September 2019
Small Caps and Corporate Credit Remain Attractive After August Sell-Off
KEY OBSERVATIONS

Continued trade tensions and concerns that trade tensions and tariffs could begin to impact the real global economy drove a sell-off across nearly all risk assets in the month of August.

  • Equity market declines were commensurate with risk as the S&P 500 fell 1.5%, while small-cap stocks declined 4.5% and emerging-market stocks fell nearly 5%.
  • U.S. Treasuries rallied and U.S. bonds were the highest-returning market segment for the month of August. The rally pushed the 10-year Treasury yield down to 1.5%, near an all-time low.
  • A bright spot was global infrastructure, which returned just under +1%, the only equity market segment in the green for the month of August. Global infrastructure ended the month of August as the highest-returning market segment year to date.

CHART OF THE MONTH
U.S. small-cap stocks have become steadily cheaper relative to U.S. large-cap stocks.

Source: Bloomberg

The relative valuation of U.S. Small-cap stocks has been declining steadily for nearly 10 years. Small caps have gone from near parity on a price-to-book basis to a nearly 40% discount.

The price-to-earnings ratio is the ratio for valuing a company that measures its current share price relative to its per-share earnings.


PERFORMANCE RECAP

Only bonds and global infrastructure managed to post positive returns in the month of August, with all other market segments in the red.

PERFORMANCE SNAPSHOT
Returns of various common market segments


Source: Bloomberg


Equity Perspectives
The Case for Small Caps

There are two key elements for the bull case for small-cap stocks. The first is valuation. As noted in the chart of the month, small-cap stocks now trade at nearly a 40% price-to-book discount to large-cap stocks. That compares to a long-term average discount of around 25%. That’s of course no guarantee that small caps are on the cusp of outperformance. That discount briefly surpassed 50% at the height of the mega-cap bubble in 2000, but it is a compelling data point.

The second element is the notion that small cap stocks tend to be outsized beneficiaries of monetary policy easing and low interest rates. The theory goes as follows: Small-cap stocks have more leverage than large-cap stocks, so small caps benefit disproportionately from lower interest rates. The evidence is mixed.

Threading the Needle

One key reason is that easing monetary policy and falling interest rates often accompany weaker economic conditions. The lower quality of small caps—manifested not just in higher leverage but lower margins as well—can be quite the liability in weak economic conditions. A modest decline in sales growth, as an example, could more than undo the benefit of lower interest rates for many low-quality small caps. With the odds of monetary policy easing quite high, but also a nontrivial chance of slowing economic growth, the small cap opportunity looks a bit like trying to thread a needle. The answer may be quality small cap stocks. Small cap stocks that have higher margins and lower leverage than the small cap universe could provide a sweet spot that may benefit from both attractive valuations and monetary policy easing—with perhaps less exposure to economic weakness.


Fixed Income Perspectives
Bond Rally Gains Steam

The continuing collapse in global yields, which had been gaining steam throughout the year, accelerated in August. The 10-year Treasury yield declined another 53 basis points in August, after a roughly 40 basis-point decline in May. Yields for U.S. Treasuries now hover around 1.5% (near an all-time low) on the 10-year, and below 2% (a record low) on the 30-year. Expectations for further Fed Funds rate reductions remain high as we head to the last few months of 2019. The precipitous declines of rates over the course of the year has reignited the question as to where income investors can find a decent level of yield.

Corporate Credit Resilience Is Notable

While most risk assets were down in August, one notable pocket of strength remains corporate credit. Both high-yield and investment-grade benchmarks continue to show strength by delivering positive returns during August, and low to mid teens performance for the year-to-date period. The duration component has certainly helped as yields declined, but spread levels over comparable tenor Treasuries have been resilient. In fact, both investment-grade and high-yield spreads ended the month of August at similar levels compared to where they began.

High-yield spread behavior has been particularly interesting as compared with equity market performance. Usually, there is a fairly high inverse correlation between equity market direction and the movement of high-yield spreads. As was the case for most of the year, equities moving higher meant high-yield spreads were tightening. But that relationship started to decouple after May’s equity selloff. As equities rallied in June and July, high-yield spreads were essentially flat. Then, the high-yield market saw spreads tighten during the equity weakness in August.

With corporate spreads presenting arguably fair valuation levels, and with the corporate credit curve decidedly not inverted, August’s resiliency could be a bullish sign for the remainder of the year, positioning corporate credit, as perhaps, a risk worth taking.



Sources for data: Bloomberg and FactSet.

This is not intended to be investment advice.

Indices 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.

Infrastructure companies in emerging and developed markets face a variety of risks. For example, governments can alter regulations and tax laws. Changes in supply and demand may reduce revenue. And natural disasters or other factors may render assets unusable or obsolete. Investments in smaller companies typically exhibit higher volatility.

Small- and mid-cap companies may have limited product lines or resources, may be dependent upon a particular market niche and may have greater fluctuations in price than the stocks of larger companies. Small- and mid-cap companies may lack the financial and personnel resources to handle economic or industry-wide setbacks and, as a result, such setbacks could have a greater effect on small- and mid-cap security prices.

Bonds will decrease in value as interest rates rise. High yield bonds may involve greater levels of credit, liquidity and valuation risk than higher-rated instruments. High yield bonds are more volatile than investment grade securities, and they involve a greater risk of loss (including loss of principal) from missed payments, defaults or downgrades because of their speculative nature.

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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