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Insights
May 2020 Market Perspective
Friday, June 5, 2020
The
S&P 500® Index has climbed over 35% from its 2020 low on March
23 and, as of May 29, was less than 10% below its February 19 all-time high. However,
the robust - yet partial - market recovery may put investors in riskier
circumstances than they faced earlier in the year. As the equity market has
trended up, estimates of future corporate earnings (as measured by 2021 estimated
earnings per share (EPS), have trended down. As a result, equity market
valuation, as
measured by price-to-earnings (P/E) ratio, is higher at the end of May than earlier
in the year, prior to the market’s peak and subsequent plunge.
Source:
Bloomberg, L.P.
While
the equity market’s upward trend has been welcomed and is encouraging, economic
data is just starting to shed light on the extent of the carnage wrought by the
COVID-19 virus mitigation efforts. It is too early to tell what the follow-on
effects will be, what shape a recovery will take, or if new large-scale
outbreaks and further economic damage are in store. Moreover, the conventional
tool used by most investors to counteract equity market risk, high-quality
fixed income investments, has a diminished capacity for meeting investor needs on
this side of the equity market chasm. U.S. Treasury yields dropped
precipitously in the first quarter and have stayed near all-time lows as the
equity market has trended up in the second quarter of 2020.
Source:
Bloomberg, L.P.
Two
forces may keep yields low for an extended time period. The minutes from the
most recent Federal Reserve Open Market Committee (the Fed) meeting noted that
they would maintain the current target range of 0% to 0.25% for the federal
funds rate “until they were confident that the economy had weathered recent
events and was on track to achieve the Committee's maximum employment and price
stability goals.” With the employment rate at double-digits for the first time
in decades and no signs of inflation, the federal funds rate is unlikely to
increase anytime soon. Indeed, the Fed meeting minutes noted that market
participants “expected the target range for the federal funds rate to remain at
the effective lower bound for the next couple of years.” Policy rates will
continue to put downward pressure on longer-term interest rates until there is
significant improvement in the employment picture.
Source:
Bloomberg, L.P.
The other force likely to keep U.S. yields low is the even-lower yields on other developed-nation sovereign bonds. The 65 basis point yield on the 10-year U.S. Treasury note as of May 31, 2020 towers over the negative yields on 10-year issues from Germany and Japan, and the yield on the 10-year U.K. Gilt - which was just barely positive at the end of May. Comparatively high yields on U.S. government issues are likely to sustain strong demand from foreign investors, thus adding downward pressure on longer term domestic bond yields.
The plunge in yields has driven strong returns from the bond market in recent quarters, however, if rates stay low for an extended period of time, investors may see a return to the longer-term trend of lower multi-year returns from fixed income investments.
Source:
Bloomberg, L.P.
The
equity market’s partial recovery is not evidence of less risky market
conditions. Pandemic-related risks abound while renewed trade tensions with
China and civil unrest across the nation have been added to the list of
investor concerns. In the current low-yield environment, investors may benefit
from supplementing fixed income allocations with other lower-volatility
investments. With implied volatility levels still well above its long-term average,
strategies that combine equity market exposure with cash flow from writing
index options may be particularly attractive.
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