Download Maybe more room to grow?

May 2016
Three areas of
expertise, one source
of investor guidance
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.
Maybe more room to grow?
When the S&P 500 Index moves toward 2,100, investors start to
wonder whether the market has any more room to grow. We don’t
see why not. Earnings appear to be hitting a trough in the first
quarter, which means they may begin to go higher. Monetary policy
in the U.S. is accommodative, and economic activity appears to
have bottomed in the first quarter. But there are so many
investment opportunities in markets outside the S&P 500 Index.
While one or two indexes approach or eclipse all-time highs, many
more have room to grow. Areas where we see opportunity include
mid-cap stocks, small-cap stocks, emerging markets, and non-U.S.
developed markets: basically, just about everything else besides the
S&P 500 Index.
Key themes we are seeing
1. The economy: Two monetary pauses yield
two different results
2. Equities: Investors remain edgy
3. Fixed income: Corporate bond markets
continue to rebound
View investment guidance for today’s markets
1. The economy: Two monetary pauses yield two
different results
The Federal Reserve (Fed) looks to be scratching its head. Labor markets
improved, despite slower economic growth. Real income is expanding solidly, but
growth in household spending has slowed. The housing sector has improved, but
business fixed investment remains weak. It’s no wonder the Fed didn’t make any
changes to its monetary policy stance on April 27.
Substantively, the Fed upgraded the health of global economic and financial developments from
posing risks to simply something to be closely monitored. That could be a step toward saying the
risks to growth and inflation appear balanced. To justify a rate hike at its June meeting, the Fed
would have to see economic data that stays robust as well as a pickup in inflation.
It seems unlikely to us that the Fed will have enough confidence in the outlook for inflation and
growth—as well as the conviction that another rate hike wouldn’t cause adverse global
reverberations—to stomach a rate hike. Instead, the Fed may want to float a trial balloon, much
like it did in October, with premonitory language about a December rate hike. Until then, the Fed
has been in wait-and-see mode.
The market moved higher on the Fed’s pause. Contrast that with the Bank of Japan (BOJ), whose
pause on policy wasn’t cheered—not at all. It actually came with jeering and hissing.
BOJ stands pat on policy, with disappointing results
Relative to what was expected, the BOJ really blew it. Instead of learning from its peers, like the
European Central Bank (ECB), and paying banks to lend, the BOJ decided to stand pat on policy on
April 27. Sure, it is purchasing not only bonds but also exchange-traded funds as part of its
massive asset-purchase program, and it has introduced a weak form of negative interest rates, but
it defied expectations by doing nothing more.
Inflation in Japan dropped to -0.3% year over year in March. Household spending has shrunk in 12
out of the past 15 months. Industrial production has been seesawing in and out of negative
territory (most recently, it bounced back 3.6% on the month in March). The economy continues to
struggle to gain traction and recently had a setback with earthquakes in the south. The yen has
been strengthening since the BOJ rolled out negative interest rates in January. This is likely largely
due to a perceived lack of commitment to the policy and little appetite to do whatever it takes to
hit its inflation goal. Unlike Mario Draghi at the ECB, who made that “do whatever it takes” phrase
famous, the BOJ appears to be reverting back to its old ways of just moving the goal posts of
policy rather than working hard to advance the ball (the BOJ pushed out its anticipation of hitting a
2% inflation target by six months).
If there are any glimmers of hope that policymakers will do more rather than not enough, support
among the BOJ governors grew for negative rates. In January, the measure passed by a five-tofour vote. This time, it passed by a seven-to-two vote. Also, a temporary lashing by markets in
pushing the yen stronger and the equity markets down could scare them into doing more when
they meet again on June 15.
While it is true that monetary easing can only do so much—and, along with BOJ officials, we
believe the existing programs will have a positive effect on the economy—investors appear to not
be nearly as patient. Until the economy shows more sustainable signs of life, Japan likely will
continue to trade more like an emerging market than a developed one.
Outlook | May 2016 | 2
2. Equities: Investors remain edgy
The S&P 500 Index advanced nicely in the early part of last month but stalled near
all-time highs in the past two weeks. This pattern of resistance—where price levels
prevent the market from moving prices upward—seem to be recurring. The S&P
500 Index had its correction back in August—its first in a long time—that, come
November, proved to be resistance. In April, November’s peak also proved to be
resistance.
The problem with resistance, which acts as a ceiling by preventing prices from moving upward, is
similar to that of support, which acts as a floor by preventing the price of an asset from being
pushed downward: It’s only resistance or support until it isn’t. That’s one of the dark secrets of
technical analysis, which tries to identify support, resistance, and ranges: It works until it doesn’t,
and there’s no consistent way to tell when it won’t work. Those of us who focus on fundamentals
believe—we think rightly—that it takes positive or negative surprises of the fundamentals to move
the markets higher or lower.
Thus far, earnings season has given us a mix of both positives and negatives. That’s created ample
winners and losers, leading to a pickup in the variation of returns. So far, earnings per share (EPS)
for the S&P 500 Index are dropping 7.6% year over year, but that’s better than what was
estimated when earnings season kicked off. At the beginning of earnings season, EPS was expected
to drop more than 9%.
Commodities advanced in mid-single digits, partially fueled by weakness in the dollar. That’s had a
double benefit for U.S. stocks. Energy stocks have received a reprieve, and export-oriented firms in
the U.S. has benefitted from the weaker dollar. A Fed that looks to be on pause has helped
financials. If you put these factors together, it’s little wonder that the sectors that fell most in
January—energy, financials, and health care—led the charge in April, with all near the top of the
performance heap.
Investors remained edgy as the month drew to a close. The three classic preconditions for a bear
market don’t look to be in sight. Where’s the recession? Where’s the aggressive Fed? And where’s
the investor exuberance? Until we see some of those three factors appear, we remain biased
toward taking on risk.
3. Fixed income: Corporate bond markets continue to
rebound
While most sectors of the bond market were relatively stable during April, the
corporate markets continued to rebound from severe sell-offs November through
February. In the non-investment-grade bond market (as measured by the BofA
Merrill Lynch U.S. High Yield Master II Index), yields have declined as much as 200
basis points (bps; 100 bps equals 1.00%) since mid-February and are now back to
early-November levels. Investment-grade yields are down approximately 50 bps
since mid-February.
Usually, rallies this significant would eliminate most or all investment value. In high yield, however,
yields had reached such extreme levels that even after the rally, they are still at unusually wide
Outlook | May 2016 | 3
spreads to Treasuries. These are levels that would be expected to produce positive returns, even if
the federal funds rate were to increase several times over the next 12 months.
Investment-grade corporates (as measured by the BoA Merrill Lynch U.S. Corporate Index) also
outperformed Treasuries in April, as spreads continued the narrowing that began in early March.
Those spreads are now within ranges that have been typical for nonrecession periods.
Because yields in the municipal market declined somewhat and Treasury yields rose from the earlyApril lows, municipal bonds (as measured by the BoA Merrill Lynch U.S. Municipal Securities Index)
outperformed in April. In the process, however, municipal-to-Treasury yield ratios declined further.
Most of those ratios are now back to prerecession ranges. Yields in many areas of the municipal
market are now the lowest they have been since the 1960s.
With Treasury and municipal yields near the lows for this cycle, we continue to recommend
conservative duration strategies for those sectors. The corporate markets offer sufficient income to
warrant an emphasis on intermediate maturities. As always, diversification and credit research are
essential when investing in the corporate markets.
Table 1
At a glance: Year-to-date bond market returns (%)
Index name
0.60
-0.63
0.83
0.99
1.46
-4.64
3.55
Q4
2015
-0.58
-0.56
-0.93
-0.65
-0.06
-2.17
1.72
April
2016
0.37
1.36
-0.12
0.03
0.17
4.00
0.77
Year to date
(April 30)
3.46
5.34
3.22
2.17
2.13
7.37
2.42
9.21
4.84
1.26
1.13
0.51
0.87
-0.11
1.70
3.26
6.16
2.93
10.72
29.43
1.49
0.91
-3.20
-1.38
-1.44
-2.09
-0.15
-0.16
-0.68
2.78
4.61
8.20
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 | May 2016 | 4
Investment guidance for today’s markets
Action items




Don’t fear the Fed. We expect it to continue to encourage economic growth, which would be
supportive of equities.
Look at the areas of the equity market that aren’t bumping up against all-time highs—for
example, mid-cap stocks, small-cap stocks, emerging markets, and non-U.S. developed
markets.
Consider opportunities in Japan, but be careful—equities here may continue to trade more
like they would in a developing market.
Emphasize fixed-income markets that that already are positioned to withstand a moderate
rise in short-term rates. Look for opportunities in short to intermediate durations.
Investment themes





Don’t overlook mid-cap equities, which may offer value.
Look for opportunities in big integrated energy stocks, a high-quality sector that may offer
value.
Consider the health care sector. Recent retrenchment has eased over valuations, as
demographics and innovation combine with government spending.
Look for opportunities in developed European equities. We believe valuations are cheap, but
fundamentals seem to be improving.
Avoid long-duration Treasuries and municipal bonds but consider high-yield corporates,
which we believe offer value.
What to watch







Listen to BOJ officials in case they start talking about more stimulus before their June
meeting to make up for disappointing investors in April.
Watch China’s economic statistics. They are improving from late last year, and we believe
this will continue.
Keep an eye on Venezuela, Brazil, Greece, and Puerto Rico. Venezuela’s implosion could
drive oil prices higher. Brazil’s impeachment process could usher in rapid changes. Greece
could unlock money from creditors before it hits some big bond repayment deadlines in late
June and early July. Puerto Rico is threatening default again. Despite the risks, investors
seem to be unperturbed so far.
Watch earnings expectations in the U.S. That may determine whether fair valuations go to
over- or undervaluations.
Watch for continued improvements in U.S. employment and housing data. American
consumers’ savings rate has inadvertently moved up because of lower oil prices. This could
be a positive driver for the economy.
Pay attention to the Fed’s signals for the outlook for the federal funds rate.
Look for a seasonal increase in new-issue volumes in the municipal market.
Outlook | May 2016 | 5
Asset allocation guide: Summary
Equity recommendations
Strategic recommendation*
U.S. vs. non-U.S. developed equities
U.S. equities
40%
Investors have gotten accustomed to slow growth. In the developed
world, we think Europe and Japan have the biggest surprises to the
upside in store.
Non-U.S.
developed
equities
60%
Growth vs. value equities
Growth and value are not opposites. Take a complementary approach to
investing by finding underpriced growth opportunities and low valuation
stocks that may grow.
Large-cap vs. small-cap equities
40%
60%
A lot of worry is built into emerging markets stock prices, but it’s hard to
imagine that concerns such as slow global growth, political issues, and
low commodity prices aren’t already priced in. Signs of growth in China
and stabilization of commodity prices could trigger a rapid repricing.
Fixed-income recommendations
Credit-risk exposure
Sectors such as commercial real estate and energy could see a pickup in
defaults, but judicious credit selection can navigate these issues. Yields,
especially relative to Treasuries, appear quite generous to justify the
higher risks in high yield.
Fixed-income duration
As the Fed normalizes interest rates, the brunt of the adjustment is likely
going to be in shorter-duration securities. By building in a credit spread,
short-term rate hikes can be absorbed. The key for investors will be to
collect income while trying to ignore temporary price changes.
Fixed vs. floating rates
We prefer fixed-rate short-term debt, which tends to have more investorfriendly debt-covenant characteristics than floating-rate debt. Also, some
floating-rate debt doesn’t float until rates rise above a certain threshold,
which might make it perform in unanticipated ways. That could become
evident as the Fed starts to hike rates.
Alternative investment strategies
Alternative investment strategies vs. traditional
investments
Our investment guidance for alternative investment strategies may range
from 0% to 20%, based on our subjective assessment of risk. We believe
the risks in the near future are slightly above average, leading us to
recommend a 15% weighting.
Value
10%
The size of the investment opportunity is more important than the size of
the company. Last year, small-cap and mid-cap stocks lagged. Staying
flexible with capitalization exposure is our preferred strategy.
Developed equities vs. emerging markets equities
Growth
Large
90%
15%
Small
Developed
equities
85%
Emerging
markets equities
Strategic recommendation*
40%
Higher yield
60%
50%
Lower yield
Short duration
50%
Long duration
40%
Fixed rate
60%
Floating rate
Strategic recommendation*
15%
Traditional
investments
85%
Alternative
investment
strategies
*A time frame of three years or longer
Outlook | May 2016 | 6
Connect with us
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The asset allocation positioning represented by the pie charts is in no way intended to offer individualized advice about which investments to
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do not predict or guarantee the performance of any Wells Fargo Fund. When applying an asset allocation strategy to your own situation,
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be considered when you determine which investments will best suit your risk profile. Please consult a financial advisor for advice on your
specific facts and circumstances.
Diversification does not ensure 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.
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
index tracks the performance of high-yield securities traded in the U.S. bond market.
The BofA Merrill Lynch U.S. Corporate Index is an unmanaged index composed of U.S. dollar–denominated investment-grade corporate debt
securities publicly issued in the U.S. domestic market with at least a one-year remaining term to final maturity.
The BofA Merrill Lynch U.S. Municipal Securities Index is an unmanaged, market-value-weighted index composed of investment-grade, fixed
rate, coupon-bearing municipal bonds.
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
duration of the bonds in the portfolio. Duration should be interpreted as the approximate change in a bond’s (or fund’s) price for a 100-basispoint change in Treasury yields.
The views expressed are as of 4-30-16 and are those of Chief Portfolio Strategist Brian Jacobsen; Chief Equity Strategist John Manley; Chief
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 | May 2016 | 7