How will Covid-19 leave a lasting stamp on the investment environment?
The COVID-19 global pandemic, and the strict lockdown policies associated with it, has created a genuinely unprecedented environment. Personal and corporate lifestyles have been completely undermined and normal established behaviours challenged. While the expectation is that the changes will be short term in nature, investors will need to critically assess that assumption. Changes in long term trends can have a substantial influence on valuation levels in financial markets, both at the overall market and individual sector level.
History tends to show that emotive observations during a major event regularly prove to be inaccurate. It should be noted that this is not the first time that we’ve had an event that was perceived as “changing everything”. We can refer back to 9/11 and the Global Financial Crisis (GFC) for recent precedents. In both crises, commentators predicted that there would be substantial changes in society, markets and the business environment. Bar one or two specific areas – such as banking regulation – the consequences have been relatively marginal.
So, can it be different this time? The answer may lie in the longevity of the crisis and the enormity of the changes associated with it. Other crises were relatively short in duration, particularly 9/11. The COVID-19 crisis, on the other hand, will remain with us for an extended period and a full return to normal life is unlikely to occur until a low-cost, high-volume vaccine is available on a global scale.
Post COVID-19, we expect many behavioural changes will be recognised as temporary in nature. However, there are certain areas where structural and more permanent change will occur which I’ll explore in this note under five broad themes:
- Geo-political issues
- Disruptive technologies become mainstream
- Behavioural changes
- New routes to market
- Business challenges
1) Geo-Political Issues
Reverse of Globalization trends
Post the experiences of the COVID-19 pandemic, questions will be asked whether the multi-decade growth in the globalisation of economies will come to an end, or potentially even reverse. This would have significant, structural long-term consequences for global economies and financial markets.
During this crisis, some of the dependencies associated with the globalisation of economies have become painfully evident. Vulnerabilities identified have included no//limited access to domestic manufacturing capacity in key segments of the economy, as well as long supply chains and high regional dependencies. Previously, the economic benefits of globalisation were expounded by governments and business, without much intensive focus on the potential shortfalls.
COVID-19 has changed the balance of that debate, hopefully in the short term, but I fear its effects could be longer lasting. The increasing nationalistic tone of political debate, evident before COVID-19 in the election of Trump and BREXIT, will undoubtedly become louder and add to this risk. National vs globalisation debates will also take place against the backdrop of a substantial increase in domestic unemployment, adding to the pressures on halting or reversing some of the trends. Any move away from globalisation could have significant consequences for economic growth and geo-political relations.
This is undoubtedly the most significant and substantial risk that we face as a result of COVID-19, particularly regarding global growth and financial markets. There were already signs of stress in the global economic system and it will require huge political leadership to avoid it escalating into something unpleasant.
More immediately, I doubt whether Trump will be able//want to reverse the China tariff increases implemented over the last couple of years and this may unnerve financial markets. Indeed, a greater risk is that such restrictive trade policies are extended to other countries. Restrictions on the free movement of workers is another sensitive issue that could get wrapped up in de-globalisation sentiment. Disappointing comments from Trump (on green card access) and SA cabinet members (on Zimbabwean workers) could reflect that emerging trend. Under this pressure, the collective ideal associated with globalisation may suffer against shorter-term priorities with negative consequences for economic growth. Our central view should be that we can no longer rely on globalisation as a tail wind for economic growth and financial markets.
Another substantial risk for global economic growth is a sustained period of anti-China sentiment. This would certainly be a concern if the COVID-19 post-mortem identifies that China lacked transparency on the initial virus outbreak.
This risk is primarily at the geo-political level but may also spread to the consumer if the post-mortem reveals that China fell short of its moral obligations. Judging by consumers’ short memories, the former is the more substantial risk and would most likely manifest itself in trade restrictions. While it is not my base case, it could very easily form part of a negative de-globalisation theme.
It must be remembered that COVID-19 has not occurred in isolation. Even prior to the pandemic there was a feeling that previous administrations, particularly in the US, had been far too accommodating towards China’s human rights abuses and, more importantly, its aggressive geo-political ambitions. For the global powers, there is little doubt that economic growth trumped broader considerations. I expect the China hawks in the US administration will exert their significant leverage to punish China from an economic standpoint. In addition, we must assume that US trade tariffs on Chinese products, implemented over the last couple of years, are also unlikely to be removed as we exit this crisis.
Addressing neglected country risks
The COVID pandemic has embarrassed several countries in their lack of preparedness for a potential crisis. Part of this reflected countries’ reluctance to invest for uncertain or unknown outcomes. In addition, however, over the last 20 years countries have been prepared to accept and rely on international companies and bodies to manage potential risks. The disappointing performance of international bodies such as the World Health Organization (WHO), and the lack of domestic supply in certain critical products, has focused minds. Post the crisis, there will be a reassessment of the domestic capability to deal with a wider collection of future risks and not to be too reliant on internationally-funded organisations. The US will undoubtedly lead this charge. Governments will be forced to increase investment in risk areas like antibiotic research, pandemic supply chains, climate change and domestic manufacture of critical products/. components.
I will pose some final questions on this topic. Will the disappointing response to the crisis result in the unwinding of certain cross-border bodies that have grown and importance over the last two decades? Will the WHO survive in its present form if the US removes funding? Will Italy remain committed to the EU, after the northern European countries once again prioritized themselves over their southern partners in a crisis?
Tax systems will need to change
There are many uncertainties about what the post-COVID-19 environment will look like. One thing we know for certain, however, is that once this pandemic is concluded, all countries will face significant fiscal pressures. This will be the case for countries that went into the crisis with reasonably strong positions but for others the position will be even more critical. For example, in SA the long-term fiscal consequences of COVID-19 will be enormous, raising questions about government’s achievable priorities.
Apart from reducing expenditure, the other significant lever government must manage fiscal deficits is taxation. Governments will have little choice but to look at both corporate and income tax regimes to address the fiscal deficits. Initial reviews will centre on closing tax loopholes – always a focus with governments, but typically lobby groups have been able to de-rail implementation. The extent of the fiscal pressure will focus minds, and presently “favoured” parties will come under tax scrutiny. This could include private equity (carried interest), the cruise industry (offshore registration), the self-employed (company tax) and even a review of tax treatment associated with different capital structures.
Radical financial remedies become mainstream
A slightly left field issue. The unprecedented monetary and fiscal response to the crisis will raise questions about whether such policies should become more permanent in nature and enter mainstream political debate. For example, only six months ago Modern Monetary Theory (MMT) was denounced as intellectually challenged and inappropriate for the US. However, the justifiable monetary and fiscal responses to the COVID-19 crisis have echoed many of the points raised by MMT. There is definitely a danger that radical economic and financial policies will become mainstream, with associated risks. Issues could include MMT, Debt Forgiveness and Universal Basic Income (UBI).
2) Disruptive Technologies become Mainstream
Growth in Internet based Transactions
The lockdown associated with the COVID-19 pandemic has provided an enforced re-appraisal by individuals and corporations of the type of transactions that can be undertaken online. This was already an area of considerable growth, particularly in the consumer space. However, it was always assumed that adoption would occur over time as consumers and corporates gradually accepted the reality of change.
What COVID-19 has undoubtedly done is accelerate that acceptance curve. Individuals and corporations have literally been forced to move to internet-based transactions. The result has been a large-scale experiment and a significant majority will recognise the unchallenged convenience and efficiency benefits. This will not just include virgin users. Equally powerful will be the existing adopters, who have now been able to broaden their online activities and will expect that to continue.
For example, the Lovett household has for many years been aggressive users of online retail for all transactions, bar food. For very personal reasons (some logical – some less so) we have insisted on retail stores for food purchases. COVID-19 has forced us to address that anomaly and it’s fair to say that we are unlikely to return to previous ways. A small change, but substantial if multiplied across millions of families and businesses. The corporate attitude to the enforced change has also been substantial – direct to consumer strategy is the buzz word amongst corporate strategists in a large number of industries, even those which have historically relied on intermediaries as a route to market.
Positive impact: Amazon, Takealot (Naspers), internet orientated retailers, last mile logistics providers, warehouse property.
Negative impact: Certain physical retailers and retail property.
Payment Technologies (incl. security)
Payment technology is already a massive market but the combination of the proliferation of commercial sales channels (see above) plus continued move away from cash transactions (hygiene) could supercharge growth rates. For hygiene reasons, a number of retailers have already moved to non-cash transactions only and many will apply that expectation post deconfinement.
Positive impact: Visa, Mastercard, PayPal.
Negative impact: Cash collection businesses (Bidvest), small businesses without the scale for payment systems investment.
Another long-term trend that I would expect to accelerate post COVID-19 is the corporate acceptance of remote working. Once again, the enforced experiment in remote working has shown its effectiveness as an alternative to the office environment. Accompanying this will be growth in workplace digital tools to help facilitate effective remote communication and interaction.
Beyond the important societal change, increased remote working will have major implications for certain critical industries. I would anticipate a long-term reduction in the demand for office space as companies reassess their requirements in such a new working environment. On the positive side, there will be a more immediate boom in technology associated with remote working. This will include the physical infrastructure as well as supporting software, particularly in the human capital environment.
Positive impact: Broadband providers, cloud-based infrastructure (Amazon, Microsoft), video conferencing capability (Zoom, Microsoft Teams), specialist HC software providers.
Negative impact: Office property, hospitality and retailers based around office clusters (coffee shops, bars, restaurants).
Growth in AI and Virtual Reality
Related to the debates above, particularly around b2c and d2c internet sales initiatives, I would anticipate an increased recognition and utilization of AI and Virtual Reality tools. There is the potential for an “arms race” in this area as companies desperately invest to differentiate their online propositions. The longer-term question is whether successful utilization of virtual reality can undermine the stranglehold that physical location-based businesses have on areas like training, events and conferences – a huge and extremely expensive component of corporate budgets.
Positive impact: specialist technology and marketing companies.
Negative impact: Traditional marketing, corporate events and conference businesses (particularly 2nd tier).
Growth in streamed entertainment
During the lockdowns initiated during the pandemic, individuals were forced to find in-home entertainment as a replacement for traditional activities. The enthusiasm for the vast majority of these activities will undoubtedly prove to be temporary – I’m personally not expecting the explosion in home baking to be sustained.
There are, however, some extremely well-established streamed activities that will be able to use the COVID-19 experience as a platform for even stronger growth going forward. This will come at the expense of more traditional consumer spend. The sceptics have been forced to consume and assess the attractiveness of instantly accessible content relative to other forms of entertainment. Streaming subscriber levels have already grown substantially during the lockdown and, while they will moderate to some degree post-containment, the new base level of consumers will be noticeably higher.
Positive impact: streamed entertainment (Netflix, Disney), online gaming businesses (Tencent, Activision), online betting businesses.
Negative impact: traditional entertainment (cinema, terrestrial television).
3) Behavioural Changes
I would like to be an optimist and suggest that the positive behavioural traits exhibited during the crisis (focus on society and family etc.) will be long-lasting in nature. Commentators anticipated this post 9/11 but New York quickly returned to business as usual. It must be assumed that life will return to normal in terms of attitudes, behaviours and the basic human desire for social interaction.
There are a couple of areas where the effect of the COVID-19 crisis could be longer lasting – hygiene and social distancing. The latter is the most controversial. There is little doubt in my mind that the extensive media coverage on germ transmission will linger for some time in people’s conscious and associated behaviours. A desire or even requirement for personal space – particularly in an indoor environment – will become embedded and will result in a slow return to normality. This will challenge high-volume, low-cost business models where utilisation rates are crucial. Hygiene concerns will also ensure that demand for hygiene-related products will remain elevated for an extended period post the end of the pandemic.
Positive Impact: exposure to consumer hygiene brands (Reckitt Benckiser, Clorox), voice activated technologies, e-bikes, home food businesses (e.g.UberEats).
Negative Impact: High volume/ low cost hospitality models (incl bars, restaurants gyms), airline industry, public transport providers, foodservice equipment.
Sharing Economy business models more challenged
One of the features of the last decade has been the substantial growth in the sharing economy. Several global businesses and brands were established on the back of this growth opportunity – many unicorns that have yet to reach profitability (e.g. Uber, Airbnb). With the post-COVID-19 hygiene concerns, there must be doubt about whether the historical growth rates can be maintained. For example, will consumers begin to challenge the relative merits of a professionally cleaned/ serviced hotel room relative to an Airbnb host? This may not totally de-rail the structural growth story but any slowdown could have material implications for business valuations in the public and private capital markets. The end of the unicorn model has been predicted for some time but perhaps COVID-19 is the catalyst for a reassessment in certain areas.
Positive impact: Branded hotel industry (marginal).
Negative impact: Sharing economy growth and business model valuations (Uber, Airbnb).
4) New routes to market
E – Healthcare
Earlier we highlighted segments of the economy where COVID-19 will accelerate already well-established growth trends. It will, however, also be the catalyst for certain emerging trends to move into the mainstream. One of the most obvious is E-Healthcare.
Consumer acceptance of remote diagnosis, engagement and even consultation during the lockdown will accelerate the attraction of e-business models focused on efficiency, immediate access and remote monitoring. The historical barrier to entry of physical engagement may no longer be applicable as telemedicine type models gain traction.
Even in the public sector, GP friends are desperate for a continuation of digital communication with patients rather than overflowing and inefficient waiting rooms. While new businesses will undoubtedly be established to capture this trend, I suspect that established healthcare/ pharmacy brands will have a competitive advantage in developing this market. This, however, will be dependent on their recognising and committing to the trend which, interestingly, the incumbents failed to address during the rise of Amazon and Netflix.
Positive impact: Consumer focused healthcare brands (Clicks, Walgreen Boots, CVS Health), wellness focus technology brands (Apple, Fitbit, GoPro).
Negative impact: Traditional providers of physical contact healthcare services.
E – Education
The other significant opportunity that COVID-19 has spotlighted is remote learning; its value and applicability have been cemented by experiences during lockdown. Very well established and professional Massive Open Online Courses (MOOCs), particularly in the US, had already attracted a committed supporter base in remote learning. Lockdowns will have profiled the optionality and attraction of remote learning, particularly those products which are supported by multi-media technology. There are also opportunities for remote application in the corporate world where location-based training is still a huge expense that could be transformed with the adoption of professional remote provision.
Positive impact: E-education providers.
Negative impact: Event or classroom provision of education or training.
E – Financial Services
The COVID-19 crisis, and particularly the corporate lockdowns, is magnifying the debate about an acceleration shift of traditional financial services advisor/ physical contact models to embrace digital. Again, COVID-19 has highlighted to people that previously unchallenged physical contact activities can be professionally serviced in a remote environment. Necessity can sometimes cause consumers to reassess change rather than insist on a mechanical return to the original approach. Unlikely to be a complete revolution but maybe a stimulus for an evolving trend.
Positive impact: Progressive financial services businesses.
Negative impact: High cost physical engagement business models.
E – Fitness
Lockdowns have generally resulted in severe restrictions on people’s ability to exercise in a traditional way. Gyms are closed and sports activities cancelled. Individuals have responded by exploring new home fitness opportunities – whether simple recorded fitness videos or the much more sophisticated multi-media orientated fitness-based products. The duration of the lock down, plus the potential lingering hygiene concerns around gyms, will result in home fitness becoming a mainstream market.
Positive impact: Multi-media fitness products (e.g. Peleton), health monitoring products (Fitbit).
Negative impact: Gyms
Moderation in regulatory barriers to new technology
This is a slightly left field view but one that could emerge as a theme. Prior to COVID-19 there was significant governmental, regulatory and media pressure to exert more control over large technology companies. Facebook et al have faced considerable challenge about whether they should be regulated/ unbundled and new technologies have been handicapped with more onerous rules. Free market capitalists had worried about this trend and, in particular, the potential loss of US leadership in technology to the Chinese. In the war on COVID-19, large technology companies are suddenly seen as part of a solution rather than a problem. The effective dissemination of information and leadership in contact tracing are seen as opportunities for redemption for the technology companies.
In addition, Asia’s relative success in dealing with the virus has been linked into the aggressive use of technology, particularly tracking technology. Regulatory concerns associated with privacy have made this impossible in the Western world. While we would not expect any fundamental change in the regulatory environment, there is a good chance that a more rational and balanced debate will take place on regulatory issues associated with technology utilisation. It is also interesting that, during the lockdown, regulations in certain new technology areas (e.g. drones) were relaxed without obvious negative outcomes. Left field but an interesting debate.
Positive impact: US technology companies.
5) Business Challenges
Prior to COVID-19, operating margins in the US market had reached record levels and surpassed previous economic cycle highs. A combination of the extended business cycle, efficiency improvements and low wage/ cost inflation had created a perfect environment for listed corporates. This was most evident in the US but was also a global feature.
There are a few issues associated with the post-COVID-19 world, however, that may challenge the ability of some companies to return to recent margin and ROCE peaks. Any perception of a ceiling on profits would obviously influence equity as the default asset class for risk investment. Strategic Asset Allocation debates could look to challenge equity with better risk-adjusted asset classes elsewhere in the capital structure (e.g. credit or separate asset classes like Infrastructure). To some degree this has already occurred internationally, but the cult of equity remains very firmly embedded in SA.
Apart from taxation, below are some of the issues that will face businesses globally:
Business held more accountable to different stakeholders
To my mind, this is the most significant post-COVID-19 business challenge. After the GFC, the perception in the western world was that the banks were morally in debt to society for the financial bailouts initiated by the central banks and government on their behalf. Even today you hear the rhetoric imploring banks to act for the greater society and against their commercial instincts.
The COVID-19 bailout, on the other hand, has benefitted the whole business community. I would anticipate that a similar moral challenge will be directed towards business, asking it to support a broader base of stakeholders, including governments and employees. Future dividend payments, and certainly share buybacks, will be scrutinised through a different prism.
In addition, payments to shareholders may have to be reconciled with the requirement for balance sheet flexibility to absorb future problems. The era of mass share buybacks to supplement shareholder returns is firmly behind us. The pressures will be even more intense for any business that accepts physical capital as part of COVID-19-related bailouts. This is potentially less likely in SA, where there have been fewer direct corporate support initiatives. I would also expect the hurdle for large public takeovers to become more challenging, as different stakeholders’ interests will need to be reconciled.
Challenge to real time supply chains
With the issue of product and component availability arising in several areas, there will be a challenge on whether the super-efficient, real-time global supply chains that industry has relied on will be replaced with logistics that has some slack for business continuity. Industries such as automotive were shown to be massively exposed when even one area of their supply chain is challenged. This was the case when the COVID-19 crisis was simply limited to China and future supply chains will probably need some flexibility which would hurt profit margins.
Some consumer behaviours will take time to reverse
This is the most important discussion in the very short term. Once lockdown ends, we will have to understand which industries will return to normal and where there will be delays. Corporate indebtedness will undoubtedly increase and a deferment of normality could raise concerns about liquidity and profit.
COVID-19 has undoubtedly driven a dramatic and sudden shift in financial systems and societies worldwide. The extent and depth of this impact still remains uncertain and is likely to be individual to each nation. Assessing whether changes across these many themes, both locally and globally, will be sustained is critical in steering our investment decision-making.