Global Investment Strategy

Weekly market insights and possible impacts on investors from the Wells Fargo Investment Institute Global Investment Strategy team.

July 25, 2016

Peter Donisanu, Global Research Analyst

Watch Sentiment—but Keep Perspective

  • A number of events this year, including global growth concerns, the UK’s surprise decision to leave the European Union (EU) and stresses on Eurozone banks have increased economic and market uncertainty.
  • Our work shows that periods of heightened uncertainty have a tendency to weigh on business and consumer confidence, which also can weaken financial market performance.

What it may mean for investors

  • We recommend frequent rebalancing, particularly ahead of uncertain market events—by bringing portfolio allocations in line with strategic objectives, while also adding and trimming allocations as favorable market conditions present themselves.

The outcome of the UK’s referendum vote on the EU caught many market participants and vote-watchers by surprise on June 24. More than three weeks after this unexpected outcome, a number of questions remain unanswered relative to the UK and EU’s fate—leaving the door open to ambiguity surrounding the UK’s pace of exit from the EU and its potential economic implications. Uncertainties surrounding the Brexit event have prompted us to assess the relationship between changes in business and consumer sentiment and financial-market performance. Our work shows that, under certain circumstances, changes in sentiment and changes in market performance share a positively-correlated relationship.

Chart 1: Consumer and Business Sentiment Are Mixed, but Are Improving GloballyChart 1: Consumer and Business Sentiment Are Mixed, but Are Improving GloballySource: Wells Fargo Investment Institute, Bloomberg, 7/12/16. Please see disclosures for sentiment measures.

Sentiment and Market Performance

Global measures of consumer and business sentiment are mixed, but have largely trended higher in recent months following heightened levels of market volatility at the start of the year (Chart 1). Improvements in sentiment had been a bright spot in an otherwise dour outlook on the global economy during the first six months of the year. Today, sentiment is now under threat from a growing number of uncertainties from multiple corners of the globe. In our own studies, we have found that events which seemingly have no precedent have led to high levels of uncertainty among businesses and consumers, weighing on confidence and subsequent near-term financial market performance.

We considered the financial market impact of the most high-profile events to date in this century. We then measured the absolute change in business and consumer sentiment along with market conditions following those events. Table 1 summarizes the range of change in sentiment and market performance. The sentiment range is measured by the difference between the maximum and minimum value observed over a 12-month period, while market reaction is shown as a percentage change in highest prices vs. lowest prices observed over a similar period.

What we are attempting to illustrate in Table 1 is the absolute degree of changes in sentiment and market moves vs. the relative time period change and market performance. The reason for this approach is to highlight the historical swing in sentiment and market prices as a result of key event risks. Not surprisingly, we have found wide swings in business and consumer sentiment as well as market performance surrounding the key events of the Lehman Brothers’ bankruptcy and the September 11, terrorist attacks. We do not believe that Brexit is similar to those events, but the effects of the UK exit from the EU could fall within a spectrum of results, as illustrated in the range of results associated with other key events.

Table 1. Business and Consumer Sentiment (along with Market Reaction) Following Key EventsTable 1. Business and Consumer Sentiment (along with Market Reaction) Following Key EventsSource: Wells Fargo Investment Institute, Bloomberg; 7/1/16. The ISM PMI is the Institute for Supply Management Purchasing Managers’ Index. UoM Consumer Sentiment is the University of Michigan Consumer Sentiment Survey. MSCI ACWI ex U.S. is the MSCI All-Country World Index, while DXY is the dollar index. EU 27 is the 27 member states of the European Union. See disclosures for definitions. US10Y Yield is the yield for the US 10-year Treasury note. Past performance is no guarantee of future results.

Another way that we interpreted the data was to look at the correlation between the changes in sentiment following these key events and subsequent performance of the S&P 500 Index over a three-month period, divided between two regimes of pre- and post-Lehman bankruptcy. Our work shows that changes in sentiment and market performance share a modestly positive contemporaneous relationship, particularly among those measures in the EU. What is also worth noting is that correlation between sentiment and U.S. stock market performance strengthened “post-Lehman” by an average of 48 percent. What this suggests is that market participants today are seemingly more sensitive to changes in forward-looking measures of economic activity—as traditional business-cycle bellwethers (such as the Federal Reserve’s tightening-easing cycle) produce less meaningful signals.

Keeping an Eye on Sentiment

A number of events this year, including China-induced global growth concerns, the UK’s surprise decision to leave the EU, Eurozone bank concerns and other developments are leading to more uncertainty than clarity for economic and financial market participants. Our work suggests that events which seemingly have no precedent tend to lead to higher levels of uncertainty among businesses and consumers than those that occurred before, which has weighed on sentiment and coincided with near-term financial market performance.

Looking ahead, Italy’s planned constitutional referendum (in October) and U.S. elections (in November) could be market-moving events. Also, new surprises may arise as London and Brussels negotiate Brexit, possibly in early 2017. We expect sentiment to weaken in the coming months, which could likely spill over into softer financial market performance or, at the very least, heightened market volatility. But, as we see in Table 1, key market events do not necessarily trigger levels of sentiment associated with economic recessions. We believe that the global economy is resilient enough to work through the outcomes of these upcoming votes and negotiations.

In light of the potential for heightened volatility, we suggest that investors employ prudent portfolio-management strategies that include aligning strategic asset allocation with long-term investment goals. We also recommend frequent rebalancing, particularly ahead of uncertain market events, by bringing portfolio allocations in line with strategic objectives, while also adding and trimming allocations as favorable market conditions present themselves. We recommend that investors seek to exploit price drops in markets as entry points for favored investments. We also suggest that investors avoid trying to time the stock markets, particularly as it relates to events surrounding Brexit—as being out of the markets at the wrong time can be costly.

Risk Factors

All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security. Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments.

Definitions

It is not possible to invest directly in an index.

EU-27 member countries include: Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovak Republic, Slovenia, Spain, Sweden and the United Kingdom.

In Chart 1, the following consumer sentiment indices were used: U.S. – The Conference Board’s Consumer Confidence Index, Eurozone – European Commission Consumer Confidence, China Consumer Confidence (DECE), Brazil FGV Consumer Confidence, UK - GFK UK Consumer Confidence Index, Mexico Consumer Confidence Index, Japan Consumer Confidence (Hous).

In Chart 1, the following business sentiment indicators were used: U.S. Economy-weighted Purchasing Managers’ Index (PMI), Eurozone – Market Eurozone Composite PMI, China Composite PMI SA, Brazil – Market Brazil Composite PMI, UK – Markit/CIPS UK Composite PMI, Mexico – Markit Mexico Composite PMI, and Japan – Nikkei Japan Composite PMI.

Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

MSCI All Country World ex US Index (MSCI ACWI ex-US) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets, excluding the USA. The Index consists of 45 country indices comprising 22 developed and 23 emerging market country indices. The developed market country indices included are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. The emerging market country indices included are: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

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 U.S. Dollar Index (USDX) measures the value of the U.S. dollar relative to majority of its most significant trading partners. This index is similar to other trade-weighted indexes, which also use the exchange rates from the same major currencies.

Global Investment Strategy 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 Global Investment Strategy division of WFII. 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.

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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