At a time when most investors are seeking out defensive positioning, savvy managers should have an eye to the opportunities provided by the unfolding pandemic. These may be asset classes that are already undervalued at the present moment, but also include those which stand to benefit from an eventual recovery to an extent not currently priced in by the market. The latter might not necessarily represent “buy now” opportunities, but may instead be triggered by changing economic circumstances. In our view, below are five asset classes to keep an eye on as we edge towards recovery.
1. High-yield credit
In the US, senior loans are currently priced at 90c on the dollar1, with potential for speedy recovery to parity as conditions stabilise. Following the 2008-09 financial crisis, in which secondary credit markets played an infamous and central role, loan pricing nevertheless returned to parity within two years2.
We believe, security selection is a vital component of investing in high-yield credit, as the asset class carries a high degree of asset-specific risk as well as potential for healthy returns. During the 2008-09 crisis, some managers achieved a default rate of as low as 2%, in the context of 10-12% across the broader market3.
2. Value stocks
The spread between growth stocks, comprising entire sectors such as technology as well as individual companies within other sectors, and their more cyclical value stock counterparts tends to operate like a rubber band, with sharp corrections following periods of greatest divergence.
Over the past two years that spread has widened dramatically in favour of growth stocks, and judging by past experience, there could be a substantial reversion as deflationary pressures ease and bond yields increase.
If and when this occurs, we believe that an asset class that would appear to be particularly underpriced is US banking stocks, trading at their lowest price to book ratio since the 2008-09 crisis4. In our view, bank balance sheets are more resilient today than in the last crisis, and current standards for up-front provisioning for non-performing loans means that the worst-case scenario is likely to be already priced in.
3. Emerging market equities
Equity markets in emerging economies are extremely cyclical, outperforming in an upswing when commodities boom and the US dollar is lower. In contrast, over most of the past decade they have tended to underperform equity markets in more developed economies, and are now struggling with a strong US dollar, commodity weakness and trade wars.
There are still hurdles to overcome for these markets, not least of which are concerns around debt liabilities and the unfolding path of the virus in the developing world.
In our view, programs of debt relief for these economies, a softening US dollar and more certainty around the outcomes of the pandemics are all key potential triggers for entry into these markets.
4. Dividend futures
Dividend futures are a financial instrument which gives exposure to dividends paid in future years at an index level.
They are susceptible to falls in value during equity market stress, as investment banks which issue certain retail products linked to price rather than total returns sell them to hedge against the risk of lower future dividends
In effect, these banks are forced sellers, and given that there are no natural buyers we believe there is a significant opening for investors to find value.
Dividend futures markets in Europe are currently priced at 30-40%5 below what we consider to be their likely real value in future years, with the current five-year contract 27% below the lowest actual dividend payout in the last 10 years6.
5. Inflation-linked bonds
Inflation-linked bonds in Australia are currently pricing in 0.8% inflation pa for the next 10 years7. Even for those who have become accustomed to a low-inflation environment this probably seems on the low side, and it is substantially so by historical standards.
We certainly believe expectations are overdone, despite the short-term output gap depressing CPI. The effect of the enormous stimulus that will enter the Australian economy may result in price inflation over the next two to three years. In our view, investors may wish to consider their portfolio’s sensitivity to rising inflation in which inflation linked bonds outperform nominal bonds and value stocks tend to outperform growth stocks.
Of course, we’re discussing the pandemic, so uncertainty is a given, if not by this stage a cliché. All of these opportunities will be to some extent affected by the pace and form taken by the eventual recovery. Through the uncertainty comes opportunities of mispriced and underloved assets that managers should be prepared to capitalise on as a recovery transpires.
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1 Bloomberg; S&P/LSTA U.S. Leveraged Loan 100 B/BB Rating Index Price, as at 28 April 2020
2 Bloomberg; S&P/LSTA U.S. Leveraged Loan 100 B/BB Rating Index Price
3 Bloomberg; S&P/LSTA U.S. Leveraged Loan 100 B/BB Rating Index Price
5 Bloomberg, as at 28 April 2020
6 Bloomberg, as at 28 April 2020
7 Bloomberg, as at 12 May 2020
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