Investment Strategy

Equities spotlight: Equity positioning for year two of the bull market

• Historically, the strongest returns have occurred in the first year of an equity bull market. While the second year has typically produced positive, but lower gains, accompanied by higher volatility.
• We believe the cyclical trends that began in the first year of the 2020 bull market will continue in the second year, benefitting asset classes and sectors that are highly sensitive to the economic rebound.

Fixed Income: Corporate bonds: Strong issuance resumes in Q1

• Investment grade and high yield corporate fixed-income performance suffered in the first quarter (Q1), mostly impacted by rising rates. However, issuance continued to climb higher, supported by positive financial conditions.
• We believe investors should remain invested in investment-grade and high-yield corporates, as they should be able to provide better yield opportunities than less credit-sensitive fixed-income investments.

Real Assets: We could use more Earth Days

• Fossil fuels represent a commanding 86% of total global energy use today, versus 81% in 1970.
• Displacing fossil fuels while the world is still growing is a herculean task.

Alternatives: Distressed investing in current environment

• We anticipate opportunities for private debt, especially in those strategies employing distressed and special-situation strategies.
• We believe a key to successful investing is the ability to patiently deploy capital into situations where managers have the flexibility to invest in capital structures that are under pressure or where secular challenges are likely to exist.

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Since the bear market bottom on March 23, 2020, global equity markets have surged higher. Over the past year, all equity classes have rallied, with the U.S. outperforming international markets, emerging outperforming developed markets, and smaller capitalization stocks outperforming large-cap stocks. These patterns are not unusual as the beginning of bull markets have often favored high-beta (more market sensitive) stocks, like small caps. While the gains have been eye-popping (in some cases over 100%), investors should not expect a repeat in the second year of the bull market.

Historically, the strongest returns have occurred in the first year of a bull market. The second year has typically produced positive — but lower — gains, accompanied by higher volatility. The average return for the S&P 500 Index in the first 12 months of the past 11 bull markets was 42%. The first year of the 2020 bull market was up a record 75%, just edging the first year of the 2009 bull market, which was up 69%. The average return for the S&P 500 Index during the second year of previous bull markets is a respectable 12.7%, with all 10 prior instances positive. The average drawdown (the peak-to-trough decline of an investment over a given time period) in year two was -9.8%.¹

S&P 500 Index performance in years one and two of bull marketsSources: Wells Fargo Investment Institute, Bloomberg. Data includes the 10 bull markets from 1957-2020. The timelines considered for drawdowns are months 13-24 of previous bull markets from 1957-2009.An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Early phases of the economic expansion can be the most bullish period for highly cyclical stocks (i.e. small caps and emerging markets). An environment with ample fiscal stimulus and a highly accommodative Federal Reserve tends to favor economically sensitive asset classes and sectors. In fact, historically, the second year of bull markets has seen leadership from Financials (as the yield curve steepens) and Industrials (as manufacturing sentiment improves).

Another trend often seen in the second year of bull markets is price-to-earnings (P/E) multiple compression. In 2020, many companies reduced expenses, creating significant operating leverage that should boost earnings in 2021. We anticipate S&P 500 Index earnings per share will grow by more than 30% this year with cyclical sectors such as Industrials, Consumer Discretionary, Materials, and Financials leading the way. While 2020 equity market returns were driven mainly by P/E multiple expansion, we expect 2021 performance to be driven by robust earnings growth. With earnings growth expected to outpace price growth, we look for multiples to recede.

Investment implications

A barbell market capitalization approach – Small caps are highly cyclical and have historically performed well in the early stages of new bull cycles. The first year of this cycle has been no different, with small caps leading the way. While the first year is typically a time of price recovery, the second year is mainly about an earnings recovery. This is key for small caps, with history (the last three bull markets) showing when the percentage of Russell 2000 Index non-earners has peaked, small-caps outperformed large caps (as measured by the S&P 500 Index) over the following one-, two-, and three-year periods. Even so, large caps remain a favored asset class as they are higher in quality, less volatile, and have tremendous earnings power. This was evident during the recent correction in the Russell 2000 Index when the S&P 500 Index significantly outperformed, offering stability and remaining near its record high. We maintain our favorable guidance on U.S. large- and small-cap equities.

Emerging over developed – We expect a broader trade recovery, a weakening U.S. dollar, higher commodity prices, and the COVID-19 vaccine to be tailwinds for emerging market equities over the next 12 months. Earnings expectations have risen dramatically over the past 6 months, and forecasted 2021 growth ranks second behind small caps. Emerging market equities have outperformed developed market equities in the early innings of past recoveries and we expect this dynamic to play out in this recovery as well. We believe recent weakness in China and U.S. dollar strength has provided an opportunity to add exposure to an area that is often underrepresented in portfolios.

Lean into cyclical sectors – Over the past 6 months, our sector guidance has shifted to areas that have tended to thrive in the early stages of economic recoveries. This includes upgrading Financials, Industrials, and Materials to favorable and Energy to neutral. We’ve also downgraded defensive sectors, such as Consumer Staples, Health Care, and Utilities. As noted above, cyclical sectors have historically maintained leadership in the second year of bull markets. We expect similar results this year and recommend investors put new money to work in our recent upgrades first (i.e. Financials, Industrials, and Materials) followed by Communication Services, Consumer Discretionary, and Information Technology.

Rising U.S. Treasury yields took the spotlight in the first quarter (Q1) as yields increased at the fastest pace over the past 60 years. Performance of investment grade (IG) corporate fixed-income markets suffered the most during the quarter, given their longer duration (a measure of a bond’s interest-rate sensitivity). High-yield (HY) bonds managed to display slim positive performance, mostly helped by the decline in corporate spreads. Fund flows were mixed, as flows towards IG bonds remained relatively flat while HY suffered some outflows.

Despite the lack of performance, issuance continued to climb higher during the quarter. Both IG and HY issuance soared, supported by the benign financial conditions currently available in the market and the strong investor appetite for credit risk. In March, we published a Fixed Income In Depth report about the continued corporate borrowing boom.² We noted that credit conditions remain favorable for corporate borrowers, and although the amount of debt outstanding is high, the growth in debt still has room to run.

Many firms have managed to refinance their debt, effectively extending their maturities and lowering their interest expense. We anticipate this should create a positive backdrop for firms to focus on increasing profits for the remainder of the year without worrying too much about higher debt-service payments, despite the higher share of debt. We believe investors should consider IG and HY corporates, as they are expected to be able to provide better yield opportunities than less credit-sensitive fixed-income investments.

Corporate bond issuance climbs higher in Q1Sources: Wells Fargo Investment Institute, SIFMA, March 31, 2021.

In 1969, California was ravaged by one of the worst oil spills in history. Roughly 3 million gallons of oil gushed from a well off the coast of Santa Barbara, killing thousands of marine life. This event sparked the green movement we know today, and the first ever Earth Day. Celebrated each year about this time, Earth Day has evolved into a global day of reflection, education, and action to honor the planet we all inhabit. The 51st consecutive Earth Day will be celebrated next week, on April 22.

Daily national celebrations are nothing new in the U.S. We celebrate everything from penguins to puzzles to presidents. We’re not here to judge, but to simply say we could probably use a few more Earth Days. We say this because the world’s addiction to fossil fuels has grown worse since 1970. Fossil fuels represent a commanding 86% of total global energy use today, versus 81% in 1970.

We’ve heard for years that fossil fuel use will soon die. Based on what we see in the chart below, we’re not as convinced. As this planet’s populations and economies have grown, so has total energy use and per-person energy use. Renewables have been fighting the good fight in recent years, but displacing fossil fuels while the world is still growing is a herculean task. If the red line (representing total renewables) in the chart could talk, it might say something like, “Please go celebrate Earth Day on April 22! And while I have a voice, who’s up for replacing National Bubble Wrap Day with a second Earth Day?”

World energy consumption by fuelSources: Bloomberg, BP Statistical Review of World Energy, Our World In Data, Wells Fargo Investment Institute. Yearly data: 1800 – 2018. Total renewables includes hydro, geothermal, wind, solar, and biomass primary energy consumption.

A little over a year has passed since the nadir of the coronavirus crash, and we are still trying to understand the implications on the credit cycle. Interest rates remain low, and default rates and distress ratios have normalized and ended 2020 near their long-term averages. Accordingly, global credit and equity markets have staged a dramatic rebound since last year, when the Federal Reserve first took unprecedented steps to steady the economy amid the pandemic. The move undoubtedly shrunk the amount of distressed debt outstanding and propped up companies that were ailing even before the pandemic hit.

But have we really experienced the natural cleansing that occurs through a normal default cycle? To some pundits, the proverbial can has once again been kicked down the road, especially considering the amount of debt issued in 2020. As the chart shows, U.S. companies now face the highest levels of debt on record — more than $10.5 trillion.³ So-called ''zombie companies,'' firms that are in debt to the point of needing bailouts to survive, have been rising steadily since the 1990s — that is, until pandemic-induced lockdowns took place. Those events caused the number of zombies to skyrocket, creating more than 600 zombie corporations (out of 3,000 large companies) with $2.6 trillion in debt.⁴

While it’s difficult to get a consensus view on where we are in the credit cycle, one thing is certain: some sectors and industries will emerge as winners, and others as losers. Importantly, the Federal Reserve's effort to stave off a rash of bankruptcies by purchasing corporate bonds might very well have prevented another depression. But in helping hundreds of ailing companies gain virtually unfettered access to credit markets, policy makers may inadvertently be directing the flow of capital to unproductive firms, depressing employment and growth for years to come. Finally, if 2020 is indicative of past financial crises, now may be an opportune time for qualified investors to consider private capital distressed debt strategies that can patiently deploy assets over the next three to five years.

Outstanding U.S. corporate bonds since pandemicSources: Federal Reserve, Securities Industry and Financial Markets Association (SIFMA), Wells Fargo Investment Institute. February 2021.

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.

¹ Year 2 data includes the 10 bull markets from 1957-2009. The timelines considered for drawdowns are months 13-24 of previous bull markets from 1957-2009.

² “The corporate borrowing boom - no end in sight”, March 4, 2021.

³ Federal Reserve, SIFMA. Includes Debt obligations of U.S. financial and nonfinancial corporations including bonds, notes, debentures, mandatory convertible securities, long-term debt, private mortgage-backed securities, and unsecured debt. Includes bonds issued both in the United States and in foreign countries, but not bonds issued in foreign countries by foreign subsidiaries of U.S. corporations. Recorded at book value.

⁴ Bloomberg.

Forecasts 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 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.

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.

Russell 3000 Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.

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.