Macro Perspective

Western Asset expects that the second half of the year should see very strong growth in global GDP as the world economy reopens. That stated, we are cautious about extrapolating short-term cyclical boosts into a presumption of a higher secular trend rate of growth or inflation. The secular challenges that have kept US and global growth to a moderate pace at best over the last several decades persist. These include the stagnation of Western societies’ middle-class wages, aging demographics and rising global debt burdens. Moreover, the small and medium-sized business destruction in many countries not seen since the Great Depression may take years to replace. Given this backdrop, Western Asset expects central banks to remain extraordinarily accommodative for the foreseeable future. Our portfolios are positioned to withstand further market volatility, yet remain flexible enough to capture 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 Corporate Credit Overview: Resilient in the Face of Rising Rates

The dominant theme in the first quarter of 2021 was the sharp and rapid rise in US interest rates as market participants priced in faster economic growth on both the passage of the third stimulus package and accelerating progress in the vaccination rollout. Dovish communication from the Federal Reserve (Fed) at its March Federal Open Market Committee meeting, where it left its policy rate projections unchanged for 2022 and 2023, along with signaling that it would react only to actual and not projected improvements in economic and labor conditions, together provided relief with rates trending sideways afterwards. Despite the higher move in rates, investment-grade credit generated a positive return for the quarter with sectors such as energy, airlines and aerospace outperforming the broader market. Primary issuance was heavier than usual and impacted by certain releveraging transactions ($25 billion from Verizon and $6 billion from AT&T to finance their 5G spectrum auction purchases) and $11 billion from Oracle for shareholder-friendly actions that resulted in a downgrade into BBB territory. Barclays reported $201 billion of gross new supply compared to $138 billion in February and $272 billion in March 2020. Overall investment-grade spreads, which had widened to 341 basis points (bps) over US Treasuries (USTs) during the depths of the crisis, have completed their round trip back to pre-crisis levels.

Within the high-yield market, spreads continued their march lower, led in large part by lower-quality (CCC and B rated) issuers. The market remained on strong footing as healthy refinancing activity and liquidity bolstering have provided runway for leveraged balance sheets to operate as the market navigates the vaccine rollout and revenue generation for pandemic-related credits heads down a path to normalcy. Strong technicals continue to persist within high-yield, most notably from institutional demand seeking income and prospects of additional total return, often most easily identified via the primary market. New-issue volume reached a monthly record in March with a total of $64.8 billion that were priced, bringing the year-to-date total to $158.6 billion (compared to $72.9 billion during the same period last year), according to JP Morgan. Overall high-yield spreads, which had widened to more than 1,100 bps over USTs during the depths of the crisis, have completed the round trip back to where they began 2020 (at +336 bps). The market may appear to be fully valued, but we believe select opportunities remain. We note that the quality of the high-yield market is improving as fallen angels are now moving back to the status of “rising stars.” We expect these trends to continue.

Exhibit 1: US High-Yield Fallen Angels/Rising Stars and Credit Quality Improvement Exhibit 1 Source: (Top) J.P. Morgan, Moody’s Investors Service, S&P. As of 31 Mar 21. (Bottom) Bloomberg, Barclays Research. As of 31 Mar 21. Select the image to expand the view.
EM Corporates: Are Risks Overstated?

US President Joe Biden released his long awaited eight-year, $2.3 trillion American Jobs Plan, which is focused on transportation, water, housing, schools and health care infrastructure—all municipal sectors that would benefit from increased federal funding. The plan specifically dedicates $621 billion to modernizing roads, bridges, railroads, public transit and airports. The plan also pledges $650 billion to affordable housing, water, electric, rural broadband and public school infrastructure.

The infrastructure plan would be positive for domestic economic growth and infrastructure spending that has declined in recent years to below 2.0% of GDP. The plan’s annual infrastructure spending is equivalent to approximately 1.3% of 2020 GDP, and the measure would bring infrastructure spending back near historical average levels at approximately 2.5% of GDP.

While infrastructure support is bipartisan, we anticipate the scope of spending that includes non-traditional infrastructure items to remain an obstacle considering the thin Democratic majority. Robust pandemic-related stimulus, along with recent positive labor market performance may limit congressional willingness to support additional spending measures.

Questions also remain around how the infrastructure proposal would be funded, and additional clarity is expected to be released in May and June. The President has touted increasing the corporate tax rate from 21% to 28% to fund the plan. Funding mechanics are also unclear, as federally subsidized bond solutions (such as the Obama-era BABs program) remain in the conversation as well as more traditional financing sources such as P3, TIFIA, and PABs (for more information see our recent blog post on the various infrastructure initiatives). We expect the structure of any bonding incentives to have a material impact on the composition of taxable and tax-exempt municipal market supply technicals over any major infrastructure funding period. Considering the biases to clean energy and climate change initiatives outlined within the plan, any bonding solution should contribute to positive impact investment opportunities for ESG investors.

Exhibit 2: The $2.3 Trillion American Jobs Plan
(Select the image to expand the view.)
Exhibit 2 Source: Whitehouse gov. As of 31 Mar 21. Select the image to expand the view.
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. 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.

Investment-Grade (IG) Credit

We are optimistic on US credit fundamentals. However, the path forward now partly rests with how quickly economic activity is allowed to resume and on how US companies handle the war chest of liquidity they’ve raised thus far. While favorable technicals endure, valuations have already returned to pre-Covid levels for many sectors. Our bias now is to sell into further strength for those sectors where valuations have returned to pre-Covid levels while maintaining overweights to banking, select reopening industries and rising-star candidates where allowed. In European investment-grade credit, liquidity profiles generally look very solid and we have seen a number of rating upgrades in 1Q21. We continue to find opportunities in subordinated financials and REITs.

High-Yield (HY) Credit

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. In European high-yield, we continue to focus on B rated issues from a valuation perspective and believe that BB rated securities will benefit from broader investor demand. We like defensive sectors such as pharma and also selective cyclical industrials and consumer-related sectors.

Municipals

Valuations remain relatively rich on a historical basis, but we believe the vaccine rollouts, direct federal aid to municipalities and favorable technicals should continue to buoy the municipal market. We continue to favor lower investment-grade revenue sectors that should continue to benefit from an economic recovery. However, we are cognizant of relative rich valuations, thus we are maintaining an above average liquidity position to maintain flexibility to navigate near-term market fluctuations associated with an extended tax season or near-term interest-rate volatility.

Emerging Markets

Notwithstanding recent market volatility, our central thesis with emerging markets (EM) is that a post-Covid recovery in the asset class is not yet complete. Two factors augur well for EM: (1) the recovery in oil and commodity prices, and (2) a resumption of international trade and tourism. In the hard currency space, we continue to take advantage of primary issuance from short- and intermediate-dated investment-grade and high-yield EM corporates. In local rates, we are mindful that certain EM central banks’ easing cycles are coming to a close. We are being highly selective in this space due to the potential for additional currency market volatility on any Covid-induced growth setbacks.

Structured Credit

By many metrics housing has already experienced a V-shaped recovery, but non-agency residential MBS spreads still remain at wider levels relative to pre-Covid. We are focusing on more seasoned borrowers with low loan-to-value (LTV) ratios, which provides more downside protection in a scenario of declining housing prices. The commercial sector remains further behind in terms of recovery especially for certain property types hit hardest by the pandemic such as hotels and retail. We believe additional economic reopenings should be a positive catalyst for commercial MBS spreads to continue recovering with single-asset single-borrower (SASB) non-agency mortgages (secured by high-quality commercial properties with strong equity sponsors) poised to benefit the most.

US Corporate Credit Overview: Resilient in the Face of Rising Rates
Corporate Icon

Despite the higher move in rates, investment-grade credit generated a positive return for the quarter with sectors such as energy, airlines and aerospace outperforming the broader market.

The dominant theme in the first quarter of 2021 was the sharp and rapid rise in US interest rates as market participants priced in faster economic growth on both the passage of the third stimulus package and accelerating progress in the vaccination rollout. Dovish communication from the Federal Reserve (Fed) at its March Federal Open Market Committee meeting, where it left its policy rate projections unchanged for 2022 and 2023, along with signaling that it would react only to actual and not projected improvements in economic and labor conditions, together provided relief with rates trending sideways afterwards. Despite the higher move in rates, investment-grade credit generated a positive return for the quarter with sectors such as energy, airlines and aerospace outperforming the broader market. Primary issuance was heavier than usual and impacted by certain releveraging transactions ($25 billion from Verizon and $6 billion from AT&T to finance their 5G spectrum auction purchases) and $11 billion from Oracle for shareholder-friendly actions that resulted in a downgrade into BBB territory. Barclays reported $201 billion of gross new supply compared to $138 billion in February and $272 billion in March 2020. Overall investment-grade spreads, which had widened to 341 basis points (bps) over US Treasuries (USTs) during the depths of the crisis, have completed their round trip back to pre-crisis levels.

Within the high-yield market, spreads continued their march lower, led in large part by lower-quality (CCC and B rated) issuers. The market remained on strong footing as healthy refinancing activity and liquidity bolstering have provided runway for leveraged balance sheets to operate as the market navigates the vaccine rollout and revenue generation for pandemic-related credits heads down a path to normalcy. Strong technicals continue to persist within high-yield, most notably from institutional demand seeking income and prospects of additional total return, often most easily identified via the primary market. New-issue volume reached a monthly record in March with a total of $64.8 billion that were priced, bringing the year-to-date total to $158.6 billion (compared to $72.9 billion during the same period last year), according to JP Morgan. Overall high-yield spreads, which had widened to more than 1,100 bps over USTs during the depths of the crisis, have completed the round trip back to where they began 2020 (at +336 bps). The market may appear to be fully valued, but we believe select opportunities remain. We note that the quality of the high-yield market is improving as fallen angels are now moving back to the status of “rising stars.” We expect these trends to continue.

Exhibit 1: US High-Yield Fallen Angels/Rising Stars and Credit Quality Improvement

Exhibit 1
Source: (Top) J.P. Morgan, Moody’s Investors Service, S&P. As of 31 Mar 21. (Bottom) Bloomberg, Barclays Research. As of 31 Mar 21. Select the image to expand the view.
Municipals: Infrastructure Policy Begins to Take Shape
Pie Dislcation Icon

The American Jobs Plan is focused on transportation, water, housing, schools and health care infrastructure that will benefit from increased federal funding.

US President Joe Biden released his long awaited eight-year, $2.3 trillion American Jobs Plan, which is focused on transportation, water, housing, schools and health care infrastructure—all municipal sectors that would benefit from increased federal funding. The plan specifically dedicates $621 billion to modernizing roads, bridges, railroads, public transit and airports. The plan also pledges $650 billion to affordable housing, water, electric, rural broadband and public school infrastructure.

The infrastructure plan would be positive for domestic economic growth and infrastructure spending that has declined in recent years to below 2.0% of GDP. The plan’s annual infrastructure spending is equivalent to approximately 1.3% of 2020 GDP, and the measure would bring infrastructure spending back near historical average levels at approximately 2.5% of GDP.

While infrastructure support is bipartisan, we anticipate the scope of spending that includes non-traditional infrastructure items to remain an obstacle considering the thin Democratic majority. Robust pandemic-related stimulus, along with recent positive labor market performance may limit congressional willingness to support additional spending measures.

Questions also remain around how the infrastructure proposal would be funded, and additional clarity is expected to be released in May and June. The President has touted increasing the corporate tax rate from 21% to 28% to fund the plan. Funding mechanics are also unclear, as federally subsidized bond solutions (such as the Obama-era BABs program) remain in the conversation as well as more traditional financing sources such as P3, TIFIA, and PABs (for more information see our recent blog post on the various infrastructure initiatives). We expect the structure of any bonding incentives to have a material impact on the composition of taxable and tax-exempt municipal market supply technicals over any major infrastructure funding period. Considering the biases to clean energy and climate change initiatives outlined within the plan, any bonding solution should contribute to positive impact investment opportunities for ESG investors.

Exhibit 2: The $2.3 Trillion American Jobs Plan

Exhibit 2
Source: Whitehouse gov. As of 31 Mar 21. Select the image to expand the view.
Global Credit Markets: Relative Value Round-Up
Pie Puzzle Pieces

We are optimistic on US credit fundamentals and the path forward rests on how quickly economic activity is allowed to resume and on how US companies handle the war chest of liquidity they’ve raised thus far.

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. 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.

Investment-Grade (IG) Credit

We are optimistic on US credit fundamentals. However, the path forward now partly rests with how quickly economic activity is allowed to resume and on how US companies handle the war chest of liquidity they’ve raised thus far. While favorable technicals endure, valuations have already returned to pre-Covid levels for many sectors. Our bias now is to sell into further strength for those sectors where valuations have returned to pre-Covid levels while maintaining overweights to banking, select reopening industries and rising-star candidates where allowed. In European investment-grade credit, liquidity profiles generally look very solid and we have seen a number of rating upgrades in 1Q21. We continue to find opportunities in subordinated financials and REITs.

High-Yield (HY) Credit

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. In European high-yield, we continue to focus on B rated issues from a valuation perspective and believe that BB rated securities will benefit from broader investor demand. We like defensive sectors such as pharma and also selective cyclical industrials and consumer-related sectors.

Municipals

Valuations remain relatively rich on a historical basis, but we believe the vaccine rollouts, direct federal aid to municipalities and favorable technicals should continue to buoy the municipal market. We continue to favor lower investment-grade revenue sectors that should continue to benefit from an economic recovery. However, we are cognizant of relative rich valuations, thus we are maintaining an above average liquidity position to maintain flexibility to navigate near-term market fluctuations associated with an extended tax season or near-term interest-rate volatility.

Emerging Markets

Notwithstanding recent market volatility, our central thesis with emerging markets (EM) is that a post-Covid recovery in the asset class is not yet complete. Two factors augur well for EM: (1) the recovery in oil and commodity prices, and (2) a resumption of international trade and tourism. In the hard currency space, we continue to take advantage of primary issuance from short- and intermediate-dated investment-grade and high-yield EM corporates. In local rates, we are mindful that certain EM central banks’ easing cycles are coming to a close. We are being highly selective in this space due to the potential for additional currency market volatility on any Covid-induced growth setbacks.

Structured Credit

By many metrics housing has already experienced a V-shaped recovery, but non-agency residential MBS spreads still remain at wider levels relative to pre-Covid. We are focusing on more seasoned borrowers with low loan-to-value (LTV) ratios, which provides more downside protection in a scenario of declining housing prices. The commercial sector remains further behind in terms of recovery especially for certain property types hit hardest by the pandemic such as hotels and retail. We believe additional economic reopenings should be a positive catalyst for commercial MBS spreads to continue recovering with single-asset single-borrower (SASB) non-agency mortgages (secured by high-quality commercial properties with strong equity sponsors) poised to benefit the most.

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. The US light vehicle market has experienced stronger than expected consumer demand, particularly for SUVs/trucks, despite the more challenging unemployment backdrop, while the European market remains burdened by extended lockdown measures; the Chinese market is the best performer, having recovered as soon as 2Q20. As we move forward throughout FY21 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. Additionally, we are closely monitoring the production challenges related to a global shortage of semiconductor chips and how this may manifest itself throughout the supply chain.
Energy
COVID-19 Impact
Baraomter Levels High
Key Observations While volatility is expected to prevail, albeit at lower levels, prices continue to be range-bound. The source of the volatility is likely more supply-side driven than demand-side given the COVID-19 vaccine; OPEC+ cooperation and resolve are still required at this juncture. We see the recent OPEC+ news of gradually increasing supply over the next quarter consistent with the cartels’ desire to maintain balanced markets given expectations of post-Covid demand increases. We recognize we are in the midst of a cyclical upswing but also understand there is a longer-term energy transition underway; still, we believe fossil fuel demand will continue to grow but at a slower pace. We continue to believe there is a distinction between companies and strategies employed to weather the down-cycle. We have seen a wave of consolidation in a short period of time which we view as necessary, and we do not believe it is over yet (only slowed). Rating agencies have begun to stabilize the ratings and outlooks at current higher oil prices and within high-yield, ratings have begun to move higher given absolute debt paydown and restrained capital spending.
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 has recovered faster than originally anticipated, as a more widespread rollout of the vaccine, consumers’ increasing willingness to travel and the receipt of government stimulus checks have proven to be strong positive catalysts. This has provided the pathway for improved occupancy rates (40%-50% throughout the week; 80%-90% on the weekend) and gross gaming revenue (GGR) trends. Macau and Singapore have rebounded much more slowly given their destination status and more onerous quarantine/travel-related 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-19 globally accelerated the pre-existing secular transition to online shopping, thus putting immense pressure on legacy non-food retailers such as department stores and mall operators. However, we believe most of the sector credit quality deterioration is now behind us and recommend an incrementally more constructive stance in selected single names. Indeed, most issuers by now have built impressive online capabilities and optimized their physical store footprints. Near-term we think the reopening of economies globally along with easy year-over-year (YoY) comparables bodes well for sector earnings over the next few quarters. Elsewhere, food retail was a pocket of stability during the pandemic and interestingly we now see an uptick in sector M&A activity. DIY/builder merchants continue to do well but we expect 2Q21/2H21 revenue normalization as consumers reallocate discretionary spending from home improvement toward categories such as travel/leisure.
Transportation
COVID-19 Impact
Baraomter Levels High
Key Observations US airlines have successfully issued billions of secured debt at favorable rates, in addition to obtaining multiple rounds of government financial support. As a result, the airlines have established fortress liquidity positions that ensure financial flexibility and also provide leverage for the rebound. Vaccine distribution is driving demand for air travel as President Biden announced that all American adults would be eligible for a vaccine by April 19. Most of the US airlines are expected to generate free cash flow in Q2 and Q3 this year thanks to tremendous pent-up demand for domestic air travel. However, international travel remains limited to essential travel only and is not expected to reopen until late 2021.
Metals & Mining
COVID-19 Impact
Baraomter Levels Medium High
Key Observations To stimulate GDP growth, governments are implementing policies that target large infrastructure spending. This combined with a continued expansionary monetary policy underscores and supports future demand for commodities in general. Further, with energy transition accelerated, the call on commodities that aid in execution also adds to demand. In addition, the potential for a weaker US dollar, in general, buoys realized commodity prices. From a supply perspective, past years’ underinvestment does restrain the ability of the industry to respond in a timely manner given the long lead times for projects to be permitted and developed and this does not take into consideration the increased focus on environmental and social responsibilities. Consequently, inventory levels are likely to be drawn down ahead of this and should further support prices. It appears incentive prices have moved higher. To add to the capital allocation conservatism, managements have also focused on protecting the balance sheet and maintaining sufficient liquidity to manage any downturn. As a result, limited debt issuance is expected (for now) and market technicals remain in favor.
Banks
COVID-19 Impact
Baraomter Levels Medium
Key Observations We continue to favor the highest-quality banks based on the resilient performance of their de-risked business models in 2020 and conservative credit ratings. For 2021 overall, we expect a meaningful economic expansion which should support a recovery in earnings while continuing fiscal and monetary stimulus combined with limited shareholder payouts should continue to limit downside risks to balance sheets if a less favorable economic path were to materialize. All major US banks beat 1Q21 expectations with the strongest balance sheets in decades. The banks maintain constructive economic and market outlooks given the combination of massive stimulus from central banks and governments, a robust economic rebound in the US and to a lesser extent elsewhere, a successful vaccine rollout in most developed countries and healthy risk animal spirits.
Health Care
COVID-19 Impact
Baraomter Levels Medium
Key Observations While health insurers faced significant increases in claims costs associated with testing and treatment for COVID-19 in 2020, these costs have been more than offset by a significant level of deferral of non-emergency care, such as elective surgeries, diagnostic testing and routine care. Within the managed care space, negative event risk is on the rise. Following the Georgia runoff races and Biden’s proposed “American Rescue Plan,” we expect the health care landscape to feature substantive federal and state policy-driven debates steered by the pandemic and the Democrats’ national health care policy. From our perspective, Biden’s stimulus package proposals are positive for high-yield managed care, hospital and health care facilities.
Food &
Beverage
COVID-19 Impact
Baraomter Levels Low
Key Observations Food and beverage companies continue to benefit from elevated demand as more people prepare meals at home due to the pandemic. However, food and beverage companies also face higher input costs and a rise in freight transportation costs, although most food and beverage companies have the ability to pass along rising costs and take price actions, where appropriate, but there could be some timing delays. Hence 2Q21 gross profits may be pressured by higher manufacturing costs caused by inefficiencies related to the pandemic’s ongoing effect on production, transportation and warehousing operations.
Pharmaceuticals
COVID-19 Impact
Baraomter Levels Low
Key Observations We remain constructive on investment-grade pharma. Investors have focused on both the potential for near-term drug price reform as well as the sector’s mid-2020s LOE cycle. We do not foresee any immediate credit changing events related to drug reform. With solid pipeline progress across the group over the past 12-24 months and a number of important readouts in 2021, we see these patent expirations as increasingly manageable and see an opportunity for the sector to re-rate on further pipeline de-risking. In high-yield, key market players have not seen major disruptions from COVID-19 and earnings results have been trending above expectations. While some saw lower demand for drugs tied to elective surgeries last summer, we are seeing some companies cite tailwinds from this pent-up demand.
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. Capital investments in hardware and software to support the evolving work-from-home 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 networking, 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, will emerge post-crisis as winners.
Telecommunications & Media
COVID-19 Impact
Baraomter Levels Low
Key Observations Telecom operators suffered only relatively minor disruptions from Covid and proved to be a safe haven during the pandemic. Early this year, however, US operators acquired new spectrum for over $80 billion, funded primarily via public debt markets. We are somewhat skeptical around operators’ ability/willingness to meaningfully de-lever over the near term and thus view the recent underperformance in secondary spreads as justified. In Europe, there remains a marked dichotomy between the telecom sector’s public and private valuation multiples. We therefore remain mindful around potential fresh take-private activity. In media, we expect a strong bounce-back in advertising spending and see evidence of that in 1Q21 reporting.
Utilities
COVID-19 Impact
Baraomter Levels Low
Key Observations Within the US, management teams continue to focus on regulated operations and we observe more companies jettisoning the non-regulated/merchant/traditional non-utility businesses from their consolidated structures. The development is good/positive for greater stability in earnings and cash flows and reduces the complexity of the business models. This is increasing in importance as the theme of grid modernization and focus on renewable investments remain. Consequently, capital budgets are set to remain elevated and negative free cash flow generation should prevail, which underscores the need for supportive regulatory environments to enable successful execution.
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. The US light vehicle market has experienced stronger than expected consumer demand, particularly for SUVs/trucks, despite the more challenging unemployment backdrop, while the European market remains burdened by extended lockdown measures; the Chinese market is the best performer, having recovered as soon as 2Q20. As we move forward throughout FY21 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. Additionally, we are closely monitoring the production challenges related to a global shortage of semiconductor chips and how this may manifest itself throughout the supply chain.
Energy Baraomter Levels High While volatility is expected to prevail, albeit at lower levels, prices continue to be range-bound. The source of the volatility is likely more supply-side driven than demand-side given the COVID-19 vaccine; OPEC+ cooperation and resolve are still required at this juncture. We see the recent OPEC+ news of gradually increasing supply over the next quarter consistent with the cartels’ desire to maintain balanced markets given expectations of post-Covid demand increases. We recognize we are in the midst of a cyclical upswing but also understand there is a longer-term energy transition underway; still, we believe fossil fuel demand will continue to grow but at a slower pace. We continue to believe there is a distinction between companies and strategies employed to weather the down-cycle. We have seen a wave of consolidation in a short period of time which we view as necessary, and we do not believe it is over yet (only slowed). Rating agencies have begun to stabilize the ratings and outlooks at current higher oil prices and within high-yield, ratings have begun to move higher given absolute debt paydown and restrained capital spending.
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 has recovered faster than originally anticipated, as a more widespread rollout of the vaccine, consumers’ increasing willingness to travel and the receipt of government stimulus checks have proven to be strong positive catalysts. This has provided the pathway for improved occupancy rates (40%-50% throughout the week; 80%-90% on the weekend) and gross gaming revenue (GGR) trends. Macau and Singapore have rebounded much more slowly given their destination status and more onerous quarantine/travel-related restrictions. Longer-term, however, we believe there is significant pent up demand in these markets.
Retailing Baraomter Levels High COVID-19 globally accelerated the pre-existing secular transition to online shopping, thus putting immense pressure on legacy non-food retailers such as department stores and mall operators. However, we believe most of the sector credit quality deterioration is now behind us and recommend an incrementally more constructive stance in selected single names. Indeed, most issuers by now have built impressive online capabilities and optimized their physical store footprints. Near-term we think the reopening of economies globally along with easy year-over-year (YoY) comparables bodes well for sector earnings over the next few quarters. Elsewhere, food retail was a pocket of stability during the pandemic and interestingly we now see an uptick in sector M&A activity. DIY/builder merchants continue to do well but we expect 2Q21/2H21 revenue normalization as consumers reallocate discretionary spending from home improvement toward categories such as travel/leisure.
Transportation Baraomter Levels High US airlines have successfully issued billions of secured debt at favorable rates, in addition to obtaining multiple rounds of government financial support. As a result, the airlines have established fortress liquidity positions that ensure financial flexibility and also provide leverage for the rebound. Vaccine distribution is driving demand for air travel as President Biden announced that all American adults would be eligible for a vaccine by April 19. Most of the US airlines are expected to generate free cash flow in Q2 and Q3 this year thanks to tremendous pent-up demand for domestic air travel. However, international travel remains limited to essential travel only and is not expected to reopen until late 2021.
Metals & Mining Baraomter Levels Medium High To stimulate GDP growth, governments are implementing policies that target large infrastructure spending. This combined with a continued expansionary monetary policy underscores and supports future demand for commodities in general. Further, with energy transition accelerated, the call on commodities that aid in execution also adds to demand. In addition, the potential for a weaker US dollar, in general, buoys realized commodity prices. From a supply perspective, past years’ underinvestment does restrain the ability of the industry to respond in a timely manner given the long lead times for projects to be permitted and developed and this does not take into consideration the increased focus on environmental and social responsibilities. Consequently, inventory levels are likely to be drawn down ahead of this and should further support prices. It appears incentive prices have moved higher. To add to the capital allocation conservatism, managements have also focused on protecting the balance sheet and maintaining sufficient liquidity to manage any downturn. As a result, limited debt issuance is expected (for now) and market technicals remain in favor.
Banks Baraomter Levels Medium We continue to favor the highest-quality banks based on the resilient performance of their de-risked business models in 2020 and conservative credit ratings. For 2021 overall, we expect a meaningful economic expansion which should support a recovery in earnings while continuing fiscal and monetary stimulus combined with limited shareholder payouts should continue to limit downside risks to balance sheets if a less favorable economic path were to materialize. All major US banks beat 1Q21 expectations with the strongest balance sheets in decades. The banks maintain constructive economic and market outlooks given the combination of massive stimulus from central banks and governments, a robust economic rebound in the US and to a lesser extent elsewhere, a successful vaccine rollout in most developed countries and healthy risk animal spirits.
Health Care Baraomter Levels Medium While health insurers faced significant increases in claims costs associated with testing and treatment for COVID-19 in 2020, these costs have been more than offset by a significant level of deferral of non-emergency care, such as elective surgeries, diagnostic testing and routine care. Within the managed care space, negative event risk is on the rise. Following the Georgia runoff races and Biden’s proposed “American Rescue Plan,” we expect the health care landscape to feature substantive federal and state policy-driven debates steered by the pandemic and the Democrats’ national health care policy. From our perspective, Biden’s stimulus package proposals are positive for high-yield managed care, hospital and health care facilities.
Food &
Beverage
Baraomter Levels Low Food and beverage companies continue to benefit from elevated demand as more people prepare meals at home due to the pandemic. However, food and beverage companies also face higher input costs and a rise in freight transportation costs, although most food and beverage companies have the ability to pass along rising costs and take price actions, where appropriate, but there could be some timing delays. Hence 2Q21 gross profits may be pressured by higher manufacturing costs caused by inefficiencies related to the pandemic’s ongoing effect on production, transportation and warehousing operations.
Pharmaceuticals Baraomter Levels Low We remain constructive on investment-grade pharma. Investors have focused on both the potential for near-term drug price reform as well as the sector’s mid-2020s LOE cycle. We do not foresee any immediate credit changing events related to drug reform. With solid pipeline progress across the group over the past 12-24 months and a number of important readouts in 2021, we see these patent expirations as increasingly manageable and see an opportunity for the sector to re-rate on further pipeline de-risking. In high-yield, key market players have not seen major disruptions from COVID-19 and earnings results have been trending above expectations. While some saw lower demand for drugs tied to elective surgeries last summer, we are seeing some companies cite tailwinds from this pent-up demand.
Technology Baraomter Levels Low As the Covid crisis has evolved, we are seeing clear signs of stability and improvement in the technology sector. Capital investments in hardware and software to support the evolving work-from-home 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 networking, 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, will emerge post-crisis as winners.
Telecommunications & Media Baraomter Levels Low Telecom operators suffered only relatively minor disruptions from Covid and proved to be a safe haven during the pandemic. Early this year, however, US operators acquired new spectrum for over $80 billion, funded primarily via public debt markets. We are somewhat skeptical around operators’ ability/willingness to meaningfully de-lever over the near term and thus view the recent underperformance in secondary spreads as justified. In Europe, there remains a marked dichotomy between the telecom sector’s public and private valuation multiples. We therefore remain mindful around potential fresh take-private activity. In media, we expect a strong bounce-back in advertising spending and see evidence of that in 1Q21 reporting.
Utilities Baraomter Levels Low Within the US, management teams continue to focus on regulated operations and we observe more companies jettisoning the non-regulated/merchant/traditional non-utility businesses from their consolidated structures. The development is good/positive for greater stability in earnings and cash flows and reduces the complexity of the business models. This is increasing in importance as the theme of grid modernization and focus on renewable investments remain. Consequently, capital budgets are set to remain elevated and negative free cash flow generation should prevail, which underscores the need for supportive regulatory environments to enable successful execution.