Investment Strategy Report
WEEKLY GUIDANCE FROM OUR INVESTMENT STRATEGY COMMITTEE
U.S. Dollar Rebound Appears Imminent Sameer Samana, CFA Global Quantitative Strategist
August 7, 2017
Key Takeaways
» The U.S. dollar has continued its slide lower in recent months as disappointing economic data, political uncertainty, and a better relative environment outside the U.S. have all weighed on its value. » We believe that a combination of fundamentals and sentiment data suggests that the move may be long in the tooth and could be near an inflection point.
What it May Mean for Investors
» Investors would do well to trim areas that could be negatively impacted by a rising U.S. dollar and where we see additional reasons to be cautious.
The Dollar Index
Asset Group Overviews Equities ............................ 4 Fixed Income ................ 5 Real Assets ..................... 6 Alternatives ................... 7
The U.S. dollar, as measured by the U.S. Dollar Index (DXY), has fallen about 9 percent since the start of the year due to domestic economic data disappointments, political uncertainty, and relatively more positive developments outside the U.S. Even the two recent rate hikes by the Federal Reserve (Fed), which historically have helped to boost the U.S. currency, have failed to stem the decline. Not helping matters, is the persistent strength of the euro, the biggest component in the DXY, which has gained as new French President Macron consolidated his position with victory in parliamentary elections, and as European Central Bank (ECB) rhetoric has become more hawkish. We revised our outlook on the U.S. dollar at mid-year to reflect development of these factors. Yet, we view the recent selling as overdone and expect a stronger U.S. dollar from current levels by year-end 2017, a reversal of the current trend. The first factor in our expectations for a rebound in the U.S. dollar is the differences among interest rates, economic growth, and inflation. U.S. Treasuries, both short and long-term, continue to yield more than their euro area counterparts (Chart 1), and remain at multi-decade highs. Much of the widening in the interest-rate differential has been driven by a divergence in monetary policy. Specifically, the Fed is raising overnight policy rates and considering shrinking its balance sheet, while the ECB will probably be stuck at a negative policy rate for some time and is just now thinking about tapering bond purchases (which will still grow the balance sheet, just at a slower pace).
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 1 of 9
U.S. Dollar Rebound Appears Imminent We see this rate differential continuing and potentially widening in the second half, especially in the shorter-tem maturities, as we expect the Fed to announce plans to shrink the balance sheet in September and hike rates one more time for 2017 in December. Also, thanks to the Fed’s early actions during the financial crisis, economic growth and inflation in the U.S. rebounded faster than in the euro area where tighter central bank policy and the Greek debt crisis weighed heavily. While that lead has narrowed as growth and inflation in the euro area have rebounded, it still favors the U.S. The second factor is ongoing political risks in the euro area. The market-friendly result of the French elections, and the inability to enact policy initiatives in the U.S. (i.e. health care reform, tax reform, fiscal/infrastructure spending) have turned the tables on investors from the start of the year, when it was elections in France that were the worry and the U.S. where a Republican President and Congress was poised to work swiftly to enact changes. However, despite the recent calm, Italy remains a larger political and economic risk to the euro area, and the possibility of early elections could lead to another reversal in the perceived stability between the two currencies. Put another way, at current levels on the currency pair, it seems that expectations for the U.S. government to get anything done are too low and for the euro area too high.
Chart 1. 10-year rate differential still favors the U.S. dollar 2.5
120 115
2
110 1.5 1
U.S. Dollar Index
10 Year Spreads
105 100
0.5
95 90
0
85 -0.5 80 -1
75
-1.5
70 '97
'98
'99
'00
'01
'02
'03 '04 '05 '06 '07 '08 U.S. German 10 Year Spread
'09 '10 '11 '12 U.S. Dollar Index
'13
'14
'15
'16
'17
Source: Bloomberg, Wells Fargo Investment Institute, 8/2/17
The third factor is investor sentiment, which after starting the year tilted towards a higher U.S. dollar, has swung into the negative. The chart below shows the aggregate futures positioning in the U.S. dollar as reported by the Commodity Futures Trading Commission (CFTC). Interestingly, this is the most negative that futures traders have been on the U.S. dollar since right before the large move higher in 2014 and 2015. While our longer-term trajectory for the U.S. dollar has moderated and valuation
© 2017 Wells Fargo Investment Institute. All rights reserved.
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U.S. Dollar Rebound Appears Imminent measures suggest that it may still be a bit rich relative to the euro, the current prevalence of negative sentiment sets the stage for positive surprises in the U.S. dollar’s favor in the second half. The most important implications for investors at this point would be to reduce positions in commodities and developed-market debt towards our current tactical underweight stance, as any improvement in the U.S. dollar’s prospects should affect these assets most adversely. Dollar strength may also lead to some tightening in financial conditions at the margin and cause greater volatility, both of which would impact high-yield fixed income holdings negatively, and where we still remain tactically underweight. Lastly, we view this as an opportune time to rebalance international equity allocations, which have benefited at the dollar’s expense, towards our neutral tactical recommendation.
105
80000
100
60000
95
40000
90
20000
85
0
80
-20000
75
Futures Contracts
100000
U.S. Dollar Index
Chart 2. Investors are the most negative on the U.S. dollar since 2014
-40000 70 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Bloomberg CFTC NYCE US Dollar Index Net Non-Commercial Futures Positions (LHS) U.S. Dollar Index (RHS)
Source: Bloomberg, Wells Fargo Investment Institute
© 2017 Wells Fargo Investment Institute. All rights reserved.
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EQUITIES
Stuart Freeman, CFA Co-Head of Global Equity Strategy
Underweight U.S. Small Cap Equities
Evenweight U.S. Large Cap Equities
Evenweight
U.S. Mid Cap Equities
Four Sectors Poised to Outperform With two-thirds of S&P 500 Index companies reported, earnings appear on a track for roughly 10 percent growth (following 15.5 percent growth in the first quarter). At the start of earnings season, consensus expectations were for a 6 percent increase for second quarter. The Consumer Discretionary, Financial, Health Care, and Information Technology sectors currently appear poised for the biggest outperformances. The largest increase is in the Energy sector as it appears headed for $3.09 this quarter against a weak second quarter of only $0.75 a year ago. In fact, while earnings are roughly 10 percent higher than a year ago, the average sector increase (ex-Energy) is around 4.9 percent. The recovery in oil prices and Energy sector earnings are skewing earnings higher. During the first quarter, earnings increased by 15.5 percent while nonEnergy sectors rose by 9.3 percent. Earnings breadth, measured by the ratio of companies reporting higher earnings versus lower earnings (green line in the chart below), is favorable. While the ratio could soften a bit as earnings season continues, we currently see 4 times more companies generating earnings increases versus decreases. The median ratio since 1992 is a 2.9:1(purple line). Earnings breadth tends to match or move below the median prior to recessions. However, not every drop below the median has led to a recession. The most recent instance occurred during the energy price decline between 2014 and 2016. We have encircled the breadth levels during the last two recessionary periods. Note that earnings breadth has dropped to or below 1:1 during the last two recessions.
Key Takeaways Evenweight Developed Market Ex-U.S. Equities
» We expect that earnings growth in the last half will be slower than in the first, due primarily to tougher comparisons. Nonetheless, we see continuing earnings growth for the last half and through 2018. » We recommend investors use any pullbacks as opportunities to average into shares of quality cyclical companies.
S&P 500 Index: Ratio, Up Versus Down EPS, Q2 To-Date S&P 500 Index Sectors: Second-Quarter 2017 Earnings Growth
6
Evenweight
4 Ratio (X)
Emerging Market Equities
Percentage Change Year-over-Year (Est.)
5
3 2 1 0 Quarter-Year
Consumer Discretionary
-0.7
Consumer Staples
5.5
Energy
312.1
Financials
11.3
Health Care
4.2
Industrials
0.6
Information Technology
19.7
Materials
5.6
Real Estate
4.8
Telecommunications Services Utilities
6.9
S&P 500 Index
9.9
5.4
Sources: Wells Fargo Investment Institute, Bloomberg; 8/2/17 © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 4 of 9
FIXED INCOME
Brian Rehling, CFA Co-Head of Global Fixed Income Strategy
Managing the Risks of A Flatter Yield Curve Underweight
High Yield Taxable Fixed Income
Underweight
Developed Market Ex.-U.S. Fixed Income
A steep interest-rate curve often foreshadows a period of accelerating economic growth, while a flattening interest-rate curve can be worrisome for investors—as it may indicate declining growth prospects. The yield (or interest-rate) curve remained relatively steep (short-term rates lower than long-term rates) for an extended period of time after the Fed engineered low-rate policies following the 2008-2009 financial crisis. In recent years, as the Fed has transitioned to tighter monetary policy, including slowly increasing short-term rates, we have seen meaningful yield-curve flattening. Despite this recent trend, it is important to note that the yield curve currently remains positively sloped, suggesting that the current slow-growth environment should remain in place for some time. The chart below reflects that positive slope, as it shows the difference between yields on two- and 10-year Treasury securities, currently nearly 90 basis points (0.9 percent).
Investment Implications Evenweight
U.S. Short Term Taxable Fixed Income
We do expect that investors will face further yield-curve flattening in the future as the Fed slowly raises short-term rates, and the current economic expansion continues to age. As the cycle plays out, we see the Fed slowly increasing short-term rates, while longer-term rates remain relatively contained. This should result in a scenario in which short-term rates rise faster than long-term rates.
Key Takeaways Evenweight
U.S. Long Term Taxable Fixed Income
Evenweight
Emerging Market Fixed Income
» The interest-rate curve has been flattening—which suggests that the U.S. economic cycle is maturing. » While curve flattening is the trend, the Treasury yield curve remains sufficiently steep, suggesting that the slow-growth environment will continue. » Should the yield curve flatten meaningfully from current levels, we would be concerned that the current U.S. economic expansion is in jeopardy.
Difference Between 2- and 10-Year Treasury Yields 2.3 2.1
Overweight
U.S. Taxable Investment Grade Fixed Income
Yield Spread
1.9 1.7 1.5 1.3 1.1 0.9
8/1/2017
6/1/2017
4/1/2017
2/1/2017
12/1/2016
10/1/2016
8/1/2016
6/1/2016
4/1/2016
2/1/2016
12/1/2015
10/1/2015
8/1/2015
6/1/2015
4/1/2015
2/1/2015
12/1/2014
0.5
10/1/2014
U.S. Intermediate Term Taxable Fixed Income
0.7
8/1/2014
Overweight
Sources: Wells Fargo Investment Institute, Bloomberg; 8/2/17. Yields represent past performance. Past performance is no guarantee of future results. Yields fluctuate as market conditions change. Current yields may be higher or lower than those quoted © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 5 of 9
REAL ASSETS
Austin Pickle, CFA
“If you just focus on the smallest details, you never get the big picture right.”
Investment Strategy Analyst
--Leroy Hood Oil Inventory Drops and Prices Pop – But the Trend Lacks Staying Power
Commodities
Each week, the oil inventory report gets a lot of attention. When inventories decline, oil uber-bulls use this as proof that oil is set to return to the good ol’ days of $100 per barrel prices. It is easy to get caught up in the euphoria. What can be difficult to do is to step back, pause, and look at the bigger picture. Given the past few weeks of inventory draws (declines), and the subsequent euphoria, we believe that now is a good time to step back.
Evenweight
The chart below shows U.S. crude-oil inventory levels versus its rolling five-year average. The oil bulls are correct in that inventories have come down, but what may be an example of oil bulls “not seeing the forest for the trees,” is the fact that the current inventory level is still nearly 100 million barrels above the five-year average. As you can see from the chart, we sit at truly unprecedented inventory levels. In short, we are abnormally awash in oil.
Overweight
This issue of oversupply will be hard to remedy—as each time oil prices pop, more production comes on line as producers rush to capitalize on higher prices. This, in turn, pressures prices back down. We expect this cycle to “rinse and repeat” over the next few years, forcing oil prices to remain range-bound between $30 and $60 per barrel. Our year-end 2017 forecast is $40-$50 per barrel for West Texas Intermediate (WTI) and $45-$55 for Brent crude oil. With WTI currently near $50 and Brent near $53, we do not see much upside today.
Underweight
Private Real Estate
Public Real Estate
Key Takeaways » Recent crude oil inventory draws have propelled prices and sentiment higher. » We do not believe that oil has much upside from here. Our year-end 2017 target range remains $40-$50 per barrel for WTI and $45-$55 for Brent.
U.S. Crude Oil Inventory Levels 570 Crude Oil Inventories 520
Five-Year Average
Millions of Barrels
470
420
370
320
270
220 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Sources: Bloomberg, Energy Information Administration (EIA), Wells Fargo Investment Institute. Weekly Data: 1/30/1987 - 7/28/2017. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 6 of 9
ALTERNATIVE INVESTMENTS
Justin Lenarcic Global Alternative Investment Strategist
M&A Wave in Europe Creates A Compelling Opportunity Evenweight
Private Equity
Evenweight
Private Debt
Evenweight
Hedge Funds-Macro
Evenweight
Hedge Funds-Event Driven
Political and economic uncertainties scared many investors away from developed market ex-U.S. equities last year. But with European business and profit cycles in earlier stages relative to the U.S. cycle, not to mention Eurozone economic growth stabilizing leading to an increase in business and consumer confidence, it’s no wonder that announced M&A (Merger and Acquisition) deal volume in Western Europe is up 26 percent year over year (as shown in the chart below). This translates to a potentially compelling opportunity for Event Driven – Merger Arbitrage strategies that can simultaneously allow investors to increase exposure to both Alternative Investments and International Equities. Merger Arbitrage strategies are designed to provide investors with exposure to specific event-driven situations such as mergers. Normally, the stock of an acquisition target appreciates while the acquiring company's stock decreases in value. This is normally accomplished through taking long and short equity positions in the target and acquiring companies respectively. The strategy’s core return driver is a tightening of the gap or “merger spread” between the target company’s current stock price and the announced premium price the acquirer pays for the target company’s stock. We anticipate a growing M&A opportunity set within Developed (non-US) markets as companies search for growth and synergies. Furthermore, the global economy continues to show signs of improvement while innovation and technology likely will continue to disrupt and transform.
Key Takeaways Overweight
Hedge Funds-Relative Value
» Non-U.S. M&A activity is accelerating, especially in the Eurozone where business and consumer confidence is increasing. » Event Driven – Merger Arbitrage strategies can provide exposure to International Equities, but in an actively managed format with less directional market exposure.
Announced M&A Volume (Year-Over-Year) 120%
Overweight
Hedge Funds-Equity Hedge
100% 80%
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.
60%
33%
31%
20%
28%
47%
41%
2016 YTD
2017 YTD
40% 20% 0% North America (-14%)
Sources: Dealogic, July 2017 © 2017 Wells Fargo Investment Institute. All rights reserved.
Western Europe (+26%)
Rest of World (-3%)
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 An index is unmanaged and not available for direct investment. Bloomberg CFTC NYCE US Dollar Index Net Non-Commercial Futures Positions measures open interest for markets in which 20 or more traders hold futures positions in the US dollar equal to or above the reporting levels established by the CFTC. This is the overall net noncommercial futures positions in the US Dollar. U.S. Dollar Index (DXY) measures the value of the U.S. dollar relative to majority of its most significant trading partners. This index is similar to other trade-weighted indexes, which also use the exchange rates from the same major currencies. 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.
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 © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 8 of 9
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 0817-00882
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 9 of 9
U.S. Dollar Rebound Appears Imminent Sameer Samana, CFA Global Quantitative Strategist
August 7, 2017
Key Takeaways
» The U.S. dollar has continued its slide lower in recent months as disappointing economic data, political uncertainty, and a better relative environment outside the U.S. have all weighed on its value. » We believe that a combination of fundamentals and sentiment data suggests that the move may be long in the tooth and could be near an inflection point.
What it May Mean for Investors
» Investors would do well to trim areas that could be negatively impacted by a rising U.S. dollar and where we see additional reasons to be cautious.
The Dollar Index
Asset Group Overviews Equities ............................ 4 Fixed Income ................ 5 Real Assets ..................... 6 Alternatives ................... 7
The U.S. dollar, as measured by the U.S. Dollar Index (DXY), has fallen about 9 percent since the start of the year due to domestic economic data disappointments, political uncertainty, and relatively more positive developments outside the U.S. Even the two recent rate hikes by the Federal Reserve (Fed), which historically have helped to boost the U.S. currency, have failed to stem the decline. Not helping matters, is the persistent strength of the euro, the biggest component in the DXY, which has gained as new French President Macron consolidated his position with victory in parliamentary elections, and as European Central Bank (ECB) rhetoric has become more hawkish. We revised our outlook on the U.S. dollar at mid-year to reflect development of these factors. Yet, we view the recent selling as overdone and expect a stronger U.S. dollar from current levels by year-end 2017, a reversal of the current trend. The first factor in our expectations for a rebound in the U.S. dollar is the differences among interest rates, economic growth, and inflation. U.S. Treasuries, both short and long-term, continue to yield more than their euro area counterparts (Chart 1), and remain at multi-decade highs. Much of the widening in the interest-rate differential has been driven by a divergence in monetary policy. Specifically, the Fed is raising overnight policy rates and considering shrinking its balance sheet, while the ECB will probably be stuck at a negative policy rate for some time and is just now thinking about tapering bond purchases (which will still grow the balance sheet, just at a slower pace).
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 1 of 9
U.S. Dollar Rebound Appears Imminent We see this rate differential continuing and potentially widening in the second half, especially in the shorter-tem maturities, as we expect the Fed to announce plans to shrink the balance sheet in September and hike rates one more time for 2017 in December. Also, thanks to the Fed’s early actions during the financial crisis, economic growth and inflation in the U.S. rebounded faster than in the euro area where tighter central bank policy and the Greek debt crisis weighed heavily. While that lead has narrowed as growth and inflation in the euro area have rebounded, it still favors the U.S. The second factor is ongoing political risks in the euro area. The market-friendly result of the French elections, and the inability to enact policy initiatives in the U.S. (i.e. health care reform, tax reform, fiscal/infrastructure spending) have turned the tables on investors from the start of the year, when it was elections in France that were the worry and the U.S. where a Republican President and Congress was poised to work swiftly to enact changes. However, despite the recent calm, Italy remains a larger political and economic risk to the euro area, and the possibility of early elections could lead to another reversal in the perceived stability between the two currencies. Put another way, at current levels on the currency pair, it seems that expectations for the U.S. government to get anything done are too low and for the euro area too high.
Chart 1. 10-year rate differential still favors the U.S. dollar 2.5
120 115
2
110 1.5 1
U.S. Dollar Index
10 Year Spreads
105 100
0.5
95 90
0
85 -0.5 80 -1
75
-1.5
70 '97
'98
'99
'00
'01
'02
'03 '04 '05 '06 '07 '08 U.S. German 10 Year Spread
'09 '10 '11 '12 U.S. Dollar Index
'13
'14
'15
'16
'17
Source: Bloomberg, Wells Fargo Investment Institute, 8/2/17
The third factor is investor sentiment, which after starting the year tilted towards a higher U.S. dollar, has swung into the negative. The chart below shows the aggregate futures positioning in the U.S. dollar as reported by the Commodity Futures Trading Commission (CFTC). Interestingly, this is the most negative that futures traders have been on the U.S. dollar since right before the large move higher in 2014 and 2015. While our longer-term trajectory for the U.S. dollar has moderated and valuation
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 2 of 9
U.S. Dollar Rebound Appears Imminent measures suggest that it may still be a bit rich relative to the euro, the current prevalence of negative sentiment sets the stage for positive surprises in the U.S. dollar’s favor in the second half. The most important implications for investors at this point would be to reduce positions in commodities and developed-market debt towards our current tactical underweight stance, as any improvement in the U.S. dollar’s prospects should affect these assets most adversely. Dollar strength may also lead to some tightening in financial conditions at the margin and cause greater volatility, both of which would impact high-yield fixed income holdings negatively, and where we still remain tactically underweight. Lastly, we view this as an opportune time to rebalance international equity allocations, which have benefited at the dollar’s expense, towards our neutral tactical recommendation.
105
80000
100
60000
95
40000
90
20000
85
0
80
-20000
75
Futures Contracts
100000
U.S. Dollar Index
Chart 2. Investors are the most negative on the U.S. dollar since 2014
-40000 70 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Bloomberg CFTC NYCE US Dollar Index Net Non-Commercial Futures Positions (LHS) U.S. Dollar Index (RHS)
Source: Bloomberg, Wells Fargo Investment Institute
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 3 of 9
EQUITIES
Stuart Freeman, CFA Co-Head of Global Equity Strategy
Underweight U.S. Small Cap Equities
Evenweight U.S. Large Cap Equities
Evenweight
U.S. Mid Cap Equities
Four Sectors Poised to Outperform With two-thirds of S&P 500 Index companies reported, earnings appear on a track for roughly 10 percent growth (following 15.5 percent growth in the first quarter). At the start of earnings season, consensus expectations were for a 6 percent increase for second quarter. The Consumer Discretionary, Financial, Health Care, and Information Technology sectors currently appear poised for the biggest outperformances. The largest increase is in the Energy sector as it appears headed for $3.09 this quarter against a weak second quarter of only $0.75 a year ago. In fact, while earnings are roughly 10 percent higher than a year ago, the average sector increase (ex-Energy) is around 4.9 percent. The recovery in oil prices and Energy sector earnings are skewing earnings higher. During the first quarter, earnings increased by 15.5 percent while nonEnergy sectors rose by 9.3 percent. Earnings breadth, measured by the ratio of companies reporting higher earnings versus lower earnings (green line in the chart below), is favorable. While the ratio could soften a bit as earnings season continues, we currently see 4 times more companies generating earnings increases versus decreases. The median ratio since 1992 is a 2.9:1(purple line). Earnings breadth tends to match or move below the median prior to recessions. However, not every drop below the median has led to a recession. The most recent instance occurred during the energy price decline between 2014 and 2016. We have encircled the breadth levels during the last two recessionary periods. Note that earnings breadth has dropped to or below 1:1 during the last two recessions.
Key Takeaways Evenweight Developed Market Ex-U.S. Equities
» We expect that earnings growth in the last half will be slower than in the first, due primarily to tougher comparisons. Nonetheless, we see continuing earnings growth for the last half and through 2018. » We recommend investors use any pullbacks as opportunities to average into shares of quality cyclical companies.
S&P 500 Index: Ratio, Up Versus Down EPS, Q2 To-Date S&P 500 Index Sectors: Second-Quarter 2017 Earnings Growth
6
Evenweight
4 Ratio (X)
Emerging Market Equities
Percentage Change Year-over-Year (Est.)
5
3 2 1 0 Quarter-Year
Consumer Discretionary
-0.7
Consumer Staples
5.5
Energy
312.1
Financials
11.3
Health Care
4.2
Industrials
0.6
Information Technology
19.7
Materials
5.6
Real Estate
4.8
Telecommunications Services Utilities
6.9
S&P 500 Index
9.9
5.4
Sources: Wells Fargo Investment Institute, Bloomberg; 8/2/17 © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 4 of 9
FIXED INCOME
Brian Rehling, CFA Co-Head of Global Fixed Income Strategy
Managing the Risks of A Flatter Yield Curve Underweight
High Yield Taxable Fixed Income
Underweight
Developed Market Ex.-U.S. Fixed Income
A steep interest-rate curve often foreshadows a period of accelerating economic growth, while a flattening interest-rate curve can be worrisome for investors—as it may indicate declining growth prospects. The yield (or interest-rate) curve remained relatively steep (short-term rates lower than long-term rates) for an extended period of time after the Fed engineered low-rate policies following the 2008-2009 financial crisis. In recent years, as the Fed has transitioned to tighter monetary policy, including slowly increasing short-term rates, we have seen meaningful yield-curve flattening. Despite this recent trend, it is important to note that the yield curve currently remains positively sloped, suggesting that the current slow-growth environment should remain in place for some time. The chart below reflects that positive slope, as it shows the difference between yields on two- and 10-year Treasury securities, currently nearly 90 basis points (0.9 percent).
Investment Implications Evenweight
U.S. Short Term Taxable Fixed Income
We do expect that investors will face further yield-curve flattening in the future as the Fed slowly raises short-term rates, and the current economic expansion continues to age. As the cycle plays out, we see the Fed slowly increasing short-term rates, while longer-term rates remain relatively contained. This should result in a scenario in which short-term rates rise faster than long-term rates.
Key Takeaways Evenweight
U.S. Long Term Taxable Fixed Income
Evenweight
Emerging Market Fixed Income
» The interest-rate curve has been flattening—which suggests that the U.S. economic cycle is maturing. » While curve flattening is the trend, the Treasury yield curve remains sufficiently steep, suggesting that the slow-growth environment will continue. » Should the yield curve flatten meaningfully from current levels, we would be concerned that the current U.S. economic expansion is in jeopardy.
Difference Between 2- and 10-Year Treasury Yields 2.3 2.1
Overweight
U.S. Taxable Investment Grade Fixed Income
Yield Spread
1.9 1.7 1.5 1.3 1.1 0.9
8/1/2017
6/1/2017
4/1/2017
2/1/2017
12/1/2016
10/1/2016
8/1/2016
6/1/2016
4/1/2016
2/1/2016
12/1/2015
10/1/2015
8/1/2015
6/1/2015
4/1/2015
2/1/2015
12/1/2014
0.5
10/1/2014
U.S. Intermediate Term Taxable Fixed Income
0.7
8/1/2014
Overweight
Sources: Wells Fargo Investment Institute, Bloomberg; 8/2/17. Yields represent past performance. Past performance is no guarantee of future results. Yields fluctuate as market conditions change. Current yields may be higher or lower than those quoted © 2017 Wells Fargo Investment Institute. All rights reserved.
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REAL ASSETS
Austin Pickle, CFA
“If you just focus on the smallest details, you never get the big picture right.”
Investment Strategy Analyst
--Leroy Hood Oil Inventory Drops and Prices Pop – But the Trend Lacks Staying Power
Commodities
Each week, the oil inventory report gets a lot of attention. When inventories decline, oil uber-bulls use this as proof that oil is set to return to the good ol’ days of $100 per barrel prices. It is easy to get caught up in the euphoria. What can be difficult to do is to step back, pause, and look at the bigger picture. Given the past few weeks of inventory draws (declines), and the subsequent euphoria, we believe that now is a good time to step back.
Evenweight
The chart below shows U.S. crude-oil inventory levels versus its rolling five-year average. The oil bulls are correct in that inventories have come down, but what may be an example of oil bulls “not seeing the forest for the trees,” is the fact that the current inventory level is still nearly 100 million barrels above the five-year average. As you can see from the chart, we sit at truly unprecedented inventory levels. In short, we are abnormally awash in oil.
Overweight
This issue of oversupply will be hard to remedy—as each time oil prices pop, more production comes on line as producers rush to capitalize on higher prices. This, in turn, pressures prices back down. We expect this cycle to “rinse and repeat” over the next few years, forcing oil prices to remain range-bound between $30 and $60 per barrel. Our year-end 2017 forecast is $40-$50 per barrel for West Texas Intermediate (WTI) and $45-$55 for Brent crude oil. With WTI currently near $50 and Brent near $53, we do not see much upside today.
Underweight
Private Real Estate
Public Real Estate
Key Takeaways » Recent crude oil inventory draws have propelled prices and sentiment higher. » We do not believe that oil has much upside from here. Our year-end 2017 target range remains $40-$50 per barrel for WTI and $45-$55 for Brent.
U.S. Crude Oil Inventory Levels 570 Crude Oil Inventories 520
Five-Year Average
Millions of Barrels
470
420
370
320
270
220 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Sources: Bloomberg, Energy Information Administration (EIA), Wells Fargo Investment Institute. Weekly Data: 1/30/1987 - 7/28/2017. © 2017 Wells Fargo Investment Institute. All rights reserved.
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ALTERNATIVE INVESTMENTS
Justin Lenarcic Global Alternative Investment Strategist
M&A Wave in Europe Creates A Compelling Opportunity Evenweight
Private Equity
Evenweight
Private Debt
Evenweight
Hedge Funds-Macro
Evenweight
Hedge Funds-Event Driven
Political and economic uncertainties scared many investors away from developed market ex-U.S. equities last year. But with European business and profit cycles in earlier stages relative to the U.S. cycle, not to mention Eurozone economic growth stabilizing leading to an increase in business and consumer confidence, it’s no wonder that announced M&A (Merger and Acquisition) deal volume in Western Europe is up 26 percent year over year (as shown in the chart below). This translates to a potentially compelling opportunity for Event Driven – Merger Arbitrage strategies that can simultaneously allow investors to increase exposure to both Alternative Investments and International Equities. Merger Arbitrage strategies are designed to provide investors with exposure to specific event-driven situations such as mergers. Normally, the stock of an acquisition target appreciates while the acquiring company's stock decreases in value. This is normally accomplished through taking long and short equity positions in the target and acquiring companies respectively. The strategy’s core return driver is a tightening of the gap or “merger spread” between the target company’s current stock price and the announced premium price the acquirer pays for the target company’s stock. We anticipate a growing M&A opportunity set within Developed (non-US) markets as companies search for growth and synergies. Furthermore, the global economy continues to show signs of improvement while innovation and technology likely will continue to disrupt and transform.
Key Takeaways Overweight
Hedge Funds-Relative Value
» Non-U.S. M&A activity is accelerating, especially in the Eurozone where business and consumer confidence is increasing. » Event Driven – Merger Arbitrage strategies can provide exposure to International Equities, but in an actively managed format with less directional market exposure.
Announced M&A Volume (Year-Over-Year) 120%
Overweight
Hedge Funds-Equity Hedge
100% 80%
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.
60%
33%
31%
20%
28%
47%
41%
2016 YTD
2017 YTD
40% 20% 0% North America (-14%)
Sources: Dealogic, July 2017 © 2017 Wells Fargo Investment Institute. All rights reserved.
Western Europe (+26%)
Rest of World (-3%)
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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. Bloomberg CFTC NYCE US Dollar Index Net Non-Commercial Futures Positions measures open interest for markets in which 20 or more traders hold futures positions in the US dollar equal to or above the reporting levels established by the CFTC. This is the overall net noncommercial futures positions in the US Dollar. U.S. Dollar Index (DXY) measures the value of the U.S. dollar relative to majority of its most significant trading partners. This index is similar to other trade-weighted indexes, which also use the exchange rates from the same major currencies. 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.
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 © 2017 Wells Fargo Investment Institute. All rights reserved.
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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 0817-00882
© 2017 Wells Fargo Investment Institute. All rights reserved.
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