WEEKLY GUIDANCE FROM OUR I NVESTMENT STRATEGY COMMITTEE June 26, 2017 The Perils of Portfolio Drift and What to Do About It Chris Haverland, CFA Global Asset Allocation Strategist» Constructing and maintaining portfolio allocations based on investment goals and risk tolerance can help investors achieve their long-term investment objectives.» Portfolio allocations can drift through market movements over time. If not regularly rebalanced back to strategic targets, the portfolio s risk may become misaligned with the investor s risk tolerance. What It May Mean for Investors» We recommend that investors periodically review their portfolios to make sure asset allocations align with strategic targets. This can help keep portfolio risk in line with an investor s risk profile. Portfolio Alignment Asset Group Overviews Equities... 4 Fixed Income... 5 Real Assets... 6 Alternative Investments... 7 Investors often construct their portfolios with certain investment goals and a risk tolerance in mind. The investment objective may be income-oriented, growth-oriented or something in between. The risk one is willing to take to achieve a goal can be classified as conservative, moderate or aggressive. These factors are key components in determining strategic asset allocation targets for each asset class in a diversified portfolio. In our view, investing in these targets and maintaining the allocations through various market environments will provide the best chance of reaching one s long-term financial goals. Once an investor has a plan, it is important to stick with it, which means periodically reviewing portfolio allocations and rebalancing back to strategic targets. This will keep the portfolio s risk potential aligned with the investor s agreed-upon risk profile. If allocations are allowed to drift based on market movements, the risk in the portfolio can become misaligned with an investor s initial risk target. For example, an investment in a simple 60 percent U.S. large-cap stock/40 percent U.S. investment-grade bond portfolio at the start of the latest bull market would look drastically different today if not periodically rebalanced (see chart on page 2). The riskier equity allocation would have increased to nearly 82 percent of total assets, significantly increasing the volatility risk of the non-rebalanced portfolio. 2017 Wells Fargo Investment Institute. All rights reserved. Page 1 of 9
The Perils of Portfolio Drift and What to Do About It Portfolio Drift during the Bull Market (March 2009 December 2016) 18.4% 40% 60% 81.6% Rebalanced Ending Equity Rebalanced Ending Fixed Income Non-Rebalanced Ending Equity Non-Rebalanced Ending Fixed Income Source: Morningstar Direct. Stocks are represented by Ibbotson Associates SBBI U.S. Large Stock TR (USD) Index. Bonds are represented by Ibbotson Associates SBBI U.S. Intermediate Term Government TR (USD) Index. Data from 3/1/09-12/31/16. Monthly Total Return Quarterly Rebalanced. Chart is a hypothetical illustration using the historical performance of the indices and assumes the reinvestment of dividends and other distributions. It does not represent the performance of any investment. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. See the end of the report for definitions of the indices and a description of the risks associated with the representative assets classes discussed in this report. All investing involves risk including the possible loss of principal. Ways to Better Align Your Portfolio 1. Remain fully invested Cash Alternatives have a place in an investment portfolio for rebalancing, tactical opportunities and transaction costs. However, the amount should be kept at a minimum as returns for this asset class historically have outpaced inflation only slightly and more recently, have lost ground to inflation. We are tactically evenweight in Cash Alternatives and recommend that investors who are overweight dollar-cost average 11 into a diversified mix of assets. 2. Don t forget fixed income Even in this low-rate environment, bonds should be included in a diversified portfolio. They can provide income and stability of principal and do not tend to move in lockstep with equities. We recommend keeping quality high and targeting the intermediate part of the curve as rates rise. 3. Take your equities abroad U.S. equity markets have outperformed their international counterparts for much of this recovery. However, that is unlikely to last forever as market leadership often varies from year to year and cycle to cycle (remember the lost decade for U.S. large-cap stocks 2000 to 2009). International economies could be at an inflection point, so, in our opinion, investors should not be underexposed to these markets as they potentially hit their stride. We favor Developed Market Ex-U.S. Equities over domestic equities for new investment. 1 A periodic investment plan such as dollar cost averaging does not assure a profit or protect against a loss in declining markets. Since such a strategy involves continuous investment, the investor should consider his or her ability to continue purchases through periods of low price levels. 2017 Wells Fargo Investment Institute. All rights reserved. Page 2 of 9
The Perils of Portfolio Drift and What to Do About It 4. Get real Public real estate remains one of our favorite investments, with reasonable valuations and a sizable yield pickup relative to equities and bonds. We continue to recommend tactically overweighting the asset class. 5. Look for an alternative We expect modest returns in many asset classes through year-end; for qualified investors, hedge funds may offer a productive alternative. Hedge funds are expected to generate positive returns as the environment for active management improves. We are tactically overweight Relative Value and Equity Hedge. 6. Stick to your plan Failing to rebalance can raise portfolio risk above the investor s intention (see chart above). Maintaining alignment with strategic targets can reduce potential overexposure to risky assets when a correction arrives. Over the long term, we believe that maintaining full exposure to a diversified portfolio based on investment goals and risk tolerance is the best path to help achieve financial success. That would include aligning your portfolio mix with your strategic asset allocation targets and periodically rebalancing to maintain appropriate portfolio risk level. 2017 Wells Fargo Investment Institute. All rights reserved. Page 3 of 9
EQUITIES Stuart Freeman, CFA, Co-Head of Global Equity Strategy Why We See Utility Stocks as Continuing Market Laggards Underweight U.S. Small Cap Equities U.S. Large Cap Equities U.S. Mid Cap Equities Developed Market Ex-U.S. Equities Emerging Market Equities A primary reason for Utility index underperformance during an economic recovery tends to be earnings growth that lags that of growing cyclical and growth sectors of the market. During this cycle, the Utilities sector has lagged the S&P 500 Index by 41 percentage points. Some of the group s modest earnings performance can be attributed to greater efficiencies of equipment that uses electricity. The S&P Utility Index tends to particularly underperform during periods in which S&P 500 Index earnings are strong, the Federal Reserve (Fed) is tightening, or the 10-year Treasury Note yield is rising. These periods tend to occur later in a cycle. In the chart below, we have highlighted three periods with rectangles. Generally, as the 10-year Treasury Note yield rises, the S&P Utility Index moves in the opposite direction. If we look at every month back to 1987 (year-to-year percentage changes, one month at a time), in 60 percent of those instances, rate increases accompanied S&P Utility Index declines, and vice versa. Today, within the far-right box, one can see that as the 10-year Treasury Note yield declined by almost 40 percent over one year, the S&P Utility Index increased by roughly 30 percent. Yet, as the 10-year Treasury Note yield rose by more than 40 percent over a year, the one-year performance of the S&P Utility Index drifted from +30 percent to +6 percent. We foresee continuing economic growth, a rise in 10-year Treasury Note yields, and more underperformance for the S&P Utility Index in the near term.» The S&P Utility Index also appears fully priced at 18.7 x forward 12-month earnings.» We recommend investors underweight this sector, which represents only 3.3 percent of the S&P 500 Index. Year-to-Year Change in S&P Utility Index versus 10-Year Treasury Note Yield Percentage Changes 100 80 60 40 20 0-20 -40-60 '88 '92 '96 '00 '04 '08 '12 '16 Utilities 10-Year Treasury Sources: Thomson Baseline, Wells Fargo Investment Institute, 6/20/17. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. Yields fluctuate as market conditions change. 2017 Wells Fargo Investment Institute. All rights reserved. Page 4 of 9
FIXED INCOME George Rusnak, CFA, Co-Head of Global Fixed Income Strategy Fed Language Signals Increasing Inflation Concerns 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 In the Federal Open Market Committee s (FOMC) statement released on June 14, the term transitory was removed when describing lower-than-anticipated inflation. The FOMC also reduced its core personal consumption expenditures (PCE) target for 2017 from 1.9 percent to 1.7 percent. (PCE prices exclude food and energy prices. This is the Fed s preferred inflation measure.) We believe that this change in language and target signaled that the Fed is becoming increasingly concerned about inflation expectations. Other U.S. inflationary measures such as the Producer Price Index (PPI) and Consumer Price Index (CPI) also have been trending lower lately. Yet, the weakening in the Fed s five-year forward breakeven inflation rate may be most concerning. This measure reflects expected future inflation and it recently has moved from a level above 2 percent in mid-february to 1.7 percent (as reflected in the chart below). Lower inflation expectations have led to flattening of the Treasury yield curve. The difference between the 2- and 30-year Treasury yields has fallen by about 51 basis points (0.51 percent) year to date. Although we are becoming more concerned about yield-curve flattening and muted inflation, we still believe that caution is warranted when searching for yield. We do not recommend that investors move further out on the yield curve, despite its recent flattening. Instead, we recommend that investors own more intermediate maturities given the potential yield pickup over shorter-term securities. The intermediate part of the curve also may help investors to experience less rate volatility than historically has characterized longer-maturity holdings.» As inflation expectations have weakened, the Treasury yield curve also has flattened.» We recommend that investors avoid the temptation to move to the long end of the yield curve in a search for yield. Instead, we favor intermediate maturities today for the potential yield pickup over shorter-maturity holdings. The Fed s Five-Year Forward Breakeven Inflation Rate 2.2 2 U.S. Taxable Investment Grade Fixed Income Percentage 1.8 1.6 1.4 U.S. Intermediate Term Taxable Fixed Income 1.2 Sources: Wells Fargo Investment Institute, Bloomberg; 6/21/17. The breakeven inflation rate represents a measure of expected inflation directed from five year Treasury Constant Maturity Securities and five-year Treasury Inflation-Indexed Constant Maturity Securities. The latest value implies what investors expect inflation to be in the next five years (on average). 2017 Wells Fargo Investment Institute. All rights reserved. Page 5 of 9
John LaForge, Head of Real Asset Strategy REAL ASSETS Oil Doom and Gloom or Golden Opportunity? Underweight Commodities Private Real Estate Public Real Estate How quickly things change it was only a few weeks ago that oil was north of $50, the market was optimistic about the OPEC (Organization of the Petroleum Exporting Countries) production-cut meeting, and outside analysts were confident in their mid- $50 to low-$60 per barrel oil-price forecasts. Fast forward to today, and West Texas Intermediate (WTI) oil is down 17 percent, forecasts are being slashed, and the news cycle is barraging viewers about the possibility of oil s price collapse. To remind our readers, our 2017 year-end forecast for WTI has remained steady at $40-$50 per barrel. Let us be clear, we do not believe in the doom and gloom narrative of another collapse to $26 oil in the near future. But we also don t see oil as a table-pounding buy either. Oil sits at a crossroads of sorts at today s $42-$43 level. Turn right, and oil bounces off this support level (horizontal black bar in the chart below) as it has done the last three times. Turn left, and oil drops to $40 or even the high $30s. Is now the time that the support finally breaks? If so, then that may be an opportunity to become near-term bullish on oil prices. Today is not that day, but you and I both know how quickly things can change. Stay tuned.» Oil has had a rough few weeks and is down nearly 20 percent from its late-may highs.» Oil sits at a crossroads at today s price level. We remain bearish, but we are watching developments closely. Oil Prices Continue to Test Support Levels WTI Oil Price (U.S. Dollars/Barrel) 110 100 90 80 70 60 50 40 30 WTI Oil Two Standard Deviations Above 21-Day SMA Two Standard Deviations Below 21-Day SMA 20 2014 2015 2016 2017 Sources: Bloomberg, Wells Fargo Investment Institute, 6/21/17. Daily Data: 1/2/14 6/21/17. Standard Deviation is a measure of the volatility of the portfolio s return. SMA stands for simple moving average. 21-Day simple moving average is calculated by adding up the closing prices of the past 21 days and dividing by 21. 2017 Wells Fargo Investment Institute. All rights reserved. Page 6 of 9
ALTERNATIVE INVESTMENTS Justin Lenarcic, Global Alternative Investments Strategist Private Equity Private Debt Hedge Funds-Macro 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. Fine Tuning Portfolios with Alternative Investments Portfolio rebalancing is an often overlooked yet critical step within an asset allocation strategy. Aligning investments with objectives can be critical, especially after a prolonged period of expansion and asset-price reflation. For many, years of underperformance by active managers and hedge funds has led to a misalignment between their current allocation to alternative investments and our recommendations based on the Wells Fargo Investment Institute Capital Market Assumptions. (Capital market and asset class assumptions are estimates of how asset classes may respond during various market environments.)we encourage investors not to look in the rearview mirror, especially when considering alternative investments. We believe that a significant improvement in the environment for hedge funds has taken place over the past year and a half, as seen in the trailing 12-month returns for the HFRI Fund Weighted Composite Index (see chart below). This improvement, which includes an increase in interest rates and inflation, coupled with expectation of a gradual removal of central-bank liquidity, has set the stage for a stock and credit picker s market that should support active management going forward.» As investors align their portfolios especially their alternative investment allocation we recommend starting with a simple question: do you want alternatives to increase or decrease exposure to equities, credit, and/or fixed income?» With U.S. equity indices at historically high levels and credit spreads tight, we believe the greatest advantage for alternative investments right now is to reduce this exposure for investors, namely through Equity Hedge and Relative Value strategies. Hedge Fund Returns Have Improved Over the Past 12 Months Rolling Twelve Month Return 25% 20% 15% 10% 5% 0% -5% -10% -15% May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 May-16 Sep-16 Jan-17 May-17 Sources: Hedge Fund Research, Wells Fargo Investment Institute, June 2017. Hedge fund returns are represented by the HFRI Fund Weighted Composite Index. HFRI Fund Weighted Composite Index is a fund-weighted (equal-weighted) index designed to measure the total returns (net of fees) of the approximately 2,000 hedge funds that comprise the Index. Because the HFR Indices are calculated based on information that is voluntarily provided, actual returns may be higher or lower than those reported. Index returns are not fund returns and reflect general market results. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. 2017 Wells Fargo Investment Institute. All rights reserved. Page 7 of 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 Economic Indices The Consumer Price Indexes (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services. Producer Price Index (PPI) is a family of indexes that measures the average change in selling prices received by domestic producers of goods and services over time. Index Definitions Ibbotson Associates SBBI U.S. Large Cap Stock Index tracks the performance of the S&P 500 Index stocks. Ibbotson Associates SBBI U.S. Intermediate-Term Government Bond Index is an unweighted index which measures the performance of fiveyear maturity U.S. Treasury Bonds. S&P Utilities Index comprises those companies included in the S&P 500 that are classified as members of the GICS utilities sector. 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. 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 & 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. 2017 Wells Fargo Investment Institute. All rights reserved. Page 8 of 9
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 0617-04445 2017 Wells Fargo Investment Institute. All rights reserved. Page 9 of 9