United States

Better virus data and reopening optimism fueled a continued market rally.

Domestic equities closed higher for the second straight month in May, with the S&P 1500® up 4.9%. The move higher was fueled by growing optimism that the US economy could successfully reopen over the coming months, combined with further liquidity support from the Federal Reserve (Fed).

Overall, mid- and small-cap stocks led markets higher, as the S&P 400® and Russell 2000® outpaced the S&P 500® with returns of 7.3%, 6.5%, and 4.8%, respectively.

Since the March 23 lows, the S&P 500 is up an impressive 36.6%. From a sector perspective, the best performers have been Energy (63.2%), Materials (44.8%), and Consumer Discretionary (40.6%). These more value-oriented and cyclical sectors are sensitive to positive virus data and hopes of reopening the economy; however, they were also some of the hardest-hit sectors in the preceding drawdown. In our view, the sharp market recovery and recent leadership of smaller-cap and value-oriented stocks are emblematic of a market that is pricing in a robust recovery in economic demand.

Historically, it is not uncommon for value-oriented and smaller-cap stocks to rebound more rapidly following periods of market stress. However, we are skeptical of the sustainability of their recovery and do not expect this to be the beginning of a broader rotation between growth and value styles. Ultimately, value stocks and associated sectors such as Financials, Materials, and Energy are operating with very poor fundamentals tied to the potential for higher interest rates, sustainably higher energy prices, and a pick-up in capital spending — each of which seems unlikely over the near term. Given this negative outlook, we believe investors will continue to be incentivized to “pay up” for stocks with more sustainable earnings growth outlooks and stronger balance sheets across sectors and market capitalizations.

Despite the market recovery, technical factors remain challenged, but we have seen improvements over the past month. Specifically, market breadth, measured by the percentage of S&P 500 companies trading above their 200-day moving average prices, climbed from 22% to 44% over the month. While the increase is encouraging, this is still below the 50% threshold typically associated with a sustainable recovery. In another encouraging sign, the spread between the CBOE Volatility Index (VIX) and its six-month futures price was no longer inverted for most of May after remaining inverted for a stretch of 43 consecutive days in March and most of April. An inversion of this spread implies investors expect near-term volatility to exceed long-term volatility. We believe the Fed’s quick and decisive actions to calm the markets and deliver liquidity kept the recent inversion period relatively short compared to the record 71 days in 2008 during the global financial crisis. While the absolute level of the VIX for May (27.5) has significantly declined from an all-time high in mid-March (82.7), it still remains above its 20-year average of 19.7.

In our view, getting the economy back to “normal” will be a long process. The public (i.e., consumers) will need clarity on state and local governments’ COVID-19 testing strategies, the level of herd immunity, and the possibility of a second wave of infections.

While the gradual decline in new confirmed COVID-19 cases in the United States has prompted governors of all 50 states to unwind various restrictions, we expect to see inconsistent progress across local economies.

In fact, if we focus on shorter time frames to gauge the success of reopening strategies, the data may be showing a disturbing trend. For example, California is the clear leader in new daily cases by state when looking at its seven-day daily moving average (DMA), which hit a new high on May 30. In addition, eight other states also hit new seven-day DMA all-time highs: Alabama, Arizona, Mississippi, North Carolina, South Carolina, Utah, Virginia, and Wisconsin. In some instances, but not all, the increases are being driven by a pick-up in cases across large cities, including Chicago, New York, Los Angeles, Washington, D.C., Philadelphia, and Minneapolis. These shorter-term trends are a reminder that in measuring the success of reopenings across local and regional economies, we will need to closely watch individual curves for those geographies versus just a single national curve (Chart 1).

New US COVID-19 Cases — Seven-Day DMA 1/28/20-5/30/20 (Chart 1)

View accessible version of chart 1

Source: Bloomberg L.P., PNC

The latest US retail sales data through April reflected both the harsh reality of the forced shutdown and a glimpse at the ongoing changes in consumer spending habits, perhaps exacerbated by stay-at-home orders. Overall, retail sales fell 16.4% month over month, nearly doubling the previous record from the March decline of 8.3%. Of the 13 categories within the retail industry, only nonstore retailers, which includes online retailers such as Amazon.com, Inc., saw a sales increase. The historic drop in consumer spending reflects the near-term economic damage from COVID-19. The duration of this consumption disruption will likely be highly dependent on the length of the ongoing business restrictions, but we expect the momentum of online shopping to continue.

Employment data throughout the month also continued to reflect the abrupt downturn in the US economy at the hands of COVID-19. Weekly jobless claims, perhaps the timeliest indication of the economic fallout, increased by another 10.7 million over the month, bringing the total jobs lost to a staggering 40.8 million since mid-March, when widespread business closures began. April’s unemployment rate rose to 14.7% but is expected to reach nearly 20% for May. In an encouraging sign, 78.3% of those unemployed consider themselves only temporarily out of work, suggesting they may be able to quickly return to their jobs as companies begin to reopen.

Given the ongoing business disruptions from the pandemic, first quarter earnings season was highly disappointing for S&P 500 companies.

The first quarter blended earnings growth rate of -14.7% (actual growth combined with consensus estimates) was well below the estimate of -6% at the end of March and the worst quarterly decline since third quarter 2009 (-15.7%). Looking forward, earnings revisions continue to decline, with the consensus estimate for 2020 earnings growth at -21.7% versus -1.8% at the end of March. For 2021, consensus expects a rapid recovery in earnings growth of 28%. While we caution that the earnings bar for 2021 may be set too high, if that level of growth is achieved, it would return earnings per share (EPS) for the S&P 500 back to its previous 2019 peak of $163.

The negative revisions to 2020 EPS, combined with the market’s rally on reopening optimism, have pushed valuation multiples to multiyear highs. The next-12-month (NTM) price-to-earnings (P/E) ratio for the S&P 500 ended May at 21.2 times (x), well above its 20-year average. It is also the first time the measure has exceeded 21x since January 2002. The declining earnings outlooks for mid- and small-cap companies have left valuations for the S&P 400 and Russell 2000 at all-time highs of 21.6x and 48.1x, respectively. With the bottom continuing to drop out of earnings and net leverage sitting at or near all-time highs, this is not the kind of multiple expansion we want to see (Chart 2).

Domestic Valuations 10 Years Ended 5/31/21 (Chart 2)

View accessible version of chart 2

Source: FactSet® Research Systems Inc., PNC

In fixed income, spread sectors broadly outperformed in May, with both corporate and municipal bond yield spreads compressing across maturities versus US Treasuries. High-yield bonds returned 4.4% in May compared to 1.1% for investment grade, while municipals returned 3.1% on signs of progress toward reopening the economy. Additionally, easing financial conditions, resulting from tighter credit spreads, stable benchmark rates, and the rally in equity markets, have aided companies’ ability to fortify their balance sheets following the liquidity squeeze in late March. 

US government bond yields continued to stabilize in May. The 10-year US Treasury yield was little changed at 0.65%, while a 12-basis-point increase in the 30-year Treasury yield to 1.41% led to continued yield-curve steepening. The lift in long-term rates was driven by a more optimistic macro outlook as the economy began to reopen, while short-term rates declined to mirror cuts in Fed policy rates.

Fed Chairman Jerome Powell continued to push for fiscal and monetary support, but pushed back against recent wagers in the federal funds futures market that suggested policy makers may consider negative interest rates, citing a wide array of other policy tools in the Fed’s arsenal.

During the month, the Fed made history by making its first purchase of exchange-traded funds as part of the Secondary Corporate Credit Facility, which was implemented to help improve liquidity in high-grade credit markets.

The broad increase in monetary policy accommodation since late March has caused the Fed’s balance sheet to swell to $7.1 trillion in assets, an 88% increase from last August, and supported an onslaught of $1 trillion in primary market bond issuance year to date.

International Developed Markets

Gradual economic reopening reveals the challenges of adjusting to a “new normal”.

A gradual decline in new confirmed cases of COVID-19, combined with accumulating economic costs, has prompted leaders in developed international markets to unwind restrictions in certain regions, but progress remains quite inconsistent. Despite widespread job-saving initiatives, labor markets remain pressured, and consumers, concerned about their future earnings, appear to be increasing their savings rates. Ultimately, we expect further reopening to be met with both pent-up demand and caution as businesses and consumers adjust to a “new normal.”

The Eurozone economy posted its worst quarterly contraction ever of -3.8% in the first quarter. The countries hit hardest by COVID-19 — Italy, Spain, and France — also saw the largest declines in economic growth (-4.7%, -5.2%, and -5.8%, respectively). Japan’s first quarter GDP fell 3.4% year over year. These readings underscore the extent of the economic damage from the implementation of lockdown precautions.

To help revive economic growth, the European Commission proposed a €750 billion recovery plan that would provide €500 billion in grants and €250 billion in loans to countries and sectors hit hardest by the pandemic.

Combined with the proposed 2021-27 budget of €1.1 trillion, total spending would amount to €1.9 trillion. In Japan, the government has proposed a second fiscal stimulus bill worth ¥31.8 trillion that would bring total spending to well over 20% of GDP. Since many developed international markets had negative interest rates heading into the global health crisis, targeted fiscal policy will be critical to returning these economies to growth.

In the meantime, investors will be keeping a close eye on economic data to gauge the pace of economic recovery. Although still in contraction territory, the IHS Markit Eurozone Composite PMI® for May showed improvement from record lows, with month-over-month increases across the manufacturing and services components in Germany, France, and the United Kingdom. In Japan, the au Jibun Bank Japan Composite PMI® improved minimally month over month, with the services component showing sequential improvement and the manufacturing component continuing to decline. We caution that a sharp snapback in diffusion indexes like PMIs may only reflect the bounce off of historically low levels (i.e., easy comparisons) rather than a significant improvement in absolute levels of activity. 

The MSCI World ex USA Index moved higher in May to 4.3%, extending its recovery from its late-March low after extensive action from central banks and new fiscal proposals helped lift the index. However, similar to the trend in US stocks, a deteriorating earnings outlook has lifted valuations for developed international equities to elevated levels. The NTM P/E for the MSCI World ex USA Index closed May at 16x, the highest level since May 2004. While recent stimulus initiatives have provided a boost to companies in the index, we believe a meaningful recovery in consumer demand and earnings is critical to sustaining current valuation levels (Chart 3).

International Valuations 10 Years Ended 5/31/20 (Chart 3)

View accesible version of chart 3

Source: FactSet® Research Systems Inc., PNC

In developed international fixed income markets, interest rates continued to stabilize after the Bank of Japan (BOJ) and the European Central Bank (ECB) announced further easing measures but left negative interest rate policies in place. That said, while the official policy rate was unchanged, the ECB effectively lowered rates up to 50 basis points by lowering the maximum discount on its Targeted Longer-Term Refinance Operations program for banks to facilitate lending.

In her statement, ECB President Christine Lagarde highlighted the need for greater fiscal accommodation from Eurozone countries after forecasting a 5-12% decline in Eurozone GDP in 2020, and she left the door open to additional central bank policy support as needed.

In Japan, the BOJ increased its commercial paper and corporate bond purchases to a combined ¥20 trillion and removed the ¥80 trillion quota for government bond purchases, as 10-year government bond yields climbed to 0.0% in May. Similar to the ECB, the BOJ also noted it will take additional easing measures as necessary.

Emerging Markets

Pop in oil prices not enough to offset rising Hong Kong tensions.

The MSCI Emerging Markets (EM) Index, at 0.8%, lagged most major global benchmarks for the month, as geopolitical issues negatively affected the EM Asia region. Relative to the ongoing rallies in both the S&P 500 and MSCI World ex-USA indexes, the EM Index struggled in May and has turned into the laggard for the year. Much of the underperformance continues to come from the Value index, which actually posted a negative return for the month of May.

As most countries began to lift COVID-19 quarantines, cases continued to ramp up in EM regions, especially in Brazil and Russia. Despite performance for the month that bested the S&P 500 and MSCI World ex-USA indexes, both Brazil and Russia (a combined 8% of the EM Index) saw new COVID-19 cases increase sharply during the month, putting the countries second and third, respectively, in terms of cases across the globe. That contrasts with India (also 8% of the EM Index), which has remained on a national lockdown since the last week of March, and the country index was down more than 2.6% for the month.

After the March OPEC+ meeting triggered a collapse in oil prices, the group agreed in April to curb production on a temporary basis, spurring a jump in Brent crude prices by approximately 40% in May. This move, along with gains in other commodity prices, was the primary driver of positive performance in energy-dependent countries such as Brazil and Russia. While the production cuts have moved Brent crude closer to Russia’s fiscal breakeven point of $40 per barrel, it is still well below Saudi Arabia’s fiscal breakeven point of approximately $80 per barrel, according to the International Monetary Fund. In our view, this breakeven dispersion along with discussions to resume prior production levels have the potential to create renewed tensions between these large OPEC+ members when the group meets again in the first week of June.

Despite performance challenges, we believe EM continues to have the strongest fundamental backdrop from an earnings perspective. Energy and Materials companies were negatively affected by the OPEC+ arrangement in the first quarter earnings season. However, as oil prices firm up, many of these companies are already back to a level of profitability. This is in stark contrast to US shale producers, which need an oil price of approximately $55 per barrel (West Texas Intermediate) to maintain historical operating budgets, according to Bloomberg data. The 2020 EPS growth estimate for EM is -10%, which continues to be the best growth rate on a relative basis across the globe. Furthermore, the 26% expected rebound in 2021 is on pace with the S&P 500 (Chart 4). This relatively better earnings growth outlook puts the NTM P/E for EM at 12.8x through the end of May, making its valuation quite reasonable relative to the United States and developed international peers.

Consensus Earnings Per Share Growth Estimates as of 5/31/20 (Chart 4)

View accessible version of chart 4

Source: FactSet Research Systems Inc., PNC

In our view, the biggest macro headwind for EM is the growing strain between Hong Kong and China. As we have written previously, Hong Kong is ruled under a “one country, two systems” principle.

However, in late May, mainland China passed a controversial national security law that some view as a move away from that long-held principle. As a result, on May 22 the Hang Seng Index had its worst one-day return since 2015. While Hong Kong is not classified as EM, 4% of the index is domiciled there. China was not unscathed from the headwinds either, as the country index was down 0.50% for the month. In spite of numerous macro headwinds, such as the Hong Kong situation, the ongoing investigation into Huawei Technologies Co.’s chief financial officer, and the COVID-19 outbreak, the MSCI China Index is only lagging the S&P 500 by six basis points year to date.

Dollar-denominated EM debt was the top-performing sector within fixed income during May, returning 4.6%. This helped the asset class recover more than two-thirds of its peak-to-trough decline from March, bringing the year-to-date return to -2.9%. The strong performance largely resulted from the recovery in oil prices, which benefited the commodity-heavy Middle Eastern and Latin American regions, making their short-term fiscal outlooks less tenuous. We continue to favor EM debt over the long term given the asset class’s attractive yields and exposure to regions experiencing higher economic growth compared to the developed world.

For more information, please contact your PNC advisor.



Chart 1: New US COVID-19 Cases — Seven-Day DMA 1/28/20-5/30/20 (view image of chart 1)

Date US Daily New COVID-19 Cases (7 DMA) US ex-NY Daily New COVID-19 Cases (7 DMA)
5/30/2020 21102 19711
5/27/2020 21154 19640
5/19/2020 22713 20662
5/11/2020 23942 21356
5/3/2020 27465 23412
4/25/2020 29138 22757
4/17/2020 28579 20564
4/9/2020 31546 21679
4/1/2020 21534 13936
3/24/2020 6656 3231
3/16/2020 524 406
3/8/2020 61 46
2/29/2020 4 4
2/21/2020 3 3
2/13/2020 0 0
2/5/2020 1 1
1/28/2020 1 0

Chart 2: Domestic Valuations 10 Years Ended 5/31/20 (view image of chart 2)

Date Russell 2000 S&P 500 S&P Mid Cap 400
1/29/2010 18.2x 13.1x 14.9x
1/31/2011 18.0x 12.8x 15.6x
1/31/2012 16.7x 12.0x 13.9x
1/31/2013 17.6x 13.0x 15.2x
1/31/2014 21.0x 14.5x 16.4x
1/30/2015 21.3x 16.1x 16.8x
1/29/2016 21.3x 15.5x 15.4x
1/31/2017 23.6x 17.1x 18.5x
1/31/2018 23.5x 18.0x 17.7x
1/31/2019 20.3x 15.8x 15.0x
1/31/2020 22.3x 18.1x 16.4x

Chart 3: International Valuations 10 Years Ended 5/31/20 (view image of chart 3)

Date MSCI World ex USA Small Cap MSCI World ex USA MSCI EM (Emerging Markets)
5/31/2010 14.5x 11.8x 10.5x
1/31/2011 14.1x 12.0x 11.2x
1/31/2012 12.1x 10.9x 10.0x
1/31/2013 14.5x 12.7x 10.4x
1/31/2014 15.2x 13.4x 9.6x
1/30/2015 15.4x 14.6x


1/29/2016 15.3x 13.8x 10.5x
1/31/2017 16.2x 14.8x 12.0x
1/31/2018 17.2x 15.0x 13.0x
1/31/2019 14.2x 12.7x 11.4x
1/31/2020 15.8x 14.4x 12.2x
5/29/2020 18.1x 16.0x 12.8x

Chart 4: Consensus Earnings Per Share Growth Estimates As of 5/31/20 (view image of chart 4)

  S&P 500 MSCI World ex USA MSCI Emerging Markets
2020 -21.7% -27.0% -10.0%
2021 28.3% 28.3% 26.1%