The week the world changed

Share markets have fallen to reflect the new reality of a sharp downturn and a substantial reduction in corporate profits.

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  1. Charles Stanley

This week the western world changed dramatically. The USA, Germany, France, UK and many other advanced economies saw the imposition of strict controls or tough guidance to reduce people’s contact with each other.

Most of the measures target hotels, restaurants, bars, travel, sporting and cultural events, theatres, cinemas and gyms. The aim is to stop or discourage people enjoying mass entertainment and tourism, ways by which the virus spreads more rapidly to more people. This will cause a sharp downturn in economic activity.

In a normal recession the downturn builds gradually. The most exposed companies offering luxuries or discretionary items suffer larger falls in turnover than those producing the basics of everyday life, but they retain substantial business. In this crisis, however, many businesses in these affected areas will simply have to close, losing all their turnover overnight. They are large employers of labour, so there will be substantial job losses, unless governments step in to pay employment subsidies to businesses to keep staff on without customers.

Some larger businesses have a spread of interests, which helps. Others may be able to earn some extra revenue from a rapid change of business model. A restaurant, for example, may be able to sell meals for home delivery from internet orders. Overall though, the hit to these businesses is very large and will depress the economy and knock confidence.

On top of the health crisis, Russia and Saudi Arabia have chosen this moment to slash oil prices and undermine expensive oil production elsewhere. That’s resulting in far less new oil investment and development. 

There will be some short-term winners from the crisis. As meals out are cancelled so more food will be sold direct to retail customers through food stores. In the short term, they will also sell more as people build up higher stocks.  As cinemas close more people will download movies from online entertainment services. As trains and buses lose customers who work from home, the suppliers and service businesses offering laptops, tablets and business connectivity will do well from a new army of homeworkers. Makers of gel, cleaning fluids, cold and flu treatments and their retailers will also see a surge in demand. 

Yet the overall net impact will be substantially negative. So far, most shares have fallen sharply with the market, though of course the most at-risk sectors and companies have fallen the fastest.

Policy response

The Central Banks have responded strongly to the challenge. Interest rates have been cut dramatically by the US Federal Reserve and lowered by the Bank of England. The Fed, Bank of Japan and the European Central Bank have announced more quantitative easing – flooding the financial system with new money. Most countries have put in place programmes to try to ensure adequate credit lines for business to borrow against a temporary downturn and to offset some of the fears.

We are now moving into a phase where governments are announcing payments to households to reduce some of the economic damage the closures are doing. They are looking at schemes to keep people’s incomes up where they are faced with unemployment or a loss of self-employed income. They are also launching or considering schemes to let businesses off tax payments or to inject cash directly into businesses struggling for customer revenue. The French President has said companies will not be allowed to go bust, which he hopes to achieve through tax breaks and credit lines. Other governments need to take action promptly.

The market reaction

So far share markets have fallen to reflect the new reality of a sharp downturn and a substantial reduction in corporate profits overall. They are also adjusting to the possibility that some companies will now be operating at a loss in the short term, and that there may be bankruptcies from the drying up of turnover.

This, in turn, affects the company debt or bond markets. Companies who have borrowed to grow their leisure and hospitality business, or to drill for expensive oil may struggle to repay. After a period when many investors bought risky bonds because interest rates were low and economies were still growing, there is now more anxiety about some of these companies’ ability to honour their debts. Bond investors have shown a preference for safer government debt despite the very low income available on it.

The outlook

What will turn this round? Buyers will return in bigger numbers when we can see an end to the closures and a pathway to a more normal economy. This will require the authorities to succeed in controlling the spread of the virus, or a change of approach that allows greater economic activity. The latter option is easier once there is a vaccination to give more people immunity.

In the meantime, the virus-induced stress looks set to accelerate trends already apparent to investors before the epidemic. There will be more flexible working. There will be more online shopping and less physical retail outlets. There will be more online entertainment, education, information and work. The digital revolution will further advance at the expense of traditional business models. In due course, its success will benefit shareholders. 

There will also be a substantial increase in the role of the state, which may lead to more moral or legal controls on company pricing, profits and remuneration. As the state makes a more active contribution to company finances it will wish to make sure its money does not result in excess dividends, bonuses and pay.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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