The coronavirus has thrown the markets for a loop, understandably. Half of the solution is understanding the problem, so we are reassured by the universal and unified policy responses globally.
On Tuesday, March 17, 2020, Laffer Associates hosted a conference call on the medical and scientific response to the coronavirus. According to Dr. Michael Stabile, a top professional in HCA’s medical system, and Dr. F.J. Campbell, Chief Medical Officer and Chief Quality Officer of Ardent Health Services, the US is much better prepared than much of Europe to minimize fatalities. A critical determinant of success is the number of intensive care unit (ICU) hospital beds per 100,000 people in a population. The US has 34 ICU beds per 100,000, similar to 29.5 in Germany but significantly above the 12.5 in Italy and 6.6 in the UK. They believe that two to three weeks ago, the US entered what in hindsight will be a two-month cycle at which point fatalities should peak, probably at much lower rates than most people now fear.
Global Policy Resolve Can End Crises and Cause or Sustain Bull Markets
I recall three periods of global policy resolve during my career, each of which launched or sustained significant equity bull markets: The Plaza Accord in 1985, Y2K in the mid-to-late 1990s, and the Global Financial Crisis in 2008-09. Each response was either in anticipation of or in the midst of serious economic setbacks and, although some of the bull markets ended in excesses that required correction, investors enjoyed equity appreciation for a minimum of two years.
After a 50% increase in the dollar from 1980 to 1985, for example, finance ministers from around the world gathered at the Plaza Hotel in New York City, acknowledged the risk of widespread deflation in a dollar-starved world, and coordinated policies to normalize currencies. In response, the S&P 500 nearly doubled during the next two years.
On the heels of a Computerworld article, “Doomsday 2000”, in 1993, Massachusetts programmer David Eddy coined the acronym Y2K in the middle of 1995, inspiring books like McGraw Hill’s “The Year 2000 Computing Crisis” in 1996 and guidelines like the British Standards Institute’s “Year 2000 Conformity Requirements” in 1997. As governments around the world aimed both fiscal and monetary policies at thwarting a technology-related economic meltdown at the dawn of the new millennium, the S&P 500 more than tripled during the four years from mid-1995 to late-1999.
Finally, during and after the subprime mortgage meltdown and Lehman Brothers’ bankruptcy during the Global Financial Crisis (GFC), fiscal and monetary policymakers around the world united in their efforts to prevent economic collapse, highlighted famously in 2012 by European Central Bank President Mario Draghi who proclaimed, “…the ECB is ready to do whatever it takes to preserve the euro… And believe me it will be enough.” From its low point in March 2009, the S&P 500 had more than quintupled at its peak earlier this year.
Global Policymakers Are United in Attacking the Coronavirus and Averting Recession
So, here we are again, this time facing the global economic consequences of a virus named “SARS-CoV-2” and the disease it causes, “coronavirus disease 2019”, COVID-19. Governments around the world are responding once again with resolve, both fiscally and monetarily.
A few weeks ago, in an effort to understand how serious COVID-19 might be, I interviewed Professor Isaiah (Shy) Arkin, the Arthur Lejwa Professor of Structural Biochemistry at The Hebrew University of Jerusalem, whose expertise includes flu viruses. Please find the link to our podcast here.
While discussing the worst, best, and most likely outcomes, without downplaying the seriousness of this virus, I began to believe that social media fears have gone more viral than will COVID-19, causing more hysteria – and stimulus – than otherwise might have been and will be the case. Indeed, this coronavirus does not seem to be hitting the young, an observation that social media seemed to have missed as of last week but may be recognizing now. In the course of comparing COVID-19 to the common flu, most of us have gained meaningful perspective on the statistics: in the US alone, the winter flu typically impacts roughly 35 million people, nearly 10% of the population, and kills almost 35,000 people, disproportionately the elderly and the young.
In contrast, as winter draws to a close, COVID-19 has impacted fewer than 200,000 people thus far, not just in the US but globally, killing 7,000-7,500, disproportionately the elderly. In the US, it has infected fewer than 5,000, killing fewer than 100. That said, because COVID-19 hit US shores much later than it did Asia and Europe, with testing in earnest beginning just in the last week, the odds are high that negative headlines will persist for several more months.
While the mortality rate is higher than that of the typical winter flu, the total number of cases is likely to be much lower, not only this year as spring approaches in the northern hemisphere but also in the future for three reasons: the Trump Administration closed our borders to non-Americans from China in late January and from Europe in mid-March; Roche developed a test in record time  while Gilead and other biotech companies are repurposing anti-viral therapies to break the back of the coronavirus. Also encouraging is a recent study based on data from China and South Korea suggesting that chloroquine, a 75 year old generic drug developed for malaria, not only controls COVID-19 but also prevents it. Moreover, while this time could be different, viruses tend not to survive in warm weather, so the odds of sustained human and economic duress are diminishing. In addition, the precautions that consumers and business have taken to avoid COVID-19, especially now that state and local governments in the US are locking down their communities, could limit the number of cases and deaths associated not only with COVID-19 but also with the more traditional winter flu.
The Odds of a Global V-Shaped Recovery Have Increased
Given the extreme policy measures in force in China and elsewhere, the odds of a V-shaped global economic recovery from this short-term shock have increased, something considered impossible based on the behavior of equity markets globally during the last few weeks. Election year stimulus in the US already seems to have greased the skids.
For the past year, I have been struck by the dichotomy between consumer and business confidence and spending in both the US and China. Until COVID-19 hit, consumer confidence and spending had been strong while businesses were retrenching. As measured by Bloomberg’s weekly Consumer Comfort Index in late February, US consumers hadn’t been as confident since the year 2000. Around the same time, the US Purchasing Manager’s Index (PMI) had plummeted to a four-year low. Consumers had been responding to record low unemployment rates  and accelerating wage gains while businesses had been unsettled, if not buffeted, by various trade conflicts and flattening to inverted yield curves. Historically, inverted yield curves have been harbingers of recession within 12 to 18 months but, as I have delineated in previous letters, they were commonplace during the last period of truly disruptive innovation in the 50 years ended the Roaring Twenties. In China, the story is the same: until recently, consumer confidence and spending had been strong while its PMI had plummeted.
In other words, inventories and capital spending have lagged well behind the optimism associated with consumer spending gains for an extended period of time, typically the recipe for a V-shaped recovery. In our view, while real GDP could be hit hard through mid-year by cancelled flights and conferences and state lockdowns, triggering another round of inventory and capital spending cuts, the rubber band associated with a global rebound has been stretching for more than a year now. As a result, a V-shaped recovery could surprise significantly on the high side of expectations at some point during the second half of this year into 2021.
Another narrative suggests that unsustainable corporate debt loads globally are in the process of fomenting a deflationary bust. By leveraging up to buy back shares or to dividend “stable” cash flows to private equity firms, many corporations have not prepared adequately for the future and do seem to be in harm’s way, particularly in sectors disrupted by this crisis and/or by disruptive innovation. We believe companies tied to energy, banks, other financial services, autos, bricks-and-mortar retail, traditional health care, and media are particularly at risk. Paying homage to technologist Clayton Christensen and to Austrian economist Joseph Schumpeter, “disruptive innovation” and “creative destruction” are likely to take on new meaning during and after this crisis.
Innovation Gains Traction During Tumultuous Times
During the worst financial crisis of our lifetimes, innovation gained more traction than most investors had anticipated. Companies offering faster, cheaper, more cost effective, and creative products/services gained significant share. During the GFC, Software-as-a-Service and online retail were prime beneficiaries. As technology budgets were cut by 20-30% in and around 2008-09, for example, during its worst quarter Salesforce.com chalked up a 20% increase in revenues. At the same time, while retail sales were falling, Amazon delivered 14% growth during its worst quarter.
In the early days of a bear market, while innovation does gain traction, the stocks associated with disruptive innovation tend to underperform. In a risk-off environment, benchmark sensitive investors sell innovation-oriented stocks as they seek “safety” in the benchmarks against which they are measured.
If the reason we founded this firm is correct, then this behavior will become counterproductive. Indeed, the risks associated with the traditional world order are rising, so much so that innovation-focused portfolios will become important hedges against benchmark sensitive and passive strategies. Digital wallets are likely to undermine bank branches and other financial services; autonomous electric vehicles should disrupt traditional autos, ridesharing, logistics, short-haul airlines, and railroads; and collaborative robots could be an answer to labor shortages and social distancing while artificial intelligence and blockchain technology solve for supply chain inefficiencies globally and payments infrastructure in emerging markets.
We believe that the turbulence caused by the coronavirus is giving innovation another opportunity to break through the traditional world order. Unlike their entrenched and bureaucratic competitors, our companies tend to be scrappy, lean, agile underdogs that know how to manage through FUD (fear, uncertainty, and doubt). Each of them is contributing to the five innovation platforms evolving today – DNA sequencing, artificial intelligence, robotics, energy storage, and blockchain technology – and offering solutions to the problem. Thanks to breakthroughs in DNA sequencing and artificial intelligence, for example, researchers sequenced the COVID-19 virus in just two days, compared to five months for the SARS coronavirus in 2003. As a result, the FDA is likely to approve the first vaccine against COVID-19 within 12-18 months. Now that we have learned that cash could be a virus “super-spreader”, consumers are likely to adopt contactless payments like Apple Pay and digital wallets like Cash App or Venmo at accelerated rates, once they venture from home. Until then, because the home is now the central hub of activity, businesses are likely to boost spending on productivity and collaboration tools/services, as well as the infrastructure to support digital employees, while consumers boost spending on streaming videos and gaming, not to mention on-line education and telemedicine services. Finally, because the coronavirus has disrupted supply chains and is causing parts shortages globally, quick-turn manufacturing and 3D printing parts closer to end demand should gain more traction, while robotics may help with social distancing and productivity gains to salvage profitability.
COVID-19 has gone viral, with social media instilling fear – if not hysteria – and exacerbating the dichotomy between consumer and business behavior that has been in place for more than a year. While inventories and capital spending are likely to fall during the next few months, governments around the world are united in their response and resolve to resurrect demand, a dynamic that has been associated historically with buoyant equity markets. As a result, the odds of a V-shaped global recovery in both economies and equity markets are increasing.
As is typical during periods of turbulence and fear, consumers and businesses are willing to think differently and change their behavior. As both look for cheaper, more productive, or more creative ways to satisfy their needs, we believe that disruptive innovation will take root and gain significant market share.
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