Stock Pickers' Market Becoming Credit Pickers' Market
WEEKLY GUIDANCE FROM OUR INVESTMENT STRATEGY COMMITTEE November 28, 2017
Stock Pickers’ Market Becoming Credit Pickers’ Market Justin Lenarcic Global Alternative Investment Strategist
Key Takeaways » Two of our three alternative investment “themes” for 2018 involve credit. The first theme is focused on Long/Short Credit—followed by strategies focused on Stressed and Distressed Credit. » Though a spike in corporate credit defaults may be a 2019 concern, we already are beginning to see broader dispersion of yields (and valuations) within the U.S. highyield corporate credit market.
What It May Mean for Investors » Even though credit spreads over U.S. Treasury yields are at very tight levels, we are seeing the U.S. corporate credit market begin to exhibit late-cycle behavior. We expect that this development could present compelling opportunities for both hedge funds and private capital strategies next year.
Asset Group Overviews Equities ............................ 5 Fixed Income ................ 6 Real Assets ..................... 7 Alternative Investments ................... 8
We have often pointed to the significance of equity correlations as an indicator of the environment for security selection. When correlations among equities are high, it is difficult for hedge funds to generate excess returns over its market-based benchmark (“alpha”) from long and short positions. We have seen a decline in equity-market correlations this year, likely driven by a monetary-policy shift toward normalization (and “quantitative tapering”). We also believe that this decline in equity correlations has been driven by short-term interest rate increases, coupled with late-cycle dynamics. This has resulted in the highest average alpha among Equity Hedge managers in the past eight years. 1 It also is the reason why we continue to recommend an overweight allocation to Equity Hedge strategies in 2018. Aside from Equity Hedge, we see compelling opportunities developing in the credit markets, specifically within U.S. high-yield corporate credit. In fact, two of our three “themes” for 2018 involve credit. The first theme is focused on Long/Short Credit—followed by strategies focused on Stressed and Distressed Credit. Importantly, our views on the opportunity set are not predicated on a recession or a credit-market collapse, but rather are based on the normal progression of the credit
1
Morgan Stanley Strategic Content Group, “October 2017 Hedge Fund Recap”.
© 2017 Wells Fargo Investment Institute. All rights reserved.
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Stock Pickers’ Market Becoming Credit Pickers’ Market cycle (which we believe was inhibited by extremely loose post-crisis monetary policy). The foundation of our view is an expectation that we will see greater dispersion in highyield corporate credit valuations, coinciding with a gradual increase in high-yield corporate credit defaults. This implies that both tactical (i.e., long and short) and opportunistic (i.e., long only) strategies capturing the illiquidity premium have the potential to perform well. For this reason, we recommend that investors utilize both hedge fund and private capital structures, which can complement each other in a dynamic, opportunistic environment.
Looking Beyond the Headline Index With an effective yield 2 of only 6.3 percent and a default rate 3 of 3.3 percent in the highyield corporate debt class, as represented by BofA Merrill lynch High Yield Master II Index 4, it may seem counterintuitive that we see a budding opportunity set for Relative Value and Event Driven strategies. Yet, we believe, looking beneath the surface reveals the fact that certain sectors may soon be the victims of secular changes or challenges (Chart 1). Historically low interest rates and strong investor demand for yield have helped lower-rated companies in these challenged industries to manage their debt, but these factors do not alleviate their declining year-over-year earnings.
Adjusted EBITDA (Year-over-Year Percent Change)
Chart 1. Year-over-Year Change in Earnings (EBITDA)—High-Yield Sectors 30 20 10 0 -10 -20 -30
Source: Bank of America Merrill Lynch, 11/17/17. EBITDA is Earnings before Interest, Taxes, Depreciation and Amortization. *Data for Gaming and Transportation is through June 2017. Data for all other sectors is through September 2017. Year-over-Year EBITDA growth for the Technology sector was 141.8 percent, but was removed from the chart to prevent distortion of the data.
2 Effective Yield = The effective yield is the yield of a bond, assuming you reinvest the coupon (interest payments), and take into consideration compounding. Yields represent past performance and fluctuate with market conditions. Past performance is no guarantee of future results. 3 Default Rate = The percentage of issuers that have failed to make a scheduled interest or principal payment in the past 12 months. 4 Bank of America, November 16, 2017. The Bank of America (BofA) Merrill Lynch High Yield Master II Index is considered representative of the high yield bond market. An index is unmanaged and not available for direct investment.
© 2017 Wells Fargo Investment Institute. All rights reserved.
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Stock Pickers’ Market Becoming Credit Pickers’ Market Declining EBITDA is generally a precursor to an increase in the distress ratio—as companies are no longer able to earn their way out of trouble. 5 EBITDA currently is declining in the Automotive, Capital Goods, Food, Retail, Transportation and Utilities sectors of the high-yield corporate debt class (Chart 2). A compelling opportunity set is developing in these sectors that is garnering the attention of Relative Value and Event Driven hedge fund managers. Collectively, these sectors represent more than 11 percent of the Bank of America Merrill Lynch High Yield Master II Index. Furthermore, the Health Care sector, which accounts for another 10 percent of this index, only recently delivered positive year-over year earnings after four quarters of declining EBITDA. As a result of this deterioration, the distress ratio is beginning to rise and reflect the impact of more than 20 percent of high-yield issuers being challenged by low or negative earnings growth. 6
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U.S. HY Distress Ratio (LHS)
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U.S. High Yield Default Rate (%)
U.S. High Yield Distress Ratio (%)
Chart 2. Distress Ratio and Defaults in U.S. High-Yield Corporate Debt Class
U.S. HY Default Rate (RHS)
Source: Bank of America Merrill Lynch, 11/17/17.
Increasing Credit Dispersion While a spike in defaults may be a 2019 concern, we already are beginning to see broader dispersion within the U.S. high-yield corporate sector. Similar to the importance of correlations for Equity Hedge strategies, an increase in the dispersion of yields (or prices) reflects a more robust opportunity set for credit-security selection. As Chart 3 shows, even though the effective yield is near the lows of the past five years, there is significantly greater credit dispersion than was the case in 2014. We believe that this dispersion will only increase as the credit cycle matures and credit spreads increase—offering potential trading opportunities for hedge fund managers that are skilled at credit underwriting and trading.
5
According to Bank of America Merrill Lynch, the distress ratio is the percentage of bonds with spreads greater than 1,000 basis points over short-term interest rates. One hundred basis points equal one percent.
6
Bank of America Merrill Lynch, November 16, 2017.
© 2017 Wells Fargo Investment Institute. All rights reserved.
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Stock Pickers’ Market Becoming Credit Pickers’ Market Chart 3. Rising High-Yield Corporate Dispersion despite Low Effective Yields 20
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Dispersion (LHS)
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High Yield Index Effective Yield
Dispersion (% of HY Index with Yields That Are +/- 100 Basis Points From Index Average)
100%
Average Effective Yield (RHS)
Source: Bank of America Merrill Lynch, 11/17/17. Data shown is from Bank of America Merrill Lynch High Yield Master II Index. Yields represent past performance and fluctuate with market conditions. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment.
Road Map for 2018 Aside from our expectations for a robust environment for Equity Hedge strategies next year, we anticipate a strengthening opportunity set for credit-oriented strategies such as Relative Value and Event Driven. Although we expect the U.S. economy to maintain its modest growth trajectory next year, we believe that there are secular changes altering the landscape for certain sectors. A dislocation in the Energy sector several years ago produced one of the most robust investment opportunities for skilled credit investors in years. While that sector has largely repaired itself, we see other sectors offering similar potential. The Retail sector often is referenced as the next sector to fall, but we believe that there are others in line that can provide opportunities for active managers. Long/Short Credit strategies could be the immediate beneficiaries of an increase in corporate-credit dispersion potentially coinciding with an increase in yields. Eventually, opportunities for strategies focused on Stressed and Distressed Credit should emerge. Regardless of the timing, we anticipate a healthy year for credit-focused hedge funds in 2018.
© 2017 Wells Fargo Investment Institute. All rights reserved.
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EQUITIES
Stuart Freeman, CFA Co-Head of Global Equity Strategy
Internal Market Breadth Remains Healthy Underweight U.S. Small Cap Equities
Evenweight U.S. Large Cap Equities
We often look to a diverse set of industry groups to evaluate recent market breadth. Within that set of 26 industry groups, we watch for the number of industry groups that have declined over a 12-month period. When few (or none) of the 26 groups have dropped over 12 months, this often is followed by a decrease in the S&P 500 Index. When many (or all) of the industry groups have declined, there is a tendency for the S&P 500 Index to rise over the following 12 months. Yet, there are periods during which market breadth is very strong and remains so for a period of time during long bull markets (for example, mid-1990s and mid-2000s); the market moves higher. There also have been periods of very weak breadth that remains weak for an extended length of time as the economy moves into recession. The chart below shows the number of industry groups in decline versus the forward 12month performance of the S&P 500 Index. Arrows set off periods of weak market breadth followed by favorable stock performance—and periods of strong breadth followed by less favorable stock-market performance.
Evenweight
U.S. Mid Cap Equities
Evenweight Developed Market Ex-U.S. Equities
Over the past 12 months, only 7 of 26 industry groups (as defined by GICS) have declined. Historically, back to 1984, this suggests more upside for stocks over the next 12 months. On average, the S&P 500 Index has increased by 10.5 percent over the following 12 months. Only 3 of 23 12-month periods posted a modest S&P 500 Index decline over the next year, and none of those forward periods included 12-month recessionary declines.
Key Takeaways » Our market breadth work suggests more upside potential for the S&P 500 Index over the next 12 months. » We remain evenweight U.S. large-cap equities (and all equity classes but small caps).
S&P 500 Index: Industry Groups (GICS) Declining and Forward 12-Month Returns
Evenweight Emerging Market Equities
Number of Groups Down over a Year and Forward 12-Month Changes in the S&P 500 Index
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-50 1984
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Number of Groups Down (of 26 back to 1984)
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Percentage Change in S&P 500 Index - Forward 12 Months
Sources: Baseline, Bloomberg, Wells Fargo Investment Institute, 11/21/17. For illustrative purposes only. Past performance is no guarantee of future results. 12-Month Performance of S&P 500 Index is the rolling performance over a 12-month period. An index is unmanaged and not available for direct investment. © 2017 Wells Fargo Investment Institute. All rights reserved.
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FIXED INCOME
Brian Rehling, CFA Co-Head of Global Fixed Income
Taxes and Bonds—the Big Picture Underweight
High Yield Taxable Fixed Income
Underweight
Developed Market Ex.-U.S. Fixed Income
Evenweight
U.S. Short Term Taxable Fixed Income
Evenweight
U.S. Long Term Taxable Fixed Income
Evenweight
Emerging Market Fixed Income
Overweight
U.S. Taxable Investment Grade Fixed Income
As tax reform continues to work its way through Congress, tax-related investment themes are emerging that may be significant for investors in the high-yield and municipal bond classes. High-Yield Debt Impact A lower corporate tax rate and a potential cap for corporate interest deductions could impact lower-rated companies, specifically those that employ significant leverage. For companies that are in decent financial shape, a lower corporate tax rate is likely to be a positive—typically leading to higher earnings and an increase in free cash flow. Companies that are lower on the credit spectrum, especially those that are significantly leveraged, may find that the cap on interest deductibility further strains their already challenged balance sheets. Municipal Bond Market Impact The elimination of (or limits on) state and local tax deductions could have a significant impact for investors in high-tax locations. Even though some individual tax rates may move lower (and the standard deduction is expected to increase), we would expect that the effective tax rates 7 for high-earning individuals in certain locations will increase (under the currently proposed tax plans). A rise in effective tax rates could increase demand for tax-exempt income inherent in most municipal securities. Also under discussion is the potential that private activity bonds, advance refunding issues and stadium financing issues will no longer qualify for tax exemption going forward (existing bonds are expected to be grandfathered). These securities account for approximately 25 percent of new municipal issuance. While we could see a rush to market before the new tax policies are implemented, we would expect to see a decline in municipal supply over time as a result of these policies. Finally, the proposed elimination of the alternative minimum tax (AMT) would put outstanding bonds that are subject to the AMT on par with other municipal securities.
Key Takeaways » We recommend that investors move up in credit quality and favor stronger credits within the high-yield debt class. » We expect that the potential for less supply (and more demand) for municipal securities (under current tax proposals) will support prices going forward.
Overweight
U.S. Intermediate Term Taxable Fixed Income 7 Effective tax rates = net tax rate that an individual pays. © 2017 Wells Fargo Investment Institute. All rights reserved.
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REAL ASSETS
Austin Pickle, CFA
“When I was young, I observed that nine out of ten things I did were failures, so I did ten times more work.”
Investment Strategy Analyst
--George Bernard Shaw
REITs: Economic Growth Trumps Interest Rates Underweight
Commodities
Evenweight
Private Real Estate
Overweight
Public Real Estate
Many fundamental factors are supportive of real estate investment trusts (REITs) today. Occupancy rates are at or near all-time highs, and valuations remain attractive. Demand is strong, and there is little evidence of oversupply. Economic-growth expectations have risen, interest-rate increases should remain benign, and credit continues to be available (yet rational). From the factors driving REIT performance, rising rates often are cited as the major risk for REITs going forward. So, do Wells Fargo Investment Institute’s (WFII) forecast for higher interest rates and its REIT overweight still make sense? The answer is “yes.” Let me explain. WFII expects rates to rise gradually and economic growth to accelerate. The table below illustrates how important that economic growth acceleration is to REIT returns. It measures REIT performance in four different growth and interest-rate scenarios. It shows that REITs perform best when rates are falling and growth is rising. REITs perform worst when rates are rising and growth is declining. When rates are rising (bad) and economic growth is rising (good), the table below shows REITs have returned significantly more than when the reverse was true (11.4 percent versus 3.9 percent, respectively). In the tug-of-war over REIT performance, economic growth clearly trumps interest rates. If interest rates spike, and get ahead of economic growth, REITs could suffer. Yet, we expect REITs to perform well in WFII’s forecasted environment of modestly higher rates with improving economic growth.
Key Takeaways » WFII forecasts modestly higher interest rates with stronger economic growth. REITs have performed well in similar environments in the past. » The overall fundamental and valuation picture is attractive. We remain overweight REITs.
REITs versus Interest Rates and Economic Growth Economic Growth Rising Rising Falling Falling
Interest Rates REIT Performance (Average Annual Return) Falling Rising Falling Rising
27.64% 11.43% 3.90% -4.05%
Sources: Bloomberg, The Conference Board, Wells Fargo Investment Institute. Monthly data analyzed from 12/31/1971 - 7/31/2017. REIT performance measured as the total return of the FTSE NAREIT All Equity REITs Index. Economic growth measured by The Conference Board U.S. Leading Economic Index. Interest rates are measured by the 10-year U.S. Treasury yield. For illustrative purposes only. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment.
© 2017 Wells Fargo Investment Institute. All rights reserved.
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ALTERNATIVE INVESTMENTS
Justin Lenarcic Global Alternative Investment Strategist
What Are High-Yield Sector-Level Default Rates Signaling?
Private Equity
Evenweight
Hedge Funds-Macro
Evenweight
Hedge Funds-Event Driven
Overweight
Hedge Funds-Relative Value
Overweight
Hedge Funds-Equity Hedge Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not suitable for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.
While the main, or headline, default rate is important, we prefer to pay closer attention to the trends beneath the surface. This involves analyzing default rates at the sector level, but also paying attention to indicators such as the ratio of bonds trading at both stressed and distressed levels—which is often a useful precursor to defaults. U.S. high-yield (HY) corporate default rates are certainly at low levels, with trailing 12month rates generally between 1.5 percent and 3.5 percent (depending on the source and index). Yet (as the chart below shows), while the Bank of America Merrill Lynch High Yield Master II Index has an overall current default rate of 3.3 percent, sectors like Utilities, Retail, Transportation, Media, and Technology have default rates that are much higher. Moreover, these sectors collectively represent more than 23 percent of the face value of this HY index. These sector-level challenges can present potential opportunities for hedge fund and private capital managers.
Key Takeaways » The default rate is an important barometer of corporate bond-market health, but looking beneath the surface can result in a more granular understanding of the opportunity set. » Though headline HY default rates are low, certain sectors are having secular challenges. These challenges can present potential opportunities for hedge fund and private capital managers.
Industry Default Rate and Proportion of High Yield Index 20%
Current Default Rate and Proportion of High Yield Index Face Value
Evenweight
Default rates are an important indicator for the overall health of the corporate credit market. While the credit-rating agencies use various methods to calculate the default rate, the most basic definition is the percentage of issuers that have failed to make a scheduled interest or principal payment in the past 12 months. As the default rate increases, the risk associated with investing in corporate credit tends to rise as well, since more issuers are having difficulty repaying their debts.
18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Utilities
Retail
Transportation
Current Default Rate
Media
Technology
Food
Health Care
Industry Distribution (Proportion of High Yield Index Face Value)
Source: Bank of America Merrill Lynch, 11/20/17. Chart shows default rate by sector of the Bank of America Merrill Lynch High Yield Master II Index (along with each sector’s proportion of this index in percentage terms). For illustrative purposes only. © 2017 Wells Fargo Investment Institute. All rights reserved.
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Risks Considerations Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. These bonds are subject to interest rate and credit/default risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. 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. Investing in distressed companies is speculative and subject to greater levels of credit, issuer and liquidity risks and the repayment of default obligations contains significant uncertainties such companies may be engaged in restructurings or bankruptcy proceedings. 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. Long/short credit strategies seek to mitigate interest rate and credit risks regardless of market environment through investment in creditrelated and structured debt vehicles. These strategies involve the use of market hedges and involve risks associated with the use of derivatives, fixed income, foreign investment, currency, hedging, leverage, liquidity, short sales, loss of principal and other material risks. 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. BofA Merrill Lynch U.S. High Yield Master II Index is a market capitalization-weighted index of domestic and Yankee high-yield bonds. The Index tracks the performance of high-yield securities traded in the U.S. bond market. Illiquidity Premium = a premium demanded by investors for investing in securities that cannot be easily converted into cash. 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. FTSE NAREIT All Equity REITs Index, a subset of the All REITs Index, is designed to track the performance of REITs representing equity interests in (as opposed to mortgages on) properties. It represents all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets, other than mortgages secured by real property that also meet minimum size and liquidity criteria.
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 © 2017 Wells Fargo Investment Institute. All rights reserved.
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this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR 1117-04061
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 10 of 10
Stock Pickers’ Market Becoming Credit Pickers’ Market Justin Lenarcic Global Alternative Investment Strategist
Key Takeaways » Two of our three alternative investment “themes” for 2018 involve credit. The first theme is focused on Long/Short Credit—followed by strategies focused on Stressed and Distressed Credit. » Though a spike in corporate credit defaults may be a 2019 concern, we already are beginning to see broader dispersion of yields (and valuations) within the U.S. highyield corporate credit market.
What It May Mean for Investors » Even though credit spreads over U.S. Treasury yields are at very tight levels, we are seeing the U.S. corporate credit market begin to exhibit late-cycle behavior. We expect that this development could present compelling opportunities for both hedge funds and private capital strategies next year.
Asset Group Overviews Equities ............................ 5 Fixed Income ................ 6 Real Assets ..................... 7 Alternative Investments ................... 8
We have often pointed to the significance of equity correlations as an indicator of the environment for security selection. When correlations among equities are high, it is difficult for hedge funds to generate excess returns over its market-based benchmark (“alpha”) from long and short positions. We have seen a decline in equity-market correlations this year, likely driven by a monetary-policy shift toward normalization (and “quantitative tapering”). We also believe that this decline in equity correlations has been driven by short-term interest rate increases, coupled with late-cycle dynamics. This has resulted in the highest average alpha among Equity Hedge managers in the past eight years. 1 It also is the reason why we continue to recommend an overweight allocation to Equity Hedge strategies in 2018. Aside from Equity Hedge, we see compelling opportunities developing in the credit markets, specifically within U.S. high-yield corporate credit. In fact, two of our three “themes” for 2018 involve credit. The first theme is focused on Long/Short Credit—followed by strategies focused on Stressed and Distressed Credit. Importantly, our views on the opportunity set are not predicated on a recession or a credit-market collapse, but rather are based on the normal progression of the credit
1
Morgan Stanley Strategic Content Group, “October 2017 Hedge Fund Recap”.
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 1 of 10
Stock Pickers’ Market Becoming Credit Pickers’ Market cycle (which we believe was inhibited by extremely loose post-crisis monetary policy). The foundation of our view is an expectation that we will see greater dispersion in highyield corporate credit valuations, coinciding with a gradual increase in high-yield corporate credit defaults. This implies that both tactical (i.e., long and short) and opportunistic (i.e., long only) strategies capturing the illiquidity premium have the potential to perform well. For this reason, we recommend that investors utilize both hedge fund and private capital structures, which can complement each other in a dynamic, opportunistic environment.
Looking Beyond the Headline Index With an effective yield 2 of only 6.3 percent and a default rate 3 of 3.3 percent in the highyield corporate debt class, as represented by BofA Merrill lynch High Yield Master II Index 4, it may seem counterintuitive that we see a budding opportunity set for Relative Value and Event Driven strategies. Yet, we believe, looking beneath the surface reveals the fact that certain sectors may soon be the victims of secular changes or challenges (Chart 1). Historically low interest rates and strong investor demand for yield have helped lower-rated companies in these challenged industries to manage their debt, but these factors do not alleviate their declining year-over-year earnings.
Adjusted EBITDA (Year-over-Year Percent Change)
Chart 1. Year-over-Year Change in Earnings (EBITDA)—High-Yield Sectors 30 20 10 0 -10 -20 -30
Source: Bank of America Merrill Lynch, 11/17/17. EBITDA is Earnings before Interest, Taxes, Depreciation and Amortization. *Data for Gaming and Transportation is through June 2017. Data for all other sectors is through September 2017. Year-over-Year EBITDA growth for the Technology sector was 141.8 percent, but was removed from the chart to prevent distortion of the data.
2 Effective Yield = The effective yield is the yield of a bond, assuming you reinvest the coupon (interest payments), and take into consideration compounding. Yields represent past performance and fluctuate with market conditions. Past performance is no guarantee of future results. 3 Default Rate = The percentage of issuers that have failed to make a scheduled interest or principal payment in the past 12 months. 4 Bank of America, November 16, 2017. The Bank of America (BofA) Merrill Lynch High Yield Master II Index is considered representative of the high yield bond market. An index is unmanaged and not available for direct investment.
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 2 of 10
Stock Pickers’ Market Becoming Credit Pickers’ Market Declining EBITDA is generally a precursor to an increase in the distress ratio—as companies are no longer able to earn their way out of trouble. 5 EBITDA currently is declining in the Automotive, Capital Goods, Food, Retail, Transportation and Utilities sectors of the high-yield corporate debt class (Chart 2). A compelling opportunity set is developing in these sectors that is garnering the attention of Relative Value and Event Driven hedge fund managers. Collectively, these sectors represent more than 11 percent of the Bank of America Merrill Lynch High Yield Master II Index. Furthermore, the Health Care sector, which accounts for another 10 percent of this index, only recently delivered positive year-over year earnings after four quarters of declining EBITDA. As a result of this deterioration, the distress ratio is beginning to rise and reflect the impact of more than 20 percent of high-yield issuers being challenged by low or negative earnings growth. 6
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U.S. High Yield Default Rate (%)
U.S. High Yield Distress Ratio (%)
Chart 2. Distress Ratio and Defaults in U.S. High-Yield Corporate Debt Class
U.S. HY Default Rate (RHS)
Source: Bank of America Merrill Lynch, 11/17/17.
Increasing Credit Dispersion While a spike in defaults may be a 2019 concern, we already are beginning to see broader dispersion within the U.S. high-yield corporate sector. Similar to the importance of correlations for Equity Hedge strategies, an increase in the dispersion of yields (or prices) reflects a more robust opportunity set for credit-security selection. As Chart 3 shows, even though the effective yield is near the lows of the past five years, there is significantly greater credit dispersion than was the case in 2014. We believe that this dispersion will only increase as the credit cycle matures and credit spreads increase—offering potential trading opportunities for hedge fund managers that are skilled at credit underwriting and trading.
5
According to Bank of America Merrill Lynch, the distress ratio is the percentage of bonds with spreads greater than 1,000 basis points over short-term interest rates. One hundred basis points equal one percent.
6
Bank of America Merrill Lynch, November 16, 2017.
© 2017 Wells Fargo Investment Institute. All rights reserved.
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Stock Pickers’ Market Becoming Credit Pickers’ Market Chart 3. Rising High-Yield Corporate Dispersion despite Low Effective Yields 20
95%
18
90%
16
85%
14
80%
12
75%
10
70%
8
65%
Dispersion (LHS)
Jul-17
Oct-17
Apr-17
Jan-17
Jul-16
Oct-16
Apr-16
Jan-16
Jul-15
Oct-15
Apr-15
Jan-15
Jul-14
Oct-14
Apr-14
Jan-14
Jul-13
Oct-13
4
Apr-13
55%
Jan-13
6
Oct-12
60%
High Yield Index Effective Yield
Dispersion (% of HY Index with Yields That Are +/- 100 Basis Points From Index Average)
100%
Average Effective Yield (RHS)
Source: Bank of America Merrill Lynch, 11/17/17. Data shown is from Bank of America Merrill Lynch High Yield Master II Index. Yields represent past performance and fluctuate with market conditions. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment.
Road Map for 2018 Aside from our expectations for a robust environment for Equity Hedge strategies next year, we anticipate a strengthening opportunity set for credit-oriented strategies such as Relative Value and Event Driven. Although we expect the U.S. economy to maintain its modest growth trajectory next year, we believe that there are secular changes altering the landscape for certain sectors. A dislocation in the Energy sector several years ago produced one of the most robust investment opportunities for skilled credit investors in years. While that sector has largely repaired itself, we see other sectors offering similar potential. The Retail sector often is referenced as the next sector to fall, but we believe that there are others in line that can provide opportunities for active managers. Long/Short Credit strategies could be the immediate beneficiaries of an increase in corporate-credit dispersion potentially coinciding with an increase in yields. Eventually, opportunities for strategies focused on Stressed and Distressed Credit should emerge. Regardless of the timing, we anticipate a healthy year for credit-focused hedge funds in 2018.
© 2017 Wells Fargo Investment Institute. All rights reserved.
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EQUITIES
Stuart Freeman, CFA Co-Head of Global Equity Strategy
Internal Market Breadth Remains Healthy Underweight U.S. Small Cap Equities
Evenweight U.S. Large Cap Equities
We often look to a diverse set of industry groups to evaluate recent market breadth. Within that set of 26 industry groups, we watch for the number of industry groups that have declined over a 12-month period. When few (or none) of the 26 groups have dropped over 12 months, this often is followed by a decrease in the S&P 500 Index. When many (or all) of the industry groups have declined, there is a tendency for the S&P 500 Index to rise over the following 12 months. Yet, there are periods during which market breadth is very strong and remains so for a period of time during long bull markets (for example, mid-1990s and mid-2000s); the market moves higher. There also have been periods of very weak breadth that remains weak for an extended length of time as the economy moves into recession. The chart below shows the number of industry groups in decline versus the forward 12month performance of the S&P 500 Index. Arrows set off periods of weak market breadth followed by favorable stock performance—and periods of strong breadth followed by less favorable stock-market performance.
Evenweight
U.S. Mid Cap Equities
Evenweight Developed Market Ex-U.S. Equities
Over the past 12 months, only 7 of 26 industry groups (as defined by GICS) have declined. Historically, back to 1984, this suggests more upside for stocks over the next 12 months. On average, the S&P 500 Index has increased by 10.5 percent over the following 12 months. Only 3 of 23 12-month periods posted a modest S&P 500 Index decline over the next year, and none of those forward periods included 12-month recessionary declines.
Key Takeaways » Our market breadth work suggests more upside potential for the S&P 500 Index over the next 12 months. » We remain evenweight U.S. large-cap equities (and all equity classes but small caps).
S&P 500 Index: Industry Groups (GICS) Declining and Forward 12-Month Returns
Evenweight Emerging Market Equities
Number of Groups Down over a Year and Forward 12-Month Changes in the S&P 500 Index
50
30
10
-10
-30
-50 1984
1988
1992
1996
Number of Groups Down (of 26 back to 1984)
2000
2004
2008
2012
2016
Percentage Change in S&P 500 Index - Forward 12 Months
Sources: Baseline, Bloomberg, Wells Fargo Investment Institute, 11/21/17. For illustrative purposes only. Past performance is no guarantee of future results. 12-Month Performance of S&P 500 Index is the rolling performance over a 12-month period. An index is unmanaged and not available for direct investment. © 2017 Wells Fargo Investment Institute. All rights reserved.
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FIXED INCOME
Brian Rehling, CFA Co-Head of Global Fixed Income
Taxes and Bonds—the Big Picture Underweight
High Yield Taxable Fixed Income
Underweight
Developed Market Ex.-U.S. Fixed Income
Evenweight
U.S. Short Term Taxable Fixed Income
Evenweight
U.S. Long Term Taxable Fixed Income
Evenweight
Emerging Market Fixed Income
Overweight
U.S. Taxable Investment Grade Fixed Income
As tax reform continues to work its way through Congress, tax-related investment themes are emerging that may be significant for investors in the high-yield and municipal bond classes. High-Yield Debt Impact A lower corporate tax rate and a potential cap for corporate interest deductions could impact lower-rated companies, specifically those that employ significant leverage. For companies that are in decent financial shape, a lower corporate tax rate is likely to be a positive—typically leading to higher earnings and an increase in free cash flow. Companies that are lower on the credit spectrum, especially those that are significantly leveraged, may find that the cap on interest deductibility further strains their already challenged balance sheets. Municipal Bond Market Impact The elimination of (or limits on) state and local tax deductions could have a significant impact for investors in high-tax locations. Even though some individual tax rates may move lower (and the standard deduction is expected to increase), we would expect that the effective tax rates 7 for high-earning individuals in certain locations will increase (under the currently proposed tax plans). A rise in effective tax rates could increase demand for tax-exempt income inherent in most municipal securities. Also under discussion is the potential that private activity bonds, advance refunding issues and stadium financing issues will no longer qualify for tax exemption going forward (existing bonds are expected to be grandfathered). These securities account for approximately 25 percent of new municipal issuance. While we could see a rush to market before the new tax policies are implemented, we would expect to see a decline in municipal supply over time as a result of these policies. Finally, the proposed elimination of the alternative minimum tax (AMT) would put outstanding bonds that are subject to the AMT on par with other municipal securities.
Key Takeaways » We recommend that investors move up in credit quality and favor stronger credits within the high-yield debt class. » We expect that the potential for less supply (and more demand) for municipal securities (under current tax proposals) will support prices going forward.
Overweight
U.S. Intermediate Term Taxable Fixed Income 7 Effective tax rates = net tax rate that an individual pays. © 2017 Wells Fargo Investment Institute. All rights reserved.
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REAL ASSETS
Austin Pickle, CFA
“When I was young, I observed that nine out of ten things I did were failures, so I did ten times more work.”
Investment Strategy Analyst
--George Bernard Shaw
REITs: Economic Growth Trumps Interest Rates Underweight
Commodities
Evenweight
Private Real Estate
Overweight
Public Real Estate
Many fundamental factors are supportive of real estate investment trusts (REITs) today. Occupancy rates are at or near all-time highs, and valuations remain attractive. Demand is strong, and there is little evidence of oversupply. Economic-growth expectations have risen, interest-rate increases should remain benign, and credit continues to be available (yet rational). From the factors driving REIT performance, rising rates often are cited as the major risk for REITs going forward. So, do Wells Fargo Investment Institute’s (WFII) forecast for higher interest rates and its REIT overweight still make sense? The answer is “yes.” Let me explain. WFII expects rates to rise gradually and economic growth to accelerate. The table below illustrates how important that economic growth acceleration is to REIT returns. It measures REIT performance in four different growth and interest-rate scenarios. It shows that REITs perform best when rates are falling and growth is rising. REITs perform worst when rates are rising and growth is declining. When rates are rising (bad) and economic growth is rising (good), the table below shows REITs have returned significantly more than when the reverse was true (11.4 percent versus 3.9 percent, respectively). In the tug-of-war over REIT performance, economic growth clearly trumps interest rates. If interest rates spike, and get ahead of economic growth, REITs could suffer. Yet, we expect REITs to perform well in WFII’s forecasted environment of modestly higher rates with improving economic growth.
Key Takeaways » WFII forecasts modestly higher interest rates with stronger economic growth. REITs have performed well in similar environments in the past. » The overall fundamental and valuation picture is attractive. We remain overweight REITs.
REITs versus Interest Rates and Economic Growth Economic Growth Rising Rising Falling Falling
Interest Rates REIT Performance (Average Annual Return) Falling Rising Falling Rising
27.64% 11.43% 3.90% -4.05%
Sources: Bloomberg, The Conference Board, Wells Fargo Investment Institute. Monthly data analyzed from 12/31/1971 - 7/31/2017. REIT performance measured as the total return of the FTSE NAREIT All Equity REITs Index. Economic growth measured by The Conference Board U.S. Leading Economic Index. Interest rates are measured by the 10-year U.S. Treasury yield. For illustrative purposes only. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment.
© 2017 Wells Fargo Investment Institute. All rights reserved.
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ALTERNATIVE INVESTMENTS
Justin Lenarcic Global Alternative Investment Strategist
What Are High-Yield Sector-Level Default Rates Signaling?
Private Equity
Evenweight
Hedge Funds-Macro
Evenweight
Hedge Funds-Event Driven
Overweight
Hedge Funds-Relative Value
Overweight
Hedge Funds-Equity Hedge Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not suitable for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.
While the main, or headline, default rate is important, we prefer to pay closer attention to the trends beneath the surface. This involves analyzing default rates at the sector level, but also paying attention to indicators such as the ratio of bonds trading at both stressed and distressed levels—which is often a useful precursor to defaults. U.S. high-yield (HY) corporate default rates are certainly at low levels, with trailing 12month rates generally between 1.5 percent and 3.5 percent (depending on the source and index). Yet (as the chart below shows), while the Bank of America Merrill Lynch High Yield Master II Index has an overall current default rate of 3.3 percent, sectors like Utilities, Retail, Transportation, Media, and Technology have default rates that are much higher. Moreover, these sectors collectively represent more than 23 percent of the face value of this HY index. These sector-level challenges can present potential opportunities for hedge fund and private capital managers.
Key Takeaways » The default rate is an important barometer of corporate bond-market health, but looking beneath the surface can result in a more granular understanding of the opportunity set. » Though headline HY default rates are low, certain sectors are having secular challenges. These challenges can present potential opportunities for hedge fund and private capital managers.
Industry Default Rate and Proportion of High Yield Index 20%
Current Default Rate and Proportion of High Yield Index Face Value
Evenweight
Default rates are an important indicator for the overall health of the corporate credit market. While the credit-rating agencies use various methods to calculate the default rate, the most basic definition is the percentage of issuers that have failed to make a scheduled interest or principal payment in the past 12 months. As the default rate increases, the risk associated with investing in corporate credit tends to rise as well, since more issuers are having difficulty repaying their debts.
18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Utilities
Retail
Transportation
Current Default Rate
Media
Technology
Food
Health Care
Industry Distribution (Proportion of High Yield Index Face Value)
Source: Bank of America Merrill Lynch, 11/20/17. Chart shows default rate by sector of the Bank of America Merrill Lynch High Yield Master II Index (along with each sector’s proportion of this index in percentage terms). For illustrative purposes only. © 2017 Wells Fargo Investment Institute. All rights reserved.
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Risks Considerations Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. These bonds are subject to interest rate and credit/default risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. 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. Investing in distressed companies is speculative and subject to greater levels of credit, issuer and liquidity risks and the repayment of default obligations contains significant uncertainties such companies may be engaged in restructurings or bankruptcy proceedings. 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. Long/short credit strategies seek to mitigate interest rate and credit risks regardless of market environment through investment in creditrelated and structured debt vehicles. These strategies involve the use of market hedges and involve risks associated with the use of derivatives, fixed income, foreign investment, currency, hedging, leverage, liquidity, short sales, loss of principal and other material risks. 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. BofA Merrill Lynch U.S. High Yield Master II Index is a market capitalization-weighted index of domestic and Yankee high-yield bonds. The Index tracks the performance of high-yield securities traded in the U.S. bond market. Illiquidity Premium = a premium demanded by investors for investing in securities that cannot be easily converted into cash. 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. FTSE NAREIT All Equity REITs Index, a subset of the All REITs Index, is designed to track the performance of REITs representing equity interests in (as opposed to mortgages on) properties. It represents all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets, other than mortgages secured by real property that also meet minimum size and liquidity criteria.
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 © 2017 Wells Fargo Investment Institute. All rights reserved.
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this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR 1117-04061
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