Some Historical Effects of Pandemics and Wars
Stocks of many high growth companies, especially in technology/software sectors and those benefitting from the pandemic, have declined sharply from 2021 highs. Many are down 50-70%, and some are even trading below 2019 pre-pandemic levels. While the individual stock prices of companies fluctuate significantly in any given year, the underlying intrinsic value is obviously much more stable, like a private business or your home. Surprisingly, the median volatility for any single stock in the US stock market (S&P 500 and Russell 2000) is 40-60% in a calm year and nearly 200% in a crisis year, such as 2008 or 2020. (1) Diversification helps; however, the entire S&P 500 Index exhibits intra-year volatility of 14% on average. (2)
When applying an ownership mentality to evaluating businesses, we strive to separate the stock price volatility from the underlying long-term fundamentals and focus on key inputs that will impact the future of each business we own. To do this, in addition to the specifics of each company, we also evaluate longer term trends on a broader thematic and industry basis. The continuing effects of the 2020 Pandemic as well as the 2022 Russian invasion of Ukraine have caused us to evaluate the businesses we own, as well as prospective investments, in light of an adjusted outlook in a variety of areas, including energy, labor, and inflation.
Oil prices have gone from the lowest in human history (less than zero) to over $100/barrel in just 18 months. Economies across the globe are forecasted to grow for years to come as they recover from the pandemic, even after accounting for the Russian invasion. Similarly, we expected energy prices to remain elevated for the medium term even before Russia’s recent actions. Consistently predicting energy prices is nearly impossible, and there is always a chance that supply increases will outpace demand, and prices will decline.
However, the First Quarter 2022 Dallas Fed Energy Survey reports that U.S. operators are currently exhibiting unusual capital discipline. (4) As indicated by the following chart, decision makers are hesitant to ramp production only to see prices decline and repeat the painful 2014 experience when oil declined from approximately $90 to below $60 per barrel for years.
Based on our research and anecdotal evidence, our sense is that while capital discipline and supply chain issues are driving current hesitation to ramp production growth, ESG, regulatory, and reduced institutional investor interest could play an increasingly significant role in the medium term. Conversely, policy makers and investors could change the course to support increasing domestic energy production and exportation. Recently, an unprecedented release of oil from U.S. strategic reserves was announced.
The Permian Basin located in West Texas and New Mexico is uniquely positioned to become the world’s most important driver of production growth due to its vast reserves, low breakeven cost per barrel, and significant transport infrastructure.(5) We expect sustained production growth in the Permian over the next several years.
Liquid natural gas growth is also projected to be driven by the U.S., especially now as Europe changes policies in response to the Russian invasion of Ukraine.
Energy investors Goehring & Rozencwajg have proposed a contrarian view that almost the entire drop in renewable energy costs over the last decade came from lower conventional energy prices, rather than technology advances. They believe there has been a large misallocation of resources to renewable technology because energy input costs were unsustainably low, like when excessively cheap capital leads to malinvestment.(3) Time will tell whether their assessment is accurate, but we acknowledge there is an increasing chance of a severe energy driven economic shock.
The broad takeaway is that the traditional U.S. energy sector is becoming increasingly relevant.
Tight Labor Market and Class Conflict
A tight labor market has emerged in the wake of the pandemic, which is consistent with the history that Nicholas Christakis details in his book, Apollo’s Arrow: The Profound and Enduring Impact of Coronavirus on the Way we Live. One study of pandemics observed that such widespread disease causes the death of working age adults while leaving capital assets relatively untouched. This results in real wages rising and real interest rates declining over the subsequent 20+ years.
On an interactive webcast, Christakis, provided additional insights. He would not be surprised to see women’s labor force participation rate, which has plateaued in the U.S., to decline over the next decade or so. According to Christakis, the pandemic has caused some people to re-evaluate their priorities with many finding new appreciation for spending time with family/children during the pandemic. Additionally, burnout has arisen as a significant factor, especially in the healthcare sector. Nursing shortages are expected to persist.
While the deaths of working age adults related to Covid are much less when compared to prior pandemic averages, many people, especially working class and essential workers, are deciding to retire early, change careers, work fewer hours, etc. This dynamic has played out before and can result in class conflict. The following account after the Black Death in Rochester, England around the middle of the 14th century gives perspective:
“Such a shortage of workers ensued that the humble turned up their noses at employment and could scarcely be persuaded to serve the eminent unless for triple wages. Instead, because of the doles handed out at funerals, those who once had to work, now began to have time for idleness, thieving, and other outrages, and thus the poor and servile have been enriched and the rich impoverished. As a result, churchmen, knights, and other worthies have been forced to thresh corn, plough the land, and perform every other unskilled task if they are to make their own bread.”(6)
The global economy is much more dynamic and resilient compared to the 14th century, but we think it is reasonable to assume a tight labor market will persist and put downward pressure on corporate margins, all other factors being equal. The number of quits in the U.S. rose after vaccines were rolled out and continues to hover near all-time highs.(7)
We believe the hybrid work environment will persist for certain professions and therefore may support certain trends centered around the internet that accelerated during the pandemic, such as in-home connected fitness services, home delivery, and online learning. Also, cybersecurity services are becoming a high priority for governments, corporations, and individuals.
Companies that have invested in employees, productivity enhancing technology, and fostered unique cultures will be better positioned to retain and attract talent, compared to companies that have not.
Pandemics, Wars, and Inflation
Future inflation rates will be a key determinant of future economic growth and investment returns. The recent U.S. 12-month trailing inflation rate of 7.9% is the highest since January 1982 when it was declining from a peak of 14.8%.(8) Fed officials have pivoted from a dovish “transitory” view to a hawkish plan to raise interest rates significantly.
Interestingly, studies of European pandemics and wars between 1314 and 2018, such as that by Bonam, Dennis and Smadu, show that on average pandemics cause inflation to decline significantly below its initial level for more than a decade, and that it takes about two decades before inflation reverts to pre-pandemic levels. More severe pandemics with higher death tolls resulted in greater economic impact compared to milder pandemics. These decreases in aggregate demand, and therefore lower inflation, stem from a decreased population due to pandemic deaths as well as a general behavioral shift towards greater levels of caution in the wake of distress including increased financial savings as well as lower levels of interpersonal interaction. Conversely, wars result in above trend inflation, with similar correlation based on severity and duration. (9)
Economists speculate that, unlike in pandemics in which physical assets are preserved, wars cause aggregate demand to increase in post war reconstruction as countries repair and replace the destroyed assets. Also, governments often relied on money printing and inflation to pay for the war costs, fueling currency devaluation.
RESPONSE OF TREND INFLATION FOLLOWING A PANDEMIC OR WAR EVENT
Notes: SHADED AREAS REPRESENT THE 90% AND 95% CONFIDENCE INTERVALS.
Source: Bonam, Dennis and Andra Smadu. “The long-run effects of pandemics on inflation: Will this time be different” Economics Letters, Volume 208, November 2021, 110065. www.sciencedirect.com/science/article/pii/S0165176521003426.
It is possible to point to both similarities and differences between the historical impacts of wars and pandemics upon inflation versus our current world experience. Many of the recent policy responses to the pandemic from industrialized nations were both swifter and larger than historical reactions. In fact, we wonder if the technology enabled a pivot to work from home and widespread government assistance have muted the economic impact relative to historical averages. Further, the monetary and fiscal stimulus enacted since the Global Financial Crisis, that ratcheted even higher during the pandemic, should theoretically increase inflationary pressures.
Large scale, capital investments have accelerated in the wake of the pandemic and may spur aggregate demand, like a post war reconstruction period. For example, Meta (aka Facebook) spent $10 billion last year on the metaverse and plans similar levels going forward. Analysts at Morgan Stanley predict a “red-hot capex cycle,” with overall global investment projected to be 121% of pre-recession levels by the end of 2022.(10) Decision makers have experienced first-hand the costs of lean inventories and non-diversified supply chains. Going forward, investors will be more willing to fund investments to protect supply chains from shocks and some industrialized nations may mandate domestic production of critical energy and raw materials, healthcare supplies and the ability to produce important next generation technology hardware.
Overall, using an economic history of pandemics as a template, our takeaway is that after a spending bump, aggregate demand may be structurally lower going forward, relative to the trend that it was in place in 2019, especially if the current “quality of life” behavior persists to the detriment of overall consumption.
Over time we will have a better understanding of the long-term economic impact of the pandemic, but we are confident there will be long lasting effects, if only on future generations, as governmental policy responses do not come freely. The following chart of U.S. federal debt held by the public as a % of Gross Domestic Product should quell any skeptics. (11)
U.S. FEDERAL DEBT AS A PERCETAGE OF GROSS DOMESTIC PRODUCT
Source: Congressional Budget Office. The 2021 Long-Term Budget Outlook.www.cbo.gov/publication/57038.
Our investment process focuses on businesses with high and/or improving returns on invested capital and strong competitive positions, which usually results in pricing power. We believe that these attributes should help protect investor wealth from an inflationary environment, should it persist. And we shall continue to be focused on owning companies with favorable tailwinds that can offset any long-term demand headwinds associated with the pandemic or Russian invasion, including those that provide goods and services that increase worker productivity, protect corporate profitability, or target the improved “quality of life” of which the recent tragedies have made human society more aware.
Redmond Asset Management, LLC April 2022
The opinions contained in the preceding commentary reflect those of Redmond Asset Management, LLC. The stated opinions are for general information only and are not meant to be predictions or an offer of individual or personalized investment advice. They also are not intended as an offer or solicitation with respect to the purchase or sale of any security. This information and these opinions are subject to change without notice. Any type of investing involves risk and there are no guarantees. Redmond Asset Management, LLC does not assume liability for any loss which may result from the reliance by any person upon any such information or opinions.
Redmond Asset Management, LLC (RAM) is an independent, SEC registered investment management firm located in Richmond, VA and is not affiliated with any parent organization. RAM was founded in 2005 and registered with the SEC on 22 Dec 2005. The company offers investment management services for equity, balanced and fixed income portfolios to corporate, institutional, and individual investors.
1 Oakcliff Capital’s Bryan R. Lawrence presentation, “A stock-picker’s two challenges.” Grant’s Conference. October 19, 2021, vimeo.com/640846688 Accessed 4/1/22.
2 J.P. Morgan Guide to the Markets, 1Q 2022, slide 16.
3 Goehring, Leigh R. & Adam Rozencwaig. “The Distortions of Cheap Energy.” Q4 2021 Commentary. info.gorozen.com/2021-q4-market-commentary-the-distortions-of-cheap-energy. 4/1/2022.
4 Federal Reserve Bank of Dallas. Q1 2022 Dallas Fed Energy Survey Special Questions. www.dallasfed.org/research/surveys/des/2022/2201.aspx#tab-questions. 4/1/2022.
5 Wethe, David, Sheela Tobben and Kevin Crowley, “Why the Global Oil Market Hinges on Five U.S. Counties.” Bloomberg. www.bloomberg.com/graphics/2022-global-oil-permian-basin/. 4/1/22.
6 “Chronicle of Black Death 1348.” The British Library. www.bl.uk/learning/timeline/item126557.html. 4/1/2022.
7 U.S. Bureau of Labor Statistics. “Number of quits at all-time high in November 2021.” TED: The Economics Daily. www.bls.gov/opub/ted/2022/number-of-quits-at-all-time-high-in-november-2021.htm. 4/2022.
8 Ip, Greg. “Why 7% Inflation Today is Far Different Than in 1982.” The Wall Street Journal. www.wsj.com/articles/why-7-inflation-today-is-far-different-than-in-1982-11642012166. 4/1/2022.
9 Bonam, Dennis and Andra Smadu. “The long-run effects of pandemics on inflation: Will this time be different” Economics Letters, Volume 208, November 2021, 110065. www.sciencedirect.com/science/article/pii/S0165176521003426. 4/1/2022.
10 “An investment bonanza is coming.” The Economist. May 29th, 2021 Edition. www.economist.com/finance-and-economics/2021/05/25/an-investment-bonanza-is-coming. 4/1/2022.
11 Congressional Budget Office. The 2021 Long-Term Budget Outlook. www.cbo.gov/publication/57038. 4/1/2022.