June 28, 2016

Sean Lynch, CFA, Co-Head of Global Equity Strategy

Our Post-Brexit Equity Perspective

  • Equity markets in the UK, Europe and the United States have declined sharply following the “Brexit” vote.
  • We expect the current equity-market volatility to continue for some time.

What it may mean for investors

  • While the Brexit vote may shave some points off developed-market economic growth, it does not change our asset-allocation weightings for major equity classes.
  • We continue to favor U.S. large-cap equities (followed by mid-caps) in a well-diversified global portfolio

In this week’s report, we answer several questions that have been on investors’ minds as it relates to global equity markets following the Brexit vote on Friday.

Does the UK referendum vote change Wells Fargo Investment Institute’s equity-market views?

The vote on Friday does not change our order of preference on where we believe investors should allocate incremental equity dollars. We continue to believe that U.S. large-cap stocks are the best equity class in which to invest, followed by U.S. mid-cap equities. Earlier this year, we lowered our view on international developed equity markets to neutral, which is our third preference, followed by U.S. small-cap equities, and lastly, emerging markets.

The Brexit vote does inject uncertainty into the global economy and may shave a few points off of economic growth numbers. Equity markets do not like uncertainty. As a result, Friday’s “leave” vote causes us to be a bit more cautious heading into the second half of the year. The market moves reflect an increased risk of slower global growth along with the potential for economic and political upheaval. We had prepared for some of this volatility by reducing our equity exposure over the past six months. While volatility is likely to persist, we do not see this as a financial disaster.

What are your views on the financial sector, which has been pressured, particularly in the UK?

We remain neutral on financial stocks. Friday’s vote is likely to result in interest rates remaining lower for longer. This is likely to put pressure on banks’ net interest margins (NIM) and could cause nonperforming loans to rise in the UK. Bank stocks in the U.S. and abroad were some of the hardest hit on June 24 and 27. It is important to note that many banks are much better capitalized today than they were in 2008-2009. Lost in last week’s news was the fact that the largest U.S. banks all passed the recent stress tests, meaning they have capital in excess of government mandates. We do not expect bank runs or any systemic collapse, but we would not advocate buying aggressively in the financial sector, especially European banks.

Will global equity markets have to digest a number of these events this year?

Following Friday’s UK referendum, investors began to handicap which country would next break from the EU or Euro block of countries. On Friday, Economist James Grant asked whether we just hit “break” in a pool game. We believe that Brexit escalates the possibility of more upheaval for populist parties in some of the countries facing elections this year.

On Sunday, Spain held elections. Following the Brexit vote (over the next 18 months), the five largest euro-area economies (Spain, Holland, France, Germany and Italy) will have held major elections. Along with the U.S. election in November, we believe political pressure against the establishment and pressure on immigration and globalization are likely to be main tenets of these elections.

What drives the equity markets from here?

Our view has long been that fundamentals and valuations drive the equity market in the long term. Currently, valuations are reasonable (Table 1). Further, fundamentals in the U.S. are improving (while they remain under pressure in international markets). We believe that the Brexit vote puts a dent in global economic and earnings growth for the UK and, to a lesser extent, for the Eurozone. The U.S. impact should be marginal and most likely to be felt, if at all, through slightly slower business spending growth; the U.S. consumer is the main driver and is unaffected by the referendum. Since less than 10 percent of sales for S&P 500 Index companies comes from Europe, the impact should be fairly modest. One other factor that may appeal to equity investors is the fact that dividend yields continue to look attractive— especially relative to many fixed-income yields. Dividends and valuation are calming factors that are often forgotten during times of volatility and uncertainty.

Table 1. Equity Index Metrics and Wells Fargo Investment Institute (“WFII”) Weightings, Estimates and Price Ranges Table 1. Equity Index Metrics and Wells Fargo Investment Institute (“WFII”) Weightings, Estimates and Price RangesSource: Wells Fargo Investment Institute, Bloomberg, 6/27/16. Past performance is no guarantee of future results.

Yet, we do believe that fundamentals may take a back seat to other issues in the second half of 2016. These issues include central-bank actions, the movement of currencies, the price of oil, and speculation around elections. An example of this is the performance of emerging markets last week. Economically, emerging markets should have limited impact from the Brexit vote as exports to the EU account for a small share of gross domestic product (GDP). However, emerging markets suffered steep declines on Friday. The reason is that emerging-market stocks have closely followed the dollar, and as the dollar strengthened on Friday (due to its status as a perceived safe-haven currency), emerging-market currencies and related stock markets faltered.

Chart 1. The S&P 500 Index Has Outperformed International Equity Markets in the Past Month Chart 1. The S&P 500 Index Has Outperformed International Equity Markets in the Past MonthSource: Bloomberg, MSCI, Standard & Poor’s, 6/27/16. Past performance is no guarantee of future results.

How long will we hear about Brexit?

A” remain” vote last week would have calmed global markets and potentially banished the term “Brexit” from our lexicon. It is now here to stay, and we likely will need to live with the consequences and the “Brexit” expression for quite some time.

Weekly Wrap and Look Ahead

Results were mixed for major domestic and international indices both last week and year-to-date.

Index Last Week’s Performance1 2016 YTD Performance
S&P 500 -1.6% -0.3%
DJIA -1.6% -0.1%
NASDAQ -1.9% -6.0%
Russell 2000 -1.5% -0.7%
MSCI EAFE -1.7% -6.6%
MSCI Emerging Markets +0.1% +2.6%
1. For the week of June 20 – June 24, 2016
Source: Wells Fargo Investment Institute, Bloomberg, 6/24/16.

Five of 10 S&P 500 Index sectors outperformed the index but only one sector gained ground on the week.

Best-Performing Sectors
Sector Last Last Week’s Performance2
Telecom Services +1.4%
Utilities -0.3%
Energy -0.6%
Worst-Performing Sectors
Sector Last Last Week’s Performance2
Materials -2.6%
Financials -2.4%
Industrials -2.4%
2. For the week of June 20 – June 24, 2016.
Source: Wells Fargo Investment Institute, Bloomberg, 6/24/16.
Past performance is no guarantee of future results.

We believe that, in the wake of the UK decision to leave the EU, equity markets around the globe will likely be quite volatile in coming weeks. However, outside of the UK, we believe that the trajectory of most economies will generally be unaltered over the next 12 months, with the Eurozone facing some Brexit-related headwinds while the U.S. economy continues its modest recovery.

The result of the UK referendum injects uncertainty into the politics and economies of the EU members and likely (to a lesser extent) the Eurozone as a whole. It may take years before the entirety of the effects of the Brexit decision will filter through the European economies, and it likely will happen in steps, not all at once. We continue to believe that the other 27 members of the EU will want to continue doing business on attractive terms with the UK. The UK runs a trade deficit with the rest of the EU, and it remains an attractive export market for goods and services. Many of those goods and services are coming from other EU members. We believe the UK (as the fifth largest economy in the world) has some leverage in any trade agreement negotiations with other individual EU members or the organization as a whole.

This week, economic news in the U.S. includes consumer confidence, pending home sales, initial jobless claims, vehicle sales and the Institute for Supply Management (ISM) manufacturing data. In our opinion, these reports, taken as a whole, will be reflective of the modest growth/modest inflation environment we are projecting into the future. It is doubtful that any of these reports will deter the current obsession with the short-term potential negatives surrounding the UK referendum results.

Sector S&P Weighting* Wells Fargo Investment Institute Guidance
Consumer Discretionary 12.3% Overweight 14.9%
Consumer Staples 10.7% Underweight 8.5%
Energy 7.3% Evenweight 6.5%
Financials 15.6% Evenweight 16.5%
Health Care 14.7% Overweight 17.2%
Industrials 10.1% Overweight 11.6%
Information Technoloy 19.8% Overweight 21.8%
Materials 2.8% Evenweight 3.0%
Telecom Services 3.0% Underweight 0.0%
Utilities 3.7% Underweight 0.0%
S&P 500 Earnings Estimate for 2016 $119.00
S&P 500 Year-end 2016 Target Range 2,190-2,290
*Sector weightings may not add to 100% due to rounding. Weightings as of 6/27/16 close. Targets are not guaranteed and may change.
Source: Wells Fargo Investment Institute, Bloomberg, 6/27/16.
Valuations and Fundamentals for Five Primary Equity Asset Classes Valuations and Fundamentals for Five Primary Equity Asset Classes*Enterprise Value.
Source: Wells Fargo Investment Institute, Bloomberg, 6/24/16.
Developed Market represented by MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the U.S. and Canada. It is unmanaged and unavailable for investment. Statistics are shown in U.S. dollars and local currency.
Emerging Markets: The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 23 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.

Risk Factors

There is no assurance that any of the target prices or other forward-looking statements mentioned will be attained.

All investing involves risks including the possible loss of principal. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities.

Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.

The prices of mid-cap company stocks are generally more volatile than large company stocks. They often involve higher risks because smaller companies may lack the management expertise, financial resources, product diversification and competitive strengths to endure adverse economic conditions.

Technology and Internet-related stocks, especially of smaller, less-seasoned companies, tend to be more volatile than the overall market.

Dividends are not guaranteed and are subject to change or elimination.

Definitions

An index is unmanaged and not available for direct investment

DJIA is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.

MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The Index consists of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 23 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.

NASDAQ is an unmanaged group of the 100 biggest companies listed on the NASDAQ Composite Index. The list is updated quarterly and companies on this Index are typically representative of technology-related industries, such as computer hardware and software products, telecommunications, biotechnology and retail/wholesale trade.

Nikkei 225 Index is the leading and most-respected index of Japanese stocks. It is a price-weighted index comprised of Japan’s top 225 blue-chip companies on the Tokyo Stock Exchange. The Nikkei is equivalent to the Dow Jones Industrial Average Index in the U.S.

Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.

Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represent approximately 25 percent of the total market capitalization of the Russell 1000® Index.

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. The Index is unmanaged and not available for direct investment.

Institute for Supply Management Manufacturing Index (ISM) is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.

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 and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by the GIS division of Wells Fargo Investment Institute. Opinions represent GIS’ opinion as of the date of this report and are for general informational 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.

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.

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