Our previous note relating to the corona virus discussed the short term impact of the frenetic global response to the pandemic, and the optimal strategy for investors in conditions of high uncertainty and fast moving markets. To recap in a concise manner: we didn’t know when the bottom would be, but our judgement and experience suggested to us that there was a real value opportunity presented as retail investors panicked and hedge funds were forced to liquidate.
As this update is written markets have risen sharply from their lows and reduced the pace of oscillation – at least for now – and we want to discuss our analysis of the longer term ramifications of the virus, of governments responses and finally to what the economy will look like when it emerges from lock-down.
We are all now comfortable with the concept of “flattening the curve”. This is the key outcome desired from the global action that has been taken and locking down the economy. In a nutshell; by prohibiting social interactions we can suppress the spread of the virus and contain it within the capacity of the NHS.
So lock down it is.
We (SORBUS) are in a privileged position. Our revenues will decline in line with our clients assets, which is absolutely appropriate, but considerably less than the fall in stock markets. We were also cloud based and tech enabled from our inception in 2012 meaning we have transitioned to working remotely with minimal disruption. We have been able to accommodate the needs of our team and our business and proceed on a “business as usual” basis with remote working. Our model has proved robust and resilient in the face of exceptional circumstances. We have no debt, no external shareholders, are amply capitalised and remain solidly profitable. Whilst we could never have foreseen these circumstances, we have always been mindful of business continuation and we absolutely recognise our (relatively) favourable position.
The key word there is “relatively”. Our situation is atypical as things stand today.
Very significant parts of the economy in catering, hospitality, events, leisure, advertising, marketing, manufacturing etc. and all of their supply and value chains are not experiencing modest declines. They are seeing their businesses eviscerated. Revenues at zero in some instances.
Harvard Epidemiologist Marc Lipsitch commented that there are:
b) Informed extrapolations from analogies to other viruses, and
c) Opinion or speculation
The scientists and medical bodies advising the government have the same limited data to try and work with to make informed recommendations, and politicians have to then suggest a course of action that is appropriate: they can operate using all of these three.
The consequence to the economy of the lockdown is currently largely devoid of fact and relies heavily on b) and c) for many reasons:
1) There is minimal data. We have startling rises in unemployment figures (the US unemployment figures today take the cumulative total of jobs lost since the March lockdowns began to more than 16m – just reflect on that figure for a moment) but little other hard data at this point. We have some informed speculation by modelling sensitivities of sectors to hypotheses and attaching probability weightings to them but the outcome of this is not much more precise than knowing the direction of travel.
2) The consequences of the governmental response are unknown. Some business costs are being met by the state, many are not.
3) We have to try and aggregate a view as to the time sensitivity of the economy to lockdown when all companies have slightly different combinations of being affected by the drop in revenue, the proportion of their cost base that is helped by the government interventions, and the state of their balance sheet.
THE ECONOMIC AND SOCIETAL COSTS OF THE LOCKDOWN
At the moment the political and media discourse is overwhelmingly about saving lives, clearly a massive societal obligation. But the growing pool of anecdotal evidence and insight we have gleaned from extensive dialogue with our clients and our intellectual and commercial networks over the last few weeks implies that the economic and societal consequences of this lockdown are profoundly more significant than is being recognised by the media/social media at the moment.
The Office for National Statistics said today that 59% of the 4,600 businesses they surveyed said they did not know or were not confident they had the financial resources to continue operating through the crisis.
We should not pretend that all of the most sensitive and exposed businesses will reopen if this lockdown lasts beyond June. It may feel comforting for employees to be furloughed. They can self-isolate and enjoy or endure the process with their pay packets down but still arriving. But at the end of the lockdown they will not be going back to work. They will be unemployed. “Lucky” companies with plenty of cash will survive, however the popular misconception is that staff will saunter back to companies employing the same number of people they did before. They will not. Companies with debt and with low profitability will fail and fail quickly. They will not reopen at all.
The extent of the unemployment and business failure will only be visible once the support announced by the UK government ends and the lockdown is rolled back. Today’s announcement that these support packages will be funded by the Bank of England printing money is another alarming signal of where we are.
On the flip side a small number of companies will profit handsomely. Supermarkets will have robust sales and profitability, consumer staples will endure and some companies will thrive. One company (Plus500) whose shares we own in our growth fund (VECTOR) reported revenues growing by 400% in a month (it offers market trading in derivatives and thrives when volatility is high). Companies providing car insurance will get a windfall as claims plummet etc. But these are exceptions. Current estimates of the recession show an economy contracting by between 15% and 30% as things stand. We always attach a very low credibility to economic forecasts but this does not seem implausible.
If we look beyond the immediate winners and losers there will be profound secular shifts in patterns of behaviours and consumption. Indeed when we examine the situation right now it is important to try to distinguish between consumption that has been temporarily postponed, accelerated, or disturbed, and new, more permanent patterns of consumption. The weekend away in Barcelona is lost, but the piles of loo rolls stockpiled is an accelerated consumption for example.
Crises accelerate change. The second World War brought a host of new ideas as the threat of war forced innovation and accelerated development, the cold war did likewise. Already companies are being forced to embrace technology to facilitate remote working. This is dramatically accelerating a trend that was already forecast but would take us 10 years to get there – the use of digital to reduce travel to and from workplaces, resulting in increased productivity and reduced environmental impact. We’ve got there in just a few weeks.
Companies that embrace the possibilities of a “good” crisis will come out leaner and meaner. We have all seen the environmental positives – the wildlife returning to urban spaces, the skies above Los Angeles clear of smog. How tolerable will it be for us to revert to the prior state?
The crisis has disrupted supply chains that were maximised for efficiency. This will change and resilience and robustness will be the response, driving flexibility into systems.
The role of women and disabled people in the workplace is likely to accelerate as these new working patterns undermine some of the barriers that previous employment structures created.
There will be manifold potential consequences as these new patterns of work, production, employment and organisation emerge. This can be enervating and creative and unleash huge amounts of innovation. There are secular shifts happening everywhere that may well ultimately be of great benefit to the economy and the environment.
But first, we have to get ourselves out of this current hole.
THE LOCKDOWN CHESS GAME
The current political position is in effect “lockdown to save lives”. This is problematic as the cost/benefit is nuanced. Firstly the trade off implied by the policy (lockdown to save lives) is not binary. It is not “lock-down = saving lives” v “going back to work = £/deaths”. These options are dynamic, in tension and do not operate in isolation. A prolonged lockdown will equal destitution and poverty the likes of which we have little comprehension of. A truly great depression. Avoiding this is also a massive societal obligation. We don’t know where the equilibrium point is – where the death toll of the lockdown will exceed the death toll from COVID-19 but we do know that we are going towards it at great pace. Our estimates of how time-sensitive the UK economy is to the lockdown is amplifying.
We must acclimatise ourselves to the notion that “saving lives at any cost is paramount, so prolong the lockdown” is a fundamentally false argument. It is not an option. All options will lead to increased deaths and societal damage. As a society we will have no choice but to roll back the lock-down in the coming weeks/months knowing that it will cause more deaths. But this is the least bad option when the opposite will cause even more deaths and societal damage.
This is an incredibly hard position to explain and justify as a politician. We do not want to criticise the government response because we do not envy their responsibility in navigating the path between this Scylla and Charybdis choice.
In the not too distant future the least bad option will be sending people back to work and trying to protect the most vulnerable, knowing that this will cost lives. But it will be the right course because the cure is exacting a greater toll than the disease.
It appears that the most plausible way out of this lockdown is as follows:
1) Raise the line
a) Increase capacity of temporary hospitals (Nightingale hospitals at EdExcel in London, the NEC in Birmingham) all over the country. The huge event facilities are going to be unused for the rest of 2020 and appear ideal venues.
b) Rush supplies of specific equipment, and we need to develop a rapid specialisation within the medical responses to allow retired medical staff to return and existing medical staff to be repurposed to the specific needs of this response.
2) Raise the curve (NOT flatten)
a) The policy must be to ensure that this extra capacity is fully used. The lockdown is being used to keep the cases below the capacity threshold. As the threshold rises then the number of cases must be allowed to rise across the country.
b) Localise the response. The universal lockdown is a solution created in London, by London dwellers for London’s problems and imposed on the rest of the country. This is obviously wrong. If Leeds (for example) has surplus capacity then Leeds must be sent back to work until the excess capacity is exhausted. Cities and regions will have to work together to try and flush as many cases through the system as possible.
c) The argument for closing schools is the least justifiable of the policy responses. Children have low risks from the virus, and they are not spreaders. The economic costs of keeping the schools closed is significant as it has a disproportionately large impact on productivity.
d) Take more risks with the curve exceeding capacity. Leaving unused capacity will cost lives due to the damage from the lockdown. The return to work will be patchy across the country. It may need reversing in certain places for a period should opening up lead to an escalation quicker that hoped. This is not failure, this is necessary experimentation.
3) Find a vaccine and therapeutic response
The end of the pandemic will be when there is a deployed vaccine that protects citizens from the virus and therapies that materially diminish the mortality rate of those that get it.
But the end of the pandemic is not the end of the problem. The government’s ability to reverse the lockdown is not wholly within its power.
THE PSYCHOLOGICAL EFFECT
People have been scared and have panicked. You can see that in the shopping practices, the stock market over reactions and in discourse on social media. They remain scared and mindful of friends and loved ones.
The end of the lockdown will not see theatres opening – who would want to go and take the risk? How will going to a restaurant feel? When will a 65 year old with asthma return to his local pub? When will couples next book a weekend break abroad?
Significant parts of the economy rely on a psychological latent precondition none of us has ever really had to examine before: people need to feel safe. They do not feel safe right now and while you can ban someone from going to work (for a period), you can’t make them go back to work or go shopping or to a football match.
It seems certain that many will continue to sanitise their lives in the future to a degree they would not previously have considered. The mind is the last thing to heal after an injury. It may take the discovery, testing, regulatory approval and deployment of a vaccine before people return to pre-pandemic behaviour patterns. This is going to be 2021 if we are lucky.
We also need to consider the durability of the solidarity being displayed throughout the country as we continue in lockdown. We are suggesting that governments will consider sending children back to schools in the knowledge that some will die as a consequence. This would be a barbaric proposal if it weren’t that the death toll from not doing so will be higher. What happens when a teacher says “we must protect the children above all else” and refuses to go back to work? What happens when a fit and healthy 30 year old Liverpudlian who is being made destitute by the lockdown refuses to comply with self-isolation?
The economic recovery will start when the lockdown starts to draw down but will not be complete by the time it finishes.
As the market panicked at the emergence and scale of the coronavirus we slowly but decisively moved from being defensively positioned to taking more risk. As we discussed at the time the justification for doing so was not because we thought we had reached the nadir of the deaths or expected a speedy recovery. It was because prices had absorbed and reflected the likely economic costs and had overshot. Equities had become too cheap. Since the lows the FTSE100 has rebounded by around 15%.
This changes the calculation again in that the cheapness has diminished and the economic consequences have become, to us, clearer. On the dial between aggressive and defensive we are again moving towards the latter. Every asset class has priced in a recession, so there is not much optimism out there – nor should there be when considering the short term prognosis. But pricing is at least calmer than it was.
The public dialogue is underestimating, in our judgement, the societal costs of the lockdown and it is underestimating the pace at which the lockdown is destroying jobs and prosperity in an irreversible manner. Our fear is that the country and government will persist with the lockdown longer than it should. The political cost of reversing the decision and advocating a policy that will lead inevitably to more virus deaths will outweigh the less public and slightly delayed societal costs from shortened lives, destitution and suicides from the economic damage.
We will continue to study and analyse this highly dynamic situation and remain both active and tightly focused on protecting our client’s best interests. We hope you have as pleasant an Easter weekend as you are able and that you and loved ones stay safe and healthy.