Trade concerns dominated May’s headlines and drove an emphatic flight to quality, with stock prices falling and U.S. Treasuries rising.
- The S&P 500 declined more than 6%.
- The U.S. Treasury curve inverted. Yields fell over 40 basis points (bps) across 2- to 10-year maturities.
- The U.S. economy, however, showed continued strength. The U.S. economy showed healthy GDP growth, strong job growth, extremely low inflation and high consumer confidence.
A trend line capturing the relationship between U.S. 10-year Treasury rates and S&P 500 price-to-earnings ratio (P/E) implies a P/E of around 20, which is materially above today's P/E.
The price-to-earnings ratio (P/E) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.
All risk assets were firmly in the red for the month of May. Equities declined, credit spreads widened and commodity prices fell. Only U.S. and International Developed bonds managed a positive return, driven by falling interest rates.
May’s rally in U.S. Treasuries was particularly stunning. Consider the following: Yields on the 10-year U.S. Treasury fell around 40 bps, which is roughly the same amount of decline experienced in Q4 when the S&P 500 declined more than 13%, as compared to just over 6% in May. And the starting point is relevant. The 10-year Treasury was still yielding over 3% at the start of Q4. By the beginning of May that yield was 2.5% and now stands at just over 2%. With the core consumer price index (CPI)—the CPI minus energy and food prices—still running around 2%, the real rate is now near zero.
Interest rates are so low, it’s tough to argue in favor of investing in longer duration bonds. The inverted yield curve means that the reward for taking duration risk comes with lower yield. One of the few ways for this bet to pay off would be if trade wars prompted a recession and yields fell even further. Keep in mind that the all-time low yield on the 10-year U.S. Treasury was just under 1.5%, so even in that scenario, the upside is likely limited.
The risk/reward tradeoff looks a bit more attractive in corporate bonds. After May’s sell-off, spreads on both investment-grade bonds and high-yield bonds now stand right around their 5-year average. Spreads on investment-grade bonds are even near their long-term average, which includes the extremely wide spreads experienced in the great recession. No doubt a significant recession would negatively impact corporate bonds, but at least they are priced for a fair return in a middle-ofthe-road scenario, which is more than can be said for U.S. Treasuries.
Despite a difficult May, the case for optimism in equities isn’t all that difficult to make. Just look at the fundamentals. Yes, it’s clear that earnings growth is decelerating, as we documented last month. The S&P 500 delivered earnings growth in the neighborhood of 25% during the first three quarters of 2018. Those levels were simply not sustainable. And while the final tally on S&P 500 earnings for Q1 was slightly negative (-0.4%), revenue growth was positive at 5.3% (per FactSet data). All but two of the S&P’s 11 sectors delivered positive revenue growth, so it’s not as if a sector or two are doing all the heavy lifting. Revenue growth with earnings erosion points to shrinking margins, but not necessarily a significant economic contraction. And since margins were recently higher than their pre-crisis peak, we believe there is a little bit of wiggle-room before alarm bells are sounded.
Investors can also make at least a reasonable argument based on valuations. We note in the chart of the month that interest rates are so low that one could consider the S&P 500 to be trading at a discount to a “fair value.” Yields tell a similar story. The dividend yield for the S&P 500 is now just over 2%, according to Bloomberg, right around the yield on the 10-year U.S. Treasury, providing an important valuation support point. And with just the modest amount of earnings growth that has been forecasted by analysts, the year-ahead earnings yield (expected earnings divided by price) is notably in excess of its historical relationship to interest rates.
One market segment that has performed remarkably well of late—and one that may continue to perform well given the backdrop of potentially slowing growth—is infrastructure. These stocks provide the essential transportation, energy, water and communication elements that allow our society to operate. Most people by now recognize a huge need exists for more infrastructure investment. And many are speculating that one item both sides of the aisle in Washington, D.C., may ultimately agree on is an infrastructure spending package.
But regardless of what happens politically, listed infrastructure stocks tend to have unique investment characteristics, and may perform in this type of market. After all, we need infrastructure regardless of the precise level of economic growth or of the ultimate outcome on matters of trade. In addition, infrastructure performance is less cyclical, and the companies have more pricing power. Their cash flows tend to be more stable at a time when the market is experiencing decelerating earnings. Listed infrastructure stocks were essentially flat in May and handily outperformed the S&P 500 and the MSCI World over the year-to-date and one-year periods.
The price-to-earnings multiple (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.
Source for data: Bloomberg, FactSet and Morningstar.
Index returns are for illustrative purposes only and do not represent actual fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
This is not intended to be investment advice.
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.
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