Corporate Decision-Making in the Fog of the COVID-19 War
If someone told you as recently as January 2020 that the economic and financial world would be brought to its knees by a virus, would you have believed it?
That within a few months, economic output would collapse and, in many countries, unemployment rates would surpass those endured during the Great Recession?
And by June, the World Bank would be forecasting a 5.2% decline in world GDP? More recently, the US Commerce department announced that American GDP fell by an annualized 32.9% in the second quarter of this year, a 9.5% decline compared with the same period a year ago—a shocking, Great Depression like figure.
What a year. Literally overnight corporate executives, sales and marketing managers, risk professionals and financial officers are facing an exigency to swiftly make a multitude of business decisions, cluttered by the overwhelming, suffocating forces caused by the fog of the coronavirus war.
Corporate decision-making is indubitably challenging in even the best of times. Our contemporary world is a complex array of interrelated factors that demand analysis—a process that has been rudely interrupted by the intrusion of a one in a hundred-year shock.
Factors that influence decisions and a force majeure
If nothing more, forty years in business has taught me that in times of unprecedented crisis, we forget the obvious. Those oft-forgotten market fundamentals always matter, especially at times of extreme, unprecedented stress. So, let’s take a step back, a deep breath, and review some time-tested fundamentals. No need for rocket science, just common sense.
Fundamental #1: Understand the differences between discretionary and nondiscretionary spending.
Businesses dependent on discretionary spending (luxury goods) are more vulnerable to economic stress and uncertainty than those reliant on nondiscretionary spending (necessities). Luxury goods, sometimes referred to as superior goods, make up a larger share of consumer outlays as an individual’s income rises. Examples include luxury automobiles, upscale restaurants, jewelry, and private education.
In contrast, as income rises, the proportion of income spent on necessities declines, even if absolute expenditure rises. Examples of necessities include used cars (or public transportation), staple foods (or fast food establishments), common household items, and public schools.
Figure 1: Luxury goods take it on the chin during recessions (source: Alfabank-Adres)
Figure 2: People shy away from costly eating options during times of stress (source: Alfabank-Adres)
Industries dependent on the manufacture or sales of luxury goods and services often succumb to consolidations during prolonged period of economic hardship as larger enterprises gobble up the smaller in a quest to ward off shrinking market shares. Or the small firms simply fail. Thus, businesses, particularly financials, will find more comfort having exposures in larger companies than the undersized that do not have the operational scale to survive downturns.
Spending often flows into travel and tourism, another segment which is highly discretionary. As such, all types of travel-related expenditures wane when the economy loses momentum.
This travel and tourism group is quite broad and entails lodging and restaurants, casinos, transportation, entertainment, convention/visitor bureaus, and support industries like travel agents and tour operators. Many businesses underestimate the long economic reach of travel and tourism, which helps drive economic growth and employment in many nations (see Figure 3).
Figure 3: Travel and tourism create jobs and profits (source: World Travel and Tourism Council)
With open-ended coronavirus-induced travel restrictions in play around the globe, and the risk that these may linger, many travel and tourism related industry groups will continue to suffer. Airlines (and aircraft manufacturers) are obvious casualties, even to a greater degree than during the Great Recession as depicted in Figure 4. Hotels, as see in Figure 5, reveal a similar pattern.
Figure 4: Airlines were crushed during the last cycle (source: Alfabank-Adres)
Figure 5: Hotels hit hard during the last cycle (source: Alfabank-Adres)
Fundamental #2: Be alert as producers and sellers of durable goods suffer during recessions and periods of uncertainty.
There is more at work than just the attributes that differentiate discretionary and nondiscretionary spending. It is equally as important to distinguish nondurable from durable goods. Nondurable goods include food, fuel, cleaning supplies, and paper products. These are products that require frequent replenishment and are often categorized as nondiscretionary.
On the other hand, many durable goods—such as automobiles, furniture, consumer electronics and appliances—are considered discretionary. Moreover, purchases of some durable items are tied to home sales and can lead to households taking on more debt—manageable during the early stages of an economic/credit cycle, but risky when recessionary clouds coalesce.
Durable goods were pounded during the Great Recession, while nondurables like tubes of toothpaste and deodorant sticks still flew off shelves. See Figures 6 and 7.
Figure 6: Durables track downturns; Nondurables are somewhat immune (source: ONS)
Figure 7: American durables mirror the cycle more than nondurables (source: BEA)
One might observe considerable variance for consumer durables in Figures 6 and 7. More on this later.
Fundamental #3: Do not underestimate the significance of capital spending cycles (CAPEX).
CAPEX—the term for corporate spending on machinery, equipment, software, training, and industrial infrastructure—is historically hyper-sensitive to both upturns and downturns in economic cycles, rendering it highly volatile. Often called private nonresidential fixed investment, CAPEX abides a simple principle: if aggregate national income increases following a recession, there will be a corresponding and magnified surge in private fixed investment. The reverse is true when economic output declines.
Figure 8: CAPEX performance is volatile becoming amplified during turning points (source: BEA, ONS, ABS)
The key lesson is that capital spending is highly cyclical, and industries correlated to CAPEX are in tow. Watch for weakened earnings from companies with a high capital intensity of production and identify their major suppliers of machinery, equipment, and software as these can collectively tank.
Incidentally, boom and bust cycles in CAPEX are equally relevant for equipment financing. Once activity erodes, defaults increase, and commensurately, asset values decrease because there is little or no demand for equipment during tough times. As collateral values fall, lenders often incur losses beyond what loss given default models predicted when capital equipment demand was robust.
Fundamental #4: Avoid being ambushed by inherent volatility.
So, what is all the concern over volatility? It can be the bane of corporate decision-making.
What makes volatility so perilous is that it often hides in waiting, with clandestine, serpentine opacity. Moreover, volatility is not always related to near-term risk—the two can be mutually exclusive. If there were a Holy Grail of metrics, volatility would be a leading candidate.
Be careful not to undervalue risks associated with historically volatile, idiosyncratic industry groups that have little correlation with economic cycles (e.g., commodity-based industries and those dependent on energy- or mineral-based suppliers). Oil and grain crops have long been among the most volatile of all commodities. Commodity-based industries are subject to the whims of global trade policies, commodity supplier petulance (think of copper and oil) and Mother Nature. See Table 1 for a summary.
(source: Alfabank-Adres)
Epilogue
In future installments, I will entertain several additional fundamentals including the challenges of retail businesses, technology and industry life cycles, recognizing the nuances of substitutable products and services, understanding the opportunities and risks of supply chains, and concentration risk. In two weeks, part 2 will be released so stay tuned.
Rick Buczynski, Ph.D.
Alfabank-Adres Chief Economist
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