Macro Perspective

Western Asset’s base case outlook is for an elongated, U-shaped global economic recovery. We expect the battle against COVID-19 will take time; however, we are encouraged by signs of progress in the global race for a vaccine and the decline in global mortality rates. Forceful policy action to date has buoyed global economic activity and restored market functioning. We expect central banks to remain extraordinarily accommodative, especially in light of subdued global inflation pressures, and to remain so to support the recovery. That stated, we continue to be wary of the upcoming US presidential election, post-Brexit trade negotiations, US-China trade discussions and geopolitical tensions as these all have the potential to disrupt economic and financial market activity. Given these uncertainties, we aim to position our portfolios to withstand further market volatility, yet remain flexible enough to capture exceptional value opportunities as they appear. Here, we provide a summary of the key drivers behind our global credit outlook and details about where we see value across credit markets.

US Elections: Potential Impact on the Oil & Gas and Health Care Industries

The 2020 US presidential election could have far-reaching implications for fixed-income investors. Beyond the race for the White House, a shift in the Senate and House majorities during this election cycle could also result in significant changes to the US economy and investment landscape. Here we provide our thoughts on the implications of the 2020 election results on two key industries. Note that some of the content below can also be found in our ongoing 2020 Vision Election Outlook series, which includes contributions from a wide range of Western Asset thought leaders.

Oil & Gas

The two leading presidential candidates highlight opposing views with regard to the oil & gas sector; one supportive of the industry and the other looking to accelerate the transition to cleaner energy alternatives. If President Trump were to be re-elected, we believe the status quo would remain and the current less-restrictive federal policy positions toward the energy sector would continue. Over the past four years under President Trump, energy policies have been supportive of the oil & gas industry as the theme of “US energy independence and security” has encouraged the development of domestic resources for energy self-sufficiency and export-led growth. The Trump administration rolled back methane regulations via the Environmental Protection Agency, dialed back lower emissions and fuel efficiency standards for the automotive industry, and expanded access to federal lands and waters, while also streamlining the pipeline permitting process.

Under a Biden administration, we believe the energy sector would likely come under increased scrutiny, but would unlikely see radical changes materially impacting the energy investment landscape in the near term. A Biden administration’s energy policy platform would be a material departure from the prior four years. The immediate action by a Biden administration would be to rejoin the Paris Climate Agreement, committing the US to reduce greenhouse gas emissions with other objectives thereafter. Looking into the broader possible Biden agenda, we would anticipate existing drilling permits on federal lands to be reviewed and new permitting likely to be slowed but not halted. Consequently, oil & gas production growth on federal lands would be reduced, but unlikely to materially impact the overall US oil & gas supply picture.

Notwithstanding the election overhang, the energy sector, independently, has already been subject to cleaner energy transition forces over the past several years. The concurrent unprecedented demand and supply shock has focused corporate managements’ attention inward, controlling what they can control amid a continued difficult macro backdrop. Given restrained capital markets, capital discipline has gripped the industry with capital budgets currently at unsustainable (below maintenance) levels. The forced discipline translates into lower activity levels as rates of return are challenged with lower realized prices below incentive prices. Not all is lost, however, as a smaller, leaner industry is still able to benefit. From a credit investor’s perspective, improved capital discipline and capital spending reductions are well underway as companies prioritize debt reduction and improved balance sheets in lieu of higher commodity prices.

Health Care

Health care remains a key topic heading into the presidential election, and the pandemic has drawn increasing attention to the gaps in our health care system regarding private insurance, government programs and varying levels of coverage. In short, if President Trump were to be re-elected, we see a largely status-quo environment for the industry. While President Trump has promised a “MUCH better, and FAR cheaper” replacement to the ACA, Republicans have not offered a comprehensive alternative plan.

In the event of a Democratic sweep or “Blue Wave,” we see an expansion of health care coverage via existing platforms in the ACA and Medicaid, but the ripple effect that would be felt from these policy changes would likely be uneven across the health care industry. In this scenario, Managed Care Organizations (MCOs) would likely see a mixed impact, with Medicaid managed care plans benefiting from greater coverage and Medicaid expansion, while others could see increased rate, membership and regulatory pressure. Hospitals and other providers would likely benefit from increased health care coverage through more subsidies and Medicaid expansion (i.e., higher volumes, improved receivables collection rates, etc.); however, we do see risks associated with the Public Option and lowering the Medicare eligibility to age 60, if these proposals were to gain more traction with the Democratic party.

Western Asset is positioned with a more cautious, defensive stance going into the election season. We have an up-in-quality bias, preference for names with visible credit catalysts and for avoiding those credits with leveraged Centers for Medicare & Medicaid Services (CMS) exposure. From our perspective, health care spreads have largely priced in a Blue Wave sweep and we will be patiently waiting for opportunities on the back of any risk reversal tied to budgetary, political and/or legal deliberation post the election.

Western Asset Coronavirus Task Force Update

After a lull in cases this summer, both Europe and the US have seen a worrisome resurgence in cases. Given that there has been limited data suggesting that SARS-CoV-2 is more likely to spread in the fall due to cold temperatures, we believe that these breakouts are due to more relaxed consumer behavior and containment, particularly in more rural settings. 38 of 50 US states currently have worsening active cases per 100,000 population over the past 14 days, likely due to college- and Labor Day-related viral spread. We have also seen a recent increase in COVID-19 flare-ups elsewhere in the world, including France, Spain, and the UK, who each now have per capita COVID-19 incidence rates above that of the US.

Many developing countries have simply not had the resources or government effectiveness to stop the virus, with India as an example of a country that has not aggressively pursued virus containment given the damage inflicted on employment and other health outcomes from continued lockdowns. Given divergence in containment approaches and virus trends across countries, we expect international borders to remain highly regulated and managed on a bilateral basis, which could have an impact on industries such as travel, tourism and manufacturing. Similar experiences in a number of Latin American countries suggest that delayed or ineffective policy measures may exacerbate the human and economic toll and weigh on EM growth relative to DM, as suggested by weak 2020 growth estimates for countries such as Mexico and Peru.

In the Global Corporate Credit Sector Views section, we provide our Investment Team’s latest views including an assessment of industry vulnerability to COVID-19 related risks.

Global Credit Markets: Relative Value Round-Up

Active management in fixed-income is essential to identify and exploit value opportunities and to manage downside risk. Here, we present our Investment Team’s high-level views across global credit markets.

Investment-Grade (IG) Credit

Despite a strong recovery in the past two quarters, IG credit market valuations remain somewhat attractive and supported by favorable demand technicals which we expect to endure. Our bias in the near term is to remain overweight, especially through the higher-quality issuers as these are the companies with robust franchises, solid balance sheets and that have the wherewithal to survive should the path of the virus force an even longer period of repressed economic activity. In Europe, earnings continue to be challenged in Covid-related names, although some of the most exposed issuers have now fallen into HY. Companies continue to be proactive in addressing liquidity needs. The IG market remains well supported by the sizeable ECB program and a market starved of yield. Valuations are not cheap in a historical context, but we think select sectors such as financials still offer some opportunity.

High-Yield (HY) Credit

Understanding the outlook for fundamentals will be challenged in the near term and subject to the path of the virus. Given our outlook, we continue to position for a “reopening trade” and remain overweight certain cyclical sectors including airlines, cruise lines and select retail segments complemented by a higher-quality bias in those less cyclical subsectors providing ballast in the portfolios. Q3 was a strong quarter for the high-yield market as the risk-on trade was in full-swing in July and August. Lower quality outperformed, but it is worth noting that is largely due to the fact that certain distressed CCC rated issuers defaulted and were therefore not included in index performance. Flows continued to be strong as net inflows totaled $3.1 billion for the quarter and are up $34.3 billion YTD. Issuance also remains high with $350 billion printing so far this year (+68% YoY). During the quarter, we took advantage of our ability to help structure certain high-quality secured transactions largely in cyclical sectors and anticipate this continuing moving forward.

Bank Loans

While September saw a flurry of transactions, we expect Q4 to be a light issuance period. On the demand front, the cost of financing CLOs has tightened to pre-COVID levels, which should drive incremental CLO issuance during the quarter. As a result, we expect demand to outstrip supply and continue ultimately to drive the bank loan market higher into year-end (post November election volatility). Defensive higher quality names will continue to grind higher as ramping CLOs look to purchase in the secondary market. Any volatility during the election season or around Covid developments will be an opportunity to purchase higher-quality credits. We have been able to selectively purchase names at attractive levels that we believe have the appropriate liquidity runway and business profile to weather the pandemic.

CLOs

CLOs will likely take their cues from the underlying credit markets (bank loans and HY), as well as supply technicals and potential market volatility as we head into the November election. While AAA CLOs have recaptured almost 80% of its March widening, it still offers an attractive spread/yield over comparably rated products. We retain our view that AAAs will continue to perform well in either a bearish or bullish scenario with plenty of opportunities across the entire AAA term structure. Generally the IG rated part of the CLO capital structure remains well insulated from potential principal impairment. We believe BBB and select BB CLOs offer compelling total return at current valuations.

Emerging Markets

We continue to favor high-quality hard currency bonds from both a carry and total return standpoint, while being observant of ongoing fundamental growth challenges in EM. We also favor local rates as they offer more favorable risk/reward, while trading EM currencies opportunistically and seeking to avoid currencies that are susceptible to oil-related and virus-induced growth setbacks, given EM currencies’ higher volatility and role as a pressure relief valve. Our convictions during this crisis continue to center on select EM countries with ample foreign exchange reserves, low external economic dependency, lower political uncertainty and effective policy executions. We are also focused on countries with stronger institutions, where structural reforms and policy flexibility should help mitigate the negative impacts of the pandemic. A focus on credit differentiation is paramount, investing in countries that we believe are better positioned to weather the outbreak-induced growth slowdown. Finally, we continue to exercise caution toward debt issued by lower-rated frontier market countries that we believe face an uphill road ahead.

Structured Credit

We remain constructive on legacy NARMBS/new-issue re-performing loan deals as many of these borrowers have already withstood similar disruptions, (i.e., the GFC and hurricanes) and are proven performers. On CMBS, we are cautious in the near term as it is uncertain how long it will take for commercial real estate markets to fully recover from the negative impacts of the pandemic. We expect the fundamental outlook to be uneven across property types and markets as the impact of COVID-19 on each property type and geography varies. Nonetheless, we are biased toward short-duration, well-structured single-borrower securitizations and loans. We remain selective and prefer bonds that can better withstand a period of reduced operating income and forbearance.

US Elections: Potential Impact on the Oil & Gas and Health Care Industries
Stars Icon

Notwithstanding the election overhang, the energy sector, independently, has already been subject to cleaner energy transition forces over the past several years.

The 2020 US presidential election could have far-reaching implications for fixed-income investors. Beyond the race for the White House, a shift in the Senate and House majorities during this election cycle could also result in significant changes to the US economy and investment landscape. Here we provide our thoughts on the implications of the 2020 election results on two key industries. Note that some of the content below can also be found in our ongoing 2020 Vision Election Outlook series, which includes contributions from a wide range of Western Asset thought leaders.

Oil & Gas

The two leading presidential candidates highlight opposing views with regard to the oil & gas sector ; one supportive of the industry and the other looking to accelerate the transition to cleaner energy alternatives. If President Trump were to be re-elected, we believe the status quo would remain and the current less-restrictive federal policy positions toward the energy sector would continue. Over the past four years under President Trump, energy policies have been supportive of the oil & gas industry as the theme of “US energy independence and security” has encouraged the development of domestic resources for energy self-sufficiency and export-led growth. The Trump administration rolled back methane regulations via the Environmental Protection Agency, dialed back lower emissions and fuel efficiency standards for the automotive industry, and expanded access to federal lands and waters, while also streamlining the pipeline permitting process.

Under a Biden administration, we believe the energy sector would likely come under increased scrutiny, but would unlikely see radical changes materially impacting the energy investment landscape in the near term. A Biden administration’s energy policy platform would be a material departure from the prior four years. The immediate action by a Biden administration would be to rejoin the Paris Climate Agreement, committing the US to reduce greenhouse gas emissions with other objectives thereafter. Looking into the broader possible Biden agenda, we would anticipate existing drilling permits on federal lands to be reviewed and new permitting likely to be slowed but not halted. Consequently, oil & gas production growth on federal lands would be reduced, but unlikely to materially impact the overall US oil & gas supply picture.

Notwithstanding the election overhang, the energy sector, independently, has already been subject to cleaner energy transition forces over the past several years. The concurrent unprecedented demand and supply shock has focused corporate managements’ attention inward, controlling what they can control amid a continued difficult macro backdrop. Given restrained capital markets, capital discipline has gripped the industry with capital budgets currently at unsustainable (below maintenance) levels. The forced discipline translates into lower activity levels as rates of return are challenged with lower realized prices below incentive prices. Not all is lost, however, as a smaller, leaner industry is still able to benefit. From a credit investor’s perspective, improved capital discipline and capital spending reductions are well underway as companies prioritize debt reduction and improved balance sheets in lieu of higher commodity prices.

Health Care

Health care remains a key topic heading into the presidential election, and the pandemic has drawn increasing attention to the gaps in our health care system regarding private insurance, government programs and varying levels of coverage. In short, if President Trump were to be re-elected, we see a largely status-quo environment for the industry. While President Trump has promised a “MUCH better, and FAR cheaper” replacement to the ACA, Republicans have not offered a comprehensive alternative plan.

In the event of a Democratic sweep or “Blue Wave,” we see an expansion of health care coverage via existing platforms in the ACA and Medicaid, but the ripple effect that would be felt from these policy changes would likely be uneven across the health care industry. In this scenario, Managed Care Organizations (MCOs) would likely see a mixed impact, with Medicaid managed care plans benefiting from greater coverage and Medicaid expansion, while others could see increased rate, membership and regulatory pressure. Hospitals and other providers would likely benefit from increased health care coverage through more subsidies and Medicaid expansion (i.e., higher volumes, improved receivables collection rates, etc.); however, we do see risks associated with the Public Option and lowering the Medicare eligibility to age 60, if these proposals were to gain more traction with the Democratic party.

Western Asset is positioned with a more cautious, defensive stance going into the election season. We have an up-in-quality bias, preference for names with visible credit catalysts and for avoiding those credits with leveraged Centers for Medicare & Medicaid Services (CMS) exposure. From our perspective, health care spreads have largely priced in a Blue Wave sweep and we will be patiently waiting for opportunities on the back of any risk reversal tied to budgetary, political and/or legal deliberation post the election.

Western Asset Coronavirus Task Force Update
Coronavirus Camouflage Icon

After a lull in cases this summer, both Europe and the US have seen a worrisome resurgence in cases. Given that there has been limited data suggesting that SARS-CoV-2 is more likely to spread in the fall due to cold temperatures, we believe that these breakouts are due to more relaxed consumer behavior and containment, particularly in more rural settings. 38 of 50 US states currently have worsening active cases per 100,000 population over the past 14 days, likely due to college- and Labor Day-related viral spread. We have also seen a recent increase in COVID-19 flare-ups elsewhere in the world, including France, Spain, and the UK, who each now have per capita COVID-19 incidence rates above that of the US.

Many developing countries have simply not had the resources or government effectiveness to stop the virus, with India as an example of a country that has not aggressively pursued virus containment given the damage inflicted on employment and other health outcomes from continued lockdowns. Given divergence in containment approaches and virus trends across countries, we expect international borders to remain highly regulated and managed on a bilateral basis, which could have an impact on industries such as travel, tourism and manufacturing. Similar experiences in a number of Latin American countries suggest that delayed or ineffective policy measures may exacerbate the human and economic toll and weigh on EM growth relative to DM, as suggested by weak 2020 growth estimates for countries such as Mexico and Peru.

In the Global Corporate Credit Sector Views section, we provide our Investment Team’s latest views including an assessment of industry vulnerability to COVID-19 related risks.

Global Credit Markets: Relative Value Round-Up
Pie Puzzle  Pieces

Our convictions during this crisis continue to center on select EM countries with ample foreign exchange reserves, low external economic dependency, lower political uncertainty and effective policy executions.

Active management in fixed-income is essential to identify and exploit value opportunities and to manage downside risk. Here, we present our Investment Team’s high-level views across global credit markets.

Investment-Grade (IG) Credit

Despite a strong recovery in the past two quarters, IG credit market valuations remain somewhat attractive and supported by favorable demand technicals which we expect to endure. Our bias in the near term is to remain overweight, especially through the higher-quality issuers as these are the companies with robust franchises, solid balance sheets and that have the wherewithal to survive should the path of the virus force an even longer period of repressed economic activity. In Europe, earnings continue to be challenged in Covid-related names, although some of the most exposed issuers have now fallen into HY. Companies continue to be proactive in addressing liquidity needs. The IG market remains well supported by the sizeable ECB program and a market starved of yield. Valuations are not cheap in a historical context, but we think select sectors such as financials still offer some opportunity.

High-Yield (HY) Credit

Understanding the outlook for fundamentals will be challenged in the near term and subject to the path of the virus. Given our outlook, we continue to position for a “reopening trade” and remain overweight certain cyclical sectors including airlines, cruise lines and select retail segments complemented by a higher-quality bias in those less cyclical subsectors providing ballast in the portfolios. Q3 was a strong quarter for the high-yield market as the risk-on trade was in full-swing in July and August. Lower quality outperformed, but it is worth noting that is largely due to the fact that certain distressed CCC rated issuers defaulted and were therefore not included in index performance. Flows continued to be strong as net inflows totaled $3.1 billion for the quarter and are up $34.3 billion YTD. Issuance also remains high with $350 billion printing so far this year (+68% YoY). During the quarter, we took advantage of our ability to help structure certain high-quality secured transactions largely in cyclical sectors and anticipate this continuing moving forward.

Bank Loans

While September saw a flurry of transactions, we expect Q4 to be a light issuance period. On the demand front, the cost of financing CLOs has tightened to pre-COVID levels, which should drive incremental CLO issuance during the quarter. As a result, we expect demand to outstrip supply and continue ultimately to drive the bank loan market higher into year-end (post November election volatility). Defensive higher quality names will continue to grind higher as ramping CLOs look to purchase in the secondary market. Any volatility during the election season or around Covid developments will be an opportunity to purchase higher-quality credits. We have been able to selectively purchase names at attractive levels that we believe have the appropriate liquidity runway and business profile to weather the pandemic.

CLOs

CLOs will likely take their cues from the underlying credit markets (bank loans and HY), as well as supply technicals and potential market volatility as we head into the November election. While AAA CLOs have recaptured almost 80% of its March widening, it still offers an attractive spread/yield over comparably rated products. We retain our view that AAAs will continue to perform well in either a bearish or bullish scenario with plenty of opportunities across the entire AAA term structure. Generally the IG rated part of the CLO capital structure remains well insulated from potential principal impairment. We believe BBB and select BB CLOs offer compelling total return at current valuations.

Emerging Markets

We continue to favor high-quality hard currency bonds from both a carry and total return standpoint, while being observant of ongoing fundamental growth challenges in EM. We also favor local rates as they offer more favorable risk/reward, while trading EM currencies opportunistically and seeking to avoid currencies that are susceptible to oil-related and virus-induced growth setbacks, given EM currencies’ higher volatility and role as a pressure relief valve. Our convictions during this crisis continue to center on select EM countries with ample foreign exchange reserves, low external economic dependency, lower political uncertainty and effective policy executions. We are also focused on countries with stronger institutions, where structural reforms and policy flexibility should help mitigate the negative impacts of the pandemic. A focus on credit differentiation is paramount, investing in countries that we believe are better positioned to weather the outbreak-induced growth slowdown. Finally, we continue to exercise caution toward debt issued by lower-rated frontier market countries that we believe face an uphill road ahead.

Structured Credit

We remain constructive on legacy NARMBS/new-issue re-performing loan deals as many of these borrowers have already withstood similar disruptions, (i.e., the GFC and hurricanes) and are proven performers. On CMBS, we are cautious in the near term as it is uncertain how long it will take for commercial real estate markets to fully recover from the negative impacts of the pandemic. We expect the fundamental outlook to be uneven across property types and markets as the impact of COVID-19 on each property type and geography varies. Nonetheless, we are biased toward short-duration, well-structured single-borrower securitizations and loans. We remain selective and prefer bonds that can better withstand a period of reduced operating income and forbearance.

Global Corporate Credit Sector Views

Auto & Related
COVID-19 Impact
Baraomter Levels High
Key Observations The global automotive sector has now moved past the worst of the Covid-related production challenges and the US light vehicle market has experienced stronger-than-expected consumer demand, particularly for SUVs/trucks, despite the more challenging unemployment backdrop. As we move forward throughout the balance of FY2020 and into FY2021 we continue to focus on each OEM/supplier’s liquidity position, ability to flex their respective cost structures, and capacity to evolve their business models to a more rapid adoption of EV/hybrid vehicle platforms.
Energy
COVID-19 Impact
Baraomter Levels High
Key Observations The market continues to rebalance slowly and requires OPEC+ to maintain cohesion and adherence to production cuts while we wait for demand to recover. This should serve to reduce inventory levels over time. US companies are currently pricing below maintenance levels that are unsustainable; we have observed some of the prior production curtailments come back. All eyes turn to the election and the impact of a change in administration. A Trump victory would yield the status quo while a Biden victory would clear the way for a change in domestic energy policy to more “green energy.” The pace of transition remains subject to debate, but it’s not likely to occur overnight.
Gaming
COVID-19 Impact
Baraomter Levels High
Key Observations Regional markets are expected to perform best given the “drive-in” nature of their operations, ability to quickly right-size their cost structures, and appeal to consumers given limited entertainment options. Las Vegas will take time to recover, as this is a destination market that requires “air lift” into town. Given consumers’ reluctance to travel on domestic airlines as a result of Covid concerns, visitation trends have been down substantially on a YoY basis, and the mid-week convention business has essentially been eliminated, resulting in occupancy rates of 20% to 30% during the week and approximately 50% on the weekends. Macau and Singapore face similar hurdles to Las Vegas given their destination status and more onerous quarantine/travel restrictions. Longer-term, however, we believe there is significant pent-up demand in these markets.
Retailing
COVID-19 Impact
Baraomter Levels High
Key Observations Covid-related lockdowns and store closures have accelerated the pre-existing secular transition to online shopping across the world, thus putting immense pressure on general retail including legacy formats particularly such as department stores and shopping malls. As a result, we have witnessed a sharp deterioration in sector credit quality with large IG issuers getting downgraded, in some case into HY territory, and many smaller/weaker names facing severe financial distress. That said, we also see pockets of strength within retail. For instance, pressure on consumers has played into the hands of the discounters while the stay-at-home theme has acted as a tailwind to DIY/builder merchants, and food retailers continue to take share from the restaurant sector.
Transportation
COVID-19 Impact
Baraomter Levels High
Key Observations In Q4, travel demand should continue to be well below 2019 levels, as both leisure and business travelers will not return until a widely distributed vaccine or therapeutic is available. Hence the US legacy carriers have announced capacity reductions of more than 40% domestically and more than 75% internationally due to travel restrictions and mandatory quarantines. Given the ongoing uncertainty, the US airlines raised billions more in debt in Q3 by pledging non-aircraft assets, such as loyalty programs and credit card agreements, which has further lengthened their liquidity runway. In late-September 2020, most of the US airlines finalized terms with the US Treasury regarding secured loans under the original CARES Act that are available at a low cost of capital, but with restrictions, such as prohibitions on dividends and share buybacks, as well as equity warrants. The industry remains hopeful regarding an additional $25 billion of payroll support that could prevent the layoff of more than 40,000 employees this fall , but the political outcome is difficult to predict. Meanwhile, the airlines are collaborating with local authorities to create temporary solutions, such as rapid Covid tests at airports, that may be available at a price for individuals traveling during the busy Thanksgiving, Christmas and New Year holidays.
Metals & Mining
COVID-19 Impact
Baraomter Levels Medium High
Key Observations Metals demand has returned in China and buoys the market for metals until the US and Europe can kick-start growth again. As previously discussed, COVID-19 has served to restrain production levels which typically leads to lower inventories and a tighter market. This should provide for a better balanced market (hence prices) going forward. Any infrastructure spend by either party’s administration is good for commodities, similarly any USD depreciation. If Biden were to be successful, we would likely see a return to a more “global” stance and movement away from protectionist policies which could provide a further tailwind for many metals.
Banks
COVID-19 Impact
Baraomter Levels Medium
Key Observations We support a large overweight to the highest-quality banks given resilient/low-risk business models, benign technicals, conservative credit ratings and attractive valuations. We expect a meaningful recession in 2020, but we believe banks will fare much better than expected given that they have the strongest balance sheets in decades. The duration and severity of the economic shutdown will determine both the degree of earnings decline and balance sheet damage, but meaningful fiscal and monetary stimulus combined with limited shareholder payouts should be supportive. Global regulatory best practices and conservative stress tests over the last decade provide strong pillars to our thesis that banks have grown into a stronger, safer and simpler industry.
Consumer
Products &
Apparel
COVID-19 Impact
Baraomter Levels Medium
Key Observations Most consumer products and apparel companies are less levered than retailers and do not carry the burden of monthly cash outflow for rent on a leased store base. We continue to see improved demand across consumer discretionary categories that bottomed out in late-March/early-April. The share of wallet shift appears to be most visible in home improvement, outdoor-related products and sporting goods. In branded apparel, the companies with strong brands and sophisticated omni-channel capabilities are best suited to benefit from the accelerating shift to online and gradual reopening of brick and mortar establishments. Looking ahead, companies are focusing on addressing supply-chain disruptions and changes in consumer buying habits.
Health Care
COVID-19 Impact
Baraomter Levels Medium
Key Observations We favor managed care over providers in the current environment, as we see higher acuity, elective surgeries delayed to 2H20. This dynamic benefited managed care via lower medical loss ratios during 1H20, while many providers will see volumes delayed to later this year. Some elective procedures will not occur at all due to rising unemployment. Liquidity profiles for health care providers were recently bolstered via various provisions under the CARES Act. The repayment terms were recently relaxed by providing hospitals a one-year holiday on repayment and then allowing them to start repaying by forgoing only 25% of their monthly reimbursement.
Food &
Beverage
COVID-19 Impact
Baraomter Levels Low
Key Observations The pandemic continues to be a revenue tailwind for the food & beverage companies due to the prolonged period of at-home eating that has helped offset weakness in the food service channel. However, costs are being pressured by strained supply chains and protein producers continue to suffer from plant closings after localized virus outbreaks. Looking ahead, food & beverage companies are focused on growing and maintaining additional market share by increasing loyalty and brand engagement. The investments in innovation and brand marketing may further pressure margins, but should result in long-term market share gains. Finally, consumers tend to retreat to value as they curb overall spending during recessionary times, which should benefit food & beverage companies.
Pharmaceuticals
COVID-19 Impact
Baraomter Levels Low
Key Observations In the IG sector, there have not been any product delivery delays. The focus continues to be on finding a vaccine and/or therapeutics to survive COVID-19. Within the HY segment, key market players have not cited any major disruptions to their supply chains. However, we have seen lower demand for drugs tied to elective surgeries, which have been reduced or delayed due to the pandemic.
Technology
COVID-19 Impact
Baraomter Levels Low
Key Observations As the Covid crisis has evolved, we are seeing clear signs of stability and improvement in the technology sector. Debt and equity markets have rebounded, reflecting growing optimism for a broader reopening of the economy, despite ongoing Covid-related economic headwinds. Capital investments in hardware and software to support the evolving work-from-home (WFH) business model are bolstered by greater demand for technology products that enable new end uses such as artificial intelligence, EV and autonomous vehicles, 5G telecommunications, virtualized net-working and cloud computing. Looking forward and into next year, we believe that many subsectors including, for example, 5G connectivity, electronic payments, tech-related infrastructure, cloud computing and cybersecurity, should emerge post-crisis in favorable positions.
Telecommunications & Media
COVID-19 Impact
Baraomter Levels Low
Key Observations In telecoms, temporary retail store closures, lower revenues from roaming amid travel restrictions as well as broader macro weakness manifesting itself in reduced enterprise/SME demand put pressure on issuers during Q2. We also flag the potential for a future rise in customer bad debts. But our research suggests that the financial impact is limited and as such we do not see any meaningful deterioration in credit quality. We therefore view the telecoms space as a safe haven that deserves to trade at a premium. We also note the proliferation of operator asset monetization initiatives across wireless and fixed infrastructure, often at highly attractive EBITDA multiples. This, coupled with rising LBO activity among small-/mid-cap telecoms names, in our view highlights once more the inherent value of physical telecoms assets. In media, we still view cuts in advertising budgets as the principal near-term headwind facing ad-driven business models such as broadcasters and ad agencies, thereby exacerbating pre-existing structural pressures.
Utilities
COVID-19 Impact
Baraomter Levels Low
Key Observations Continued WFH policies buoy residential load growth while we see a slow return in industrial and commercial loads as the economy recovers. Bad debts are likely higher with higher unemployment rates. A change in the presidential administration and the push for net zero emissions in the electric utility sector would mean increased capital investment required and the need for more supportive state regulatory environment. Previously uneconomic nuclear generation would likely be saved with subsidies and coal-fired generation replacement likely accelerated with renewables, but the short timeframe to achieve this would be in question without help from a transition fuel like natural gas.
Industry COVID-19 Impact Key Observations
Auto & Related Baraomter Levels High The global automotive sector has now moved past the worst of the Covid-related production challenges and the US light vehicle market has experienced stronger-than-expected consumer demand, particularly for SUVs/trucks, despite the more challenging unemployment backdrop. As we move forward throughout the balance of FY2020 and into FY2021 we continue to focus on each OEM/supplier’s liquidity position, ability to flex their respective cost structures, and capacity to evolve their business models to a more rapid adoption of EV/hybrid vehicle platforms.
Energy Baraomter Levels High The market continues to rebalance slowly and requires OPEC+ to maintain cohesion and adherence to production cuts while we wait for demand to recover. This should serve to reduce inventory levels over time. US companies are currently pricing below maintenance levels that are unsustainable; we have observed some of the prior production curtailments come back. All eyes turn to the election and the impact of a change in administration. A Trump victory would yield the status quo while a Biden victory would clear the way for a change in domestic energy policy to more “green energy.” The pace of transition remains subject to debate, but it’s not likely to occur overnight.
Gaming Baraomter Levels High Regional markets are expected to perform best given the “drive-in” nature of their operations, ability to quickly right-size their cost structures, and appeal to consumers given limited entertainment options. Las Vegas will take time to recover, as this is a destination market that requires “air lift” into town. Given consumers’ reluctance to travel on domestic airlines as a result of Covid concerns, visitation trends have been down substantially on a YoY basis, and the mid-week convention business has essentially been eliminated, resulting in occupancy rates of 20% to 30% during the week and approximately 50% on the weekends. Macau and Singapore face similar hurdles to Las Vegas given their destination status and more onerous quarantine/travel restrictions. Longer-term, however, we believe there is significant pent-up demand in these markets.
Retailing Baraomter Levels High Covid-related lockdowns and store closures have accelerated the pre-existing secular transition to online shopping across the world, thus putting immense pressure on general retail including legacy formats particularly such as department stores and shopping malls. As a result, we have witnessed a sharp deterioration in sector credit quality with large IG issuers getting downgraded, in some case into HY territory, and many smaller/weaker names facing severe financial distress. That said, we also see pockets of strength within retail. For instance, pressure on consumers has played into the hands of the discounters while the stay-at-home theme has acted as a tailwind to DIY/builder merchants, and food retailers continue to take share from the restaurant sector.
Transportation Baraomter Levels High In Q4, travel demand should continue to be well below 2019 levels, as both leisure and business travelers will not return until a widely distributed vaccine or therapeutic is available. Hence the US legacy carriers have announced capacity reductions of more than 40% domestically and more than 75% internationally due to travel restrictions and mandatory quarantines. Given the ongoing uncertainty, the US airlines raised billions more in debt in Q3 by pledging non-aircraft assets, such as loyalty programs and credit card agreements, which has further lengthened their liquidity runway. In late-September 2020, most of the US airlines finalized terms with the US Treasury regarding secured loans under the original CARES Act that are available at a low cost of capital, but with restrictions, such as prohibitions on dividends and share buybacks, as well as equity warrants. The industry remains hopeful regarding an additional $25 billion of payroll support that could prevent the layoff of more than 40,000 employees this fall , but the political outcome is difficult to predict. Meanwhile, the airlines are collaborating with local authorities to create temporary solutions, such as rapid Covid tests at airports, that may be available at a price for individuals traveling during the busy Thanksgiving, Christmas and New Year holidays.
Metals & Mining Baraomter Levels Medium High Metals demand has returned in China and buoys the market for metals until the US and Europe can kick-start growth again. As previously discussed, COVID-19 has served to restrain production levels which typically leads to lower inventories and a tighter market. This should provide for a better balanced market (hence prices) going forward. Any infrastructure spend by either party’s administration is good for commodities, similarly any USD depreciation. If Biden were to be successful, we would likely see a return to a more “global” stance and movement away from protectionist policies which could provide a further tailwind for many metals.
Banks Baraomter Levels Medium We support a large overweight to the highest-quality banks given resilient/low-risk business models, benign technicals, conservative credit ratings and attractive valuations. We expect a meaningful recession in 2020, but we believe banks will fare much better than expected given that they have the strongest balance sheets in decades. The duration and severity of the economic shutdown will determine both the degree of earnings decline and balance sheet damage, but meaningful fiscal and monetary stimulus combined with limited shareholder payouts should be supportive. Global regulatory best practices and conservative stress tests over the last decade provide strong pillars to our thesis that banks have grown into a stronger, safer and simpler industry.
Consumer
Products &
Apparel
Baraomter Levels Medium Most consumer products and apparel companies are less levered than retailers and do not carry the burden of monthly cash outflow for rent on a leased store base. We continue to see improved demand across consumer discretionary categories that bottomed out in late-March/early-April. The share of wallet shift appears to be most visible in home improvement, outdoor-related products and sporting goods. In branded apparel, the companies with strong brands and sophisticated omni-channel capabilities are best suited to benefit from the accelerating shift to online and gradual reopening of brick and mortar establishments. Looking ahead, companies are focusing on addressing supply-chain disruptions and changes in consumer buying habits.
Health Care Baraomter Levels Medium We favor managed care over providers in the current environment, as we see higher acuity, elective surgeries delayed to 2H20. This dynamic benefited managed care via lower medical loss ratios during 1H20, while many providers will see volumes delayed to later this year. Some elective procedures will not occur at all due to rising unemployment. Liquidity profiles for health care providers were recently bolstered via various provisions under the CARES Act. The repayment terms were recently relaxed by providing hospitals a one-year holiday on repayment and then allowing them to start repaying by forgoing only 25% of their monthly reimbursement.
Food &
Beverage
Baraomter Levels Low The pandemic continues to be a revenue tailwind for the food & beverage companies due to the prolonged period of at-home eating that has helped offset weakness in the food service channel. However, costs are being pressured by strained supply chains and protein producers continue to suffer from plant closings after localized virus outbreaks. Looking ahead, food & beverage companies are focused on growing and maintaining additional market share by increasing loyalty and brand engagement. The investments in innovation and brand marketing may further pressure margins, but should result in long-term market share gains. Finally, consumers tend to retreat to value as they curb overall spending during recessionary times, which should benefit food & beverage companies.
Pharmaceuticals Baraomter Levels Low In the IG sector, there have not been any product delivery delays. The focus continues to be on finding a vaccine and/or therapeutics to survive COVID-19. Within the HY segment, key market players have not cited any major disruptions to their supply chains. However, we have seen lower demand for drugs tied to elective surgeries, which have been reduced or delayed due to the pandemic.
Technology Baraomter Levels Low As the Covid crisis has evolved, we are seeing clear signs of stability and improvement in the technology sector. Debt and equity markets have rebounded, reflecting growing optimism for a broader reopening of the economy, despite ongoing Covid-related economic headwinds. Capital investments in hardware and software to support the evolving work-from-home (WFH) business model are bolstered by greater demand for technology products that enable new end uses such as artificial intelligence, EV and autonomous vehicles, 5G telecommunications, virtualized net-working and cloud computing. Looking forward and into next year, we believe that many subsectors including, for example, 5G connectivity, electronic payments, tech-related infrastructure, cloud computing and cybersecurity, should emerge post-crisis in favorable positions.
Telecommunications & Media Baraomter Levels Low In telecoms, temporary retail store closures, lower revenues from roaming amid travel restrictions as well as broader macro weakness manifesting itself in reduced enterprise/SME demand put pressure on issuers during Q2. We also flag the potential for a future rise in customer bad debts. But our research suggests that the financial impact is limited and as such we do not see any meaningful deterioration in credit quality. We therefore view the telecoms space as a safe haven that deserves to trade at a premium. We also note the proliferation of operator asset monetization initiatives across wireless and fixed infrastructure, often at highly attractive EBITDA multiples. This, coupled with rising LBO activity among small-/mid-cap telecoms names, in our view highlights once more the inherent value of physical telecoms assets. In media, we still view cuts in advertising budgets as the principal near-term headwind facing ad-driven business models such as broadcasters and ad agencies, thereby exacerbating pre-existing structural pressures.
Utilities Baraomter Levels Low Continued WFH policies buoy residential load growth while we see a slow return in industrial and commercial loads as the economy recovers. Bad debts are likely higher with higher unemployment rates. A change in the presidential administration and the push for net zero emissions in the electric utility sector would mean increased capital investment required and the need for more supportive state regulatory environment. Previously uneconomic nuclear generation would likely be saved with subsidies and coal-fired generation replacement likely accelerated with renewables, but the short timeframe to achieve this would be in question without help from a transition fuel like natural gas.