Equity Strategy

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

June 21, 2017

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

The Changing Impact of Technology on Emerging Markets

  • The technology weight in the MSCI Emerging Markets Index has risen from 14 to 25.5 percent in the past five years.
  • The emerging equity-market move toward more exposure to the Information Technology sector could create a steadier stream of corporate earnings for emerging markets.

What it may mean for investors

  • It is important for investors to be aware of the sector changes occurring in emerging equity markets, and to not be surprised by them.
  • While we are evenweight on most equity classes, we still favor the emerging markets ahead of U.S. markets for investment of new assets today.

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speedometer reading of equities: large cap, mid cap, developed markets, small cap, and emerging-market.

In 2017, many investors have been focused on technology stocks—following the major rally in the largest market-cap companies. These stocks have carried the S&P 500 and NASDAQ indices to all-time highs. Yet, over the past two weeks, we have seen a pullback in the equity prices of technology companies. We believe that investors should keep the recent weakness in perspective since year to date (YTD); the Information Technology sector remains the top-performing sector in the United States. The Information Technology sector of the S&P 500 Index has returned 19.8 percent YTD in 2017, while the NASDAQ Index is up 15.6 percent. Both of these returns have handily exceeded the 9.4 percent YTD return of the S&P 500 Index. The influence of technology stocks has spilled over into international markets as well—in particular, to the emerging markets.

Table 1 shows that the technology weight in the MSCI Emerging Markets Index has increased from 14 percent to 25.5 percent in the past five years. This has been at the expense of the Materials and Energy sectors, which represented a combined 25.5 percent of the MSCI Emerging Markets Index in 2012, but now equals nearly half of that, at 13.9 percent. These changes have ramifications for earnings growth, valuation, and volatility in the emerging equity markets.

Table 1. Sector Composition of the MSCI Emerging Markets IndexTable 1. Sector Composition of the MSCI Emerging Markets IndexSources: MSCI, Bloomberg; 6/20/17.

The Impact on Earnings and Valuation

Emerging-market stocks have led the way in global markets this year with a 17.3 percent YTD return. The catalyst for continued outperformance could be further earnings improvement in the second half of the year. The volatility of earnings in emerging markets has historically been much higher than in domestic markets. Part of this has been due to these economies’ large dependence on commodity industries like energy and basic materials. With the move toward more economic exposure to the technology industry, this could create a steadier earnings stream for emerging markets. Once dominated by financials and commodity companies, emerging markets now see nearly half of their equity-market benchmark weights in just two sectors—Financials and Information Technology.

We believe that if a steadier stream of earnings develops in the coming years, emerging-market valuations may be impacted. An investor will place a higher value on a dollar’s worth of earnings if it offers better growth potential—but also if the investor is more certain about the growth potential of those earnings. The move away from commodity dependence toward technology looks to improve emerging equity-market potential on both of these fronts. Emerging markets have historically traded at price/earnings discounts to international developed and U.S. equity markets. One reason for this was the more volatile nature of the economies and earnings that make up these markets. While we do not believe that emerging equity markets should be valued at the same level as U.S. markets, we would argue that the valuation discount could be narrowed going forward.

Investment Implications

In December, Wells Fargo Investment Institute upgraded its tactical emerging-market equity recommendation to evenweight (neutral) from underweight. One of the rationales for this positioning upgrade was the better earnings visibility that we may see from this equity group in 2017. While emerging markets have performed very well this year, we are concerned that they could be due for a breather. The impact of Federal Reserve (Fed) rate hikes and the possibility of a stronger dollar could result in some downside pressure on these markets. In addition, the equity markets in emerging economies (and elsewhere) are highly susceptible to political risk and uncertainty today. We already have seen a pullback this year in countries such as Brazil following corruption allegations. While the emerging-market move toward more technology has many positive attributes, it also brings some specific risks that are inherent in technology—product-cycle upgrades and changes in consumption patterns to name just two.

While we have an evenweight recommendation for all equity classes (with the exception of small caps), we still favor emerging equity markets ahead of U.S. equity markets for investment of new assets today. Yet, we do believe that investors should maintain their equity-class weightings at their targeted levels. Investors need to be careful not to be surprised by the changes occurring within emerging markets, which now are much more dependent on smartphones and online commerce that the prices of oil and iron ore.

Weekly Wrap and Look Ahead

All major domestic and international indices were positive year to date. Weekly results were mixed.

Index Last Week’s Performance1 2017 YTD Performance
S&P 500 +0.1% +8.7%
DJIA +0.5% +8.2%
NASDAQ -0.9% +14.3%
Russell 2000 -1.1% +3.7%
MSCI EAFE No Change +12.4%
MSCI Emerging Markets -1.5% +16.3%

1. For the week of June 12 – June 16, 2017
Sources: Wells Fargo Investment Institute, Bloomberg, 6/19/17

Seven of 11 S&P 500 Index sectors outperformed the index. The same number gained ground on the week.

Best-Performing Sectors
Sector Last Week’s Performance2
Industrials +1.6%
Utilities +1.6%
Real Estate +1.4%
Worst-Performing Sectors
Sector Last Week’s Performance2
Information Technology -1.2%
Materials -0.8%
Consumer Staples -0.6%

2. For the week of June 12 – June 16 , 2017
Source: Wells Fargo Investment Institute, 6/19/17
Past performance is no guarantee of future results.

This is quite a slow week on the economic data front. Yet, investors appear unfazed, so far, by stretched valuations, the seeming lack of fiscal-stimulus progress in Washington, D.C., and a Fed monetary policy that calls for a total of four more rate hikes between now and the end of next year. Trading volumes have been low on most days over the past few months, with only a few exceptions.

We get the feeling that many investors are “comfortably cautious.” If you are a contrarian, this may signal to you that the stock market is going to keep moving higher, at least in the near term. That may be so. Yet, we continue to believe that the above-mentioned headwinds, along with concerns that wage pressures will negatively affect corporate margins late this year (and in 2018), will result in the S&P 500 Index closing modestly lower than current levels at year-end 2017. We continue to carry a 2230-2330 year-end target range for the index.

At this point, we recommend that investors remain invested at their current (tactical and strategic) equity-market allocations, based on our modest downside U.S. large-cap expectations over the balance of the year. We continue to believe that this cycle is not over and the next several years are likely to offer additional equity upside for the major domestic indices. We are expecting a mid-single-digit return this year and possibly a return somewhat better than that in 2018.

We continue to have the most interest in the Financials, Health Care, Consumer Discretionary and Industrials sectors.

Sector S&P Weighting* Wells Fargo Investment Institute Guidance
Consumer Discretionary 12.3% Overweight 14.9%
Consumer Staples 9.2% Underweight 5.5%
Energy 6.0% Underweight 4.0%
Financials 14.3% Overweight 16.4%
Health Care 14.2% Overweight 17.2%
Industrials 10.3% Overweight 11.6%
Information Technoloy 22.8% Evenweight 21.8%
Materials 2.9% Evenweight 3.0%
Real Estate 2.9% Evenweight 3.1%
Telecom Services 2.2% Evenweight 2.5%
Utilities 3.2% Underweight 0.0%
S&P 500 Earnings Estimate for 2017 $127.00
S&P 500 Year-end 2017 Target Range 2230-2330

*Sector weightings may not add to 100 percent due to rounding. Weightings as of 6/19/17. Targets are not guaranteed and may change.
Sources: Wells Fargo Investment Institute, Bloomberg, 6/19/17.

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, 6/19/17. Developed Markets: MSCI EAFE Index (Europe, Australasia, and Far East). Emerging Markets: MSCI Emerging Markets Index.

Risk Factors

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.

The prices of small-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.

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.

There is no assurance that any of the target prices or other forward-looking statements mentioned will be attained. Any market prices are only indications of market values and are subject to change.

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.

The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.

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.

The Russell 3000® Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.

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 Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by the GIS division of WFII. 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.

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.

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