Weekly market insights and possible impacts on investors from the Wells Fargo Investment Institute Global Investment Strategy team.
Brian Rehling, CFA, Co-Head of Global Fixed Income Strategy
What Could Surprise Fixed-Income Investors in 2018?
- Following a year of extraordinary calm in the bond markets, the landscape is changing in 2018—with a new Federal Reserve (Fed) chair (and several open Fed governor seats), a maturating economic cycle, and a recent uptrend in inflationary expectations.
- It is important to plan for potential risks in fixed-income markets, even as we anticipate only gradually rising interest rates.
What it May Mean for Investors
- We recommend that investors remain broadly and globally diversified, while moving up in credit quality (and avoiding lower-quality issuers).
- We favor a neutral duration profile for fixed-income allocations across the yield curve. We also recommend including a nominal allocation to Treasury Inflation-Protected Securities (TIPS) in portfolios today. At current valuations, we believe that TIPS offer an affordable hedge against unexpected inflation with minimal downside risk.
Markets can be unpredictable, but in 2017, the U.S. fixed-income market was anything but unpredictable. Short-term rates increased as expected, and longer-term rates were little changed. The 10-year Treasury note yield ended the year within our projected target range. Meanwhile, credit spreads slowly moved tighter (lower) throughout the year as corporate default rates remained low.
While we have experienced an extraordinary period of calm in the bond markets, we must always be alert for potential risks. Risks often have their biggest impact when they materialize during a period of complacency—not unlike the current market environment. There are always many risks that could develop at any point in time, but we have identified three that we believe are most acute for fixed-income investors over the next year. These include the potential for:
- An unexpected inflation surprise
- Changing Fed dynamics
- Deteriorating credit markets
It is important to note that these are not the only risks to the bond market—just those we have identified with the most potential to cause harm. We do not expect any of these risks to materialize in 2018. Yet markets change, and we always aim to plan ahead and adjust strategy when risks unexpectedly materialize and impact markets.
An inflation surprise
Inflation materializes when demand outstrips supply—or when input prices rise as raw material costs or wages increase rapidly. U.S. inflation has trended at a very low level for years and remains below the Fed’s 2.0% personal consumption expenditures (PCE) inflation target. In fact, the Fed does not expect inflation to rise to its 2.0% target level until 2019.
(as measured by the Fed’s five-year forward breakeven inflation rate)Sources: Bloomberg, January 10, 2018.
The Fed’s five-year forward breakeven inflation rate is a good indicator of the market’s expectation for inflation pressure (on average) five years from today. Rather than using this indicator to project exactly where inflation rates will be in the future, we find this data useful in monitoring market trends. While levels currently remain low on a historical scale, we have seen an upward trend in recent weeks.
Changing Fed dynamics
In early February, Jerome Powell will take the reins of the Federal Open Market Committee (FOMC) from Janet Yellen as chairman. We look for Powell to continue to advocate for gradual rate increases, consistent with Janet Yellen’s policy views. Yet, Mr. Powell will preside over a number of new voting members and a changing Fed membership.
The FOMC consists of 12 members—7 permanent members of the Board of Governors, the president of the Federal Reserve Bank of New York, and 4 regional Federal Reserve Bank presidents that serve one-year rotating terms. Currently, three Board of Governors positions remain vacant—leaving just nine voting members. Throughout 2018, we could see presidential nominations to fill open governor positions. The uncertainty around a meaningful turnover in FOMC membership increases the possibility of messaging or policy errors in 2018.
Deteriorating credit markets
It is difficult to find any valuation metric that would classify high-yield debt as inexpensive, or cheap, today. Rather, most valuation measures show that the high-yield bond class now is quite expensive. Credit spreads (over Treasury security yields) for the Bloomberg Barclays U.S. Corporate High Yield Index currently stand near 320 basis points1 (3.2 percent). This is the lowest level that high-yield credit spreads have reached in this cycle. The 20-year average spread level of the Bloomberg Barclays U.S. Corporate High Yield Index is 580 basis points (5.8 percent). As credit spreads tighten (decline), valuations increase—all else being equal. The opposite occurs as spreads widen or increase. Within the fixed-income asset class, and within the overall investment universe, we believe that better risk-adjusted return opportunities present themselves today.
We do not expect meaningful spread widening in 2018. Historically, periods of meaningful spread widening in the high-yield sector often have been associated with “events.” Event risk is very unpredictable—and in the past—has included developments that followed September 11 and concerns surrounding Enron, WorldCom, Greek solvency, and the collapse in oil prices. In 2018, such a trigger could come from geopolitical concerns, a natural disaster, a terrorist attack, or an event that adjusts market sentiment, such as a major cyberattack. In our opinion, credit risk to investors is currently heightened given the lofty valuations in the investment-grade and high-yield credit space.
It is impossible to ignore the fact that fixed income risks are increasing. The Fed is tightening monetary policy, the yield curve has flattened, and credit spreads are near historically tight levels. While the risks we have discussed are not in our base case expectations for 2018, these risks are not insignificant. We believe that investors need to consider potential late-cycle risks and be thoughtful regarding fixed-income portfolio positions. We recommend diversifying holdings across the interest-rate curve (while keeping duration2 neutral), moving up in credit quality, and including a small allocation to TIPS in fixed income portfolios to protect against unexpected inflation. Times of complacency often pose the greatest risks for investors.
Stuart Freeman, CFA, Co-Head of Global Equity Strategy
The meaning of Dow 25,000
During 2017 and early 2018, we have watched the Dow click past “1,000 marks,” one after another. From the start of 2017 to today, the index has moved through six new “1,000 marks,” between 20,000 and 25,000. In previous times, we have only occasionally been able to celebrate such milestones. The strength of the economy, the increase in consumer confidence, and rising investor sentiment all have contributed to these accelerated celebrations.
However, it is critical to keep in mind that 1,000-point moves in the Dow represent smaller and smaller percentage increases as the Dow moves to higher levels. We have presented the data in the chart below. While the move between 2,000 and 3,000 took 39 months (and represented a 50% increase in the index), the move between 24,000 and 25,000 occurred in just two months (but only represented an increase of roughly 4% for the Dow).
Solid fundamentals are driving the rally, but volatility risks are rising
Fundamentals are still driving the equity markets, and new highs are possible later this year. But the path higher may not be as smooth as it was in 2017.
- Atop an already-improving economy, the tax overhaul should drive markedly stronger domestic corporate revenue and earnings growth. We do not currently see the signs for recession in 2018.
- Stronger spending should reinforce the gradual uptrend in inflation, but long-term factors (e.g., the aging population) should restrain inflation. Our inflation outlook remains benign for equities this year.
- Institutional investors, corporations, and households still hold significant cash positions that are available to support equity markets.
- The market’s fundamental outlook does not suggest a bubble.
Yet, the path higher may be bumpy as volatility increases. Volatility could result from the relatively narrow market breadth of 2017—as investors take profits or rebalance portfolios this year. Absolute valuations remain extended above their historical medians, and the last S&P 500 Index pullback of 3% occurred more than 380 days ago.
We recommend that investors rebalance their portfolios to reflect our allocation changes to U.S. Small Cap Equities and U.S. Intermediate Term Fixed Income, while remaining broadly and globally diversified at target exposure levels. Additionally, investors should consider rebalancing across domestic industry sectors, given the outsized performance of the Information Technology sector (as an example) over the past year.
Peter Wilson, Global Fixed Income Strategist
Developed-market yields to drift higher as central bank buying slows
2018 may mark a turning point for some of the world’s largest sovereign bond markets, which have become accustomed to ultra-low yields and the support of purchases from central banks. The Fed will gradually reduce its holdings of U.S. Treasury securities; the European Central Bank will trim its monthly bond purchases by half starting in January 2018, and it may end them altogether in October; only the Bank of Japan (BoJ) continues aggressive accommodation. Yet, even for the BoJ, bond buying has slowed as the central bank now targets a 10-year sovereign debt yield of around zero percent, rather than the quantity of asset purchases.
This means that developed-market (DM) yields outside the U.S. likely will drift higher this year, in the eurozone—or remain virtually static at very low levels, in Japan. Our strategic index for DM bonds is the JP Morgan Government Bond Index Global ex-U.S. (JPMGBI), and Japanese Government Bonds (JGBs) are the largest constituent in this index, at 32.6%. Collectively, bonds from eurozone countries make up more than 48% of the index.
Therefore, we see little prospect of significant coupon income in DMs outside the U.S. this year. Further, as yields rise, there is a likelihood of moderate capital losses from at least 80% of the DM bond index. This is not to say that DM bonds cannot outperform in 2018 as they did in 2017; but such outperformance would depend on currency gains stemming from further U.S. dollar declines. Since our outlook for the U.S. dollar versus DM currencies is broadly neutral in 2018, we do not foresee significant currency gains or losses. We therefore maintain our underweight in this fixed-income sector.
- Withdrawal of central bank support means that yields may either remain at low levels or rise gradually in 2018, across more than 80% of the JPMGBI.
- In our view, absent currency appreciation, the limited prospects for coupon income or capital gain mean that it will be very hard for DM sovereign bonds (outside the U.S.) to outperform in 2018.
John LaForge, Head of Real Asset Strategy
Oil is Out of Gas
“Never underestimate the difficulty of changing false beliefs by facts.” --Henry Rosovsky, Harvard economic historian
Time to lean into commodities?
We received a question last week on whether it is time to lean into (meaning: buy) commodities, versus stocks, on a strategic (10 years or longer) asset-allocation basis. It is a reasonable question—as the U.S. stock market has had a great run since 2009, while commodities have largely struggled since 2011. Our answer to favoring commodities on a strategic basis, however, is still a firm—no. We believe that it is still too early.
Commodity prices typically run in long boom or bust cycles, which we refer to as super-cycles. The average commodity bull super-cycle has lasted roughly 16 years, while the average bear super-cycle has lasted nearly 20 years, using data back to the year 1800. Today’s bear super-cycle has lasted only seven years (since 2011), which is not even nearing the 20-year average. The shortest bear on record was 12 years (1929-1941). Short-term (cyclical) price rallies can happen, as we witnessed in 2017, but history says that these rallies will be capped.
Stocks and bonds run in long price super-cycles too, but their cycles are quite different. One way to see this is in the chart below, which accumulates rolling 10-year returns for the stock market (top panel), the bond market (middle panel), and the commodity market (bottom panel). Notice that commodity returns are much more volatile (turn quickly from boom to bust) than those of the other asset classes. Plus, commodities tend to spend many more years accumulating negative returns (i.e. longer bear markets) than other asset classes do.
- Commodities are in year seven of a bear super-cycle, which is nowhere near the 20-year average.
- We believe that it is still too early to favor commodities on a strategic basis.
, Global Alternative Investment Strategist
“Phasing” into the right environment for hedge funds
Attempting to pinpoint precisely where we are in the business cycle can be challenging. This time is no different, except that there is the added complexity of incorporating historically low interest rates—along with the recently enacted tax reform and an abundance of central-bank-fueled liquidity. While it is possible that an already elongated cycle can be extended further, it seems more likely that we are moving into the “early innings of the latter phase” of the business cycle.
Historically, transitioning into the latter stages of the cycle has coincided with improvement in hedge funds’ absolute and relative performance. This is largely due to a decoupling of equity and credit securities, which is signaled by a decline in correlations across indices, sectors, industries, or geographies. Alongside this improved security-selection environment is the potential ability of hedge funds to capitalize on the illiquidity premium as markets weaken and volatility rises. This could be a particularly important source of hedge fund returns in this current cycle, given the post-financial-crisis regulatory changes—and the proliferation of passive investment vehicles.
While it is important to note that we do not expect a recession in 2018, the charts below show that hedge funds have outperformed the long-only benchmark in the latter phases of the two previous business cycles. As the current cycle matures, and the environment for security selection continues to improve, we anticipate a similar pattern.
- As we progress into the early innings of the latter phase of the cycle, we shift into an environment in which security selection becomes increasingly important.
- Hedge funds may outperform long-only benchmarks in these phases by exploiting both long and short positioning opportunities, and by capturing the illiquidity premium in times of stress.
1 100 basis points equals 1%.
2 Duration measures how sensitive a portfolio is to movements in interest rates.
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. In addition to the risks associated with investing in international and emerging markets, sovereign debt involves the risk that the issuing entity may not be able or willing to repay principal and/or interest when due in accordance with the terms of the debt agreement. 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.
Bloomberg Barclays U.S. Corporate High Yield Index covers the universe of fixed-rate, noninvestment-grade debt.
Commodity Composite Index Measures a basket of commodity prices as well as inflation. It blends the historical commodity index introduced by George F. Warren & Frank A. Pearson, former academics at Cornell, collected and published commodity price data in their book, Prices, and the producer price index for commodities (PPI-Commodities), and the National Bureau of Economic Research (NBER) Index of Wholesale Prices of 15 Commodities and the Reuters Continuous Commodity Index. The index components and weightings, from Warren and Pearson’s Prices, change over time but the 11 commodity groups used from 1786-1932 are: Farm Products, Foods, Hides and Leather products, Textile Products, Fuel and Lighting, Metals and Metal Products, Building Materials, Chemicals and drugs, Spirits (stopped tracking 1890), House furnishing Goods, and Miscellaneous. The PPI-Commodities is compiled by the Bureau of Labor Statistics and shows the average price change from the previous month for commodities such as energy, coal, crude oil and the steel scrap. The NBER Index of Wholesale Prices of 15 Commodities is a measure of price movements of 15 sensitive basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions. The Reuters Continuous Commodity Index comprises 17 commodity futures that are continuously rebalanced: cocoa, coffee, copper, corn, cotton, crude oil, gold, heating oil, live cattle, Live hogs, natural gas, orange juice, platinum, silver, soybeans, sugar no. 11, and wheat.
HFRI Fund Weighted Composite Index. A global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database. Constituent funds report monthly net-of-all-fees performance in U.S. Dollars and have a minimum of $50 Million under management or a 12-month track record of active performance. The HFRI Fund Weighted Composite Index does not include Funds of Hedge Funds.
JPMorgan Government Bond Index Global ex-US in USD is a representative of the total return performance in U.S. dollars of major non-U.S. bond markets.
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. The Index is unmanaged and not available for direct investment.
Bond rating firms, such as Standard & Poor's, use different designations consisting of upper- and lower-case letters 'A' and 'B' to identify a bond's credit quality rating. 'AAA' and 'AA' (high credit quality) and 'A' and 'BBB' (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ('BB', 'B', 'CCC', etc.) are considered low credit quality, and are commonly referred to as "junk bonds."
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.
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