Given talk in the media that a recession may be in the offing, healthcare income statements could be stressed from both declining net patient revenue and higher operating costs. In addition, as consumer costs are likely to increase due to tariffs, healthcare consumers may reduce their healthcare spend.
The Status of Tariffs
Global economic growth has slowed in 2019, and the trade war between the United States and China intensified over the summer. In August, President Trump announced higher tariffs on $350 billion of goods imports from China to the United States and some of the tariffs took effect on September 1. China responded with tariffs of its own on U.S. imports, and imposed non-tariff barriers.
More recently, President Trump canceled a planned further increase in tariffs scheduled for October 15, citing progress in negotiations between the United States and China. Both sides have dialed back some of their actions and rhetoric, but the trade war will be a drag on U.S., global, and Chinese economic growth in the near term. Still, the current U.S. economic expansion, already the longest in history, is likely to continue at least into 2020.
Impact of the Trade War
On net, the impact of the trade war on the U.S. economy will be negative. Some industries that face import competition will benefit. But the tariffs are a tax on imports from China, raising prices for households and businesses. These higher costs will weigh on consumer purchases of goods and services and business investment, not just on products from China, but on other products as well.
Higher prices reduce inflation-adjusted household income and corporate profits. At the same time, higher Chinese tariffs will weigh on U.S. exports. The trade war could last much longer than the Trump administration expects.
U.S. leverage over China is limited. Exports from China to the U.S. made up about 4% of Chinese GDP in 2017, down from almost 11% in the middle of the last decade. Also, unlike in the United States, Chinese leadership does not have to face an electorate. And there is strong nationalist sentiment in China to take a hard line against the United States. PNC’s forecast assumes that there will be no substantive trade deal between the U.S. and China until after the 2020 presidential election.
In addition to the direct effects, the unsettled outlook will weigh on business spending, especially if it drags on. U.S. companies that import from China will be more reluctant to invest and hire if they don’t know what tariffs will be and what prices they will be paying. Some companies will reconfigure their supply chains, sourcing imports from other countries, causing disruptions and raising costs.
U.S. manufacturing has been --at best-- treading water in 2019. The trade war and uncertainty have been significant drags on manufacturing output, which has been flat to down this year. The Institute for Supply Management’s manufacturing index shows an outright contraction in the industry in the late summer and early fall. The recent autoworkers’ strike against GM has been another concern. The strong dollar is also weighing on U.S. manufacturing.
Solid Fundamentals Help to Balance the Negatives
Although manufacturing and the trade war are negatives for the U.S. economy in the near term, the expansion should continue thanks to solid household fundamentals and support from the Federal Reserve. Higher prices from the tariffs should only be a small speed bump.
Consumer spending makes up more than two-thirds of the U.S. economy, and households are in excellent shape, with solid job growth and good wage gains as a result of the tight labor market. Overall consumer debt burdens are low, and the recent drop in interest rates will support household borrowing for big-ticket items. The housing market will be another positive for growth in the near term, with lower mortgage rates providing a boost.
Still, there are major downside risks in the outlook. Although there has been encouraging news on the trade front recently, it is easy to see how miscalculations could cause the trade war to spiral out of control, causing much more significant damage to the U.S. and Chinese economies.
There is still a great deal of uncertainty about whether and how the United Kingdom will leave the European Union. A decision by the U.K. to leave the E.U. without a trade deal could cause a worldwide recession, especially given already slowing global growth.
With impeachment discussions heating up, political gridlock and uncertainty could cause U.S. consumers and businesses to pull back. PNC puts the risk of recession by the end of 2020 at a significant 40%, although the Trump administration has very strong incentives to pull out all the stops to avoid an economic contraction ahead of the 2020 election.
A Mild Recession?
Any U.S. recession should be mild; much milder than the Great Recession in 2007 through 2009. Consumers are in good shape, with solid income growth, high savings, and sturdy balance sheets. The corporate sector is more exposed to a potential downturn, with high debt burdens. But low interest rates should help soften the blow.
With the drag from the trade war and a fading boost from the 2018 tax cuts, real GDP growth will slow through the middle of 2020 to around 1.6% on a year-over-year basis, then reaccelerate in the second half of next year. Monthly job growth will slow to around 60,000 by mid-2020, then gradually pick back up. The unemployment rate will slowly increase, ending 2019 at around 3.7% and 2020 at around 4.0%. The Federal Open Market Committee will cut the Fed funds rate one more time this year to guard against downside risks to the expansion, and then keep it in a range of 1.50 to 1.75% through 2020.
How the Economic Outlook Can Result in Declining Revenue for Healthcare
Given the outlook described above, healthcare income statements may be stressed from both declining net patient revenue and higher operating costs. As consumer costs may increase due to tariffs, this may have a crowding out effect with healthcare consumers reducing their healthcare spend. Given the trend towards higher deductibles, this reduction in spend may be magnified as consumers defer elective and to some extent, less urgent non elective care. Higher deductibles put further pressure on healthcare providers in collecting revenue and managing bad debt expense.
Further pressure may develop around labor costs. As noted, the labor market is tight, and given that labor costs typically account for at least 50% of healthcare operating costs, pressure to raise wages will persist. Likewise, recent domestic labor disputes may ignite and energize existing unionized employees to take a tougher stance in negotiations.
Unionized members of healthcare systems may look to UAW, Chicago Teachers Union, the Los Angeles Teachers Union, and National Nurses Organizing Committee/National Nurses United and conclude these trends establish additional leverage, particularly given the backdrop of positive economic trends in the economy.
Impact of the Bond Rally
Finally, while the rally in the rates market can lower a system’s cost of capital, the impact of the 2019 bond rally may have a significant adverse impact to unfunded liabilities, notably pension obligations. As of November 4th, 2019, the 30-year UST and 10-year UST are down 75.2 and 90.7 basis points respectively (year to date).
The drop in rates throughout the year, in particular during Q3, negatively impacted total-return- driven corporate pension plans by an average of 5% and liability-driven plans by an average of 1.6% during the most recent quarter.
Assuming a $50 million unfunded liability and using a 15-year duration, a 50 basis point fall in the discount rate could result in a $3.5 million increase in the unfunded liability (6.5% of liability). Such volatility can put additional stress on the best intended contribution strategies.
Overall, the not-for-profit healthcare sector has maintained stability since coming out of the Great Recession. According to a special report published by Fitch Ratings, key balance sheet metrics (days cash on hand, cash to debt, and leverage metrics) have remained highly consistent and stable in the last two years.
Managing Key Resources
With a potential economic downturn, healthcare providers must consider how best to manage key resources in light of declining margins to maintain liquidity while investing in fundamental strategic and capital needs. You might:
- Increase the efficiency of revenue cycle management for improved profitability to fund growth and stability.
- Make disciplined investment in strategies that will generate growth and returns.
- Look for opportunities to differentiate your organization from competitors and gain an advantage at a time when others may be pulling back.
- Balance liquidity and leverage.
- Increase financial flexibility to withstand potential volatility.
- Evaluate any non-core assets that do not contribute to the long-term strategy of the organization and consider monetization of those assets. These strategies may reduce leverage and/or operating losses and/or generate liquidity and/or working capital.
With the significant rally in UST and MMD rates, many healthcare providers have accessed the capital markets for both new money and refunding markets. A significant number of providers have borrowed in the taxable market to build up cash position without constraints on the use of bond proceeds.
Given the lack of constraints on proceeds, the middle part of the UST yield curve, 7-10 years, has become more attractive for longer-term investment portfolios. Operating and short-term capital needs are more adequately positioned in short Treasuries and money markets given the continued inversion between the 1 month and 5 year Treasury. Investment Grade credit and structured product (MBS/ABS) have become more attractive versus the UST which provides the flexibility to add high-quality yield with shorter durations.
Ready to Help
While focus is often on the threats and risks of an economic downturn, an organization that can position its balance sheet well may be able to take advantage of opportunities that arise during a downturn. To begin, an assessment of current strategic position and financial strength is an important step in preparing for an economic downturn so the organization can act decisively when faced with a downturn. Reach out to your PNC Healthcare representative for an analysis of your specific situation.
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