While the S&P 500 suggests a V-shaped recovery is priced in, at the sector level the narrative is more nuanced. From the start of the year to the S&P 500 trough in March, some of the most obviously affected sectors were hardest hit. Meanwhile, the likely winners from people remaining at home, other than for their food shop, outperformed.
The bounce-back since March has included some of the worst performers during the sell-off (see chart below). For example, energy, autos, clothing retailers and restaurants have all outperformed during the rally, presumably on hopes of a partial rebound in activity as the economy starts to reopen. But some of the perceived beneficiaries of a world with more working and shopping from home, such as home improvement retailers, tech companies and industrial (including warehouse) properties have also rallied strongly. Meanwhile, despite improvement from their lows, airlines, hotels, department stores and retail properties remain among the weakest performers year to date.
S&P 500 sector performance
% price return
What are the risks and opportunities from here under different potential scenarios?
Scenario 1: A full and sustainable reopening of the economy with social distancing no longer required. The most beaten-up sectors could rally further, while the sectors that have gained the most could be vulnerable to profit taking and rotation into cheaper companies as it becomes clear we won’t all work and shop from home forever. This would also likely coincide with a style rotation from large cap to small.
Scenario 2: An acceleration in infection rates leading to renewed shutdowns. At least part of the rally since March could reverse for most sectors, but those most exposed to further shutdowns could suffer the most as solvency concerns increase.
Scenario 3: Partial reopening of the economy but with some social distancing remaining in place. Sectors that might be able to reopen with some social distancing, such as department stores, autos and energy, could benefit further. Airlines, hotels and dine-in restaurants could struggle as solvency concerns increase. The most expensive stocks among the current winners could also suffer from valuation deratings and earnings disappointments, as unemployment remains elevated.
Which scenario plays out depends largely on the path of the virus itself, which is unknown. Given this uncertainty, we think it makes sense to avoid potential value traps, where solvency concerns could increase further. But we also think it makes sense to avoid the most expensive companies, where there is a lot of good news already in the price.
We also think this recession will increase the momentum behind sustainable investing. Robust ESG screening processes should capture the risks to corporate earnings from potential changes to taxes and other political interventions. The crisis has underscored the benefits of screening companies on non-financial metrics such as corporate governance and human capital management. We believe companies will increasingly be rewarded for demonstrating responsible capitalism given that there are, unfortunately, likely to be more lasting consequences of this recession for lower income and minority groups. Finally, although governments will be strapped for cash coming out of this recession they will also been keen to support infrastructure projects that can fuel the recovery. We expect these projects to be focused on the shift to a zero-carbon economy. The European Green deal is one such example.
An active, nimble approach, with a current focus on quality companies (see chart below), a keen eye on valuations, and consideration of ESG risks, therefore appears the best way of navigating the uncertainty facing investors.
S&P 500 Quality/S&P 500 relative performance
Relative total return index level, rebased to 100 in 1990