03 Jun 2020
As we move through the different phases of the Covid-19 crisis and recovery, continuously evolving market dislocations will present challenges and opportunities. Global CIO Andrew McCaffery and our Global Macro Team discuss why investors should allocate capital that is sensitive to recovery rates, as well as identifying some key themes that will shape returns over a longer-term horizon.
A global economic recovery will unfold in several phases: fixing the financial plumbing, stabilising the spread of cases country-by-country, building back the real economy and finally, economic expansion.
A wide dispersion in outcomes for regions, sectors and individual companies means selectivity will be key to capturing the long-term value creation. Identifying survivors and winners while avoiding value destruction in harder-hit segments will require detailed knowledge of companies and sectors. This means being nimble and adjusting investment approach and asset allocations as we move through different phases of the crisis and recovery.
The near-term uncertainty and indiscriminate selling resulted in major price anomalies, particularly for high quality businesses where earnings and dividends could start to normalise as lockdown restrictions are lifted. The nature of this crisis is very different to almost any other - companies that proved resilient in the Global Financial Crisis have seen parts or all of their business shuttered overnight. Understanding their capacity to manage this situation through access to funding and the ability to manage their cost base is vital and requires a deep understanding of the company and the industry in which it operates.
Companies with the most sustainable financial structures tend to perform better in highly uncertain environments and take market share from struggling competitors. This provides some protection from downside risks as well as offering an upside in the recovery phase. Companies exposed to global and Chinese growth trends should be able to recover more quickly.
Both liquidity and valuations in the credit markets have responded positively to massive policy interventions, although Developed Market government bond yields remain near historical lows. Credit spreads globally have recovered significantly, and liquidity and market access for bond issuers have improved. Valuations post the rally reflect a desire to ‘look through’ the challenging macroeconomic backdrop, warranting some caution and selectiveness.
However, we believe parts of the high yield market compensate for the increased default risk and offer attractive risk-adjusted returns over the long-term, even if volatility remains elevated as we move through the crisis. Credit rating downgrades will continue in the coming months, with rating agencies lagging corporate stress as they update their assessments. Some of the fallen angel credits - investment grade companies downgraded to high yield - are providing opportunities, particularly those that can deleverage and eventually return to investment grade and/or benefit from central bank purchases targeted at BB-rated securities.
Differing speeds and conditions of normalisation will create winners and losers at the country level and over different time horizons. Allocating capital in a way that is sensitive to recovery rates and learning from recovery trajectories can offer opportunities.
Longer-term, demographics remain a relatively predictable and central input into investment outcomes. Countries with youthful populations and growing middle classes will have consumption tailwinds, first in technology, and later in leisure and travel. Countries with ageing populations will require investment in healthcare and technology solutions. We believe that Asia, with its faster normalisation and young populations, offers some of the best long-term growth opportunities, particularly in insurance and healthcare. We are more concerned about non-Asian emerging market countries given their more limited resources in responding to the crisis.
The conditions of globalisation were already changing before Covid-19 - most clearly reflected in the US-China trade war. That shift has been accelerated by the Covid-19 shock testing supply chains in healthcare and pharmaceuticals, food supply chains and technology infrastructure. These sectors will be increasingly treated as areas of national security, with sourcing brought inside country borders or regional blocs. They will also be subjected to increased regulation and oversight, giving them characteristics closer to the utility or defence industries.
While more regulation could lead to lower profits over time, it is also likely to create more stable earnings and cash flows, potentially benefiting valuations. These sectors should prove to be winners, but due to less physical travel between and within countries, travel and leisure, lodging, transport and cross-border education could be impaired.
The lockdowns have forced consumption away from physical retail and towards e-commerce and home delivery. The shift is especially visible in online food retail, where adoption was previously slow but is now experiencing a step-change in pace that we expect will persist after the lockdowns.
Consumers are also paying more attention to their well-being, benefiting sporting goods and companies that improve quality of life. Leisure travel will eventually resume, particularly among younger people, but with more concern around the safety and quality of destinations and accommodation.
People are adapting to working from home and we will probably see consumers investing in their home offices and digital equipment as a result. Telecommunications, technology and connectivity should be long-term winners, as well as contactless payments, education and medical consultations.
More broadly, many activities which have been forced online such as face-to-face work meetings, gym workouts and grocery shopping will continue post-lockdown as people enjoy time and cost savings. Companies that own the platforms used for these services and the connectivity/infrastructure providers that deliver them will benefit. Connectivity providers could also be elevated to greater national importance, receiving increased investment. Europe is behind the US and China in adapting networks for the next telecommunication standard (5G), but post-pandemic it could receive more attention, given the likely increase in online activity.
Covid-19 has reframed the debates around online privacy and the dominance of ‘Big Tech’. The crisis has brought to prominence how critical the technology giants are in modern society, most clearly seen in the approval of Amazon’s investment into Deliveroo because food delivery is deemed an essential service. Another example is China’s ubiquitous video surveillance that is perceived negatively in Europe and North America but enabled China to contact-trace effectively and enforce lockdowns. That perception could evolve through the crisis, creating opportunities for a number of technology companies.
The healthcare industry is set to change in several ways. Firstly, pharmaceutical and biotech companies are at the forefront of the fight against the pandemic and could find political and pricing pressures ease given their role. Another area that is set to benefit is diagnostics. Diagnostics are a cost-effective and crucial way to identify the spread of the virus and we expect greater investment in this area in the future.
Telemedicine, the practice of caring for patients remotely, has seen a significant increase in demand and this should continue in the longer-term as part of ongoing investment in healthcare IT and digitalisation.
Finally, the crisis has shown that some hospital systems are underfunded, and it’s reasonable to expect increased investment in the future to ensure they are better prepared for pandemics. The costs of this will be low compared to the economic destruction that can occur from lockdowns.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. Investments in small and emerging markets can also be more volatile than other more developed markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only.