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Investment Strategy

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

June 21, 2021

John LaForge, Head of Real Asset Strategy

Ken Johnson, CFA, Investment Strategy Analyst

Peter Wilson, Global Fixed-Income Strategist

Justin Lenarcic, CAIA, Senior Global Alternative Investment Strategist

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Real Assets Spotlight: Oil — Demand is key

  • Slow demand growth could be the key to higher oil prices.
  • We are still expecting higher oil prices in 2021 and 2022.

Equities: Equity markets have room to run in 2022

  • We believe cyclical equity classes and sectors should continue to outperform if economic growth surges and monetary policy remains accommodative.
  • We believe investors should continue to lean into U.S. Large Cap Equities, U.S. Small Cap Equities, and Emerging Market Equities while maintaining allocations to U.S. Mid Cap Equities at strategic target weights.

Fixed Income: Inflation: Between “transitory” and “runaway”?

  • Despite the U.S. Treasury market’s benign reaction to recent inflation reports, the jury is still very much out on the medium-term inflation outlook.
  • Given our expectations of strong global growth, higher oil prices, and a weaker dollar, we believe it is reasonable to see medium-term inflation expectations returning to the 2.5%–3.5% regime that prevailed before 2014. This would be consistent with 10-year yields above 2.0%.

Alternatives: Corporates cleaning house as divestiture volume surges

  • Through mid-year, corporate divestiture volume already exceeds the 20-year average despite a continued decline in the number of deals.
  • As economic growth stabilizes and the post-coronavirus world takes shape, we could see a further increase in volume as well as the number of divestitures, which may bode well for Event Driven managers.

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Real Assets Spotlight

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Oil — Demand is key

“Get your facts first, and then you can distort them as much as you please”
--Mark Twain
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When trying to figure the short-term direction of oil prices, there are many pieces to the puzzle. It is rarely just as simple as matching current supply to current demand. We would love it if that were always the case because it would probably make predicting oil prices easier. Oil is the most used commodity globally, and many factors matter. Some of the other, bigger pieces to the oil price puzzle are sentiment, super cycles, interest rates, investor positioning, and geopolitics. The chart below, created by the New York Federal Reserve, breaks down the drivers of oil prices through time. Orange bars represent demand, gray bars represent supply, and purple bars represent all other pieces of the oil puzzle. Notice that through most of 2020, oil prices were driven by the other pieces of the oil puzzle (purple). This happened because oil prices had a hard time pinning down the true supply and demand mix at any given time. Now that things are getting back to normal in 2021, we can see more orange bars in Chart 1. This tells us that demand is slowly becoming a key driver of oil prices once again. We suspect that demand could be the key oil-price driver throughout 2021 and 2022.

Oil price driversOil price driversSource: Oil Price Dynamics Report, Federal Reserve Bank of New York. Data as of June 1, 2021.

We believe that demand will be the key driver because suppliers have a strong incentive to keep the status quo — to match current demand, but not much more. It is an ideal environment for suppliers. They know that global growth is coming, and with it oil demand, as global governments push to reach pre-coronavirus levels of demand. Demand growth, however, is just slow enough that it pays to be patient as a supplier. Flooding the market and trying to gain market share will likely not do a supplier any good. Suppliers are realizing that the more patient they are, the higher oil prices will likely go, and the more money that can be made. We believe oil prices should rise as long as global demand growth remains slow and consistent — oil suppliers have an incentive to match demand, but not much more.

This dynamic could be here to stay for a while. Global demand has recovered, but not to pre-coronavirus levels. We will use the U.S. fuel trends as an example in the chart below. It highlights U.S. demand for gasoline, jet fuel, and distillates (like diesel). Notice that since July 2020, demand for each fuel type has been slowly grinding higher, but has remained well below pre-coronavirus levels. Considering the amount of money being pumped into global economies these days by central banks, it is reasonable to expect that fuel demand should eventually trend higher than pre-coronavirus levels. The bottom line is that we believe oil demand and oil prices probably have a ways to run before they run out of fuel.

U.S. gasoline, jet fuel, and distillate demand versus the normU.S. gasoline, jet fuel, and distillate demand versus the normSources: Department of Energy, Bloomberg, and Wells Fargo Investment Institute. Weekly data: January 3, 2020–June 11, 2021. Demand data shown is a rolling four-week average which is then compared to the normal 2015–2019 average.
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Equity markets have room to run in 2022

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We recently introduced our 2022 equity earnings and price targets. We see the pace of earnings growth slowing for all equity classes but expect operating margins to climb as labor productivity improves and corporate pricing power firms. Even as corporate taxes rise in 2022, we believe supportive monetary policy, along with public and private spending, will push equity markets higher through the year. We expect earnings to drive returns in 2022. We estimate that earnings per share in the S&P 500 Index will increase to $220 in 2022. Rising interest rates could put downward pressure on price/earnings ratios in 2022. Our year-end median price target for the S&P 500 Index is 4,900.

Russell Midcap and Russell 2000 (small-cap) indices should see improved profitability due to stronger U.S. growth. We expect this earnings recovery to be key for U.S. Small Cap Equities — history (since inception) has shown that when the percentage of Russell 2000 Index non-earners has peaked, U.S. Small Cap Equities outperformed U.S. Large Cap Equities (as measured by the S&P 500 Index) over the following one-, two-, and three-year periods.

We believe that overseas firms will find additional support from the broader economic expansion and modest dollar weakness. However, Developed Market ex-U.S. Equities may be restrained by a moderate recovery in Japan. Nevertheless, it is our belief that both the MSCI Emerging Markets Index and MSCI EAFE Index targets have reasonable upside potential at current price levels and we remain favorable Emerging Market Equities.

2022 Equity Targets2022 Equity TargetsSource: Wells Fargo Investment Institute, June 16, 2021. Forecasts and targets are based on certain assumptions and on views of market and economic conditions which are subject to change. An index is unmanaged and not available for direct investment.
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Fixed Income

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Inflation: Between “transitory” and “runaway”?

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The May inflation report saw U.S. inflation at 5%, its highest rate in 13 years, yet U.S. Treasury bond participants shrugged and the 10-year yield pushed below 1.5%. We do not think that the debate is settled over whether the U.S. inflation outlook is “transitory”, as the Federal Reserve (Fed) insists, or something more akin to the “runaway” inflation of the 1970s. The reality may lie somewhere between these two extremes.

The current level of medium-term inflation expectations is actually close to the middle of the 1.5%–3.5% range seen this century. As the chart shows, inflation expectations stand at around 2.5%, near the cusp of two regimes — the broad 2.5%–3.5% range that prevailed before 2014, and the 1.5%–2.5% band seen since then. There are a number of reasons why inflation expectations slipped into a lower range about that time: the slump in the crude oil price with the advent of U.S. shale production; a stronger dollar, with the U.S. Dollar Index (DXY) trading in the 90–100 range compared to the levels around 80 seen previously; and growing disillusionment about central banks’ ability to combat disinflation as major quantitative easing programs globally showed few signs of success.

We believe conditions are in place for at least a partial reversal. We anticipate higher oil prices and a weaker dollar in 2022. The Fed’s current policy is explicitly aiming at inflation above 2.0% for a period of time. In this case, medium-term inflation expectations back in the higher 2.5%–3.5% range would be consistent with 10-year U.S. Treasury yields in a range around 2.5%, as we expect.

Inflation expectations can rise further without cause for alarmInflation expectations can rise further without cause for alarmSources: Bloomberg and Wells Fargo Investment Institute. Data as of June 15, 2021. TIPS = Treasury Inflation-Protected Securities. The five-year (5Y), five-year (5Y) forward inflation rate shown is derived from TIPS and represents an expected annual rate of inflation for the five-year period that begins in five years’ time. The DXY is a weighted average dollar exchange rate index against six major currencies with a base year of 1973, calculated by ICE Futures U.S. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.
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Corporates cleaning house as divestiture volume surges

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Historical trends indicate that corporate deal activity generally slumps in the throes of crisis, but then accelerates rapidly in the wake. This happens because balance sheets are often in a weakened state, economic growth is uncertain, and new secular challenges present themselves that affect sector and industry dynamics. Companies also try to take advantage of low borrowing rates — which normally coincide with dislocations — to either manufacture revenue or remove competition through mergers and acquisitions. This is one reason we have seen strong performance from Merger Arbitrage as well as Activist focused hedge funds; the opportunity set is extremely fertile.

Corporate divestitures also tend to increase post-crisis as management examines and considers shedding business units that may not be as profitable or as efficient going forward. We believe we are in the early innings of a similar trend and expect to see divestiture volume increase, especially if equity markets remain supportive. Interestingly, volume is already above the 20-year average despite the number of deals declining in recent years. This means that larger corporations are shedding business units. If we begin to see both an increase in volume and the number of deals, we would anticipate an even better environment for Event Driven managers than what already exists.

Divestitures on pace for record yearDivestitures on pace for record yearSource: Dealogic. Data as of June 17, 2021.

Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not appropriate for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.

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Risk Considerations

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Forecasts and targets are 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. 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.

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MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.

MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.

Russell Midcap Index measures the performance of the 800 smallest companies in the Russell 1000 Index.

Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.

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.

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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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