May 2021
Earnings Season Brings a Not-Too-Hot, Not-Too-Cold "Goldilocks" Economy for Stocks, But Not Bonds
KEY OBSERVATIONS

A steady stream of positive economic news left one key question unanswered—will the good news be reflected in corporate earnings? With roughly two-thirds of companies reporting, the answer is a resounding yes. A reopening economy, piled-up household savings, the possibility of additional stimulus checks, falling unemployment, and many other factors have driven results that have beaten expectations for nearly nine out of 10 companies.

How May Rising Rates Impact Equities?

Interest rates may have taken a pause last month, but the Fed was clear last week: They intend to let the economy run a little hot for a bit—specifically, they plan to let inflation run a little higher than the long-term target of 2%. Won’t this continue to drive up interest rates and harm equities?

Before we answer that question, let’s review bonds. Importantly, the Fed shows no indication that tapering of quantitative easing will happen any time soon. The Fed will likely not let long-term treasury yields rise uncontrollably. Think about it this way: The Fed will likely let treasury yields rise sufficiently to hurt bonds (think 2- 2.5% on the 10-year Treasury) but not enough to slow the economy, and likely not enough to hurt stocks.

With bond durations at all-time highs, it’s clear why a 50-100 basis points (bps) rise in treasury yields could do meaningful damage to bonds. The broad investment-grade universe has a duration approaching 10 years, so a 50-100 bps rise in treasury yields could result in a 5-10% market value loss for those bonds.

Quantitative easing is a form of monetary stimulus in which the Fed purchases securities in order to increase the money supply and encourage lending and investment.

Duration is a measure of bond price sensitivity to a change in interest rates.



CHART OF THE MONTH:
A Goldilocks Backdrop Could Be in Store for Stocks

As we look at historical price-to-earnings ratios and 10-year Treasury yields, there’s a good chance rising rates won’t hurt equities.

Price-to-Earnings Ratio vs. Interest Rates, 1962-March 2021

Source: Bloomberg. 2021 Est P/E Ratio is plotted on the x-axis using the 10-year Treasury Yield as of 3/31/21.

Price to earnings is the ratio of the price of a stock (or index) to the earnings per share.


So why isn’t that level of interest rates likely to hurt stocks? There are two reasons. First, even if interest rates were to rise past 2% on the 10-year Treasury, that would still be quite low from a historical perspective. And as seen in the preceding chart, lower interest rates have historically driven higher P/E multiples. A 2-2.5% Treasury yield lines up with roughly a 20x P/E multiple.

The second reason is that, unlike defenseless fixed coupon bonds, stocks can grow their earnings. At a 30x P/E multiple, stocks are clearly expensive based on 2020 earnings, but fortunately 2021 earnings are likely to be significantly higher. In fact, stocks are trading at only 22x 2021 consensus earnings estimates. Here’s the even better news: Those earnings results are coming in substantially above consensus estimates—nearly 25% higher so far. If that trend persisted, it would equate to roughly 17x 2021 earnings—nicely below the historical trend line. Bottom line: A Fed letting the economy run a little hot and still engaging in substantial quantitative easing just might be a bit of a Goldilocks backdrop for stocks.

PERFORMANCE RECAP

Commodities were at the top of the charts for the month of April, which is consistent with a whiff of inflation. Mid-caps—the often-forgotten equity market segment—reigns year-to-date.

Returns of Various Common Market Segments

Source: Bloomberg. Performance quoted represents past performance and does not guarantee future results.



Economic Calendar

This month, we’re introducing our calendar of key economic releases, which can serve as a guide to potential market indicators.

Key Economic Releases

Source: Bloomberg



Equity Perspectives
Earnings Bonanza

Through April 30, approximately 60% of the S&P 500 companies have reported Q1 earnings. One would be challenged to describe those earnings as anything other than fantastic. Almost 90% of companies thus far have reported a positive earnings surprise; almost 80% are reporting positive surprises on the top line. This level of earnings surprise is unusual and will be hard to beat in the future.

In aggregate, companies are reporting earnings that are almost 23% above estimates, more than 3x greater than typical upside surprise percentages. When all is said and done for this reporting period, earnings are expected to have grown 46% over the same period in 2020. Granted, the year-ago period included a portion of the effects of COVID-induced shutdowns, nevertheless, the results have been spectacular. In addition, expectations of more blow-out earnings for the remainder of the year are also growing. Analysts now expect high double-digit earnings growth for the remaining three quarters, and 32% growth rate for calendar year 2021.

Earnings Season by the Numbers

Source: FactSet, data as of 4/30/21


Corporate America, What Have You Done for Me Lately?

It’s a question many equity investors seem to be asking corporate America during the current earnings season. Reactions to this quarter’s exceptionally strong earnings results have been rather muted. For the companies that reported positive earnings surprises, the average price increase during the current reporting season has been 0.9%, essentially indistinguishable from the recent 5-year average of 0.8% to positive surprises (source: FactSet).

It should be noted that this trend of muted response to strong earnings is not new. Companies that delivered positive earnings surprises during the Q4 earnings season saw negative responses in their share prices as investors “sold the news.” So, in one sense, the trend can be viewed as improving, albeit modestly. What’s behind the lackluster response is, of course, hard to diagnose. Perhaps stocks are simply taking a breather after a very strong run since the lows of last March, or maybe investors correctly recognize that comparisons going forward from here will be increasingly difficult to beat. Whatever the reason, one thing that seems clear is that the combination of massive stimulus, continuing positive economic momentum, and effective vaccine rollouts is translating quite well to corporate bottom lines.

Where to Look for Value

All this brings us back to the valuation question. Based on analyst expectations, the S&P 500 is currently trading at 22.4 times the next 12 months’ worth of earnings, an amount well ahead of the historical multiple of 16 times earnings. Cause for concern? In our chart of the month and related comments, we note that low interest rates and an earnings bonanza combine for a reasonably bullish equity backdrop. However, that’s from a broad market perspective. Relative valuations opportunities (and challenges) lie within. A potential sweet spot continues to be dividend growth strategies, like the S&P 500 Dividend Aristocrats. Historically, the Aristocrats have typically traded at a premium of approximately 2% to the S&P 500, making today’s discount of approximately 10% a relative bargain.

Source: FactSet, data as of 4/30/21



Fixed Income Perspectives
Fed Meeting Highlights? More of the Same…

During the month, the Federal Reserve reiterated its focus on maintaining accommodative monetary policy until results indicate that the United States is achieving its goal of full employment. This indicates that we are still ways away from any change in course. While the Fed acknowledged that the economy is accelerating, it appears it’s too soon for Chairman Powell to consider altering the Fed’s initiatives in an attempt to avoid any preemptive moves.

While full employment is one policy goal, let us not forget the Fed’s objective of price stability. We have recently seen an uptick in inflation, though the Fed’s preferred measure of inflation, core personal consumption expenditures (PCE), was up just 1.8% year-over-year in March. Other inflation indicators, such as headline consumer price index (CPI), indicated a change of 2.6% year-over-year in March.

There are several intricacies that differentiate the two, but it is not uncommon for measures of CPI to be more volatile than core PCE. CPI typically makes the most headlines and is, in fact, the measure that Treasury Inflation Protected Securities (TIPs) are linked to. However, the Fed focuses on core PCE. One crucial detail is that core PCE strips out food and energy prices, which can be more volatile.

Inflation Rises, Yields Fall

Source: Bloomberg, Month-over-month change, 3/31/21-4/30/21


While the yield curve was fairly stable for the month, longer-term yields fell slightly, helping the U.S. aggregate bond market to post positive returns for the month, up 0.79%. With headline CPI creeping up, TIPs was one of the top performing bond segments, though up just 1.40%. Corporate bonds also saw a boost as credit spreads tightened slightly, with investment grade spreads falling 2 basis points (bps) and high yield spreads down 18 bps.

Sources: Bloomberg. Investment grade spreads tracked by the Bloomberg Barclays US Agg Corporate Bond Index and high yield spreads tracked by the Bloomberg Barclays US Corporate High Yield Index.


Source: Bloomberg


Treasury Yields Likely Have Further Room to Rise

Despite the 10-year Treasury yield falling slightly during the month of April, longer-term yields have risen significantly throughout 2021 thus far as indicated in the preceding chart. Real Treasury yields, as reported by the Department of Treasury, remain negative across the curve (besides the 30-year tenor which had a real yield of just 0.02% as of April 30). The good news is that negative real yields continue to support economic expansion, but it’s unlikely that they will remain negative for an extended period of time. And with inflation seeming to tick up, it may take a substantial rise in nominal yields in order to counteract the impact from inflation.

Source: Bloomberg. Floating Rate tracked by Bloomberg Barclays US FRN < 5 years Total Return Index Value Unhedged USD, Short Term (1-3 Year) High Yield tracked by Bloomberg Barclays US High Yield 1-3 Year Total Return Index Value Unhedged USD, High Yield Bonds tracked by Bloomberg Barclays US Corporate High Yield Total Return Index Value Unhedged USD, Mortgage Backed Securities tracked by Bloomberg Barclays US MBS Index Total Return Value Unhedged USD, U.S. Aggregate Bond Market tracked by Bloomberg Barclays US Agg Total Return Value Unhedged USD, Treasury Bonds tracked by Bloomberg Barclays US Treasury Total Return Unhedged USD, Treasury Inflation Protected (TIPS) tracked by Bloomberg Barclays US Treasury Inflation Notes TR Index Value Unhedged USD, and Corporate Bonds tracked by Bloomberg Barclays US Corporate Total Return Value Unhedged USD. Performance quoted represents past performance and does not guarantee future results.


ProShares Investment Strategy Team



Sources for data and statistics: Bloomberg, FactSet, Morningstar, ProShares

The different market segments represented in the performance recap charts use the following indexes: U.S. Large Cap: S&P 500 TR; U.S. 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: Russell 2000 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.

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