April 23, 2018

George Rusnak, CFA, Co-Head of Global Fixed Income Strategy

New Faces—but the Same Fed

Key Takeaways

• Last week, President Trump announced that he would nominate Richard Clarida and Michelle Bowman as Federal Reserve (Fed) governors.
• If confirmed by the Senate, Mr. Clarida and Ms. Bowman will join the existing Fed governors and recent Fed nominees, Jerome Powell (Fed chair), and Randal Quarles (Vice Chairman for Supervision) on the Federal Reserve Board of Governors, along with John Williams (recently named as president of the Federal Reserve Bank of New York).

What it May Mean for Investors

• Despite the new “faces at the Fed,” we expect that the Fed will maintain its gradual and measured approach to normalizing interest rates and trimming the Fed’s balance sheet.

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Last week, President Trump announced his plan to nominate Richard Clarida as vice chairman and Michelle Bowman as governor of the Federal Reserve Board. If confirmed by the Senate, Richard Clarida and Michelle Bowman would become the newest board members on the Federal Open Market Committee (FOMC).

Additionally, it recently was announced that John Williams will shift from president of the Federal Reserve Bank of San Francisco to become president of the Federal Reserve Bank of New York on June 18. John Williams will replace William Dudley, who announced earlier that he would step down in June. This change is significant, because the Federal Reserve Bank of New York president comes with a non-rotating FOMC board seat. The Federal Reserve Bank of San Francisco will need to replace John Williams as he assumes his new role. And it remains unclear whether Fed nominee Marvin Goodfriend will receive Senate approval following his confirmation hearings earlier this year.

With so many new faces at the Fed, some investors may be wondering whether this is the “right team” to address the challenges the Fed may encounter as it works to remove unprecedented interest-rate stimulus while also reducing the Fed’s balance sheet. In today’s report, we share perspectives on the new Fed nominees and their likely policy approach.

Richard Clarida

If confirmed by the Senate as vice chairman, Richard Clarida will work closely with Fed Chairman Powell in addressing monetary-policy issues. Despite his experience as an investment banker, attorney, and former Under Secretary of the Treasury, Jerome Powell is the first Fed chair in several decades without a Ph.D. in economics. Fortunately, Richard Clarida has a deep grounding in economics, having served as the top economist in the Treasury Department in the George W. Bush administration, as a Columbia University economics professor (and department chair), and as a Managing Director at Pacific Investment Management Company (PIMCO). He has written extensively on monetary policy and economics. His strengths as an economist and monetary policy specialist should complement Fed Chair Powell’s leadership skills and experience. Additionally, Richard Clarida’s expertise in computer modeling may prove useful as the Fed evaluates the economic impact of simultaneously raising rates and reducing the Fed’s balance sheet. Mr. Clarida is seen as a centrist and a pragmatic thinker.

Michelle Bowman

If confirmed, Michelle Bowman will have an important role as Fed governor and as the Fed’s community bank representative. Ms. Bowman has served as a Kansas bank regulator, vice president of her family’s Farmers & Drovers Bank, and in top positions at FEMA (Federal Emergency Management Agency) and the Department of Homeland Security in the George W. Bush administration.

Market reaction and Senate confirmation

The initial market reaction to these nominations was generally positive. Most market participants appear to believe that these Fed nominations are noncontroversial. Yet, Senate and public sentiment can shift quickly, and the Senate approval process may be more challenging than initially expected. For example, the Senate Banking Committee approved Marvin Goodfriend’s nomination, but his nomination process is highly uncertain as Republican Senator Rand Paul (and several Democrats) spoke out against his nomination.

Monetary policy and investment implications

If confirmed by the Senate, we believe that the additions of Richard Clarida and Michelle Bowman will benefit the FOMC through their complementary skill sets and significant expertise, should the Fed encounter more pressing U.S. economic challenges. Most importantly, we don’t believe that these changes will disrupt the Fed’s current path of gradual rate increases and measured balance-sheet reduction.

Richard Clarida has written extensively on Fed policy in his role at PIMCO, and he generally has been supportive of former Fed Chair Yellen’s efforts to gradually raise rates and trim the Fed’s balance sheet. Michelle Bowman’s experience as a Kansas bank commissioner should serve the Fed well from a regulatory standpoint.

President Trump’s recent Fed nominees, including Randal Quarles, Jerome Powell, Richard Clarida, and Michelle Bowman have U.S. government and financial services experience and are generally viewed as pragmatists. While there are new faces at the Fed, we believe that the Fed is likely to “stay the course” as it works to unwind unprecedented monetary stimulus.

We expect a total of three Fed rate hikes in 2018. Our year-end fed funds interest-rate target is 2.00-2.25%, while our year-end target ranges for the 10-year and 30-year Treasury yields are 2.75-3.25% and 3.25-3.75%, respectively. As shorter-term yields have risen and the yield curve has flattened, we recommend that investors reduce duration relative to their individually selected benchmarks.¹ We favor shorter maturities, raising average credit quality, and believe investors should remain broadly and globally diversified.

Equities

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

Finding value in international developed markets

We recently were asked where investors can find value in today’s equity markets. It is important to remember that value doesn’t necessarily equate to opportunity—at times, equities are cheap for a reason. Today, we prefer to invest incremental equity allocations in U.S. markets first, then international markets. Yet, the best value today may be in international developed-market equities.

Earnings recently have grown nicely for the MSCI EAFE Index. Earnings per share (EPS) rose from $80.39 in 2015 to $125.04 in 2017. Yet the local developed-equity markets have been lackluster over the past year—as the MSCI Germany Index and the MSCI United Kingdom Index have risen by 5.4% and 4.6%, respectively.² We expect economic and earnings growth to continue into 2019—but not at the same pace as in the past few years.

Of our five main equity benchmarks, the MSCI EAFE Index is the only one for which the trailing 12-month price/earnings (P/E) ratio trades below its 10-year rolling average. The current trailing P/E ratio is 16.5 versus the 10-year average of 20.2. MSCI EAFE’s lackluster performance and cheap valuation can be linked to weaker European economic data, rising Japanese political risks, and concern over possibly escalating trade issues. Earnings have been “catching up” to valuation in recent years. When asked where value can be found in today’s markets, international developed markets is our answer. We currently recommend that investors steer toward their strategic weights in international developed equity markets.

Key Takeaways

• Today, we favor investing incremental equity allocations in U.S. markets first, then international markets. Yet, the best value today may be in international developed equities.
• Of our five main equity benchmarks, MSCI EAFE is the only index for which the trailing 12-month P/E ratio trades below its own 10-year rolling average.

Fixed Income

Brian Rehling, CFA, Co-Head of Global Fixed Income Strategy

Short-term yields have been steadily increasing since September 2017. U.S. shorter-maturity issues now offer yield opportunities that have not been available in almost a decade. To highlight this opportunity from a risk/reward perspective, let’s examine the portfolio impact of duration.

Is duration worth the risk today?

Generally speaking, if interest rates rise, bond prices fall—and the opposite occurs as interest rates decrease. As the yield curve has flattened, there is less yield opportunity for investors moving out the curve into longer maturities. In the Treasury market, investors purchasing a 10-year note rather than a 2-year note gain just 43 basis points, despite the fact that they would lock in current rates for an additional 8 years.³ While this is not a great risk/reward tradeoff, moving further out on the curve offers even less value. Purchasing a 30-year Treasury bond offers just 18 basis points in additional yield, despite a final maturity that is 20 years longer.

The price impacts of these duration decisions are meaningful. The table below shows the price impact on a fixed-income security should rates increase by 100 basis points across the interest-rate curve. Clearly, a marginal pickup in yield (from longer maturities) results in a significantly negative market-price impact if rates increase. We believe that this is an unfavorable proposition, and we recommend that investors reduce duration relative to their individually selected benchmarks.

Key takeaways

• We believe that higher short-term yields offer investors an opportunity to shorten duration and improve the risk/return profile of their fixed-income holdings.
• Our guidance recommendation is favorable on short-term fixed income and most unfavorable on long-term fixed income.
• Given the value on the yield curve, we recommend an unfavorable below-benchmark duration portfolio positioning. For reference, the Bloomberg Barclays U.S. Aggregate Bond Index currently has a duration of 6.09 years.

Real Assets

John LaForge, Head of Real Asset Strategy

Oil watchers—watch Russia

“There is no subject so old that something new cannot be said about it.”
--Fyodor Dostoyevsky

After oil prices tanked (falling below $30 per barrel) in 2016, 21 oil-producing countries developed a plan to stop the price drop (by cutting oil production). The two largest oil-producing countries (aside from the U.S.), Saudi Arabia and Russia, led the cuts. Since these cuts began in January 2017, most countries have complied. Oil prices have responded nicely—rising by 22% since January 2017.

History suggests that these types of coordinated production-cut plans have a hard time holding. The reason is that production cuts can lead to higher oil prices, which tempts countries to produce more oil. This is especially the case for countries dependent on oil revenue to cover expenditures (social programs, building roads and bridges, etc.). So far, so good, though. The March 2018 numbers are in, and most countries continue to comply.

Yet, one interesting non-compliant member in March was Russia. For the first time in a year, Russia fell below 90% compliance. One number does not make a trend, but Russia is the world’s second-largest petroleum producer. Russia ignoring production quotas should be watched, especially in the wake of recent U.S. sanctions. Since U.S. sanctions were announced, the Russian ruble has lost 7% of its value versus the U.S. dollar.⁴ In response, Brent oil, priced in rubles, hit record highs (see chart).

Oil watchers should be watching Russia. Should Russia want to defend the ruble, it likely will need more hard currency, such as the U.S. dollar. One way to gain U.S. dollars is to sell more oil.

Key Takeaways

• U.S. sanctions could result in pressure on Russia to sell more oil.
• We expect to see lower oil prices by year-end 2018.

Alternative Investments

Justin Lenarcic , Global Alternative Investment Strategist

Visualizing the “active” of active management

The debate between active and passive management is garnering more attention lately. We would remind investors that the decision between active and passive strategies should not be binary—not choosing just one or the other—but rather, should center on combining the two based on investment goals, financial situation and an understanding of how actively managed strategies historically have performed in up and down markets.

Two statistics needed for this decision are the upside capture and downside capture ratios. These represent the percentage of positive (and negative) returns captured by active management relative to a passive index. Historical analysis shows that, on average, the HFRI Fund Weighted Composite Index has captured 54% of the positive rolling 12-month S&P 500 Index returns and 22% of the negative rolling 12-month returns.⁵ Yet, historical averages can be deceiving—as there is a large degree of variation in these ratios over time.

As the chart shows, there has been much less variation in these ratios during the post-crisis period. In fact, over the past 10 years, the HFRI Fund Weighted Composite up capture ratio has averaged 34% (of the S&P 500 Index) while the down capture ratio has averaged 38%. We do not see these ratios as representative of what to expect going forward, given the difficult environment for security selection in the post-crisis period. We expect an increase in the dispersion of these ratios as monetary stimulus is gradually removed and fundamentals become more important.

Key Takeaways

• We recommend that investors consider combining both active and passive strategies within a portfolio, rather than employing just one approach.
• Understanding upside and downside capture ratios on a historical basis can help investors to determine the proportion of active strategies to include within a portfolio.

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.

¹ Duration measures a bond’s price sensitivity to interest-rate changes.
² Bloomberg, as of April 18, 2018, in local terms.
³ This assumes that the security is held to maturity. One hundred basis points equal 1%.
⁴ As of April 17, 2018.
⁵ Source: MPI. Calculated using the average, rolling 12-month upside/downside capture ratio versus the S&P 500 Index from January 1990 through March 2018.

Risk 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

Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.

HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2000 single-manager funds that report to HFR Database. Constituent funds report monthly net-of-all-fees performance in U.S. dollars and have a minimum of $50 Million under management or a 12-month track record of active performance. The HFRI Fund Weighted Composite Index does not include Funds of Hedge Funds.

MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada.

MSCI Germany Index is designed to measure the performance of the large and mid-cap segments of the German market. With 63 constituents, the index covers about 85% of the equity universe in Germany.

MSCI United Kingdom Index is designed to measure the performance of the large and mid-cap segments of the UK market. With 103 constituents, the index covers about 85% of the free float-adjusted market capitalization in the UK.

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.

An 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 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.

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