Market Pulse: Portfolio Manager Perspectives

As a growing number of US states have started to incrementally reopen their economies (under a variety of measures such as mask usage and capacity restrictions), we got our first official look at COVID-19’s toll on the nation’s economic output. The federal government announced on Wednesday that US gross domestic product (GDP) fell 4.8% in the first quarter.¹ That’s the fastest rate of decline since the fourth quarter of 2008, when US GDP fell 8.4%, and it was driven by a drop in consumer spending not seen since 1980.² Later on Wednesday, the Federal Reserve issued a statement affirming its commitment to use “its full range of tools to support the US economy in this challenging time.”

While broad data points can give us a good overview of where the economy currently stands, it’s important to remember that each industry, each US state and each global region will experience its own unique path toward recovery. With that in mind, I’ve asked a variety of Invesco portfolio managers to talk about their areas of expertise, and the possibilities that they see ahead.

• William Grubbs, Managing Director and Head of US Funds Management for Invesco Real Estate
• Tim Bellman, Managing Director and Head of Global Research, Invesco Real Estate
• Joe Portera, Chief Investment Officer, High Yield and Multi-Sector Credit, Invesco Fixed Income
• Brian Jurkash, Senior Portfolio Manager and Co-Lead, US Value Equities team
• Matt Titus, Senior Portfolio Manager and Co-Lead, US Value Equities team
• Matt Peden, Senior Portfolio Manager, International Select Equity team

Direct real estate: Three sectors that may be resilient in this environment

William Grubbs & Tim Bellman: The COVID-19 pandemic has led to a major disruption of the global economy; it is not a typical recession. Both the emergency itself and the varying policy response in different countries have consequences for real estate worldwide:

• Asset management. The public health emergency has demanded swift and decisive measures by real estate asset managers and property managers.
• Portfolio management. The unfolding economic crisis will demand a measured response depending on the depth and duration of the period of dislocation.
• Capital markets. The turmoil may generate transaction opportunities if a level of stress and distress leads to the potential to recapitalize otherwise sound real estate.

The depth of the slowdown and potential shape of the recovery are hard to predict. They likely vary from city-to-city and country-to-country. Looking forward, what can we have conviction about? Long-term trends. Real estate themes that flow from secular trends in technology and demography that were driving forces pre-COVID-19 which have been accelerated include:

• Logistics. This sector includes warehouses, distribution facilities, and fulfillment centers, and we believe its position as a strong outperforming sector has been reinforced.
• Offices. In our view, prime central business district locations and innovation/life science hubs are likely to have strong performance.
• Multi-family. This sector may be resilient in the slowdown; it is possible to maintain occupancy.

Before COVID-19, Asia Pacific appeared relatively well-placed with stronger economic growth driving real estate demand in major markets. Direct real estate in Asia outperformed Europe and North America slightly in the fourth quarter of 2019. As waves of the pandemic ripple out across the world from Asia Pacific, ironically Asia Pacific real estate continues to look relatively well-positioned in the near-term, in our view. But in time, once the economic restart is under way, we believe the dynamism of the US private sector economy is likely to power relatively strong performance.

Multi-sector credit: The ‘new normal’ may be driven by 5G and automation

Joe Portera: COVID-19 has wreaked havoc on global markets, but it has also presented investors with compelling investment opportunities. We believe this pandemic will have lasting impacts on economies via behavioral shifts, some of them likely to be permanent. At the center of it all we have witnessed technology taking an even more central role within each industry. Disruptions in everything from supply chains to education have put additional pressure on innovators to develop, manufacture, and deploy solutions at record speeds. Over the past 12 to 18 months, one of our highest-conviction themes was in technology, media and communications (TMT), specifically focusing on 5G and automation.

Our favorable outlook in TMT is supported by an accelerated shift in the economy. As populations and behaviors adapt to the new normal, we believe 5G will be an instrumental catalyst for unlocking a new technological revolution built on the force of unprecedented connectivity in terms of speed, capacity, and coverage. This in turn may allow implementation of robotics, artificial intelligence, and distributed cloud computing in the industrial sphere like never before. Some examples of trial technologies like self-driving and drones may get pushed forward towards reality. A disruption in the food supply chain due to issues with trucking networks, or an inability to deliver critical medical supplies to someone just a few miles away, when no contact is a key criteria, are just some of the challenges these technologies aim to answer.  

In addition to our positive fundamental outlook, valuations in recent months have become more attractive, in our view. A great deal of default risk is currently priced into the high-yield market – by our calculations, prices reflect an expectation of roughly twice the credit losses ultimately incurred during the 2008 global financial crisis. There have been only a few times in history when spreads between high-yield bonds and Treasuries have been wider than they are now. In each of those previous occasions, the market was able to generate substantial forward gains as investors scooped up bargains not readily available under more normal market conditions.

While markets are beginning to stabilize, we believe the combination of fundamental drivers and attractive valuations provide for appealing investment opportunities. Without question, this crisis has underscored the demand from markets for solutions and has brought to the forefront the need for 5G to facilitate the implementation of those solutions.

Value stocks: Could cheaper stocks experience a stronger rebound?

Brian Jurkash & Matt Titus. For more than a decade, large-cap US growth stocks have outperformed large-cap US value stocks.³ However, we believe this current market sell-off may have created an opportunity for value to come back into favor. In March, valuation spreads — which measure the difference between the market’s most expensive stocks and its cheapest stocks — hit a standard deviation of 4.5, indicating that the difference is dramatically larger than usual.⁴ In fact, the only other time they have been at that level or higher was during the Great Depression and the global financial crisis.

Why do we think this is important? Coming out of past recessions, stocks with cheap valuations tended to lead the way, which we believe should bode well for value managers when we come out of this one. Also, economically sensitive sectors (financials, for example) have historically rallied after market downturns, and value strategies tend to have a significant overweight to these sectors versus growth managers. In comparison, growth’s performance has been driven by technology stocks: The Russell 1000 Growth Index has about a 40% weight in the sector versus the Russell 1000 Value Index which has roughly 7%.⁵ Looking at valuation metrics such as price-to-earnings and price-to-book ratios, the tech sector is substantially more expensive than financials, for example.⁶

More broadly speaking, another factor that may help boost stocks is the fiscal response that has occurred. This response is far greater than what investors experienced during the global financial crisis (GFC), and this time it only took 22 days for Congress to pass its first stimulus package, versus almost 12 months during the GFC.⁷ The Federal Reserve has also been more aggressive on monetary policy than during the prior crisis. We are also starting to see some bright spots in terms of a decline of new COVID-19 cases, increased recoveries, and containment. Also, many cities, counties, and states are laying the groundwork to reopen.

Global equities: Seeking to avoid stocks with overly optimistic valuations

Matt Peden: Equity markets have experienced a dramatic rebound from their March lows. But as long-term focused investors, we find it difficult to reconcile the current market valuations of many businesses with their underlying earnings prospects given the expected impact of the novel coronavirus. For most businesses, the coronavirus pandemic should be reasonably expected to have a noticeable negative impact on corporate revenue, margins, and after-tax earnings, with the magnitude of the impact dependent on the time required for societies to gain widespread immunity (either through a viable vaccine or herd immunity, if possible), the duration of government-imposed shutdown measures, and the extent to which the current situation influences longer-term consumer behavior. With most nations discussing only a gradual easing of restrictions beginning in May, leading to lockdowns averaging six to eight weeks, the coronavirus may have already engendered the most acute short-term economic downturn of the post-World War II era.

The near-term economic impacts of mass business closures and commensurate unemployment should not be underestimated. At no point during the financial crisis did entire industries shut down for months at a time, forcing layoffs of unprecedented scale and the loss of irrecoverable revenues in service-based industries. Moreover, with a viable vaccine believed to be at least 12 to 18 months away, widespread immunity remains elusive and the threat of subsequent waves of infection will persist following any gradual easing of initial shelter-at-home and social distancing measures. To assume that consumers will flock back to restaurants, bars, movie theaters, shopping malls, hotels and airplanes, while the risk of infection from a deadly virus looms, seems overly optimistic, in our view. Hence, we expect the virus to likely have a mid-term impact on consumer behavior, and thereby, corporate revenues and margins beyond any easing of government-mandated restrictions.

In recognition of the gravity of the crisis, governments around the world considerably expanded fiscal support for individuals, small businesses, and even corporations in the most severely impacted industries. However, this fiscal stimulus, unprecedented in size and scope, may elevate government debt to levels not witnessed since World War II and create lasting budget deficits due to challenges in unwinding social benefits after the crisis. As government debt must ultimately be serviced and budget deficits must eventually be funded from sources other than more borrowing, corporate and/or individual taxation may need to increase post-crisis. A corporate tax increase to fund the immense current stimulus programs would negatively impact equity values, in our view. Alternatively, any increase in personal tax rates would reduce disposable income and may constrain long-term consumer spending. At the time of writing, the S&P 500 Index was trading at mid-2019 levels and the MSCI World Index at early 2019 levels. Assuming that current intrinsic business values are equal to or higher than underlying values eight to 12 months prior to the coronavirus outbreak is illogical, in our view, indicating that investors may be incorporating overly optimistic assumptions into prevailing market prices.

Given the severity of the coronavirus situation in the US, the more exaggerated market recovery across US equities, and the greater magnitude of stimulus measures enacted within America (and thereby higher probability of future tax increases), we are presently seeing more attractive investment opportunities amongst the international companies we own and follow compared to their US peers. In other words, we believe the disparity between business values based on rational expectations and market prices appears most pronounced in US equity markets, with current prices in many cases reflecting overly optimistic assumptions. In addition to the disparity between US and international valuations, we continue to see a discrepancy between large- and small-cap valuations, with small-cap valuations continuing to remain more attractive, in our view. Our team seeks to avoid companies and areas where we believe excessively optimistic underlying business performance assumptions are imbedded in current market prices. Instead, we focus on a select number of businesses that we believe are rationally priced, high performing, and competitively entrenched.