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Economic Scenario Planning and Strategic Forecasting

Tools to navigate uncertain times

Planning for the future is a crucial organizational activity that every business needs to do in order to set priorities, allocate scarce resources efficiently, and encourage all parts of the organization to work toward common objectives. In this planning process, businesses often try to forecast the behavior of their fundamental variables like revenue and profit, or in the case of financial or lending institutions, performance of their portfolios. Then strategies are based on targets drawn from these forecasts. However, time and again, this approach does not take into account several external factors that might affect a business’s day-to-day functions. This may result in inadequate planning, followed by missed targets and confusion within the organizational process.

In these circumstances, management needs to be mindful of the fact that a business cannot exist or operate in a void. Every business’s trade and financial performance is affected (albeit in diverse degrees) by changing economic conditions. Businesses tend to perform their strongest during a thriving economy, and conversely, performance tends to suffer during an economic slump. The impact of economic conditions tends to vary by the industry and geographical location of the business as well.

Hence, although carving out a focused strategy may enable a business to perform a few activities well, failing to account for external factors may derail these plans when the unexpected occurs.

Weaving strategic forecasting and scenario planning together brings about better preparedness by having several forecasts and tying each one to a particular scenario or economic condition. These forecasts take into account the extent to which major economic, socio-political, or natural events can alter businesses’ everyday processes, and in turn change the performance of revenue, profit, or portfolios. These scenario-based forecasts, allow businesses to make decisions that more correctly reflect the current business environment and create targets built specifically for it.

The process of scenario planning involves simulating a range of reasonable “what if” scenarios that capture the scope of possibilities an event may give rise to based on macroeconomic series and linking those possibilities to financial targets or portfolio performance. These scenarios can be formulated either by using guidance from government agencies such as the Federal Reserve, which provides guidelines for stress test scenarios, or by customizing them with the business’s specific conditions in mind.

Building custom scenarios remains the most critical part of the scenario planning process. It involves building out some alternative but plausible future trajectories with a specific event in mind. It is a systematic and creative activity with elements of economics, statistics, and mathematics embedded into the process. It requires the quantification of an event’s repercussions over time, taking into account complex interactions of the scenario triggers with each other.

The scenario triggers or driving forces are the key variables that have been determined to influence the planning issue in question. In the most common use cases of scenario planning, these triggers are economic in nature (e.g. GDP or employment), but could very well come from other areas as well, including demographics (e.g. population), sociopolitics (e.g. sentiment of media events), climatic (e.g. storm surges) – anything a business may deem relevant to its focal planning issue. While a financial institution will be more interested in how many credit card accounts in its portfolio may become severely delinquent if there is a dip in the economy at some point in the future, an insurance business may be interested in the recovery rate of the region it caters to after the region has been hit by a natural disaster such as a hurricane or a wildfire.

Once the most relevant scenarios are decided on, they can be applied to the planning issue in question. Like the scenarios themselves, the focal planning issue can be very diverse. It could be as critical as a large bank holding company’s stress-testing exercise, which is conducted as a part its regulatory compliance process or a portfolio management exercise by a regional bank to review the health of its portfolio. It could involve businesses planning for policy issues like Brexit, or monetary policy changes by a country’s central bank.

Although it is not humanly possible to predict the future exactly, scenario planning blended with strategic forecasting provides a good approximation of how some key variables and their volumes would behave in the changing trajectories of the future. Monitoring key indicators, even in apparently low-risk economic conditions, will help businesses keep tabs on any anticipated changes a reasonable distance into the future and be prepared for all eventualities by evaluating the effectiveness of alternative strategies across a wide range of scenarios.

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