a recession — a decline in gross domestic product (GDP) for two or more consecutive quarters — it's impossible to identify one until it's already begun. Be that as it may, those who toil near or inside the world of finance often prefer their own set of field-tested barometers when it comes to getting a read on the economy.

Spreads between various investments are increasing, indicating a likely recession, says James Hamilton, professor of economics at the University of California, San Diego. For instance, the spread between 30-day A2/P2 and AA nonfinancial commercial paper jumped from fewer than 20 to about 100 basis points between mid-2007 and early 2008, according to the Federal Reserve Bank. “The historical rules of thumb have changed,” Hamilton says. So, a treasurer who's used to borrowing at, for instance, 25 basis points over treasury notes may find this no longer doable.

The upshot? While it may take a few months to determine whether the economy has met the technical definition of a recession, it makes sense that treasurers act with the tightening economy in mind. As a starting point, given that credit is likely to remain constrained — according to the Federal Reserve's January survey of senior bank lending officers, about one-third of banks had tightened standards for firms with revenue of $50 million-plus — treasurers will want to maintain a healthy buffer of cash and cash equivalents, says Asha Bangalore, vice president with Northern Trust Global Economic Research, Chicago.

Already, many financial executives appear to be reordering their investment priorities, says Scott Horan, vice president and group product manager with PNC Financial Services Group. Until six months ago, treasurers were focused on yield, with liquidity and then safety at the bottom of the list. “Risk creep” occurred, with companies moving from, for example, money market funds to enhanced cash funds, which can include investments with longer maturities. “Now, safety is a high first,” Horan says. Corporate investors that had been invested in money market funds, for instance, now are shifting to treasuries.

Of course, no reasonable person is going to argue against safe short-term investments. However, a sort of “herd mentality” appears to be at work, with some organizations eliminating entire asset classes from their investment parameters, says Horan. Rather than move from one investment extreme to the other, treasurers and executive teams should step back and rethink their investment approach.