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Assets differentiate themselves most during a crisis. Even during the best of times, dispersion of equity returns matters. Over the past ten years, the total return spread between the top performing sector—technology, up 330%–and bottom performing sector–energy, down -30%—was 360%, more than double the S&P 500’s 167% total return.1 Now, as the world tries to recover from the economic impact of the coronavirus, we expect dispersion to pick up, with potentially significant consequences for investors’ portfolios.

There remains a great deal of uncertainty and opinions surrounding the economic fallout from COVID-19. Some investors are “buying the dip” and adding cyclical exposure, others are preparing for a prolonged downturn and buying defensive exposures. We would highlight another option for those who don’t have high conviction on the cyclical outlook: Look beyond the cycle and focus on companies exploiting durable, long-term trends rather than those at the whims of cyclical growth.

We drill down into four sectors to examine the near-term fallout from COVID-19, reassess the long-term drivers, and survey earnings and valuations. Given the near-term uncertainty of an unprecedented “sudden stop” in global economic activity, we have much greater conviction in megatrends and prefer to take risk there for long-term investing. As the dispersion of industry returns over the past decade illustrate, long-term themes are often far more consequential than cyclical growth.

Industry opportunities are greatest in times of crises

Line charts showing rolling six month dispersion of S&P 500 industry returns.

Source: Bloomberg, BlackRock. Note: dispersion measures cross sectional volatility of rolling 6 month returns using S&P 500 GICS2 industry indexes. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

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Sector overview

Prior to the sell off, tech had been the market leader for several years now thanks to unmatched earnings growth and an increasingly strong secular outlook. 5G rollout is underwriting massive demand for semiconductors, global information technology (IT) spending continues to rise, and cloud adoption remains in its infancy. We see these trends accelerating or remaining largely unphased by COVID-19 and tech remains our favorite sector.

COVID-19 impact

COVID-19 has pushed all sectors in the broad market lower and led tech to experience some of the largest valuation contractions across industries. However, earnings expectations appear to remain intact, as do tech’s long-term drivers. Unlike other industries that saw a commensurate fall in earnings expectations alongside market prices—which can keep earnings-based valuations constant—expectations for tech earnings remain favorable while valuations have materially cheapened. In software, for example, the price-to-earnings (P/E) ratio fell by 6.0, outdoing hard hit industries like capital goods, consumer services and the S&P 500 Index overall.2 Such valuation discounts appear unwarranted.

The valuation contraction is notable given the immediate concern in markets was if companies have cash to weather the “sudden stop” in economic activity. Here again, tech looks favorable with its cash rich balance sheets and the lowest net debt/EBITDA across sectors.3 Corporate cash flow needs ex-tech could lead to a pullback in capital expenditures, however many corporates are likely to find IT CAPEX is both a cost saving and growth opportunity, particularly among mature cloud computing (“the cloud”) platforms. The cloud is the technology underwriting and enabling the massive shift to remote work; adoption remains nascent and primed for future growth.

Long-term drivers

Global IT spending estimates suggest cloud investments will lead software to be the fastest growing major market again this year.4 Public cloud penetration rate estimates average a mere 10%, indicating a substantial runway for future growth.5 The ability—and remarkable success so far—of companies to map over entire operations and workforces is likely to sharpen the need for best-in-class network infrastructure and data analytics, particularly given the growing role of providing platform-based data solutions. This in turn breeds a whole second order demand wave for ancillary tech products, from greater network infrastructure to support cloud activities, to data storage, and data analytics.

Perhaps most importantly, the cloud illustrates a broader appeal of most tech business models: They are scalable, often capture recurring revenue, and have high cross-sale opportunities, particularly for “platform as a service” (PaaS) models. These are an enduring mix of features as equally well suited to today’s environment as they are towards capturing the next decade’s defining trends.

Elsewhere, advances in 5G, robotics, artificial intelligence (AI), data storage and analytics, the internet-of-things, digital media, and cyber security represent significant tailwinds that should drive demand across semiconductors, hardware, and software.

Even non-technology firms see these advances as increasingly vital core competencies. Biopharma companies have embraced AI to improve drug research and design while cutting costs. Hospitals use natural language processing to read every medical journal article ever published. Manufacturers use data analytics to improve procurement and pricing. Finance companies are pouring billions into new AI methods and proprietary datasets. And, of course, central to any data intensive operation is cyber security. With companies increasingly building data-based core competencies, the need to understand data through AI and protect data through cybersecurity will also become core focal points for businesses.

Valuations and earnings

We see tech earnings as increasingly driven by structural tailwinds and less so by traditional, cyclical growth patterns. It’s surprising then to see such a strong contraction in valuations, particularly as the market shares our view that these structural tailwinds remain intact. With expectations of continued adoption of the themes mentioned above, the earnings outlook remains as compelling as ever. Currently, the consensus among Wall Street analysts is for software, hardware, and semiconductors to all post stronger earnings growth than the S&P 500 Index.6 Despite software’s relative richness to hardware and semiconductors, it has experienced one of the largest valuation contractions during this selloff despite little-to-no change in the long-term outlook.

Cloud penetration is in its infancy with a long runway for growth

Bar charts showing global business information technology spending.

Source: Gartner, Goldman Sachs Investment Research. As of January 2020.

Sector overview

True to its defensive form, healthcare has outperformed the S&P 500 by 12% since the market peak.7 Healthcare received an added boost in early March as political tail risks faded as well. The once-in-a-century global pandemic has increased demand for treatments, vaccines, and diagnostic equipment. COVID-19 has certainly focused attention on biopharma amid a search for a vaccine, however we see healthcare’s inelastic demand providing downside protection to further growth weakness while deferred elective procedures should help managed care companies offset higher costs from COVID-19. In our view, we prefer biopharma, managed care, and retail pharmacies over medical technology, labs, and hospitals.

COVID-19 impact

The Medicare-for-all call is growing in response to the COVID-19 outbreak. Hospitals, drugmakers, and pharmacy benefit managers (PBMs) would be hardest hit in such a move, while med tech firms would likely benefit. We assign low probability to such a policy outcome and note that even if a watered down version were approved, markets have tended to overly discount the impact on healthcare, particularly the managed care space which saw material membership growth through Medicare Advantage. Med tech companies face more concrete headwinds from supply-side hospital capacity constraints and demand-side constraints as hospitals pull back on CAPEX and patients defer elective procedures which should instead benefit managed care.

It's rightly said that hospital workers are on the front lines fighting COVID-19. Behind the scenes, however, are numerous companies working on genomic and immunology research to combat COVID-19 and other diseases. Genomics is at the forefront of the mRNA work to understand the virus. The virus, SARS-CoV-2, indiscriminately spreads to everyone within reach, while the disease, COVID-19, only appears to affect some people. Genomics is studying why, using AI to translate billions of data points into actionable insights. And just as in tech, we expect to see positive spillovers across the healthcare landscape: Genomic research that can map out a DNA-based explanation for how pathogens spread is likely to see tremendous applications to gene therapy treatments as well.

Long-term drivers

Aging demographics and innovative research continue to underpin long-term healthcare trends. Medicare Advantage’s penetration rate remains under 35%, allowing for continued growth while over 10,000 baby boomers age into Medicare every day. Contrary to initial policy fears, the Affordable Care Act added over 15mm newly insured, which represents new revenue streams for managed care.8 A move towards a public option could ultimately deliver a similar outcome to the Affordable Care Act (ACA) and positively surprise markets.

On the drug development side, advances in computational biology, machine learning, and big data could lead to a substantial paradigm shift in drug development and treatment while dramatically lowering the time and cost of research and development. A partial list of long-term developments to watch include bi-specifics, bicycles, gene therapy, HIV and cancer vaccines, and regenerative medicine.9 Companies focused on genomics and immunology are most likely to benefit from advances in computational biology, which is happening at an astonishingly fast pace.

Valuations and earnings

The COVID-19 impact is particularly murky for healthcare. Some aspects depend on future patient behavior. Do they forgo elective procedures or not? Do hospitals pull back or double down on CAPEX? Still, demographic trends haven’t changed nor has the importance of bending the cost curve lessoned. There remains a strong incentive structure for managed care companies, which we expect to continue outperforming. Biopharma remains one of the top spenders on research and development—a precursor to strong cash flow—and there are a series of developments on the cusp of truly reshaping the global healthcare landscape.

Genomics and immunology appear uniquely situated to monetize key medical breakthroughs, and demographic trends augur for an even greater demand for such treatments. Such breakthroughs could greatly replenish drug companies patent-protected revenue streams for years to come. Valuations suggest these prospects aren’t priced. Relative healthcare valuations look comparatively cheap, suggesting a greater balance of policy risk is being priced in over the long-term structural growth themes.

Healthcare valuations look cheap as more policy risk than growth is priced in

Line graph showing relative price-to-earnings ratio of healthcare vs the S&P 500.

Source: Refinitiv. As of April 6, 2020. Notes: The chart compares the ratio of price-to-earnings ratios on the S&P 500 GICS1 Healthcare Index vs the S&P 500. ACA stands for Affordable Care Act.

Sector overview

Energy markets have been hit by both a massive supply shock (OPEC+) and demand shock (COVID-19). While oil and renewable energy companies have each faced the same demand shock, the diverging policy backdrop between oil and renewables—wind, solar, biofuels, hydro-electric, geothermal, waste regeneration—could not be sharper. Oil markets are fundamentally oversupplied and prices are vulnerable to OPEC+ production targets, which each member is incentivized to break to steal greater market share. In contrast, renewables are experiencing policy support globally, nationally, and often locally. The OPEC+ breakdown is a microcosm of global energy markets: infighting has cratered oil markets while global coordination is supporting renewables.

COVID-19 impact

Even with an OPEC+ deal emerging to curtail output by 10mm barrels/day, we expect oil to remain under $40/barrel.10 We expect exploration and production (E&P) companies will adopt a survival mentality, slashing CAPEX by up 40% and likely being forced to cut dividends. We expect defaults and restructurings to pick up in 2021 and 2022 as existing oil hedges roll off. In contrast, renewables are expected to only see a temporary hit to activity, similar to other sectors. Some renewables, like wind, are even seeing intense demand pressure in 2020 as developers rush to complete projects in the U.S. to qualify for full production tax credits.

Long-term drivers

The oil market’s long-term dynamics are well captured by the relative performance of oil equities vs oil prices. In the early 2000s when excess supply was unfathomable, energy equities exhibited positive oil convexity: Energy equity outperformance on oil up days was much greater than underperformance on oil down days. That convexity pattern has flipped since 2014, when excess supply fears became the new normal for oil markets. That not only leaves energy equities at the mercy of oil prices, it also means the risk/reward is increasingly unfavorable for investors.

Renewables appear to have a brighter outlook with strong policy support at nearly all levels of government. For instance, residential building code requirements in California requiring rooftop solar systems on new homes could lead to a 33% growth in residential solar installations in 2020.11 Globally, similar support measures are being enacted to drive renewable adoption. These policy measures not only underwrite demand for renewables, they’ve also de-risked the market for renewables by diversifying end-user markets. Even as China, the biggest market for solar, dialed back solar installations in recent years, a broad array of countries across Asia, Europe, and Latin America have materially stepped up their investments in solar to more than offset China’s decline. Even countries without subsidies in place have increased solar installations, which speaks to the broader economic viability of renewables.

One of the very few areas not providing support is the U.S. federal government, which neglected renewables in the latest stimulus measures. Yet here we believe the longer-term push towards renewables is likely to outlast the political calendar. Current U.S. federal policy is one of the last holdouts supporting conventional oil markets over renewables. The next administration could join every other nation in supporting renewables, providing another sizeable policy support.

Valuations and earnings

Oil equities are cheap but don’t offer much value. Oil companies actually saw some valuation metrics increase during the selloff because earnings and cash flow expectations have fallen faster than prices. The outlook for oil companies in 2021 and 2022 is equally grim as hedges roll off and the maturity wall approaches. The 10mm barrels/day cut announced by OPEC+ over Easter weekend is likely to provide temporary though insufficient relief at best. We see oil markets remaining structurally oversupplied given the structural shift towards renewables.

Renewables appear to have firmer near-term and long-term footing. Long the nation’s standard setter, California’s low-carbon fuel standards are driving renewable biofuel demand, while California’s building code is supporting residential solar installation. Globally, a renewed push for solar and wind has diversified end markets and supported demand. As governments expedite the shift from oil to clean energy, we see renewable energy companies as the clear favored winners in the decades to come.

Global policy support is driving solar growth and diversification across countries

Bar graph showing global solar installations in gigawatts by top ten countries and rest of the world.

Source: Bloomberg. As of April 9, 2020.

Sector overview

Over the last decade, banks have deleveraged, increased liquidity, and simplified their balance sheets. They are increasingly utility-like investments, able to withstand economic downturns but lacking material upside catalysts outside of reflationary environments. We view the backdrop of ever lower rates, mounting credit stress and deteriorating labor markets as unfavorable. Within financials, we continue to favor U.S. over European banks and large caps over smaller, regional peers.

COVID-19 impact

COVID-19, or the response to be more specific, has led to a massive spike in liquidity demand from nonfinancial corporates (NFC) and consumers. Regulators have relaxed capital and liquidity buffers to help banks meet customer liquidity needs. However, as the duration of the fallout extends and labor market weakness emerges, we are most concerned over consumer credit exposure, which total approximately $2 trillion in aggregate, and often exhibit a one-for-one relationship with unemployment.12 Outside of credit cards, banks are seeing significant cash flow disruption at corporate borrowers and a sharp deteriorating in asset quality as credit spreads widen.

Long-term drivers

Rates, specifically net interest margins, continue to fall while asset quality is declining sharply. Past experience suggests regional banks will be most challenged. Aside from cyclical headwinds, banks have fundamentally changed into utility-like entities. They’re heavily regulated with highly constrained growth options by design. Outside of reflationary environments, where growth & asset quality improve and rates bear steepen, we think financials are likely to struggle to outperform other equities.

Valuations and earnings outlook

Banks now trade at just 0.8 times price-to-book, down from 1.3, as the Federal Reserve took rates to zero amid the COVID-19 fallout. Diversified financials and insurance each saw a 0.5x decline in price-to-book ratios as well, making it one of the cheapest sectors overall. Bank earnings are expected to contract over the next year while diversified financials and insurance are expected to grow earnings just 3.5% and 5.3%, respectively.13 Valuations suggest a great deal of bad news is already priced in, however the long-term growth outlook does not appear conducive towards a large bounce back. We expect diversified financials to continue outperforming banks, particularly smaller regional banks that aren’t able to diversify as easily or successfully as large cap counterparts.

U.S. banks continue to outperform eurozone peers

Line graph showing US Banks & Eurozone Banks return on equity over the past 20 years.

Source: Refinitiv. As of April 6, 2020. Indices used are Datastream US Banks Index and Datastream EMU Banks Index. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Christopher Dhanraj
Director, Head of iShares Investment Strategy
Thomas Logan contributed to this article.
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