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At a glance

Oil contract prices hit negative territory in April, creating a situation where some holders of futures contracts may have had to pay to have their oil taken away as storage capacity fills up. While oil could contribute to volatility in credit and equities over the coming months, we extreme market dislocations in the second half of the year. This creates opportunities in energy stocks that are less dependent on an oil price recovery.

How does the coronavirus outbreak impact the US dollar?

The US dollar gained in the early stages of the COVID crisis, hitting a three-year high on a trade weighted basis, amid a flight to quality and a liquidity squeeze. The euro hit a low for the year against the dollar in mid-March, while the British pound dropped to a 35-year low.

But we see both supports for the US dollar ending and expect the currency to head lower in both our central and upside scenarios for the COVID pandemic. Only if the crisis takes a turn for the worse would we see a further appreciation of the US currency.

First, the Federal Reserve has moved decisively to alleviate funding stresses that had been pushing the US currency higher. While further action may be needed, we believe the Fed remains committed to alleviating this problem. Second, safe haven support for the US dollar is likely to ebb assuming the global economy makes progress towards normalizing sustainably from December. With these dollar-positive forces reduces, we expect fundaments to reassert themselves. Aggressive rate cuts by the Federal Reserve due to the COVID crisis have eroded the carry advantage enjoyed by the US currency. A global trade recovery later in the year should favor heavily export-oriented markets like the Eurozone over more domestic-driven ones like the US.

As a result, we see US dollar depreciation in two of our three COVID-19 scenarios:

  • In our central scenario, severe restrictions to limit the spread of the virus are lifted by mid-May in Europe and by early June in the US. The economic recovery is U-shaped. We expect EURUSD to trade at 1.13 and GBPUSD at 1.33.
  • In our upside scenario, suppression restrictions are lifted from early-May, with EURUSD at 1.19 and GBPUSD at 1.38.
  • In our downside scenario, repeated outbreaks prove difficult to control, leading to severe restrictions being re-imposed intermittently.. We see EURUSD at 1.05 and GBPUSD at 1.10.
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Oil markets

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

Energy companies have been material issuers in US high yield (accounting for 15% of the market) and investment grade (accounting for 10% of issuers) credit. In addition, oil is a key export for certain nations whose debt is included in major emerging market (EM) benchmarks like JP Morgan’s emerging market sovereign bond index (EMBIG). But while the market is heavily oversupplied this quarter, we expect it to move toward balance next quarter and become undersupplied in 4Q this year. This recovery should occur as travel restrictions start to be lifted from mid-May, in line with our central scenario, and as oil demand picks up in the second half of the year. Hence, we forecast Brent to recover from around USD 22/bbl at present to USD 43/bbl by year-end, and maintain our preference for credit. We believe US IG, US HY, and EMBIG 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.

Within US IG bonds, after the sharp sell-off in March, valuations for some of the major oil and gas companies are looking attractive in light of strong credit profiles, mitigating actions, and our expectations for oil prices to recover over the medium term. We see opportunities in energy issuers that have underperformed and look better placed to weather a downturn in oil prices.

We see a less marked impact on equities overall from the drop in oil prices – —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 70% discount to the wider index on price-to-book terms. Overall we are neutral on the energy sector

Within the US energy equity market, we focus on operators whose financial position is strong, and whose asset portfolio and operating skill set enables above-average returns and cash flow. These operators should be relatively resilient through oil price cycles.

In the European energy market, we also focus on the defensive end of the sector, where the recovery potential is not as dependent on the timing of an eventual oil price recovery. In energy services and exploration & production, we are very selective about balance sheet quality and competitive positioning.

Key investment takeaways

  • Oil prices set market history in April after a May contract traded as low as USD minus 40/bbl.
  • hough this creates concerns for the credit space, we expect the spreads in assets such as US IG, US HY, and EMBIG to compensate for this.
  • Stocks should be less concerned about an oil price collapse, and we like energy stocks that are less dependent on a recovery in prices.

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