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Oil markets made history in April, with the May 2020 WTI futures contract falling as low as USD minus 40/bbl. We believe distortions in oil markets are likely to contribute to continued volatility in markets.

Overall, we do not see volatility in the oil market disrupting risk assets overall. This is despite the fact that energy companies have been major participants in US credit markets, accounting for about 15% of the high yield and around 10% of investment grade issuance. In addition, oil is a key export for certain nations whose debt is included in major emerging market (EM) benchmarks like JPMorgan’s emerging market sovereign bond index (EMBIGD). But we believe US IG, US HY, and EM USD-denominated sovereign bonds have already moved to price in increased default risks from a low oil price, and spreads in all these assets more than compensate investors for risks from COVID-19 and the energy shock. Additionally, we expect the global oil glut to clear, leading to a rise in prices in the second half of 2020 with Brent reaching around USD 43/bbl by year-end.

Indeed we believe market conditions have created appealing opportunities in the energy space. Notably:

• In stocks. The S&P 500 energy sector makes up less than 3% of the overall index, and has already priced in an oil price collapse, trading at a larger than usual discount to the wider index on price-to-book terms. Overall we are neutral on the energy sector. But clients looking for opportunities should focus on operators with strong financial positions and the ability to generate above-average returns and cash flows. We also see opportunities in select services companies that either have global exposure or are in a specialized niche with limited competition. Within the European energy sector we prefer the relatively defensive end of the sector, where the recovery does not depend so much on the timing of an eventual oil price recovery. In the US, energy stocks appear to be pricing in oil prices that are significantly below our long-term normalized oil price expectations. However, it may take some time for oil markets to get into better balance, which is a key catalyst to unlock the upside potential for the US energy sector.
• In fixed income. We continue to see opportunities across almost the entire rating spectrum, with a preference for issuers with low production costs, comparatively strong fundamentals, and access to capital. In terms of regions, Gulf Cooperation Council (GCC) nations and Russia are best positioned to weather lower energy prices. Reserve assets accumulated while oil prices were high provide significant buffers for Saudi Arabia, Kuwait, the UAE, and Qatar.
• In currencies. The Russian ruble combines high yield and attractive valuation, and is supported by sound policymaking and large buffers in the form of FX reserves. For investors who can implement them, they may use options to add some downside protection.
  

• While we expect continued near-term volatility in oil, we expect prices to recover in the second half of the year and end 2020 around USD 43/bbl for Brent.
• The weakness of oil prices has created opportunities in a range of asset classes, including stocks, credit, sovereign debt, and foreign exchange.
• In equities, clients looking for opportunities should focus on operators with strong financial positions and the ability to generate above-average returns and cash flows.