Peak China pessimism?
call out “Start where you are. Use what you have. Do what you can.”
– Arthur Ashe end call out
A number of policy, macro, and geopolitical headwinds have buffeted China and resulted in an exodus of investors and severe underperformance of China stocks over the past couple years. At nearly 30%, China is the single-largest country weight in our EM Equities benchmark — the MSCI Emerging Markets Index. Needless to say, our view on China heavily influences our rating on EM Equities overall. We have held an unfavorable rating on EM Equities for nearly two years. Is now the time to take that tilt off the table? Let’s discuss.
Macro
China is facing a number of well-known structural headwinds, not least of which is slowing growth brought on by the planned shift to a consumer-led economy, as well as the potential emergence of a middle-income trap. (A middle-income trap occurs when wage gains — and often debt levels — undermine an export-led economy’s global competitiveness before it can transition to consumer-led growth.) Additionally, policy errors — including regulatory uncertainties in technology and other highly visible parts of the economy — as well as labor disruptions tied to an abrupt slowdown in growth have conspired to keep consumer and business sentiment depressed.
Yet, lately, there have been some encouraging near-term developments. August saw China industrial production and retail sales growth jump above expectations. This follows efforts by the government to support a recovery, including cutting the cost of borrowing, reducing the stamp duty on stock transactions, and lowering down payment requirements for homes (and other policies to encourage home buying).
While we believe that these and other easing measures should certainly help, we believe they lack the potency of the monetary and fiscal stimulus China has unleashed during past downturns. We suspect that Beijing will remain reluctant to turn to that level of stimulus due to its need to balance economic stimulus against the risk of adding to local government debt.
Chart 1. The MSCI China Index has dropped over 50% since its 2021 peak 
Sources: Bloomberg and Wells Fargo Investment Institute. Daily data: February 17, 2021 to September 19, 2023. Indexed to 100 as of the start date. An index is unmanaged and not available for direct investment.
Past performance is no guarantee of future results.
Markets
China’s equity underperformance since February 2021 has been steep. In fact, the MSCI China Index is still down over 50% since its 2021 peak. For reference, the S&P 500 Index has returned a positive 18% during this time, despite experiencing a drawdown of over 20% in 2022 (see chart 1).
After such poor returns over such an extended period, there is a decent argument to make that markets have reached peak China pessimism. Yet, there are considerations that keep us from upgrading our unfavorable outlook on EM Equities — for now. Ongoing political risks from Chinese regulatory reform, increasing U.S.-China diplomatic and economic strains, and the potential for U.S. and European recessions in coming months are just a few. In this environment, we prefer to emphasize the relative quality of U.S. Large Cap Equities over the elevated risks and volatility we see in EM Equities. In fact, we believe the long-term track record of EM returns has left much to be desired (see chart 2).
Chart 2. EM equity returns have been poor over the past 16 years 
Sources: Bloomberg and Wells Fargo Investment Institute. Daily data: October 29, 2007 – September 19, 2023. U.S. stocks represented by the total return of the S&P 500 Index. EM stocks represented by the total return of the MSCI Emerging Markets Index. U.S. bonds represented by the total return of the Bloomberg U.S. Aggregate Index. An index is unmanaged and not available for direct investment.
Past performance is no guarantee of future results.
Yet, if events unfold as we forecast, an EM Equities upgrade may not be far off. EM Equities should underperform if, as we expect, the global economy slows into U.S. and eurozone recessions and the U.S. dollar attracts flows as a perceived risk haven. But once EM prices reflect these developments, we would look to pivot to a more favorable outlook on EM Equities, which historically have benefited from economic recoveries.
For now, however, we urge investors to stay patient and focus on quality in portfolios as the economic cycle rolls over. We remain unfavorable on EM Equities. We believe that for investors who find themselves with little or no exposure to EM Equities, however, the recent weakness may provide a potential opportunity to bring portfolio allocations to our recommended weights. Remember, an “unfavorable” rating does not mean a zero weighting.
Fed continues to reduce its balance sheet
In May 2022, the Fed announced that it would begin reducing its bond holdings. At each Federal Open Market Committee (FOMC) meeting since, the Fed reiterated that it would continue to reduce its holdings of Treasury securities, agency debt, and agency mortgage-backed securities. As the Fed reduces its holdings, market liquidity has been negatively impacted.
Earlier this year, we experienced the impact of reduced liquidity as several notable banks failed and sent equity markets into a temporary tailspin. Regulators quickly injected capital and stemmed the capital flight, but continued reductions in the Fed balance sheet have made markets susceptible to event risk. While difficult to predict, the possibility of a more challenging liquidity environment in bond markets could begin to emerge at any time. The risks of a bond market liquidity event also increases as we move through an economic slowdown and a potential recession as we expect.
Fixed income plays a vital role in many investors’ portfolios and is often used with the intention of reducing portfolio volatility. With this in mind, it is important for investors to understand the potential liquidity risks embedded in their fixed-income holdings. In an effort to help mitigate liquidity risks in fixed-income investments, investors can diversify portfolios, avoid overexposure to lower credit quality fixed-income classes, raise credit quality, and review individual liquidity needs with an investment professional.
If we experience a period of market stress, we believe there can also be opportunities for investors. Liquidity events may offer nimble market participants that are willing and able to withstand the volatility that occurs during these market shocks the opportunity to purchase some fixed-income securities at a notable discount to today’s prices. In a period of illiquidity and risk-off, investors may consider opportunistically adding to typically less liquid fixed income sectors and asset classes, such as high yield and preferred securities.
Fed balance sheet 
Source: Bloomberg. Data as of September 19, 2023.
Higher gasoline prices could stick around in 2023
Crude oil prices have been on a tear this summer. After spending much of the springtime bouncing between $65 and $75 per barrel, WTI crude hit $90 per barrel last week. The impact was seen in U.S. gasoline prices, which hit an average of $3.81 per gallon on September 18. This was the highest price seen this late in the summer since 2004 at a time when prices would typically roll over from less seasonal demand (see chart).
As expected, such a big move in gasoline prices has caught the attention of consumers, investors, and politicians alike. The White House, especially, has been commenting more regularly on the level of gasoline prices. President Biden recently made reference to the strain that higher gasoline prices have placed on family budgets, and that he will be “laser focused on cutting energy costs, including by investing in clean energy to bolster our energy security.”1
While some may find comfort in such pronouncements, we do not see energy prices coming down anytime soon, and we do not believe that there is much that the U.S. government can do about it. First, the rise in oil prices is global — driven by supply and demand globally — not only in the U.S. Second, the main driver of the recent move in oil prices is a lack of supply. While U.S. oil producers do have the capacity to increase supply, many producers remain hesitant as current U.S. policies incentivize renewable energy over fossil fuels. Third, we expect that investments in clean energy should not have any positive short-term impacts on energy prices. Lastly, the U.S. government will not have the Strategic Petroleum Reserve (SPR) to draw on in 2023, as it did in 2022, when it wanted to force gasoline prices lower. The SPR today sits at its lowest level since 1983.
The bottom line is that we do not see relief from high energy prices anytime soon in the U.S., and we believe there is not much the U.S. government can do about it.
Seasonality of gasoline prices 
Sources: Bloomberg, American Automobile Association, and Wells Fargo Investment Institute. Daily data is from March 1, 2004 – September 18, 2023.
1 “Statement from President Joe Biden on August Consumer Price Index.” White House briefing room statement. September 13, 2023.
Private infrastructure growth fuels secondary market
The private infrastructure primary market has experienced five-fold growth in fundraising over the past decade, driven by the sustained low interest rate environment and consistent uncorrelated outperformance relative to other asset classes. In recent years, institutional investors have increased their allocations to infrastructure, and alternatives generally.
This has led to notable expansion in secondary infrastructure investment opportunities, as the total addressable market has continued to grow and both limited partners and infrastructure sponsors have sought more regular liquidity. Other factors that have contributed to growth in the secondary infrastructure market are the secular trend of active portfolio management among global private fund investors and the proliferation of continuation funds, as underlying assets outlive finite fund structures.
In contrast to the market size growth and increasing supply of deals, buyer demand in the secondary infrastructure space has been limited by information disadvantages, restricted manager access, and lack of scale. In our view, this imbalance of supply and demand can result in potential opportunities for qualified investors to acquire high-quality infrastructure assets in mature, seasoned fund holdings at attractive valuations.
In addition to buyer-favorable conditions, we believe accessing infrastructure through the secondary market has the potential to offer several other advantages — elimination of blind pool risk, a shorter time frame to harvest investments, and higher current yield. There are also challenges — difficulty in obtaining information to value individual assets, lack of transparency from fund sponsors, and limited partners’ reluctance to publicly dispose of their commitment. Overcoming such hurdles requires extensive manager expertise, a strong industry network, as well as the ability to transact quickly, confidentially, and in all sizes. If executed well, a secondary infrastructure strategy may have the potential for qualified investors, in our view, to deliver outsized returns relative to its level of risk.
Primary infrastructure fundraising by vintage year from 2000 through 2022 
Sources: Preqin and Wells Fargo Investment Institute. Data as of September 20, 2023. Vintage year=year at which the portfolio investment held its first closing.
Past performance is not a guarantee of future results.
Secondary investments are interests in existing private equity funds that are acquired in privately negotiated transactions after the end of the private equity fund's fundraising period. Typically these funds have portfolios of existing investments as well as capital available for new investments. 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.
Cash Alternatives and Fixed Income
Most Unfavorable |
Unfavorable |
Neutral |
Favorable |
Most Favorable |
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- U.S. Intermediate Term Taxable Fixed Income
- High Yield Taxable Fixed Income
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- Cash Alternatives
- Developed Market Ex-U.S. Fixed Income
- Emerging Market Fixed Income
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- U.S. Taxable Investment Grade Fixed Income
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- U.S. Long Term Taxable Fixed Income
- U.S. Short Term Taxable Fixed Income
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Equities
Most Unfavorable |
Unfavorable |
Neutral |
Favorable |
Most Favorable |
|
|
- U.S. Mid Cap Equities
- Developed Market Ex-U.S. Equities
|
|
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Real Assets
Most Unfavorable |
Unfavorable |
Neutral |
Favorable |
Most Favorable |
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|
|
|
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Alternative Investments*
Most Unfavorable |
Unfavorable |
Neutral |
Favorable |
Most Favorable |
intentionally blank
|
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- Hedge Funds—Event Driven
- Hedge Funds—Equity Hedge
- Private Equity
- Private Debt
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- Hedge Funds—Relative Value
- Hedge Funds—Macro
|
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Source: Wells Fargo Investment Institute, September 25, 2023.
*Alternative investments are not appropriate for all investors. They 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. Please see end of report for important definitions and disclosures.