Like many long-term investors, we’re thinking about the potential long-term effects of the COVID-19 crisis. These are early days, of course, but we believe the effects of the pandemic could potentially shift relationships among corporations, their stakeholders and the state in ways that could have important long-term implications for equity investors.
In this article, we consider two themes on this subject: ESG and the rebalancing of company stakeholder interests; and fiscal stimulus and the likelihood of higher taxes and swollen government debt.
ESG and the rebalancing of stakeholder interests
Since the first coronavirus outbreaks, many companies have made an effort to help workers and customers who are particularly vulnerable to the financial and health risks associated with COVID-19. Often that has led to actions that are more favorable to stakeholders (including workers and society at large) and potentially less favorable to shareholders in the near term, although it is unclear how permanent this shift may be.
Among those actions are cuts in dividends and buybacks. This reverses a post-financial crisis trend of rising dividend payout ratios and buybacks, often secured through issuance of corporate debt, particularly in the U.S. Increased dividends and buybacks had been favorable to owners of capital, who saw their returns increase substantially. And in the past 20 years, a growing share of S&P 500 companies have linked CEO compensation to shareholder returns.
Amid the global pandemic, companies are cutting their dividends and buyback programs. At the same time, they are taking action to help their customers and workers. For example, Rightmove, a UK real estate company, announced significant reductions in the fees it collects from independent estate and lettings agents. Banks have announced repayment holidays and U.S. auto insurers have agreed to return a portion of excess profits derived from lower accident frequency due to lower miles driven during the crisis. A leading European luxury goods company is producing hand sanitizer in its perfume factories and plans to distribute 40 million face masks.
In emerging economies, companies are taking similar actions to support their communities, employees and business partners. Shortly after the virus hit, a leading Chinese restaurant chain provided free meals to emergency workers in China’s Wuhan province, where the virus first emerged, and began to roll out health insurance to all its restaurant managers. To help meet demand for personal protective equipment for health care workers, a Belarus-based digital design company developed a surgical mask that can be 3D printed, with design and manufacturing instructions available for free. In Brazil, a major retailer offered various kinds of support to its suppliers, including extended credit lines and guidance on accessing market financing.
We’d already seen corporate social responsibility gathering steam before COVID-19, and the crisis likely increases its importance as a differentiating factor among companies. Once the crisis passes, that importance may recede somewhat, but we don’t think it will disappear. As a result, we could see diminished profitability and reduced dividend payouts in more stakeholder-friendly businesses, especially in Europe. On the other hand, firms that are able to be “part of the solution” to the crisis (for example in the technology, health care and banking sectors) have an opportunity to enhance their standing with regulators and society.
Financial stimulus, higher taxes and sovereign debt
As most countries around the world have deployed unprecedented fiscal and monetary stimulus to mitigate the negative shocks from the coronavirus shutdowns, it seems clear that budget deficits and sovereign debt levels are likely to rise substantially. This may be compounded by increased spending on health care and welfare. As a result, taxes may need to increase to offset this stimulus.
The amount of fiscal stimulus announced so far already greatly exceeds the measures taken during the global financial crisis (GFC) in 2008–09 (Exhibit 1). As governments raise taxes to prevent fiscal deficits from spiraling out of control, we expect that wealthier households will generate a greater share of national tax revenues. Policymakers may have to make key choices regarding the mix of direct vs. indirect taxes (income tax is a direct tax, while a sales tax is indirect) and the taxation of labor vs. capital. Will existing tax credits be eliminated? Will new taxes be introduced? These are among the questions that will impact corporate profits and equity markets.
Announced stimulus greatly exceeds the measures taken during the global financial crisis
EXHBIT 1: CHANGE IN CYCLICALLY ADJUSTED PRIMARY FISCAL BALANCE AS A PERCENT OF GLOBAL GDP
Source: CBO, European Commission, Haver, UBS; data as of June 2020.
It is too early to speculate on what the exact impact of the different policy choices might be on sectors and companies, but the effects could be far-reaching. The upcoming U.S. election adds additional uncertainty: in the event of a Democratic sweep we may see an increase in the corporate tax rate to pay for recent fiscal stimulus. This would likely hurt some of the more domestic businesses that benefited significantly from tax reform in 2018, but we think the impact would be fairly broad-based.
Increased stimulus has been accompanied by much higher levels of sovereign debt issuance, another issue that will have an impact on the corporate landscape. The debt buildup implies that the risk of unsustainable public debts, and of sovereign defaults, is likely to increase meaningfully for many countries. For example, South Africa, which recently lost its investment grade status, will likely soon breach the 80% sovereign debt-to-GDP level, which is often seen in emerging markets as the “trigger point” for sovereign crisis.
We think the COVID-19 crisis has the potential to shift the relationships among corporations, their stakeholders and the state in ways that might have subtle but important long-term implications, especially in the regulation and freedom of capital deployment. We also think the government stimulus, while welcome in the short term, may lead to higher taxes in the long run, impacting companies in unpredictable ways. We continue to monitor all these risks as we analyze companies and sectors across the global economy.
Listen to our audio podcast on remaking stakeholder relationships after COVID-19