Uneven recovery not enough to stop equities from reaching new all-time highs.
Domestic equities rode better-than-expected earnings and strong fiscal and monetary stimulus to new all-time highs in August. On August 18 the S&P 500® closed at 3,389, eclipsing its pre-COVID February 19 high of 3,386 and marking an incredible 52.7% gain from March lows. It took only six months for the index to recover to its previous high after the sharpest market sell-off in history. For context, it took the S&P 500 over five years to regain its previous high following the global financial crisis in 2008.
Despite being a seasonally weak month (the broader S&P 1500® has an average return of -1.1% in August over the last 10 years), August marked the fifth consecutive month of positive returns for domestic stocks.
The S&P 1500 closed 6.9% higher — large-cap stocks again led markets with the S&P 500 up 7.2%, outpacing the S&P 400®, which was up 3.5%, and the Russell 2000®, up 5.6%.
Market breadth, measured as the percent of companies within the S&P 500 above their 200-day moving average, is just 62% compared to 80% at the pre-COVID high. Further reflecting the market’s narrow leadership, the index is up 9.7% year to date, but the average stock in the index is actually down 2.9%. The five largest stocks in the index, Apple Inc., Microsoft Corporation, Amazon.com, Inc., Alphabet Inc., and Facebook, Inc. (more commonly known as the FAANG stocks) represent a 24% weight and have contributed 114% of the S&P 500’s total return for the year.
This performance bifurcation is also reflected in the Nasdaq-100®, which is dominated by large-cap high growth and technology stocks that have benefitted from the “stay-at-home” trends prevalent since the beginning of the economic shutdown in March. The index continues to outpace all major US equity indices, up 11.2% for the month and an amazing 39.6% for the year — its best year-to-date return through August in 20 years. Alternatively, the Russell 2000® Value Index, a proxy for the “go-outside” trade, continues to be the market laggard, down 17.7% for the year. The fundamental strength of large-cap growth relative to small-cap value, as seen in second-quarter earnings results, continues to be the key driver of this divergence.
Encouragingly, new US daily cases of COVID-19 fell steadily throughout the month. Measured using the seven-day moving average of new cases, August 31 marked the low point for the month at just over 41,000 cases. However, new cases remain elevated compared to levels seen earlier in the year and relative to other developed nations. In our view, the inconsistent virus data, persistently volatile high-frequency economic metrics (i.e., weekly jobless claims, restaurant bookings, public transportation usage), and lack of progress on a “Phase Four” fiscal stimulus agreement suggest to us a broader economic rebound will likely remain bumpy.
Economic data over the month reflected the uneven recovery for both consumers and businesses. Consumer confidence as measured by The Conference Board’s monthly metric fell to a six-year low versus expectations of an increase (Chart 1). Respondents cited greater concern about income and job prospects after a variety of unemployment benefits expired at the end of July. Weaker consumer confidence was reflected in softer-than-expected retail sales, which increased by only 1.2% in July versus 8.4% in June. With personal consumption accounting for about 70% of US economic growth, a stall in consumer spending would be a major risk to the economic recovery.
Disconnect between Main Street and Wall Street? As of 8/31/2020 (Chart 1)
Source: Bloomberg L.P., PNC
Consistent with consumer sentiment worries, labor market data were also mixed in August. On one hand, the economy added 1.8 million new jobs in July (the third consecutive monthly upside surprise), pulling the unemployment rate down to 10.2% from 11.1% in June. However, only 42% of the jobs lost earlier in the year due to forced shutdowns and ensuing recession have been recovered as of the end of July. Also, the July ADP National Employment Report®, measuring changes in non-farm private payrolls, missed expectations by over 1 million jobs. In our view, the pace of the recovery for the labor market remains an important gauge of the economic recovery.
The July US manufacturing PMI index improved to 54.2 from June’s 52.6, its second month in expansionary territory (a reading above 50 indicates that the manufacturing economy is generally expanding) since the plunge in manufacturing activities following the forced shutdowns earlier in the year. Durable goods orders, a historically reliable measure of business investment, increased 11.2% month over month in August, more than double economists’ expectations. While the total value of orders remains below its pre-COVID level, the quick pace of the recovery should help provide a near-term tailwind for manufacturing jobs. In our view, better durable goods orders and the strong PMI data suggest greater confidence among business leaders, an encouraging sign amidst the economy’s reopening efforts.
The second-quarter earnings season is largely complete and, as expected, was the sharpest year-over-year decline in S&P 500 earnings since fourth-quarter 2008.
The blended earnings growth rate (actual reported results combined with consensus estimates for those yet to report) ended August at -30.5%, better than the -44.1% expected coming into the reporting period. Only 3 of 11 sectors (Information Technology, Health Care, and Utilities) posted positive earnings growth over the quarter.
Earnings for mid and small caps (S&P 400 and Russell 2000, respectively) remain challenged with second-quarter blended earnings growth rates of -54.1% and -103%, respectively. Both indices have now delivered overall earnings misses for four consecutive quarters. Despite the more challenging earnings backdrop for small caps, the consensus earnings growth estimate for the Russell 2000 for 2021 is more than 170%. The majority of the rebound is expected to come from the Consumer Discretionary and Energy sectors, which have the largest number of bankruptcies this year, creating potential risk for this growth estimate.
Since the S&P 500 bottomed on March 23, the next-12-months (NTM) price-to-earnings ratio (P/E) has expanded from 13.1 times (x) to just shy of 23x at the end of August — its highest level since March 2000 (Chart 2). With valuations already elevated, the market path forward may be limited from earnings growth alone. The consensus estimate for earnings-per-share (EPS) growth in 2020 is -19%, with an expected rebound of 25% in 2021. That leaves a NTM EPS growth rate of just 0.9%.
Domestic Valuations 10 Years Ended 8/31/2020 (Chart 2)
Source: Bloomberg L.P., PNC
At the annual Jackson Hole Economic Policy Symposium, Federal Reserve (Fed) Chairman Jerome Powell detailed two key updates to the Fed’s monetary policy framework. First, the Federal Open Market Committee will seek to achieve inflation that averages 2% over time, and second, the committee emphasized maximum employment is an inclusive goal measured by “shortfalls” rather than “deviations” of employment from the maximum level. While the announcement may preserve flexibility for Fed monetary policy actions, the update underscores our expectations of a “lower for even longer” interest rate environment. For context, the Fed’s preferred inflation metric, the Core Personal Consumption Expenditure, has averaged just 1.7% since 2000 and just 1.6% over the most recent business cycle (July 2009–February 2020).
In reaction to the announcement, the 10-year Treasury yield rose to 0.75%, its highest level in three months (to close August at 0.70%), and the yield curve (10-year Treasury minus 2-year Treasury) steepened to the highest level in approximately two months. In our view, a steeper yield curve is necessary for increasing inflation expectations to take hold. Yet the spread of the curve is still about 200 basis points (bps) narrower than it was in 2009 exiting the last recession. The rise in interest rates over the course of the month outweighed falling credit spreads and pushed the Bloomberg Barclays Aggregate Bond Index to its first monthly loss since March, down 0.81%. However, the Barclays US High Yield Index, which is actually more correlated to equity markets, closed the month 0.95% higher.
The pace of rampant bond issuance continued into August, as high-grade companies issued more than $136 billion of bonds and junk issuers borrowed around $53 billion, leaving this year’s pace running 80% above last year’s pace.
Developed International Markets
Financial markets not rattled by rising virus case counts.
Stocks in Europe and Japan continued to climb higher despite an ongoing myriad of virus and geopolitical concerns. In US dollar terms, the STOXX® Europe 600 rose 4.4% and the Japanese Nikkei 225 climbed 6.7% in August. The broader MSCI World ex USA Index advanced 5.2% with positive returns from nearly every country, led primarily by strong performance in Japan, Germany, Canada, and France. At a sector level, a rotation into cyclical sectors also drove index performance and helped value names outperform their growth counterparts for the month, a notable divergence from the trend in US equities.
Although pockets of Europe and Japan slowed or even slightly reversed reopening plans as new virus cases continued to tick up, higher frequency data still show encouraging consumer activity across these regions. For example, the TomTom Traffic Index, a measure of urban traffic congestion, continues to increase in Italy and France, and electricity usage from the Tokyo Electric Power Company continues to recover. Activity on OpenTable’s restaurant reservation app in Germany exceeds pre-COVID levels and is now 27.8% greater than this time last year, although that may just be an indication of growing popularity of the app itself. Other macro data suggest a more mixed view of economic growth across most developed international economies. For instance, Eurozone retail sales have rebounded quickly from April lows and are now greater than levels seen before the global pandemic.
However, Eurozone composite PMI data fell to 51.6 in August from 54.9 in the prior month. In Japan, retail sales growth continues to be negative, falling 2.8% year over year in July, and the au Jibun Bank Japan Composite PMI® was flat relative to the prior month while remaining in contraction territory (below 50). Overall, economic data are likely to continue to reflect an uneven recovery across developed global economies until greater clarity is achieved with regard to the path of the virus and ongoing political challenges. With that uneven economic growth backdrop across the developed international landscape, we would expect a continuation of accommodative monetary policy, supporting our view of a “lower for even longer” interest rate backdrop.
With the second-quarter earnings season nearly complete, the blended earnings growth rate for the MSCI World ex USA Index stands at -55%, modestly better than the -59% expected at the beginning of the quarter.
While the second quarter likely marked the bottom for earnings growth this year for the index, overall EPS growth expectations for 2020 of -31.9% imply the need for a meaningful improvement in second-half earnings. The outlook for 2021 remains upbeat, with EPS growth expectations of nearly 34%, significantly ahead of the S&P 500 projection of 25%. Meeting these growth hurdles will likely depend heavily on stunting a second wave of the virus across developed market economies.
Reflective of the poor earnings performance, and along with the strong price appreciation for the index, the MSCI World ex USA’s NTM P/E finished the month at 17.5x. This level marks an all-time high for the index’s valuation, but on a relative basis it still compares favorably with the 22.9x level of the S&P 500 (Chart 3). Other valuation metrics such as the P/E to growth ratio are more in line for both indexes, with the MSCI World ex-US at 2.0 and the S&P 500 at 2.1.
International Valuations 10 Years Ended 8/31/2020 (Chart 3)
Source: Bloomberg L.P., PNC
Interest rates rose across most developed markets in August, although to a lesser degree than the Bloomberg Barclays US Aggregate Index, and the Bloomberg Barclays Pan-European Aggregate Index outperformed on a relative basis by 8 bps. However, a significant portion of developed market debt remains at negative yields; through August 31 more than $14 trillion in global bonds were “paying” negative yields (Chart 4). In below-IG markets, similar to US markets, it was the best performing August in the last 10 years as global equities rallied. The number of “fallen angel” issuers (IG issuers downgraded to below-IG status) has slowed to a normalized pace relative to the first and second quarters, with just two new fallen angels thus far in the third quarter compared to a combined 20 in the first half of the year.
Global Negative Yielding Debt As of 8/31/2020 (Chart 4)
Source: Bloomberg L.P., PNC
Renewed trade tensions not enough to slow the EM rally.
The MSCI Emerging Markets (EM) Index recorded its fifth consecutive month of positive performance (+2.2%), the longest streak in three years. Despite the strong performance rally of late, the month of August saw EMs lag both international developed and S&P 500 equities on a relative basis as trade tensions and ongoing challenges with COVID-19 linger.
Two countries that curbed performance for the month were Taiwan and Brazil – the second and fifth largest countries in the EM Index, down -1.6% and -8.8%, respectively. Taiwan Information Technology stocks were negatively impacted by ongoing trade tensions between the Chinese telecommunications company Huawei Technologies Co., Ltd. and the United States.
As Huawei begins to turn its supply chain completely in-house, its prior relationships with semiconductor manufacturers, many of which are based in Taiwan, could be expected to suffer.
All Brazilian sectors were down on the month, as COVID-19 daily cases continued to be second only to the United States, a clear indicator the virus is far from contained in the largest Latin American economy (Chart 5). Since COVID-19 was declared a global pandemic on March 11, the MSCI Brazil Index is lagging the EM Index by more than 1,800 bps.
Daily New COVID-19 Cases, 7-Day Daily Moving Average 1/18/2020 – 8/31/2020 (Chart 5)
Source: Bloomberg L.P., PNC
We continue to believe the path of COVID-19 is going to dictate the progress of global economic reopenings, and we see encouraging bright spots within EM Asia using high frequency data points. China continues to see virus cases decrease and both China and India have seen city traffic conditions rising to the highest levels since countrywide lockdowns were lifted. In China specifically, the Caixin China Composite PMI™ recorded its third consecutive reading above 50 (54.5), indicating an ongoing expansion in the Chinese economy. The primary driver of that growth was manufacturing, as consumer data such as the Services PMI and retail sales both came in below expectations, and Chinese retail sales have delivered negative year-over-year growth each month since March. We view this as confirmation of a global economic recovery from an industrial perspective, whereas the true headwinds started and remain with consumers affected by national lockdowns and ongoing social distancing efforts.
An additional signal that the global economy is thawing is reflected in a pickup in capital markets, including the announcement in August that Ant Group, 33% owned by Chinese e-commerce giant Alibaba Group Holdings Ltd., intends to go public later this year. Expectations are for a total company valuation of more than $200 billion, with the company expecting to raise approximately $30 billion in the transaction. This could break the Saudi Arabian Oil Company’s (Aramco’s) record $29 billion generated last year for its initial public offer (IPO) (for perspective, Facebook’s record-breaking IPO in 2012 raised $16 billion). As a potential symbol of the strained relations between the United States and China, Ant Group hired four underwriters: three US banks as well as the China International Capital Corporation, which is 80% owned by the China sovereign wealth fund. This contrasts with Alibaba’s 2014 IPO where all six underwriters were either US or European investment banks. The Ant Group is going to dual list its shares only on the Hong Kong and Shanghai exchanges, and thus ADR shares for US-based investors will not be made available.
Earnings season for the collective countries in the EM Index is drawing to a close, and the overall growth rate trended lower throughout the period. The primary culprit for weaker-than-expected earnings growth was the embattled Energy sector, which contributed approximately 50% of the decline despite just a 6% weighting in the EM Index.
The EM Index continues to have the strongest outlook for earnings compared to domestic and developed international markets, with 2020 EPS growth expected to decline 15% and then rebound 32% in 2021. At a forward P/E of 14.9x, its relative P/E ratio to the S&P 500 of 0.65 remains below the 5- and 10-year averages. On a free cash flow yield basis (currently 4.7%), the valuation differential has been higher than that of the S&P 500 for essentially the last 10 years.
As interest rates moved higher across the globe in August, fixed income returns were fairly muted relative to July, with the Barclays EM Aggregate Index up 54 bps. Notably, the ongoing weakness in the US dollar has been a strong tailwind for dollar-denominated issuers. Since the dollar began its decline in mid-May, the dollar-denominated index has outpaced the local currency index by more than 600 bps (Chart 6). The currency impact cannot be stressed enough, as the dollar-denominated index has a much greater weighting to oil-exporting countries, which have been under severe strain from low oil prices this year, and yet that economic weakness has been more than offset by the declining value of the dollar.
US Dollar Index (DXY) 5 Years Ended 8/31/2020 (Chart 6)
Source: Bloomberg L.P., PNC
TEXT VERSION OF CHARTS
Chart 1: Disconnect between Main Street and Wall Street? As of 8/31/2020 (view image of chart 1)
Chart 2: Domestic Valuations 10 Years Ended 8/31/2020 (view image of chart 2)
Chart 3:International Valuations 10 Years Ended 8/31/2020 (view image of chart 3)
Chart 4: Global Negative Yielding Debt As of 8/31/2020 (view image of chart 4)
Chart 5: Daily New COVID-19 Cases, 7-Day Daily Moving Average 1/18/2020 – 8/31/2020 (view image of chart 5)
Chart 6: US Dollar Index (DXY) 5 Years Ended 8/31/2020 (view image of chart 6)
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