Download Steady as she goes?

September 2016
Three areas of
expertise, one source
of investor guidance
Steady as she goes?
A lot of people went into August thinking that it would be a rough
month. People were trying to go on vacation, which creates lighter
trading volumes, and the equity markets were at record highs.
Instead, August was relatively dull. As measured by the standard
deviation of daily returns, the S&P 500 Index for August had the
fourth-lowest volatility out of the 255 months since June 1995. The
Russell Midcap® Index had the 10th lowest. Small-cap stocks, as
measured by the Russell 2000® Index, had the 27th lowest.
Fixed-income markets had a bit more excitement, mainly due to
talk out of central bankers, but that volatility was just run of the
mill. The BofA Merrill Lynch High Yield Index’s volatility was nearly
smack-dab in the middle of its historical volatility (127 out of 255).
The Barclays U.S. Aggregate Bond Index had slightly lower volatility
than its median (117 out of 255).
John Manley, CFA
Chief Equity Strategist
James Kochan
Chief Fixed-Income Strategist
Brian Jacobsen, Ph.D., CFA,
CFP®
Chief Portfolio Strategist
Our strategists offer their view
on the economy, the equities
markets, and the fixed-income
markets, both in the U.S. and
abroad.
Their combined view of the
investment landscape gives
investors a comprehensive
perspective on recent market
activity and clear guidance for
allocating their investment
portfolios going forward.
Will September be steady as she goes? Probably not. We think it’s
prudent to expect volatility and just be delighted when it doesn’t
show up. Given the focus on the September 21 announcements
from the Bank of Japan (BOJ) and the Federal Open Market
Committee (FOMC), there’s certainly the seed of volatility. But given
how many people are just waiting for volatility to surge, often
what’s widely expected doesn’t materialize. In markets,
expectations of drops or pops tend to be self-destroying. If it’s
steady as she goes for the markets, it should be steady as she goes
for your portfolio.
Key themes we are seeing
1. The economy: Talk is cheap
2. Equities: Maybe a stutter, but not a full stop
3. Fixed income: Interest is driving total returns
View investment guidance for today’s markets
1.
The economy: Talk is cheap
One of the highlights of the summer for economists is the Kansas City Federal
Reserve’s Economic Symposium in Jackson Hole, Wyoming. The meetings are a
chance to hear from central bankers and academics about hot topics in monetary
policy. As you can imagine, when central bankers talk, investors listen.
This year’s theme was “Designing Resilient Monetary Policy Frameworks for the Future.” Most
participants argued that negative rates can be effective in helping central banks stoke the flames of
inflation, but there are limits to how effective negative rates can be. They tend to cause distortions
in the credit markets and sometimes banks aren’t willing or able to pass those low rates through to
depositors or borrowers. There also seemed to be agreement that central banks should use their
balance sheets to conduct monetary policy through purchasing a wide variety of assets. Finally, the
finger was pointed squarely at fiscal policymakers for not doing enough to help stoke growth or
inflation.
In other words, the symposium was a chance to talk about how maybe what’s needed for areas like
Japan and the eurozone is just a little bit more of what they’ve been doing, especially if the
headwind of austerity (tax increases and spending cuts) is abating. Governor Kuroda of the BOJ
took the opportunity to talk about how the BOJ could cut rates further into negative territory and
do more with asset purchases. The yen responded by weakening relative to the dollar, but there is
the danger that Kuroda may be raising expectations for action too high. Talk is cheap, especially
after the BOJ disappointed investors in June and July. September will be a critical month for Kuroda
to—quite literally—put his money where his mouth is.
While the BOJ is talking up more action, Federal Reserve (Fed) officials were talking about action in
the opposite direction: raising rates. Fed Chair Janet Yellen—who is the most important one to
listen to—struck an optimistic tone on the economy. Vice Chair Stanley Fischer talked about how
the Fed could still hike twice this year. Other voting members of the FOMC also talked about hiking.
Will they, or won’t they? It depends on the data. If we see wages rising and payrolls expanding like
they have been, measures of manufacturing activity improving, housing activity staying robust,
and consumer spending proving to be resilient, two rate hikes this year is a distinct possibility.
Those are some pretty big ifs, though. Business investment is still sluggish and manufacturing is
early in recovering from the April–May slowdown. A Fed that isn’t in a hurry to hike may wait until
November rather than jump the gun and go in September.
2.
Equities: Maybe a stutter, but not a full stop
Equities have rebounded smartly since the Brexit scare and some pretty smart
investors are looking for a correction. That’s always possible but 4%–6% pullbacks
are notoriously hard to profit from. U.S. equities seem fairly valued at 17 times
forward earnings expectations. After two years of stagnation, earnings
expectations appear to be rising again. This is more pronounced in mid-cap stocks,
which tend to be less affected by a strong dollar.
Outlook | September 2016 | 2
Chart 1
Large-cap earnings estimates are rising
Source: FactSet, July 28, 2016. Past performance is no guarantee of future results.
Chart 2
Mid-cap earnings estimates are rising as well
Source: FactSet, July 28, 2016. Past performance is no guarantee of future results.
Outlook | September 2016 | 3
The Fed seems ready to nudge rates higher but, in our opinion, not likely to tighten. Chair Yellen
seems encouraged by growth but unlikely to try to stifle it. Investor sentiment is far from giddy.
We still wince at every loud economic noise we hear.
Financials have done better in August and we find that encouraging. Investors seem to be sensing
that better growth and slightly higher short-term rates are not the poison they were perceived to
be in the days of the taper tantrum, that period in 2013 when rates began to rise and both stock
and bond markets had short-term overreactions. Economically sensitive stocks are also
outperforming as signs of U.S. economic improvement seem to percolate into view.
We think that appetite for risk has been piqued but not yet satisfied. Investors are less fearful than
two years ago but have not yet developed enthusiasm. After so many mini panics, we may be
getting ready to substitute hope for fear and appreciation potential for up-front income.
3.
Fixed income: Interest is driving total returns
Interest income was the key to better performance in the bond markets during
August. The best total returns came from those segments that offer higher interest
income. In the high-yield market, credits rated CCC and weaker outperformed
credits rated BB by 200 basis points (bps; 100 bps equals 1.00%). Among
investment-grade corporates, the BBB-rated segment outperformed the AA-rated
segment by 50 bps. The BBB-rated municipals outperformed the AAA-rated munis
by 40 bps. International markets exhibited the same patterns. Emerging markets
debt outperformed the developed markets by 150 bps.
Treasuries and agencies—fixed-income sectors with the lowest yields—recorded negative total
returns in August. Those markets are most sensitive to the outlook for Fed policy, and that outlook
darkened somewhat during August. With the economy performing better, the Fed’s hints of one or
two rate increases before year-end seem credible. The yield on the 2-year note, which is the most
sensitive to the outlook for the funds rate, rose 15 bps in August.
Because yields have declined and yield curves have flattened, the longer maturities show the best
year-to-date returns. This relative performance would not be expected to prevail if the federal
funds rate were to rise. The August experience, in which only the very short Treasury maturities
produced positive returns, could be repeated in the months ahead. Durations are so extended that
even relatively small yield increases can result in negative returns for the longer maturities.
Outlook | September 2016 | 4
Table 1
At a glance: Year-to-date bond market total returns (%)
Index name
0.60
-0.63
0.83
0.99
1.46
-4.64
3.55
Q2
2016
2.28
3.50
2.24
1.34
1.12
5.89
2.72
August
2016
-0.14
0.27
-0.57
-0.20
0.11
2.23
0.23
Year to date
(8-31-16)
5.96
9.42
5.50
3.58
3.43
14.58
4.59
9.21
4.84
1.26
1.13
2.62
4.44
-0.09
1.42
6.50
12.25
2.93
10.72
29.43
1.49
0.91
-3.20
1.38
3.02
7.33
-0.62
-0.97
-0.78
3.72
7.37
19.34
2014
2015
Broad Market Index
Corporate
Treasuries
Agencies
Mortgages
High yield
Municipal
6.27
7.51
6.02
4.04
6.07
2.51
9.78
International bond (ex U.S.)
Emerging markets ($ den.)
5-year Treasury
10-year Treasury
30-year Treasury
Source: Bloomberg L.P. Past performance is no guarantee of future results.
Outlook | September 2016 | 5
Investment thoughts for today’s markets
Action items
•
Don’t be afraid to buy on the dips if the market falls on good economic data. That could just
be the market repricing a rate hike by the Fed. If the Fed is hiking into economic strength,
not weakness, that’s nothing to be afraid of.
•
Consider stocking up on mid caps. Greater investor risk tolerance and better earnings
growth could tilt the field toward mid caps. Earnings expectations are rising for mid caps in
particular.
•
Consider opportunistic hedging of currency risk.
•
As the Fed warms to hiking, brace for higher yields by favoring credit risk over duration risk.
•
Try to go for yield. Fixed-income sectors with the greatest interest income are likely to have
the best total returns. But avoid the weakest of high-yield corporate and muni credits.
•
Reduce exposure to long-duration securities.
Investment themes
•
Valuations are now slightly above historical norms but not very extended.
•
A seasonally weak period lies before us, but seasonality hasn’t worked this year.
•
Individual investors may soon begin to shake off fears of another panic.
•
Durations should be conservative.
What to watch
•
Watch the Fed. Chair Yellen will want to encourage, not discourage, growth, and it appears
that the Fed is preparing to raise rates.
•
September 21 is the big day of the month with the BOJ and FOMC meetings.
•
Don’t forget to watch data out of Europe. The Brexit effect hasn’t been too bad. It’s not
great, but things seem to be beating expectations.
•
Commodity prices can continue to be buffeted by the changing value of the dollar. We could
see some dollar strength if it’s looking clear that the Fed will hike before Election Day.
•
Watch earnings expectations. A better economy usually brings better earnings.
•
Keep an eye on emerging markets. They were surprisingly resilient earlier this year.
Valuations may be compelling.
•
Monitor economic indicators. Stronger data is likely to be bearish for Treasuries but bullish
for junk bonds.
Outlook | September 2016 | 6
Asset allocation guide
For long-term investors with a time frame of three years or longer, we suggest the following strategic portfolio
allocation, compared with a market-cap-weighted* portfolio:
Summary portfolios
Market-cap-weighted portfolio
Our suggested portfolio
Asset allocation breakdown
Equities
Fixed income
Our suggested portfolio rationale for:
Equities

U.S. vs. non-U.S. developed equities: Forget going where growth is already good. Go where growth
could be better than expected. Despite the Brexit shock, Europe’s growth looks to be getting better. Japan
is a bit of a wildcard, but if the BOJ goes big in September, it should help short-term sentiment.

Developed equities vs. emerging markets equities: We see some positive developments for
emerging markets. India’s new head central banker could credibly fight inflation. Brazil just impeached
President Rousseff and launched pro-business reforms. China is stabilizing growth and excess capacity.

Large-cap vs. small-cap equities: Why choose? Why not both? And don’t overlook mid caps, with their
slightly more domestic focus and stronger resilience against a strengthening dollar than large caps.
Fixed income

Credit risk exposure: In seeking income, it’s better to take on modest credit risk than duration risk.
Lower-quality investment-grade credits and higher-quality junk may help cushion rising Treasury yields.

Fixed-income duration: We’re not comfortable with a 10-year Treasury yield below 1.7%. If the Fed
hikes this year, we think this yield will move higher. That can be painful for investors in longer-dated
Treasuries. Shorter-dated Treasuries offer scant income, so we prefer short-term high yield for income.
Alternative investment strategies

Alternatives exposure: A diversified set of alternative investments can help reduce the risk of one
particular style or strategy underperforming. With heightened uncertainty about the exact timing of a Fed
rate hike, we see good value in adding 15% exposure to a diversified pool of alternative strategies. These
tend to be global and flexible, which can be useful when there’s a lot of ambiguity in the outlook.
*Portfolio allocations may not sum to exactly 100% due to rounding.
Outlook | September 2016 | 7
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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.
The S&P MidCap 400 Index measures the performance of the mid-size company segment of the U.S. market; this index is used by more than
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The S&P SmallCap 600 Index measures the performance of the small-cap segment of the U.S. equity market. It is a market-value-weighted
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The Bond Buyer 20 Index is a representation of municipal bond trends, based on a portfolio of 20 general obligation bonds that mature in 20
years. The index is based on a survey of municipal bond traders rather than actual prices or yields. The Bond Buyer 20 Index is published by
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The BofA Merrill Lynch U.S. High Yield Master II Index is a market-capitalization-weighted index of domestic and Yankee high-yield bonds. The
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The BofA Merrill Lynch U.S. Corporate Index is an unmanaged index composed of U.S. dollar–denominated investment-grade corporate debt
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The BofA Merrill Lynch U.S. Municipal Securities Index is an unmanaged, market-value-weighted index composed of investment-grade, fixed
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You cannot invest directly in an index.
The ratings indicated are from Standard & Poor’s and/or Moody’s Investors Service. Credit-quality ratings: Credit-quality ratings apply to
corporate and municipal bond issues. Standard & Poor’s rates the creditworthiness of bonds from AAA (highest) to D (lowest). Ratings from A
to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the ratings categories. Moody’s rates
the creditworthiness of bonds from Aaa (highest) to C (lowest). Ratings Aa to B may be modified by the addition of a number 1 (highest) to 3
(lowest) to show relative standing within the ratings categories.
Duration is a measurement of the sensitivity of a bond’s price to changes in Treasury yields. A fund’s duration is the weighted average of
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Fixed-Income Strategist James Kochan; and Wells Fargo Funds Management, LLC. The information and statistics in this report have been
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Outlook | September 2016 | 8