Tom Record and Tom Morris consider the sorts of long-lasting behavioural changes that could stay with us beyond the Covid-19 pandemic.
Reading time: 11 minutes.
Vladimir Lenin famously said, “There are decades where nothing happens, and there are weeks when decades happen.” Ostensibly voiced about a century ago when Russia was gripped by revolutionary fervour, these words could just as easily have been said today. The pace at which the Covid-19 pandemic has brought the world economy to a near-standstill has been startling, as has been the extraordinary policy reponse. We have recently written about the many ways that the lockdown has hastened the prevalence of technology in our working and social lives, and the sorts of companies that are seeing a strong structural tailwind as a result. With lockdowns tentatively starting to ease, we would like to share some of our team’s views about the potential long-lasting behavioural changes that might occur as a result of the pandemic.
A prolonged era of big government
During one of our team macro chats last October we considered possible government and central bank responses when the next crisis hit. Our conclusion was that fiscal and monetary stimulus would be fast and extreme, with a new level of co-ordination. So called ‘helicopter money’ was raised as probable. So far, central banks around the world have not disappointed us. This is part of the rationale behind our long-running holdings in gold miners such as Barrick Gold. The scale of the stimulus is immense, and we think there is some truth to the phrase ‘nothing is more permanent than a temporary government measure’. We are in an election year in the US and Donald Trump will do everything he can to get the economy back on track – fiscal stimulus is likely to continue for a while.
We believe that we have entered a period of big government, where no party in the West is going to compete on an austerity ticket. At the same time, the supranational institutions that have helped create stability since World War II are being side-lined in the relationships with the governments who should value them the most – the World Trade Organisation and World Health Organisation are great examples of this. Trump’s America First campaign, which is deemphasising the US’s role in the rest of the world, tied in with the prolific increase in Treasury issuance and the US Federal Reserve’s balance sheet (the latter grew $1.6trn just in March) make the US and the USD an increasingly uncomfortable partnership. China’s relative parsimony on the fiscal front, its ability to control movement of people more effectively and its (now) more coordinated response are likely to accelerate the shift of the world’s centre of power to the East.
EU stability put to the test
At times of stress, relationships can be challenged. The relationships between the different member states of the EU have further deteriorated in recent months. With the UK having left the bloc, and its scheduled exit from the transition agreement looming in nine months’ time, many in Italy and Spain feel let down by a lack of help and support from their northern neighbours. While we are aware that this is a well-rehearsed discussion, we feel that this crisis and the common enemy it provides are doing more to drive neighbouring countries apart rather than bring them together. Indeed, we have seen increasing nationalist rhetoric and seizures of power by individuals in countries such as Hungary. We think it is likely that the varied degrees of coronavirus impact between member economies could lead to differential approaches to exiting the pandemic. This could provide further tensions within the block, when the ECB potentially moves from all-out stimulus to an approach that is unlikely to fit all.
Social distancing could bring inflation closer
Inflation is something that has been absent for many years. With immense government debt levels now being built up in order to fund lockdowns and stimulus, Treasury rates will need to stay low for many years to finance the state. Should we expect very low corporate bond yields to continue, or will governments pursue higher inflation in order to reduce the real cost of their debts? We believe that it is worth keeping an eye out for inflation in the medium term. Financial repression, whereby central banks, commercial banks and insurers are forced to buy long-term bonds in order to keep yields down, could be accompanied by inflation. Where would the inflation come from? We think there are a number of sources that reflect the peculiarities of this virus crisis.
Social distancing of some sort is likely to persist for a long while. Our rationale for how this can drive inflation is most easily exemplified with a restaurant: if every table is further apart then the number of tables available will be cut. To generate a similar return on the assets and capital invested, prices will have to rise. The same is true of other industries such as retailers, where the number of people in a shop is limited, and cinemas or airlines, where middle seats are left empty. Social distancing will lower supply and so push up pricing. In a similar vein, industrial companies with just-in-time inventory supply are starting to build inventories – as supply chain production becomes less secure it makes sense to have some spare inventory on hand. Similarly, the challenges of globalisation in shipping product and getting it cleared through customs (especially for medical supplies) has led to a resurgence of nationalism – more companies are considering bringing their production onshore, or in some cases bringing more of the supply chain in house. This could be an opportunity for factory automation names, but overall we believe that this is likely to raise costs and so be inflationary.
The discussion within the team on this topic is very varied in viewpoint. Some hold that the excess of labour and likely slow recovery, coupled with low commodity prices, will keep inflation low for many years, as will a lack of animal spirits. A further offset to the inflationary medium-term stance that we describe above is the impact of online penetration increasing. As online services have been used more and more, the benefits of scale have accrued to the largest operators and this should enable their costs to come down. When viewed against physical high street costs rising, it could accelerate the positive feedback loop of online service adoption. We are starting to see retailers being disintermediated – suppliers to restaurants are gaining direct relationships with customers for example. This may cut out excess profits in the distribution chain, and so be anti-inflationary; it also chimes well with customers’ desire to have authentic goods, whose provenance they can relate to and feel affinity with. The balance of all these factors is something that we are watching carefully.
The impact of financial repression on Banks, Insurers and other regulated financials could be very negative for a prolonged period of time. In that context, we are happy that we have sold over recent months our holdings in companies such as JPMorgan.
Big Tech to regroup
It’s apparent that as people have been locked down, online services have flourished. People who had been reluctant to try online versions of their services are now being forced to give them a go, and in some cases they will never look back. Everything from ecommerce, cloud computing for work and education to media streaming have had a strong tailwind. What interests us is that these months of lockdown are likely to have accelerated the long-term trend of services shifting online. When we think of this in the context of a company such as Google, the benefits from this acceleration will likely more than offset the costs of the advertising recession that accompanies the pandemic. Another aspect that is also evolving in Big Tech’s favour is the regulatory focus on these businesses, which has shifted from a ‘regulate or split them up’ view to a ‘these are essential services that we all need and are being provided pretty seamlessly at a low cost’. The final aspect to add to this is that a number of start-up Unicorns have had funding issues recently and perhaps they will not be viewed with the halo that they have been in recent years. Reduced funding for start-ups means less risk of disruption for the established tech giants, and also potentially a movement of top talent back into their ranks.
Working from home to cause a real estate rethink
Businesses have been forced to spend on their IT to enable employees to work from home. After the pandemic, they are likely to be more flexible and willing to have less office space. Furthermore, there are many Silicon Valley entrepreneurs who are working from home and are noticing shortcomings from business software that doesn’t work and so will be innovating to improve it. We believe that over the long term, we will see businesses save money by having more employees working more of the time from home. This should be cheaper, just as efficient (if not more so) and frees employees to spend more time with their families (those of you on lockdown with small children may question the advantages of this!). So what happens to all the real estate? Do rents fall? Does most real estate become a liability rather than an asset? Does demand collapse? In many cities, the marginal occupier for office space was WeWork, which has its own problems at the moment. Longer term, it is likely that the services that WeWork offers (flexible office space) could fit businesses better – perhaps WeWork’s future is as an outsourced operator of real estate companies’ assets.
Online video, gaming and streaming will move up a level
In recent months we have written extensively about online gaming and explored the topic in an Analyst Insights video. In the months since the lockdowns began we have seen gaming expanding its appeal across age groups. Nintendo’s Switch console has sold out across most of the world, user numbers and time spent has increased and eSports have been shown on major TV channels in place of live traditional sport. We believe this is just an acceleration of what was already happening, as the evolution in technology allowing for online distribution and in-game purchases has led to game franchises becoming more profitable, longer in duration, more sociable and more enjoyable to play. This is why we have held Take-Two Interactive for many years and why we recently added to Electronic Arts. The closure of cinemas, loss of sports, downturn in advertising and closure of theme parks are likely to expose the weaknesses of the big media companies’ business models and we wouldn’t be surprised if they tried to acquire gaming franchises to add much-needed resilience and diversity. Even after cinemas reopen, the film release schedule will be too congested to allow everything to be shown; there is already a rumoured oversupply of new films being offered to Amazon Prime and Netflix (including rumours of programming being sold at a discount to normal rates). Gaming and eSports are an increasingly important part of the media complex.
Cars will go the distance
There are a number of moving parts to consider here. We expect that people will try to avoid public transport. They may upgrade to ride sharing, but again that won’t be viewed as an ideal way of avoiding other people. Indeed, we think there may be a resurgence in car purchases relatively quickly after the economy reopens. This is similar to what we have seen in China where weekly car sales are now up year-on-year. In UBS’s March China consumer survey, 27% of respondents said that the virus had increased their desire to buy a car (up from 17% in the previous month). This could have implications for car parts companies, insurers, some semiconductor businesses, car OEMs, battery makers and other suppliers in the auto in supply chain.
Responsible Capitalism credentials come to fore
How companies react at times of stress often provides insights into the quality and values of the businesses that they run. At one extreme companies like Novo Nordisk (held in the Fund) immediately shortened the payment terms for their small suppliers, started using their facilities to make hand sanitiser, offered individuals in the US who had recently lost their jobs and medical coverage 90 days of free insulin, and set up a Covid-19 testing facility in Denmark. Similarly, Credicorp (held in the Fund) suspended interest and principal payments on loans for 90 days (repeating what it did in some areas after the El Nino floods a few years ago), and donated 100 million soles to a fund for vulnerable people. These are actions that show them to be responsible corporate citizens, with a focus on the long-term reputation and health of their businesses. They are willing to do what is right to ensure that they can thrive in the coming years.
At the other extreme, we have seen companies refusing to pay suppliers for items that have been consumed and sold on (e.g. Wetherspoons in the UK, not held), who have sought government bail-outs after spending billions on share buy-backs (e.g. Boeing, also not held) and who have fired workers while increasing management pay.
Even those companies who are not suffering much from the crisis (e.g. the food retailer Tesco, held in the Fund) need to be thoughtful in their response to the pandemic. In Tesco’s case it is recycling all the benefits from higher sales into support for its employees, suppliers and customers, such that it does not expect a profit benefit. We think this is absolutely the right choice.
Investors have good reason to keep active
The consequences of the pandemic are wide and varied and it is important at these times to think about the longer-term implications from changes in behaviour that months of lockdown have initiated or accelerated. The portfolio is full of companies we think can survive and prosper in the post-virus world. There are many facets that we cannot be certain about, but we view this as a good thing, since it is that uncertainty that provides the opportunity for outperformance. We believe that now is the time that a truly active, long-term investment approach can shine. A focus on identifying companies that have varied long-term, individual risks and opportunities that will dominate their returns should dwarf the uncertainty from shorter-term Covid-19 risks and opportunities, and so create the asymmetrical return profile that we look for in our holdings. As ever, we will continue to monitor, discuss and challenge each other’s views while looking to build a diverse portfolio of stocks with potential returns asymmetrically skewed to the upside.