We believe opportunities to build wealth through venture capital will continue largely unabated because venture capital is all about innovation.
THAT DREADED BIG RED CORONAVIRUS
Last year at this time, we couldn’t imagine a virus impacting the world as the New Coronavirus, COVID-19, is impacting us today. Its repercussions will continue to be felt for a long time. Impact to date has been painful. In the U.S., more than 80,000 have died. Hopefully the growth in that number will slow significantly and quickly. Even more startling, 33 million jobs in the U.S. have been lost in just seven weeks, and we expect many of those won’t come back for a long while, and some never, as a substantial re-sorting of our economy takes place.
We need now to think about what this virus will mean to the economy over the foreseeable future. As venture capitalists, our VCapital team is thinking hard about this, and especially about what it will mean for our investors.
We will share some of that thinking here in depth, exploring a range of possibilities, because nobody knows for sure how the situation will unfold. Yet we all need to make longer-term decisions in the face of those uncertainties. I’ll conclude with what we believe all this will mean for venture capital investment.
CAN HISTORY HELP US FORECAST THE POST-COVID RE-SORTING AND RECOVERY?
The COVID-19 crisis is in many ways unlike anything we’ve ever experienced, and yet history does at least highlight some variables we need to pay close attention to.
The closest historical analogy is the Great Influenza of 1918, also known as the Spanish Flu. It was the deadliest pandemic in modern history, taking over 50 million lives worldwide and 675,000 in the U.S. For perspective, the U.S. population in 1918 was 103 million, less than one-third of today’s 331 million. An equivalent COVID-19 death rate in 2020 would mean over two million deaths. Thankfully our advanced knowledge and resulting actions are making it far less deadly. Unfortunately, though, the economic impact has been and will continue to be much greater than with the Great Influenza of 1918.
The U.S. did take some action on the health front during the Great Influenza of 1918. Business hours for many were staggered to reduce interpersonal contact, and schools were shuttered for a time. Yet without our modern medical knowledge and tools, far less action was taken, too many were infected, and far too many of those infected died.
The 1918 historical context was also very different. That virus came to our shores as WW I was approaching its deadly close. It spread like wildfire among huge military camps where soldiers were in very close living and working conditions.
While unfortunately there is really no coordinated global strategic plan to stamp out COVID-19 today, the absence of not only such a grand plan but also the kind of information dissemination we see today was also lacking a century ago. With the war still in progress, there were just some futile tactical efforts to contain the virus, which varied country-to-country, and even state-to-state, and were of dubious value.
ECONOMIC IMPACT OF THE GREAT INFLUENZA OF 1918 LIMITED BY LACK OF KNOWLEDGE . . . AND MAYBE SOME COVERT DECEPTION TOO
Focused on the war effort in 1918, the government “under-played” the danger from the virus, suggesting to the public that it was just the normal grippe that had been around for years. This may have been due to legitimate lack of knowledge, but maybe also due to some deception to help sustain war efforts.
Most medical personnel, despite a heroic effort, had no idea what was causing the pandemic or what could be done to break its back. While some leading doctors and researchers may have had somewhat greater knowledge, no one really knew what was making the virus so deadly . . . or even if it was “just a virus.” It was many years later that it was discovered that three genes of the virus weakened the bronchial tubes, leading to lung failure. Moreover, half of the deaths in the U.S. were actually due to resulting bronchial pneumonia, which killed in the absence of antibiotics.
Despite the unimaginable death toll, the U.S. got lucky from an economic perspective. With a war raging, large portions of the economy could not be closed. The Federal Reserve, established just five years earlier in 1913, was actively supporting the war effort, stimulating war bond sales by lending at low interest rates to banks to facilitate the purchase of those bonds and Treasury certificates. Those low interest rates also eased overall credit conditions, encouraging business and consumer borrowing, helping further to sustain the economy further.
Economic data for the period is spotty, but the flu impact, as reported by newspapers, was short term, generally constraining only selected service and entertainment industries, which were not the major component of the economy that they are today. As a result, U.S. GDP decline in the face of this horrific pandemic was just 1.6%.
At war’s end, pent-up demand following war rationing and redirection of resources from the war economy to the consumer economy resulted in a boom. The growth of new industries -- including radio, mass advertising, automobiles and airplanes -- helped stimulate the economy further, as the U.S. swung into the Roaring Twenties.
SO YES, OUR REALITY IS DRAMATICALLY DIFFERENT TODAY
While there is still much we don’t know about COVID-19, we are fortunate to benefit from the vast knowledge and technological advances amassed over the past century. We do know more about viruses and about epidemiology. We understand how viruses spread and the importance of social distancing. And modern technology has enabled much of the population to work from home. So as sad as 80,000+ U.S. deaths to date is, it is nothing like the death rate suffered with The Great Influenza, which would have translated to over two million deaths in 2020.
The vast differences in our economy versus 100 years ago also bring negatives. Industry sectors most affected – travel, tourism, hospitality, food service, entertainment, retailing -- account for a far greater portion of today’s economy than they did 100 years ago. That has meant 33 million people filing for unemployment in just seven weeks, and that toll (as well as the death count) is still rising.
Fortunately, more is also known about fiscal and monetary policy, and so aggressive government actions have been taken to cushion the economic toll as much as possible. Nevertheless, every day we hear about more businesses whose worker furloughs are turning into permanent shutdowns.
With all these differences in historical context, what can we learn from history to help us figure out how to approach the post- COVID period?
THE GREAT INFLUENZA'S THREE WAVES: IMPORTANT LEARNING
The Great Influenza raged in the U.S. for about 18 months, going through three waves. The first wasn’t too bad, but the second was far worse, before easing considerably in the final wave.
Eventually, despite numerous failed efforts to create a serum or vaccine, the virus essentially just burned itself out, evolving to a much lower level challenge -- the N1H1 flu. It appears that this “burn-out” was due perhaps to so many people becoming infected that subsequent herd immunity simply limited the extent of potential spreading. Unfortunately though, the N1H1 flu is still with us periodically, though at a lower level, and may even come back this fall along with COVID-19. In any given year, 3,000 to 60,000 in the U.S. die of N1H1.
As focus shifts to reopening the economy, it is important to consider the Great Influenza’s three-waves learning.
If the reopening is not managed very carefully, in measured steps to be sure a second wave does not suddenly emerge, a second, more lethal wave is possible, despite our antibiotics, respirators, ventilators, a better understanding of viruses, and better, faster public health responses. That could result in another round of broad closings, not only hammering the economy immediately, but also injuring our societal psyche further, causing much of our population to retreat even further inwardly and even more businesses to fail. While we are all hoping for efficacious treatments to emerge quickly and, even better, a vaccine to be qualified on record timing, these aids are unlikely to become accessible fast enough to stop that second wave, should it emerge over the next few months.
WHAT SHAPE WILL THE RECOVERY TAKE?
Thinking on this critical question has been evolving quickly. Initially there was more optimism, with many forecasting a fast, V-shaped recovery. But two months into urgent closures, as many furloughs have quickly become permanent closures, the extent of the economic damage is become clearer. Those forecasts of a V-shaped recovery have morphed into recognition that a more gradual U-shaped recovery, perhaps over two to three years, is probably the best we can expect.
Even if unprecedented pharmaceutical efforts succeed in qualifying a vaccine by later this year, it will be many more months, if not longer, before accessibility will extend beyond healthcare and other front line workers to the masses. As Bill Gates keeps pointing out, discovering the vaccine alone will not be enough. Even the production of the billions of pharma-quality glass vials will take time.
It will more likely be at least 24 to 36 months before a working vaccine is ready and in full production. By then, the virus may have infected a large enough percentage of the population, hopefully most with just moderate symptoms or, even better, asymptomatically, and a high degree of herd immunity will have developed.
The ultimate shape of the recovery appears to hinge importantly on whether the economy can successfully reopen in a carefully managed manner, region by region, including by-region in many states, with an unfortunate but ultimately tolerable incidence of COVID. If that is the case, and if projected herd immunity develops, then much of the economy will have reopened with the projected U-shaped recovery over two to three years. Pent-up demand, fiscal and monetary stimulus to accelerate demand, and the survival of the human fittest will win.
Nevertheless, even that measured reopening, likely reinforced by broad public caution, will still lead to large numbers of failures among businesses most dependent on traffic -- like travel, tourism, hospitality, food service, entertainment, and retailing -- along with additional sectors such as commercial real estate. That economic hollowing will take at least two to three years to re-sort and recover.
On the other hand, if the dreaded, more severe second COVID wave emerges and the economy needs to be closed again broadly, on anything close to a national level, then the damage could be great enough to cause a virtual re-run of the Great Depression, an L-shaped economic hollowing that could last for a decade. While this is a possibility that cannot be ignored, we do not expect such a broad close-down, with such dire economic consequences, will be politically feasible for either party.
The anticipated, carefully managed reopening plus the Fed’s aggressive actions seem to be the main reasons the stock market rebounded after its dramatic initial decline rather than plunging even further as those 33 million unemployment compensation applications were being filed. The market also seems to be signaling expectation of further massive demand stimulus, perhaps another $3 trillion from Congress and additional from the Federal Reserve on top of the trillions to date, aimed particularly at the consumer, to help prevent a more prolonged downturn.
We therefore expect that further COVID waves would instead result in more measured, incremental closures, differing substantially by region. While this would unfortunately result in more deaths, hopefully the toll can be contained. We believe that increasing recognition of the total human toll of business closures – economic as well as psychological and health-related -- along with the will of large portions of the public and resulting political pressure, will prevent another Great Depression. Nevertheless, the greater those measured closures, the more business failures and dislocation likely, which could result in a longer recovery – not a Great Depression L shape but perhaps more like a Nike swoosh-like shape.
OTHER CONSEQUENCES OF A LONG RECOVERY
COVID’s consequences, both from a health and economic perspective, are hitting the least advantaged members of our society the hardest. The longer the recovery takes, the more likely pressure will grow to re-sort tax, other fiscal, and monetary policies.
Tax increases among the more affluent would be likely. We expect younger Americans in particular to push for greater income redistribution in anticipation of the burden they will eventually bear in repaying the current massive government deficits.
While we believe that consumer caution and resulting muted demand will prevent any near-term surge in inflation, we do expect that over perhaps the next five to 10 years, inflation will increase substantially. As long as enough of the Federal debt has been financed by low interest/long duration borrowing, it will be in the government’s best interest to allow an increase in inflation to help repay some of the ballooning debt. Increased inflation, by benefiting debtors versus creditors, will similarly benefit younger Americans and those less advantaged and hit hardest by the COVID crisis.
IMPLICATIONS FOR INVESTORS: A RE-SORTING OF THE ECONOMY
Regardless of the recovery’s shape, there will be a significant re-sorting of the economy. Some of our expectations reflect trends that were already underway pre-COVID and that have been reflected in pre-COVID as well as more recent stock market movements. Traditional industry behemoths, as reflected by the Dow, have not been faring as well as the more diverse S&P 500 and even less well relative to the tech-heavy Nasdaq.
|2019 Index Change||+22%||+29%||+35%|
|Index Change 2020 YTD||-18%||-12%||0%|
Some big recent trends, like the growing importance of the FAANG companies – Facebook, Apple, Amazon, Netflix, and Google/Alphabet – will continue. And declining valuation of troubled sectors like brick-and-mortar retailing and movie theaters will similarly continue.
As our society becomes increasingly accustomed to the possibilities and benefits of remote work, home exercise, home entertainment, and other staples of COVID’s social distancing, we expect some of the recent trends to accelerate significantly. Brick-and-mortar retailing, movie theaters, automotive sales, and demand for office space are likely to decline rapidly. On the other hand, fortunes are likely to grow for those addressing demand for at-home work technology (and furnishings), home exercise equipment and services, streaming entertainment, in-home health measurement/management tools, telehealth, and many other industries.
It’s tougher to forecast how long extreme social distancing behaviors will continue and how long and to what degree people will continue to eschew airline travel, hotels, Airbnb, restaurants, and entertainment venues like theaters, stadiums, and arenas.
WHAT WILL ALL THIS MEAN FOR VENTURE CAPITAL INVESTMENT?
Again, regardless of the recovery’s shape, and at the risk of simply sounding self-serving, we believe opportunities to build wealth through venture capital will continue largely unabated. The fundamental reason is that venture capital is all about innovation, and the kind of changes already taking place and that are likely to accelerate will fuel demand and opportunities for innovation.
Some well-known VC-driven companies, whether still private or recently publicly traded, will be hit hard. This expectation probably won’t be a surprise. We expect companies who will be hit hurt badly by the sea change in societal sensitivities and needs will include folks like Uber, Lyft, Airbnb, and WeWorks. Frankly, we were never fans of companies like those pre-COVID as well, that are characterized by high variable costs, people and/or capital intensity, and relatively low barriers to entry for smaller and more localized competitors.
Our expectations for major opportunity areas probably won’t come as too great a surprise either. We were already focused in these areas pre- COVID, and we believe COVID-driven sensitivities and needs, while they will moderate somewhat, will still persist even after the crisis is hopefully behind us, magnifying investor opportunities.
- Healthcare: We believe that the COVID crisis will lead to greater awareness of and sensitization to healthcare matters even long after the crisis has passed. Areas where we expect potential may be particularly great include telehealth, in-home health-related measurement and monitoring, and more personalized diagnosis and treatment. We also expect potential to be great for technological advances that enable not only more effective but also more efficient healthcare to better leverage limited, costly human healthcare provider resources.
- Information Technology: No surprise here. While we are already well into the information technology era, the potential advances just seem to be getting greater. We have barely scratched the surface of practical applications and benefits from Artificial Intelligence. The Internet of Things is similarly at an early stage, and will require major advances in IT technology infrastructure.
If our expectation of increased inflation in the next five to 10 years is correct, then the opportunity to build wealth through venture capital investment will become even more important.
We hope you’ve found the thinking here provocative. If you have, we look forward to hearing from you.
Len Batterson, VCapital Chairman and CEO
Ken Freeman, VCapital Strategic Advisor
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