Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Carnage in energy sector and the hunt for yield
Peter Garnry
Chief Investment Strategist
Summary: The US energy sector has extended its drawdown to 55% as oil prices remain low due to the demand shock from COVID-19. There will be extraordinary opportunities in the US energy but it desperately needs credit events to force the weak companies into bankruptcy. In today's equity update we also provide investors with a map of where shareholder yield is the highest and lowest among the different sectors as investors will begin to hunt for yield as the US 10-year yield dipped below 1% yesterday.
The market pushed the Fed to fold and deliver a 50 bps. rate cut and more central banks around the world are expected to follow. Our view is that a rate cut on the margin delivers close to zero impact for the people and companies living the COVID-19 nightmare on the ground. It doesn’t make you buy more burgers or going to a concert. The only thing that will offset a pending global recession is fiscal policy which at this point seems behind the curve and not anticipating a global pandemic. As with all public policy action will not be delivered until after the fact.
Despite central banks efforts to help the market the carnage continues in oil and energy stocks. Oil is still sending stress signals on the demand side of the economy causing US energy stocks to fall 3% in yesterday’s session. The drawdown for US energy stocks has now extended to 55%. We have essentially been negative since 2015 on the energy sector constantly pounding on the oversupply and depressing return on capital relative to valuation. So far we have been proving right. But part of our thesis has been escalating credit events but so far the sector has pulled it off, but we fell more certain than ever that credit events are lurking around the corner.
Luckily for the energy sector credit events are the necessary ‘forest fire’ that will restore profitability for the stronger players in the sector when the carnage is over. The energy sector has gone from one of the largest sectors in US equity markets 35 years ago to being one of the smallest. And this is despite energy being a fundamental condition for our modern society – the oxygen for factories and entertainment. Our view is that the energy sector will present investors with a decade worth opportunity on the long side after the ‘forest fire’ has run its course.
Another important event that happened yesterday was the US 10-year yield dropping below 1% for the first time in 150 years closing at 0.95%. Assuming the equity risk premium is unchanged over the coming 10 years at 4.8% then the lower yield is implying significantly lower growth in dividends in the future. Dividends have been growing at 6.2% in the US since 1970 but the bond market is saying 4.7% going forward. With yields being pushed down investors are looking elsewhere to get some yield.
In equities the traditional way of looking at yield was the dividend yield. As buybacks have increased due to its tax effectiveness for a multinational company the dividend yield has been replaced by what is called the shareholder yield, which is essentially the capital returned to shareholders. This yield has three components: dividends, buybacks and debt reduction. The reason why debt reduction is part of the equation is that is a financing activity that could have been used to buy back shares or pay out as dividends – in the case the company is not forced to pay down debt. For financials the changes in debt on the balance sheet is excluded.
Based on current numbers the three sectors with the highest shareholder yield are financials, materials and consumer staples and the sectors offering the lowest shareholder yield are health care, real estate and utilities.
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