What Might Higher LIBOR Mean for Bonds and the Dollar?

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1 WEEKLY GUIDANCE FROM OUR I NVESTMENT STRATEGY COMMITTEE Peter Wilson International Fixed Income Strategist October 29, 2018 What Might Higher LIBOR Mean for Bonds and the Dollar? Key takeaways» The London Interbank Offered Rate (LIBOR) in U.S. dollars surged early this year. 1 As a result, the cost of currency-hedging dollar exposure rose for investors outside the United States. Treasury yields rose and the U.S. dollar (USD) fell.» These market moves were partially reversed over the summer as LIBOR stabilized. Yet, since September, Treasury yields are rising again, and currency hedging costs are once more a market focus. What it may mean for investors» Now that the spread between LIBOR and the federal funds rate has normalized, any further fed funds rate hikes are likely to be reflected in higher LIBOR rates and rising dollar hedging costs.» The rise in USD LIBOR and our expectation for higher hedging costs for overseas investors help to support our view that Treasury yields are set to rise somewhat further, and that the dollar is likely to resume its decline in A sharp early-2018 rise in USD LIBOR Asset Group Overviews Equities... 5 Fixed Income... 6 Real Assets... 7 Alternative Investments... 8 Earlier this year, financial markets took note of the sharp rise in LIBOR for U.S. dollar funds. For example, three-month USD LIBOR surged from 1.70% at the start of the year to a peak of 2.37% by early May. As Chart 1 shows, this was far in excess of the rise that might have been expected in line with the gradual fed funds rate increase. This widening of the spread between LIBOR and other less risky short-term rates led to market concerns about financial institutions credit quality. 1 LIBOR is a benchmark rate that leading banks charge each other for short-term loans. It is based on five currencies: the U.S. dollar, euro, British pound sterling, Japanese yen, and Swiss franc. LIBOR includes seven different maturities: overnight, 1 week, and 1, 2, 3, 6, and 12 months. There are 35 different LIBOR rates each business day. The most commonly quoted rate is the threemonth U.S. dollar rate Wells Fargo Investment Institute. All rights reserved. Page 1 of 10

2 What Might Higher LIBOR Mean for Bonds and the Dollar? Chart 1. Three-month LIBOR and the federal funds rate 3.0% Rate 2.5% 2.0% 1.5% 1.0% 3-Month Dollar LIBOR Fed funds rate target range (midpoint) 0.5% 0.0% 1.0% Three-month USD LIBOR minus midpoint rate for fed funds target range Spread 0.5% 0.0% Sources: Bloomberg, Wells Fargo Investment Institute; October 22, For illustrative purposes only. The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight and is set by the Federal Reserve. LIBOR is often defined as the cost of short-term borrowing between global banks and is sensitive to movements in the fed funds rate. Targets are not guaranteed and are subject to change based on economic and market conditions. At the time, Wells Fargo Investment Institute (WFII) was not of this opinion, as WFII attributed the excess rise in LIBOR to a couple of technical factors that were impacting markets in early These were U.S. corporations repatriation of large amounts of dollar funds previously held overseas, which reduced demand for LIBOR-linked instruments and a large increase in the U.S. government s issuance of short-term Treasury bills, which forced other short-term rates higher at a faster pace than the rise in the fed funds rate. Where is LIBOR heading now? These views proved correct, but today, we are not concerned with the causes of the January-May LIBOR rise. We are more interested in the possible market implications if LIBOR, which was remarkably stable between May and September, should resume its rise once more as seems likely to happen. Take another look at Chart 1 above. If the three-month LIBOR rate was able to virtually flatline between May and September, this was because it already had risen far enough above the fed funds rate to absorb two 25-basis-point hikes from the Federal Reserve (Fed) in March and June (for the technical reasons above). From September, we can see that three-month LIBOR is resuming its move higher. In part, this may be due to a somewhat more hawkish tone in the rhetoric of Fed chair Jerome Powell and other Fed governors. Yet, it is also because, as Chart 1 shows, the passage of time has normalized the spread between LIBOR and the fed funds rate. WFII expects the Fed to raise the fed funds rate by 25 basis points in December, and twice again by the middle of It is highly probable that most (if not all) of this Wells Fargo Investment Institute. All rights reserved. Page 2 of 10

3 What Might Higher LIBOR Mean for Bonds and the Dollar? basis-point increase will be reflected in a rise in three-month LIBOR. 2 This may have some interesting implications for bond and currency markets in late 2018 and into 2019 as currency markets may see movements that were supressed by the unusual stability of LIBOR rates through mid Chart 2. LIBOR differential and foreign-exchange forward points 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 3-Month USD LIBOR minus 3-Month EURIBOR (left axis) Euro-USD 3-month forward points (right axis) % 0 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 Sources: Bloomberg, Wells Fargo Investment Institute; October 22, For illustrative purposes only. EURIBOR = the euro equivalent of three-month USD LIBOR. Forward points reflect the cost of hedging U.S. dollar exposure back into euro in currency markets. EURIBOR and LIBOR are comparable base rates. EURIBOR is the average interbank interest rate at which European banks are prepared to lend to one another. The main difference between EUIBOR and LIBOR is that LIBOR is quoted in different currencies. Market implications of a resumption in LIBOR s rise Three-month EURIBOR (the euro equivalent of U.S. three-month LIBOR) has barely changed over this period. Last week, it stood at approximately -0.32%. This means that, since the start of 2018, the spread between dollar LIBOR and EURIBOR first rose from around 2% then peaked near 2.70% in May. This was a level that it did not exceed again until September. As Chart 2 illustrates, the relevance of this is that this short-term interest rate differential is closely linked to the cost of hedging U.S. dollar exposure back into euro in currency markets (known in foreign-exchange terminology as forward points ). This cost had been rising quickly as the Fed tightened interest rates in 2017, and this rise accelerated in early 2018 as LIBOR rates surged. The key point is that, by this metric, dollar-hedging costs into euro actually peaked in March 2018 then fell appreciably through the summer (because of LIBOR stabilization) and only exceeded the March peak when the Fed raised rates in September. Investor implications Recall that at the start of the year when USD LIBOR and dollar hedging costs were on the rise the market environment also was characterized by a sharp rise in U.S. Treasury yields and a falling dollar. Market participants (correctly, in our opinion) rationalized this somewhat unusual combination by noting the anticipated increased supply of Treasury securities with the expansion of the fiscal deficit, as well as waning demand from overseas buyers such as Japanese and European life insurers and pension funds (accounts that would typically hedge the dollar exposure of Treasury purchases). 2 One hundred basis points equal 1% Wells Fargo Investment Institute. All rights reserved. Page 3 of 10

4 What Might Higher LIBOR Mean for Bonds and the Dollar? This narrative understandably went quiet during the summer months, as LIBOR and hedging costs stabilized, U.S. Treasury yields traded relatively stable within a range, and the dollar recovered its losses. It is not a coincidence that hedging costs are now once more a common topic of market commentary. Of course, the factors above are not the only ones impacting bond and currency markets, and the dollar remains finely poised with real economic and political risks in both directions. Yet, we believe that the rise in dollar LIBOR and higher hedging costs to overseas investors are factors that support our view that Treasury yields are set to rise a little further and that the dollar will resume its decline in Wells Fargo Investment Institute. All rights reserved. Page 4 of 10

5 EQUITIES Audrey Kaplan, Head of Global Equity Strategy Ken Johnson, CFA, Investment Strategy Analyst U.S. Large Cap Equities U.S. Mid Cap Equities U.S. Small Cap Equities Developed Market Ex-U.S. Equities Emerging Market Equities Finding opportunity in emerging market equities While emerging market (EM) equities entered a bear market in September after declining by more than 20% (down 24.5% since the January high), the region s fundamentals have been steadily improving. 3 Both earnings per share (EPS) and dividends per share (DPS) have been rising steadily since their post-recession lows in August And for the first time since 2011, companies in the MSCI Emerging Markets Index are hitting the EPS and DPS targets of the average analyst consensus forecasts made 12 months ago (see chart for EPS). Our current emerging market EPS growth estimate for the next 12 months, at $93 per share, reflects a modest double-digit increase from the current, actual level of $79.40 per share. There are several factors that support our emerging market EPS forecast. The first is EM economies being earlier in their business cycle than the U.S. economy is. A second supportive factor is the fact that EM governments, such as those of China, South Korea, and India, are providing fiscal and monetary stimulus to fuel growth. The third is our expectation for higher commodity prices in 2019 and a weakening U.S. dollar next year. Based on our recent evaluation of important market pillars, such as growth, valuation, quality, and macroeconomic characteristics, we maintain our favorable rating on EM equities for the tactical time horizon. Key takeaways» Bad news already has been priced in for EM equities. We see EM equity opportunity for investors in the tactical time frame (6-18 months).» We believe that fundamentals, including EPS, DPS, and cash flow per share, are supportive of EM equities. EM EPS has been improving and meeting analyst consensus expectations Earnings per share $120 $110 $100 $90 $80 $70 $60 $50 WFII 10/1/19 EPS Estimate $ Forward earnings per share (moved ahead 1 year) Trailing earnings per share Sources: FactSet, Wells Fargo Investment Institute. As of October 23, Chart shows consensus analyst EPS forecasts for the MSCI Emerging Markets Index versus actual trailing EPS. The final data point for forward EPS (only) shows the Wells Fargo Investment Institute (WFII) forecast. Forward EPS data points have been moved forward by one year to facilitate comparison with actual EPS data. A consensus estimate is a shared prediction of a company's quarterly or annual earnings per share. EPS refers to the portion of a company's profits that are allocated to every outstanding share of stock. It indicates a company's ability to produce net profits for common shareholders. Forward EPS is an estimate for the future, based on either company or analyst-generated estimates. Trailing EPS is a company's EPS from a time period that has already passed. WFII forecasts and estimates are based on our current view of market and economic conditions are are subject to change. MSCI Emerging Markets Index is a free float-adjusted market capitalization-weighted index designed to measure equity market performance of 24 emerging market countries. Am index is unmanaged and not available for direct investment. 3 Based on the MSCI Emerging Markets Index, October Wells Fargo Investment Institute. All rights reserved. Page 5 of 10

6 FIXED INCOME Brian Rehling, CFA Co-Head of Global Fixed Income Strategy Unfavorable U.S. Taxable Investment Grade Fixed Income U.S. Short-Term Taxable Fixed Income U.S. Intermediate Term Taxable Fixed Income Most Unfavorable U.S. Long-Term Taxable Fixed Income Unfavorable High Yield Taxable Fixed Income Unfavorable Developed Market Ex.-U.S. Fixed Income Flatter not steeper over time In recent years, as the Fed has transitioned to tighter monetary policy, we have seen meaningful yield-curve flattening (the yield spread between long-and short-term interest rates narrows). The interest-rate curve follows fairly predictable long-term trends; steepening early in an economic recovery before flattening into an eventual economic downturn. This pattern has been repeated consistently over the past 30 years. Theories abound to explain why this time is different from the impact of quantitative easing to global relative value. We do not believe that this time is different, and a slowly flattening yield curve anchors our interest-rate expectations. The yield curve (10 year 1 year) has been flattening throughout the Fed tightening cycle (see chart). It is important to note that while a flat yield curve is indicative of late-cycle bond market behavior it does not indicate that a recession is imminent. While curve flattening has been the trend, it is important to note that the yield curve between 1- and 10-year Treasury securities, currently near 50 basis points (0.50%), remains positively sloped (100 basis points equals 1%). This suggests that the current economic growth environment should remain in place in the near term. Once the yield curve does invert, history suggests that it could still be as long as two years before a recession. In fact, the relatively slow pace of curve flattening suggests that the U.S. economic expansion will continue throughout If the yield curve were to quicken its pace of flattening (most likely with the Fed s help), investors would probably be justified in increasing their level of concern. Key takeaways» While curve flattening is currently the overall trend, the yield curve remains sufficiently steep to suggest that the slow-growth environment will continue.» If any curve steepening were to occur, we would expect it to be only temporary.» Higher short-term rates may present investors with an attractive opportunity to own high quality short-term securities at yield levels that have not been available for some time. We have a favorable view of the short-term investment grade debt class. A flattening yield curve (10-year Treasury yield 1-year Treasury yield) Basis points Emerging Market Fixed Income Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sources: Bloomberg, October 19, For illustrative purposes only. The Ten-Year Treasury Constant Maturity and the One-Year Treasury Constant Maturity Indexes are published by the Federal Reserve Board and are based on the average yield of a range of Treasury securities, all adjusted to the equivalent of a 10-year maturity and the equivalent of a one-year maturity.. Yields on Treasury securities at constant maturity are determined by the U.S. Treasury from the daily yield curve. The difference between the Ten-year Treasury note yield and the One-year Treasury note yield measures the spread between short and long-term interest rates Wells Fargo Investment Institute. All rights reserved. Page 6 of 10 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 May-16 Sep-16 Jan-17 May-17 Sep-17 Jan-18 May-18 Sep-18

7 REAL ASSETS Austin Pickle, CFA Investment Strategy Analyst Our worst misfortunes never happen, and most miseries lie in anticipation. --Honore de Balzac Gold shines in the face of fear Commodities Unfavorable Private Real Estate Public Real Estate During the past year, gold s price largely has traded in inverse lockstep with the U.S. dollar. When the value of the dollar increased, gold s price decreased and vice versa. Given that the dollar has risen by nearly 1.5% so far in October, one may expect that the price of gold has dropped. 4 But, that has not been the case. In fact, gold was up 3% through October 24. So what prompted this divergence? Fear. Let me explain. In case you missed it, equity markets have been in turmoil recently. As an example, the S&P 500 Index has declined by nearly 9% in October alone. 5 When there is as much equity-market downside volatility as we have seen recently, investors tend to run for the hills into the perceived safe haven investments with the two most popular being Treasury securities and gold. Many investors behave this way because they fear additional losses and want (what they view as) protection. This investor reaction is why gold is sometimes referred to as portfolio insurance. Does this mean that when equity markets stabilize and push higher (which we expect) gold will tumble from today s level? We don t believe so. At that point, gold the chameleon will likely switch from perceived safe-haven mode to dollar-mirror mode or commodity mode. Either way, we see higher gold prices ahead as we expect commodity prices in general to increase and the U.S. dollar to weaken. Our rolling 12- month target price for gold remains $1,250 - $1,350 per ounce. Key takeaways» Gold recently has benefited from stock market pain.» Our gold rolling 12-month target remains $1,250 - $1,350 per troy ounce. Gold versus the U.S. dollar 86 U.S. Dollar Index (left scale - inverse) Gold spot price (right scale) 1400 Dollar Index Gold price (U.S. dollar per ounce) Oct-17 Jan-18 Apr-18 Jul-18 Oct-18 Sources: Wells Fargo Investment Institute, Bloomberg; October 24, Daily data October 24, 2017 October 24, Forecasts, targets and estimates are based on certain assumptions and on our current views of market and economic conditions, which are subject to change. 4 Data is through October 24, Ibid Wells Fargo Investment Institute. All rights reserved. Page 7 of 10

8 ALTERNATIVE INVESTMENTS Jim Sweetman Senior Global Alternative Investment Strategist Private Equity Hedge Funds-Macro Hedge Funds-Event Driven Hedge Funds-Relative Value Most Hedge Funds-Equity Hedge Downgrading private real estate to unfavorable Late last week, we downgraded our guidance on private real estate to unfavorable, despite a current environment that is largely supportive of private real estate fundamentals. We believe that future risks are rising and that they have the potential to negatively impact the private real estate sector. Our concerns are focused on the following: Rising rates may have a considerable impact on property capitalization rates applied to a property s net operating income. This could pressure property values. Uncertainty and capital-market volatility have been ratcheted up due to multiple, ongoing geopolitical events across the U.S., Europe, and Asia. The next several years likely will see higher interest rates and capitalization rates; lower returns that are fueled by income growth; pockets of illiquidity and distress; and a slowing of capital flows driven by fewer, more selective investment opportunities. Cracks already are appearing in major U.S. cities as the upward momentum that commercial real estate prices and values had experiencing recently has slowed relative to its appreciation trajectory starting two years after the credit crisis. The prevailing trend in private equity real estate is a moderation in the pace of asset value appreciation, which is consistent with late-cycle expectations. The most recent Pension Real Estate Association (PREA) consensus forecast for core U.S. real estate projects a return of 6.2% for 2018 followed by 5% in 2019, 4.4% in 2020, and (an annual average of) 5.2% between 2018 and The equivalent figures for capital appreciation (returns generated by rising prices) illustrate the flat outlook: 1.5%, 0.3%, -0.5% and 0.3%, respectively, for these periods. Key takeaways» Despite the fundamental backdrop for real estate investment remaining generally supportive, risk is on the rise as concerns regarding the potential impact of higher rates have narrowed the risk premium for the private real estate strategy.» Major economies and real estate markets are at different cycle points. We see more attractive investing opportunities in Europe and Asia relative to the U.S., and we prefer value-add and opportunistic strategies over core strategies. Moderating returns for U.S. core real estate 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. Annual return (%) F* 2019F* 2020F* 2021F* 2022F* Income Capital appreciation Total Source: Pension Real Estate (PREA) Consensus Forecast Survey of the NCREIF, October 24, F* - indicates forecast. Property return forecasts do not reflect investment management fees and expenses and are subject to change. Past performance is no guarantee of future results. Data as of September Please see Risk Considerations for a description of the risks associated with investing in core real estate Wells Fargo Investment Institute. All rights reserved. Page 8 of 10

9 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. 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. 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. 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. Private real estate strategies are speculative and not suitable for all investors. Core investments in real estate are considered less risky and are characterized as having lower risk and lower return potential. The value of any property may decline as a result of a downturn in the property market, and economic and market conditions. The value-added strategy seeks to add value by making enhancements to properties. These properties may have operational issues and usually require additional leverage to acquire. There is no guarantee value appreciation will be achieved and the operating company may be forced to sell properties at a lower price than anticipated. An opportunistic investment style bears the highest level of risk among real estate strategies as it typically involve a significant amount of value creation through the development of underperforming properties in less competitive markets or other properties with unsustainable capital structures. Although these investments have the potential to generate income, there is no guarantee they will do so over their investment time periods. In addition, private real estate is considered illiquid, there is no assurance a secondary market will exist and there may be restrictions on transferring interests. Since the opportunistic properties have little to no cash flows at time of acquisition, higher leverage is often employed and sponsors may be subject to less favorable debt terms and higher interest rates than more stabilized properties. All investments may be negatively impacted by varied economic and market condition which may be unpredictable. Definitions The U.S. Dollar Index (USDX) measures the value of the U.S. dollar relative to majority of its most significant trading partners. This index is similar to other trade-weighted indexes, which also use the exchange rates from the same major currencies. An index is unmanaged and not available for direct investment. 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 this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report Wells Fargo Investment Institute. All rights reserved. Page 9 of 10

10 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 Wells Fargo Investment Institute. All rights reserved. Page 10 of 10