As COVID-19 vaccinations get underway across the globe, it feels like the beginning of the end. However, even after the memory of the coronavirus pandemic eventually fades, the effects on the economy may persist.
History provides us some lessons in navigating a post-pandemic world. This year there have been many changes, and investors must consider which will remain and which will revert to what we’re familiar with. And then we must consider how that will affect our portfolios.
There are few recent pandemics (SARS in 2002, H1N1 in 2009) and epidemics (H7N9 in 2013) from which we can conclude. There was a lack of recorded data following the Spanish flu (1918). However, we can add to the data set by tracking trends that followed World War II, the oil price shock of the 1970s and the 9/11 terrorist attacks.
World War II allowed for a couple of comparisons. In the United Kingdom, supply-chain disruptions deprived people of goods. Products such as bacon, butter, sugar, eggs, meat, lard and breakfast cereals in the first half of the 1940s (during the war) had to be rationed. The rationing continued for the second half of the decade as supply chains were being reconstructed. Consumption for these goods went down anywhere from 21% (lard) to 64% (eggs). Despite a decade of forcing behaviors to change, when rationing became relaxed in the early 1950s, it only took a few years for Brits to consume food such as meat, lard, sugar and eggs in excess of pre-war levels.
Back in the U.S., the women’s labor-force participation rate rose meaningfully during World War II because women were needed, and the ladies eagerly and effectively stepped up. Post-World War II, the growth rate of women did not recede; it grew. You can credit other factors for assisting in that trend. However, the reality is that habits played a role in igniting that movement, as women became more accustomed to working outside the home.
Without World War II, the trend of women in the American workforce may not have begun until decades later, as it was an experiment that employers and households were not ready to give a chance. Putting in the effort to get past a sticking point is an example of a “sunk cost,” the expense of which would not have otherwise been incurred.
Another example of a sunk cost occurred after the oil price shock of the 1970s. Oil demand had grown at an average of 7% per annum from 1940 to 1973, and prices spiked.
From 1974 to 1985, oil demand growth averaged merely 0.5%. That decline in demand was due in part to higher oil prices. However, even after prices receded, oil demand remained depressed. In 1986 there was a new era of lower oil prices, but oil demand only grew 1.7% per annum to 2000. (Average-miles-traveled data didn’t appear to be a significant factor). That 1.7% growth rate was notably lower than the 7% growth rate before the oil price shock.
Oil demand dropped because of improved fuel efficiency. In response to higher oil prices, U.S. politicians began to regulate energy conservation for vehicles. Mandating less wasteful gasoline use didn’t happen before the oil price shock, in part because doing so would have had its own political costs. But once oil prices began falling, politicians had already incurred the “sunk” costs of changed legislation. It wasn’t worth it to them to roll back the fuel efficiency standards. Additionally, the technology developed by car manufacturers to increase gasoline mileage for cars was their own sunk costs. Car manufacturers wouldn’t have put money into research and development unless they had to. But they were forced to do so, and so now the technology was available.
After the 9/11 terrorist attacks of 2001, air travel was depressed for several years as consumers feared another attack. There was a bit of a turnaround in 2004. By 2010, according to many measures, air travel was embraced by travelers again. Air travel had mostly recovered even after having been decimated for years. However, many business travelers had developed new habits. They had become accustomed to using telephone calls and emails as a replacement for flights.
Recent pandemics and epidemics witnessed various social behavior changes, including masks and social distancing, that turned out to be only temporary. Other changes were associated with consumer behavior, but those changes appeared to have been ongoing trends that predated the illnesses. The illnesses looked to have only accelerated those trends that already existed by forcing people to accept certain sunk costs. These costs were not just of the monetary variety but also of time, effort and experimentation.
I suspect what happened after previous major shocks are what will occur after the COVID-19 pandemic. Most social changes will revert to the normal we knew. Trends that had been in place before the pandemic but were accelerated because of it will remain intact. I believe the stock market is already beginning to price this in. The prices of Energy company stocks remain suppressed, predicting that people will permanently drive and fly less. And the price of commercial real estate is languishing, suggesting that people will continue to work from home, at least more so than they were pre-pandemic.
Commercial real estate’s future may be forever changed as industries were forced to pay the sunk cost of working from home. The surge in remote working required the consumption of new hardware, the effort to learn new technologies, and the creation of corporate policies and workflows associated with remote employees. The move to remote working was a gamble many companies would not have taken if they were not forced to because it was a lot of effort. Also, companies were unsure of the effect on employee productivity.
While the gamble may have been involuntary, it paid off. The demand for commercial real estate will be permanently impaired. Certain individual real estate investment trusts may be worth holding onto, especially for the yield. But I would not advise starting new positions in any portfolio of REITs. And don’t buy any individual REITs unless your financial advisor thoroughly vets it. (That sounds a little like a legal disclaimer, but it’s more of a warning. And don’t call me about them because I’m probably not going to give you my blessing.)
Whether you examine consumption and employment habits post-World War II or social habits after previous pandemics, it seems improbable that people won’t go back to eating at restaurants or enjoying other forms of social gathering after some time has passed. I’d suspect that for a while longer, people might avoid the largest and densest forms of gatherings, such as public transit, cruises or indoor concerts. However, people will be able to shop for retail goods and groceries easily and remotely.
It will take longer to reclaim the pre-pandemic U.S. gross domestic product levels than some people may think, but only because there are these specific areas that will remain a drag for the economy. Other areas will enjoy a tailwind and will provide potentially good investment opportunities. Suppose you are considering reallocations to your portfolio. In that case, I’d encourage you to consider lightening up on Energy stocks and REITs. I’d rather invest in the Consumer Discretionary retail sector and, at some point, possibly Emerging Market equity.
Consumer Discretionary stocks could be buoyed via a rotation in stocks vs. bonds and among equity sectors. The distribution of COVID-19 vaccines has boosted expectations of more robust growth for the U.S. economy. In addition to Consumer Discretionary stocks, the anticipation of more economic growth has been a tailwind for Financials and Industrials. A more robust economy typically leads to higher interest rates for government bonds, which means a decline in bond prices. That loss of capital could shift investor holdings from Treasuries to cash and stocks.
Globally, Emerging Market stocks have begun to outpace the stocks of foreign developed companies, which is another sign of rotation. The recent improvement of EM equity prices is, I think, a sign of things to come. Vaccine immunization programs are getting started in developed nations ahead of EM nations. Even if immunizations lag developing countries, the recovery of the developed nations is expected to boost the earnings of EM companies. As shown in the graphic above, not only are the valuations of EMs more attractive than their developed counterparts, but their expected profits for 2021 are forecasted to be higher.
The lower valuations and better earnings expectations of EMs portend a continued advance in their stock prices for 2021. In my Nov. 15 column “Build a House in China,” I announced that I took a position in iShares China Large-Cap ETF (symbol: FXI). FXI is a “developed nation” way to gain access to emerging markets in Asia. During the coming weeks, I hope to either find a better entry point, or a hedged strategy, to broaden exposure to the emerging markets of Europe, Africa, the Middle East and Latin America.
Last week I made some comments about a possible rotation from Technology stocks. I am still holding more than a market-weight allocation to Technology stocks. But there is mounting evidence that I should reduce those positions in the coming months.
Compared to 2018 and 2019, the yield of the 10-year Treasury note is lower today. Lower interest rates can validate some level of higher valuations. However, that validation, at some point, becomes irrational. In the Tech-laden Nasdaq stock market index, nearly twice as many companies are selling at 20 or more times sales (as of Dec. 14) than in 2018.
A good rule of thumb in the private equity market is that you pay roughly five times free cash flow for a company. Five times. Free cash flow. Not 20 times sales. Valuations haven’t mattered, but at some point, they will.
This column appeared originally in The Berkshire Edge on December 21, 2020.