• The Chinese government has changed its policy tone to promote Chinese growth and stabilize the economy in the face of U.S.–China trade war tensions.
• China has the fiscal and monetary policy flexibility to support a gross domestic product (GDP) growth target of approximately 6.5%. We believe this should support continued Chinese corporate earnings growth, which would be beneficial for emerging-market (EM) equities.

• Trade war rhetoric has dominated the summer season. Yet, we are watching for signs in China—and elsewhere in the emerging markets—that the trade conflict has discounted equity prices to a level at which the upside potential would warrant an upgrade of the EM equity class above our current neutral view.

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In July, the People’s Bank of China (PBoC) and the Chinese State Council announced several positive measures to support domestic demand. These stimulus measures are policies intended to help China stabilize slowing infrastructure spending. The Chinese government particularly prizes stability and has injected spending and lending stimulus to stabilize its economy amid economic reforms since 2015. The stimulus measures directly support sectors of the economy adversely affected by tightening Chinese lending regulations earlier this year. The supports also act to offset concerns about a growth slowdown related to the trade dispute.

We have summarized some key highlights of China’s economic stimulus program below:

• In late July, China announced greater coordination between fiscal and financial policy measures in an effort to boost domestic demand.

• China also is implementing several monetary policy easing steps:

  • The PBoC will be easing liquidity conditions to help support funding for small businesses.

  • China is implementing targeted required reserve ratio cuts for banks. The third rate reduction was on June 24. The rate cut for the five largest state banks and 12 joint-stock banks frees 500 billion yuan ($73.3 billion) in liquidity.

• The country’s fiscal policy announcements included:

  • Lower corporate tax rates: The Chinese State Council set a target of 1.1 trillion renminbi ($161 billion) in tax cuts (equal to just over 1% of GDP), in addition to 65 billion renminbi ($9.5 billion) in tax reductions tied to 2018 research spending. The 113 billion renminbi ($16.5 billion) in tax refunds for advanced manufacturing and the services industry also will be implemented by the end of September.

  • Local government funding: There will be special bond issuance and funding arrangements launched at the local government level. This means that local governments should be able to secure more funding in the remainder of 2018.

We expect the net result of these policy stimulus actions to be a resumption of Chinese economic growth in the autumn. We already are seeing signs of economic stabilization from the Chinese economic data releases as shown on Chart 1.

Chart 1. China Economic Surprise Index signals stabilizing economic data releasesSources: Bloomberg, Wells Fargo Investment Institute, August 7, 2018. The Citigroup Economic Surprise Indices measure data surprises relative to market expectations. Note: A positive reading means that economic data releases have been stronger than expected, and a negative reading means that data releases have been worse than was expected.

Economic growth often translates into corporate earnings per share (EPS) growth. The current consensus EPS estimates suggest that for 2019, the year-over-year MSCI China Index EPS growth will be 16.1%, and for 2020, it will be 14.6%.¹ Both of these figures are above the current consensus Chinese EPS growth forecast of 13.3% for 2018 (Chart 2). While the U.S. is likely to see peak EPS growth this year, China and the rest of Asia are expected to see a continued earnings growth uptick.

Chart 2. Consensus expects Chinese EPS growth to outpace U.S. EPS growthSources: Bloomberg, Wells Fargo Investment Institute, August 7, 2018. EPS = earnings per share. E= consensus estimate of EPS growth. The S&P 500 Index is a market capitalization-weighted index of 500 stocks generally considered representative of the U.S. stock market. MSCI China Index captures large- and mid-cap representation across China H shares, B shares, Red chips, P chips and foreign listings (e.g., ADRs) of Chinese stock. China A shares are partially included in the index, making it the de facto index for all of China. An index is unmanaged and not available for direct investment.

We expect the Chinese government to succeed in stabilizing the country’s 2018 economic growth through tax cuts, greater infrastructure spending, and increased credit availability and liquidity for banks, businesses, and consumers. We are watching for any signs that Chinese growth and corporate earnings will improve in the future, once the new easing policy stance begins to stimulate the world’s second largest economy over the next 6 to 12 months.

China’s equity market is important for EM and global equities, as China’s equity market capitalization represented 31.2% of the MSCI Emerging Markets Index as of July month-end.² Chinese equities have declined by 6.1% year to date (as measured by the MSCI China Index) on concern over the U.S.-Chinese trade conflict. Our analysis indicates that this sharp price decline has brought Chinese equity valuations to more compelling levels. We moved our EM equity rating from underweight to neutral in June, based partly on improved valuations. At this time, we retain our neutral rating. The Chinese stimulus is a positive, but uncertainties about the future of the U.S. trade disputes with various trading partners could continue to weigh on equity market sentiment. Our strong conviction is that additional tariffs and other punitive trade measures will be limited by the constraint that countries want to minimize self-imposed economic damage. While tariffs remain low and have limited application, the economic stimulus could counter negative tariff effects.

Last month, we looked at the mega-cap stocks that will be moving into the new Communication Services sector when Standard & Poor’s revises the current GICS system after the stock-market close on September 28, 2018. The GICS reconfiguration was announced last year. In the table below, we list the 27 stocks in the S&P 500 Index that will be changing sector classifications when the GICS revision takes place. Note that three of the five FAANG (Facebook, Apple, Amazon, Netflix, and Alphabet) stocks will be involved in the realignment (Facebook, Alphabet, and Netflix).

While there will be significant media coverage surrounding this realignment as we move closer to September 28, we want to note that the actual changes only are happening in the Consumer Discretionary, Information Technology, and Telecommunications Services sectors. The remaining eight sectors will be unchanged. Importantly, the Telecommunications Services sector will be eliminated and replaced by the Communication Services sector.

Based on current pricing, approximately 10.4% of the S&P 500’s total market capitalization will be involved in the reconfiguration. Every company in the Media sub-industry group, currently in the Consumer Discretionary sector, will be moving to the new Communication Services sector (along with several companies currently in the Internet and Direct Marketing Retail sub-industry group). Select companies in the Internet Software and Services sub-industry group, and from the Software industry within Information Technology, also will move into the new Communication Services sector—plus the three companies making up the Telecommunications Services sector.

• Standard & Poor’s will reconfigure the current 11-sector GICS classification system after the stock market closes on September 28, 2018.
• There are 27 companies currently in the S&P 500 Index that will be involved in this realignment. Three of the FAANG stocks are involved.

S&P 500 Index stocks moving to the Communication Services sectorSources: Standard & Poor’s, Wells Fargo Investment Institute, August 8, 2018. *Based on August 7, 2018 closing prices. The mention of specific securities is not a recommendation or solicitation for any person to buy, sell, or hold any particular security.

In our Midyear Outlook report, we noted that the U.S. economic cycle is well advanced, but that emerging-market (EM) economies are in early- to mid-cycle.³ One implication of this is our constructive view on EM sovereign debt. We are favorable on U.S.-dollar-denominated (USD) EM sovereigns, driven by a supportive macro backdrop, attractive yield levels, and relative resilience versus local-currency EM bonds should EM currencies decline further.

We also believe that EM sovereign debt shows compelling valuations on a spread basis versus similarly-rated U.S. corporate bonds. The average S&P rating of the (USD) J.P. Morgan Emerging Markets Bond Index (EMBIG) is BB+—just below investment-grade. We are unfavorable on U.S. high-yield (HY) corporate debt—as we don’t believe that currently tight spreads adequately compensate investors for risks. This concern is driven partly by the typical late-cycle phenomenon of deteriorating HY credit quality.

The chart illustrates the value in EM sovereigns versus comparably-rated U.S. corporates below. The hunt for yield in the U.S. bond market—and a bias toward the higher-quality end of the HY spectrum—has kept BB-rated debt spreads relatively tight, at just over 200 basis points above Treasury yields (100 basis points equal 1%). At yield spreads near 300 basis points over Treasury yields, EM sovereigns already were cheap versus 2017 and early-2018 levels (when the EM currency sell-off spilled into USD-denominated corporate spreads). At current spread levels near 140 basis points above BB-rated U.S. corporate spreads, this spread gap is at its widest level since 2010.

• We are favorable on EM sovereign debt denominated in dollars, but unfavorable on the U.S. HY corporate sector.
• Valuations support this position—as the yield-spread difference between EM sovereigns and BB-rated U.S. corporates is near its widest levels since 2010.

EM sovereign yield spreads exceed those of comparably-rated U.S. corporatesSources: JP Morgan, Bloomberg, Barclays, Wells Fargo Investment Institute, August 7, 2018. The dollar-denominated EM bond index is the JP Morgan Emerging EMBIG. The U.S. corporate index is the Bloomberg Barclays (Ba/BB) U.S. Corporate High Yield Index. For illustrative purposes only. Yields represent past performance and fluctuate with market conditions. Current yields may be higher or lower than those quoted above. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment. Please see the end of this report for the definitions of the indices.

“An injury is much sooner forgotten than an insult.”
--Philip Stanhope

Gold, right? Actually, no. For nearly five decades, the “gold medal” has gone to real estate investment trusts (REITs). This may come as a surprise—after all, gold is priced in U.S. dollars, so when the dollar falls, gold prices tend to rise. But gold has two main flaws as a long-term inflation hedge: 1) gold investors do not get “paid to wait” (i.e., no dividends), and 2) gold prices tend to run in super-cycles, with bear cycles lasting 20 years, on average. This is a long time to wait for higher prices, with inflation eating away at the holder’s real returns.

On the other hand, REITs can pay a handsome dividend, and they tend to run in much shorter cycles.⁴ There are a few REITs characteristics that help them to outpace inflation. The first is that they own real estate, and (for the most part) real estate values have increased as inflation has risen. Also, many REITs have terms in their lease contracts that account for inflation, even if new leases are not signed. REITs’ ability to outpace inflation (and gold and oil) is illustrated in the chart below, which takes REITs, gold, and oil—and divides each by the Consumer Price Index (CPI). When a line is increasing, it means that the investment is outpacing inflation, and vice versa. Notice that REITs have outperformed gold over this time period—and how much more consistent REITs have been at beating inflation (a steadily rising blue line).

• Historically, REITs have been a better inflation “hedge” than gold has been.
• We remain neutral on REITs today.

REITs, gold, and oil versus CPISources: Bloomberg, Wells Fargo Investment Institute. Indexed to 100 as of start date. REITs are measured by the total return of the FTSE NAREIT All Equity Index. Gold is spot gold. Oil prices from 1951 to April 1983 are Bloomberg Arabian Gulf Light Crude Spot prices, and prices from May 1983 to current are Bloomberg West Texas Intermediate Cushing Crude Spot prices. For illustrative purposes only. CPI is a measure of the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. Changes in CPI are used to assess price changes associated with the cost of living. FTSE NAREIT All Equity REITs Index is a free-float adjusted, market capitalization-weighted index of U.S. equity REITs. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Stock correlations peaked in late 2011 and generally have remained above historical averages in the years that followed—driven in part by accommodative monetary policy. Yet, the Federal Reserve (Fed) policy shift to gradual interest-rate increases in recent years has steadily increased the dispersion (decreased the correlations) of stock returns.

The global financial crisis of 2008, the eurozone crisis in 2010 and 2011, and the China/commodity downturn in 2015 all led to large equity correlation spikes at both broader index and sector-specific levels. Outside of these extreme instances, there have been periods of “normal” correlation levels in which stock prices were more reflective of company fundamentals, leading to wider return dispersion and opportunities for long and short alpha (excess return) for Equity Hedge managers.

What is encouraging for Equity Hedge managers in the current environment is the fact that we are in a more normal environment, with monetary policy normalization. In fact, when measuring intra-sector stock correlations in Man Numeric’s U.S. investment universe (slightly larger than the Russell 3000 Index), 8 of the 10 sectors’ correlations are below normal levels.⁵

While Equity Hedge managers can benefit from casting a wide net to identify attractive regions, market capitalizations, and themes, managers also can use industry expertise to understand sector-specific nuances, such as company management styles, structural changes with regulation, and consumer preference trends. The rise in stock dispersion at index and sector-specific levels reinforces our positive view of the Equity Hedge strategy as a complement to long-only equity exposure late in the market cycle.

• The increase in stock dispersion has become evident at more granular sector-specific levels, adding another conducive element to stock selection.
• Continued monetary tightening can present opportunities for long and short alpha for Equity Hedge managers, which is vital for investors late in the market cycle.

Intra-sector dispersion is driving opportunities for stock selectionSources: Numeric Investors, LLC., Bloomberg, August 9, 2018. For illustrative purposes only. There is no guarantee that future intra-market correlations will remain the same. Correlation represents past performance. Past performance is no guarantee of future results. Crisis periods include the 2008 global financial crisis, the 2010 and 2011 eurozone crisis, and the 2015 China/commodity downturn.

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.

¹Bloomberg, August 7, 2018.

²MSCI, July 31, 2018.

³Wells Fargo Investment Institute, Midyear Outlook, “Late Cycle Doesn’t Mean End of Cycle,” June 14, 2018.

⁴Dividends paid by REITs are considered non-qualified and generally taxed at ordinary income tax rates. However, all or a portion of a distribution may consist of a return of capital. Dividends are not guaranteed and are subject to change or elimination.

⁵There currently are 11 sectors in Man Numeric’s U.S. investment universe. Real Estate was a recently-added sector, so historical data on correlations is limited.

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. In addition to the risks associated with investing in international and emerging markets, sovereign debt involves the risk that the issuing entity may not be able or willing to repay principal and/or interest when due in accordance with the terms of the debt agreement. 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. Investing in physical commodities, such as gold, exposes a portfolio to material risk considerations such as potentially severe price fluctuations over short periods of time and storage costs that exceed the custodial and/or brokerage costs associated with the portfolio's other holdings. 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.

An index is unmanaged and not available for direct investment.

Bloomberg Barclays U.S. Corporate High-Yield Bond Index covers the U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bond market.

J.P. Morgan EMBI Global Index (USD) is a U.S. dollar-denominated, investible, market cap-weighted index representing a broad universe of emerging market sovereign and quasi-sovereign debt.

MSCI EAFE (DM) and MSCI Emerging Markets (EM) Indices are equity indices which capture large and mid-cap representation across 21 DM countries (excluding Canada and the U.S.) and 24 EM countries around the world.