A Fresh Focus at the Fed

Transcription

1 WEEKLY GUIDANCE FROM OUR I NVESTMENT STRATEGY COMMITTEE George Rusnak Co-Head of Fixed Income Strategy A Fresh Focus at the Fed February 4, 2019 Key takeaways» Several new voting members joined the Federal Open Market Committee (FOMC) last week, and markets were reassured by Federal Reserve (Fed) Chair Powell s comments following the meeting.» The Fed paused on rate hikes at the January meeting and noted that it would be evaluating its balance sheet normalization plans at upcoming meetings. What it may mean for investors» We see opportunities for investors on the shorter end of the yield curve. Yet, we caution investors to remain well-diversified across the yield curve, while retaining broad exposure to U.S. and international fixed income classes and sectors. The FOMC met last week and decided to maintain the target range of the federal funds rate at 2.25% %. The Fed also will continue reducing Treasury security purchases by up to $30 billion per month and mortgage-backed-security purchases by up to $20 billion monthly. The Fed left open the possibility of adjusting its balance sheet reduction plan in the future if it needs to respond to economic and financial developments. Markets responded positively to the Fed s announcement. Asset Group Overviews Equities... 5 Fixed Income... 6 Real Assets... 7 Alternative Investments... 8 Fed Chair Powell held a press conference following last week s meeting, and he noted that the Fed will discuss balance sheet plans and reserve levels at future meetings, while continuing to follow a data-dependent approach to any rate changes. To help increase transparency, Chair Powell has initiated the practice of holding a press conference after every FOMC meeting, while press conferences generally were held at every other meeting in the past. This change in communication likely will allow for more dialogue and clarity, and we believe that this may improve the market s understanding of the FOMC s stance. FOMC members change annually, and they do so at the first regularly scheduled meeting each year. In today s report, we will discuss the FOMC s new voting membership and explore the balance sheet topic that has been garnering recent market focus on the Fed Wells Fargo Investment Institute. All rights reserved. Page 1 of 10

2 A Fresh Focus at the Fed FOMC membership changes As we noted, FOMC committee members change each year at the first regularly scheduled meeting. This is part of a regular rotation of voting members. Last week, the new committee members joining the FOMC included Eric Rosengren, James Bullard, Esther George, and Charles Evans (see Table 1). It is somewhat challenging to classify the new members as dovish (favoring less restrictive monetary policy) or hawkish (voting for more restrictive policy). Yet, based on their previous remarks, it is likely that the new members are fairly split, and they may lean slightly more dovish as a group. The most outspoken member on the dovish side has been James Bullard from the Federal Reserve Bank of St. Louis. He has expressed concern over the recent yieldcurve flattening, and he has even proposed a new method for evaluating the neutral fed funds rate (suggesting that the fed funds rate could be at, or through, the neutral rate already). Charles Evans is widely thought to be fairly moderate (with a tendency toward a more dovish view). Esther George and Eric Rosengren appear to be more moderate, and possibly mildly hawkish. Overall, we believe that the new composition of the FOMC leans toward being more dovish in nature. This profile may signal an opportunity for the FOMC to pause in the near future and digest its recent series of rate hikes. In fact, we view last week s message from the Fed as more dovish in nature, clearly suggesting that the Fed will be patient in its approach to raising rates in the future. Table 1. Changes in FOMC voting members in January 2019 FOMC members Jerome Powell, Chairman John Williams New York, Vice Chairman Michelle Bowman Lael Brainard Richard Clarida Randal Quarles Thomas Barkin Richmond Raphael Bostic Atlanta Mary Day San Francisco Loretta Mester Cleveland New FOMC members beginning January 29-30, 2019 Jerome Powell, Chairman John Williams New York, Vice Chairman Michelle Bowman Lael Brainard Richard Clarida Randal Quarles Eric Rosengren Boston James Bullard St. Louis Esther George Kansas City Charles Evans Chicago Sources: Federal Reserve, Wells Fargo Investment Institute, January 30, Wells Fargo Investment Institute. All rights reserved. Page 2 of 10

3 A Fresh Focus at the Fed Quantitative tightening There clearly has been market focus on the Fed reducing its balance sheet which currently stands at just below $4 trillion (see Chart 1). One of the more challenging recent comments from Fed Chair Powell came at the December 19 press conference, when he suggested that the balance sheet reduction, currently at $50 billion monthly, was on autopilot. It was clear that market participants had hoped the Fed chair would be more flexible around balance-sheet adjustment, and the market reacted negatively to this news. We have not been seeing liquidity concerns or stresses within the bond market stemming from Fed balance sheet reduction so we do not believe that the FOMC needs to adjust this process now. In the past, the Fed had stated a desired goal of trying to reduce its balance sheet to approximately $2 to $3 trillion. We believe that the Fed may not have the luxury of winding down its balance sheet to this originally desired level. We also believe that the FOMC may begin communicating a more comprehensive plan on balance sheet normalization later this year. Chart 1. Federal Reserve balance sheet $ 5,000,000 $ 4,500,000 $ 4,000,000 $ 3,500,000 Other MBS Treasury securities $ 3,000,000 $ 2,500,000 $ 2,000,000 $ 1,500,000 $ 1,000,000 $ 500,000 - Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19 Sources: Bloomberg, Wells Fargo Investment Institute, January 30, MBS = mortgage-backed securities. We appreciate the increased transparency that comes from the press conferences at every 2019 meeting and believe that the new FOMC voting members lean slightly more dovish than the members they replaced. However, we do not believe that either change will alter the course that the FOMC takes. Going forward, we believe that the FOMC will likely pause at its upcoming meetings in March and May, but we view the likely outcome at the June meeting as undecided at this point. Based on fed funds futures, the current market view reflects less than an 18% probability that the Fed will raise rates in June (Table 2). However, these probability figures have been historically volatile and there will be significant data to evaluate prior to that meeting. We recently reduced our fed funds rate forecast to two rate hikes in 2019, and we believe that the risks are skewed to the downside in terms of Fed rate hikes Wells Fargo Investment Institute. All rights reserved. Page 3 of 10

4 A Fresh Focus at the Fed Table 2. Market expectations of Fed rate hikes (based on fed funds futures) Meeting dates Hike probability 3/20/ % 5/1/ % 6/19/ % 7/31/ % 9/18/ % 10/30/ % 12/11/ % Sources: Bloomberg, Wells Fargo Investment Institute, January 30, We believe that investors can benefit from the higher rates now available on the short part of the yield curve while also seeking to mitigate interest-rate risk through holdings on this part of the curve. Yet, in our opinion, it is important to remain welldiversified, with positions across the yield curve and across fixed-income classes and sectors. We may be looking to capitalize upon more opportunities further out on the yield curve as we move further along in this business and interest-rate cycle 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 Earnings season: Not so bad U.S. Large Cap Equities U.S. Mid Cap Equities U.S. Small Cap Equities Neutral Developed Market Ex-U.S. Equities At the end of 2018, global business uncertainty spiked to a 22-year high, according to companies surveyed through IHS Markit s Purchasing Managers Index (PMI) questionnaires. These firms reported large increases in political, economic and trade risks. The timing of this survey roughly coincided with the S&P 500 Index trough in late December. This followed a second-half (2018) period in which many corporate profit growth levels were marked lower. However, as of January 30, the number of companies beating fourth-quarter earnings expectations (71%) was greater than those disappointing. Nevertheless, the beat percentage has been modestly below the average achieved over the past five years. Based on the 41% of S&P 500 Index companies that had reported through January month-end, fourth-quarter and full-year 2018 earnings growth for the index is likely to exceed 10% and 19%, respectively (according to FactSet). This would mark the fifth consecutive quarter for double-digit S&P 500 earnings growth. Reported profit growth in 6 of the 11 S&P 500 sectors has been higher than the September 2018 forecast. Further, only Real Estate and Consumer Staples are expected to have sub-10% growth, with the remaining 9 sectors achieving double-digit growth for full-year We likely have seen the peak earnings growth for this economic cycle. However, we still expect solid 2019 earnings growth, with increases in the mid-single-digits, led by a robust U.S. economy with modest wage growth, a strong consumer, and a patient Fed currently on pause. Key takeaways» Despite record high global business uncertainty at year-end, 2018 S&P 500 earnings per share (EPS) growth is likely to be in the range of 19-21%.» We forecast 2019 S&P 500 EPS growth to be in the modest mid-single-digits, but still positive. This should help to extend this economic cycle. Most Emerging Market Equities S&P 500 Index earnings per share growth (%) record high 2019 EPS is expected 50.0% 40.5% 40.0% Earnings per share growth (%) 30.0% 20.0% 10.0% 0.0% 13.6% 6.4% 5.9% 6.8% -0.3% 0.5% 11.9% 20.6% 7.0% -10.0% -20.0% -15.9% E WFII 2019E Sources: Wells Fargo Investment Institute, FactSet, January 30, WFII = Wells Fargo Investment Institute. E = estimate. Earning Per Share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock and often serves as an indicator of a company's profitability. Forecasts, targets and estimates are based on certain assumptions and on our current views of market and economic conditions, which are subject to change Wells Fargo Investment Institute. All rights reserved. Page 5 of 10

6 Peter Wilson Global Fixed Income Strategist FIXED INCOME U.S. Taxable Investment Grade Fixed Income Most U.S. Short-Term Taxable Fixed Income U.S. Intermediate Term Taxable Fixed Income U.S. Long-Term Taxable Fixed Income High Yield Taxable Fixed Income Developed Market Ex.-U.S. Fixed Income Emerging Market Fixed Income Emerging market debt performance After stabilizing in the second half of 2018, all emerging-market (EM) bond classes rallied sharply in December and this rally gathered pace in January. After bottoming in September 2018, EM foreign exchange has risen by 5.6%, and local-currencydenominated EM government debt has gained 7.9% (in dollar terms). U.S.-dollardenominated EM sovereign debt, which we favor, did not reach a bottom until late November. Yet, since then, this bond class has delivered a total return of 6.0%. 1 This recovery has been driven by several factors: the Fed s pivot to a more dovish stance and stalling of the U.S. dollar s (USD) rally; active Chinese leadership measures to counter China s economic slowdown; and hopes that a U.S.-China trade resolution will ease global growth headwinds for this bond class. We believe that this recovery has more room to run, and we maintain our favorable rating on USD-denominated EM debt. However, as the rally gathers pace, it will bear close watching. While the Fed s caution is real, the risk of further rate increases has not been taken off the table. Even if the U.S.-China trade confrontation becomes less of a headwind (as we expect), the global growth cycle is extended so the window for continued EM debt outperformance may be narrowing. Further, we note that EM debt yields have fallen from highs of 7.37% in November to near 6.50% today, and spreads over U.S. Treasury yields have declined from 440 basis points to below 400 today. 2 Key takeaways» Dollar-denominated EM debt has recovered strongly since the late-november lows, and the rally gathered pace in January. Drivers included more dovish perceptions of the Fed and hopes of a resolution to the U.S.-China trade dispute.» We remain favorable on the EM bond class, but we note that risks now are less well compensated by valuations as yields have declined from recent highs. EM fixed income and foreign exchange returns: 2018 and January 2019 Total return (1/1/18 = 100) EM FX index (indexed, 1/1/18 = 100) LC-denominated government bonds (in USD terms, indexed, 1/1/18=100) USD-denominated sovereigns (ndexed, 1/1/18 = 100) 84 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Oct-18 Nov-18 Dec-18 Jan-19 Feb-19 Sources: Bloomberg, JP Morgan, Wells Fargo Investment Institute, January 29, EM FX is represented by the JP Morgan Emerging Markets Currency Index (EMCI); EM local-currency bond returns are represented by the JP Morgan Government Bond Index, Emerging Markets (Global) Index (GBI-EM). USD-denominated bond returns are represented by the JP Morgan Emerging Markets Bond Index Global (EMBIG). FX = foreign exchange. For illustrative purposes only. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. Please see the end of this report for descriptions of the asset class risks and definitions of the indices. 1 Return was from November 27, 2018 through January 29, 2019, as represented by the JP Morgan Emerging Markets Bond Index Global. 2 One hundred basis points equal 1%. Index yields are those of the JP Morgan Emerging Markets Bond Index Global (EMBIG) Wells Fargo Investment Institute. All rights reserved. Page 6 of 10

7 REAL ASSETS John LaForge Head of Real Asset Strategy Commodities Private Real Estate Public Real Estate China Changing commodity seasons Knowledge will give you power, but character respect. --Bruce Lee Virtually all commodity prices rose last month. The largest gains were in the oil patch; West Texas Intermediate (WTI) +20%, Brent +15%, and heating oil +13%. 3 But the commodity rally has been broad. Nearly all precious metals, industrial metals, and foodstuffs were up too. Is this normal? The answer is no. In the short term, say weeks and months, individual commodity prices typically react quite differently. This is because they have different buying and selling seasons. For example, North American corn and soybean prices often revolve around the planting and harvesting seasons. Typically, prices rise into planting periods (February-April), and fall as we near harvesting (August-September). In contrast, oil prices frequently ebb and flow based on the fill (spring/summer) and draw (autumn/winter) seasons. So, why the broad commodity gains so far in 2019? The likely answer is that commodities are bouncing from oversold conditions late in Nearly all commodity prices fell in the fourth quarter especially oil (WTI -38%) as global economic growth was called into question. Another possible, yet quirky, driver of January s commodity gains could be the Chinese New Year (New Year). China s industrial production tends to slow moving into the New Year (January/February), and then reaccelerates for months thereafter. We have noticed that commodity prices, especially economically sensitive ones, often move with this pattern. Copper is a prime example (see chart). Copper prices (orange line) often fade for months moving into the New Year (vertical black dashed line), but begin rising as the New Year approaches, anticipating the industrial reacceleration that often follows the New Year. Key takeaways» Virtually all major commodity prices are higher to date in 2019, likely due largely to a bounce from oversold levels.» Certain commodities, like copper, also may be anticipating the industrial reacceleration that often follows the Chinese New Year. Average copper performance around the Chinese New Year Average copper performance Indexed level Days before and after the Chinese New Year Sources: Bloomberg, Wells Fargo Investment Institute. Daily data: 90 days before and after the Chinese New Year since Indexed to 100 as of the Chinese New Year. 3 Commodity price performance is monthly, through January 30, WTI and Brent Crude are grades of crude oil used as benchmarks in oil pricing. Brent crude is considered a global benchmark Wells Fargo Investment Institute. All rights reserved. Page 7 of 10

8 ALTERNATIVE INVESTMENTS Justin Lenarcic Global Alternative Investment Strategist Neutral Private Equity Neutral Hedge Funds-Macro Neutral Hedge Funds-Event Driven Hedge Funds-Relative Value 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. Dynamic correlation of Discretionary Macro After several years of disappointing returns, some question the role of the Macro strategy. Although performance has been below expectations, especially for Systematic Macro, the Discretionary Macro strategy still offers advantages that other asset classes do not. This comes from the way most Discretionary Macro portfolios are constructed. They, in our opinion, can either be long or short and they can be leveraged. This implies that Discretionary Macro portfolios are more than just diversifiers. In fact, while they can serve in a risk-reduction capacity, they can pivot to a risk-enhancing strategy rather quickly, potentially augmenting returns in one environment and mitigating losses in the other. The best way to visualize how a Discretionary Macro allocation can interact with a portfolio is to compare the rolling two-year correlation between the 10-year Treasury note and the S&P 5oo Index price with the rolling two-year correlation of the HFRI Discretionary Macro (Total) Index and the S&P 500 Index. One can see in the chart below that, in certain periods, Discretionary Macro has a high positive correlation to equities, while in other periods, it has a low correlation or even a negative one. While its performance has been disappointing over the past 10 years, we still believe that an allocation to the Discretionary Macro strategy can be beneficial. We believe that the low volatility, low rate, and high liquidity environment is changing. An allocation that can quickly pivot to having a low, or negative, correlation with equities could be more important going forward than it has been in recent years. Key takeaways» The Discretionary Macro strategy can provide diversification and also increase returns, depending on the environment.» While performance has been disappointing, the ability of the Discretionary Macro strategy to quickly pivot to being negatively correlated to equities could be beneficial going forward. Dynamic correlations to equities could benefit investors late in the cycle Correlation Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 S&P 500 Price (RHS) Correlation between S&P 500 and 10-year Treasury note (price to price) (LHS) Correlation between S&P 500 and HFRI Macro: Discretionary Thematic Index (price to price) (LHS) Sources: Credit Suisse, Hedge Fund Research, Inc., Wells Fargo Investment Institute, January For illustrative purposes only. Correlation represents past performance. A price index is not a total return index and does not include the reinvestment of dividends. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. Please see the end of this report for the risks associated with the use of a discretionary macro strategy and for the definitions of the indices S&P 500 Index (Price) 2019 Wells Fargo Investment Institute. All rights reserved. Page 8 of 10

9 Risk 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. Discretionary macro strategies seek to profit by taking long and short positions based on future movements in the equity, fixed income, and currency and commodity markets. Definitions Broad-Based Securities Market Index Definitions: JPMorgan Emerging Market Currency Index tracks the performance of emerging-market currencies relative to the U.S. dollar. JPMorgan Emerging Markets Bond Index Global (EMBI Global), which currently covers 27 emerging market countries. Included in the EMBI Global are U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasisovereign entities. 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. Hedge Fund Strategy Definition: HFRI Macro: Discretionary Thematic Index --Discretionary Thematic strategies are primarily reliant on the evaluation of market data, relationships and influences, as interpreted by an individual or group of individuals who make decisions on portfolio positions; strategies employ an investment process most heavily influenced by top down analysis of macroeconomic variables. Investment Managers may trade actively in developed and emerging markets, focusing on both absolute and relative levels on equity markets, interest rates/fixed income markets, currency and commodity markets; frequently employing spread trades to isolate a differential between instrument identified by the Investment Manager to be inconsistent with expected value. Portfolio positions typically are predicated on the evolution of investment themes the Manager expect to materialize over a relevant time frame, which in many cases contain contrarian or volatility focused components Wells Fargo Investment Institute. All rights reserved. Page 9 of 10

10 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. 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