Investment Strategy Report - Wells Fargo Advisors - Jamie Waldren
WEEKLY GUIDANCE FROM OUR INVESTMENT STRATEGY COMMITTEE November 13, 2017
Equity Valuations Matter—But We Don’t See a Bubble Sean Lynch, CFA Co-Head of Global Equity Strategy
Key Takeaways
» Market valuations typically expand throughout the business cycle, before falling as recession looms. U.S. equity-market valuations, such as price/earnings (P/E) ratios, could remain stretched for an extended period of time. » Elevated P/E ratios are a tough predictor for near-term market direction, especially late in the cycle. They are better longer-term market predictors.
What It May Mean for Investors
» We believe that international valuations have more room to expand than U.S. equity valuations do. We favor international equity markets (over U.S. markets) today.
Asset Group Overviews Equities ............................ 4 Fixed Income ................ 5 Real Assets ..................... 6 Alternative Investments ................... 7
The S&P 500 Index is likely to be up for the ninth consecutive year in 2017—and it has delivered gains in 12 consecutive months for only the third time in 90 years. Emerging equity markets, as represented by the MSCI Emerging Markets Index, have returned 34 percent year to date (YTD), while developed equity markets, as represented by the MSCI EAFE Index, have returned 22 percent YTD. With these gains, equity valuations have risen—but not to levels that should warrant broad-based selling of equities. This year’s gains have stemmed primarily from stronger earnings (less so from expanded valuations). We also believe that elevated P/E ratios are a tough predictor for near-term market direction, especially late in the business cycle. They are better longer-term predictors late in the cycle. Our view is that earnings will have to do the heavy lifting in U.S. equity markets for further gains to be achieved. Valuations may be slow to expand as inflation levels gradually increase, along with interest rates. International markets may have a few more levers to pull to achieve higher equity valuations. Namely, international markets are at a different part of the business and economic cycle than U.S. markets are. Further, some long-term drivers, such as improved corporate governance and an increased technology-sector focus, may result in higher valuations abroad.
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 1 of 9
Equity Valuations Matter—But We Don’t See a Bubble Price/Earnings Ratios: U.S. and International Equities 30
Forward Price to Earnings Ratio
25
20
10 Year Average: 15.5
15
10 Year Average: 13.9 10 Year Average: 12.1 10
5 S&P 500: 19.4x
MSCI EAFE (Developed Markets): 15.1x
MSCI Emerging Markets: 12.8x
Sources: Bloomberg, Wells Fargo Investment Institute, 11/9/17. The forward price to earnings ratio is the ratio of a company's stock price at a given time divided by its projected earnings.
Fundamentals Improve This year has been a pivotal one for underlying equity-market fundamentals. With valuations hovering near 10-year highs, and with a backdrop of rising bond yields and Federal Reserve (Fed) rate increases, it has been crucial for companies to show that the potential for further earnings gains remains. The business cycle continues to move along—and with the possibility of tax reform—it could be extended even longer. Market valuations typically expand throughout the cycle, before falling as recession looms. One saying we use for equity markets is that “high valuations can persist for long periods of time.” It is bubbles that get popped, and our belief is that we are not in an equity bubble today. While currently elevated valuations may confound some investors, we believe that valuations could remain stretched for an extended period of time (with periodic corrections).
International Valuations We believe that valuations in international equity markets could expand from current levels. In emerging markets, this is due to the changing composition of the major indices. More focus on technology and less focus on commodities can lead to stronger and more predictable earnings growth. This could result in investors “paying more” for these markets than they have historically. In developed markets, we are finally seeing earnings guidance revised steadily higher (as this year has advanced). This is the first time that we have seen this development in six years. Stronger earnings growth in Japan, and a perception that we are through the European debt crisis, eventually could result in higher valuations for the MSCI EAFE Index. Several factors have led us to a more favorable view of international equity markets than U.S. stock markets today. These include valuations, earnings momentum, and sentiment. One wrinkle that could cause us to adjust that strong preference today would be major tax reform in the United States. This development could substantially benefit U.S. earnings and may extend the domestic business cycle even further. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 2 of 9
Equity Valuations Matter—But We Don’t See a Bubble Valuations: U.S. and International Equities Current
Markets
Broad Markets S&P 500 INDEX MSCI EAFE MSCI EM Developed Markets MSCI JAPAN MSCI FRANCE MSCI GERMANY MSCI UK Emerging Markets MSCI BRAZIL MSCI CHINA MSCI INDIA MSCI KOREA
Rolling 10-Year Average Forward Forward Forward Forward Forward Forward Price to Price to Price to Price to Price to Price to Cash Cash Equity Book Equity Book Flow Flow 19.4 15.1 12.8
3.2 1.8 1.8
14.0 9.3 7.9
15.5 13.9 12.1
2.3 1.5 1.6
10.3 7.8 7.4
15.3 16.6 15.4 14.7
1.5 1.7 1.9 1.9
12.8 5.8 7.7 12.4
18.3 13.3 12.4 12.8
1.2 1.4 1.5 1.7
6.8 7.4 7.2 8.0
14.1 15.6 21.1 10.2
1.7 2.1 3.1 1.2
11.2 5.7 25.0 6.8
12.0 11.9 17.0 10.6
1.6 1.7 2.6 1.2
7.0 8.0 12.1 5.7
Bolded valuations are undervalued relative to history. Sources: Bloomberg, Wells Fargo Investment Institute, 11/9/17.
Investment Implications Valuations, in particular, P/E multiples, capture market sentiment. Higher P/E multiples reflect improved investor confidence in the earnings outlook for major equity markets. Yet, in isolation, a P/E multiple does not say much. It is essential to analyze P/E ratios on a relative basis, and understand those relative differences. While a measure like a P/E ratio may seem simple, the more one knows about this valuation measure, the more complicated it becomes. I like to say that a three-hour baseball game may seem boring to a casual observer, but the more you know about the game and the decisions being made, the more interesting it can become. The same dynamic can apply to the equity-valuation landscape. Throughout 2017, we have not been calling for an end to the domestic cyclical bull market. Earnings continue to support the market, but we do believe that U.S. equity markets are due for a modest correction. Despite strong gains this year, we see little reason for international stock markets to experience a major pullback. We remain fully allocated toward our strategic equity targets in U.S large- and mid-cap equities, as well as in emerging and developed equity markets. (We are underweight U.S. small-cap equities.) It should be noted that we have raised this strategic allocation toward largecap equities, and equities overall, quite substantially over the past few years. Across all investment objectives, our strategic allocation has increased by 4 percent for U.S. largecap equities and 4.9 percent for all equities, over the past five years. We believe that interest rates are a potential risk for equity investors to monitor going forward. As the Fed prepares to raise rates in December and to continue along that path in 2018, and as the European Central Bank (ECB) embarks on its asset-purchase tapering program, interest rates may come under pressure (that is, they may rise as monetary policy is normalized and inflation rises). As Berkshire Hathaway Chairman Warren Buffett said at the company’s 2017 annual meeting, “the most important item for a stock valuation over time is interest rates.” We are not calling for materially higher interest rates in 2018, but any missteps by central banks, and the expectation for higher interest rates, may pressure domestic equity valuations. Nevertheless, in the longer term, valuations may remain stretched for a while longer. Valuation matters, but it is a better longer-term predictor late in the business cycle. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 3 of 9
EQUITIES
Stuart Freeman, CFA Co-Head of Global Equity Strategy
Manufacturing Showing Healthy Signs of Later-Cycle Growth Underweight U.S. Small Cap Equities
Evenweight U.S. Large Cap Equities
Evenweight
U.S. Mid Cap Equities
Evenweight Developed Market Ex-U.S. Equities
The Institute for Supply Management (ISM) reports monthly on the strength of the manufacturing economy (their purchasing managers’ index, or PMI). This number represents polling of purchasing managers in 18 manufacturing industries on the strength of their businesses. A reading over 50 percent generally represents growth in the manufacturing economy. It is relatively rare for the manufacturing PMI to register a level of 60 percent or higher. It only has done so in 19 months—from January 1980 to today (see chart). Yet, in September 2017, it reached 60.8 percent. Looking back into the 1980s, we wanted to see how the S&P 500 Index performed in months following an ISM manufacturing index reading of 60 percent or higher. Although a 60-percent index level suggests strong manufacturing growth, it tends to be followed by tepid equity-market returns over the following three and six months (historically). On average, the S&P 500 Index has declined by 2.2 and 1.0 percent, respectively, in the next three- and six-month periods. This is interesting, but it hardly defines a bear market. We are noting increasingly stronger signs of industrial-order growth and global capital expenditures, which is typical in the latter portions of a cycle. This is positive for job growth and wages. It does not concern us that the S&P 500 Index frequently has been flat to modestly lower in months following a PMI of 60 or above. Such reports often are met with very positive market reactions, followed by periods of simple market consolidation.
Key Takeaways » Manufacturing data is showing more persistent growth, as reflected in the ISM’s atypically strong manufacturing PMI in September 2017. » The U.S. equity market tends to respond favorably to very strong later-cycle manufacturing data. Yet, it often consolidates for a few months following that report.
ISM Manufacturing Index—The Stronger the Better? 80
Evenweight
70
ISM Manufacturing Index
Emerging Market Equities
60 50 40 30 20 '80
'82
'84
'86
'88
'90
'92 '94 '96 '98 ISM Manufacturing
'00
'02 '04 '06 Level Threshold
'08
'10
'12
'14
'16
Sources: Wells Fargo Investment Institute, Bloomberg; 11/8/17 © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 4 of 9
FIXED INCOME
Brian Rehling, CFA Co-Head of Global Fixed Income Strategy
High Yield—High Valuation Underweight
High Yield Taxable Fixed Income
Underweight
Developed Market Ex.-U.S. Fixed Income
It is difficult to find any valuation metric that would classify high-yield debt as inexpensive, or cheap, today. Rather, most valuation measures show that the high-yield bond class now is quite expensive. Credit spreads (over Treasury security yields) for the Bloomberg Barclays U.S. Corporate High Yield Index currently stand near 340 basis points (3.40 percent), down 60 basis points since the beginning of this year. 1 The 10year average spread level of the Bloomberg Barclays U.S. Corporate High Yield Index is 610 basis points (6.1 percent). The lowest (or “most expensive”) credit spreads have been in this economic cycle is 323 basis points (3.23 percent) on June 23, 2014. As credit spreads tighten (decline), valuations increase—all else being equal. The opposite occurs as spreads widen or increase. Within the fixed-income asset class, and within the overall investment universe, we believe that better risk-adjusted return opportunities present themselves today.
Portfolio Implications Evenweight
We recommend that fixed-income investors move up in credit quality while minimizing exposure to lower-quality issuers. Given the substantial rise in high-yield debt valuations in recent quarters, we do not believe that “chasing” the added yield is worth the additional risk (given our view that the upside potential of this debt class is currently quite limited). We recommend that investors take profits in high-yield allocations and underweight the high-yield bond class.
Evenweight
Key Takeaways
U.S. Short Term Taxable Fixed Income
U.S. Long Term Taxable Fixed Income
» At current valuations, we believe that the high-yield debt class offers an asymmetric risk profile, with limited upside potential and meaningful downside risk. » We believe that a strong economic scenario that supports high-yield valuations also is likely to provide equity investors with better return potential.
Evenweight
Emerging Market Fixed Income
» We recommend that investors take profits in high-yield allocations and underweight the high-yield bond class going forward.
Credit Spreads: Bloomberg Barclays U.S. Corporate High Yield Index
Overweight
U.S. Taxable Investment Grade Fixed Income
Overweight
U.S. Intermediate Term Taxable Fixed Income
Bloomberg Barclays U.S. Corporate High Yield Index Basis Points
25
20
15
10
5
0 May-07
May-08
May-09
May-10
May-11
May-12
May-13
May-14
May-15
May-16
May-17
Sources: Wells Fargo Investment Institute, Bloomberg; 11/8/17 1 One hundred basis points equal one percent. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 5 of 9
REAL ASSETS
John LaForge
“Good judgment comes from experience, and experience usually comes from bad judgment.” - Anonymous
Head of Real Asset Strategy
Oil—Why We Are Staying the Course Underweight
Commodities
Evenweight
Private Real Estate
Overweight
Public Real Estate
For most of 2017, West Texas Intermediate (WTI) crude-oil prices have behaved— staying within our year-end target range of $40-$50 per barrel. Yet, recently, this has changed. WTI traded as high as $57 last week—at a time when oil prices typically fade. WTI’s move to the mid-$50s can be blamed on OPEC’s (Organization of the Petroleum Exporting Countries) production cut saber-rattling, Saudi Arabia arrests, and a more balanced global supply/demand picture. So, are we changing our targets? The answer is no. There is always the possibility that we may have to, but we aren’t at that point yet. While WTI recently has been on a tear, we need to keep the long term in perspective. We believe that oil prices remain stuck inside a bear market super-cycle. This means that WTI prices are likely to be stuck between $30 and $60 per barrel for the next five years—possibly even longer. WTI’s $57 price is clearly above our year-end 2017 target range of $40-$50, but it is not above our $30-60 long-term range. Most importantly, we do not believe that prices near $60 can be held for long. We believe a supply response will come fairly soon, pushing prices lower. Chart 1 shows that, since 2015, rig counts (bottom panel) eventually increased after oil prices held north of $50 (top panel). Oil prices then faded as more rigs came online and production rose. We are expecting this dynamic to play out again over the next few months. Should rig counts and production not increase over the coming months, then we may have to change our minds on oil.
Key Takeaways » Oil prices have been trending higher—and may have somewhat more room to run. But, we are expecting oil supply to rise soon, hitting oil prices once again. » We do not recommend buying oil at these lofty price levels.
Crude Oil Price versus Rig Count 55
55
50
50
45
45 40
40 35
$55 - $60 oil brought rigs back online
$45 - $55 oil brought rigs back online
35
30
30
25 20
25 20
10
10
0
0
Oil Price (U.S. Dollar/barrel)
60
-10
-10
-20
-20 -30
-30 -40
U.S. Oil Rig Count (Weekly Change)
-40
-50
-50
-60
-60
-70
-70
Number of Rigs
WTI Crude Oil Spot Price
Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17
Number of Rigs
Oil Price (U.S. Dollar/barrel)
60
Sources: Bloomberg, Baker Hughes, Wells Fargo Investment Institute. Data Sample; Weekly 3/6/2015 - 11/3/2017. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 6 of 9
ALTERNATIVE INVESTMENTS
Jim Sweetman Senior Global Alternative Investment Strategist
Hedge Fund Performance and Positioning into Year-End Evenweight
Private Equity
Evenweight
Hedge Funds-Macro
Evenweight
Hedge Funds-Event Driven
Overweight
Hedge Funds-Relative Value
So far this year, hedge funds (as represented by the HFRI Fund Weighted Composite Index), are headed for their best annual return since 2013. Year to date, hedge funds have gained 7.23 percent, and they have posted gains in 12 consecutive months and 19 of the past 20 months. This represents the best “batting average” over any 20-month period since the November 1990 to June 1992 period. While benefiting from rising equity markets, hedge funds have been able to generate excess return on both the long and short sides of their portfolios through security selection, with relatively low net exposure. The breakdown of tight correlations, in which securities and sectors have generally moved in sync—both up and down—has led to improved fundamentals and rising dispersion across equity and credit markets (see chart). This, in turn, has created a more favorable environment for hedge funds. Heading into year-end, hedge-fund managers have begun adjusting positioning to reflect the current environment. High market valuations and investor complacency have led to caution regarding the late-stage cycle, while optimism has been driven by the continuation of fundamentally based investing and a healthy global economy. Three prominent themes for hedge-fund investors heading into year-end include the following: 1) decreasing correlations and increasing dispersion can create a better security-selection environment; 2) Rising retail-sector distress ratios and defaults can offer opportunities to invest in distressed credit; and 3) non-U.S. exposure is at postcrisis highs as U.S. equity valuations are meaningfully higher than those in the rest of the world.
Key Takeaways » The breakdown of tight correlations has allowed hedge funds to generate excess return (alpha) on both the long and short side of their portfolios.
Overweight
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.
» Hedge funds have been opportunistically deploying capital to reflect the late-stage cycle of the equity and credit markets, while also focusing on identifying opportunities that could generate compelling returns while limiting directional market risk.
S&P 500 Index: Rolling 65-Day Correlations of Underlying Stocks 0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 Jan-90
Jan-93
Jan-96
Jan-99
Jan-02
65-Day Correlations
Jan-05
Jan-08
Jan-11
Jan-14
Jan-17
Historical Average
Sources: Strategas, Bloomberg, 11/7/17. Data sample: 1/1/90 – 11/7/17. An index is unmanaged and not available for direct investment. Correlation represents past performance. Past performance is no guarantee of future results. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 7 of 9
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 Bloomberg Barclays US Corporate High-Yield Index covers the universe of fixed-rate, non-investment-grade debt. HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database. MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI Emerging Markets Index (net) is a free float-adjusted market capitalization-weighted index that measures developed equity market performance in the global emerging markets. S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market. An index is unmanaged and not available for direct investment.
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. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 8 of 9
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 1117-01956
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 9 of 9
Equity Valuations Matter—But We Don’t See a Bubble Sean Lynch, CFA Co-Head of Global Equity Strategy
Key Takeaways
» Market valuations typically expand throughout the business cycle, before falling as recession looms. U.S. equity-market valuations, such as price/earnings (P/E) ratios, could remain stretched for an extended period of time. » Elevated P/E ratios are a tough predictor for near-term market direction, especially late in the cycle. They are better longer-term market predictors.
What It May Mean for Investors
» We believe that international valuations have more room to expand than U.S. equity valuations do. We favor international equity markets (over U.S. markets) today.
Asset Group Overviews Equities ............................ 4 Fixed Income ................ 5 Real Assets ..................... 6 Alternative Investments ................... 7
The S&P 500 Index is likely to be up for the ninth consecutive year in 2017—and it has delivered gains in 12 consecutive months for only the third time in 90 years. Emerging equity markets, as represented by the MSCI Emerging Markets Index, have returned 34 percent year to date (YTD), while developed equity markets, as represented by the MSCI EAFE Index, have returned 22 percent YTD. With these gains, equity valuations have risen—but not to levels that should warrant broad-based selling of equities. This year’s gains have stemmed primarily from stronger earnings (less so from expanded valuations). We also believe that elevated P/E ratios are a tough predictor for near-term market direction, especially late in the business cycle. They are better longer-term predictors late in the cycle. Our view is that earnings will have to do the heavy lifting in U.S. equity markets for further gains to be achieved. Valuations may be slow to expand as inflation levels gradually increase, along with interest rates. International markets may have a few more levers to pull to achieve higher equity valuations. Namely, international markets are at a different part of the business and economic cycle than U.S. markets are. Further, some long-term drivers, such as improved corporate governance and an increased technology-sector focus, may result in higher valuations abroad.
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 1 of 9
Equity Valuations Matter—But We Don’t See a Bubble Price/Earnings Ratios: U.S. and International Equities 30
Forward Price to Earnings Ratio
25
20
10 Year Average: 15.5
15
10 Year Average: 13.9 10 Year Average: 12.1 10
5 S&P 500: 19.4x
MSCI EAFE (Developed Markets): 15.1x
MSCI Emerging Markets: 12.8x
Sources: Bloomberg, Wells Fargo Investment Institute, 11/9/17. The forward price to earnings ratio is the ratio of a company's stock price at a given time divided by its projected earnings.
Fundamentals Improve This year has been a pivotal one for underlying equity-market fundamentals. With valuations hovering near 10-year highs, and with a backdrop of rising bond yields and Federal Reserve (Fed) rate increases, it has been crucial for companies to show that the potential for further earnings gains remains. The business cycle continues to move along—and with the possibility of tax reform—it could be extended even longer. Market valuations typically expand throughout the cycle, before falling as recession looms. One saying we use for equity markets is that “high valuations can persist for long periods of time.” It is bubbles that get popped, and our belief is that we are not in an equity bubble today. While currently elevated valuations may confound some investors, we believe that valuations could remain stretched for an extended period of time (with periodic corrections).
International Valuations We believe that valuations in international equity markets could expand from current levels. In emerging markets, this is due to the changing composition of the major indices. More focus on technology and less focus on commodities can lead to stronger and more predictable earnings growth. This could result in investors “paying more” for these markets than they have historically. In developed markets, we are finally seeing earnings guidance revised steadily higher (as this year has advanced). This is the first time that we have seen this development in six years. Stronger earnings growth in Japan, and a perception that we are through the European debt crisis, eventually could result in higher valuations for the MSCI EAFE Index. Several factors have led us to a more favorable view of international equity markets than U.S. stock markets today. These include valuations, earnings momentum, and sentiment. One wrinkle that could cause us to adjust that strong preference today would be major tax reform in the United States. This development could substantially benefit U.S. earnings and may extend the domestic business cycle even further. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 2 of 9
Equity Valuations Matter—But We Don’t See a Bubble Valuations: U.S. and International Equities Current
Markets
Broad Markets S&P 500 INDEX MSCI EAFE MSCI EM Developed Markets MSCI JAPAN MSCI FRANCE MSCI GERMANY MSCI UK Emerging Markets MSCI BRAZIL MSCI CHINA MSCI INDIA MSCI KOREA
Rolling 10-Year Average Forward Forward Forward Forward Forward Forward Price to Price to Price to Price to Price to Price to Cash Cash Equity Book Equity Book Flow Flow 19.4 15.1 12.8
3.2 1.8 1.8
14.0 9.3 7.9
15.5 13.9 12.1
2.3 1.5 1.6
10.3 7.8 7.4
15.3 16.6 15.4 14.7
1.5 1.7 1.9 1.9
12.8 5.8 7.7 12.4
18.3 13.3 12.4 12.8
1.2 1.4 1.5 1.7
6.8 7.4 7.2 8.0
14.1 15.6 21.1 10.2
1.7 2.1 3.1 1.2
11.2 5.7 25.0 6.8
12.0 11.9 17.0 10.6
1.6 1.7 2.6 1.2
7.0 8.0 12.1 5.7
Bolded valuations are undervalued relative to history. Sources: Bloomberg, Wells Fargo Investment Institute, 11/9/17.
Investment Implications Valuations, in particular, P/E multiples, capture market sentiment. Higher P/E multiples reflect improved investor confidence in the earnings outlook for major equity markets. Yet, in isolation, a P/E multiple does not say much. It is essential to analyze P/E ratios on a relative basis, and understand those relative differences. While a measure like a P/E ratio may seem simple, the more one knows about this valuation measure, the more complicated it becomes. I like to say that a three-hour baseball game may seem boring to a casual observer, but the more you know about the game and the decisions being made, the more interesting it can become. The same dynamic can apply to the equity-valuation landscape. Throughout 2017, we have not been calling for an end to the domestic cyclical bull market. Earnings continue to support the market, but we do believe that U.S. equity markets are due for a modest correction. Despite strong gains this year, we see little reason for international stock markets to experience a major pullback. We remain fully allocated toward our strategic equity targets in U.S large- and mid-cap equities, as well as in emerging and developed equity markets. (We are underweight U.S. small-cap equities.) It should be noted that we have raised this strategic allocation toward largecap equities, and equities overall, quite substantially over the past few years. Across all investment objectives, our strategic allocation has increased by 4 percent for U.S. largecap equities and 4.9 percent for all equities, over the past five years. We believe that interest rates are a potential risk for equity investors to monitor going forward. As the Fed prepares to raise rates in December and to continue along that path in 2018, and as the European Central Bank (ECB) embarks on its asset-purchase tapering program, interest rates may come under pressure (that is, they may rise as monetary policy is normalized and inflation rises). As Berkshire Hathaway Chairman Warren Buffett said at the company’s 2017 annual meeting, “the most important item for a stock valuation over time is interest rates.” We are not calling for materially higher interest rates in 2018, but any missteps by central banks, and the expectation for higher interest rates, may pressure domestic equity valuations. Nevertheless, in the longer term, valuations may remain stretched for a while longer. Valuation matters, but it is a better longer-term predictor late in the business cycle. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 3 of 9
EQUITIES
Stuart Freeman, CFA Co-Head of Global Equity Strategy
Manufacturing Showing Healthy Signs of Later-Cycle Growth Underweight U.S. Small Cap Equities
Evenweight U.S. Large Cap Equities
Evenweight
U.S. Mid Cap Equities
Evenweight Developed Market Ex-U.S. Equities
The Institute for Supply Management (ISM) reports monthly on the strength of the manufacturing economy (their purchasing managers’ index, or PMI). This number represents polling of purchasing managers in 18 manufacturing industries on the strength of their businesses. A reading over 50 percent generally represents growth in the manufacturing economy. It is relatively rare for the manufacturing PMI to register a level of 60 percent or higher. It only has done so in 19 months—from January 1980 to today (see chart). Yet, in September 2017, it reached 60.8 percent. Looking back into the 1980s, we wanted to see how the S&P 500 Index performed in months following an ISM manufacturing index reading of 60 percent or higher. Although a 60-percent index level suggests strong manufacturing growth, it tends to be followed by tepid equity-market returns over the following three and six months (historically). On average, the S&P 500 Index has declined by 2.2 and 1.0 percent, respectively, in the next three- and six-month periods. This is interesting, but it hardly defines a bear market. We are noting increasingly stronger signs of industrial-order growth and global capital expenditures, which is typical in the latter portions of a cycle. This is positive for job growth and wages. It does not concern us that the S&P 500 Index frequently has been flat to modestly lower in months following a PMI of 60 or above. Such reports often are met with very positive market reactions, followed by periods of simple market consolidation.
Key Takeaways » Manufacturing data is showing more persistent growth, as reflected in the ISM’s atypically strong manufacturing PMI in September 2017. » The U.S. equity market tends to respond favorably to very strong later-cycle manufacturing data. Yet, it often consolidates for a few months following that report.
ISM Manufacturing Index—The Stronger the Better? 80
Evenweight
70
ISM Manufacturing Index
Emerging Market Equities
60 50 40 30 20 '80
'82
'84
'86
'88
'90
'92 '94 '96 '98 ISM Manufacturing
'00
'02 '04 '06 Level Threshold
'08
'10
'12
'14
'16
Sources: Wells Fargo Investment Institute, Bloomberg; 11/8/17 © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 4 of 9
FIXED INCOME
Brian Rehling, CFA Co-Head of Global Fixed Income Strategy
High Yield—High Valuation Underweight
High Yield Taxable Fixed Income
Underweight
Developed Market Ex.-U.S. Fixed Income
It is difficult to find any valuation metric that would classify high-yield debt as inexpensive, or cheap, today. Rather, most valuation measures show that the high-yield bond class now is quite expensive. Credit spreads (over Treasury security yields) for the Bloomberg Barclays U.S. Corporate High Yield Index currently stand near 340 basis points (3.40 percent), down 60 basis points since the beginning of this year. 1 The 10year average spread level of the Bloomberg Barclays U.S. Corporate High Yield Index is 610 basis points (6.1 percent). The lowest (or “most expensive”) credit spreads have been in this economic cycle is 323 basis points (3.23 percent) on June 23, 2014. As credit spreads tighten (decline), valuations increase—all else being equal. The opposite occurs as spreads widen or increase. Within the fixed-income asset class, and within the overall investment universe, we believe that better risk-adjusted return opportunities present themselves today.
Portfolio Implications Evenweight
We recommend that fixed-income investors move up in credit quality while minimizing exposure to lower-quality issuers. Given the substantial rise in high-yield debt valuations in recent quarters, we do not believe that “chasing” the added yield is worth the additional risk (given our view that the upside potential of this debt class is currently quite limited). We recommend that investors take profits in high-yield allocations and underweight the high-yield bond class.
Evenweight
Key Takeaways
U.S. Short Term Taxable Fixed Income
U.S. Long Term Taxable Fixed Income
» At current valuations, we believe that the high-yield debt class offers an asymmetric risk profile, with limited upside potential and meaningful downside risk. » We believe that a strong economic scenario that supports high-yield valuations also is likely to provide equity investors with better return potential.
Evenweight
Emerging Market Fixed Income
» We recommend that investors take profits in high-yield allocations and underweight the high-yield bond class going forward.
Credit Spreads: Bloomberg Barclays U.S. Corporate High Yield Index
Overweight
U.S. Taxable Investment Grade Fixed Income
Overweight
U.S. Intermediate Term Taxable Fixed Income
Bloomberg Barclays U.S. Corporate High Yield Index Basis Points
25
20
15
10
5
0 May-07
May-08
May-09
May-10
May-11
May-12
May-13
May-14
May-15
May-16
May-17
Sources: Wells Fargo Investment Institute, Bloomberg; 11/8/17 1 One hundred basis points equal one percent. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 5 of 9
REAL ASSETS
John LaForge
“Good judgment comes from experience, and experience usually comes from bad judgment.” - Anonymous
Head of Real Asset Strategy
Oil—Why We Are Staying the Course Underweight
Commodities
Evenweight
Private Real Estate
Overweight
Public Real Estate
For most of 2017, West Texas Intermediate (WTI) crude-oil prices have behaved— staying within our year-end target range of $40-$50 per barrel. Yet, recently, this has changed. WTI traded as high as $57 last week—at a time when oil prices typically fade. WTI’s move to the mid-$50s can be blamed on OPEC’s (Organization of the Petroleum Exporting Countries) production cut saber-rattling, Saudi Arabia arrests, and a more balanced global supply/demand picture. So, are we changing our targets? The answer is no. There is always the possibility that we may have to, but we aren’t at that point yet. While WTI recently has been on a tear, we need to keep the long term in perspective. We believe that oil prices remain stuck inside a bear market super-cycle. This means that WTI prices are likely to be stuck between $30 and $60 per barrel for the next five years—possibly even longer. WTI’s $57 price is clearly above our year-end 2017 target range of $40-$50, but it is not above our $30-60 long-term range. Most importantly, we do not believe that prices near $60 can be held for long. We believe a supply response will come fairly soon, pushing prices lower. Chart 1 shows that, since 2015, rig counts (bottom panel) eventually increased after oil prices held north of $50 (top panel). Oil prices then faded as more rigs came online and production rose. We are expecting this dynamic to play out again over the next few months. Should rig counts and production not increase over the coming months, then we may have to change our minds on oil.
Key Takeaways » Oil prices have been trending higher—and may have somewhat more room to run. But, we are expecting oil supply to rise soon, hitting oil prices once again. » We do not recommend buying oil at these lofty price levels.
Crude Oil Price versus Rig Count 55
55
50
50
45
45 40
40 35
$55 - $60 oil brought rigs back online
$45 - $55 oil brought rigs back online
35
30
30
25 20
25 20
10
10
0
0
Oil Price (U.S. Dollar/barrel)
60
-10
-10
-20
-20 -30
-30 -40
U.S. Oil Rig Count (Weekly Change)
-40
-50
-50
-60
-60
-70
-70
Number of Rigs
WTI Crude Oil Spot Price
Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17
Number of Rigs
Oil Price (U.S. Dollar/barrel)
60
Sources: Bloomberg, Baker Hughes, Wells Fargo Investment Institute. Data Sample; Weekly 3/6/2015 - 11/3/2017. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 6 of 9
ALTERNATIVE INVESTMENTS
Jim Sweetman Senior Global Alternative Investment Strategist
Hedge Fund Performance and Positioning into Year-End Evenweight
Private Equity
Evenweight
Hedge Funds-Macro
Evenweight
Hedge Funds-Event Driven
Overweight
Hedge Funds-Relative Value
So far this year, hedge funds (as represented by the HFRI Fund Weighted Composite Index), are headed for their best annual return since 2013. Year to date, hedge funds have gained 7.23 percent, and they have posted gains in 12 consecutive months and 19 of the past 20 months. This represents the best “batting average” over any 20-month period since the November 1990 to June 1992 period. While benefiting from rising equity markets, hedge funds have been able to generate excess return on both the long and short sides of their portfolios through security selection, with relatively low net exposure. The breakdown of tight correlations, in which securities and sectors have generally moved in sync—both up and down—has led to improved fundamentals and rising dispersion across equity and credit markets (see chart). This, in turn, has created a more favorable environment for hedge funds. Heading into year-end, hedge-fund managers have begun adjusting positioning to reflect the current environment. High market valuations and investor complacency have led to caution regarding the late-stage cycle, while optimism has been driven by the continuation of fundamentally based investing and a healthy global economy. Three prominent themes for hedge-fund investors heading into year-end include the following: 1) decreasing correlations and increasing dispersion can create a better security-selection environment; 2) Rising retail-sector distress ratios and defaults can offer opportunities to invest in distressed credit; and 3) non-U.S. exposure is at postcrisis highs as U.S. equity valuations are meaningfully higher than those in the rest of the world.
Key Takeaways » The breakdown of tight correlations has allowed hedge funds to generate excess return (alpha) on both the long and short side of their portfolios.
Overweight
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.
» Hedge funds have been opportunistically deploying capital to reflect the late-stage cycle of the equity and credit markets, while also focusing on identifying opportunities that could generate compelling returns while limiting directional market risk.
S&P 500 Index: Rolling 65-Day Correlations of Underlying Stocks 0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 Jan-90
Jan-93
Jan-96
Jan-99
Jan-02
65-Day Correlations
Jan-05
Jan-08
Jan-11
Jan-14
Jan-17
Historical Average
Sources: Strategas, Bloomberg, 11/7/17. Data sample: 1/1/90 – 11/7/17. An index is unmanaged and not available for direct investment. Correlation represents past performance. Past performance is no guarantee of future results. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 7 of 9
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 Bloomberg Barclays US Corporate High-Yield Index covers the universe of fixed-rate, non-investment-grade debt. HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database. MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI Emerging Markets Index (net) is a free float-adjusted market capitalization-weighted index that measures developed equity market performance in the global emerging markets. S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market. An index is unmanaged and not available for direct investment.
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. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 8 of 9
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 1117-01956
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 9 of 9
