Three Types of Situation and their Implications

Master the Crisis Understanding the Situation Three Types of Situation and their Implications

We distinguish between three types* of critical situation that our businesses can face.

First, there are the short term shocks.

A short-term closure of public life to stop the spread of the virus would be such a shock. A short-term market decline because of extraordinary events is such a shock.

The negative economic impact of such a shock will be limited only. The majority of businesses have reserves for shorter time periods. For those who don’t, public economic programmes can provide relief. Most important, if an end is foreseeable, companies still can plan ahead. They are unlikely to lay off employees. Therefore there are no extending effects on the labor markets to be expected.

Then there are longer downturns.

These do have a larger negative impact. Unemployment rates rise, the number of bankruptcies increases. Yet, the negative effects are still somehow limited in comparison to our next candidate. A downturn has an important element. It has a direction. This means that companies still can plan, because they can see the direction that the economy is going. Many businesses will adjust their cost structure to weather the crisis. They will have to lay off people. But the planning horizon also means that many can stay in businesses, and keep other people employed. Some businesses will be able to benefit from the overcapacity’s in the markets and acquire resources cheaply. They may invest in physical assets or in human resources, using the opportunity to acquire talent at lower cost.

Our Last Candidate:

Uncertainty and Structural Changes

This is when everything stops. Businesses do not know whether the economy will go up or down in the next months. This lack of visibility will make them wait before pursuing any investments. They cannot assess whether they will be able to hire and invest or not, because they don’t know where their revenue will stand in a few months. Similarly, private individuals don’t know whether they will keep their jobs, so they also will put major purchases on hold. This is what we saw during the banking crisis.

There is also a twin brother to this uncertainty, his name is "structural changes". He is a bit more mature, we know that the rules of the game change, but we are not quite clear yet what the new rules are. In private equity we would put a huge emphasis on distinction between cyclical and structural changes. This distinction is crucial, because it tells you whether or not you will have to adjust your business for the long term, by rethinking your strategy, or whether you should focus on short-term initiatives.

So where do we stand today with respect to these three candidates?

We can't generalise. It depends on the industry you operate in and the country you are based in. Even in long-term downturns, different industries are affected at different stages of the cycle.

Going into the full economic implications is beyond our scope here, but to guide us to the main patterns we could distinguish between two situations. Each situation depends on how well the country you are in has brought the pandemic under control and will keep it under control.

the stable countries

Once health systems have been stabilised, public life has step by step returned to the new normal, people are getting accustomed to wear masks when shopping or having close interactions with others, customer-facing businesses implement measures to prevent a further spread of the virus.

Here there is a good chance that the economy can recover without lasting damage in the medium-term. Yet, the impact from a downturn of the global economy will be felt, and there are some industries that hit in the long-term, like travel, which might have a longer lasting impact on other sectors as well.

the other ones

In those countries where pandemic lasts longer, where public authority have not managed to stop the spread of the virus within a few months the situation looks different.

here we will be facing two problems:

First, the resulting uncertainty will bring many investment activities to a standstill. This will mean, there is less money in the system to keep the economy going. This is what we have experienced during the credit crisis.
The second problem is the contentedness of the economy. Usually this is a good thing. But in a crisis, problems in one field can extend into other fields. If the customers of a business face a decline in revenue then this business will face similar trouble. The other way around, the trouble of a supplier can mean that the supplied company is not able to produce products, leading to a revenue shortfall.
- This is why automotive OEM’s suddenly started to financially support their battered suppliers during the credit crisis.
- Today’s challenges that travel companies, restaurants and shops face will extend into many other areas. They will not purchase raw materials and equipment, spreading the economic virus down the value chain. They will have to lay off employees, who then will not make any purchases as consumers, taking away a stimulus from the economy.

But for this I would like to hand over to a person who is probably one of the best experts on market dynamics. Chairman of Oaktree capital and author of two excellent books on the elements that drive markets.

He publishes highly insightful memo's which I recommend you:

... put on your reading list

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