Investment Strategy

Equities spotlight: Record profit margin: Is it sustainable?

• We believe that operating margins will remain elevated in 2022 despite potential above-average inflation and wage growth.
• The high margin level is consistent with our favorable views on the S&P 500 Index as well as on select cyclical and secular growth sectors.

Fixed Income: Powell taking note of inflation

• The Federal Reserve is highlighting inflation concerns and is likely to speed up the taper process.
• We currently favor investors continuing to play defense in their fixed-income positioning.

Real Assets: REIT guidance changes

• On November 24, we upgraded infrastructure (cell tower) real estate investment trusts (REITs) from neutral to favorable, downgraded lodging REITs from neutral to unfavorable, and initiated guidance on self-storage REITs at favorable.
• More details and a view of our latest guidance can be found in our Real Assets Quarterly Guidance report.

Alternatives: Yield alternatives are still in focus

• Nearly 14 years after the Global Financial Crisis, the need for alternative yield is as strong as ever.
• We have favorable views on several sources of alternative income, including Direct Lending private capital strategies as well as Relative Value hedge fund strategies.

Download the report (PDF)

Driven by the economic recovery and expansion in 2021, the S&P 500 Index corporate profit margin has increased to a record level. A similar dynamic was seen in prior economic expansion periods, when upticks in customer demand and company productivity translated into both earnings and margin growth. The improvement in margin this time was also widespread. As shown in Chart 1, compared to a year ago, both cyclical sectors (such as Financials and Energy) and secular growth sectors (including Information Technology) benefited. The only exceptions were defensive sectors, like Utilities and Consumer Staples.

Chart 1. Operating profit margin for the S&P 500 Index and sectorsSources: Bloomberg and Wells Fargo Investment Institute. The chart shows the operating profit margin for the S&P 500 Index as well as equity sectors. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

We believe that operating margins will remain elevated in 2022 despite potential above-average inflation and wage growth. Three reasons support our view:

• As a key driver to margins, we expect global economic growth to maintain a healthy rate in 2022. Although some events (for example, new COVID-19 variants) could trigger temporary economic disruptions, high consumer demand and business activity should support corporate fundamentals, including profitability.
• High-inflation periods have been infrequent in recent decades but have generally occurred when manufacturers found it difficult to keep up with surging consumer demand. As shown in Chart 2, the headwinds from higher input prices typically didn’t negate the tailwinds from economic growth as companies have been able to pass the higher cost to consumers. Furthermore, cyclical sectors generally are less impacted by the increases in input costs due to their input costs typically accounting for a smaller share of total costs. As many companies are working on easing the supply chain disruptions, we also believe the probability is low for an inflation-induced acceleration of the Federal Reserve’s plan to raise short-term interest rates from today’s near-zero rates.
• The recent spike in wage costs was largely driven by a shortage of labor supply for a number of industries. In the past, a higher-than-4% wage increase has typically been observed during a late economic cycle, when the economy has achieved full employment. Thus, the unavoidable higher wage cost to companies has been able to negatively impact margins. This time, the economic lockdown and the expanded unemployment benefits are unique drivers of the labor shortage. As more and more people rejoin the workforce, we believe wage growth will normalize to a slower rate.

Ultimately, a key support of high profit margins is the soothing of imbalances in the global supply chain, retail market, and workforce. We expect these factors to improve in 2022, supporting margins at record levels and maintaining healthy fundamentals for the S&P 500 Index. Furthermore, the record margin levels are consistent with our favorable views of select cyclical and secular growth sectors.

Chart 2. Average profit margin change during periods between 1990 and 2020 and in 2021Sources: Bloomberg and Wells Fargo Investment Institute. Data as of October 29, 2021. Cyclical sectors include Industrials, Financials, Energy, and Materials. Secular growth sectors include Information Technology and Consumer Discretionary. Defensive sectors include Health Care, Consumer Staples, and Utilities. Real Estate and Communication Services were not included due to short history or material membership change in recent years. High inflation periods are months: (1) between 1990 and 2020 (2) when year-over-year consumer price index change was above 3.5% (3) that did not overlap with recessions. High wage growth periods are months (1) between 1990 and 2020 (2) when the year-over-year wage increase was above 4% (3) that did not overlap with recessions. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

In recent comments to Congress, Federal Reserve (Fed) Chair Jerome Powell suggested that the central bank will consider speeding up the pace of tapering at the upcoming Federal Open Market Committee (FOMC) meeting. Chair Powell is no longer classifying inflation as transitory, suggesting that the Fed is becoming more concerned about the factors that are impacting higher prices. While these comments were prepared in advance of knowledge of how the new Omicron variant of COVID-19 could impact the economy and inflation trends, we expect that the Fed will announce a new, faster taper on December 15.

To date, fixed-income markets have handled tapering in an orderly manner, and we do not expect this trend to change, should tapering increase at a faster pace. A faster pace of tapering also suggests that Fed rate increases may be moved up if the risks of persistent higher inflation remain. The bands of uncertainty around a Fed rate hike(s) in 2022 have increased. Continued economic expansion coupled with more sustained inflation data could increase the timing and pace of rate hikes. However, the emerging Omicron variant may lead to more uncertainty in the growth outlook. Our current guidance is that the Fed will end tapering around March 2022, and will raise rates one time in 2022. However, the probability of multiple 2022 rate hikes is increasing.

We continue to expect the 10-year Treasury yield to trade in a range of 1.75%–2.25% by year-end 2022. In the context of a continuing economic recovery and still historically low yields, we continue to favor equities over fixed income, and have an unfavorable view on U.S. government securities. We believe income-seeking investors should maintain a neutral weighting in credit sectors such as U.S. investment-grade corporates, U.S. high-yield, and emerging market dollar-denominated debt. For more aggressive income-oriented investors, we currently have a favorable guidance view on preferred securities.

On November 24 we announced three real estate investment trust (REIT) subsector guidance changes. We upgraded infrastructure (cell tower) REITs from neutral to favorable, downgraded lodging REITs from neutral to unfavorable, and initiated guidance on self-storage REITs at favorable. Today, we highlight those changes and the rationale.

We had downgraded infrastructure REITs to neutral in February 2021 on deteriorating relative strength trends and a desire to lock in a strong run on our previous favorable call which lasted from 2019 to 2021. The downgrade proved to be a good move as the subsector underperformed to the tune of about 8% between our February downgrade and our November 24 upgrade. Infrastructure REIT relative performance had been hurt during this time by the reopening trade and market participants’ preference for REIT subsectors more closely tied to a booming economy. Yet, the long-term demand story of the buildout of the fifth generation (5G) network has not wavered. The recent underperformance improved valuations and, in our view, offered an attractive entry point and warranted an upgrade to favorable.

While leisure travel demand has improved significantly — and even has reached back to pre-pandemic levels — business travel demand will likely remain depressed for some time. We may be witnessing a secular demand shift. As the availability of, and familiarity with, virtual meetings surges, why pay employee travel costs — at least to the same extent as before? This uncertainty will likely weigh on lodging REITs for a lengthy amount of time even absent future COVID-19 waves. Lodging REITs had bounced strong on the recovery trade but that upside momentum appears spent — we expect the poor fundamental story to take back the performance driving reins. As a result, we downgraded lodging REITs from neutral to unfavorable.

On November 24, we also initiated coverage of self-storage REITs with a favorable rating. Both fundamentals and relative strength trends look attractive. The group enjoys all-time high occupancy, a net operating income outlook that seems to continually be increased, rapidly rising property values and slowed development pipelines. Self-storage REITs also operate on short-term leases which we believe are well-suited to capitalize on increasing inflation and interest rates which can weigh on other REIT subsectors more heavily.

More details and a view of our latest guidance can be found in our Real Assets Quarterly Guidance report (November 24, 2021).

The idea of alternative income has been a focus of ours since the aftermath of the 2008 Global Financial Crisis, when acronyms such as ZIRP (zero interest rate policy) and even QE (quantitative easing) were expected to suppress yields from traditional fixed-income assets. Almost 14 years later, the yield on the U.S. 10-year Treasury bond is nearly 75 basis points (0.75%) below the level seen in December 2008, making the need for alternative income even more important going forward.

Fortunately, there are a variety of alternative assets that can generate attractive yields. We continue to have a favorable view on Direct Lending strategies and will likely explore adding additional business development company (BDC) options going forward. Opportunities within real assets – such as Real Estate and Infrastructure – are also being explored. And of course we continue to provide avenues for exposure to leveraged loans, securitized assets, and convertible bonds within several of the relative value hedge funds.

For those qualified investors seeking income that have not yet considered alternatives, it is not too late.

Wide spectrum of yields across alternative, fixed income and equity assetsSources: BAML, Bloomberg, Cliffwater, FTSE, MSCI, and NCREIF. Data as of November 30, 2021 with the exception of the yield for Direct Lending which is as of June 30, 2021 as well as Farmland and Timberland which are as of September 30, 2021. Asset classes are represented by the following indices: Direct Lending (Cliffwater Direct Lending Index); BDC (Cliffwater BDC Index); Emerging market high yield (Bloomberg Emerging Markets USD Aggregate Bond Index); Farmland (NCREIF Farmland Property Index); Timberland (NCREIF Timberland Property Index); U.S. High Yield (Bloomberg U.S. Corporate High Yield); Leveraged Loans (S&P/LSTA U.S. Leveraged Loan 100 Index); Global Infrastructure (MSCI World Infrastructure Net Total Return USD Index); Global Public Real Estate (FTSE NAREIT Equity REITs Index); International Equity (MSCI AC World Ex-US); Securitized Assets (Bloomberg U.S. Securitized: MBS/ABS/CMBS); U.S. Investment Grade (Bloomberg U.S. Aggregate Corporate Investment Grade Bond Index); U.S. Equity (MSCI USA Index); and Global Convertible Bonds (Bloomberg Global Convertibles Composite Total Return Unhedged USD). 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.

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.

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. Preferred securities have special risks associated with investing. Preferred securities are subject to interest rate and credit risks. 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. 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. Investing in a Business Development Company (BDC) involves economic, credit and liquidity risks in addition to the special risks associated with investing in a portfolio of small and developing or financially trouble businesses. BDCs are exposed to high credit risk amplified through leverage. The use of leverage can magnify any price movements resulting in high volatility and potentially significant loss of principal.

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.

Bloomberg Emerging Markets High Yield Index is a flagship hard currency Emerging Markets debt benchmark that includes non-investment grade fixed and floating-rate US dollar-denominated debt issued from sovereign, quasi-sovereign, and corporate EM issuers.

Bloomberg Global Convertibles Composite Total Return Unhedged USD is an index that blends the three regional Bloomberg Barclays Convertibles Indices - the US Convertibles Index, the MEA Convertibles Index, and the APAC Convertibles Index - into a single global benchmark for the convertible asset class. The Global Convertibles Index is rules-based with an objective and transparent set of criteria used for index membership determination and rebalancing

Bloomberg U.S. Corporate High Yield Index covers the universe of fixed-rate, noninvestment-grade debt

Bloomberg U.S. Corporate Investment Grade Bond Index measures the investment grade, fixed rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility and financial issuers.

Bloomberg U.S. Securitized Index includes agency mortgage backed pass-through, investment-grade market of US Agency and US Non-Agency conduit and fusion CMBS deals and asset-backed securities.

Cliffwater BDC Index measures the performance of lending-oriented, exchange-traded Business Development Companies (BDCs), subject to certain eligibility criteria regarding portfolio composition, market capitalization, and dividend history. The CWBDC is a capitalization-weighted index that is calculated on a daily basis using publicly-available closing share prices and reported dividend payouts. The CWBDC Total Return Index includes two components: (1) Income Return and (2) Price Return.

Cliffwater Direct Lending Index seeks to measure the unlevered, gross of fee performance of U.S. middle market corporate loans, as represented by the asset-weighted performance of the underlying assets of Business Development Companies (BDCs), including both exchange-traded and unlisted BDCs, subject to certain eligibility requirements. The CDLI Total Return Index includes three components: Income Return, Realized Gain/Loss, and Unrealized Gain/Loss.

FTSE NAREIT Equity REIT Index is a market-capitalization-weighted index of all publicly traded REITs that invest predominantly in the equity ownership of real estate. The index is designed to reflect the performance of all publicly traded equity REITs as a whole.

MSCI All Country World ex US Index (MSCI ACWI ex-US) is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world. It consists of 46 country indexes comprising 23 developed and 23 emerging market countries.

MSCI USA Index is designed to measure the performance of the large and mid-cap segments of the US market. With 621 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the U.S.

MSCI World Infrastructure Net Total Return USD Index is a free float-adjusted market cap weighted index. Its members are infra owners and operators who tend to demonstrate highly inelastic demand patterns, stable, predictable returns and inflation-linked pricing power. Includes companies in the telecom, utilities, energy, transportation and social infra sectors.

Note: 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.

NCREIF Farmland Property Index represents data collected from the Data Contributing Members of the National Council of Real Estate Investment Fiduciaries (NCREIF). Such data, once aggregated, may not be representative of performance of the farmland property universe. In addition, the data is limited by the data collection process, including NCREIF’s changing membership and changing member portfolios. Membership requires that all eligible properties be reported.

NCREIF Timberland Property Index represents data collected from the Voting Members of the National Council of Real Estate Investment Fiduciaries (NCREIF). Such data, once aggregated, may not be representative of performance of the institutional property universe. Membership requires that all eligible portfolios be reported.

S&P/LSTA US Leveraged Loan 100 Index is designed to track the market-weighted performance of the largest institutional leveraged loans based on market weightings, spreads and interest payments.

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.