Global Investment Strategy

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

May 22, 2017

Tracie McMillion, CFA, Head of Global Asset Allocation Strategy

Unflappable?

  • Improving corporate earnings and global economic conditions have supported financial markets in 2017, despite political uncertainty.
  • While periodic volatility is likely as investors watch developments in Washington D.C., we do not believe that political events will change the U.S. economy’s upward trajectory.
  • Yet, we expect that investors increasingly will focus on the potential for valuations, inflation and interest-rate trends to cause market pullbacks as the year progresses.

What it may mean for investors

  • We believe investors should continue to position their portfolios for modestly higher U.S. growth, inflation and interest rates. We recommend that investors use any market weakness to rebalance portfolio positions back to target allocations.

The Merriam-Webster dictionary defines unflappable as, “not easily upset: unusually calm in difficult situations.” Until last week, most global markets had been unflappable this year amid a barrage of headlines that we think would have upset markets in a less solid economic environment. Indeed, financial markets have held up exceptionally well to the uncertainty they have faced. We believe that market gains have been supported by improving corporate earnings and a stronger global growth outlook, and think these conditions should persist through year end.

But, fear of a U.S. constitutional crisis, media discussion about the possibility of presidential impeachment proceedings, and even citations of the 25th amendment finally got investors’ attention—for one day. Volatility spiked 46 percent higher last Wednesday and 15 percent higher for all of last week. By Thursday, apparent calm had returned to the equity markets, which were assuaged by the naming of former FBI director Robert Mueller as special counsel in the Russia investigation. Reassured that the investigation would be credible and that talk of impeachment was premature, markets ended the week only modestly lower than where they began.

Reasons for Caution

Since late last year, we have been forecasting that U.S. markets would reach their highs near midyear. Current market prices are near our year-end targets for most equity and fixed income markets. We believe that investors will continue to watch developments in Washington, D. C.— but we also expect that they increasingly will focus on rising valuations, the potential for wage inflation and Federal Reserve (Fed) tightening as catalysts for a potential market pullback.

The appointment of a special counsel to explore ties between President Trump’s campaign and Russian officials clearly could give markets another reason for caution as we approach the summer. The report that President Trump asked former FBI director James Comey to halt investigation of former national security adviser, Michael Flynn, led to media discussion of potential presidential impeachment.

Political disappointments are nothing new in any presidency, and it’s hard to judge a story’s sustainable interest just from the initial reaction. Apart from regular elections, changes in U.S. presidents are extremely rare events, and departures for legal reasons historically have taken a long time. The game changer would be if Mr. Comey testifies under oath before Congress that the White House obstructed the FBI’s investigation. In that scenario, a special prosecutor could be appointed, or it’s possible that the president would either resign or be removed via impeachment or the 25th amendment. The probability of removing the president from office may no longer be trivial, but all of these scenarios seem very unlikely to us with the facts now available.

Instead, we believe it to be more likely that the latest political noise from Washington complicates the job of building congressional consensus for health care and tax reform. That new disappointment may induce some investors to take profits. Still, some parts of the agenda are continuing. In particular, the president may be close to appointing a vice chair of the Fed for supervision. The Senate needs to approve the appointment, but it’s possible that this appointment could go through even with the recent news stories. We believe that this could be an important step toward advancing financial deregulation through the supervisory channel.

Chart 1. U.S. and International Developed Equity Markets Have Been Resilient in Recent MonthsChart 1. U.S. and International Developed Equity Markets Have Been Resilient in Recent MonthsSource: Bloomberg, 5/18/17. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment.

Economic Conditions Support Market Prices

U.S. markets should be most directly impacted by U.S. presidential politics, although international markets frequently react to U.S. political news. Last week was no exception, as developed international markets sold off in sympathy with U.S. equities, but by much less, extending their 2017 lead over U.S. equities and highlighting the attractive diversification properties that international markets can help provide to U.S. investors. Emerging markets confronted their own political crisis last week as allegations of political misconduct in Brazil severely dented Brazil’s equity market and currency.

Political policies, reforms and other events have the potential to help or hurt the financial environment in a given country, but the underlying economic and earnings trends are most important for investors to watch. Today, we have rising corporate earnings and improving global economic growth that we expect will exceed last year’s rate of economic expansion. We see little evidence of an upcoming U.S. recession in the near term and do not believe that political events will change the underlying economy’s upward trajectory. This supports our belief that we can end this year near the all-time highs we saw just one week ago. We believe investors should continue to position their portfolios for modestly higher domestic growth, inflation and interest rates—using any market weakness to rebalance portfolio positions back to target allocations.

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.

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.

Definitions

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 US & 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.

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.

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.

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 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.

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.

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