Bank for International Settlements, February

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1 WEEKLY GUIDANCE FROM OUR I NVESTMENT STRATEGY COMMITTEE Peter Wilson Global Fixed Income Strategist Asset Group Overviews Equities... 4 Fixed Income... 5 Real Assets... 6 Alternative Investments... 7 March 5, 2018 Is Emerging-Market Debt Vulnerable to Rate Increases?» Although spreads have narrowed for U.S.-dollar-denominated emerging market sovereign bonds in recent years, this has not been matched by credit-rating upgrades. Economic and political risks will more than likely be seen in some large emergingmarket sovereigns in 2018.» Yet, we believe that investors are likely to continue supporting this asset class even as rates rise moderately. Yields of 6% are above average for the post-financial-crisis period, macroeconomic conditions remain benign, and emerging-market sovereign debt levels (relative to gross domestic product, or GDP) are very low relative to those of developed-market sovereigns. What it may mean for investors» Balancing these factors, and acknowledging that yields in developed markets are unlikely to reach levels as high as the 5-10% range seen in the 2000s, we remain evenweight emerging-market sovereign debt while underweight developed-market sovereigns.» We believe that fixed-income portfolios need to include an allocation to emergingmarket sovereign debt, to enhance diversification in a world in which international bonds represent nearly two-thirds of global debt outstanding. 1 It s been a bumpy start to 2018 for emerging-market (EM) bonds. Year to date (through February 26), dollar-denominated emerging market sovereign debt is down 2.0%, with virtually all the declines coming in February. U.S.-dollar-denominated (USD) EM debt returns are driven by three factors U.S. Treasury yields, the credit spread over U.S. Treasury yields, and defaults so we do not have to look too far to find the source of February s underperformance. There were no defaults. But after trading in a fairly stable range near 2.30% in the fourth quarter, the 7-year U.S. Treasury yield (which roughly matches the EM sovereign index duration) rose some 50 basis points to 2.80% in the first two months of In January, spread compression offset most of the rise in U.S. Treasury yields, as spreads on USD EM bonds tightened from 310 basis points to below 290 basis points. 3 1 Bank for International Settlements, February One hundred basis points equal 1%. Duration measures a bond s price sensitivity to interest-rate changes. 3 Based on the J.P. Morgan Emerging Markets Bond Index (EMBIG), which covers more than 60 emerging-market countries. This index reflects USD emerging-market bonds Wells Fargo Investment Institute. All rights reserved. Page 1 of 9

2 Is Emerging-Market Debt Vulnerable to Rate Increases? However, with the risk-averse mood sparked by the global equity sell-off, spreads widened again in February, and as Treasury rates were moving higher too, USDdenominated EM index yields jumped from around 5.5% to above 6%, causing the dip in EM bond returns. 4 Emerging-market debt outlook So much for history but where do we go from here? In the near term, we do not expect this underperformance to continue, since it is unlikely that U.S. Treasury yields will continue to rise with the steep trajectory of January and February. Also, as equities stabilize, EM credit spreads should consolidate within recent ranges. However, part of the market narrative for EM debt is that it is supported by a hunt for yield from institutional investors driven out of quantitative-easing-depressed developed markets. Thus, we need to ask how vulnerable EM sovereign bond markets might be in an environment of rising developed-market rates, as the Federal Reserve (Fed) continues to tighten and rates are normalized in other major developed economies. Let us answer that question now. First, a certain amount of caution is warranted. We know that the emergence of EM debt as a mainstream asset class for fixed-income investors went alongside dramatic improvements in market structure (for example, the shift from pegged to free-floating exchange rates); in policies and governance; and in market liquidity (the rise of localcurrency debt markets as the primary funding source) over the decade and a half since the EM crises of the late 1990s. Ratings agencies rewarded the major sovereign borrowers (for these improvements) with a series of credit-rating upgrades in the early years of this century. However, in the past two years, even as spreads have tightened, there have been considerably more EM credit-rating downgrades than upgrades. Among the 64 countries that comprised the J.P. Morgan Emerging Markets Bond Index in both January 2016 and January 2018, Standard & Poor s made a total of 25 credit-rating downgrade notches (including three notches for South Africa and two for Brazil), against just 6 upgrades. And 2018 will bring risks for some of the major EM sovereign credits, which will need to be closely monitored. Mexico remains vulnerable to U.S. trade policy and the NAFTA (North American Free Trade Agreement) renegotiation, and Mexico s presidential and general elections in July raise the possibility of a change in economic policy. Brazil also has elections this year, in October. So there is plenty of room for volatility in spreads over the coming months. More positively, valuations have improved as USD EM bond index yields are now near 6%, above average for the post-financial crisis period. Further, much of the institutional investment that has taken place in recent years has come from an underweight EM position, and investors may feel that they have room to increase allocations if yields rise more (buying on price dips). The relatively benign EM macroeconomic environment including a stable-to-weaker dollar, steady growth, and modest inflation looks set to continue, allowing EM central banks to keep interest rates low. 4 Ibid Wells Fargo Investment Institute. All rights reserved. Page 2 of 9

3 Is Emerging-Market Debt Vulnerable to Rate Increases? Economic imbalances, including trade and fiscal deficits, recently have been smaller and far more manageable than they were in the past. Finally, it is worth pointing out that even as developed-market central banks normalize policy over the coming years, interest rates and bond yields in those markets are not likely to rise to the higher ranges seen in the past. Demographics, modest growth, and only sluggish inflation pressures may mean that a range for major developed-market yields of, say, 2-4% is more realistic than even the 5-10% yields seen in the 1990s and early 2000s. Emerging-market sovereign debt-to-gdp ratios are far lower than those in developed markets 120% 100% 80% 60% 40% 20% Emerging market debt-to-gdp ratio Mature (developed) market debt-to-gdp ratio 0% Sources: Institute of International Finance (IIF), Wells Fargo Investment Institute, February 26, Mature markets are equivalent to developed markets (IIF terminology). If rates were to rise more than that (which we do not anticipate), it is possible that developed debt markets would be more vulnerable than emerging debt markets. After all, one driver for increasing institutional investment allocations toward EM debt has been the sharp rise in developed market debt-to-gdp ratios following the global financial crisis of According to the Institute of International Finance (IIF), for government debt, these ratios now stand above 100% for mature (developed) markets, more than twice the level for emerging markets. Investment implications Balancing the near-term credit risks in certain EM sovereigns with the improved macro environment for the sector as a whole, and seeing yields in the region of 6% as relatively attractive even as developed-market central banks normalize short-term rates, we remain evenweight EM sovereigns denominated in U.S. dollars (although we are underweight developed market fixed income outside the U.S.). The bottom line is that the valuation, yield and macroeconomic backdrop for emerging market debt appears generally more attractive to us than for developed bond markets outside the U.S. We believe that fixed-income portfolios need to include a market-weighted allocation to emerging market sovereign debt, to enhance diversification in a world in which international bonds represent nearly two-thirds of global debt outstanding. 5 5 Bank for International Settlements, February, Wells Fargo Investment Institute. All rights reserved. Page 3 of 9

4 EQUITIES Sean Lynch, CFA Co-Head of Global Equity Strategy U.S. Small Cap Equities U.S. Large Cap Equities U.S. Mid Cap Equities Developed Market Ex-U.S. Equities Elements of style Growth versus value Growth stocks have outperformed value stocks over the past year across all U.S. marketcapitalization spectrums. Yet, these patterns can change quickly as growth stocks were hit the hardest in the recent correction. Historically, later in an economic cycle, growth can outperform value as we generally have seen during this bull market. One investment rule is that growth companies historically do better when growth is scarce. But many other factors such as tax reform, can complicate the growth versus value equation. Let s first define the growth and value equity styles. Growth companies typically have faster earnings and revenue growth than the average company in their industry (and the market). A growth stock s return is more likely to come from price appreciation than from dividends. Value stocks typically have higher dividend yields and lower valuations, such as price-earnings ratios and price-to-book ratios. 6 What does Wells Fargo Investment Institute (WFII) prefer growth or value stocks? Currently, WFII is neutral on growth versus value. At this point in the economic cycle, investors may not need to choose between growth and value. Rather, investors could potentially benefit by combining the two styles. Certain sectors, such as Information Technology and Health Care, tend to be more growth-oriented, while Financial Services and Utilities are more value-oriented sectors. WFII currently favors the Health Care and Financial sectors but also Consumer Discretionary and Industrials. In other words, we have diversified our sector preferences between growth and value styles, and we recommend that investors do as well.» Growth stocks have handily beat value stocks over the past year across all marketcap spectrums. Yet, these patterns can change quickly as growth stocks were hit the hardest in the recent market correction.» WFII s favored sectors are currently a combination of growth- and value-oriented sectors. Growth recently has outperformed value Emerging Market Equities Growth of $1, '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 Russell 1000 Growth Index Russell 1000 Value Index Source: Bloomberg, February 28, The Russell 1000 Growth Index measures the performance of those Russell 1000 company with higher price-tobook ratios and higher forecasted growth values. The Russell 1000 Value Index measure the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. 6 For more on defining growth and value stocks, please request WFII Ask the Institute publication titled, What is the Difference Between Growth and Value Stocks? Wells Fargo Investment Institute. All rights reserved. Page 4 of 9

5 FIXED INCOME Brian Rehling, CFA Co-Head of Global Fixed Income Strategy Underweight High Yield Taxable Fixed Income Underweight Developed Market Ex.-U.S. Fixed Income U.S. Short Term Taxable Fixed Income U.S. Long Term Taxable Fixed Income Emerging Market Fixed Income U.S. Taxable Investment Grade Fixed Income U.S. Intermediate Term Taxable Fixed Income Fed Chair Powell sticks to the script Last week, Fed Chair Jerome Powell made his first major public appearance in his new role. He delivered the Fed s Semiannual Monetary Policy Report to Congress with appearances before both the House Financial Services Committee and the Senate Banking Committee. His initial comments sent bond yields higher and stock prices lower. Upon further reflection, markets reversed course and stabilized as Powell drew little distinction between himself and Janet Yellen, indicating that continuity in monetary policy likely would continue. We drew a couple of interesting observations from his testimony. The Fed always has focused on its two mandates of full employment and price stability. In recent years, it could be argued that the Fed also considered capital-market stability. Powell testified that near-term market movements may enter into the Fed s thinking but that he would be unlikely to adjust the path of monetary policy as a result. It would take a financial-market event that would have a meaningful impact to the economy to adjust the Fed s course. Mr. Powell testified that the increase in fiscal spending likely would strengthen the U.S. economy in the near term. This raises the likelihood of three Fed rate hikes in 2018 and potentially puts a fourth rate hike on the table. We do not expect a fourth interest-rate hike in 2018, but this cannot be ruled out if fiscal spending increases growth projections above expectations. Acknowledgment of these fiscal spending concerns would seem to limit the potential that the Fed will hike rates just twice in Increased fiscal spending means added debt for the nation. Powell acknowledged that the current U.S. debt trends are unsustainable over the long run. While servicing the debt is going to get more expensive as rates increase, the reality is that we are a long way from a public crisis of confidence in the ability of the United States to pay its debts. Markets should take comfort that the Fed s monetary policy is likely to continue down the same path that previously was set by Chair Yellen.» Fed monetary policy is likely to continue down the previous path. We now look for three rate hikes in 2018.» We favor a neutral duration profile within fixed-income allocations across the yield curve.» We recommend that investors upgrade their fixed-income credit profiles, favoring investment-grade-rated debt over lower-rated bonds Wells Fargo Investment Institute. All rights reserved. Page 5 of 9

6 Austin Pickle, CFA Investment Strategy Analyst REAL ASSETS Kindness is the language which the deaf can hear and the blind can see. --Mark Twain Is gold a good inflation hedge? Underweight Commodities Private Real Estate Overweight Public Real Estate As concerns over increasing inflation have crept into the national narrative, we have started to receive more questions on gold s effectiveness as an inflation hedge. The common perception seems to be that gold is the asset to own to protect against a deterioration of purchasing power. In reality, gold has had a somewhat spotty track record as an inflation hedge. Gold s inconsistency makes us consider gold as a decent, but not a great, inflation hedge. To illustrate this point, we created the chart below. It shows the relative performance of the price of gold versus inflation as measured by the Consumer Price Index (CPI). When the blue line is increasing, it means that the price of gold is outpacing inflation. When it is decreasing, it means that inflation is beating gold. If gold was a consistently excellent inflation hedge, you would expect the blue line to be upward sloping or at least flat the majority of the time. But, as you can see, this is not the case. In fact, there have been long periods of time during which gold has not been a good U.S. inflation hedge (shaded areas in the chart below). The bottom line is that gold has beaten inflation over the long run, but it has a habit of underperforming the rate of inflation over extended time periods (see the 21-year period starting in 1980 and the 7-year period from 2011 through February 2018). We would classify gold as a decent, but not a great, inflation hedge.» Gold has beaten U.S. inflation over the long run ( ), but it has underperformed inflation over extended time periods.» Gold has been a decent domestic inflation hedge, but not a great one. Gold versus inflation Gold price / CPI Ratio Shaded areas represent gold underperforming inflation Sources: Bloomberg, Bureau of Labor Statistics (BLS), Wells Fargo Investment Institute. Monthly data: January 31, January 31, Ratio is the spot price of gold divided by the Consumer Price Index (CPI), which measures the price of a fixed basket of goods and services purchased by an average consumer Wells Fargo Investment Institute. All rights reserved. Page 6 of

7 ALTERNATIVE INVESTMENTS Justin Lenarcic Global Alternative Investment Strategy Private Equity Hedge Funds-Macro Hedge Funds-Event Driven Overweight Hedge Funds-Relative Value Overweight 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. Macro driven by stability of correlations rather than by magnitude Just as stock and credit correlations are a key driver for our views on Equity Hedge and Relative Value, cross-asset correlations are critical to our outlook on Macro strategy performance. However, the difference is that Macro returns are more sensitive to the stability of correlations than they are to the magnitude, or absolute value, of correlations. Said differently, sharp reversals in correlations such as those seen in the right hand shaded box below are problematic for Macro strategies, whereas gradually rising or falling correlations are much more tradable. From April 2003 through April 2010, a period that had stable asset correlations, the HFRX Macro Index was up nearly 26%. However, the Macro strategy lost more than 4% from May 2010 through February 2018, a period which we have defined as having unstable correlation. Observers may be confused by that performance, given the significant rise in global equity markets during this period. But it is important to remember that equities are only one component of a Macro portfolio, and the interrelationship between global currencies, interest rates, and commodities is of equal, if not greater, importance. The abrupt shift in correlations seen in recent years, which we attribute to global monetary policy, is a key reason why we currently maintain a neutral view on the Macro strategy. While global central banks might be in the early phases of reducing their balance sheets and normalizing interest rates, we are focusing our attention on cross-asset correlations as an indication of an improving opportunity set.» Macro strategy performance is more sensitive to the stability of cross-asset correlations than it is to the magnitude of correlations.» We anticipate a reversion to a more stable era for correlations as central bankers normalize policy and reduce liquidity. Macro can thrive when global asset correlations are stable HFRX Macro Index (Indexed at 100) STABLE CORRELATIONS UNSTABLE CORRELATIONS Global Correlation Index (%) HFRX Macro Index (LHS) Global Correlation Index, Six Month, % (RHS) Sources: Morgan Stanley, Bloomberg, Hedge Fund Research Inc., February The Global Correlation Index is an average of regional correlations and cross-asset correlations, with the sub-components from the equity, credit, rates and foreign exchange asset classes. The HFRX Macro Index is defined at the end of the report. Correlations represent past performance. Past performance is no guarantee of future results. There is no guarantee that future correlations between the indices will remain the same. An index is unmanaged and not available for direct investment Wells Fargo Investment Institute. All rights reserved. Page 7 of 9

8 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. Technology and Internet-related stocks, especially of smaller, less-seasoned companies, tend to be more volatile than the overall market. Growth stocks may be more volatile than other stocks and there is no guarantee growth will be realized. There are no guarantees that value stocks will increase in value or that their intrinsic values will eventually be recognized by the overall market. Both growth and value types of investing tend to shift in and out of favor. 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. Sovereign debt is generally a riskier investment when it comes from a developing country and tends to be a less risky investment when it comes from a developed country. The stability of the issuing government is an important factor to consider, when assessing the risk of investing in sovereign debt, and sovereign credit ratings help investors weigh this 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 An index is unmanaged and not available for direct investment. HFRX Macro Index includes a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets. A variety of techniques are employed: discretionary and systematic analysis, combinations of top down and bottom up theses, quantitative and fundamental approaches and long and short term holding periods. Macro strategies primary investment thesis is predicated on predicted or future movements in the underlying instruments, and the impact movements in underlying macroeconomic variables may have on security prices. JPMorgan Emerging Markets Bond Index (EMBI) measures the total return performance of international government bonds issued by emerging market countries that are considered sovereign (issued in something other than local currency) and that meet specific liquidity and structural requirements. 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 2018 Wells Fargo Investment Institute. All rights reserved. Page 8 of 9

9 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