2Q 2020 US Equity Outlook: Looking to upgrade portfolios amid turmoil
While the sell-off has been broad based, Ramiz Chelat finds bright spots in areas that will recover quicker such as med tech and software. For sectors that will have a longer recovery, like consumer discretionary and staples, differentiation is key. Companies with strong balance sheets will be poised to take market share from weaker rivals once the crisis is quelled.
In the grip of a global economic slowdown, second quarter GDP estimates are substantially lower, with the US expecting a double-digit decline in growth. Given the extent of the coronavirus-induced shock, we anticipate a rise in unemployment and some corporate casualties, such as over-leveraged energy or airline companies. Although the extent and timing of a recovery is uncertain, we expect to see improvement as early as the second half of this year and into 2021.
Sectors exposed to essential services could experience the quickest recoveries. For instance, medical procedures cannot be delayed indefinitely, which would in turn support the medtech space. Neither are companies likely to cut back their use of ERP software systems, with the likes of SAP and Microsoft particularly well positioned.
We expect consumer discretionary companies to take longer to recover as consumer budgets will be tight and confidence will be low. But there are still some interesting opportunities for investors with a three-to-five-year horizon. Competitive advantages and structural growth drivers remain intact for some athleisure companies or off-price retailers. And even though these companies will be substantially impacted by store shutdowns, the situation is temporary.
Owing to its correlation to travel, luxury spend has been severely impacted and stocks in the sector have sold off more aggressively than the rest of the market. In our view, it could take six to 12 months for luxury to begin to recover. Some multi-brand luxury conglomerates with strong balance sheets are better placed than single-brand businesses.
Travel companies did rebound from previous crises, such as 9/11 or the SARS outbreak, and the inherent demand for travel still exists. Companies like Booking.com, a dominant player in online travel, or the aerospace company Safran, with its exposure to aftermarket engine maintenance, should be well-placed for a recovery.
To some extent, investors have sold consumer staples indiscriminately. However, it is important to differentiate in this sector. Companies with strong balance sheets that exhibited solid organic growth before the crisis should prove to be resilient – albeit on a 12-24-month timeframe. In addition, businesses exposed to greater on-trade consumption (restaurants and bars) are suffering more than those that are less discretionary. But while roughly a third of Anheuser-Busch Inbev, Coke and Pepsi’s businesses target the on-trade, a portion should be picked up by an increase in off-trade (at home) demand. We think investors are underestimating the potential switch to off-trade consumption.
As a result of the monetary policy response, low interests rates in developed markets will persist for the foreseeable future. This will certainly have a negative impact on banks’ net interest margins (NIMs). As well, the downturn also increases the risk of a higher level of non-performing loans (NPLs) over the next six to 12 months. In emerging markets, however, there are still interesting opportunities where interest rates are not quite so low. Leading lenders, such as India’s Housing Development Finance Corporation and HDFC Bank, can still earn very attractive returns.
On an individual company basis, survivability is key in the current environment. Regardless of the strength of their competitive advantages, companies will be tested during this difficult time. Investors should analyze the free cash flows of the companies they own, their access to liquidity, and whether or not those companies have any significant debt maturities over the next year or two. Companies with strong balance sheets able to survive the next 12-24 months should be in a stronger position to take market share from weaker rivals when conditions normalize.