Time to Buy Late-Stage Commodities?

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1 WEEKLY GUIDANCE FROM OUR I NVESTMENT STRATEGY COMMITTEE John LaForge Head of Real Asset Strategy Time to Buy Late-Stage Commodities? Key takeaways» Late in economic cycles, commodities have outperformed stocks and bonds (on average).» Yet, commodities frequently have lost their late-stage outperformance when a commodity bear super-cycle (see below for more details) also has been present. April 9, 2018 What it may mean for investors» We believe that commodities remain within a bear super-cycle that is likely to cap performance of this asset class. We remain underweight commodities today. Facts are accumulated with great effort, but truth reveals itself effortlessly. Dr. David Hawkins, Power versus Force Asset Group Overviews Equities... 5 Fixed Income... 6 Real Assets... 7 Alternative Investments... 8 Since the beginning of 2017, the major oil price benchmarks (West Texas Intermediate, or WTI, and Brent) have risen roughly 19%, while copper prices have gained by 21%, and gold prices have risen by 17%. As these three commodities garner most of the financial media attention, this has left the impression in many investors minds that prices are rallying from all corners of the commodity complex. This has not been the case, however. Over this same time period, the commodity complex, measured by the Bloomberg Commodity Index (BCOM) (Chart 1) has only managed a 0.3% return. By comparison, most major assets have outperformed the BCOM over this period; the S&P 500 Index, as an example, is up 20% (as of April 4, 2018). With that being said, stocks have stumbled in recent months, while many commodities have held their own. History has shown that commodities often perform well late in economic cycles (in fact, commodities have tended to outperform stocks and bonds late in cycles). Wells Fargo Investment Institute (WFII) believes that the U.S. is likely in the latter stages of its economic expansion. As 2018 progresses, we will share more insight on this topic. Yet, for today, we want to specifically address commodities, and whether or not it is time to buy. Our answer is still no even though the U.S. economy appears to be in the latter stages of its expansion. Why we remain commodity bears is our topic for today Wells Fargo Investment Institute. All rights reserved. Page 1 of 10

2 Chart 1. Bloomberg Commodity Index 375 Bloomberg Commodity Index 325 Index value Sources: Bloomberg, Wells Fargo Investment Institute. Daily data: January 31, 2010 April 4, Past performance is no guarantee of future results. The Bloomberg Commodity Index (BCOM) is calculated on an excess return basis and reflects commodity futures price movements. An index is unmanaged and not available for direct investment. Let s begin with Chart 2, which shows how commodities historically have performed in the latter stages of U.S. economic cycles. There are many ways to define latter stages of U.S. economic cycles. For today s publication, we decided to show this as the final two years before the economy has entered a recession. (To be clear WFII is not expecting a recession anytime soon, even though WFII does believe that the U.S economy is in the latter stages of its expansion.) The vertical dashed line in Chart 2 represents the start of the 22 U.S. recessions, since 1902 (the 15 U.S. recessions since 1926 for bonds). To the left of the black dashed line are the two years before recessions begin, while the right side of the black dashed line represents the two years after recessions begin (the average U.S. recession, since 1902, has lasted roughly 15 months). The colored lines represent average performance for commodities (blue line), commodities versus stocks (green line), and commodities versus bonds (purple line). Notice that all three lines begin rising about eight months before recessions begin. This tells us that overweighting commodities late in economic expansions has been the right move, on average Wells Fargo Investment Institute. All rights reserved. Page 2 of 10

3 Time to Buy Late-Stage Commodities? Chart 2. Commodity performance around recessions Indexed value Commodity Composite Commodities/stocks Commodities/bonds Months before and after the start of a recession Sources: Bloomberg, Bureau of Labor Statistics (BLS), National Bureau of Economic Research (NBER), Ned Davis Research, and Wells Fargo Investment Institute; Prices by G.F. Warren and F.A. Pearson. Monthly data. Indexed to 100 at the start of recessions. Lines represent average performance of commodities, commodities relative to stocks, and commodities relative to bonds in periods around the 22 U.S. recessions since 1902 (the 15 U.S. recessions since1926 for bonds). Commodities represented by the Commodity Composite, stocks by the Dow Jones Industrial Average, and bonds by the Bloomberg Barclays Long Term Treasury Index. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. Index definitions and asset class risks provided at end of report. We bolded the words on average in the last paragraph on purpose. The reason is that it hasn t always been the smart move to favor commodities at the end of economic expansions. In fact, history shows that there have been very specific times when commodities have underperformed near the end of economic expansions. It is interesting to note that those times revolve around another influential cycle, a dauntingly negative one for commodities that we write about often the commodity bear super-cycle. When the commodity asset class is in a bear super-cycle, even if the U.S. economy is in the latter stages of its economic cycle, commodities often turn in negative performance and frequently underperform stocks and bonds. This can be seen in Chart 3, which shows average commodity performance around the 11 recessions, since 1902, in which commodities were fighting a bear super-cycle. Commodities are represented by the blue line, commodities versus stocks are shown in the green line, and commodities versus bonds are shown in the purple line. Notice the stark performance differences between Chart 2 and Chart 3. For those who are not familiar with our past reports, commodity bear super-cycles are a phenomenon that have impacted commodities for centuries. In our view, the current commodity bear super-cycle began in 2011, and we suspect it has at least another five years left before it concludes. Commodity bears historically last 20 years on average, using data back to the year Bear cycles are multi-year periods in which the majority of commodities fight massive oversupplies. We believe that this is the case in At this point in today s bear super-cycle, if history is any guide, commodity prices will struggle to hold rallies and largely will remain range-bound Wells Fargo Investment Institute. All rights reserved. Page 3 of 10

4 Time to Buy Late-Stage Commodities? The bottom line is that we remain underweight commodities. While some individual commodities did perform well over the past year, the complex as a whole continues to underwhelm. Investors have recently warmed up to commodities, anticipating that they could outperform should the U.S. be in its latter stages of economic expansion. We understand the late-stage interest in commodities, as they have tended to outperform, on average, late in economic cycles. Yet, there is a major caveat we fear that investors may be missing the commodity bear super-cycle. History suggests the commodities frequently lose their late-cycle outperformance, when a bear-super cycle is present as well. Chart 3. Commodity performance around recessions and during bear super-cycles Indexed value Commodity Composite Commodities/stocks Commodities/bonds Months before and after the start of a recession Sources: Bloomberg, Prices by G.F. Warren and F.A. Pearson, Bureau of Labor Statistics (BLS), National Bureau of Economic Research (NBER), Ned Davis Research, Wells Fargo Investment Institute. Monthly data. Indexed to 100 at the start of recessions. Lines represent average performance of commodities, commodities relative to stocks, and commodities relative to bonds in periods around the 22 U.S. recessions since 1902 (the 15 U.S. recessions since 1926 for bonds) that also occurred during a commodity bear super-cycle. Commodities represented by the Commodity Composite, stocks by the Dow Jones Industrial Average, and bonds by the Bloomberg Barclays Long Term Treasury Index. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. Index definitions and asset class risks provided at end of report Wells Fargo Investment Institute. All rights reserved. Page 4 of 10

5 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 Will earnings take the market spotlight off of trade issues? First quarter earnings season begins in earnest this week. Corporate tax reform and continuing global economic growth should result in a strong reporting season. The key for markets will be whether earnings can take back investors focus from concerns over a trade war and Information Technology (IT) challenges. Investors also will be watching how companies plan to use their tax savings to support growth. WFII expects that first-quarter S&P 500 Index earnings will reflect a 16-17% increase over first-quarter 2017 earnings. For 2018, WFII expects 16.0% year-over-year (YoY) earnings growth (see table). We expect the largest quarterly earnings increases to come from the Energy, Financials, and IT sectors. Energy is benefiting from an easy quarterly comparison with first-quarter 2017 earnings, while Financials and IT are expected to show broad-based earnings and revenue increases. We are overweight Financials, evenweight IT, and underweight Energy. Wells Fargo Investment Institute Estimates S&P 500 Industry Sector First Quarter 2018 EPS Growth (%) Est. Consumer Discretionary 7.0% 15.0% Consumer Staples 11.0% 9.5% Energy 70.0% 50.0% Financials 24.0% 24.0% Health Care 8.0% 10.5% Industrials 15.0% 16.0% Information Technology 19.0% 15.5% Materials 17.0% 20.0% Real Estate -7.0% -3.0% Telecom Services 17.0% 11.5% Utilities 12.0% 4.5% 2018 EPS Growth (%) Est. S&P 500 Index % 16.1% Emerging Market Equities S&P 500 Index operating EPS $ Sources: Wells Fargo Investment Institute, S&P Capital IQ, April 4, EPS = earnings per share. The S&P 500 Index moved below its 200-day moving average last week. WFII has discussed how technical indicators have been key drivers of short-term trading and volatility. Over the long term, we believe that markets should reflect economic fundamentals and corporate earnings. A strong earnings season may allow fundamentals to regain market focus. Investors also should watch the forward guidance that companies issue with their reports, especially comments relating to trade and how that might impact the second-half outlook. Key takeaways» A strong earnings season may enable investors to refocus on fundamentals, rather than trade-war concerns.» WFII expects 16-17% YoY first quarter S&P 500 Index earnings growth and 16.1% YoY 2018 earnings growth Wells Fargo Investment Institute. All rights reserved. Page 5 of 10

6 FIXED INCOME Brian Rehling, CFA Co-Head of Fixed Income Strategy Underweight High Yield Taxable Fixed Income Underweight Developed Market Ex.-U.S. Fixed Income Overweight U.S. Short Term Taxable Fixed Income Underweight U.S. Long Term Taxable Fixed Income Emerging Market Fixed Income Opportunity in a flatter yield curve In recent years, as the Federal Reserve (Fed) has transitioned to tighter monetary policy, we have seen a meaningful flattening of the interest-rate curve. While the recent trend has been one of yield-curve flattening, it is important to note that the interest-rate curve between 2- and 10-year Treasury securities remains positively sloped, with a 50- basis point (0.50%) difference between 2-and 10-year Treasury yields. 1 The curve steepness in this area suggests that the current moderate growth environment should remain in place. Much of the recent curve flattening has been the result of short-term interest rates rising at a faster pace than long-term rates. Higher short-term interest rates could present investors with an attractive risk/reward opportunity. We expect that investors will face further interest-rate curve flattening in the future as the Fed continues to raise short-term rates in response to full employment and modestly rising inflation pressures. As the economic cycle plays out, we see the Fed continuing to increase short-term interest rates, while longer-term rates remain relatively contained (but trend modestly higher). Under such a scenario, short-term positions offer the potential for higher yields with limited price volatility, while longermaturity positions generally would face modestly negative pricing pressures and offer the potential only for a small increase in current yield. Key takeaways» While curve flattening is the trend, the yield curve remains sufficiently steep to suggest that the slow-growth environment will continue.» We recommend an overweight to U.S. short-term fixed income and an underweight to U.S. long-term fixed income while targeting below benchmark duration (duration measures a bond s price sensitivity to movements in interest rates) portfolio positioning.» We view the recent spread widening in short-term corporate securities as an opportunity for investors looking for added yield in high quality short-term paper. Treasury yield curve The yield curve (10 year 2 year) has been flattening throughout the Fed tightening cycle U.S. Taxable Investment Grade Fixed Income Percent (%) U.S. Intermediate Term Taxable Fixed Income /3/2008 3/3/2009 3/3/2010 3/3/2011 3/3/2012 3/3/2013 3/3/2014 3/3/2015 3/3/2016 3/3/2017 3/3/2018 Source: Bloomberg, April 3, Ten-Year Treasury Constant Maturity and the Two-Year 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 two-year maturity. Yields represent past performance and fluctuate as market conditions change. Past performance is no guarantee of future results. 1 One hundred basis points equal 1% Wells Fargo Investment Institute. All rights reserved. Page 6 of 10

7 Austin Pickle, CFA Investment Strategy Analyst REAL ASSETS Experience is a hard teacher. She gives the test first, and the lesson afterwards. --Vernon Sanders Law Copper and oil outshine other commodities late in the cycle Underweight Commodities Private Real Estate Overweight Public Real Estate WFII sees very little chance of an imminent recession over the next 12 months. In fact, WFII foresees moderate acceleration in economic growth both domestically and globally. Even so, we recently have received inquiries about how commodities have performed late in the business cycle. We discuss our view on commodities overall earlier in this report. Here, we review how select individual commodities have performed late in the business cycle. We focus on the 12 months leading up to a recession and how often each commodity has performed positively. Given that late-cycle action tends to be characterized by higher market volatility, and gold s role as a perceived safe-haven asset, one may assume that gold has had the best record over these periods. Surprisingly, this has not been the case. Gold has (more often than not) had negative performance leading up to a recession. A possible explanation for this may be that both peak optimism and higher interest rates are common leading up to a recession both of which tend to lower the demand for gold. Copper and oil have had the best overall track record during these periods performing positively (more often than not) during the 12 months leading up to a recession. Yet, notice how that consistent positive performance has disappeared the closer the economy gets to a recession (see table). The bottom line is that copper and oil (the economically sensitive commodities) tend to perform well in the last one to two years of an economic expansion. Yet, as the economy takes its last gasp (in the economic cycle), they tend to perform negatively. Key takeaways» Copper and oil have had the best overall track record in the one to two years leading up to a recession.» Yet, none of the commodities shown below have consistently performed well during the last moments of an economic expansion. Percent of time a commodity had positive returns prior to recessions All recessions Recessions during bear super-cycles 12 months prior 6 months prior 12 months prior 6 months prior Copper 63.6% 36.4% 77.8% 44.4% Oil 68.2% 45.5% 55.6% 22.2% Gold 40.9% 22.7% 33.3% 11.1% Wheat 45.5% 50.0% 33.3% 44.4% Sources: Bloomberg, United States Geological Survey, Ned Davis Research, Wells Fargo Investment Institute, April 5, Figures are based on all U.S. recessions since Silver prices used as a proxy for gold prices prior to 1968 as the price of gold was fixed. Oil prices from 1861 to 1950 are taken from BP statistical review. Prices from 1951 to April 1983 are Bloomberg Arabian Gulf Arab Light Crude Spot prices, and prices from May 1983 to current are West Texas Intermediate Cushing Crude Spot price. Green indicates that the commodity has had positive returns more than half of the time. Red indicates the commodity has had negative returns more than half of the time Wells Fargo Investment Institute. All rights reserved. Page 7 of 10

8 ALTERNATIVE INVESTMENTS Ryan McWalter Investment Research Analyst 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. The value of hedge fund strategies in the current market environment Since the 2008 global financial crisis, investors generally have experienced upwardtrending equity markets, supported by unprecedented global monetary policy. Over this period, U.S equity markets had extremely low volatility interrupted, at times, by sharp (and often short-lived) market downturns. During periods of downside volatility, many hedge fund strategies will de-risk and lower their exposure levels to help preserve capital. Although this has offered downside protection, it has limited managers ability to fully capture the benefit of market recoveries. The most recent stock-market decline that began in late January may be different. It already has lasted longer than 8 of the 12 post-crisis 5% downturns (see chart below). Furthermore, headwinds include the potential for more Fed rate hikes than market participants expect, concerns over tariff escalation, and the possibility of new Information Technology regulations. It helps to remember that market drawdowns can take time to play out (as they did in 2010, 2011, and ), involving months of volatility and choppiness. 2 We believe that the recent equity-market dislocation (unlike other recent downturns) will not be supported by ongoing central-bank monetary accommodation. In our opinion, this validates the growing importance of active management, and hedge funds, in investors portfolios. At this point in the cycle, allocating to hedge fund strategies such as Equity Hedge and Relative Value can potentially help to mitigate a portfolio s market sensitivity by dampening volatility through short exposure and identifying idiosyncratic alpha-generation opportunities independent of broader equity and credit market directionality. Key takeaways» Higher stock dispersion and more sustained volatility should be expected as central banks raise rates and normalize monetary policy, following a long period of accommodation.» In particular, security dispersion could be more pronounced following broader market declines as stronger, more fundamentally sound companies can recoup market value, potentially rewarding more selective fundamental strategies, such as Equity Hedge and Relative Value. More selective recoveries to come? Number of trading days Number of trading days to recover from a 5% decline back to previous peak (S&P 500 Index) * Periods in which the S&P 500 Index declined by 5% or more and recovered to the previous peak Sources: Bloomberg, Wells Fargo Investment Institute, April 4, 2018 The S&P 500 Index is a market capitalization weighted index considered representative of the U.S. stock market. It is unmanaged and not available for direct investment. 2 Wells Fargo Investment Institute, Equity Strategy Report, What is Behind the Equity Sell-off?, March 26, Wells Fargo Investment Institute. All rights reserved. Page 8 of 10

9 Forecasts, targets and estimates are based on certain assumptions and on our current views of market and economic conditions and are subject to change. 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 An index is unmanaged and not available for direct investment. Bloomberg Barclays Long-Term U.S. Treasury Index includes all publicly issued, U.S. Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value. Commodity Composite measures a basket of commodity prices as well as inflation. It blends the historical commodity index introduced by George F. Warren & Frank A. Pearson, former academics at Cornell, collected and published commodity price data in their book, Prices, and the producer price index for commodities (PPI-Commodities), and the National Bureau of Economic Research (NBER) Index of Wholesale Prices of 15 Commodities and the Reuters Continuous Commodity Index. The index components and weightings, from Warren and Pearson s Prices, change over time but the 11 commodity groups used from are: Farm Products, Foods, Hides and Leather products, Textile Products, Fuel and Lighting, Metals and Metal Products, Building Materials, Chemicals and drugs, Spirits (stopped tracking 1890), House furnishing Goods, and Miscellaneous. The PPI-Commodities is compiled by the Bureau of Labor Statistics and shows the average price change from the previous month for commodities such as energy, coal, crude oil and the steel scrap. The NBER Index of Wholesale Prices of 15 Commodities is a measure of price movements of 15 sensitive basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions. The Reuters Continuous Commodity Index comprises 17 commodity futures that are continuously rebalanced: cocoa, coffee, copper, corn, cotton, crude oil, gold, heating oil, live cattle, Live hogs, natural gas, orange juice, platinum, silver, soybeans, sugar no. 11, and wheat. The Commodity Composite connects the aforementioned components at the following years: Warren and Pearson- Prices: , BLS PPI-Commodities: , NBER: , Reuters Continuous Commodity Index: 1956-Current. Dow Jones Industrial Average is an unweighted index of 30 "blue-chip" industrial U.S. stocks. 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 Wells Fargo Investment Institute. All rights reserved. Page 9 of 10

10 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