The post-COVID-19 period could be labeled the “New Century” as much of the past will remain just that — in the past. In the meantime, without broadly available vaccines for some unknown period, Americans will need to adjust to living with exposure to the virus. At the same time, Americans already live with other risks and, therefore, will likely gradually adapt to this new one. Certainly, investors will adjust since they normally invest under uncertainty. As important, selective industry sectors, particularly services such as hospitality, leisure, and travel, will likely continue to suffer until vaccines become broadly available or therapeutics successfully treat the virus.
How Americans adjust to this new risk will prove one key to the speed of the economic recovery. Epidemiologists express concerns about the continued presence of transmission risks from the virus. Despite those warnings, average Americans will gradually take increasingly active steps to reconnect as the economy opens up (see Figure 1). Unlike recovery from past lengthy recessions, recent economic strength still remains fresh in consumer minds. Their memory may help stimulate those steps leading to a strong sequential third-quarter economic recovery.
Nonetheless, consumers likely suffered psychological scars from the pandemic. If that proves correct, the resulting impact may cause consumers to limit their spending to products and services they need not want and therefore save more of their incomes. This possible shift will likely see traditional and generic brands gain at the expense of new products from younger companies. This change will also likely further benefit general merchandisers with their value pricing, e-commerce giants, as well as dollar stores. These shifting currents will likely hurt middle-market retailers and further reduce the number of storefronts. As in other industries, the “New Century” will lead to greater consolidation among the largest corporations serving consumers while testing whether the weakest can survive.
In our view, investors do not give sufficient importance to the roles that both service sectors and small businesses will play to move the economy forward and lower unemployment. Overall, services contribute 70% to GDP. The government-mandated recession truly brought many service sectors to a halt. For example, one major service sector — leisure and hospitality — lost nearly half of its 17 million jobs. That decline represented the biggest job loss of any sector (see Figure 2).
Many service sectors depend on high customer densities for their success. Therefore, fully regaining “normal” business levels may be hampered as customers feel reluctant to patronize them until vaccines become more widely available. With the continuing need for social distancing, many of these affected service sectors will need to innovate new methods to serve their customers. At the same time, in the “New Century,” more entertainment and leisure time will likely center around the home to the advantage of various products and services. When widely available vaccines show up, many of these trends will still likely continue.
A recent Baron’s article outlined the importance and potential contribution of small business to an economic and employment recovery. More specifically, small businesses contribute half of US GDP and generate 40% of total business revenues while employing half of US workers.
It seems likely that economic lockdowns hurt small businesses more so than large corporations. A University of California Santa Clara economic study showed the number of working business owners declined from 15 million this February to 11.7 million in April, a decline of 22%. The damage to small businesses may explain, in part, why investors scratch their heads when they see a “V” shaped rebound of equity markets marked against a cloudy economic outlook. This difference shows up when comparing the performance of the S&P 500 index — comprising large corporations — which declined roughly 5% so far this year while the Russell 2000 — representative of the small business sector — dropped approximately 16%.
Recently revised more favorable terms for the Fed’s main street lending program should enable both small and mid-sized businesses to take greater advantage of these loans. More than 19,000 firms employing a total of 30-40 million would come under this program. If the program proves successful, it will likely boost the small business outlook , thereby helping to restart the economy.
Housing construction provides a major impetus to economic recoveries. In the past, housing construction contributed 18% to incremental GDP growth following each recession since 1970, with one exception (see Figure 3). The one exception – the 2008 Great Financial Crisis (GFC). Fundamentals today, unlike that period, should enable housing construction to contribute importantly to a potential economic recovery. According to Harvard’s Joint Center for Housing Studies, those important current fundamentals show that housing declined nearly 2 million units since 2007, while over that same period, households grew over 12 million. As a result, vacancies stand at their lowest level in decades.
Adding to those favorable housing fundamentals, the 30-year fixed mortgage rate recently reached record lows (see Figure 4). With these low interest rates, purchase mortgage applications reached multi-year highs (see Figure 5).
Therefore, unlike the post GFC period, a stronger housing recovery seems more likely. If that proves the case, the housing recovery will benefit many sectors supporting the new and secondary housing markets. As important, housing construction would make a meaningful contribution to reducing unemployment. To reemphasize our prior comment, in the “New Century,” the influence of the pandemic will see Americans refocus activities on their home, including working from it.
Recession in an election year also makes for a political event. Current polls suggest a blue wave in November — with this caveat 2016 polls also did not favor the President. If that change occurs, this new direction will likely reverse economic programs enacted in periods before COVID-19, expand social programs, and review the direction of regulatory actions. Therefore, matching increasing dominance by the largest US corporations in the “New Century” will be an increasing role for the Federal government.
With the potential change in Washington, social programs enacted during the pandemic to replace lost incomes and extend the safety net will likely be made permanent. These new programs and already growing deficits will bring higher taxes — no matter which party wins. However, tax rate increases may wait until signs that the recovery shows sustainable strength. The following table from the tax foundation provides a brief outline of tax proposals from the Biden camp (see Figure 6).
One tax policy change raises the corporate tax rate from its current 21% to 28%. According to a Goldman Sachs estimate, each one percent increase in a corporation’s “effective” income tax rate reduces earnings somewhat over one percent. If the polls prove predictive, investors will need to rejuggle long-term earnings growth expectations.
The pandemic renders “meaningless” most earnings forecasts for this year. Therefore, there exists no forecastable “E” in P/E ratios for a large majority of US companies. Without earnings as a basis for valuation, the “V” shaped market recovery, instead, reflects investors' response to the Fed’s “nationalization” of credit markets, which flooded those markets with liquidity. Those actions forced investors to turn to the equity markets to boost their returns by assuming greater risks.
Earnings reality will likely return to the equity markets later this year and for 2021. For next year, investors will likely base their earnings forecasts off of historical operating, income, and balance sheet relationships. However, in the “New Century,” the past will remain just that — the past. If that assumption proves correct, then using historical financial and operating reports will provide little basis for forecasting future results for many companies.
In our view, the impact of the pandemic will lead to major differences between corporate haves and have nots. The haves will likely grow much larger and increase their dominance. No doubt, the timing of when vaccines become broadly available will determine the extent those differences grow. However, in our view, many forces unleashed by the pandemic may still prove difficult to reverse. As we move into 2021, these forces will likely create surprising earnings results, both positive and negative. The overall market effect will likely lead to a number of big winners, big losers, and big volatility.
While the pandemic creates greater uncertainty and potential for change, it also creates greater opportunity for the dynamism and ingenuity of American businesses and workers to take advantage of that change. In our view, the resulting outcome may speed up the introduction of more productive systems, to the advantage of long-term economic growth. Recognizing the near-term uncertainties outlined in this commentary, our investment recommendation remains 40% equities, 35% alternatives, and 25% fixed income. Based on this commentary, quality companies that will take advantage of these changes and show long-term above-average growth should come out big winners. In the case of fixed income, we continue to recommend short-term credits to preserve capital. Finally, alternatives fit ideally into the environment described in this commentary.
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