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Wells Capital Management Perspective Economic and Market Bringing you national and global economic trends for more than 30 years July 14, 2016 The elephant in the room — Bond yields? James W. Paulsen, Ph.D Chief Investment Strategist, Wells Capital Management, Inc. The U.S. stock market has risen by more than 17% in the last five months to an all-time record high immediately after a Brexit crisis that many believed ensured a bear market. And yet, the elephant in the room, the biggest question pondered today by investors, is not about stocks but rather is “will bond yields ever bottom”? The U.S. 10-year Treasury bond yield declined to an historic low last week among several negative -- yielding international sovereign bond yields. The slowest growing economic recovery in post-war history combined with unprecedented and massive monetary policies employed in concert about the globe have pushed bond yields significantly lower than most anyone anticipated. Indeed, they have fallen by so much for so long that calls for higher yields have mostly gone silent. Therefore, it is only with great trepidation of potentially being premature (which most calls for a bottom in yields have been throughout this recovery) that we suggest the current bond route feels like a final blow off near its end. At this juncture, although yields could certainly decline further, we think investors are best served by preparing for an eventual period of rising yields. Several factors are converging for the first time in this recovery that may finally prove a formidable foe for bond yields. First, the U.S. economic recovery has recently returned to some semblance of full employment changing the interest rate dynamics from earlier in the recovery. Second, the annual rate of core consumer price inflation has begun to accelerate across the globe. Third, for the first time, economic policy officials almost everywhere are universally accommodative. Fourth, bond yields increasingly and alarmingly appear divorced and disconnected from many measures of economic activity (e.g., GDP growth, core inflation, wages, loan growth and commodity prices). Finally, despite mounting fundamental evidence that yields should be higher, calls for imminently higher interest rates are almost nonexistent. When a financial trend persists for so long and when its magnitude becomes so overwhelmingly large, it begins to feel normal. After years of periodic calls for higher yields, most have simply given up and jumped on the “lower for longer” bandwagon. But the Nifty-Fifty, oil prices, dot.com stocks or house prices can’t rise forever and neither will bond prices. We certainly do not know when bond yields will ultimately bottom. However, it is worthwhile to consider just how much the sand under the bond bull is changing. A full employment recovery Until recently, the economic recovery proceeded without creating substantial pressure on bond yields because it exhibited so much slack. High levels of unemployment allowed the economy to grow without aggravating inflation or cost push pressures and therefore without pressuring yields. Chart 1 U.S. wage inflation and unemployment rate Solid (left) — Annual U.S. wage inflation, six-month average Dotted (right) — U.S. unemployment rate Economic and Market Perspective | July 14, 2016 Now, as shown in Chart 1, even modest economic growth may worsen yield pressures because the economy has finally returned to some semblance of full employment. Until the labor unemployment rate returned to about 5.5% in early 2015, wage and core consumer price inflation were largely dormant in this recovery. Since, however, for the first time in this recovery, economic growth (even subpar economic growth) is forcing labor costs (and core consumer price inflation, see Chart 2) higher which ultimately will likely force a reset in U.S. yields. A global rise in core inflation A dramatic collapse in commodity prices in the last couple of years has concealed the most significant and broad-based global advance in “core inflation” yet in this recovery. In the U.S. (Chart 2), the annual rate of core consumer price inflation is currently close to its fastest pace of the recovery. In Japan (Chart 3), despite concerns about weak economic growth, core inflation has been running hotter since 2014. Similarly, during the last year in Europe (Charts 4 and 5), the core inflation rate has also turned higher. Although Canada certainly suffered from the recent collapse in energy prices, as shown in Chart 6, core consumer price inflation recently rose to its highest pace of the recovery. Finally, in China (Chart 7), while concerns linger about slowing economic growth, core price inflation has accelerated again since early 2015. a different cycle. China (Chart 11) spent much of this recovery attempting to moderate its expansion fearing overheat conditions. As shown, bond yields in China trended mostly higher in this recovery until mid-2014. As they finally are today, policy officials have seldom been on the same page simultaneously attempting to improve global economic growth. Although the U.S. has been pushing upward persistently, its efforts were often in conflict with less aggressive or ambivalent Japanese actions (e.g., until the summer of 2013), with outright tightening actions by the ECB (e.g., between 2010 until mid-2011 and again between mid-2013 to 2015) and with the recovery moderating actions of Chinese officials. Since the start of 2015, however, almost all global policy officials are pushing upward on economic recoveries and therefore creating the best chance yet that global yield structures may finally trend higher. Simultaneously, long-term yields have collapsed from the U.S. to the eurozone, Japan and China. Moreover, the U.S. central bank balance sheet remains massive and in the last couple years, bank balance sheets have also been expanded in both the eurozone and in Japan. In short, for the first time since this recovery began, policies across the globe are synchronized in a collective effort to improve economic growth and force yields higher. Divergences defy logic The eye-catching collapse in commodity prices since the summer of 2014 certainly heighted concerns about deflation and economic stagnation and these anxieties weighed on bond yields about the globe. However, lost amongst the drama of a global commodity price collapse was a U.S. economic recovery that returned to full employment and a rise in global core inflation. As the curtain closes on the recent commodity crisis, bond investors and policy officials will be faced with rising commodity prices “and” a core inflation rate that has already been rising without fanfare for more than a year. Policy officials are all pushing upward Prior to the 2008 crisis, the 10-year U.S. Treasury yield was between 4.5% to 5%. Even at the worst of the crisis in late-2008, the 10-year yield briefly declined to only 2%. Despite beginning the eighth year of this economic recovery, the current 10-year yield is near an all-time record low more than 0.5% lower than at any time during the 2008 crisis. That is, for an economy now in expansion for more than seven years growing at about 2% with a core consumer price inflation rate of 2.2% and a wage inflation rate of 2.6%, a sub-1.5% 10-year bond yield appears ridiculous. Increasingly, U.S. bond yields appear alarmingly divorced from many measures of economic activity. Charts 12 through 17 illustrate just a few examples of how “out of whack” the U.S. yield structure is compared to historic norms. Charts 12 and 13 show that the 10-year Treasury yield is currently less than the core consumer price inflation rate and the wage infla inflation rate. Indeed, relative to both of these traditional inflation measures, the current 10-year yield has not been this low in about 35 years! For the first time in this recovery, “all” policy officials are simultaneously stimulating the global recovery. The U.S. adopted aggressively accommodative policies (Chart 8) early and often in this recovery. As shown, annual growth in the U.S. money supply is currently about 7%, twice as fast as nominal GDP growth. However, Japan did not embrace full-scale central bank easing (Chart 9) until about mid-2013. Eurozone officials (Chart 10) initially tightened by implementing fiscal austerity measures, did not expand the ECB balance sheet until late-2011, and then reversed these actions between mid-2013 until 2015. Finally, the emerging economic recovery has often been on | 2 | Economic and Market Perspective | July 14, 2016 Chart 2 Chart 3 Chart 4 U.S. annual core consumer price inflation rate Japan annual core consumer price inflation rate Great Britain annual core consumer price inflation rate Chart 5 Chart 6 Chart 7 Eurozone annual core consumer price inflation rate Canada annual core consumer price inflation rate China annual core consumer price inflation rate | 3 | Economic and Market Perspective | July 14, 2016 Chart 8 Chart 9 U.S. M2 money supply growth Annualized six-month rates Japan central bank balance sheet — Total assets Natual log scale Chart 10 Chart 11 ECB central bank balance sheet — Total assets Natural log scale China 10-year government bond yield | 4 | Economic and Market Perspective | July 14, 2016 Chart 12 Chart 13 Real 10-year Treasury bond yield* *10-year yield less annual core consumer price inflation rate 10-year Treasury bond yield ralative to wage inflation* *10-year yield less annual wage inflation rate Chart 14 Chart 15 Real 10-year Treasury bond yield and commodity prices Solid (left) — U.S. 10-year Treasury bond yield Dotted (right) — JOC - ECRI Industrial Commodity Price Index Treasury bond yield and nominal GDP growth Solid — U.S. 10-year Treasury bond yield Dotted — Trailing five-year annualized growth in U.S. nominal GDP | 5 | Economic and Market Perspective | July 14, 2016 While exhibiting a fairly close relationship to commodity price movements throughout this recovery, Chart 14 shows that the 10-year yield failed to respond this year to a significant revival in commodity prices. Chart 15 shows that the average annualized growth in nominal GDP relative to bond yields has widened to its largest divergence of this recovery and one of the largest divergences since 1960. Chart 16 illustrates a breakdown in the last couple of years between bond yields and measures of economic confidence. Currently, while consumer confidence is close to one of its highest levels of this recovery, bond yields have collapsed to record lows. Finally, Chart 17 shows a recent break in the close relationship between yield movements and corporate yield spreads. Since at least 2000, corporate yield spreads have oscillated closely with the direction of the 10-year Treasury yield. Specifically, corporate spreads have usually tightened when yields have risen and widened as yields have fallen. However, since early this year, corporate spreads have tightened despite much lower Treasury bond yields. That is, for the first time in this recovery, the messages coming from within the bond market itself seem conflicted. Lower Treasury bond yields seem to suggest rising anxieties surrounding economic growth and deflation whereas tighter corporate bond yield spreads simultaneously suggest rising confidence in financial strength, corporate earnings results and the durability of the overall recovery. These examples are not an exhaustive list of the broken historic relationships traditionally tying the yield structure to the overall economy. For example, the 10-year yield has declined by about 1% in the last year despite U.S. bank loan growth rising by almost 8% to its fastest pace of the recovery. Additionally, the trailing 12-month earnings yield on the U.S. stock market is currently at one of its widest spreads relative to the 10-year Treasury yield in the post-war era. Chart 16 Confidence and real Treasury bond yield Chart 17 Treasury yield and corporate bond yield spread Solid (left) — U.S. 10-year Treasury bond yield Dotted (right) — Chase high yield bond spread, inverted scale in U.S. nominal GDP Breaks in the traditional relationships between Treasury yields and economic performance are both numerous and extreme today. Importantly, this was not the case until recently. Earlier in this recovery, the 10-year yield was 1% to 2% above the rates of wage and core inflation (Charts 12 and 13). It wasn’t until 2014 that the spread between nominal GDP growth and the 10-year yield became extreme (Chart 15). Confidence measures and bond yields began to diverge only since 2014 (Chart 16). Moreover, until recently, loan growth remained very modest consistent with very low yields. Finally, it wasn’t until this year that the 10-year yield disconnected from both commodity prices and corporate bond yield spreads (Charts 14 and 17). Bottom line? Unlike earlier in this recovery, the U.S. yield structure appears increasingly disconnected from and unsustainably low relative to the underlying performance of the economy. | 6 | Economic and Market Perspective | July 14, 2016 Chart 18 Chart 19 U.S. 10-year government bond yield Source: Shiller and Bloomberg S&P 500 Dividend Aristocrats Index relative total return vs. 10-year U.S. Treasury bond yield Solid (left) — S&P 500 Dividend Aristocrats Relative Total Return Index Dotted (right) — 10-year U.S. Treasury bond yield, inverted scale A mantra of “lower for longer” U.S. bond yields have been in a downward trend for more than 35 years and have fallen to levels almost nobody expected during this recovery. However, persistence in a trend is probably the primary ingredient in a consensus belief. And now, after years of periodic calls for higher yields, most have simply given up and jumped on the “lower for longer” bandwagon. Indeed, even the Federal Reserve seems to have recently adopted this mantra. Chart 18 is a good reminder of just how silly the current yield structure in the U.S. appears. Currently, the 10-year yield is near an all-time low dating back to 1870! Today, more people are employed in this country than ever before, the unemployment rate is lower than about 72% of the time since WWII, nominal GDP is about 25% higher than at the end of the last expansion, disposable personal income is almost 30% higher, household net worth is 30% higher, core consumer price inflation and wage inflation are between 2% and 2.6%, the annual auto sales rate in the U.S. is near an all-time record, bank lending is up by 8% in the last year, corporate profits are almost 15% above peak levels in the last recovery, the stock market is at an all-time record high and the current economic recovery is now the third longest on record. | 7 | With this as a backdrop, does it make sense that the 10-year Treasury bond yield is currently lower than it was at any point during the entire Great Depression? Bond blow-off in the stock market? Stock investors should take note of just how much the bond bull has infiltrated the stock market and perhaps take appropriate defensive action. Chart 19 overlays the relative performance of a popular stock index with bond yields. The solid line shows the relative total return performance of the S&P 500 Dividend Aristocrats Index (relative to the overall S&P 500 Index). This index measures the performance of the S&P 500 constituents that have followed a policy of consistently increasing dividends every year for at least 25 consecutive years. Essentially, this index captures the most high quality bond-like stocks within the S&P 500 Index. Economic and Market Perspective | July 14, 2016 Chart 20 Chart 21 S&P 500 Utilities Index relative total return vs. 10-year U.S. Treasury bond yield Solid (left) — S&P 500 Utilities Index relative total return Dotted (right) — 10-year U.S. Treasury bond yield, inverted scale S&P 500 Consumer Staples Index relative total return vs. 10-year U.S. Treasury bond yield Solid (left) — S&P 500 Consumer Staples Index Dotted (right) — 10-year U.S. Treasury bond yield, inverted scale Chart 22 Chart 23 Dow Jones REIT Index relative total return vs. 10-year U.S. Treasury bond yield Solid (left) — Equal-weighted relative total index comparing S&P 500 financials, energy, and industrial sectors Dotted (right) — 10-year U.S. Treasury bond yield, inverted scale S&P 500 Anti-bond Dividend Index* relative total return vs. 10-year U.S. Treasury bond yield Solid (left) — Equal-weighted relative total index comparing S&P 500 financials, energy, and industrial sectors Dotted (right) — 10-year U.S. Treasury bond yield | 8 | Economic and Market Perspective | July 14, 2016 As shown, the performance of bond-like stocks has followed the bond market very closely since 2000 (the dotted line is the 10-year Treasury bond yield on an inverted scale). Many investors have adopted equity portfolios comprising stocks similar to those in the Dividend Aristocrats Index — high quality, premium dividend payers with steady profitability. Three of the most popular stock sectors possessing these preferred characteristics are utilities, real estate investment trusts and consumer staples. Charts 20, 21 and 22 show that the superior relative total return performances of each of these sectors have been strongly tied to a trend of lower bond yields. Investors should consider lightening up on bond-like sectors and consider overweighting some “anti-bond” sectors. Chart 23 provides an illustration of three sectors that have exhibited a propensity to outperform during periods of rising yields. The solid line is an equal weighted relative total return index for the S&P 500 financials, energy and industrials sectors. Between 2000 and 2002, this index outpaced the overall S&P 500 Index despite falling yields but this was primarily because all sectors outside of technology stocks outperformed during the initial stages of the dot.com market collapse. Since 2002, however, the relative performance of these three sectors has been closely tied to the direction of bond yields. Should bond yields trend higher, these sectors should outpace the highly popular bond-like stocks. Whether global policy officials are artificially pegging U.S. yields at low levels or whether these yields simply reflect widespread global fears among private investors, the current U.S. yield structure appears increasingly unsustainable. Written by James W. Paulsen, Ph.D. An investment management industry professional since 1983, Jim is nationally recognized for his views on the economy and frequently appears on several CNBC and Bloomberg Television programs, including regular appearances as a guest host on CNBC. BusinessWeek named him Top Economic Forecaster, and BondWeek twice named him Interest Rate Forecaster of the Year. For more than 30 years, Jim has published his own commentary assessing economic and market trends through his newsletter, Economic and Market Perspective, which was named one of “101 Things Every Investor Should Know” by Money magazine. Summary and conclusions Who knows when U.S. bond yields will ultimately bottom? In our view, however, investors should prepare for an upward trend in yields during the balance of this recovery. This should include examining the allocation of the portfolio between stocks and bonds, the duration and quality exposures within the fixed-income segment and the sector weightings employed in the stock allocation. Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. WFAM includes Affiliated Managers (Galliard Capital Management, Inc.; Golden Capital Management, LLC; and The Rock Creek Group); Wells Capital Management, Inc. (also includes First International Advisors, LLC and ECM Asset Management Ltd.); Wells Fargo Funds Distributor, LLC; Wells Fargo Asset Management Luxembourg S.A.; and Wells Fargo Funds Management, LLC. Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at www.wellscap.com, or refer to our Form ADV Part II, which is available upon request by calling 415.396.8000. | 9 |