Market Leadership to Remain Intact in a Post-COVID-19 World

Jennison Associates’ 2Q 2020 outlook discusses the current global landscape, equity sector views, and companies best positioned to thrive once conditions stabilize.

April 13, 2020

The first quarter of 2020 will go on record as one of the most disconcerting periods in recent history, as the devastating COVID-19 outbreak spread rapidly around the globe, disrupting markets and daily life virtually everywhere. The pandemic and efforts to contain it are causing a spike in unemployment and a sharp drop in gross domestic product (GDP) worldwide, with small businesses especially pressured. The result will likely be a global slowdown of historic proportions. Stocks peaked at new highs on February 19, then posted one of the swiftest and sharpest declines on record—major indexes posted a peak-to-trough drop of more than 30% in only 25 trading days. Exacerbating the turmoil, major crude oil producers Saudi Arabia and Russia declared a price war, plummeting the price of West Texas Intermediate crude oil more than 65% in the quarter, to approximately $20 per barrel.

Although dire, the current situation is fundamentally different from the credit crisis of 2007-2008. Thirteen years ago, structural economic deficiencies and a delay in addressing them made recovery protracted and painful. Today, economic activity is being halted or curtailed to limit the spread of the virus and human suffering. Massive fiscal and monetary stimulus measures are being implemented rapidly. Underlying economic conditions before the outbreak were largely solid, and when the crisis subsides—when a vaccine is developed or the virus runs its seasonal course—fundamentally healthy economic structures would be expected to support resumption of economic activity. However, we do not expect recovery to be uniform, and vulnerable businesses may not survive. There is also uncertainty about a potential reemergence of the virus in the coming fall and winter.

In such an environment, we believe stocks of businesses that lead their industries and grow at substantially faster rates than the market average will fare better than the broader market. We also favor higher-quality companies that generate significant cash flow, allowing them to weather difficult times and sustain the competitive advantages necessary to create true economic value over the long term. We are confident that once conditions stabilize and economic activity revives, the companies that entered this crisis with the strongest competitive positions will emerge best positioned to thrive in a post-COVID-19 world.

 

Equity Sector Views at a Glance

Information technology was the best-performing sector for the quarter and 1, 3, 5, and trailing 10 years, maintaining its leadership even with the sell-off and volatility. In the quarter, defensive sectors like consumer staples, health care, and utilities also performed well as one would expect in a sharply negative environment. Cyclical sectors, notably financials, industrials, and materials underperformed in the first quarter and lagged for longer time periods as well. Energy was the weakest sector for all time periods.

Jennison Associates 2Q 2020 Outlook

Sector

Outlook

Information Technology

Information technology was the best-performing sector in the S&P 500 Index in the first quarter of 2020, falling 11.9% but outperforming the broader index by 7.7%. We attribute this favorable relative performance to recent strong technology sector earnings reports and market recognition of the underlying strength of technology company business models. The market should continue to favor companies with faster organic growth in the current COVID-19-induced recessionary environment. With the market’s recent broad-based downturn, we believe tech stocks are now very attractively valued. Reasonable relative valuations continue to be driven by the sector’s overall stronger ROEs and free cash flow generation, often as a result of innovative and disruptive product offerings. Specifically, many tech companies have wide competitive moats and other competitive advantages, as well as secular tailwinds, that we believe support durable, high-quality fundamentals, including faster-than-average revenue growth and better-than-average margins.

Spotlight

Investors are viewing tech companies with products and services that facilitate seamless off-site work and communication capabilities with renewed appreciation. The use of digital technologies to create new (or alter existing) business processes, cultures, and customer experiences has become a strategic imperative as enterprises seek to meet changing business and market needs. Software as a service (SaaS) delivers mission-critical cloud applications and services that are disrupting the software industry. As the strategic necessity of implementing software enhancements as they become available becomes increasingly apparent, businesses are being driven to adopt the SaaS model. With penetration rates remaining relatively low, SaaS expansion opportunities over the coming decade look substantial.

Health Care

In the first quarter, the health care sector of the S&P 500 Index fell 12.7%, outperforming the overall index, which declined 19.6%. Heightened market volatility reflects increased uncertainty as the magnitude and scope of the COVID-19 pandemic grows. The degree of uncertainty has led investors to de-risk and de-lever their portfolios. In such periods, stocks with higher levels of perceived risk—small and mid-caps, biotechs, and other earlier-stage health care companies—are disproportionately affected. Many of these companies do not produce profits and rely on external funding. Medical device companies with products used in elective procedures will also likely experience a slowdown in their businesses. Looking beyond the current troubled environment, we view the sector’s multi-year outlook positively based on a range of industry trends, especially the innovation occurring across a broad range of company types, products, and business models.

Spotlight

Oncology companies will likely be less affected than other-disease-focused companies, as treatment for metastatic cancer patients is not optional.

Financials

In response to the COVID-19 pandemic and the resulting collapse of both the global economy and interest rates, the S&P 500 Index’s financial sector had a very difficult first quarter, falling 32% relative to the broader market’s return of -19.6%. In some respects, the sector has suffered losses on a scale equal to what we saw during the 2008-2009 global financial crisis. Overall, the banks are significantly better positioned today than they were in 2008-2009 across a broad range of balance sheet, capital, and risk management metrics. But at this point, there are just too many unknowns around the impact of rates, credit losses, drastically lower economic output, destroyed consumer and business confidence, and the financial hit to businesses and consumer balance sheets.

Spotlight

Secular growth companies with defensive attributes (low leverage rates, asset light models, sustainable, high margin, and high free cash flow businesses) should continue to fare better in this type of environment. Several digital payment and financial technology companies meet these criteria.

Midstream Infrastructure

The Alerian MLP Index declined over 57%, while the broader energy sector within the S&P 500 Index lost 50% in the first quarter of 2020. With the global economy and energy sector both having suffered simultaneous shocks to supply and demand, the midstream infrastructure sector has been hit particularly hard. The unprecedented market volatility has likely been exacerbated by exogenous factors such as the algorithmic trading nature of markets and the forced selling by levered investors. Those midstream companies with exposure to either weak basins or weaker customers have been hit hardest, while the larger, higher-quality names with integrated assets and established customers have held up better, relative to the broader sector.

Spotlight

We favor firms with integrated business models with multiple touchpoints along the energy value chain as they have higher barriers-to-entry, along with steady cash-flows.

Utilities

Historically considered a defensive asset during downturns, utilities fell 13% in the quarter, outperforming the broader S&P 500 Index. Within the S&P 500 Utilities Index, all segments declined over the period with electric utilities contributing the most to its overall underperformance, followed by multi-utilities—both of which comprise over 90% of the overall index. To a much lesser extent, the independent power producers and energy traders, along with gas utilities and water utilities, were among the segments that detracted the least from total returns given all three segments comprise less than 3% of the overall index weight.

Spotlight

Wired broadband network and datacenter operators are well positioned to capitalize on exponential global data demand growth, as are tower operators given their critical infrastructure, multi-year contracts, and strong free cash-flow generation.

The full Market Review and Outlook PDF opens in a new window is available for financial professionals.


 

The Alerian MLP Index is an unmanaged index and the leading gauge of energy master limited partnerships (MLPs). The capped, float-adjusted, capitalization-weighted index constituents represent approximately 85% of total float-adjusted market capitalization. The S&P 500 Index is an unmanaged index of 500 common stocks of large U.S. companies, weighted by market capitalization. It gives a broad look at how U.S. stock prices have performed.

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Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy.

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