Using scenarios to build strategies for an uncertain world economy
Building economic scenarios can help stress-test strategies and bring more discipline to planning for a turbulent world. Here’s one way we do it.
November 2011 | By Lowell Bryan
Like it or not, we live in very uncertain times. But wringing your hands in the face of uncertainty is not a sufficient response. In our work with clients, we find that the most helpful approach is to focus on the most critical uncertainties and then try to understand which future outcomes could result, depending on how these uncertainties are resolved. The scenarios that emerge from this exercise provide a mental model for alternative potential futures—a tool to identify the consequences of alternative strategies, to stress-test how a company would fare in the worst-case (even if unlikely) scenarios, and to estimate the value of building flexibility into strategy. In other words, scenarios can help you think in a more disciplined way about how to navigate an uncertain future.
Dividing the global economy into developed and emerging blocs creates four main scenarios.
Scenario planning can address uncertainties at the company, industry, or macroeconomic levels. Over the past several years, we have gained considerable experience working, in particular, with global macro scenarios at McKinsey’s Center for Managing Uncertainty, set up in 2008 shortly after the global financial crisis started. The first scenarios we developed focused on the entire global economy and, in simplified form, described the possible future paths of economic recovery as V shaped, U shaped, L shaped, and so on. For the most part, the actual path of the global economy has fallen within the range estimated under these initial scenarios. Moreover, thanks to the magnitude of the monetary and fiscal stimulus governments applied, the global economy moved relatively quickly in late 2009 and 2010 away from the outcomes we had identified as worst case.
While our original macroeconomic scenarios were certainly useful, since 2008 we have built up our capabilities to track, in even finer-grained fashion, economic indicators in the world’s most economically important countries. We have also built an economic database covering 30 years of history for nearly every country in the world. Drawing on this data, we have developed a modeling capability that enables us to create much more specific scenarios generated from the individual-country level. We start with a base case produced by projecting forward the specific fundamentals at work in each of these countries and use the model to estimate optimistic and pessimistic scenarios for them, incorporating consistent global assumptions (for instance, about the price of oil). Whenever we want, we can aggregate such national scenarios to create scenarios for the entire world economy.
Being able to build world economic scenarios from the bottom up is critical because the variation in expected base-case growth rates is very large from country to country—for instance, ranging from a little over 1 percent for Japan to nearly 9 percent for India. Indeed, a weakness in our original scenarios from 2009 was that they basically assumed a single worldwide economic recovery, with little variation among individual countries. The reality, of course, is that their growth rates have diverged dramatically since 2009 and, in particular, between countries in the developed world and the leading ones in the emerging world.
Emerging-market nations like China had V-shaped recoveries, while in developed-world countries, such as Spain, the recovery has been modest. For that reason, in 2010 we began creating global scenarios that decomposed the world’s economy into emerging markets and developed ones, to reflect the reality that the former have been growing quickly, the latter slowly.
By dividing the world into these two economic blocs and creating a base case for each, we could then show what would happen if the developed world grew faster (that is, by 3 percent) or slower (1 percent) and the emerging countries grew faster (9 percent) or slower (4 percent). The exhibit above provides a graphical overview of the four resulting scenarios.
Over the past year, we’ve been surveying 1,300 executives around the world to get their assessments of which of these four scenarios is most likely to occur. Over the past six months, executives have become much more pessimistic: the percentage believing that the most pessimistic scenario is the likeliest has increased from 19 percent in March to 29 percent in September. Of greatest concern for the developed world, 69 percent of the surveyed executives expect the rate of growth there to be modest; only 31 percent believe it will be strong.
We are updating all our scenarios to reflect what has happened in the economy over the past year and to reflect uncertainties that have become more prominent, such as the outcome of the European debt crisis. These new scenarios will be available soon. Given the global economic slowdown that has already occurred in 2011, we now find it necessary to lower the base-case numbers. In creating updated scenarios, however, we are well aware that the future is truly uncertain. We will therefore also be putting extra effort into looking at scenarios that could surprise on the upside, not just the downside. In an uncertain world, strategy has become more a journey than a destination.
Lowell Bryan is a director in McKinsey’s New York office.