Three central banks will dominate ex-u.s. developed bond returns

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1 WEEKLY GUIDANCE FROM OUR I NVESTMENT STRATEGY COMMITTEE Peter Wilson Global Fixed Income Strategist May 14, 2018 Monetary Policy and Bond Returns Outside the U.S.» The market expects very gradual rate increases from the European Central Bank (ECB) and virtually unchanged rates from the Bank of Japan (BOJ) in the coming years. We concur.» We expect income returns in developed markets (ex-u.s.) to remain very low, and bond prices to fall (albeit slowly). Currency gains may boost overall returns, but these are far less predictable and should greatly increase volatility. What it may mean for investors» Eurozone sovereign bonds, Japanese government bonds (JGBs), and U.K. government bonds (or gilts ) make up almost 94% of our strategic benchmark 1. Very limited prospects for income and capital gain returns from these markets, and uncertain and volatile currency returns, mean that we maintain an unfavorable rating on developed market bonds (ex-u.s.) for now. Three central banks will dominate ex-u.s. developed bond returns Asset Group Overviews Equities... 5 Fixed Income... 6 Real Assets... 7 Alternative Investments... 8 A recent Global Perspectives report 2 looked at central bank policy in the eurozone and Japan. From a fixed income perspective, government bond markets in these two locales, along with U.K. government bonds ( gilts ), make up the three largest constituents of the Wells Fargo Investment Institute (WFII) strategic index for the developed bond markets (ex-u.s.) asset class. Together, eurozone sovereign bonds, Japanese government bonds, and U.K. gilts account for almost 94% of this strategic index, the JP Morgan Government Bond Index (GBI) Global ex-u.s. Given their importance, developments in these three bond markets and currencies will have (by far) the largest impact on our return expectations for this asset class. To complement the macroeconomic focus of the Global Perspectives publication, in today s report, we review how the market expects central bank policy rates 3 to evolve in the coming years and share our outlook for these rates. Additionally, we outline what this may mean for developed market (ex-u.s.) bond returns. 1 The JP Morgan Government Bond Index (GBI) Global ex-u.s. 2 Wells Fargo Investment Institute, Global Perspectives, Monetary Policy Divergence Could Last a Little Longer, May 8, The International Monetary Fund defines the central bank policy rate as follows: The central bank policy rate is the rate that is used by central banks to implement or signal its monetary policy stance. It is most commonly set by the central bank s policy making committees (e.g., the Federal Open Market Committee) Wells Fargo Investment Institute. All rights reserved. Page 1 of 9

2 Monetary Policy and Bond Returns Outside the U.S. Divergence, then convergence Chart 1 clearly shows market expectations for the major central bank policy rates over the next five years. 4 This chart shows that the gap between the U.S. federal funds rate and other developed central banks policy rates likely will continue to widen for the next year or so. It also suggests that the period between mid-2019 and mid-2020 will be a pivotal point when divergence turns to convergence and the rate gap starts to narrow. What the market expects and why We can use Chart 1 to make inferences about why the market holds such policy views, and how susceptible these market views are to change. We can see that in the U.S., while the Overnight Index Swap (OIS) 5 market still tends to expect a lower terminal (or peak) rate for the fed funds rate in this cycle than the Federal Reserve (Fed) does, the swaps market shares with the fed funds futures market the prediction that the Fed will continue to raise rates in 2018 and 2019 but that it will be effectively finished by late 2019 and early Consequently, the expected fed funds profile flattens out from that point. Chart 1. Market expectations for central bank policy rates 3.0% 2.5% 2.0% Federal funds target (mid-rate) ECB deposit rate BOJ policy balance rate Bank of England official bank rate Interest rate 1.5% 1.0% U.S. dollar OIS-implied overnight rate Euro Overnight Index Average (EONIA)-implied ECB deposit rate Japanese yen OIS-implied rate GBP - OIS-implied overnight rate 0.5% % Sources: Bloomberg, Wells Fargo Investment Institute, May 8, These forward-looking policy rates are derived from the Overnight Index Swaps (OIS) market. An overnight index swap is an interest rate swap involving the overnight rate being exchanged for a fixed interest rate. GBP = British pound sterling. The expected path of ECB policy rates shows a strongly held market view that ECB policy rates will start to rise somewhere around mid-2019 and will move higher in a gradual (but regular) fashion thereafter. This reflects the ECB s efforts at transparent forward guidance, indicating that its bond-purchase program will be terminated by year-end 2018 or early 2019 and that ECB policy rates will only then rise after an 4 These are derived from the Overnight Index Swaps (OIS) market. 5 An overnight index swap is an interest rate swap involving the overnight rate being exchanged for a fixed interest rate Wells Fargo Investment Institute. All rights reserved. Page 2 of 9

3 Monetary Policy and Bond Returns Outside the U.S. extended period of time. This time period is widely understood in the market to be around six months after the end of the ECB bond-purchase program. For the BOJ, some commentators have speculated that the Japanese central bank might be preparing to exit its policy of negative short-term rates and a 10-year sovereign bond yield target around zero sometime next year. The ultra-flat profile of BOJ policy rates implied by the OIS market suggests extreme skepticism about this opinion and cautions against reacting too strongly to early views of policy change emanating from Japan. The path of OIS policy rates in the U.K. (flattening after two years to a more gradual slope) is the kind of shape one might find in a monetary policy textbook the default expectation for monetary policy in a normal recovery. We take this to indicate that market participants are reluctant to commit to any strong view, given the uncertainties associated with the Brexit process (in which the U.K is scheduled to exit the European Union by March 2019). Our expectations What do we expect? For the ECB, we believe it is highly likely that the bond-purchase program will be terminated on schedule by the end of the first quarter of 2019 at the latest. Yet, we do expect any announcement of the program s termination date to be pushed back from the June ECB meeting to the July meeting this year. And if inflation rates do not recover toward the central bank s near-2% target in line with staff projections, it is possible to see the first interest-rate increases pushed back in 2019 toward the end of this year. We are not holding our breath for any imminent BOJ policy change. We would not be surprised if two years from now inflation rates are still far from the BOJ s 2% target and policy settings are little changed. For the Bank of England, we sympathize with the market s uncertainties about the macroeconomic implications of the Brexit process. We would not rule out the possibility that the whole idea dies a death because of Brexit fatigue within the U.K. political establishment; but neither would we discount worst-case scenarios of a disorderly and unprepared cliff-edge Brexit with very negative impacts on real economic output and unpredictable knock-on inflation effects. Low coupons and slowly falling prices What do these market and central-bank dynamics mean for our view on developed market bonds ex-u.s.? Let s start with the eurozone. Eurozone yields likely will initially remain very low (with core markets seeing interest rates around or below 1% for 10-year sovereign bonds). In advance of ECB policy rate normalization, we expect market yields to rise albeit in a stop-start fashion. We expect these yield increases to deliver small (but continuing) capital losses to investors, undercutting the total returns on these bonds. Even by the end of the period shown in Chart 1, eurozone sovereign debt rates may still not exceed those available in the U.S. markets. For Japanese government bonds, the outlook is broadly similar but less volatile. We expect very low income returns to JGB investors as yields are fixed near zero. We see 2018 Wells Fargo Investment Institute. All rights reserved. Page 3 of 9

4 Monetary Policy and Bond Returns Outside the U.S. small prospects of significant capital gain or loss until there is material BOJ policy change. As for the U.K. bond market, we see much less certainty on the outlook for U.K. gilt yields and bond price movements. Investment implications Putting it all together, we expect very low coupon income to continue in the eurozone sovereign bond market (which represents 49% of our ex-u.s. developed market bond index, the JP Morgan GBI Global ex-u.s. Index) and in JGBs (33% of this index). We expect small capital losses in the eurozone sovereign bond markets and very little capital value change for JGBs. So even if U.K. gilts (just 12% of index capitalization) were to surprise by delivering capital gains post-brexit, this would almost certainly not materially improve the overall return outlook. All this means is that, looking ahead, we see little prospect of strong returns from the income and capital gain components of these three bond markets (the eurozone sovereign market, the JGB market, and the U.K.). This leaves only currency return as a possible savior. The challenge remains that currency returns are much more volatile and the outlook is harder to predict than income and capital gain. On the currency front, we expect the euro to gain against the U.S. dollar on a one-year view (potentially delivering positive currency returns for U.S. investors), but we see the yen outlook as broadly neutral and we believe that the British pound is likely to fall. So, we expect limited and uncertain currency gains (albeit from the largest index currency constituent, the euro) that are not enough to offset the expectation of lackluster returns from income and capital gain. Consequently, we maintain an unfavorable view of the developed-market ex-u.s. fixed income class for now Wells Fargo Investment Institute. All rights reserved. Page 4 of 9

5 EQUITIES Scott Wren Senior Global Equity Strategy U.S. Small Cap Equities U.S. Large Cap Equities U.S. Mid Cap Equities Developed Market Ex-U.S. Equities Emerging Market Equities First quarter earnings season is strong No ifs, ands, or buts" about it, S&P 500 Index earnings for the first quarter have come in strong. Relative to our estimates and those of our peers on the Street, companies have delivered as the economy and the new tax law have combined to make upside surprises the norm for this reporting season. Revenues also have come in ahead of expectations (thus far). Prior to the start of reporting season, our work suggested that year-over-year earnings comparisons would show a first-quarter earnings increase in the 16% to 17% range, which was mostly in line with the Street s call for the first quarter of We expected good earnings results from the Financials, Industrials, and Information Technology sectors going into this reporting season, and we have not been disappointed. These three sectors together make up slightly more than 50% of the total market capitalization of the S&P 500 Index. Good results from these heavyweights are necessary not only for overall earnings growth but also to help push the market higher into our year-end target range. We continue to have confidence in our year-end S&P 500 Index target. Looking ahead over the remaining quarters of 2018, the consensus earnings growth projections are somewhat more optimistic than ours are. However, we continue to look for strong 2018 earnings performance. Yet we also believe that the main drivers of stock-market performance will be more macro-oriented issues, such as wage pressures, general inflation, and Fed monetary policy decisions.» First-quarter 2018 earnings growth has been strong for S&P 500 Index companies, and we expect solid earnings growth for the year as a whole.» We remain confident in our year-end target range for the S&P 500 Index, and still favor the cyclical Consumer Discretionary, Financials, and Industrials sectors, along with Health Care. S&P 500 sectors: WFII first quarter earnings estimates and actual first quarter earnings WFII estimate of YoY percent change prior to the start of earnings season Actual percentage change YoY (as of May 7) Consumer Discretionary 7.0% 13.1% Consumer Staples 11.0% 13.3% Energy 70.0% 83.5% Financials 24.0% 30.2% Health Care 8.0% 13.3% Industrials 15.0% 25.9% Information Technology 19.0% 24.6% Materials 17.0% 19.1% Real Estate -7.0& 15.6% Telecommunications Services 17.0% 17.7% Utilities 12.0% 14.6% S&P 500 Index 16% - 17% 22.7% Sources: Wells Fargo Investment Institute, S&P Capital IQ, May 7, WFII estimates were established prior to the start of reporting season. Actual results are as of May 7, Wells Fargo Investment Institute. All rights reserved. Page 5 of 9

6 FIXED INCOME Brian Rehling, CFA Co-Head of Global Fixed Income Strategy U.S. Taxable Investment Grade Fixed Income U.S. Short Term Taxable Fixed Income U.S. Intermediate Term Taxable Fixed Income Most U.S. Long Term Taxable Fixed Income High Yield Taxable Fixed Income Developed Market Ex.-U.S. Fixed Income Emerging Market Fixed Income Credit sector holding up despite the risks Credit spread is the additional yield that a fixed-income investor receives over the riskfree rate of return. With interest rates at low levels, many investors have accumulated significant credit-sector (and credit-spread) exposure in recent years as they seek to increase the income from their fixed-income holdings. Investors in credit-focused holdings, such as investment-grade and high yield corporate debt as well as municipal bonds, can be impacted by interest-rate changes (like all fixed-income investors). Yet, credit-market investors also can be impacted by credit-spread changes. With taxable credit spreads near their tightest levels of the past five years, some investors are asking is taking credit risk still a good choice today? Credit spreads tend to rise in periods of uncertainty as investors question the stability of debt payments from lower-quality issuers. In general, as credit spreads increase, bond prices fall reducing returns for holders of fixed-income credit investments. The chart below illustrates this phenomenon. Since 2000, there have been six periods of uncertainty in the credit market, including the technology bubble, September 11, the Enron and WorldCom fraud, the great recession, the Greek euro crisis, and the energyprice collapse in Many factors could trigger an investor-sentiment change on credit, and investors who hold lower-quality debt should be aware of and be willing to accept such an event risk. With credit spreads at historically tight levels, the opportunity for meaningful upside performance has diminished. We do not believe that investors are being adequately compensated to take on incremental credit risk today, and we have an unfavorable view on the high-yield debt class.» At current valuations, we believe that the high-yield debt class offers an asymmetric risk profile with limited upside potential and meaningful downside risk. We recommend that investors move up in credit quality.» We remain favorable on high-quality corporate debt, due to the yield potential, but even investment-grade debt is susceptible to a market credit shock, and investors should expect increased volatility. Bloomberg Barclays U.S. Corporate High Yield Average OAS Index Spread Percent (%) '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 Source: FactSet, May 8, For illustrative purposes. Option Adjusted Spread is the difference in yield over equivalent-duration Treasuries. Bloomberg Barclays U.S. Corporate High-Yield Bond Index is an unmanaged index that covers the U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bond market. It is not possible to invest directly in an index. Index returns reflect general market results, assume the reinvestment of dividends and other distributions and do not reflect deduction for fees, expenses or taxes. Past performance is no guarantee of future results Wells Fargo Investment Institute. All rights reserved. Page 6 of 9

7 REAL ASSETS John LaForge Head of Real Asset Strategy Commodities Private Real Estate Public Real Estate Man spends his life in reasoning on the past, in complaining of the present, in fearing future. --Antoine Rivarol Perspectives on Iran and oil During the presidential campaign, President Trump said that he wanted to alter the Iran nuclear agreement, and here we are. Last week, the president decided to opt out of the agreement that has been in place since The initial reaction sunk oil prices, as low as $67.50, but within 24 hours, West Texas Intermediate (WTI) crude oil had reversed course, closing above $71 per barrel. Geopolitical uncertainties, especially in the Middle East, have a history of toying with oil prices. Until we hear more substance from the other interested parties (U.S. allies, Iranian allies, oil-producing countries, etc.), we suspect that oil prices will remain volatile. At times, geopolitical uncertainties can drive oil prices, and that has been the case in For the remainder of the year, however, we suspect a new driver of oil prices will emerge fundamentals. And under the surface, fundamentals have been softening. In recent months, the global supply/demand balance has tipped in favor of supply, which (historically speaking), often has led to capped if not eventually lower oil prices. We show this supply/demand balance in the chart below. The blue line is the price of Brent crude oil, which is a major global oil benchmark. The green line is the balance between global oil demand growth and supply growth. A falling green line indicates that supply growth is outstripping demand growth. While the Iran news is timely, important, and fluid, the most important oil story for the remainder of 2018 may be fading oil fundamentals.» Geopolitical uncertainties continue to drive oil prices not fundamentals.» We are expecting softening oil fundamentals to drive oil prices in the second half of Brent oil price versus global oil demand/supply balance Global demand growth minus supply growth (%) Global demand growth minus supply growth YoY (12 month average) Brent crude Brent crude price (U.S. dollars per barrel) Sources: U.S. Energy Information Administration, Bloomberg, Wells Fargo Investment Institute. Monthly Data: January April 30, Wells Fargo Investment Institute. All rights reserved. Page 7 of 9

8 ALTERNATIVE INVESTMENTS Justin Lenarcic Global Alternative Investment Strategist Private Equity Hedge Funds-Macro Hedge Funds-Event Driven Hedge Funds-Relative Value Most 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. Currency trading landscape improving for Macro strategies Some of the largest and most profitable Macro trades have involved currency devaluation or collapse. Others, notably the carry trade, simply involve borrowing in a low-yielding currency to invest in a higher-yielding currency, and capturing the interest-rate spread between the two. 6 Regardless of the approach, successfully trading global currencies is a necessity for any Systematic or Discretionary Macro portfolio. And historically, performance for the Macro strategy improves when volatility and trends increase among global currencies. As a global reserve currency, the U.S. dollar (and its trends) can significantly impact both developed and emerging market currencies. Therefore, it should be no surprise that the nearly 4% move in the U.S. Dollar Spot Index since mid-april is causing ripples throughout the global foreign exchange market. In late April, the Hong Kong monetary authority spent nearly 20% of its excess reserves defending the 35-year-old currency peg with the U.S. dollar. Recently, Argentina requested support from the International Monetary Fund (IMF) to help strengthen the country s economy and slow the decline in the currency. Trading opportunities aren t limited to emerging market currencies, as concerns about European economic growth have put the euro on a back foot in recent weeks. Divergent monetary policy has long been an anticipated driver of currency fluctuations, but the recent increase in U.S. interest rates seems to be rattling the cage of foreign exchange traders. We could potentially be entering into a very interesting environment for Macro trading.» Opportunities within global currency markets are critical for Macro portfolio performance.» The U.S. dollar s large, and rather abrupt, move recently has ramifications for multiple emerging and developed market currencies, which we anticipate will benefit Macro strategies. Large move in U.S. dollar versus Argentina peso in recent days Currency exchange rate /2 1/12 1/22 2/1 2/11 2/21 3/3 3/13 3/23 4/2 4/12 4/22 5/2 U.S. dollar versus Argentina peso Sources: Wells Fargo Investment Institute, Bloomberg. May Carry refers to excess yield potential available from one fixed-income investment over another Wells Fargo Investment Institute. All rights reserved. Page 8 of 9

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. Definitions JPMorgan GBI Global ex-us (Unhedged) in USD is a representative of the total return performance in U.S. dollars on an unhedged basis of major non-u.s. bond markets. 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. 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. 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 9 of 9