The month of June closed out with a couple of surprisingly strong pieces of economic data. The conference board’s consumer confidence reading and the Institute of Supply Management (ISM) Manufacturing Report both strongly beat expectations. These forward-looking survey measures faced off against worrisome developments on the virus front, with many areas of the United States, particularly the Sun Belt, experiencing a substantial uptick in cases and hospitalizations. It’s an anxiety-provoking tug-of-war, which, at least for the month of June, was won by the optimists and bulls, with most risk assets in the green and strong performance by higher-risk areas such as emerging markets and small caps.
Please—no broken clock references … Yes, it’s been a very long period of underperformance for international developed markets. The S&P 500 has delivered nearly triple the return of the MSCI EAFE Index since the lows of the Great Financial Crisis of 2008, as we've come to call it. As a result, valuations and dividend yields look attractive.
Source: Bloomberg. S&P 500 Index and MSCI EAFE Index, total cumulative return 2/27/09 to 6/30/20. Price-to-book ratio as of 6/30/20.
No doubt you’ve heard this story before. Here are three reasons why now may be the time to at least consider commencing international positions or adding to them:
- Europe, a large piece of the MSCI EAFE, appears to be doing a better job of containing the coronavirus right now.
- Recent steps have been taken toward a truly integrated Europe, including the possibility of commonly issued debt, a coordinated virus response plan, wealth transfer and massive pooling of national financial resources.
- There's a considerably more modest technology weighting—8% for the MSCI EAFE Index compared to 27% for the S&P 500.
Nearly all green in June.
Back in the day (before the Great Financial Crisis of 2008), fixed income market participants and strategists worked under the following basic principle: The Federal Reserve Bank only controlled the fed funds rate, and all the rates further out on the U.S. Treasury curve were set by the market. Of course, even back then, the Fed’s “guidance” mattered. If the Fed suggested that it was going to keep the fed funds rate low for a long period of time, market forces would collectively digest and reflect that in longer-dated Treasury yields, allowing the Fed to have some impact beyond the fed funds rate.
That impact was usually felt on the shorter end of the curve—say, through two-year maturities—with longer-term rates driven by longer-term market forecasts of economic growth and inflation. And then came quantitative easing (QE). To keep interest rates low even farther out on the curve, the Fed began buying longer-dated Treasuries to keep a lid on longer-term interest rates. To a large extent, it worked. We have not seen a “normal” (long-term average) 10-year bond yield since before the Great Financial Crisis. Still, there are limits. Take a look at the following chart:
With all of the aggressive action that the Fed has taken and words it has spoken in response to the pandemic, rates have fallen less the farther one goes out on the yield curve. But wait. The Fed has one more card to play—yield curve control. QE buys bonds to push rates down. Yield curve control goes one step further and targets a specific yield(s) out on the curve, implying that the Fed would keep buying bonds of a particular maturity until a targeted yield is reached.
Most Fed watchers believe that, even if the Fed chose this path (which the Fed itself has expressed skepticism around), it would likely focus on relatively short maturities like the two-year yield. All of this suggests that longer-term treasury rates, such as 5, 10 and 30 years, will still be materially market driven. Which means they can go up.
Could they “normalize”? Depending on your view of long-term inflation, “normal” could mean anywhere from a 3%-5% yield on the 10-year. It’s fair to consider even the low end of this range to be a stretch, given the pandemic’s economic impact and economic uncertainty. However, perhaps halfway to normal would be reasonable. With the 10-year Treasury yield now below 70 basis points, even an increase to just 1.5% would result in material price declines for U.S. Treasuries and other interest-rate-sensitive fixed income securities.
With the stock market seesawing during the first half of the year, analysts remain unclear as to what is in store for the remainder of 2020. Despite an estimated year-over-year earnings decline of 43.9% during the second quarter, the S&P 500 continued its remarkable rally in June.1 Fiscal and monetary stimulus can help explain a large part of the v-shaped recovery in the stock market, but uncertainties surrounding the impact of COVID-19 serve as headline risk for equities, with some states halting or reversing their reopening plans, potentially curbing an economic recovery. A stark contrast between S&P 500 returns and the change in earnings estimates for 2020, highlighted below, may give some investors pause.
But is there reason for optimism? Second-quarter earnings announcements will soon begin, and investors will be able to better understand how corporations were impacted by the lockdown. It may be important to consider that while the United States is recording the largest number of COVID-19 cases in the world, 40% of S&P 500 revenues are derived internationally.2 Countries that were able to “flatten the curve” may in fact become larger sources of revenue during the pandemic. When all is said and done, it is likely still wise to exercise caution when identifying which segment of the market to jump into.
Market movement year-to-date has left many valuation metrics stretched, but different metrics can provide different insights. With earnings estimates varying drastically, price-to-book values may provide a more stable way to evaluate equities in the current environment. Growth stocks have outperformed, but they have also seen their price-to-book ratios stretch by 10%.3 Value stocks, on the other hand, have seen their price- to-book ratios drop. Rather than falling into the “value trap,” quality dividend growers, such as the Dividend Aristocrats, may have an appeal.
The S&P 500® Dividend Aristocrats®, which have consistently increased their dividends for a minimum of 25 years, have also seen their price-to-book ratios contract this year. And while they currently trade at valuations below the broader market, they have shown higher profitability, as indicated by return on assets.
Bloomberg as of 6/30/20
These types of quality dividend growers may provide some comfort while we continue on into uncharted territory. The S&P 500 Dividend Aristocrats have proven resilient over time, which we further detail in our most recent installment of Dividend Viewpoint.
1Source for year-over-year earnings estimate: FactSet as of 6/26/20
2Source for geographical revenue exposure: FactSet
Source for data and statistics: Bloomberg, FactSet
The 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.
Indices are unmanaged, and one cannot invest 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.
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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.
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