30 March 2020

Coronavirus, business confidence and what comes next


The Covid-19 crisis is approaching its economic peak. Most Western economies are largely closed. Stock markets have been in freefall for several weeks, and may yet test deeper lows. Companies are in shell-shocked reaction mode, scrambling to protect what remains by cutting commitments across the board. Yet that instinctive reaction – to conserve by reducing risk and locking away cash – might well be the worst possible thing they could do.

Consider the asymmetry of the private and public worlds. Governments across the developed world have taken one look at the Covid-19 challenge and reached for the money taps. A rough calculation of the stimulus already agreed puts it around $4 trillion right now, but expect that figure to rise. It is already the biggest government spending spree since the Second World War.

This would not have happened if the private economy had not moved in the opposite direction. There are exceptions, like Amazon’s reported plan to hire 100,000 new staff, but most companies are retrenching: shutting up factories and offices, closing retail chains, and standing down distribution networks. Governments are turning on the taps because businesses are wrenching them in the opposite direction.

Imagine the setting of a large corporate crisis management team today. Most big companies will have a team structure and protocols already in place as part of their routine disaster recovery planning. They will have been through simulations of pandemics, along with other disasters like terrorist attacks including dirty bombs, nuclear accidents, bacterial releases, and severe weather. They may have psychological profiles of how employees are likely to react, and resilience maps to show how strong or vulnerable their business partners are. They will have designated crisis leaders (usually not the chief executive, who is more likely to be tasked with running what is left of business-as-usual), and frontline teams designed to feed back data to the crisis management office.

Yet for most of the last few weeks the most important thing these crisis teams need will have been missing, and that missing thing is information. The list of known unknowns has been very long. What is the true case fatality rate of Covid-19? What is the transmission rate? How long will the pandemic last, and where will it emerge next? What are government guidelines and policies today? What will they be tomorrow? In a vortex of uncertainty like this the temptation to act fast and act defensively becomes very strong.

Hard data show that businesses have already begun to do that. The Purchasing Manager’s Index which measures spending intentions in the corporate economy and is a good guide to near-future business activity has collapsed to record lows across Europe and the US – and those readings are based on data gathered just before the Covid-19 virus fully took hold.

Effectively, business has become ultra-short term. Long-term confidence has evaporated. Cash is king, and meanwhile budgets not yet allocated are being suspended. Projects, hiring and capital expenditure are all on hold because amid extreme uncertainty anything beyond the end of the month spells risk.

Companies will say that is how it has to be, because they have no idea what their future revenues will be. But is that really how it ought to be? There is evidence that businesses that meet a downturn by cutting back hard and fast on investment, talent and new projects may not do particularly well when the economy recovers. They may not even survive at all.

A few years ago Harvard Business School looked at how businesses had reacted to several downturns including the recessions of the 1980s and 1990s, the dotcom bust of 2000 and the global financial crisis. The research gauged how companies changed their investment strategies, their hiring and their financing. In all, over 4,000 company histories were profiled according to their reactions to recession (bear in mind the UK along with the rest of Europe and the US is almost certainly in recessionary conditions right now, although technical recession will only be called after two consecutive quarters of data).

In the Harvard study companies were grouped according to how defensive they were during and after a recession. The most defensive cut their costs faster and deeper during the downturn, and held that strategy for longer. They were also the least likely to succeed during the recovery period. Some did, but around 75% of companies with purely defensive strategies did not do well in terms of financial performance, or sales and revenue growth, compared to the average.

Take just one example, the Japanese electronics giant Sony. It was once the Apple of the personal electronics world – its products were desirable, innovative and beautifully made (who didn’t want a Walkman when they were new?). Shiny Sony things were more expensive and more profitable than the competition.

Today? Not so much. Sony remains an important company, not least because the Sony PlayStation is the world’s most successful gaming console, but there have been no more Walkmans. Sony smartphones do not greatly excite, Sony cameras struggle to capture attention, Sony computers are hardly front-of-mind. What happened?

During the global financial crisis Sony was one of those companies that cut very hard, closing factories, reducing headcount by 16,000, and delaying investments. This was merely a repeat of the company’s strategy following the earlier dotcom bust, when workforce, research and development, and capital investment were all cut back sharply. The cuts had their intended effect which was to improve profit margins immediately, but they came with the unintended effect of reducing sales growth drastically (from 11% to 1% in the case of the 2000 slowdown).

Exactly why purely defensive strategies seem not to work well is a matter for debate. The Harvard researchers suggest it might be because when cost-cutting is the only thing the company seems to be doing then a systemic pessimism takes hold that is very hard to shake off. Cutting exposures and risks becomes the primary strategy, irrespective of whether risks are well worth taking. And even when the crisis has passed, negative assumptions persist.

Talking up investment, innovation and creativity in the midst of the biggest public health crisis for a century may seem invidious – but experience suggests that planning for the recovery is usually the weakest part of any crisis and resilience strategy, and is frequently left far too late. When everyone is focussing on practical problems and practical solutions including a safety-first approach to business and to life, it can be difficult to remember that deep pessimism is rarely borne out by actual performance.

Recovery calls for vision, and a willingness to take risks. Companies unwilling to take a gamble on the likely future now may pay a price in the actual future.

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Richard Walker is a journalist and communications adviser to financial companies.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.