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Investment Strategy

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

November 29, 2021

Peter Wilson, Global Fixed-Income Strategist

Chris Haverland, CFA, Global Equity Strategist

Austin Pickle, CFA, Investment Strategy Analyst

James Sweetman, Senior Global Alternative Investment Strategist

Fixed Income spotlight: Inflation and monetary divergence — Twin themes in 2022

  • As inflation accelerates, the market expects a growing divergence in policy responses within developed economy central banks. Notably, rates are expected to rise within the next year in the U.S. while rates are expected to see little change in the eurozone, Japan, and Switzerland.
  • Emerging economy central banks have been ahead of the rate-rise game, many having already increased policy rates. We expect this rate gap to get wider in the near term but may not support emerging market currencies much.

Equities: Operating margins resilient in the third quarter

  • With most companies having reported third-quarter earnings, S&P 500 Index profits grew by a much better than expected 41%.
  • While we expect operating margins to decline modestly in the fourth quarter, they likely will rebound in 2022, supporting above-average earnings growth.

Real Assets: Oil’s tug of war — Producers versus consumers

  • Last week, the U.S. and others announced the release of oil from national strategic reserves to combat rising prices.
  • We should not have to wait long for OPEC+’s response — which will have obvious near-term price and geopolitical implications — as the next OPEC+ meeting is December 2.

Alternatives: Hedge fund returns strong but crowded longs detracting

  • Hedge fund strategies have posted strong absolute returns year-to-date across all strategies, but hedge funds’ concentrated long equity positions have suffered a difficult year, underperforming the S&P 500 Index by close to 12%.
  • Heading into 2022, we believe qualified investors may be best served by positioning hedge funds in 2022 as a source of low-correlated, defensive returns. We do not believe that now is the time to use hedge fund strategies to augment or leverage long-only returns, but rather to help mitigate risk and provide diversification. We believe the strategies best-positioned entering 2022 are low-net, low-beta Equity Hedge strategies, Arbitrage strategies, and Macro strategies.

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Fixed Income spotlight

Inflation and monetary divergence — Twin themes in 2022

Rising inflation in many economies this year has been a game changer for interest-rate expectations in 2022. It has led to growing market divergences among developed central banks and also between emerging and developed markets. At the start of 2021, market expectations for central bank policy rates anticipated a mere 0.25% tightening from the U.S. Federal Reserve (Fed) by the end of a three-year period. However, over the year, as annual U.S. consumer price inflation accelerated from just 1.4% in December 2020 to reach 6.2% in the latest October release, these benign lower-for-longer views quickly succumbed to reality. Norges Bank (the central bank of Norway) became the first developed market central bank to increase policy rates post-coronavirus on September 24, and the Reserve Bank of New Zealand followed less than a month later.

Mind the gap

The current state of expectations for central bank policy rates in developed markets is shown in the chart below. Rates are seen rising a certain amount everywhere (with the exception of Japan). However, the gap is immediately apparent between two categories of central banks: those expected to quickly raise rates and normalize post-coronavirus monetary policy and those where policy is expected to remain exceptionally easy and rates exceptionally low, even negative. New Zealand is leading the move to normalize rates, but we believe it will be the U.S. Federal Reserve where policy will be most important for domestic and global bond markets and currencies.

Chart 1. Inflation reveals the gap between interest-rate doves and normalizersThis is a bar chart showing nine groups of vertical columns, illustrating interest-rate expectations in nine major developed economies. From left to right, the nine groups show rate expectations in Switzerland, the eurozone, Japan, Sweden, the U.K., the U.S., Australia, Canada, and New Zealand. Each group contains four columns, showing, from left to right within each group, the levels that the market anticipates for one-month interest rates one year, two years, three years, and four years into the future. One-year forward expectations are in solid blue, two-year in red dotted with white, three-year in speckled purple, and four-year expectations in diagonal orange stripes. The chart is designed to illustrate that while rates in the United States and many other developed economies (that is, the six groups of taller bars to the right of the chart) are expected to rise to levels of between 1% and 3% over the next four years, rates in Switzerland and the eurozone are seen rising much less, and in Japan rates are hardly expected to move at all from current levels (that is, the three much smaller or negative bars on the left-hand side of the chart).Sources: Bloomberg and Wells Fargo Investment Institute. Latest data as of November 19, 2021. These interest rate expectations are derived from the Overnight Index Swaps (OIS) market. An OIS is a fixed to floating interest rate swap where the floating leg is computed using a published overnight index rate, and these swap rates are commonly used (as here) to indicate market expectations of central bank policy rates.

The Fed is expected to lift the federal funds rate off zero soon after midyear in 2022, and federal funds futures markets are implying two to three 0.25% rate hikes before the end of the year. By contrast, market participants are unsure if the European Central Bank (ECB) will even move its benchmark deposit rate off the -0.5% lows next year. This is in part because the ECB is seen as more dovish than the Fed and in part because eurozone inflation rates are significantly lower than those in the U.S. The clear implication of these views, already playing out in markets, is that the interest-rate differential between the U.S. and the eurozone should continue to widen, at least until inflation is seen to have peaked, and this should be a powerful support for the dollar.

On a broader level, central bank policy rates have already started to diverge between emerging and developed economies. As the chart below illustrates, emerging market (EM) central banks have been raising rates for well over a year now. This movement gathered pace in 2021, with central banks across Latin America and Eastern Europe, and even the Bank of Korea in Asia, moving to normalize rates. Of the 26 EM central banks we follow, 12 have so far raised rates in 2021.

Chart 2. Policy rate divergence between emerging and developed economies is well under wayThis chart shows average central bank monetary policy interest rates in developed market and emerging market countries from the start of 2004 through November 19, 2021. The solid blue line shows the weighted-average central bank policy interest rate in 11 developed economies (using gross domestic product at purchasing power parity as weights). This line peaks near 4% in 2007, remains at very low positive levels between 2009 and 2017, and rises only slightly to near 1% in 2019 before diving back below zero in early 2020, where it remains to date at slightly negative levels. The higher, dashed orange line represents the weighted-average central bank policy interest rate in 26 emerging economies (averaged using the same methodology). This line slowly declines over the period from a 7%–9% range in the 2004–2010 period, dropping to a 3.0%-3.5% low by mid-2020. It then rises back over 4% as various emerging market central banks began to raise rates.Sources: International Monetary Fund, Bank for International Settlements, national central banks, Bloomberg, and Wells Fargo Investment Institute. Latest data as of November 19, 2021. The developed markets (DM) series is a weighted average of 11 DM central bank policy rates, using gross domestic product (GDP) at purchasing power parity (PPP) as weights. The EM series is a weighted average of 26 EM central bank policy rates, using GDP at PPP as weights. Purchasing power parity is the measurement of prices in different countries that uses the prices of specific goods to compare the absolute purchasing power of the countries' currencies.

Emerging market implications

Many EM economies have lower levels of government debt than developed markets, and this factor may be enabling them to be more proactive in raising rates to combat inflation. While higher rates in EM domestic markets may hit local-currency bond returns, and — insofar as they cool the overall economy — also decrease prospects for EM equities, we believe dollar-denominated sovereign credit should continue to hold up well in this environment. While higher rates may not strongly boost EM currencies in the coming year, they may limit their potential depreciation, and weaker EM foreign exchange rates may continue to reflect the strength of the dollar against developed market currencies (notably the euro and yen).



Operating margins resilient in the third quarter

Third-quarter earnings season is coming to a close with the S&P 500 Index posting record profits. 68% of companies have beaten Bloomberg consensus sales expectations, while 82% of companies have exceeded earnings expectations. Entering the season, consensus expectations were for earnings to grow by 28%. With 95% of companies reporting, profits actually grew by 41% in the quarter.

Earnings growth has been concentrated in the highly cyclical sectors. The Energy, Industrials, and Materials sectors led the way, while defensive sectors (Consumer Staples and Utilities) lagged. Growth-oriented sectors also showed strength with Information Technology posting the fourth-highest earnings growth for the quarter.

Many companies referenced rising input prices and global supply chain constraints. However, the S&P 500 Index operating margin was resilient, coming in slightly below the record high set in the second quarter. Excluding the Financials sector, the index operating margin actually expanded in the quarter. Operating margins are expected to decline in the fourth quarter but rebound next year as supply chain bottlenecks ease (see chart below).

Looking forward, we expect earnings growth to slow in the coming quarters as year-over-year comparisons become more challenging. Even so, profits are likely to grow at above-average levels in 2022. These will be supported by accommodative fiscal and monetary policies, pent-up consumer demand, rebounding capital expenditures (capex), and firming pricing power. We recently increased our 2022 S&P 500 Index earnings per share forecast to $235.

S&P 500 Index operating margin remains near record levelThe line chart shows quarterly S&P 500 Index operating margins from the first quarter of 2011 to the third quarter of 2021. The operating margin hit a record level in the second quarter of 2021 and fell slightly in the third quarter of 2021. Bloomberg consensus projects a further decline in the fourth quarter of 2021, and then a rebound in margins in 2022.Sources: Wells Fargo Investment Institute, Bloomberg as of November 22, 2021. S&P 500 Index operating margin quarterly data from the first quarter of 2011 to the third quarter of 2021. Bloomberg consensus forecasts from the fourth quarter of 2021 to the third quarter of 2022. Forecasts are not guaranteed and based on certain assumptions and on views of market and economic conditions which are subject to change.

Real Assets spotlight

Oil’s tug of war — Producers versus consumers

call out “Life is not a matter of holding good cards, but of playing a poor hand well.”
--Robert Louis Stevenson end call out

After touching multiyear highs in October, oil price benchmarks West Texas Intermediate (WTI) and Brent have traded off roughly 10% (as of November 22). What should investors know? In a bid to tamp down rising energy costs, the U.S. and other major oil-consuming nations pleaded with OPEC+1 for the cartel to boost production greater than its predetermined amount. OPEC+ met November 4, presumably discussed the request and then promptly refused. In response, major oil-consuming nations have taken matters into their own hands. The U.S. announced a coordinated release — along with China, India, Japan, U.K., and South Korea — of national strategic oil reserves last week. This move had been widely discussed for weeks as one recourse available to oil-consuming nations to help ease oil price pressures. In our view, market anticipation of this action has been a major driver of the recent oil price swoon. Another has been ramping COVID-19 cases and the risk that poses to oil demand. So that is the backstory, now what?

Keep an eye on December 2 — the next OPEC+ meeting. OPEC+ delegates have said that tapping national reserves may prompt them to reconsider adding more supply. We will see what hand OPEC+ plays at this week’s meeting, but pausing planned production increases is certainly on the table. The decision will have obvious near-term oil price and geopolitical implications.

While oil prices could be volatile as the producer and consumer tug-of-war plays out, we do expect higher prices by year-end 2022. Restrained supply growth that lags demand should boost prices higher.

2021 oil pricesThe chart shows the price of WTI and Brent oil from January 1, 2021 to November 22, 2021. After peaking in October 2021, both have dropped nearly 10% based on surging COVID-19 cases and speculation that the U.S. and others would tap their national strategic oil reserves. The speculation turned out to be correct, as announcements were made last week to that effect.Sources: Bloomberg, Wells Fargo Investment Institute. Daily data: January 1, 2021 – November 22, 2021. WTI = West Texas Intermediate. Past performance is not a guarantee of future results.


Hedge fund returns strong but crowded longs detracting

Hedge fund performance year-to-date (YTD) through October 2021 is on track for the best calendar year performance since 2009, when hedge funds were up 20%. The HFRI Fund Weighted Composite Index is up 11.2% through October,2 and all of the major hedge fund strategies are posting strong positive absolute returns beyond the Wells Fargo Investment Institute’s strategic capital market assumptions. After a gain in October, hedge funds posted positive performance in 16 of the past 19 months. They captured approximately 55% of the upside of global equites while offering strong absolute returns relative to the fixed-income markets.

Hedge fund performance year-to-date (YTD)Source: Hedge Fund Research (HFR) – November 2021

Despite the strong strategy performance YTD, we have seen pockets of underperformance in crowded long equity positions held by hedge funds. According to the latest Goldman Sachs Hedge Fund Trend Monitor report (which analyzes 799 hedge funds with $2.9 trillion of gross equity positions based on 13F filings as of November 15), “the most popular hedge fund long positions have suffered a record stretch of underperformance this year.” In fact, the Goldman Sachs VIP Index is underperforming the S&P 500 Index YTD by close to 12% through November 22, 2021. Among the various reasons cited for underperformance are the rotation earlier this year into value versus growth and the collapse in Chinese stocks. These were a very popular holding among hedge funds at the start of the year, but they experienced losses when escalating crackdowns from China against whole sectors of the market sent some of the most popular Chinese names into a tailspin. Recently, hedge funds have been reshuffling their long exposures, with some common names dropping, and they have become more tilted toward value versus growth since 2015.

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.

1 The Organization of the Petroleum Exporting Countries and non-OPEC nations such as Russia.

2 Hedge Fund Research (HFR), November 2021.

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. There are no guarantees that growth or value stocks will increase in value or that their intrinsic values will eventually be recognized by the overall market. The return and principal value of stocks fluctuate with changes in market conditions. The growth and value type of investing tends to shift in and out of favor. 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.

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 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. 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 U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.

Bloomberg Commodity Total Return Index reflects the returns that are potentially available through an unleveraged investment in the futures contracts on 19 physical commodities comprising the Index plus the rate of interest that could be earned on cash collateral invested in specified Treasury Bills. The Index is a rolling index rebalancing annually.

HFRI Event-Driven (Total) Index consists of Investment Managers who maintain positions in securities of companies currently or prospectively involved in corporate transactions of a wide variety, including but not limited to: mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. ED exposure contains a combination of sensitivities to equity markets, credit markets and idiosyncratic, company specific developments. Investment theses are typically predicated on fundamental characteristics (as opposed to quantitative), with the realization of the thesis predicated on a specific development exogenous to the existing capital structure.

HFRI Equity Hedge (Total) Index maintains positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations, and valuation ranges of typical portfolios.

HFRI Macro (Total) Index consists of investment managers who trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed-income, hard currency, and commodity markets.

HFRI Relative Value (Total) Index consists of Investment Managers who maintain positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities Manager employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivative or other security types. RVA position may be involved in corporate transactions also, but as opposed to ED exposures, the investment thesis is predicated on realization of a pricing discrepancy between related securities, as opposed to the outcome of the corporate transaction.

HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2000 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.

Note: HFRI Indices have limitations (some of which are typical of other widely used indices). These limitations include survivorship bias (the returns of the indices may not be representative of all the hedge funds in the universe because of the tendency of lower performing funds to leave the index); heterogeneity (not all hedge funds are alike or comparable to one another, and the index may not accurately reflect the performance of a described style); and limited data (many hedge funds do not report to indices, and, therefore, the index may omit funds, the inclusion of which might significantly affect the performance shown. The HFRI Indices are based on information self‐reported by hedge fund managers that decide on their own, at any time, whether or not they want to provide, or continue to provide, information to HFR Asset Management, L.L.C. Results for funds that go out of business are included in the index until the date that they cease operations. Therefore, these indices may not be complete or accurate representations of the hedge fund universe, and may be biased in several ways. Returns of the underlying hedge funds are net of fees and are denominated in USD.

MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of 23 developed market countries including the United States.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.

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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