Market Perspective
2010 Mid-Year Update—Great Expectations MARKET PERSPECTIVES
James Kochan, Chief Fixed-Income Strategist
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July 2010
The market has been very volatile over the first half of 2010, and it appears likely to stay that way into the second half. After the “Great Moderation” of the 1990s and 2000s, characterized by low inflation and steady growth, we entered the “Great Recession”—a time during which the excesses that built up over decades finally resulted in a drop in housing prices, a jump in unemployment, and a loss of confidence. Now we are caught up in “Great Expectations,” a period characterized by a swing in market sentiment between hope that sustainable growth with low inflation can return and despair over the possibility that the opposite will be the case. We continue to believe that neither of these extremes is likely. The pace of the economic recovery, however, continues to be a key issue for investors. Below, we offer our outlooks on the economy, the fixed-income markets, and the equity markets for the remainder of 2010. The Economy
John Lynch, Chief Equity Strategist
Brian Jacobsen, Chief Portfolio Strategist
The unemployment rate has stayed at an elevated level of around 9.7%. It’s not growing worse, but this is only due to temporary Census jobs and other government hiring, along with a shrinking of the labor force. Private payrolls have expanded, but not robustly, and we’re concerned that businesses may not aggressively add to payrolls, thereby counteracting the cuts they made during the recession. Even if wages stay flat, the prospect of mandated health care benefits that will increase payroll costs may keep businesses from hiring. A rapid economic recovery could help overcome this inertia, but businesses are looking for more evidence of growth before making a commitment to expanding payrolls. Expectations, however, are for slower growth. First-quarter gross domestic product (GDP) was revised down to 2.7%, held back by the lack of contribution from housing and by businesses’ fears of restocking too much inventory too soon. Much strength in spending appears to have come from temporary measures. The homebuyer tax credit, the Cash for Clunkers program, subsidies to upgrade appliances, and sundry other programs have shifted consumption from the future to the present—or from one sector of the economy to another. As these programs expire, we believe real growth will continue to stay low, though not turn negative. The recovery’s pace is uneven, and so is its impact. Manufacturing seems to be recovering more rapidly than the service sector, and construction is still in the dumps. Although economic growth seems slow, it also looks sustainable. It’s not built on housing, which is a shaky foundation for
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economic growth. Retail sales are rising, durable goods orders are up, and the manufacturing expansion appears to be gaining traction. Housing prices look like they may dip down again after the expiration of the homebuyer tax credit, but we don’t think that will crimp consumer spending in the near term, as most people have probably already adjusted to expectations of lower home prices. Despite falling mortgage rates and near-record affordability, the demand for housing has been weakened. The pool of first-time homebuyers has been depleted. Speculators and investors will make up a significant portion of the remaining demand. Reported months’ available supply will stay elevated as the “shadow inventory” (homes owned by banks) trickles into the market, if and when home prices recover. As home prices rise, the banks have an incentive to put these properties back on the market. Weak demand and steadily growing supply will likely cause home prices to decline. The Fed Slow growth augurs well for inflation. Credit conditions, however, are not improving, due not only to restricted supply but also to anemic demand. Slow growth with a lot of spare capacity, along with weak credit creation, makes for a low inflation environment. It also makes for a low interest-rate environment, which could persist for the rest of the year—or at least until credit conditions materially improve. These conditions make for greater price distortions rather than price inflation. The Federal Reserve has said it will keep rates low for “an extended period of time”—a phrase it’s been using for an extended period of time and may use again in the third quarter. Whatever the Fed says, it seems to want to telegraph everything it will do, lest people start panicking. While some investors may think the Fed will raise rates in 2010, we think renewed quantitative easing is more likely. Just as the Fed stepped in to buy mortgage-related debt in the midst of the housing crisis, we think it may buy European debt. But this depends on what happens in Europe and is not highly probable—but is more likely than the Fed raising rates with unemployment hovering above 9%. Thanks to the prospects of higher labor costs, businesses have been aggressively investing in small-scale, productivity-enhancing technologies. This investment in capital has created some growth and has increased worker productivity. Typically, we’d expect higher productivity to be accompanied by higher wages, but with a large army of unemployed and underemployed workers, there is no wage-inflation pressure. This has resulted in a recovery characterized by growth without inflation. In fact, some parts of the economy are experiencing outright deflation—computing costs are falling, housing costs are falling, and food costs are falling. Even automobile prices are lower. Instead of inflation or deflation, we have both. That’s great for businesses that can protect their bottom lines through pricing power, but it could mean trouble for those that need more financing and those focused on niche markets.
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July 2010
Fixed-Income With certificates of deposit and money market accounts yielding pittances, investors are looking for income. But they shouldn’t expect help from the Fed. It has its hands full—and will for an extended period. The steepness of the Treasury yield curve means investors may get a little more yield by extending maturities a little further out or by moving up the risk curve into slightly lower-grade securities. Since nominal rates are historically low, investors may be wondering if they should prepare for rising rates. They might not have to. In fact, we don’t think rates— especially intermediate- to longer-term rates—will move appreciably for the rest of 2010. The U.S. bond market is again benefiting from strong inflows from overseas. From 2004 to 2006, these flows helped to keep bond yields relatively steady, as the Federal Reserve raised the fed funds rate from 1.00% to 5.25%. At the start of that tightening process, the yield on the 30-year Treasury bond was 5.25%, and at the end of the tightening, that yield was 5.125%. Then-Fed Chairman Alan Greenspan called this somewhat unusual behavior “a conundrum.” Current Fed Chairman Ben Bernanke referred to a glut of worldwide savings as the primary explanation for this anomalous market action. He meant that exporters in Asia and the oil-producing countries were accumulating dollars and were not spending them on U.S. goods and services but rather were investing them in bonds, thereby keeping bond yields from rising. C ha r T 1: Tr Ea s U rY YI E ld C U r v E s, J U lY 2004 a n d J U lY 2006 6%
Percentage
5% 4% 3% 7-12-04
7-17-06
2% 1% 0% 1/4
1
3
5
9 12 Term to Maturity (In Years)
15
20
30
Source: Bloomberg Past performance is no guarantee of future results.
A close approximation of that conundrum appears to be making an impact on the bond market now. Turmoil in the European debt markets has apparently caused some redirection of savings toward the relative safety of the dollar markets, especially Treasuries. Since the turmoil began in April, the yield on the benchmark ten-year Treasury note has dropped from around 4.00% to around 3.25%. The monthly reports on foreign investors’ purchases of dollar securities have shown a big jump in Treasury purchases starting in March, when concerns about Greece began to emerge. In March and April, those purchases averaged $110 billion, versus a monthly average of $50 billion over the prior six months. In the 2004–2006 period of Fed tightening, the monthly average was approximately $70 billion.
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One problem with comparing today’s conditions to those from 2004 to 2006 is that, during the previous period, Treasury borrowing was only averaging around $300 billion per year—now that borrowing pace is more than $1 trillion. It is important to note, however, that typically, the private sector of the economy borrows much more than the Treasury. For example, in that 2004–2006 period, private-sector borrowing averaged $2 trillion per year, approximately seven times more than Treasury borrowing. Currently, however, private-sector borrowing is essentially zero—thanks to the recession and the deleveraging of household and business balance sheets. Whether or not the markets are experiencing another conundrum is of crucial importance to investors in the fixed-income markets from 2010 to 2011. The Federal Reserve will likely start raising the federal funds rate sometime over the next 12 months, and that would be expected to push yields on one-and five-year Treasury notes upward. How the longer maturities respond usually depends on supply-and-demand fundamentals in that segment of the maturity spectrum. So while the 2004–2006 conundrum was largely the product of unusually strong demand for notes and bonds from overseas, today’s conundrum is the result of strong demand for debt securities facing a reduced supply. The Treasury is issuing a large volume of new debt, but the private sector is issuing hardly any. For the next 12 to 24 months, the primary factors that influence total bond returns are likely to be the very steep yield curves and still-generous quality spreads rather than Federal Reserve policy. We believe the Fed is likely to keep the federal funds rate near zero for the rest of 2010 and perhaps longer—and raise it relatively slowly in 2011—we expect bonds and bond funds to provide substantially better returns than cash equivalents and other defensive investment strategies. steep Curves Yield curves in the Treasury, corporate, and municipal markets are some of the steepest on record. This is important for two reasons. Steep curves reward investing in the longer-maturity issues, as those issues provide significantly better yields. They also protect the longer maturities from the full impact of rising short-term interest rates. Currently, for example, Treasury bonds yield almost four percentage points more than one-year Treasury bills and three-and-a-half percentage points more than two-year Treasury notes. In the corporate market, yields on long maturities are four to five percentage points higher than yields on one-year issues. In the municipal market, the investor gains approximately four percentage points in interest income by owning long-term bonds or funds instead of one-year notes or short-term funds. For every $100,000 invested, the investor sacrifices approximately $4,000 of income per year in return for the relative “safety” of short-term investments.
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July 2010
C ha r T 2: MUn ICI pa l Bon d s p r E ad, 30-YE ar aaa v E r s U s o n E - YE a r 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1-3-94
1-3-96
1-3-98
1-3-00
1-3-02
1-3-04
1-3-06
1-3-08
1-3-10
Source: Bloomberg Past performance is no guarantee of future results.
The pattern of returns thus far in 2010 has, in most instances, reflected the very steep curves. In every market except high yield, total returns in the ten-year and longer-maturity segments are much greater than in the shorter-maturity segments. Among Treasuries, bills produced a return of only 0.12%, and one- to three-year notes have returned 1.50%. Maturities beyond ten years returned approximately 7.50%, or five times the returns from the shorter notes. In the corporate and municipal markets, returns from the longer maturities were triple those from the one- to three-year segment. The exception was in the high-yield market, where returns were remarkably uniform across maturities. C ha r T 3: ToTa l r E T Ur n s a lon G T h E C U r v E, Y T d, as o F 6-30-10 14.00%
Short Term, 1-3 Yr Maturity; Treasury = Tbills Long Term, 10+ Yr Maturity
12.00%
Total Returns %
10.00% 8.00% 6.00% 4.00% 2.00% 0.00%
Treasuries
Corporates
High Yield
Source: Merrill Lynch Past performance is no guarantee of future results.
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Municipals
MARKET PERSPECTIVES
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July 2010
Quality spreads Two sectors—high-yield corporates and A/BBB rated municipals—continue to offer unusually generous yield spreads versus Treasuries. In the high-yield market, the spread between yields on B-rated corporate bonds and the yield on the ten-year Treasury has widened approximately 100 basis points (bps), to more than 500 bps, since the onset of the debt crisis in Europe. While dwarfed by the extreme spreads of late 2008, the current spread is almost as wide as the peak spreads seen from 1990 to 1991 and 2001 to 2002, the previous bear markets in high yield. Moreover, the absolute yields are a percentage point higher than they were in early May and once again above the ranges that prevailed from 2003 to 2006. During that period of rising short-term rates, ten- and 30-year B-rated bond yields were in the 7.00%–8.00% range. Those yields are now around 8.50% to 9.25%. In our view, the BB/B segments of the high-yield market again offer good relative and absolute values. C ha r T 4: B-r aT E d Cor por aT E Bon d YI E l d s v E r s U s T E n- YE ar T r E a s U rY YI E ld s 1,400 1,200 1,000 800 600 400 200 0 5-7-92
5-7-94
5-7-96
5-7-98
5-7-00
5-7-02
5-7-04
5-7-06
5-7-08
5-7-10
Source: Bloomberg Past performance is no guarantee of future results.
In the municipal sector, yields on A- and BBB-rated issues are well above Treasury yields, despite the huge rally in 2009. The ratio of yields on ten-year A-rated municipals to ten-year Treasury yields is almost 1.30, far above the 0.85–0.90 range that was the norm prior to 2008. For the 30-year maturities, that ratio is also 1.30 versus a long-term average of 0.90. Yields on the tenand 30-year A-rated general obligation bonds are a full percentage point higher than yields on the same maturities of AAA bonds. Typically, those spreads are in the 20–30 bp range. These yield ratios and yield spreads, along with the steepness of the yield curves, mark the ten-year and longer A/BBB maturities as unusually good values.
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C ha r T 5: r aTI o oF YI E ld s o n MU n ICI pa l a - r aT E d B o n d s To T E n- YE ar T r E a s U r I E s 2.5 2.0 1.5 1.0 0.5 0.0 3-28-91
3-28-93
3-28-95
3-28-97
3-28-99
3-28-01
3-28-03
3-28-05
3-28-07
3-28-09
Source: Bloomberg Past performance is no guarantee of future results.
These recommendations typically prompt two questions. One is whether or not we are giving appropriate weight to the fiscal problems of state and local governments and the attendant risks of municipal bond defaults. Although history shows that, even during periods of severe fiscal stress, defaults by those issuers are rare, the risk of credit downgrades and unfavorable media reports in the months ahead is high. In this market environment, we believe a high degree of portfolio diversification and solid credit research capabilities are extremely beneficial. The second question is whether or not we recommend owning longer maturities—in order to take advantage of steep yield curves—at a time when the next major move in interest rates is very likely upward. The conventional wisdom is that investors should become defensive, overweighting cash equivalents or floating-rate securities. We have argued that it is too early in this cycle to become defensive. It may be another 12 months before short-term rates trend higher, and even then, if yield curves flatten as we expect (another conundrum), bond funds would likely continue to produce substantially better returns than the defensive portfolios. In our opinion, the income investors may forgo by pursuing defensive strategies over the next 12 months would be too great to justify ultraconservative investment policy recommendations. Equities The effective combination of monetary policy and fiscal stimulus enabled the equity market, as defined by the S&P 500 Index, to climb in excess of 80.0% from its March 2009 trough to its April 2010 peak. Throughout much of this time period, stocks climbed with little interruption, as the surge in global liquidity after the credit crisis resulted in an environment of more dollars chasing fewer shares, pushing the equity markets higher. Indeed, we wrote many times of our belief that the market technicals (price and volume patterns) were superior to fundamentals (sources for economic and profit growth), as the major equity indices continued to eclipse one hurdle after another. Yet investors’ inevitable comeuppance with this liquidity-driven market
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arrived in early May, as a perfect storm of worries collided head-on with the markets, including sovereign debt, financial regulation, credit tightening in China, the Gulf oil disaster, and a variety of geopolitical threats. Consequently, the heretofore solid market technicals broke down, sending the S&P 500 Index tumbling by 14.0% in just a little more than three weeks for the market’s first official correction of this cycle. Ironically, it appeared that, just as the technicals started to break down, the fundamentals began to gain some traction. Home prices fell at a slower rate, inflation fears were muted, and job growth, although spotty, resumed. Moreover, the escalation of the sovereign debt situation in Europe likely bought another year of accommodation from the Federal Reserve. Corporations were once again generating profits, and as the first half of the year progressed, it became evident that the earnings gains came not only from cost cutting, but also from impressive sales gains. After all, shouldn’t a backdrop of low inflation, low interest rates, and improving profit growth drive stock prices higher? Alas … Technical outlook In keeping with our track-and-field analogies from our last Market Update (“Starting Blocks,” June 17, 2010), the equity market finally tripped over its last hurdle beginning in early May (see chart 6). Indeed, over the previous 14 months, the S&P 500 Index successfully climbed a variety of technical hurdles, surpassing each with relative ease. Yet we remind investors that two of the index’s most significant hurdles, the 38% retracement (1,015) and the 50% retracement (1,120), each took approximately four months before market resistance transitioned into market support. (Retracement levels signify the market’s recoupment of the losses sustained from the S&P 500 Index’s peak of 1,570 in October 2007 to its low of 670 in March 2009.) To be sure, in the market’s first attempt at a 62% retracement (1,228), it failed miserably, topping out in the 1,215 range before plunging to 1,040, aided, no doubt, by the confluence of events and worries highlighted above. C ha r T 6: s&p 500 I n d E x, 50-d Ma, a n d 200-d Ma 1,300 S&P 500 Index
50-DMA
200-DMA
1,200 1,100 1,000 900 800 700 6-18-09
7-22-09
8-24-09
9-25-09 10-28-09 12-1-09
1-5-10
2-8-10
3-12-10
4-15-10
5-18-10
Source: Bloomberg Past performance is no guarantee of future results.
We believe the market’s interaction with its 200-day moving average (DMA), currently in the 1,110 range, will be a critical factor in settling the question of whether or not stocks can sustain another sprint higher. Indeed, several technical indicators—such as relative strength, volume,
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and sentiment—recently suggested that the S&P 500 Index had capitulated in the 1,040 range, where stocks appeared to have made a “double bottom.” As the index climbed from this level, it has become critical for equities to exhibit “follow-through,” whereby gains are met with an upward bias rather than profit-taking, potentially allowing for the market to reestablish its longer-term trend above its 200-DMA. If stocks can achieve this objective over a period of days or weeks, we see initial technical resistance at 1,120 (50% retracement) and 1,150 (January high) before psychological resistance at 1,200, where investors can prepare for the S&P 500 Index’s next attempt at the 1,228 level. If the S&P 500 Index breaks through the 1,040 level for a number of days, it could head lower, with little resistance, until we hit the 880 level. Fundamental outlook In addition to the improving technical picture, several economic and corporate fundamentals have also gathered strength. It appears inflation, for the time being, is a nonstarter, and, since the Federal Reserve reopened its currency swap lines as part of the eurozone bailout plan, it looks as though monetary policymakers will keep the federal funds rate near zero into 2011, as we discussed above. Fortunately, this backdrop also includes a return to corporate profitability. To be sure, much of the criticism of earnings per share (EPS) growth these past few quarters has involved concerns that the gains were unsustainable due to the benefits of one-time, and often dramatic, cost cutting. Yet it has become evident that companies have been able to not only hold the line on costs, but also improve their sales figures. Considering this top- and bottom-line strength, along with improved corporate visibility on the outlook for future EPS gains, we recently increased our operating EPS projection by $5.00, to $77.50, for the S&P 500 Index in 2010. In addition, we introduced our forecast of $85.00 for the index in 2011 (see chart 7). It should be noted that these projections remain well below the Wall Street consensus estimates, which are approximately $82.50 for 2010 and $95.00 for 2011, according to Standard and Poor’s. Our concerns regarding the extent of the recovery, the lack of contribution from financial leverage, deficit spending, dollar strength, and sovereign credit risks all prevent us from matching, or exceeding, consensus expectations. C ha r T 7: s&p 500 I n d E x QUa r T E r lY E p s aC T Ua l ( a ) an d E s T IMaT E ( E ), as o F 6-1-2010
2009A
2010E
2011E
Q1
$10.10
-39%
$19.25
91%
$20.50
6%
Q2
$13.80
-19%
$19.30
40%
$20.75
8%
Q3
$15.80
-1%
$19.45
23%
$21.50
11%
Q4
$17.15
–
$19.50
14%
$22.25
14%
Full Year
$56.85
15%
$77.50
36%
$85.00
10%
Source: 500 Index and author’s calculations Past performance is no guarantee of future results.
Despite the longer-term or secular challenges facing the economy and the markets, including the sovereign credit risks in Europe, we suspect that the domestic cyclical strengths will ultimately prove to be the primary driver for equity prices in the coming months and quarters, as was the case following the crises involving the Mexican peso in 1994, the Thai baht in 1997, and the
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Russian ruble in 1998. In addition, we believe that the recent washout in stocks will result in more quality leadership as this cycle matures. We continue to believe that applying a historically average price/earnings ratio of 16.5 times our below-consensus 2010 EPS estimate of $77.50 would result in the S&P 500 Index being fairly valued in the 1,275 range by year-end. The need for patience and active diversification For the next two years, we think the economy risks staying on a low-growth trajectory, with higher-than-usual unemployment and lower-than-usual inflation (disinflation). Unlike the “stagflation” of the late 1970s and early 1980s, characterized by high unemployment and high inflation, this period of “disemployment” is a textbook example of the type of economy that can’t be built up with loose money or big budget deficits. It will only improve with time, as people and businesses reorient themselves to changing market conditions. It’s a complex problem with a simple solution: patience. For investors, this calls for discipline and an open-minded search for opportunities. There is no longer one obvious sector or asset class that is overvalued or undervalued, so we recommend “active diversification.” An actively diversified portfolio is not simply a matter of the quantity of securities but also the price an investor pays for each security. Active diversification is about making many varied small investments and being aware of valuations. As a result of these considerations, we continue to emphasize fully diversified strategies for long-term equity investors in order to participate in potential market gains while limiting the potential for losses. Periods of low nominal GDP growth have historically been accompanied by increases in market volatility, allowing for active managers to typically outperform more passive strategies. Therefore, we encourage investors to have appropriate equity and bond market exposure relative to capitalization, investment style, and region.
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strength. Expertise. partnership. Wells Fargo Advantage Funds® skillfully guides institutions, financial advisors, and individuals through the investment terrain to help them reach their financial objectives. Everything we do on behalf of our investors is built on the standards of integrity and service established by our parent company, Wells Fargo & Company; the expertise of our independent investment teams and rigorous ongoing investment review; and the collaborative level of superior service that is our trademark.
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The views expressed are as of June 30, 2010, and are those of Brian Jacobsen, James Kochan, John Lynch, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the authors and are not intended to be used as investment advice. The views are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index with each stock’s weight in The index proportionate to its market value. You cannot invest directly in an index.
Stock fund values fluctuate in response to the activities of individual companies and general market and economic conditions. Bond fund values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. In general, when interest rates rise, bond fund values fall and investors may lose principal value. Some funds, including nondiversified funds and funds investing in foreign investments, high-yield bonds, small and mid cap stocks, and/or more volatile segments of the economy, entail additional risk and may not be appropriate for all investors. Consult a Fund’s prospectus for additional information on these and other risks. Carefully consider a fund’s investment objectives, risks, charges, and expenses before investing. For a current prospectus, containing this and other information, visit www.wellsfargo.com/advantagefunds. Read it carefully before investing. Wells Fargo Funds Management, LLC, a wholly owned subsidiary of Wells Fargo & Company, provides investment advisory and administrative services for Wells Fargo Advantage Funds. Other affiliates of Wells Fargo & Company provide subadvisory and other services for the Funds. The Funds are distributed by Wells Fargo Funds Distributor, LLC, Member FINRA/SIPC, an affiliate of Wells Fargo & Company. 123796 07-10
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FAWP027 07-10
James Kochan, Chief Fixed-Income Strategist
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July 2010
The market has been very volatile over the first half of 2010, and it appears likely to stay that way into the second half. After the “Great Moderation” of the 1990s and 2000s, characterized by low inflation and steady growth, we entered the “Great Recession”—a time during which the excesses that built up over decades finally resulted in a drop in housing prices, a jump in unemployment, and a loss of confidence. Now we are caught up in “Great Expectations,” a period characterized by a swing in market sentiment between hope that sustainable growth with low inflation can return and despair over the possibility that the opposite will be the case. We continue to believe that neither of these extremes is likely. The pace of the economic recovery, however, continues to be a key issue for investors. Below, we offer our outlooks on the economy, the fixed-income markets, and the equity markets for the remainder of 2010. The Economy
John Lynch, Chief Equity Strategist
Brian Jacobsen, Chief Portfolio Strategist
The unemployment rate has stayed at an elevated level of around 9.7%. It’s not growing worse, but this is only due to temporary Census jobs and other government hiring, along with a shrinking of the labor force. Private payrolls have expanded, but not robustly, and we’re concerned that businesses may not aggressively add to payrolls, thereby counteracting the cuts they made during the recession. Even if wages stay flat, the prospect of mandated health care benefits that will increase payroll costs may keep businesses from hiring. A rapid economic recovery could help overcome this inertia, but businesses are looking for more evidence of growth before making a commitment to expanding payrolls. Expectations, however, are for slower growth. First-quarter gross domestic product (GDP) was revised down to 2.7%, held back by the lack of contribution from housing and by businesses’ fears of restocking too much inventory too soon. Much strength in spending appears to have come from temporary measures. The homebuyer tax credit, the Cash for Clunkers program, subsidies to upgrade appliances, and sundry other programs have shifted consumption from the future to the present—or from one sector of the economy to another. As these programs expire, we believe real growth will continue to stay low, though not turn negative. The recovery’s pace is uneven, and so is its impact. Manufacturing seems to be recovering more rapidly than the service sector, and construction is still in the dumps. Although economic growth seems slow, it also looks sustainable. It’s not built on housing, which is a shaky foundation for
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economic growth. Retail sales are rising, durable goods orders are up, and the manufacturing expansion appears to be gaining traction. Housing prices look like they may dip down again after the expiration of the homebuyer tax credit, but we don’t think that will crimp consumer spending in the near term, as most people have probably already adjusted to expectations of lower home prices. Despite falling mortgage rates and near-record affordability, the demand for housing has been weakened. The pool of first-time homebuyers has been depleted. Speculators and investors will make up a significant portion of the remaining demand. Reported months’ available supply will stay elevated as the “shadow inventory” (homes owned by banks) trickles into the market, if and when home prices recover. As home prices rise, the banks have an incentive to put these properties back on the market. Weak demand and steadily growing supply will likely cause home prices to decline. The Fed Slow growth augurs well for inflation. Credit conditions, however, are not improving, due not only to restricted supply but also to anemic demand. Slow growth with a lot of spare capacity, along with weak credit creation, makes for a low inflation environment. It also makes for a low interest-rate environment, which could persist for the rest of the year—or at least until credit conditions materially improve. These conditions make for greater price distortions rather than price inflation. The Federal Reserve has said it will keep rates low for “an extended period of time”—a phrase it’s been using for an extended period of time and may use again in the third quarter. Whatever the Fed says, it seems to want to telegraph everything it will do, lest people start panicking. While some investors may think the Fed will raise rates in 2010, we think renewed quantitative easing is more likely. Just as the Fed stepped in to buy mortgage-related debt in the midst of the housing crisis, we think it may buy European debt. But this depends on what happens in Europe and is not highly probable—but is more likely than the Fed raising rates with unemployment hovering above 9%. Thanks to the prospects of higher labor costs, businesses have been aggressively investing in small-scale, productivity-enhancing technologies. This investment in capital has created some growth and has increased worker productivity. Typically, we’d expect higher productivity to be accompanied by higher wages, but with a large army of unemployed and underemployed workers, there is no wage-inflation pressure. This has resulted in a recovery characterized by growth without inflation. In fact, some parts of the economy are experiencing outright deflation—computing costs are falling, housing costs are falling, and food costs are falling. Even automobile prices are lower. Instead of inflation or deflation, we have both. That’s great for businesses that can protect their bottom lines through pricing power, but it could mean trouble for those that need more financing and those focused on niche markets.
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Fixed-Income With certificates of deposit and money market accounts yielding pittances, investors are looking for income. But they shouldn’t expect help from the Fed. It has its hands full—and will for an extended period. The steepness of the Treasury yield curve means investors may get a little more yield by extending maturities a little further out or by moving up the risk curve into slightly lower-grade securities. Since nominal rates are historically low, investors may be wondering if they should prepare for rising rates. They might not have to. In fact, we don’t think rates— especially intermediate- to longer-term rates—will move appreciably for the rest of 2010. The U.S. bond market is again benefiting from strong inflows from overseas. From 2004 to 2006, these flows helped to keep bond yields relatively steady, as the Federal Reserve raised the fed funds rate from 1.00% to 5.25%. At the start of that tightening process, the yield on the 30-year Treasury bond was 5.25%, and at the end of the tightening, that yield was 5.125%. Then-Fed Chairman Alan Greenspan called this somewhat unusual behavior “a conundrum.” Current Fed Chairman Ben Bernanke referred to a glut of worldwide savings as the primary explanation for this anomalous market action. He meant that exporters in Asia and the oil-producing countries were accumulating dollars and were not spending them on U.S. goods and services but rather were investing them in bonds, thereby keeping bond yields from rising. C ha r T 1: Tr Ea s U rY YI E ld C U r v E s, J U lY 2004 a n d J U lY 2006 6%
Percentage
5% 4% 3% 7-12-04
7-17-06
2% 1% 0% 1/4
1
3
5
9 12 Term to Maturity (In Years)
15
20
30
Source: Bloomberg Past performance is no guarantee of future results.
A close approximation of that conundrum appears to be making an impact on the bond market now. Turmoil in the European debt markets has apparently caused some redirection of savings toward the relative safety of the dollar markets, especially Treasuries. Since the turmoil began in April, the yield on the benchmark ten-year Treasury note has dropped from around 4.00% to around 3.25%. The monthly reports on foreign investors’ purchases of dollar securities have shown a big jump in Treasury purchases starting in March, when concerns about Greece began to emerge. In March and April, those purchases averaged $110 billion, versus a monthly average of $50 billion over the prior six months. In the 2004–2006 period of Fed tightening, the monthly average was approximately $70 billion.
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One problem with comparing today’s conditions to those from 2004 to 2006 is that, during the previous period, Treasury borrowing was only averaging around $300 billion per year—now that borrowing pace is more than $1 trillion. It is important to note, however, that typically, the private sector of the economy borrows much more than the Treasury. For example, in that 2004–2006 period, private-sector borrowing averaged $2 trillion per year, approximately seven times more than Treasury borrowing. Currently, however, private-sector borrowing is essentially zero—thanks to the recession and the deleveraging of household and business balance sheets. Whether or not the markets are experiencing another conundrum is of crucial importance to investors in the fixed-income markets from 2010 to 2011. The Federal Reserve will likely start raising the federal funds rate sometime over the next 12 months, and that would be expected to push yields on one-and five-year Treasury notes upward. How the longer maturities respond usually depends on supply-and-demand fundamentals in that segment of the maturity spectrum. So while the 2004–2006 conundrum was largely the product of unusually strong demand for notes and bonds from overseas, today’s conundrum is the result of strong demand for debt securities facing a reduced supply. The Treasury is issuing a large volume of new debt, but the private sector is issuing hardly any. For the next 12 to 24 months, the primary factors that influence total bond returns are likely to be the very steep yield curves and still-generous quality spreads rather than Federal Reserve policy. We believe the Fed is likely to keep the federal funds rate near zero for the rest of 2010 and perhaps longer—and raise it relatively slowly in 2011—we expect bonds and bond funds to provide substantially better returns than cash equivalents and other defensive investment strategies. steep Curves Yield curves in the Treasury, corporate, and municipal markets are some of the steepest on record. This is important for two reasons. Steep curves reward investing in the longer-maturity issues, as those issues provide significantly better yields. They also protect the longer maturities from the full impact of rising short-term interest rates. Currently, for example, Treasury bonds yield almost four percentage points more than one-year Treasury bills and three-and-a-half percentage points more than two-year Treasury notes. In the corporate market, yields on long maturities are four to five percentage points higher than yields on one-year issues. In the municipal market, the investor gains approximately four percentage points in interest income by owning long-term bonds or funds instead of one-year notes or short-term funds. For every $100,000 invested, the investor sacrifices approximately $4,000 of income per year in return for the relative “safety” of short-term investments.
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C ha r T 2: MUn ICI pa l Bon d s p r E ad, 30-YE ar aaa v E r s U s o n E - YE a r 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1-3-94
1-3-96
1-3-98
1-3-00
1-3-02
1-3-04
1-3-06
1-3-08
1-3-10
Source: Bloomberg Past performance is no guarantee of future results.
The pattern of returns thus far in 2010 has, in most instances, reflected the very steep curves. In every market except high yield, total returns in the ten-year and longer-maturity segments are much greater than in the shorter-maturity segments. Among Treasuries, bills produced a return of only 0.12%, and one- to three-year notes have returned 1.50%. Maturities beyond ten years returned approximately 7.50%, or five times the returns from the shorter notes. In the corporate and municipal markets, returns from the longer maturities were triple those from the one- to three-year segment. The exception was in the high-yield market, where returns were remarkably uniform across maturities. C ha r T 3: ToTa l r E T Ur n s a lon G T h E C U r v E, Y T d, as o F 6-30-10 14.00%
Short Term, 1-3 Yr Maturity; Treasury = Tbills Long Term, 10+ Yr Maturity
12.00%
Total Returns %
10.00% 8.00% 6.00% 4.00% 2.00% 0.00%
Treasuries
Corporates
High Yield
Source: Merrill Lynch Past performance is no guarantee of future results.
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Municipals
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Quality spreads Two sectors—high-yield corporates and A/BBB rated municipals—continue to offer unusually generous yield spreads versus Treasuries. In the high-yield market, the spread between yields on B-rated corporate bonds and the yield on the ten-year Treasury has widened approximately 100 basis points (bps), to more than 500 bps, since the onset of the debt crisis in Europe. While dwarfed by the extreme spreads of late 2008, the current spread is almost as wide as the peak spreads seen from 1990 to 1991 and 2001 to 2002, the previous bear markets in high yield. Moreover, the absolute yields are a percentage point higher than they were in early May and once again above the ranges that prevailed from 2003 to 2006. During that period of rising short-term rates, ten- and 30-year B-rated bond yields were in the 7.00%–8.00% range. Those yields are now around 8.50% to 9.25%. In our view, the BB/B segments of the high-yield market again offer good relative and absolute values. C ha r T 4: B-r aT E d Cor por aT E Bon d YI E l d s v E r s U s T E n- YE ar T r E a s U rY YI E ld s 1,400 1,200 1,000 800 600 400 200 0 5-7-92
5-7-94
5-7-96
5-7-98
5-7-00
5-7-02
5-7-04
5-7-06
5-7-08
5-7-10
Source: Bloomberg Past performance is no guarantee of future results.
In the municipal sector, yields on A- and BBB-rated issues are well above Treasury yields, despite the huge rally in 2009. The ratio of yields on ten-year A-rated municipals to ten-year Treasury yields is almost 1.30, far above the 0.85–0.90 range that was the norm prior to 2008. For the 30-year maturities, that ratio is also 1.30 versus a long-term average of 0.90. Yields on the tenand 30-year A-rated general obligation bonds are a full percentage point higher than yields on the same maturities of AAA bonds. Typically, those spreads are in the 20–30 bp range. These yield ratios and yield spreads, along with the steepness of the yield curves, mark the ten-year and longer A/BBB maturities as unusually good values.
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C ha r T 5: r aTI o oF YI E ld s o n MU n ICI pa l a - r aT E d B o n d s To T E n- YE ar T r E a s U r I E s 2.5 2.0 1.5 1.0 0.5 0.0 3-28-91
3-28-93
3-28-95
3-28-97
3-28-99
3-28-01
3-28-03
3-28-05
3-28-07
3-28-09
Source: Bloomberg Past performance is no guarantee of future results.
These recommendations typically prompt two questions. One is whether or not we are giving appropriate weight to the fiscal problems of state and local governments and the attendant risks of municipal bond defaults. Although history shows that, even during periods of severe fiscal stress, defaults by those issuers are rare, the risk of credit downgrades and unfavorable media reports in the months ahead is high. In this market environment, we believe a high degree of portfolio diversification and solid credit research capabilities are extremely beneficial. The second question is whether or not we recommend owning longer maturities—in order to take advantage of steep yield curves—at a time when the next major move in interest rates is very likely upward. The conventional wisdom is that investors should become defensive, overweighting cash equivalents or floating-rate securities. We have argued that it is too early in this cycle to become defensive. It may be another 12 months before short-term rates trend higher, and even then, if yield curves flatten as we expect (another conundrum), bond funds would likely continue to produce substantially better returns than the defensive portfolios. In our opinion, the income investors may forgo by pursuing defensive strategies over the next 12 months would be too great to justify ultraconservative investment policy recommendations. Equities The effective combination of monetary policy and fiscal stimulus enabled the equity market, as defined by the S&P 500 Index, to climb in excess of 80.0% from its March 2009 trough to its April 2010 peak. Throughout much of this time period, stocks climbed with little interruption, as the surge in global liquidity after the credit crisis resulted in an environment of more dollars chasing fewer shares, pushing the equity markets higher. Indeed, we wrote many times of our belief that the market technicals (price and volume patterns) were superior to fundamentals (sources for economic and profit growth), as the major equity indices continued to eclipse one hurdle after another. Yet investors’ inevitable comeuppance with this liquidity-driven market
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arrived in early May, as a perfect storm of worries collided head-on with the markets, including sovereign debt, financial regulation, credit tightening in China, the Gulf oil disaster, and a variety of geopolitical threats. Consequently, the heretofore solid market technicals broke down, sending the S&P 500 Index tumbling by 14.0% in just a little more than three weeks for the market’s first official correction of this cycle. Ironically, it appeared that, just as the technicals started to break down, the fundamentals began to gain some traction. Home prices fell at a slower rate, inflation fears were muted, and job growth, although spotty, resumed. Moreover, the escalation of the sovereign debt situation in Europe likely bought another year of accommodation from the Federal Reserve. Corporations were once again generating profits, and as the first half of the year progressed, it became evident that the earnings gains came not only from cost cutting, but also from impressive sales gains. After all, shouldn’t a backdrop of low inflation, low interest rates, and improving profit growth drive stock prices higher? Alas … Technical outlook In keeping with our track-and-field analogies from our last Market Update (“Starting Blocks,” June 17, 2010), the equity market finally tripped over its last hurdle beginning in early May (see chart 6). Indeed, over the previous 14 months, the S&P 500 Index successfully climbed a variety of technical hurdles, surpassing each with relative ease. Yet we remind investors that two of the index’s most significant hurdles, the 38% retracement (1,015) and the 50% retracement (1,120), each took approximately four months before market resistance transitioned into market support. (Retracement levels signify the market’s recoupment of the losses sustained from the S&P 500 Index’s peak of 1,570 in October 2007 to its low of 670 in March 2009.) To be sure, in the market’s first attempt at a 62% retracement (1,228), it failed miserably, topping out in the 1,215 range before plunging to 1,040, aided, no doubt, by the confluence of events and worries highlighted above. C ha r T 6: s&p 500 I n d E x, 50-d Ma, a n d 200-d Ma 1,300 S&P 500 Index
50-DMA
200-DMA
1,200 1,100 1,000 900 800 700 6-18-09
7-22-09
8-24-09
9-25-09 10-28-09 12-1-09
1-5-10
2-8-10
3-12-10
4-15-10
5-18-10
Source: Bloomberg Past performance is no guarantee of future results.
We believe the market’s interaction with its 200-day moving average (DMA), currently in the 1,110 range, will be a critical factor in settling the question of whether or not stocks can sustain another sprint higher. Indeed, several technical indicators—such as relative strength, volume,
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and sentiment—recently suggested that the S&P 500 Index had capitulated in the 1,040 range, where stocks appeared to have made a “double bottom.” As the index climbed from this level, it has become critical for equities to exhibit “follow-through,” whereby gains are met with an upward bias rather than profit-taking, potentially allowing for the market to reestablish its longer-term trend above its 200-DMA. If stocks can achieve this objective over a period of days or weeks, we see initial technical resistance at 1,120 (50% retracement) and 1,150 (January high) before psychological resistance at 1,200, where investors can prepare for the S&P 500 Index’s next attempt at the 1,228 level. If the S&P 500 Index breaks through the 1,040 level for a number of days, it could head lower, with little resistance, until we hit the 880 level. Fundamental outlook In addition to the improving technical picture, several economic and corporate fundamentals have also gathered strength. It appears inflation, for the time being, is a nonstarter, and, since the Federal Reserve reopened its currency swap lines as part of the eurozone bailout plan, it looks as though monetary policymakers will keep the federal funds rate near zero into 2011, as we discussed above. Fortunately, this backdrop also includes a return to corporate profitability. To be sure, much of the criticism of earnings per share (EPS) growth these past few quarters has involved concerns that the gains were unsustainable due to the benefits of one-time, and often dramatic, cost cutting. Yet it has become evident that companies have been able to not only hold the line on costs, but also improve their sales figures. Considering this top- and bottom-line strength, along with improved corporate visibility on the outlook for future EPS gains, we recently increased our operating EPS projection by $5.00, to $77.50, for the S&P 500 Index in 2010. In addition, we introduced our forecast of $85.00 for the index in 2011 (see chart 7). It should be noted that these projections remain well below the Wall Street consensus estimates, which are approximately $82.50 for 2010 and $95.00 for 2011, according to Standard and Poor’s. Our concerns regarding the extent of the recovery, the lack of contribution from financial leverage, deficit spending, dollar strength, and sovereign credit risks all prevent us from matching, or exceeding, consensus expectations. C ha r T 7: s&p 500 I n d E x QUa r T E r lY E p s aC T Ua l ( a ) an d E s T IMaT E ( E ), as o F 6-1-2010
2009A
2010E
2011E
Q1
$10.10
-39%
$19.25
91%
$20.50
6%
Q2
$13.80
-19%
$19.30
40%
$20.75
8%
Q3
$15.80
-1%
$19.45
23%
$21.50
11%
Q4
$17.15
–
$19.50
14%
$22.25
14%
Full Year
$56.85
15%
$77.50
36%
$85.00
10%
Source: 500 Index and author’s calculations Past performance is no guarantee of future results.
Despite the longer-term or secular challenges facing the economy and the markets, including the sovereign credit risks in Europe, we suspect that the domestic cyclical strengths will ultimately prove to be the primary driver for equity prices in the coming months and quarters, as was the case following the crises involving the Mexican peso in 1994, the Thai baht in 1997, and the
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Russian ruble in 1998. In addition, we believe that the recent washout in stocks will result in more quality leadership as this cycle matures. We continue to believe that applying a historically average price/earnings ratio of 16.5 times our below-consensus 2010 EPS estimate of $77.50 would result in the S&P 500 Index being fairly valued in the 1,275 range by year-end. The need for patience and active diversification For the next two years, we think the economy risks staying on a low-growth trajectory, with higher-than-usual unemployment and lower-than-usual inflation (disinflation). Unlike the “stagflation” of the late 1970s and early 1980s, characterized by high unemployment and high inflation, this period of “disemployment” is a textbook example of the type of economy that can’t be built up with loose money or big budget deficits. It will only improve with time, as people and businesses reorient themselves to changing market conditions. It’s a complex problem with a simple solution: patience. For investors, this calls for discipline and an open-minded search for opportunities. There is no longer one obvious sector or asset class that is overvalued or undervalued, so we recommend “active diversification.” An actively diversified portfolio is not simply a matter of the quantity of securities but also the price an investor pays for each security. Active diversification is about making many varied small investments and being aware of valuations. As a result of these considerations, we continue to emphasize fully diversified strategies for long-term equity investors in order to participate in potential market gains while limiting the potential for losses. Periods of low nominal GDP growth have historically been accompanied by increases in market volatility, allowing for active managers to typically outperform more passive strategies. Therefore, we encourage investors to have appropriate equity and bond market exposure relative to capitalization, investment style, and region.
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strength. Expertise. partnership. Wells Fargo Advantage Funds® skillfully guides institutions, financial advisors, and individuals through the investment terrain to help them reach their financial objectives. Everything we do on behalf of our investors is built on the standards of integrity and service established by our parent company, Wells Fargo & Company; the expertise of our independent investment teams and rigorous ongoing investment review; and the collaborative level of superior service that is our trademark.
More information about Wells Fargo Advantage Funds® is available free upon request. To obtain literature, please write, e-mail, or call: Wells Fargo Advantage Funds P.O. Box 8266 Boston, MA 02266-8266 E-mail: [email protected] Institutional Investment Professionals: 1-888-253-6572 Retail Investment Professionals: 1-888-877-9275 Web site: www.wellsfargo.com/advantagefunds
The views expressed are as of June 30, 2010, and are those of Brian Jacobsen, James Kochan, John Lynch, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the authors and are not intended to be used as investment advice. The views are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index with each stock’s weight in The index proportionate to its market value. You cannot invest directly in an index.
Stock fund values fluctuate in response to the activities of individual companies and general market and economic conditions. Bond fund values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. In general, when interest rates rise, bond fund values fall and investors may lose principal value. Some funds, including nondiversified funds and funds investing in foreign investments, high-yield bonds, small and mid cap stocks, and/or more volatile segments of the economy, entail additional risk and may not be appropriate for all investors. Consult a Fund’s prospectus for additional information on these and other risks. Carefully consider a fund’s investment objectives, risks, charges, and expenses before investing. For a current prospectus, containing this and other information, visit www.wellsfargo.com/advantagefunds. Read it carefully before investing. Wells Fargo Funds Management, LLC, a wholly owned subsidiary of Wells Fargo & Company, provides investment advisory and administrative services for Wells Fargo Advantage Funds. Other affiliates of Wells Fargo & Company provide subadvisory and other services for the Funds. The Funds are distributed by Wells Fargo Funds Distributor, LLC, Member FINRA/SIPC, an affiliate of Wells Fargo & Company. 123796 07-10
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