Investment Strategy

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

Equities | Fixed Income | Real Assets

October 22, 2018

Brian Rehling, CFA , Co-Head of Global Fixed Income Strategy

Short-Term Pain for Longer-Term Gain

Key Takeaways

  • As U.S. bond yields rise, fixed-income investors may be feeling some “short-term pain” as they review recent performance.
  • Yet, bonds held to maturity typically have positive returns (barring a credit event or default). Further, rising rates can offer fixed-income investors the potential for “long-term gain” by raising coupon levels and returns in the long term.

What it May Mean for Investors

  • We recommend that investors remain well-diversified; favor shorter-term securities over longer-term issues; and move up in credit quality.
  • A bond ladder or active management often can help fixed-income investors to capitalize upon rising interest rates more effectively.1

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Many fixed-income investors have focused on the recent interest-rate increase and the potential for further yield increases (and rightfully so). Year-to-date (YTD) performance in fixed-income markets has been poor, almost across the board. As of October 12, the Bloomberg Barclays U.S. Aggregate Bond Index2 had a total YTD return of -2.05%. For longer-term U.S. bonds, the index performance has been even worse, as the Bloomberg Barclays U.S. Aggregate 10+ Year Bond Index had a total YTD return of -6.83%. But higher rates are not all bad for fixed-income investors. First, an investor who holds a bond to maturity will continue to receive their expected cash flow (unless there is a credit event or default). Second, the recent U.S. yield increase should help to push future yields higher for fixed-income investors.

Yields tell a story

Fixed-income investors have long been attracted to yield, because “yield” typically is a good proxy for cash flow—which is precisely what investors are seeking to generate sustainable income for living expenses or other funding needs. But beyond simple cash-flow needs, the prevailing yield in high-quality fixed income also has another use for investors; it historically has been quite good at predicting total return performance over longer time periods. This is especially true of high-quality fixed income classes.

Using Bloomberg Barclays U.S. Aggregate Bond Index data starting with its inception in 1976, we analyzed its total return over a period of years—and how much of that return could be forecasted by the prevailing yield level. Over the past 40 years, the current yield was a very strong indicator of future returns for the Bloomberg Barclays U.S. Aggregate Bond Index. We found the strongest correlation to the initial yield level was near the five-year average total return of this index. Other factors may contribute to an understanding of yield and return; thus, this analysis may not be indicative of future results (and multiple factors need to be considered when assessing yield and return analysis).

The average variation between the initial yield and the ensuing annualized five-year, total return is just 0.37% since the inception of the Bloomberg Barclays U.S. Aggregate Index in 1976. The yield of the investment-grade, taxable holdings in the Bloomberg Barclays U.S. Aggregate Index was 3.57% on October 15, 2018. This represented an increase from a yield low of 1.61% in September 2012 and just 2.55% a year ago. We believe that the recent yield increase should add to future fixed-income returns for taxable investment-grade issues overall. Based on this yield model alone, we believe that investors in a well-diversified, investment-grade, taxable bond portfolio may experience low single-digit average yearly total return over the next five years. Let’s look at this analysis visually in Chart 1.

Chart 1. Bloomberg Barclays U.S. Aggregate Index—initial yield at inception versus five-year annualized total return as of July 2018Bloomberg Barclays U.S. Aggregate Index—initial yield at inception versus five-year annualized total return as of July 2018 Sources: Bloomberg, FactSet, Wells Fargo Investment Institute; October 16, 2018. Index return information is provided for illustrative purposes only. Index returns do not represent investment returns or the results of actual trading nor are they forecasts of expected gains or losses a portfolio might experience. Index returns reflect general market results, assume the reinvestment of dividends and other distributions, and do not reflect deduction for fees, expenses or taxes applicable to an actual investment. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. Current performance may be higher or lower than the performance quoted above. Yields and returns will fluctuate as market conditions change.

Predictably, the relationship between yield and total return loses its strong historical correlation as one moves down in credit quality. Thus, we would not suggest that investors use a similar model in the high-yield debt class. The higher default rates inherent in lower-credit-quality securities have pushed five-year total returns below current yields during most periods (historically). As of October 12, 2018, the Bloomberg Barclays U.S. Corporate High Yield Index yielded 6.58%.

Investor implications

Our analysis implies that investors in investment-grade debt may potentially experience modest, but positive, total returns overall in the near term (barring a credit event or default). Yield tells a story, and its relevance to performance is significant.

While return expectations should be set relatively low for taxable investment-grade debt going forward, owning bonds in a portfolio should not be all about return. Fixed-income holdings can play an important role in many portfolios, by providing an investor with diversification, by lowering volatility, and by providing liquidity.

Both recent and longer-term history has shown that high-yield allocations have the potential to be far more volatile than traditional investment-grade security holdings. We currently have an unfavorable view of the high-yield debt class, and we suggest investors avoid the temptation to “reach for yield” as valuations are relatively expensive in the below-investment-grade space. We recommend moving up in credit quality within the high-yield universe and in fixed-income portfolios overall.

Additional yield increases in the future may lead to short-term pain for investors’ fixed-income portfolios (particularly relating to market-price trends at the index or individual security level). But investors should remember that, over time, that pain could be turned into investment gains as those higher yields can help boost future coupon (and overall bond) returns. In summary:

  • We recommend maintaining duration at levels below individually-selected benchmarks in fixed-income portfolios, given the relatively flat Treasury yield curve and our expectation for modestly higher interest rates.3
  • We remain unfavorable on the high-yield debt class, given expensive valuation and an asymmetric risk/return profile.
  • In our view, investors should look for opportunities to move up in credit quality and focus on maintaining a well-diversified portfolio that is not overly concentrated in any one name, sector, or asset class. It is important to remember that diversification does not guarantee investment returns or eliminate risk of loss.

Equities

Scott Wren, Senior Global Equity Strategist

A brighter outlook ahead for the Financials sector

The Financials sector has outperformed the S&P 500 Index since July 2016, but the road from there to current levels has been anything but smooth. In fact, since the end of February 2018, this sector has underperformed as doubts about the level of loan demand and a flattening yield curve (a flattening yield curve means that the difference between short-term and long-term bonds is decreasing) have worried investors (see chart below). Net interest margin has been squeezed in recent years as the yield curve has flattened. Keep in mind that Financials typically outperform from the halfway point of a recession into the middle portion of the cycle as the yield curve steepens. Of course, the current cycle can be categorized as anything but typical. In addition, since this sector represented “ground zero” for the financial crisis, consistent early cycle outperformance simply did not occur as some of the largest-cap companies in the sector paid large fines totaling billions of dollars

But our forward outlook from here is more positive. We recently upgraded the Financials sector to most favorable from our previous favorable rating. From a valuation perspective, this sector rates best among the 11 sectors, based on our methodology. The total yield (dividend yield plus buyback [share repurchases] yield) is expected to be robust.

From a quality perspective, the narrowness of consensus earnings forecast dispersion shows that analysts covering the individual companies within the sector have confidence in their forecasts. More certain growth is important later in the cycle.

Key takeaways

  • The Financials sector recently has underperformed, but valuations have reached compelling levels, and our forward outlook for this sector is positive.
  • We have a most favorable view of Financials as we see tailwinds from continued economic growth, the new tax code, rising rates, and increased loan demand.
Financials recently have had a rocky road, but our forward outlook is positiveFinancials recently have had a rocky road, but our forward outlook is positiveSources: FactSet, Wells Fargo Investment Institute, October 17, 2018. Index return information is provided for illustrative purposes only. The S&P 500 Sector Indices measure the performance of the widely-used Global Industry Classification Standard (GICS®) sectors and sub-industries. Each index comprises those companies included in the S&P 500 that are classified as members of their respective GICS sectors. The S&P 500 is a market capitalization-weighted index generally considered representative of the US stock market. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Fixed Income

Luis Alvarado, Investment Strategy Analyst

The return of normal bond-market volatility

Over the past two weeks, volatility has returned to the bond markets. The Treasury yield curve tends to steepen (longer-term rates moving higher than shorter-term rates) when volatility occurs. This time was no exception. Over the past five years, there have been other instances when bond-market volatility has increased as the 10-year Treasury yield rose (see yellow circles in chart). In three of those cases, volatility remained above its five-year average for several months after the initial Treasury yield increase. If U.S. bond yields continue an upward trend, this likely will cause some additional pressure on prices, particularly on the long end of the yield curve.

Bond-market volatility had been trending below normal for much of this year. Yet, as central banks continue down the path of rate normalization, we anticipate a return to more normal bond-market volatility (we expect the Federal Reserve (Fed) to raise rates again in December). In such an environment, it is likely that investors will be subject to more meaningful yield moves, both higher and lower. In our opinion, investors should be prepared for a return to normal bond-market volatility, rather than the below-normal environment that we recently have experienced.

Key takeaways

  • By recognizing that interest-rate volatility is a normal part of bond-market trading patterns, investors can be more prepared when the inevitable periods of volatility occur.
  • We are favorable on short-term fixed income and most unfavorable on long-term fixed income. We see better risk/return opportunities in shorter maturities than in longer-maturity issues.
Expect increased bond-market volatility as yields riseExpect increased bond-market volatility as yields riseSource: Bloomberg, as of October 15, 2018. Chart shows Bloomberg Barclays U.S. Aggregate Bond Index volatility and the 10-year U.S. Treasury yield. Circles depict periods of increased U.S. bond-market volatility. For illustrative purposes only. Yields rise as bond prices fall. Yields represent past performance and fluctuate with market conditions. Unlike corporate bonds, U.S. Treasury securities are guaranteed as to payment of principal and interest if held to maturity. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Real Assets

John LaForge, Head of Real Asset Strategy

Geopolitical concerns are a risk to oil targets

“There is no education like adversity.”
--Benjamin Disraeli

Oil prices have had a great run so far in 2018—up roughly 18%. This is much better than we had anticipated. So, what have we missed? The answer, we believe, is heightened geopolitical fears, which we’ll explain.

The chart below comes from the Federal Reserve Bank of New York (NY Fed), which breaks down drivers of 2018 oil returns. The Fed attempts to explain weekly oil-price changes by dividing them into demand effects (blue area) and supply effects (red area). Anything that cannot be explained directly by supply and demand gets grouped into a catch-all category, called residual (green area). Heightened geopolitical fears represent a performance driver that would be captured in the residual portion of the chart.

According to the NY Fed, this year’s 18% oil-price return can be broken down to 3% demand, 6% supply, and 9% residual (everything else). It is not possible to know precisely what is captured inside the residual category. But it makes sense that one of the largest residual factors would be related to heightened geopolitical fears, which 2018 has seen its fair share of (global tariffs, Iranian nuclear sanctions, missing reporter in Saudi Arabia, etc.). In most years (data back to 1986), supply and demand variables impact oil returns the most—not residual effects.

As 2018 has shown, oil prices can deviate significantly from what the supply/demand factors would dictate. In our view, geopolitical risks have driven oil’s strength year to date. While we believe concerns over excess supplies will eventually overtake elevated oil prices, heightened geopolitics are a risk to our bearish view.

Key Takeaways

  • According to the NY Fed, much of oil’s impressive 2018 return cannot be explained by supply and demand factors alone.
  • We believe geopolitical risks are the key driver of oil’s significant 2018 price increase.
Oil price driversOil price driversSources: Federal Reserve Bank of New York, Wells Fargo Investment Institute. Weekly data: December 29, 2017 - October 12, 2018.

Alternative Investments

Jim Sweetman, Senior Global Alternative Investment Strategist

Distressed debt investing can combine the “best of both worlds”

Over the next several years, we believe that significant segments of the global economy could face meaningful market-price dislocations, which can create opportunities for distressed debt strategies (both liquid and illiquid) to capitalize on those dislocations. While the U.S. is leading the $1.3 trillion market in nonfinancial leveraged loans, the U.K. is not far behind, with a record £38 billion ($49.9 billion) of such loans issued last year to nonfinancial companies (see chart).4 In particular, rising rates could pressure some debtors with floating-rate obligations or those needing to issue new debt securities. The weaker underwriting standards and lenient credit terms that led to the 2007-2008 debt-driven asset bubbles have returned, as competitive pressures have caused lenders and other creditors to increase issuance of “covenant-lite” debt to record levels.

In this environment, we believe that the distressed debt strategy offers the “best of both worlds”—the cash flow potential of debt investments with the upside potential of equities. Distressed debt generally trades at a significant discount to par value (for example, $300 for a $1,000 bond), because the borrower is under financial stress and faces default risk—or from volatility that has lowered the price of both distressed and healthy debt. Investors can participate via liquid alternative funds that employ hedge fund replication strategies that give access to a seasoned portfolio of distressed investments or through an illiquid private debt, drawdown structure, available to "accredited" or "qualified purchasers" only, that allows the manager to opportunistically deploy capital over a three-to-five year period as market dislocations occur.

Key Takeaways

  • Lending standards have been loosening globally, particularly for leveraged loans. With 80% of leveraged-loan deals now “covenant-lite,” an eventual credit downturn could create attractive investment opportunities for the distressed debt strategy.5
  • We suggest that investors consider the distressed debt strategy, which combines the cash flow potential of debt with the potential upside of equities.
Nonfinancial firms are taking on rising amounts of leveraged loan debtNonfinancial firms are taking on rising amounts of leveraged loan debtSources: International Monetary Fund (IMF), Moody’s Analytics, October 2018. Chart shows global issuance and debt outstanding. Issuance is YTD annualized for 2018. "Covenant-lite" is a term used to describe a type of loan that has fewer covenants to protect the lender and fewer restrictions on the borrower regarding payment terms, income requirements and collateral. Distressed debt is often debt issued by companies that are in default. Because liquid alternative funds must hold 85% in liquid securities, investment in distressed debt can be problematic for the fund. Investing in distressed companies is speculative and involves a high degree of risk. Distressed companies most likely will declare bankruptcy shortly, could currently be in bankruptcy proceedings or just emerging from bankruptcy. Because of their distressed situation, these securities may be illiquid, have low trading volumes, and be subject to substantial interest rate and credit risks.

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.

1A bond ladder is a fixed-income portfolio in which each security has a different maturity date. This helps the investor to reinvest at regular intervals. It can be useful in a rising-rate environment. Keep in mind, bond laddering does not assure a profit or protect against investment loss. Nor does it eliminate interest rate risk as the price of bonds in the ladder will continue to fluctuate as interest rates change. In addition, an investor may still face periodic reinvestment risk.

2The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship index that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed, asset-backed, and commercial mortgage-backed securities.

3Duration is a measure of interest-rate risk. Bonds with shorter duration (and maturities) tend to be less sensitive to changes in interest rates (assuming a parallel shift in the yield curve). Bonds, and bond strategies, such as bond laddering with longer durations, are generally more price sensitive and volatile than those with shorter durations.

4Source: The Bank of England, October 2018.

5Source: Bloomberg, October 2018.

Risk Considerations

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.

Definitions

Bloomberg Barclays U.S. Aggregate 10+ Year Bond Index is composed of the Barclays U.S. Government/Credit Index and the Barclays U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 10 years or more.

Bloomberg Barclays U.S. Corporate High Yield Index covers the universe of fixed-rate, noninvestment-grade debt. An index is unmanaged and not available for direct investment.

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.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

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