February 2020
Coronavirus Infects the Markets, But Recovery Is Expected
KEY OBSERVATIONS
Equity Markets Recovering from Coronavirus

2019’s equity market rally continued into the early days of 2020 until rudely interrupted by the coronavirus. Stocks fell across the board over fears of contagion and economic slowdown. Equity markets, however, have historically performed just fine subsequent to pandemics. And the economic backdrop continues to be supportive of equities with strong consumer sentiment combining with a middling manufacturing sector to deliver what could be characterized as a Goldilocks economy. Even corporate earnings, which had been shrinking, could be on the mend. In fact, the S&P 500 Ex-Energy index (as the energy sector has been specifically impacted by falling prices) has posted 3% earnings growth so far this season. Doing nothing may be the best course of action.

Could Zero Coupon Bonds Be Immune from the Pandemic?

For investors who feel compelled to do something, zero coupon bonds are one of the few investments that are likely to increase in value if the virus situation worsens and risk assets fall. With durations of 25 years or higher, zero coupon Treasuries rise substantially as Treasury yields fall. And Treasury yields—which have already fallen materially—would likely fall further in that scenario.



CHART OF THE MONTH
Zero coupon bonds paid off in the month of January—but won't if yields rise

Zero coupon bonds as measured by the ICE BofAML Long US Treasury Principal Strips versus investment grade bonds as measured by the IBOXIG Markit iBoxx $ Liquid Investment Grade Index. For comparison, periods shown are January 2020 and July 8, 2016, to December 15, 2016, which was a trough to near-term peak in 10-year yields.


Get In, and Get Out: Diversifiers, but Not Risk Reducers

Zero coupon bonds paid off in the month of January. The ICE BofAML Long U.S. Treasury Principal Strips Index, which has a duration of over 27 years, returned +10.2% in January. With that kind of interest rate risk, zero coupon bonds could lose money quickly if the virus situation is resolved, as rates would likely bounce back.

For example, in the second half of 2016, subsequent to a bottoming out of the yield on the U.S. 10-Year Treasury at 1.36%, that same index lost 23.7% as the 10-year Treasury yield rose to 2.6% in just over five months. Zero coupon bonds are diversifiers. They can come in handy when equities and other risk assets fall, but they are not risk reducers, which many investors assume nearly all fixed income is.

Virus Drives Bond Yields Down

Even more pedestrian fixed income choices can have a bit more volatility than expected. The chart above also shows the performance of regular, coupon-paying investment grade bonds. The IBOXIG Markit iBoxx $ Liquid Investment Grade Index did produce some modest upside in January as interest rates fell, but looking again at the second half of 2016, the loss was 5.3%. So, as the coronavirus has driven down Treasury yields, investors should take a close look at interest rate exposure in their bond portfolios and consider how they might perform in a post-virus world.


PERFORMANCE SNAPSHOT

Equity markets take a hit from coronavirus fears.

Returns of various common market segments

Source: Bloomberg1


Equity Perspectives
A Market Driven by the Technology Sector

The general narrative explaining the strong gains delivered by the equity markets in 2019 can be attributed to things like supportive central bank monetary policy, improved sentiment, and a healthy economic backdrop. These explanations, of course, all contribute to understanding what drove market returns at a macro level. However, there is also a more direct and perhaps simpler explanation: Look at what happened at the sector level. Technology is the market's largest sector, and with returns of over 50% in 2019, was by far the strongest performing group of stocks in the S&P 500. The next best performing sector wasn’t even close, lagging almost 20% behind the gains of tech shares. Technology shares alone accounted for about one third of the markets total gains for the year.

Valuations: Are Tech Shares Getting Ahead of Themselves?

Amidst the euphoria around performance, investors need to ask themselves if tech shares are getting ahead of themselves. After all, at almost 28x earnings, the tech sector is the most expensive sector in the market. And today’s valuations are the most expensive tech has been in at least 10 years.

The strong performance has also driven technology’s share of the S&P 500’s market capitalization to almost 25%, which is larger than the smallest five sectors combined. Another potentially concerning dynamic is that the largest tech names by market capitalization have had some of the strongest performance. This means that relatively few names represent the bulk of the sector’s weight as measured by market capitalization. In fact, the top 10 technology names represent over 66% of the entire sector!

Manage Allocations and Exposure

Importantly, none of this is to suggest that recent momentum will end or that technology shares will underperform in the near term. Rather, we bring attention to these dynamics to highlight that tech will likely have an outsized impact on the market’s direction going forward, both good and bad. At some point in the future, tech stocks will lag, and many investors may unknowingly have a larger-than-expected allocation to one sector. Perhaps it’s time for investors to be a little cautious with their technology exposure.

An Approach for the Tech Sector Selection

Well-established technology-related names, such as those underlying the S&P Technology Dividend Aristocrats Index—an equal weight collection of technology-related names that have grown their dividends for at least seven consecutive years—represent a compelling idea. For one, they are trading at more attractive valuations on just about any measure–nearly a 40% discount on a price-to-book and a price-to-sales basis. Even more fundamentally, they provide an interesting take on a familiar strategy. Companies that grow their dividends consistently over time represent quality, which have held up better in periods of market stress.


Fixed Income Perspectives
Coronavirus Fears Boost Returns for Fixed Income

Investors turned to safe haven assets as fears of the spread of the coronavirus and the potential economic impact made headlines. The question over literal contagion helped to boost returns for the broad fixed income market, climbing 1.92% as measured by the Bloomberg Barclays U.S. AGG Bond Index.

Yield Curve Re-Inverted

With investors gobbling up Treasury bonds, which are considered one of the safer segments of the market, the 10-year Treasury yield fell 41 bps, ending the month at 1.51%. Unfortunately, this means that the yield curve has now re-inverted, as the Fed Funds rate currently sits at 1.75%. As is often the case, credit spreads moved in the opposite direction of the 10-year and widened, with high yield spreads widening by 54 bps.

Where to Turn for Yields? Consider High-Yield with a Hedge

Though the economic impact of the coronavirus remains unknown, the yield on the 10-year Treasury is at historic lows. Assuming that no major hit to global gross domestic product (GDP) is caused by the outbreak, it is likely that the 10-year Treasury will rise from current levels. For those investors looking for income in this low-rate environment, it should be of interest that while the Treasury curve is inverted, the corporate bond curve is anything but—especially if you dip into the high yield market. The yield curve for B-rated corporate bonds is in fact quite steep, with the spread between two- and 10-year bonds up over 215 bps. This trade does come with both credit and interest rate risk. In order to avoid a potential hit from an increase in longer-term Treasury yields, investors may consider high yield strategies that include a hedge against rising Treasury yields.

ProShares Investment Strategy Team



Source for data and statistics: Bloomberg, FactSet

1The different market segments represented in the chart use the following indexes: US Large Cap: S&P 500 TR; US Large Cap Growth: S&P 500 Growth TR; U.S. Large Cap Value: S&P 500 Value TR; U.S. Mid Cap: S&P Mid Cap TR; U.S. Small Cap: S&P U.S. 600 SC TR; International Developed Stocks: MSCI Daily TR NET EAFE; Emerging Markets Stocks: MSCI Daily TR Net Emerging Markets; Global Infrastructure: Dow Jones Brookfield Global Infrastructure Composite; Commodities: Bloomberg Commodity TR; U.S. Bonds: Bloomberg Barclays U.S. Aggregate; U.S. High Yield: Bloomberg Barclays Corporate High Yield; International Developed Bonds: Bloomberg Barclays Global Agg ex-USD; Emerging Market Bonds: DBIQ Emerging Markets USD Liquid Balanced.

This is not intended to be investment advice.

Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Any forward-looking statements herein are based on expectations of ProShare Advisors LLC at this time. Whether or not actual results and developments will conform to ProShare Advisors LLC's expectations and predictions, however, is subject to a number of risks and uncertainties, including general economic, market and business conditions; changes in laws or regulations or other actions made by governmental authorities or regulatory bodies; and other world economic and political developments. ProShare Advisors LLC undertakes no duty to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Investing involves risk, including the possible loss of principal. This information is not meant to be investment advice.

Bonds will decrease in value as interest rates rise. International investments may also involve risks from geographic concentration, differences in valuation and valuation times, unfavorable fluctuations in currency, differences in generally accepted accounting principles, and economic or political instability. In emerging markets, many risks are heightened, and lower trading volumes may occur.

Technology companies may be subject to intense competition, product obsolescence, general economic conditions and government regulation and may have limited product lines, markets, financial resources or personnel.

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