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Investment Strategy

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

September 28, 2020

Tracie McMillion, CFA, Head of Global Asset Allocation Strategy

Chris Haverland, CFA, Global Asset Allocation Strategist

Brian Rehling, CFA , Head of Global Fixed Income Strategy

John LaForge, Head of Real Asset Strategy

James Sweetman, Senior Global Alternative Investment Strategist

Asset Allocation spotlight: The easy gains are likely behind us

  • Investors are much more worried about the economic recovery than the equity market’s performance.1
  • Both the U.S. equity market and the U.S. economy suffered significant declines and sizable rebounds over the past two quarters, and both should see more modest growth in the coming quarters.

Equities: Is this a garden variety pullback?

  • After a strong rally in August, the S&P 500 Index has declined by nearly 10% in September.
  • While there could be additional volatility through the election, this appears to be a garden variety pullback that provides a great opportunity to rebalance portfolios.

Fixed Income: The Federal Reserve forces tough decisions

  • Federal Reserve (Fed) projections suggest short-term rates will remain at the lower zero bound for years.
  • In this difficult environment, we look at actions investors in search of yield can consider.

Real Assets: We’re buyers of gold

  • Gold’s record 2020 run was due to correct some. The recent U.S. dollar rally is partly to blame.
  • Fundamentals still look solid, and we remain gold buyers.

Alternatives: M&A down significantly year-over-year but showing signs of recovery

  • Global mergers and acquisitions (M&A) volumes are down 35% year-over-year, but there has been a noticeable pickup in activity over the last several months.
  • While M&A activity appears to be out of sync with public equity markets, we believe — heading into year end — volumes will increase due to rise of special purpose acquisition companies (SPACs), with focus on the technology sector.

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Asset Allocation spotlight

The easy gains are likely behind us

In mid-August, we surveyed investors to gauge their optimism about the economy and the markets.2 In the midst of what will likely turn out to be the biggest quarterly gain in the history of the U.S. economy, 71% of investors said they were worried about economic growth, while only 6% said they were worried about the equity market’s performance. The survey was taken before the recent stock market correction, but illustrates the point that investors have seen U.S. large cap equities recover more quickly than the economy. In fact, even with the expected large third quarter gain, U.S. economic activity may not rise to pre-pandemic levels until the end of 2021 or possibly 2022.3

The U.S. equity market has rebounded more quickly than the U.S. economyThe U.S. equity market has rebounded more quickly than the U.S. economySources: Wells Fargo Investment Institute, Wells Fargo Securities, and Bloomberg. Data as of 9/21/2020. Third quarter 2020 - first quarter 2021 data are WFII 2020 year-end S&P 500 Index estimates as shown by the blue dash. E=estimate. U.S. GDP = GDP CHWG Index: Gross domestic product (GDP) measures the final market value of all goods and services produced within a country. It is the most frequently used indicator of economic activity. The GDP by expenditure approach measures total final expenditures (at purchasers' prices), including exports less imports and adjusted for inflation. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

The survey highlighted investors’ concerns about future economic growth, with two-thirds saying that the economy will experience at least one more downturn before fully recovering. Their concern was corroborated by Federal Reserve (Fed) Chairman Jay Powell last week when he noted that “both employment and overall economic activity remain well below their pre-pandemic levels and the path ahead continues to be highly uncertain.”4

Our expectation is that U.S. economic growth will moderate but remain positive. The slowdown in the growth rate, concerns about a new wave of coronavirus cases, and uncertainty surrounding the upcoming elections are likely contributing to investor’s uneasiness. We believe that investors will soon begin to look through the fears of the current quarter to the first half of 2021 — a period where we expect to see better news regarding the virus and less geopolitical uncertainty than we are experiencing today.

Moderate economic growth should support overall earnings growth and potentially push equity prices higher by year end. Indeed, our year-end estimate for the S&P 500 index is 3,580, approximately 8.5% higher than prices on September 25, 2020. Current prices and our economic forecast have us favoring U.S. large cap and U.S. mid cap stocks in the near term. Additionally, we suggest that investors maintain their long-term target allocations to the broad asset groups of equity, fixed income, real assets, and alternative investments. Should the economy grow modestly in the coming quarters as we expect, interest rates may also begin to move a bit higher, placing some pressure on bond prices. Even so, we continue to believe that bonds can act as a stabilizer during periods of market declines, and we would maintain allocations to most fixed-income asset classes. At present, we prefer high-yield bonds to short-term investment-grade bonds. In real assets, we suggest a modest tactical allocation to commodities and favor gold within the commodities complex. Hedge funds can provide a buffer to market volatility by providing access to trading strategies that are less correlated with traditional asset classes, thereby providing some diversification benefits to investors for whom this asset class is appropriate. Private capital is another attractive area for qualified investors, as these asset classes can provide an illiquidity premium relative to public markets over the longer term.5

While investors understandably are nervous about the events of the coming months, we believe it is important to look through the near-term uncertainty to potentially positive developments in the coming quarters. This means keeping target weights to broad asset groups steady through rebalancing into market volatility. The easy gains of this cycle in the U.S. equity markets are likely be behind us, but we anticipate equities should continue to be the growth driver in allocations in the coming years.



Is this a garden variety pullback?

After reaching a record high on September 2, the S&P 500 Index declined nearly 10% through September 23. An August rally that appeared to be fueled by excitement over large company stock splits quickly crumbled as investors acknowledged prices became somewhat dislocated from fundamentals. Rising coronavirus cases in Europe, the lack of a new fiscal stimulus package in the U.S., and renewed election uncertainty also weighed on equity markets in the month.

Defensive sectors, such as Utilities and Consumer Staples, outperformed during the pullback. Energy was the worst-performing sector and has been all year. Meanwhile, sectors that have heavy weights to mega-cap technology stocks (Information Technology and Communication Services) also underperformed the broader benchmark.

Modest pullbacks of 5-10% are typically called “garden variety” as they are commonplace in equity market investing. In fact, since 1928, the S&P 500 Index has averaged 3-4 of these kinds of downdrafts per year. The September decline was the fourth of this magnitude since the bear market bottom in March. Although some pullbacks turn into full-blown corrections (down 10-20%), the majority stay on the modest side and end just over a month after beginning.

It’s difficult to declare an end to an equity market pullback, especially heading into an election. Further downside is possible from a technical perspective. However, many signs from interest rates, credit markets, and options markets are signaling the worst may be behind us. Given that we have entered a new bull market for equities, garden-variety pullbacks could be viewed as buying opportunities and a great time to rebalance portfolios.

S&P 500 Index pullbacks since the March bottomS&P 500 Index pullbacks since the March bottomSources: Wells Fargo Investment Institute, Bloomberg, September 24, 2020. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Fixed Income

The Federal Reserve forces tough decisions

The Fed has indicated that short-term rates are expected to remain at historically low levels for years to come. While longer-term rates may show a gradual upward bias, we do not anticipate significantly higher rates further out the curve. Such an environment poses challenges for fixed income. The lack of yield — especially in higher-quality fixed-income securities — can force investors to make difficult decisions between risk and yield. While there are no easy answers to this yield challenge in the current market, there are some actions investors can consider.

Moving down the credit spectrum is a viable strategy to increase yield, but it must be done with caution. We recommend investors use active management when purchasing lower-quality investments. We are currently favorable on both credit and the high-yield asset classes.

Investors may find somewhat higher yields, longer duration, and more equitylike characteristics in preferred securities, which we currently rate as favorable. While higher-yield expectations in preferred securities may be desirable for many investors, this sector can exhibit unusually high volatility during times of stress. Investors should purchase income in this sector with a buy-and-hold mentality.

In order to boost return, investors may consider using bonds to rebalance into equities. In other words, when equity prices fall, investors might consider lightening bond positions to generate cash with which to put into comparatively cheaper equities.

While yields are currently very low, for those looking to invest in money market funds, we continue to favor government funds over Treasury funds, given that government funds have more flexibility based on the types of securities in which they can invest.


Real Assets

We’re buyers of gold

“The individual activity of one man with backbone will do more than a thousand men with a mere wishbone.”
--William J.H. Boetcker

After a great seven-month run, gold cooled off in August and September. Gold spot prices today sits about $200 lower than its all-time high of $2,075, per ounce set in August. We believe that this 10% pullback is partly due to froth and partly due to the U.S. dollar (chart).

From the froth perspective, gold’s 37% year-to-date rally through the August 7 high had been quite dramatic. It was warranted, but dramatic nonetheless. Only five times since 1980 has gold seen 37%+ rallies in such a short amount of time. These types of rallies are hard to hold onto, and gold was due to cool off some.

The U.S. dollar likely had an impact on gold’s recent correction, too. It had been fading most of 2020, through August, which helped gold jump to its record highs. Starting in early August, though, the U.S. dollar stopped moving lower. And in recent weeks, it has even started moving higher.

In the end, we remain gold bulls, as the fundamental backdrop looks good. Interest rates remain low, money supplies excessive (quantitative easing), and we are doubtful that the U.S. dollar’s September rally has long legs. We view gold at these prices as a good buying opportunity and, as evidenced by our 2021 year-end targets, expect higher gold prices.

Gold versus the U.S. dollarGold versus the U.S. dollarSources: Bloomberg, Wells Fargo Investment Institute. Daily data: September 23, 2019 - September 23, 2020. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.


M&A down significantly year-over-year but showing signs of recovery

Due to abundant concerns regarding world health, politics, and economic activity, global M&A activity volumes are down 35% year-over-year, and 2020 has the weakest first eight months since 2013 (see chart). Difficulty in conducting due diligence and lack of pro forma visibility added uncertainty to merger processes and caused activity to drop precipitously. Accordingly, U.S. consumer confidence fell for the second straight month in August to its lowest levels in six years over concerns about the fragile economic recovery and an uncertain job market.

While the pause button on mergers has been pressed, recent activity indicates that the M&A space appears to be showing early signs of a rebound. In August, North America recorded its highest monthly M&A volumes since October 2019 as the number of $1 billion+ deals increased for the fourth consecutive month, and for the first time this year. SPAC-related M&A activity continues to rise to the highest levels ever, contributing $43 billion of global M&A volume year-to-date with technology targets accounting for majority of SPAC mergers. Finally, Private Equity sponsors announced 17 $1 billion+ M&A deals in August, the strongest since February.

While many of these uncertainties remain entering the last four months of 2020, we are encouraged that the recent surge in global M&A volumes will continue. We believe this will be driven by the Technology sector due to the boost triggered by the pandemic compelling companies to adjust to changing consumer habits in order to gain market share. These efforts would likely lead to consolidation across various sectors of the market.

Global M&A deal volume down significantly in 2020Global M&A deal volume down significantly in 2020Sources: Dealogic, through August 31, 2020.

1 Wells Fargo Gallup Investor Optimism Survey, August, 2020.

2 Wells Fargo Gallup Investor Optimism Survey, August, 2020.

3 Congressional Budget Office, Economic Projection Gross Domestic Product, as of September 21, 2020.

4 Jerome Powell, House Financial Services Committee Testimony, September 22, 2020.

5 Liquidity premium is the excess return relative to the public market that historically has been generated to compensate investors for holding assets that cannot be easily traded.

Risk Considerations

Forecasts are not guaranteed and based on certain assumptions and on views of market and economic conditions which are subject to change.

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. There are special risks associated with investing in preferred securities. Preferred securities are subject to interest rate and credit risks. Interest rate risk is the risk that preferred securities will decline in value because of changes in interest rates. Credit risk is the risk that an issuer will default on payments of interest and principal. Preferred securities are generally subordinated to bonds or other debt instruments in an issuer's capital structure, subjecting them to a greater risk of non-payment than more senior securities. In addition, the issue may be callable which may negatively impact the return of the security. Preferred dividends are not guaranteed and are subject to deferral or elimination. 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 appropriate 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.

Sector Risks

Sector investing can be more volatile than investments that are broadly diversified over numerous sectors of the economy and will increase a portfolio’s vulnerability to any single economic, political, or regulatory development affecting the sector. This can result in greater price volatility. Communication services companies are vulnerable to their products and services becoming outdated because of technological advancement and the innovation of competitors. Companies in the communication services sector may also be affected by rapid technology changes; pricing competition, large equipment upgrades, substantial capital requirements and government regulation and approval of products and services. In addition, companies within the industry may invest heavily in research and development which is not guaranteed to lead to successful implementation of the proposed product. Consumer Staples industries can be significantly affected by competitive pricing particularly with respect to the growth of low-cost emerging market production, government regulation, the performance of the overall economy, interest rates, and consumer confidence. The Energy sector may be adversely affected by changes in worldwide energy prices, exploration, production spending, government regulation, and changes in exchange rates, depletion of natural resources, and risks that arise from extreme weather conditions. Risks associated with the Technology sector include increased competition from domestic and international companies, unexpected changes in demand, regulatory actions, technical problems with key products, and the departure of key members of management. Technology and Internet-related stocks, especially smaller, less-seasoned companies, tend to be more volatile than the overall market. Utilities are sensitive to changes in interest rates, and the securities within the sector can be volatile and may underperform in a slow economy.

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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