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

January 14, 2019

Peter Wilson , Global Fixed Income Strategist

Outlook for European Central Bank Policy in 2019

Key Takeaways

  • The European Central Bank (ECB) may make its first rise in the deposit rate (currently -0.4%) in September 2019, earlier than the markets expect, and if circumstances permit, take rates back to zero by year end.
  • The ECB ended its net bond purchases in 2018 without negative market reaction, as expected. In 2019, we expect continued gross purchases for reinvestment to support bond markets and to moderate yield increases as policy rates start to rise.

What it May Mean for Investors

  • While the policy-rate increases from late in 2019 may push eurozone bond yields higher from mid-year, we think these rises should be contained and gradual. If the ECB begins to signal its intention to normalize rates sooner than the market expects, this should support our forecast for a moderate euro appreciation against the dollar in 2019.

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The ECB terminated net bond purchases in December. However, in our opinion, this is not the end of Quantitative Easing (QE), and policy still remains accommodative. Importantly, as the U.S. Federal Reserve (Fed) did, the ECB will continue to reinvest principal and interest from its roughly 2.5 trillion euro ($2.9 trillion) in holdings of (mainly government) bonds. At the ECB’s last monetary policy meeting on December 13, the central bank enhanced its guidance on QE reinvestments, stating in its press release that reinvestment of principal would continue for “an extended period of time past the date when it starts raising the key ECB interest rates.”1 The ECB also gave itself more flexibility on the reinvestment timing by widening the time window within which it can reinvest maturity payments: “The reinvestment of principal redemptions will be distributed over the year to allow for a regular and balanced market presence.”2

We believe that, even as net purchases have ceased, continued gross purchases for reinvestment will be supportive of the supply/demand balance in the market and will keep yield rises moderate. The ability to increase the pace of monthly reinvestments, which are allowed by widening the investment window, may permit the ECB to respond to market volatility, and to some extent, counter sharp market-driven yield increases (perhaps in Italy) should these occur. The issues of ending reinvestment and reducing the ECB’s balance sheet will likely not be a concern for the market, at least until late 2020 or 2021—which we believe is how the central bank will want it.

Interest rate policy

Currently the ECB’s key policy interest rate, the deposit facility rate (DFR) stands at -0.40%. The ECB’s current forward guidance on rates, which remained unchanged at the December meeting, states that policy interest rates are expected to remain at current levels “at least through the summer of 2019.”3 Chart 1 shows the current expectations for rises in the DFR based on pricing in the overnight interest rate swaps (OIS) market. If we assume that the first rise in the deposit rate will be in increments of 15 or 20 basis points (0.15-0.20%), then it is clear to us that such an increase is not fully factored into market expectations until the second quarter of 2020. The deposit rate is not expected to exit from negative territory until mid-2021. We believe this view is too cautious, and we anticipate that the ECB may seek, given the right conditions, to “normalize” (i.e., restore to zero or positive levels) the deposit rate by early 2020 or the end of 2019.

Market expectations for ECB rate rises may be too cautiousMarket expectations for ECB rate rises may be too cautiousSources: Bloomberg, Wells Fargo Investment Institute, January 9, 2019. For illustrative purposes only. These forward-looking policy rates are derived from the Overnight Index Swaps (OIS) market. An overnight index swap is an interest rate swap involving the overnight rate being exchanged for a fixed interest rate. The deposit facility rate is one of the three interest rates the ECB sets every six weeks as part of its monetary policy. The rate defines the interest banks receive for depositing money with the central bank overnight

There are several reasons why we expect the ECB to begin raising rates earlier than the market foresees. First, the deposit rate is in negative territory and will take at least two rate moves to restore to zero. However, these increases can be credibly presented as “normalization” rather than as the start of a tightening cycle.

Second, the ECB’s governing council make-up will change in 2019 and may assume a less dovish slant. The term for ECB’s chief economist Peter Praet—considered relatively dovish—will expire on May 31, 2019. ECB President Draghi’s term expires on October 31, 2019, and council member Benoît Coeuré’s term ends December 31, 2019. Internal discussions on Draghi’s successor will likely begin at mid-year (around the June 6 monetary policy meeting), but the first rate increase decision could be taken before Draghi leaves office, effectively making the job for Draghi’s successor easier. Under this scenario, we might expect an initial rate increase in the DFR of 15 or 20 basis points (100 basis points equals 1%) during the September 9 policy meeting, and a second taking the deposit rate back to zero on December 12.

Liquidity supply

Third, the ECB will likely take offsetting measures to continue providing cheap, long-term funding to the banking system. In the first or second quarters of 2019, we expect to see further discussions on a new round of Long-Term Refinancing Operations (LTROs), which provide funds to banks over a period of years (current operations roll-off between June 2020 and May 2021). If new such operations can be put in place by mid-year, then the ECB may begin raising rates without sparking a steep rise in the risk premium for banks or for longer-term bond yields.

Risks

Two main risks could derail this scenario. The first is continued economic and inflation disappointment. In our view, a sluggish economy had no impact on the schedule for ending net asset purchases. We expect that gross domestic product growth might need to significantly undershoot the ECB’s 1.7% 2019 projection in order to impact the desire to normalize rates. While an undershoot of the ECB’s 1.4% core inflation forecast for 2019 looks possible, the central bank may still move on rates, provided its longer-run forecasts remain close to target. The bank projects 2021 core inflation at 1.8%, effectively in-line with its price stability target of “below, but close to, 2% over the medium term.”4

The second risk is another spike in bond-market volatility. Italian yields remain elevated, while the European Union’s budget confrontation appears to have been defused for now. Volatility may return after the European Parliament elections in May, particularly if Italian populists are emboldened by electoral success either to intensify their demands or call snap national elections.

Market implications

As for the markets, if rates do rise earlier in 2019 than interest rate swaps currently anticipate, we believe eurozone bond yields may need to start factoring this in and begin to trend higher from mid-year. However, we also believe that the ECB will successfully contain any excessive increase in risk premium, and rises will be gradual and moderate. We would expect 10-year German bund yields, for example, to exceed their 2018 highs of 0.80% but not by much, potentially reaching 1% by early 2020.

The impact on the euro’s exchange rate versus the dollar is less certain for 2019. Our ECB view tends to support our belief that the dollar will weaken somewhat (around $1.21 versus the single currency by year end) as the policy rate divergence—which has supported the dollar recently—finally turns towards gradual convergence.

Equities

Scott Wren, Senior Global Equity Strategist
Ken Johnson, CFA, Investment Strategy Analyst

The S&P 500 Index’s operating margins

Equity strategists often think in terms of operating earnings when analyzing an index like the S&P 500. Operating earnings are produced by a firm's primary business operations, excluding extraordinary income and expenses. Operating earnings can give an accurate view of a firm's profitability. An operating margin is simply operating earnings divided by a firm’s revenue (sales).

Margin expansion is common during most recoveries. The chart below shows operating margins rising in a mostly steady fashion during the long expansion since the end of the last recession, which officially ended June 2009. Think about it this way: during recessions, companies cut expenses to get as lean as possible in order to ride out the downturn and maintain profitability. When the recession ends, these firms normally continue to operate in a lean fashion—while revenues rebound, and the economy improves. But eventually, as the expansion continues, companies must hire more workers and potentially add additional equipment, etc., to meet increased demand.

During the bulk of the latest recovery, companies held back on capital spending and mostly hired only when absolutely necessary, allowing profit margins to reach lofty levels as the economy improved. Our analysis suggests that margins will be flat or range-bound in 2019. We are watching for signs that they will either peak or turn down, which could indicate a future recession. Currently, we do not see signs of a downturn in margins, as they are at a record high in several sectors. We believe this will be a key indicator to monitor as 2019 progresses.

Key takeaways

  • S&P 500 Index’s operating margins have climbed higher during this long expansion.
  • Our analysis suggests margins will be flat or range-bound in 2019. We are closely monitoring factors influencing margins.
S&P 500 operating marginsS&P 500 operating marginsSources: Wells Fargo Investment Institute, FactSet, January 9, 2019. For illustrative purposes only.

Fixed Income

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

Details behind our decision to lower rate targets

We recently reduced our interest rate targets for year-end 2019. We decreased our federal funds rate, 10-year Treasury yield, and 30-year Treasury yield targets by 25 basis points each. Our new targets imply two rate hikes in 2019. We still expect the Fed to end the rate hike cycle in 2019, and our new expected terminal federal funds rate for this cycle is now 2.75-3.00%.

Since publishing our initial 2019 targets in early December, oil, equities, and rates have all fallen significantly, and a risk-off sentiment gripped the market. That alone would not have led us to change our rate targets; however, the price and sentiment changes appear to be impacting Fed thinking, and the causes (trade, political dysfunction, and central bank tightening) may impact economic numbers, resulting in modestly slower growth and lower inflation than expected.

Our new rate expectations remain above the market’s expectations. Currently, Fed fund futures suggest that the market does not expect the Fed to hike in 2019. However, we expect that over time the negative market sentiment will abate lifting market rate hike expectations. While the Fed decreased its 2019 rate-hike expectations in December, 11 of 17 members still project at least two rate hikes this year. Given the current uncertainty in the markets, risks to our new targets remain on the downside.

While our new rate targets do not change our projected yield curve slope, which remains positively sloped, we expect yield curve volatility and the risk of yield curve inversion to remain elevated. If the yield curve inverts, we believe the likely result may be a continued risk-off sentiment in the markets that brings longer-term rates lower than we expect.

Key takeaways

  • While we have modestly decreased our economic and rate projections, we believe that the U.S. economy will remain healthy in the near term, and see the economic expansion continuing into 2019.
  • Our new targets are consistent with our unfavorable duration guidance (duration is a measure of a bond’s interest rate sensitivity), which suggests that new investments in the investment-grade fixed income asset classes should be concentrated in short-term maturities.

Real Assets

Austin Pickle, CFA, Investment Strategy Analyst

Gold rally is a sprint, not a marathon

“The bad news is nothing lasts forever. The good news is nothing lasts forever.”
--J. Cole

2018’s fourth quarter was a tough one for investors. The S&P 500 Index dropped nearly 14%; oil prices were down roughly 40%; and commodities, overall, returned -10% (as measured by the Bloomberg Commodity Index). Finding an investment that provided outsized positive returns during this tumultuous period was challenging. Gold was one such investment—having returned 8%. Gold now sits smack dab in the middle of our 2019 year-end target range of $1250-$1350 per ounce. Yet, we don’t expect gold’s price to stay static for 12 months. What should we expect from here?

Some evidence indicates that gold could extend its rally a bit further. After similar stock market drawdowns in the past, gold tends to rally for a few months alongside stocks—presumably because fear of another crash takes time to fade. Gold may also benefit from a weaker U.S. dollar and rising commodity prices (both represent our 2019 expectations). Additionally, a reduction in the percentage of short money manager positions could provide a short-term tailwind to prices (see chart below). These developments could push gold to test or break the upper bounds of our target range. Unfortunately for gold bulls, gold’s weak fundamental backdrop and centuries’ of commodity super-cycle5 history argue that this break above would likely be short lived.

Given this, we believe investors should resist the urge to jump on the gold bandwagon if this rally continues. If the gold price breaks beyond our target range ($1350), we would likely become unfavorable on the yellow metal.

Key Takeaways

  • The current gold rally may have some life left in it in the short term, but we expect to end 2019 near where we are today.
  • If gold breaks above $1350, we may turn negative on the metal.
Gold versus managed money short positionsGold versus managed money short positionsSources: Bloomberg, Commodity Futures Trading Commission (CFTC), Wells Fargo Investment Institute. Top panel, daily data: August 28, 2015 - January 9, 2019. For illustrative purposes only. Bottom panel, weekly data. August 28, 2015 - December 18, 2018. Open interest is the total of all futures and/or option contracts entered into and not yet offset by a transaction that are held by market participants at the end of each day. The aggregate of all long open interest is equal to the aggregate of all short open interest. Increasing the open interest means new money is flowing into the marketplace. Declining open interest means that the market is liquidating and implies that the prevailing price trend is coming to an end. Therefore, open interest provides a lead indication of an impending change of trend. Please see Risk Considerations for the risks associated with investments in gold.

Alternative Investments

Justin Lenarcic, Global Alternative Investment Strategist

Watch for declining correlations to corporate-credit spreads

Prior to the Global Financial Crisis, the performance of credit-sensitive strategies, like Relative Value and Event Driven, were not nearly as correlated with corporate-credit spreads (the option adjusted spread of the Bloomberg Barclays U.S. Corporate BBB ex-Financials Index) as they have been over the last decade. We believe the increased sensitivity to credit spreads in the post-crisis era is largely the result of extremely low borrowing costs, which made it difficult for hedge funds to generate attractive returns from isolating fundamentally strong from weak corporate-debt securities. With the process of interest rate normalization well under way, we anticipate that the correlation among Relative Value and Event Driven strategies to corporate-credit spreads will revert to historical averages with the potential for these strategies to deliver positive returns as credit spreads widen.

We continue to anticipate a growing opportunity set for hedge funds within corporate credit. By combining an allocation to Relative Value: Long/Short Credit with Event Driven: Distressed, investors can potentially capitalize on weakening credit fundamentals, indiscriminate selling, and deep value. We also see less challenges for active management within credit markets as opposed to equities, which continue to be influenced by algorithmic trading, factor reversals, and a tremendous growth of passive, rules-based investment structures. As corporate credit volatility grows, we expect a rising opportunity set for Relative Value and Event Driven strategies in 2019.

Key Takeaways

  • Both Relative Value and Event Driven strategies have been highly correlated to U.S. corporate-credit spreads since the financial crisis.
  • We believe this is due to accommodative monetary policy being removed. Credit selection is becoming much more important, which may reduce correlations.
Credit spreads have been a key influence on returns post Global Financial CrisisCredit spreads have been a key influence on returns post Global Financial CrisisSources: Bloomberg, Wells Fargo Investment Institute, January 8, 2019. Data as of December 31, 2018. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. Please see the end of this report for the definitions of the indices and a description of the asset class 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.

1 ECB press releases from the monetary policy meeting on December 13, 2018.

2 Ibid.

3 Ibid.

4 ECB, The definition of price stability.

5 Commodity prices over the very long term (hundreds of years) tend to move in overall bull and bear cycles, some lasting decades. These are super-cycles.

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. Investing in physical commodities, such as gold, exposes a portfolio to material risk considerations such as potentially severe price fluctuations over short periods of time and storage costs that exceed the custodial and/or brokerage costs associated with the portfolio's other holdings. 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 US Corporates BBB ex Financials Index includes all BBB-rated corporate debt other than bonds issued by companies in the Financial sector.

Bloomberg Commodity Index represents futures contracts on 22 physical commodities. No related group of commodities (e.g., energy, precious metals, livestock and grains) may constitute more than 33 percent of the index as of the annual re-weightings of the components. No single commodity may constitute less than 2 percent of the index.

HFRI Event Driven: Distressed / Restructuring Index includes strategies which employ an investment process focused on corporate fixed income instruments, primarily on corporate credit instruments of companies trading at significant discounts to their value at issuance or obliged (par value) at maturity as a result of either formal bankruptcy proceeding or financial market perception of near term proceedings. Managers are typically actively involved with the management of these companies, frequently involved on creditors' committees in negotiating the exchange of securities for alternative obligations, either swaps of debt, equity or hybrid securities. Managers employ fundamental credit processes focused on valuation and asset coverage of securities of distressed firms; in most cases portfolio exposures are concentrated in instruments which are publicly traded, in some cases actively and in others under reduced liquidity but in general for which a reasonable public market exists.

HFRI Relative Value Fixed Income: Corporate Index includes strategies in which the investment thesis is predicated on realization of a spread between related instruments in which one or multiple components of the spread is a corporate fixed income instrument. Strategies employ an investment process designed to isolate attractive opportunities between a variety of fixed income instruments, typically realizing an attractive spread between multiple corporate bonds or between a corporate and risk free government bond.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.

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.

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