Crash to recovery – what's next?

While uncertainty regarding the implications of COVID-19 continues, some industries, such as pharmaceuticals, have already seen a bounce back amid strong buying support and increased demand. Currently, we believe pharmaceuticals are fully valued, though over the long term we continue to favor pharmaceuticals given their resilience and valuation support.

In the energy sector, we expect the price of crude oil to rise further but this is already reflected in equity prices. While there are some emerging signs of supply discipline, spare capacity will eventually be added back resulting in higher oil prices. We expect to see a longer-term decline in oil demand but expect the demand support for fossil fuel alternatives, such as renewables, to increase.

With the global pandemic drastically reducing travel and tourism demand and revenues, we don’t expect that to change quickly, so our airline and tourism outlook remains cautious. We believe opportunities exist in quality cyclicals, most notably software companies and healthcare equipment providers, while industrials and semiconductors stocks have some way to go.

For normalization of the market to take place, a vaccine that is both effective and accessible is essential.

Among the winning sectors including cloud, semiconductor equipment and digitalization, there are interesting differences in how medium/smaller companies are perceived vs. larger companies. Smaller companies often struggle to generate profit and in some cases even suffer substantial losses. However, simply because their starting revenue base is small they benefit from enormous sales growth in the range of 30%−100%.

As investors have no alternatives other than sales to value these companies, they resort to using enterprise value-to-sales as a valuation measure. As a result these companies are rewarded with high multiples because their growth is so high. We believe there is too much uncertainty as to whether these smaller companies will ever be able to reach profitability or generate cash flows.

In contrast, innovative large companies like Microsoft and Alphabet are highly profitable industry leaders dominating the market. Their sales growth is moderate in comparison due to the sheer size of their revenue base. These companies trade on profit metrics and tend to have very robust balance sheets. At this stage of the cycle, we find large, innovative companies more attractive on risk vs. reward as their free cash flows give them the flexibility and ability to reward shareholders.

Source: Earnest, UBS Asset Management (Quantitative Evidence and Data Science team), data as of 6 May 2020.

Arguably, the biggest question facing investors is what will happen to inflation? In many countries, structural factors have kept inflation below targets for years. In the short term, these structural factors have now been joined by the deflationary effects of COVID-19 via the dramatic curtailment of private sector spending and investment. But could things be changing?

On the one hand higher savings of ageing workforces and the impact of technology continue to depress inflation. However, the sharp transition now from fiscal austerity to fiscal expansion in many countries or the interruption to the global supply chain through trade and other geopolitical tensions, particularly relating to China, may prove inflationary.

Finally, the balance of power may swing away from capital and towards labor, reversing a trend of the past 20 years. We cannot be certain how these themes will play out but higher inflation remains a risk which investors must now take seriously.

Source: Bloomberg, data as of 6 of April 2020.

So, we believe holding some form of inflation protection in portfolios makes sense. In the US, five-year inflation protected securities (TIPS) currently yield about -60bp but we think yields could fall even further if the US Federal Reserve continues to keep the policy rate pegged at very low levels, and if inflation expectations start to rise. For example, the yield on 5-year TIPS fell as low as -1.7% in 2013.

In many ways the US corporate credit market has been the epicenter of both risk and opportunity so far this year. Although decisive US Federal Reserve policy intervention enabled a significant gap tightening, investment grade and high yield spread normalization occurred at spread levels roughly two times wider than in January, averaging around 190 bps for investment grade and 750 bps for high yield cash bonds. While the duration of the extreme risk aversion was brief due to the Fed’s comprehensive credit market support and the CARES Act to offset economic contraction, the investment landscape for corporate credit investing has been dramatically altered as the market digests significant issuance and assesses the both the magnitude and duration of the pandemic on corporate business models and the broader economy.

With the market having to digest such immense supply in just a few months amid market and economic disruption, we expect the credit markets to continue to be fairly choppy for the next 18 months, presenting ample opportunities for active and dynamic investors to capitalize on this volatility as the resumption of economic and business activity dictates relative winners and losers across the markets.

Similarly, the pandemic has opened up relative value and capital structure trades across high yield and convertible debt that allow investors potential to capitalize on mispriced risk between both secured and unsecured debt, as well as debt vs. equity, as companies with more balance sheet leverage struggle to adjust to current conditions.

We expect a high level of dispersion in credit performance and faster-than-normal convergence on relative value trades within credit markets over the next eighteen months.

Two-sided tail risks loom in this early cycle environment.

On the downside, a second wave of COVID-19, escalating US-China tensions, and concerns around the US election could lead to a more uneven recovery and stoke volatility that roils markets. Conversely, the momentum in risk assets suggests right-tail outcomes could be achieved if policy success begets incremental improvements in activity.

The lofty levels to which equities have already ascended are expensive from an absolute perspective, reflecting expectations for a swift recovery in earnings that seem too optimistic. In our view, this setup leaves little margin for error with stocks vulnerable to downside risk if the virus returns, policy falls short or the economic rebound falters.

We favor relative value trades rather than taking large directional bets. We prefer to take a barbell approach by selectively adding to early cyclical exposures that we believe have the most room to run in an enduring recovery, while maintaining defensive positions with solid fundamentals looking to protect against a downturn. We prefer US investment grade credit relative to sovereign bonds given Fed support and attractive carry characteristics. Recently, we’ve boosted our exposure to dollar-denominated EMD, which has lagged the degree of recovery enjoyed by other segments in the credit space, providing greater scope for capital appreciation. We favor assets which we believe would benefit from upside surprises to growth and trade at extremely inexpensive valuations (such as selective emerging market currencies).

Source: Bloomberg LLC, data as of 22 May 2020.