Global Equity Strategy

Weekly discussion of recent equity market action with equity sector highlights and what it may mean for investors.

August 24, 2016

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

Assets Flow to Emerging Markets—But Beware of the Rocks

  • In recent weeks, asset inflows to emerging-market equities have been strong. This has helped to fuel the group’s outperformance.
  • These flows have been supported by central-bank easing and an investor return to risk assets in the face of widespread negative interest rates in developed markets.

What it may mean for investors

  • As emerging-market equities remain challenged by weak fundamentals and structural issues in several markets, we remain cautious. We continue to underweight the emerging-market equity group.
speedometer reading of equities: large cap, mid cap, developed markets, small cap, and emerging-market.

Last month, we wrote about emerging markets and whether an economic and market recovery was underway.1 Since then, emerging-market equities have moved slightly higher as negative interest rates continue to entice investors toward riskier assets. According to EPFR Global data, emerging-market equity funds saw inflows of $5.1 billion during the week ended August 17 (a 58-week high).2 The money flowing into emerging-market equity and fixed-income investments is offering a nice tailwind to these asset groups. In this Global Equity Strategy Report, we revisit emerging markets and present our views on whether the strong returns are likely to continue, along with what concerns us about the recent equity-market appreciation and emerging-market inflows.

Commodity Prices Have Been Supportive

Emerging-market stocks continued to move higher as oil and other commodity prices rose over the past few weeks. Global credit conditions have eased, and risk appetites have increased as well. The S&P 500 and MSCI EAFE indices also have gained, but at a slower pace. Oil prices bounced back above $50 last week, which resulted in some dollar weakness. This also may have signaled improvement in global growth. These factors are both positive for emerging markets. Yet, we believe that oil prices are likely to weaken (from last week’s level) by year-end. It also is possible that the optimism around improving global growth may fade as well. This would dampen some of the investor interest that recently has buoyed emerging-market stocks.

Another factor leading to the appreciation in emerging-market assets is the investor belief that accommodative global monetary policies are likely to continue in many markets. This has fueled a rise in emerging-market currencies (as the Federal Reserve (Fed) has remained patient, while central banks abroad have continued easing). The value of negative-yielding bonds stood at nearly $10 trillion in early July (and we believe has likely risen from that level).3 This is helping to drive investment flows into emerging-market debt and equity funds. While lower global interest rates should help to drive borrowing costs lower, many emerging-market corporations have become overleveraged. One of our concerns is that these economies may go through a prolonged deleveraging cycle (and possible disinvestment as well).

Lastly, it used to be said that, “as goes China, so go the emerging markets.” That wasn’t the case in the early part of this year as China lagged the high-flying countries of Brazil and Taiwan in equity-market performance. Yet, China recently has joined the emerging-market party and been one of the strongest performers over the past month. The MSCI China Index rose by 7.3 percent in dollar terms and 7.2 percent in local currency terms over the past month. Table 1 shows how equity-market leadership has changed within the emerging markets. China’s recent performance strength gained momentum following last week’s announcement of the Shenzhen-Hong Kong Stock Connect program. Ultimately, this should increase investor interest in China’s equity market as it opens up these individual markets to more investors. Yet, that change does not come without concerns. As witnessed last year with the spike in the volatility of the China “A” share markets, the Shenzhen exchange may be even more volatile (as it contains smaller- and mid-cap Chinese companies; many of them in the Technology sector).

Table 1. Recent Returns of Selected Emerging and Developed Equity Markets (%) Table 1. Recent Returns of Selected Emerging and Developed Equity Markets (%)Source: Bloomberg, data as of 8/19/16. Table shows total returns in percent. Please see disclosures for index definitions. One month = 7/19/16-8/19/16.

Investment Recommendations

As we discussed last month, valuations remain high for most emerging-market equities. Investors may be disappointed if economic (and earnings) growth once again disappoints or is delayed. Should this happen, we believe that emerging-market stocks may take a breather and give up some of their recent gains. They have had a very strong run on the basis of some stabilization in their economies and the support of central banks. We remain cautious on emerging- market equities. We also believe that investors are likely to have some time to position portfolios should emerging-market fundamentals start to improve. We do believe that there is a strong possibility that disappointments (or, at least, delays) will result as the emerging world continues to seek recovery from heavy debt burdens and structural issues. In the coming weeks, we may reevaluate our year-end price targets. Nevertheless, we reiterate our underweight to the group.

Weekly Wrap and Look Ahead

All major domestic and international indices were positive year to date. Several were positive for the week.

Index Last Week’s Performance1 2016 YTD Performance
S&P 500 0.0% +6.9%
DJIA -0.1% +6.5%
NASDAQ +0.1% +4.6%
Russell 2000 +0.6% +8.9%
MSCI EAFE -0.6% +1.7%
MSCI Emerging Markets +0.1% +16.9%
1. For the week of August 15 – August 19, 2016.
Source: Wells Fargo Investment Institute, Bloomberg, 8/19/16.

Five of 10 S&P 500 Index outperformed the index, and the same number gained ground on the week.

Best-Performing Sectors
Sector Last Last Week’s Performance2
Energy +2.0%
Materials +1.3%
Industrials +0.7%
Worst-Performing Sectors
Sector Last Last Week’s Performance2
Telecom Services -3.8%
Utilities -1.3%
Consumer Discretionary -0.7%
2. For the week of August 15 – August 19, 2016
Source: Wells Fargo Investment Institute, Bloomberg, 8/19/16.
Past performance is no guarantee of future results.

Since the mid-February lows for the S&P 500 Index, the cyclical sectors of the index have been the best performers. Our recommended underweights in Telecom Services, Consumer Staples and Utilities have been the three worst-performing sectors since that February 11 low.

We continue to believe that a slowly-improving labor market will lead to higher consumer confidence and improved spending. Indeed, the best year-over-year earnings comparisons for the second quarter were in the Consumer Discretionary sector (+14.5 percent), followed by the Industrials sector (+13.5 percent). We look for this pattern of cyclical outperformance to hold over the balance of this year.

On a day-to-day basis, it seems that various Federal Reserve (Fed) governors are coming out with conflicting statements on what the central bank might do in terms of rate hikes through the end of this year. We believe that Janet Yellen and other Fed voting members want the market to believe that it is possible that a rate hike would occur this year. We do not expect that the Fed will raise rates before year-end. This week, the speculation will be over what Chairwoman Yellen may or may not say at the Kansas City Fed’s annual symposium in Jackson Hole, Wyoming which starts on August 26. The stock market is not expecting a rate hike at the September monetary -policy meeting. Will that meeting still be in play for a rate hike after the Jackson Hole symposium? We do not believe so. We believe that investors need a heads up well in advance of any rate hike, and we are too close to the September meeting for such advance notice to occur.

Sector S&P Weighting* Wells Fargo Investment Institute Guidance
Consumer Discretionary 12.3% Overweight 14.9%
Consumer Staples 10.1% Underweight 8.5%
Energy 7.1% Evenweight 6.5%
Financials 15.9% Evenweight 16.5%
Health Care 14.9% Overweight 17.2%
Industrials 9.9% Overweight 11.6%
Information Technoloy 20.9% Overweight 21.8%
Materials 2.9% Evenweight 3.0%
Telecom Services 2.7% Underweight 0.0%
Utilities 3.3% 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 8/19/16 close. Targets are not guaranteed and many change.
Source: Wells Fargo Investment Institute, Bloomberg, 8/22/16.
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, 8/19/16. Developed Markets: MSCI EAFE Developed Market Index (Europe, Australasia, Far East). Emerging Markets: The MSCI Emerging Markets.

1 Global Equity Strategy Report, “A Recovery Underway—or Just Riding on U.S. Coattails?”, July 27, 2016.
2The Financial Times, “Emerging Markets Back in Vogue”, August 20, 2016.
3Bloomberg, July 6, 2016.

Risk Factors

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.

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

The prices of small- and 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

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.

The MSCI China Indexes consist of a range of country, composite and non-domestic indexes for the Chinese market, intended for both international and domestic investors, including Qualified Domestic Institutional Investors (QDII) and Qualified Foreign Institutional Investors (QFII) licensees. The indexes are calculated according to the MSCI Global Investable Market Indexes (GIMI) Methodology.

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 eight percent 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 U.S. stock market. The Index is unmanaged and not available for direct investment.

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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