By: David McGrath
What is the New Normal?
With the massive spending by the Federal Government and sharp revenue declines for public entities across the country, it is hard to imagine taxes not going up at some point (but not until after the election). As such, do not be surprised to see both individual and corporate rates eventually increase. The political pull and lack of economic insight in Washington will simply be too strong.
While the CARES act was being negotiated in Congress, there was an intense focus to ensure the money would not go towards executive compensation or share repurchases. As a result, many corporations immediately announced the suspension of their share repurchase programs. This is extremely important.
As the economy slowly recovered from the 2008/09 financial meltdown, many companies found it difficult to significantly grow top line sales. In order to increase their earnings per share more rapidly than they could by revenue growth alone, companies used a substantial portion of their profit to shrink the number of outstanding shares in the open market. This has been a major driver of per share earnings growth for the past 11 years. So, if share buybacks are not going to be part of the equation for increasing earnings growth, we can expect a headwind on share prices.
While the impact of COVID-19 will vary between companies and industries, the pressure on margins will be considerable across the board. From the need (and desire) to social distance, the need to constantly sanitize surfaces, reduced capacity in stores, etc., will all put downward pressure on margins.
Social distancing and the move towards remote working over the past few months has dried up merger activity. After all, it is difficult to get everyone in the same room to make a deal when nobody wants to, well, be in the same room. As we start to reopen the economy, we should expect to see merger activity increase. Many companies have been left vulnerable with the strain placed on weak balance sheets, and leverage has swung from sellers to the buyers. The companies with strong balance sheets will look to gain new competitive advantages by acquiring weakened players which could fill a void in their current offerings, while eliminating unnecessary overheard.
The other player that will look to take advantage of the current situation will be the rapidly growing private equity market. Capital in the past few years has been flowing out of hedge funds and into private equity funds. Until the COVID-19 crisis, private equity was running out of publicly traded targets that made financial sense to take private, but that seems to be changing. We look for a significant increase in private equity deals the over the next 12 months.
Between mergers and publicly traded companies getting purchased by private equity firms, the trend of declining number of publicly traded companies will continue. The other consideration for mergers is political. Larger mergers need government approval, and the general thought is Republicans are more willing to allow larger mergers, and Democrats tend to be against mergers of larger corporations. With the election in November, and the uncertainty of who will control the White House and both chambers of Congress, larger mergers may happen sooner rather than later. Just a few weeks ago, Massachusetts Senator Elizabeth Warren and New York Representative Alexandria Ocasio-Cortez announced the “Pandemic Anti-Monopoly Act”, which would place a moratorium on mergers on companies with a market capitalization of $100 million or greater. The bill has very little chance of becoming law, but it is another reminder that elections have consequences.
The COVID-19 crisis has also place a spotlight on our reliance on China for many of the items that are now deemed of national security. There will be a renewed focus on getting many of these products produced in the US, or at least countries that we have better relation with (eg Mexico). This will create a small manufacturing renaissance in the US. This will be important as many of the jobs that are being lost in the service and hospitality industries will not return, and those workers will need to “retool” their skills to find employment. This will take some time, and one of the results will be an unemployment rate that will remain higher that many expect as we recover from the economic shutdown.
In a trend that has been in place for quite some time, the demand for skilled workers remains high, with low unemployment rates and much higher wages than the lower-educated, unskilled workers. This “transition” from service jobs to manufacturing jobs will exacerbate that situation. The large pool of unskilled workers available to fill any new jobs created will keep wages low, while increasing demand for the small pool of skilled laborers will allow for above average wage increases. Don’t be surprised if this is a major topic of debate in the presidential election.
As in any recession, some industries will be effected more than others. This crisis is no different. The current sectors that will see dramatic changes include:
Restaurants
On average, not a very high margin business. The reduction in capacity, forced compliance with new safety regulations and potentially lower demand will make it difficult for many restaurants to survive. The buffet style restaurants will be forced to completely rethink their business model.
Retail
The continued trend toward online shopping places more and more pressure on the traditional brick and mortar retailers. The demise of the mall concept will be set into overdrive, and foot traffic will not return to the pre-pandemic levels.
Real Estate
The change in the retail sector, combined with the sudden realization that a significant number of people can work remotely, will have an effect on the real estate industry. We are not sure how much of the workforce will be asked (or request) to work remotely when we are past the current pandemic, buy it will not be 0%.
Oil
The domestic oil industry was hit with a terrible one-two punch. First, the synchronized global slowdown that saw worldwide demand for oil fall by roughly 30%. Then, Saudi Arabia and Russia started a price war the flooded the world with unwanted oil. The collapse of oil prices from the $61 price at the start of 2020 to around $20 as this is written, will make it challenging for many domestic oil companies to keep the doors open. It will also have an impact on the financial institutions that have an unusually large amount of their loans made to these companies. We will need to see a dramatic increase in global demand just to allow us to have enough available storage to put the excess oil.
One sector that should benefit from the current conditions is healthcare. The constant headwind since the early days of the Clinton administration on healthcare, and more specifically pharmaceutical companies, seems to be subsiding. It is now understood that the ability to quickly find solutions to new viruses is as much a national security issue as a health issue. We all look with hope are promise to those companies to find a solution to the COVID-19 pandemic. The sudden glairing importance on a strong and robust drug and healthcare system should allow political cover that this sector has not seen in decades.
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