Investment Strategy Report - Wells Fargo Advisors - Jamie Waldren
WEEKLY GUIDANCE FROM OUR INVESTMENT STRATEGY COMMITTEE September 25, 2017
George Rusnak, CFA Co-Head of Global Fixed Income Strategy
Applying the Monetary Brakes—What Investors Should Know Key Takeaways
» The Federal Reserve (Fed) has announced that it will start trimming its balance sheet next month, and Federal Open Market Committee (FOMC) members expect a rate hike in December and three rate increases next year. The Fed clearly is “applying the brakes” on its unprecedented monetary easing; monetary tightening is underway. » The European Central Bank (ECB) also is expected to start planning to reduce its asset purchases later this year, and the Bank of England (BoE) may raise rates soon. Yet, the Bank of Japan (BoJ) remains fully committed to monetary easing.
What It May Mean for Investors
» Investors still can benefit in this environment of diverging central-bank policy, but greater caution, and more active monitoring of markets and positioning, likely will be needed. We recommend that investors remain broadly and globally diversified. In today’s report, we provide specific investment insights by asset class.
Asset Group Overviews Equities ............................ 4 Fixed Income ................ 5 Real Assets ..................... 6 Alternative Investments ................... 7
Developed-market central banks around the world have engaged in unprecedented monetary accommodation through interest rates and asset purchases. As developedmarket economies stabilize and strengthen, many central banks now are facing a more daunting challenge—removing this stimulus while avoiding an economic pullback or overheating. This stimulus reduction is complicated by the market distortions that may have been created by monetary easing. Citing strengthening economic conditions, the Fed has announced that it will start to trim its balance sheet in October. Most FOMC members expect the Fed to raise rates again in December. We believe that the U.S. is best positioned (among developedmarket central banks) to reduce its balance sheet and gradually raise interest rates without significant near-term economic impact.
Different Stages of Stimulus Four notable developed-market economies have implemented significant monetary stimulus and now are evaluating next steps.
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 1 of 8
Applying the Monetary Brakes—What Investors Should Know Japan: The BoJ remains fully on the accelerator in terms of monetary stimulus—with negative short-term rates, active quantitative easing (QE) through asset purchases, and a zero-percent 10-year sovereign bond yield target. We expect the BoJ to maintain this posture for the remainder of 2017 and in 2018. Eurozone: The ECB is soon expected to ease off the accelerator in its monetary stimulus. Although many Eurozone sovereign-bond interest rates remain negative, the ECB may initiate plans to reduce its QE asset purchases when it meets in October. (Alternatively, it may defer that decision until December.) We believe that the ECB will proceed cautiously in removing QE stimulus. This process could last throughout 2018 before the ECB addresses short-term rates. U.K.: The BoE may soon put the brakes on monetary stimulus by raising rates as early as this year (given the recent pickup in inflation). The BoE recently stated that “some withdrawal of monetary stimulus is likely to be appropriate over the coming months in order to return inflation sustainably to target.” We believe that the BoE could begin raising rates as soon as November, but this is likely to be a short-lived event and not necessarily the sign of a less accommodative strategy in the longer term. U.S.: The Fed has been tapping on the brakes of its stimulus by raising interest rates four times since late 2015. As we noted, the Fed has announced plans to begin reducing the size of its $4.5 trillion balance sheet starting in October. The process of winding down the Fed balance sheet could last for years to come.
Fed Balance Sheet Now Exceeds $4 Trillion—Trimming Begins Next Month $5,000 $4,500 $4,000
U.S. Dollars (in billions)
$3,500 $3,000 $2,500 $2,000 $1,500 $1,000 $500 $2002
2004
2006
2008
2010
2012
2014
2016
Source: Board of Governors of the Federal Reserve System, 9/20/17
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 2 of 8
Applying the Monetary Brakes—What Investors Should Know Market Distortions In international developed debt markets, we believe that negative short-term interest rates, combined with QE stimulus, have created some market distortions. It will be important for the ECB to address its QE tapering and eventual interest-rate increases carefully. Fixed-income markets tend to be forward-looking. There is a risk that a significant rise in European rates (in relative terms) may occur as markets begin to discount future ECB monetary-policy changes. This risk of a significant rise in European bond yields has been one of the factors leading us to underweight developedmarket debt.
Outcome and Market Impacts We believe that the BoJ is most heavily involved in monetary policy easing today in both magnitude and complexity. Given Japan’s demographic challenges, the BoJ likely will remain in a stimulative monetary posture for quite some time. The ECB and BoE face their own set of challenges. The ECB needs to evaluate multiple country data inputs and is likely to make monetary-policy decisions based on its weakest constituents. We believe that this approach will lead the ECB to a more gradual path of monetary-accommodation removal that could last for several years. Separately, the BoE needs to consider not only short-term inflation challenges, but also the longterm impacts of Brexit. We believe that many of the Brexit outcomes will present economic challenges for the U.K. It is possible that BoE rate increases prior to Brexit may need to be reversed once Brexit is completed (that is expected in March 2019). Finally, the Fed now is moving directionally toward a less-accommodative monetary policy. (Chair Yellen did signal last week that the Fed reserves the right to revert to a stimulative policy in the event of a market shock.) While we don’t believe that the U.S. is in danger of a significant and/or rapid rise in interest rates, we believe that a slight increase in rates is likely both this year and in 2018. Investors still can benefit in this environment, but greater caution, and more active monitoring of markets and positioning, likely will be needed. In today’s report, we provide some insight on this positioning by asset class.
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 3 of 8
EQUITIES
Sean Lynch, CFA Co-Head of Global Equity Strategy
Equity Markets Shrug Off Well-Telegraphed Fed Actions Underweight U.S. Small Cap Equities
Evenweight
U.S. Large Cap Equities
Evenweight
U.S. Mid Cap Equities
“Stocks Close Once Again at an All-time High!” This was a headline last week after the S&P 500 Index rose modestly following the latest Fed meeting. Both the Wells Fargo Investment Institute and consensus view is that the Fed will raise rates again in December. U.S. stocks have shrugged off the four previous interest-rates hikes, with the S&P 500 Index increasing by 500 points or 25 percent since the initial Fed rate increase. From the equity-market reaction last week, U.S. investors seem to believe that the fundamentals are strong enough to withstand additional Fed rate increases. Even more surprising is how emerging markets have fared over this Fed tightening cycle. In past cycles, equity markets were believed to handle the first increase (or two) in the fed funds rate, but problems would begin to mount when these increases began to stack on top of each other. Emerging equity markets have not only done well during the recent Fed moves, but since the second rate hike in December 2016, they have clearly led global equity-market returns. The MSCI Emerging Markets Index is up 31 percent year to date, helped along by a weakening dollar. Yet, even in local-currency terms, emerging equity markets have been one of the best performers. The biggest difference between current and past tightening cycles is the enormous amount of liquidity still in the system. Several central banks are signaling a change in philosophy, but this has not put much of a dent in the liquidity currently available. Additionally, the prescriptive Fed commentary has helped to prepare investors for additional rate hikes, and we do not see their well-telegraphed actions derailing the domestic equity bull market.
Key Takeaways Evenweight Developed Market Ex-U.S. Equities
» Emerging markets have done well during recent Fed moves, and since the second Fed rate hike in December 2016, they have led global equity markets. » The biggest difference between current and past tightening cycles is the extraordinary amount of liquidity still in the global financial system.
Equities Recently Have Risen Along With the Fed Funds Rate 130
120
Index Level (indexed at 100)
Evenweight Emerging Market Equities
2
1
3
4
110
100
90
80
70
60
Fed Rate Hike
S&P 500
MSCI Emerging Markets
Sources: Wells Fargo Investment Institute, Bloomberg; 9/21//17. Numbers in circles denote the sequence of rate hikes since the financial crisis. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 4 of 8
FIXED INCOME
Brian Rehling, CFA Co-Head of Global Fixed Income Strategy
The Fed Starts Shrinking Its Balance Sheet
Underweight
High Yield Taxable Fixed Income
Underweight
Developed Market Ex.-U.S. Fixed Income
Evenweight
U.S. Short Term Taxable Fixed Income
Evenweight
U.S. Long Term Taxable Fixed Income
Finally—it was announced at last week’s FOMC meeting that the Fed will begin the long process of shrinking its balance sheet. We do not expect the initiation of balance-sheet reduction to have a material impact on the bond market. The Fed will not sell bonds outright. Rather, it simply will decrease the total reinvestment of maturing positions. Beginning in October, the Fed will reduce its Treasury purchases by $6 billion per month and mortgage-backed-security purchases by $4 billion per month. We expect that the Fed will increase the roll-off every quarter, until it reaches $30 billion in monthly Treasury security reductions and $20 billion in monthly mortgage-backed-security reductions. The Fed’s balance sheet stood near $800 billion before the initiation of quantitative easing in 2008. After the Fed had announced three separate rounds of bond purchases, its balance sheet ballooned to its current size of $4.5 trillion. The balance sheet is primarily made up of Treasury and mortgage-backed securities. Going forward, we anticipate that the Fed will maintain a much larger normalized balance sheet than it did before the financial crisis. Under a modest economic-growth scenario, we foresee the Fed balance sheet slowly decreasing to a size of $2.5 - $3 trillion over the next several years—at which point it would be considered normalized. We believe the current timing works well. In 2018, maturing Treasury securities should spike to more than $425 billion. As a result, even if the full balance-sheet-reduction plan is implemented, the Fed will buy more Treasury securities through its reinvestment program in 2018 than it did in 2017. This peak in maturing bonds should help to limit the market impact of balance-sheet reduction at this time.
Key Takeaways » We do not expect balance-sheet reduction to have a material bond-market impact.
Evenweight
Emerging Market Fixed Income
» The Fed intends for balance-sheet reduction to be a passive process and not a primary tool for implementing monetary policy. » We recommend that investors stay the course and do not change fixed-income strategy as a result of upcoming Fed balance-sheet-reduction operations.
The Fed’s Balance Sheet—Maturing Treasury Securities Spike in 2018 700
Overweight
Overweight
U.S. Intermediate Term Taxable Fixed Income
600
U.S. Dollars (in Billions)
U.S. Taxable Investment Grade Fixed Income
500 400 300 200 100 2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027 and Beyond
Source: Federal Reserve, 9/20/17. The 2017 total is as of January 1, 2017. All other data is as of September 20, 2017. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 5 of 8
REAL ASSETS
John LaForge
“I’ve learned that people will forget what you said, people will forget what what you did, but people will never forget how you made them feel.”
Head of Real Asset Strategy
--Maya Angelou
Real Estate—Performing and Still Cheap
Commodities
The Global REIT Index that we follow (FTSE EPRA/NAREIT Developed Index) has gained 8.3 percent since we upgraded the asset class to overweight on January 3, 2017. While real estate investment trusts (REITs) are not the best-performing major asset class to date in 2017—that distinction belongs to equities—an 8.3 percent gain from early January through most of September is pretty good.
Evenweight
Importantly, we still see REITs as an asset class to overweight as we approach 2018. Year-over-year commercial real estate price gains continue to chug along in the midsingle-digit range. On top of that, REITs look like good values, even after the nice yearto-date move. As the chart below shows, REITs trade at a discount of roughly 2.5 percent from the value of their underlying real-estate holdings. The horizontal dashed green line shows that since 1990, REITs typically have traded at a 2.6 percent premium to their underlying real-estate holdings.
Overweight
Although REITs are considered a “yield investment,” leading some to conclude that they will underperform in periods of monetary tightening and rising rates, history has shown that REITs have performed well during periods of gradually rising rates that also are supported by strengthening economic growth. This environment tends to coincide with better REIT fundamentals. We believe that all of these conditions exist today.
Underweight
Private Real Estate
Public Real Estate
Although we have recently voiced our concerns that real estate may be in the later stages of its expansion, we do not believe that the cycle is over. We continue to recommend an overweight position for REITs.
Key Takeaways » REITs have had a good run in 2017, yet remain relatively “cheap.” » We continue to recommend an overweight position.
Equity REITs: Premium to Net Asset Value All REITs Premium to NAV Median
35% 25%
NAV Premium
15% 5% -5% -15% -25% -35% -45% 1990
1993
1996
1999
2002
2005
2008
2011
2014
2017
Sources: Green Street Advisors, Wells Fargo Investment Institute. Monthly Data: 2/1/1990 - 9/1/2017. All REITs’ Premium to NAV is a weighted average (weighted by NAV shares outstanding) of all US-listed companies in Green Street's coverage universe, excluding Hotels and those without a published opinion. Dates selected to show all available data from source.
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 6 of 8
ALTERNATIVE INVESTMENTS
Justin Lenarcic Global Alternative Investment Strategist
Balance Sheet Runoff Could Benefit Security Selection
Evenweight
Private Debt
Evenweight
Hedge Funds-Macro
Evenweight
Hedge Funds-Event Driven
Overweight
Hedge Funds-Relative Value
Hedge Funds-Equity Hedge Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not suitable for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.
Key Takeaways » We believe that the Fed’s massive injection of liquidity into U.S. markets posed a significant challenge for hedge funds, and active management in general. » We expect the gradual reduction of the Fed’s balance sheet to foster a stronger environment for security selection.
Equity Correlations versus Federal Reserve Balance Sheet 0.9
28 26
0.8
24 0.7
22
0.6
20 18
0.5
16 0.4
0.3 Dec-08
14
Federal Reserve Balance Sheet as % of GDP
Overweight
While the Fed’s balance sheet as a percentage of GDP remains elevated at 23.1 percent, we expect a steady reduction in liquidity, with the anticipated balance sheet runoff program only serving to expedite the process. Though we are in the early days of a new “era” for post-crisis monetary policy, we find it interesting to see the rather significant decline in equity correlations that has coincided with news of Fed balance-sheet runoff plans (which the market began discussing in late 2016). Although the actual impact of a significantly smaller Fed balance sheet has not yet been felt, we believe that the prospect of tighter liquidity and a Fed slowly removing its imprint on markets can be a driving force for an improved environment for security selection. Furthermore, we expect an increase in fixed-income volatility to provide trading opportunities for Relative Value strategies.
65-Day Correlation of S&P 500 Constituents
Evenweight
Private Equity
We believe that Fed QE may prove to be a key reason why many hedge funds have underperformed passive equity indices since 2011. The expansion of the Fed’s balance sheet from 17.4 percent of U.S. gross domestic product (“GDP”) in September 2012 to 25.7 percent of GDP in October 2014, posed a significant challenge to strategies driven by security selection. A concurrent reduction of both interest rates and volatility to historically low levels led to higher correlations among equities. It has been extremely difficult to be a stock picker in such an environment.
12 Dec-09
Dec-10
Dec-11
65-Day Correlation (Left Axis) QE TAPERING PERIOD
Dec-12
Dec-13
Dec-14
Dec-15
Dec-16
Federal Reserve Balance Sheet as a % of GDP (Right Axis) FED ANNOUNCES BALANCE SHEET RUNOFF
Sources: Federal Reserve, Strategas Research Partners, 9/17. Correlation represents past performance. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment.
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 7 of 8
Risks Considerations Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions. Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing. Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.
Definitions An index is unmanaged and not available for direct investment. FTSE EPRA/NAREIT Developed Index is designed to track the performance of listed real-estate companies and REITs in developed countries worldwide. MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of 23 emerging markets. S&P 500 Index is a capitalization-weighted index calculated on a total return basis with dividends reinvested. The index includes 500 widely held U.S. market industrial, utility, transportation and financial companies.
General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR 0917-03830. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 8 of 8
George Rusnak, CFA Co-Head of Global Fixed Income Strategy
Applying the Monetary Brakes—What Investors Should Know Key Takeaways
» The Federal Reserve (Fed) has announced that it will start trimming its balance sheet next month, and Federal Open Market Committee (FOMC) members expect a rate hike in December and three rate increases next year. The Fed clearly is “applying the brakes” on its unprecedented monetary easing; monetary tightening is underway. » The European Central Bank (ECB) also is expected to start planning to reduce its asset purchases later this year, and the Bank of England (BoE) may raise rates soon. Yet, the Bank of Japan (BoJ) remains fully committed to monetary easing.
What It May Mean for Investors
» Investors still can benefit in this environment of diverging central-bank policy, but greater caution, and more active monitoring of markets and positioning, likely will be needed. We recommend that investors remain broadly and globally diversified. In today’s report, we provide specific investment insights by asset class.
Asset Group Overviews Equities ............................ 4 Fixed Income ................ 5 Real Assets ..................... 6 Alternative Investments ................... 7
Developed-market central banks around the world have engaged in unprecedented monetary accommodation through interest rates and asset purchases. As developedmarket economies stabilize and strengthen, many central banks now are facing a more daunting challenge—removing this stimulus while avoiding an economic pullback or overheating. This stimulus reduction is complicated by the market distortions that may have been created by monetary easing. Citing strengthening economic conditions, the Fed has announced that it will start to trim its balance sheet in October. Most FOMC members expect the Fed to raise rates again in December. We believe that the U.S. is best positioned (among developedmarket central banks) to reduce its balance sheet and gradually raise interest rates without significant near-term economic impact.
Different Stages of Stimulus Four notable developed-market economies have implemented significant monetary stimulus and now are evaluating next steps.
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 1 of 8
Applying the Monetary Brakes—What Investors Should Know Japan: The BoJ remains fully on the accelerator in terms of monetary stimulus—with negative short-term rates, active quantitative easing (QE) through asset purchases, and a zero-percent 10-year sovereign bond yield target. We expect the BoJ to maintain this posture for the remainder of 2017 and in 2018. Eurozone: The ECB is soon expected to ease off the accelerator in its monetary stimulus. Although many Eurozone sovereign-bond interest rates remain negative, the ECB may initiate plans to reduce its QE asset purchases when it meets in October. (Alternatively, it may defer that decision until December.) We believe that the ECB will proceed cautiously in removing QE stimulus. This process could last throughout 2018 before the ECB addresses short-term rates. U.K.: The BoE may soon put the brakes on monetary stimulus by raising rates as early as this year (given the recent pickup in inflation). The BoE recently stated that “some withdrawal of monetary stimulus is likely to be appropriate over the coming months in order to return inflation sustainably to target.” We believe that the BoE could begin raising rates as soon as November, but this is likely to be a short-lived event and not necessarily the sign of a less accommodative strategy in the longer term. U.S.: The Fed has been tapping on the brakes of its stimulus by raising interest rates four times since late 2015. As we noted, the Fed has announced plans to begin reducing the size of its $4.5 trillion balance sheet starting in October. The process of winding down the Fed balance sheet could last for years to come.
Fed Balance Sheet Now Exceeds $4 Trillion—Trimming Begins Next Month $5,000 $4,500 $4,000
U.S. Dollars (in billions)
$3,500 $3,000 $2,500 $2,000 $1,500 $1,000 $500 $2002
2004
2006
2008
2010
2012
2014
2016
Source: Board of Governors of the Federal Reserve System, 9/20/17
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 2 of 8
Applying the Monetary Brakes—What Investors Should Know Market Distortions In international developed debt markets, we believe that negative short-term interest rates, combined with QE stimulus, have created some market distortions. It will be important for the ECB to address its QE tapering and eventual interest-rate increases carefully. Fixed-income markets tend to be forward-looking. There is a risk that a significant rise in European rates (in relative terms) may occur as markets begin to discount future ECB monetary-policy changes. This risk of a significant rise in European bond yields has been one of the factors leading us to underweight developedmarket debt.
Outcome and Market Impacts We believe that the BoJ is most heavily involved in monetary policy easing today in both magnitude and complexity. Given Japan’s demographic challenges, the BoJ likely will remain in a stimulative monetary posture for quite some time. The ECB and BoE face their own set of challenges. The ECB needs to evaluate multiple country data inputs and is likely to make monetary-policy decisions based on its weakest constituents. We believe that this approach will lead the ECB to a more gradual path of monetary-accommodation removal that could last for several years. Separately, the BoE needs to consider not only short-term inflation challenges, but also the longterm impacts of Brexit. We believe that many of the Brexit outcomes will present economic challenges for the U.K. It is possible that BoE rate increases prior to Brexit may need to be reversed once Brexit is completed (that is expected in March 2019). Finally, the Fed now is moving directionally toward a less-accommodative monetary policy. (Chair Yellen did signal last week that the Fed reserves the right to revert to a stimulative policy in the event of a market shock.) While we don’t believe that the U.S. is in danger of a significant and/or rapid rise in interest rates, we believe that a slight increase in rates is likely both this year and in 2018. Investors still can benefit in this environment, but greater caution, and more active monitoring of markets and positioning, likely will be needed. In today’s report, we provide some insight on this positioning by asset class.
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 3 of 8
EQUITIES
Sean Lynch, CFA Co-Head of Global Equity Strategy
Equity Markets Shrug Off Well-Telegraphed Fed Actions Underweight U.S. Small Cap Equities
Evenweight
U.S. Large Cap Equities
Evenweight
U.S. Mid Cap Equities
“Stocks Close Once Again at an All-time High!” This was a headline last week after the S&P 500 Index rose modestly following the latest Fed meeting. Both the Wells Fargo Investment Institute and consensus view is that the Fed will raise rates again in December. U.S. stocks have shrugged off the four previous interest-rates hikes, with the S&P 500 Index increasing by 500 points or 25 percent since the initial Fed rate increase. From the equity-market reaction last week, U.S. investors seem to believe that the fundamentals are strong enough to withstand additional Fed rate increases. Even more surprising is how emerging markets have fared over this Fed tightening cycle. In past cycles, equity markets were believed to handle the first increase (or two) in the fed funds rate, but problems would begin to mount when these increases began to stack on top of each other. Emerging equity markets have not only done well during the recent Fed moves, but since the second rate hike in December 2016, they have clearly led global equity-market returns. The MSCI Emerging Markets Index is up 31 percent year to date, helped along by a weakening dollar. Yet, even in local-currency terms, emerging equity markets have been one of the best performers. The biggest difference between current and past tightening cycles is the enormous amount of liquidity still in the system. Several central banks are signaling a change in philosophy, but this has not put much of a dent in the liquidity currently available. Additionally, the prescriptive Fed commentary has helped to prepare investors for additional rate hikes, and we do not see their well-telegraphed actions derailing the domestic equity bull market.
Key Takeaways Evenweight Developed Market Ex-U.S. Equities
» Emerging markets have done well during recent Fed moves, and since the second Fed rate hike in December 2016, they have led global equity markets. » The biggest difference between current and past tightening cycles is the extraordinary amount of liquidity still in the global financial system.
Equities Recently Have Risen Along With the Fed Funds Rate 130
120
Index Level (indexed at 100)
Evenweight Emerging Market Equities
2
1
3
4
110
100
90
80
70
60
Fed Rate Hike
S&P 500
MSCI Emerging Markets
Sources: Wells Fargo Investment Institute, Bloomberg; 9/21//17. Numbers in circles denote the sequence of rate hikes since the financial crisis. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 4 of 8
FIXED INCOME
Brian Rehling, CFA Co-Head of Global Fixed Income Strategy
The Fed Starts Shrinking Its Balance Sheet
Underweight
High Yield Taxable Fixed Income
Underweight
Developed Market Ex.-U.S. Fixed Income
Evenweight
U.S. Short Term Taxable Fixed Income
Evenweight
U.S. Long Term Taxable Fixed Income
Finally—it was announced at last week’s FOMC meeting that the Fed will begin the long process of shrinking its balance sheet. We do not expect the initiation of balance-sheet reduction to have a material impact on the bond market. The Fed will not sell bonds outright. Rather, it simply will decrease the total reinvestment of maturing positions. Beginning in October, the Fed will reduce its Treasury purchases by $6 billion per month and mortgage-backed-security purchases by $4 billion per month. We expect that the Fed will increase the roll-off every quarter, until it reaches $30 billion in monthly Treasury security reductions and $20 billion in monthly mortgage-backed-security reductions. The Fed’s balance sheet stood near $800 billion before the initiation of quantitative easing in 2008. After the Fed had announced three separate rounds of bond purchases, its balance sheet ballooned to its current size of $4.5 trillion. The balance sheet is primarily made up of Treasury and mortgage-backed securities. Going forward, we anticipate that the Fed will maintain a much larger normalized balance sheet than it did before the financial crisis. Under a modest economic-growth scenario, we foresee the Fed balance sheet slowly decreasing to a size of $2.5 - $3 trillion over the next several years—at which point it would be considered normalized. We believe the current timing works well. In 2018, maturing Treasury securities should spike to more than $425 billion. As a result, even if the full balance-sheet-reduction plan is implemented, the Fed will buy more Treasury securities through its reinvestment program in 2018 than it did in 2017. This peak in maturing bonds should help to limit the market impact of balance-sheet reduction at this time.
Key Takeaways » We do not expect balance-sheet reduction to have a material bond-market impact.
Evenweight
Emerging Market Fixed Income
» The Fed intends for balance-sheet reduction to be a passive process and not a primary tool for implementing monetary policy. » We recommend that investors stay the course and do not change fixed-income strategy as a result of upcoming Fed balance-sheet-reduction operations.
The Fed’s Balance Sheet—Maturing Treasury Securities Spike in 2018 700
Overweight
Overweight
U.S. Intermediate Term Taxable Fixed Income
600
U.S. Dollars (in Billions)
U.S. Taxable Investment Grade Fixed Income
500 400 300 200 100 2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027 and Beyond
Source: Federal Reserve, 9/20/17. The 2017 total is as of January 1, 2017. All other data is as of September 20, 2017. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 5 of 8
REAL ASSETS
John LaForge
“I’ve learned that people will forget what you said, people will forget what what you did, but people will never forget how you made them feel.”
Head of Real Asset Strategy
--Maya Angelou
Real Estate—Performing and Still Cheap
Commodities
The Global REIT Index that we follow (FTSE EPRA/NAREIT Developed Index) has gained 8.3 percent since we upgraded the asset class to overweight on January 3, 2017. While real estate investment trusts (REITs) are not the best-performing major asset class to date in 2017—that distinction belongs to equities—an 8.3 percent gain from early January through most of September is pretty good.
Evenweight
Importantly, we still see REITs as an asset class to overweight as we approach 2018. Year-over-year commercial real estate price gains continue to chug along in the midsingle-digit range. On top of that, REITs look like good values, even after the nice yearto-date move. As the chart below shows, REITs trade at a discount of roughly 2.5 percent from the value of their underlying real-estate holdings. The horizontal dashed green line shows that since 1990, REITs typically have traded at a 2.6 percent premium to their underlying real-estate holdings.
Overweight
Although REITs are considered a “yield investment,” leading some to conclude that they will underperform in periods of monetary tightening and rising rates, history has shown that REITs have performed well during periods of gradually rising rates that also are supported by strengthening economic growth. This environment tends to coincide with better REIT fundamentals. We believe that all of these conditions exist today.
Underweight
Private Real Estate
Public Real Estate
Although we have recently voiced our concerns that real estate may be in the later stages of its expansion, we do not believe that the cycle is over. We continue to recommend an overweight position for REITs.
Key Takeaways » REITs have had a good run in 2017, yet remain relatively “cheap.” » We continue to recommend an overweight position.
Equity REITs: Premium to Net Asset Value All REITs Premium to NAV Median
35% 25%
NAV Premium
15% 5% -5% -15% -25% -35% -45% 1990
1993
1996
1999
2002
2005
2008
2011
2014
2017
Sources: Green Street Advisors, Wells Fargo Investment Institute. Monthly Data: 2/1/1990 - 9/1/2017. All REITs’ Premium to NAV is a weighted average (weighted by NAV shares outstanding) of all US-listed companies in Green Street's coverage universe, excluding Hotels and those without a published opinion. Dates selected to show all available data from source.
© 2017 Wells Fargo Investment Institute. All rights reserved.
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ALTERNATIVE INVESTMENTS
Justin Lenarcic Global Alternative Investment Strategist
Balance Sheet Runoff Could Benefit Security Selection
Evenweight
Private Debt
Evenweight
Hedge Funds-Macro
Evenweight
Hedge Funds-Event Driven
Overweight
Hedge Funds-Relative Value
Hedge Funds-Equity Hedge Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not suitable for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.
Key Takeaways » We believe that the Fed’s massive injection of liquidity into U.S. markets posed a significant challenge for hedge funds, and active management in general. » We expect the gradual reduction of the Fed’s balance sheet to foster a stronger environment for security selection.
Equity Correlations versus Federal Reserve Balance Sheet 0.9
28 26
0.8
24 0.7
22
0.6
20 18
0.5
16 0.4
0.3 Dec-08
14
Federal Reserve Balance Sheet as % of GDP
Overweight
While the Fed’s balance sheet as a percentage of GDP remains elevated at 23.1 percent, we expect a steady reduction in liquidity, with the anticipated balance sheet runoff program only serving to expedite the process. Though we are in the early days of a new “era” for post-crisis monetary policy, we find it interesting to see the rather significant decline in equity correlations that has coincided with news of Fed balance-sheet runoff plans (which the market began discussing in late 2016). Although the actual impact of a significantly smaller Fed balance sheet has not yet been felt, we believe that the prospect of tighter liquidity and a Fed slowly removing its imprint on markets can be a driving force for an improved environment for security selection. Furthermore, we expect an increase in fixed-income volatility to provide trading opportunities for Relative Value strategies.
65-Day Correlation of S&P 500 Constituents
Evenweight
Private Equity
We believe that Fed QE may prove to be a key reason why many hedge funds have underperformed passive equity indices since 2011. The expansion of the Fed’s balance sheet from 17.4 percent of U.S. gross domestic product (“GDP”) in September 2012 to 25.7 percent of GDP in October 2014, posed a significant challenge to strategies driven by security selection. A concurrent reduction of both interest rates and volatility to historically low levels led to higher correlations among equities. It has been extremely difficult to be a stock picker in such an environment.
12 Dec-09
Dec-10
Dec-11
65-Day Correlation (Left Axis) QE TAPERING PERIOD
Dec-12
Dec-13
Dec-14
Dec-15
Dec-16
Federal Reserve Balance Sheet as a % of GDP (Right Axis) FED ANNOUNCES BALANCE SHEET RUNOFF
Sources: Federal Reserve, Strategas Research Partners, 9/17. Correlation represents past performance. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment.
© 2017 Wells Fargo Investment Institute. All rights reserved.
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Risks Considerations Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions. Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing. Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.
Definitions An index is unmanaged and not available for direct investment. FTSE EPRA/NAREIT Developed Index is designed to track the performance of listed real-estate companies and REITs in developed countries worldwide. MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of 23 emerging markets. S&P 500 Index is a capitalization-weighted index calculated on a total return basis with dividends reinvested. The index includes 500 widely held U.S. market industrial, utility, transportation and financial companies.
General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR 0917-03830. © 2017 Wells Fargo Investment Institute. All rights reserved.
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