• When we ask whether the current economic expansion and the uptrend in equity markets can continue, the availability of liquidity is a crucial part of our answer.
• While the Federal Reserve’s steady interest-rate hikes may make credit less accessible today, as shown in chart 1, managers and households still have substantial (and even growing) cash stockpiles—for reasons that predate (or are unrelated to) the Federal Reserve’s policy changes.

• We find that solid economic growth, low inflation, and healthy corporate and household liquidity all should help to insulate the U.S. economy from another 2008-style crisis. We still see a favorable environment for equities generally, and particularly for growth-oriented equity sectors (notably Consumer Discretionary and Industrials)—as well as for the Health Care and Financials sectors.

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Along with the state of the economy, liquidity helps to drive risk appetite and the potential for financial-market advances. Liquidity includes cash, cash alternatives (such as savings deposits at a bank), and debt securities that can turn into cash quickly and easily. The problem is that liquidity is not always easy for investors to track.

The U.S. economy is still growing. Yet, policy makers are raising interest rates, and measures of the money available for bank lending are suggesting declines. As the economic cycle becomes extended and credit availability tightens further, many businesses and households eventually will be forced to work down their savings and available cash. Historically, the more that unexpected events force investors to cover margin debt and oblige company managers to tap credit lines, the more that shocks can disrupt markets. As the U.S. economic expansion matures further, we expect liquidity to become scarce—leaving markets more vulnerable to increasingly significant price volatility. The question is whether that point has arrived yet.

Credit may be less easy to access today, but managers and households still have substantial (and even growing) cash stockpiles—for reasons that predate (or are unrelated to) current Federal Reserve (Fed) policy.¹ For example, record corporate issuance of new bonds since 2009 has exploited low borrowing costs. To some extent, bond issuance largely has replaced more traditional sources of business credit, such as bank borrowing. Largely because of this substitution, total business debt has grown below its 8% quarterly average (since 1952) in 34 of the 37 quarters in this economic expansion (since June 2009)². A considerable portion of the borrowing proceeds is sitting in cash. Corporate liquid assets as a percentage of total assets was 17% in June 2018, near its highest share since 2005. This percentage could prove to be a peak, as other data since June indicate that a gradual drawdown in business cash is gradually emerging. Typically, businesses do begin to use more cash as the economic expansion matures, but that trend is still early and does not suggest an imminent problem.

For their part, households also hold significant cash. Households continue to save at rates close to their average pace dating back to 1952. What has changed since the 2008 financial crisis is that mortgage debt is growing more slowly than personal savings. It is true that credit card and auto debt are growing rapidly, but mortgage debt is the lion’s share of consumer debt—70% of the average household’s balance sheet since 1952³. So, the mortgage slowdown makes total household borrowing modest and, importantly, slower than savings growth.

Chart 1 illustrates these trends. It shows total household liquid assets, including checking, savings, and money market deposits, plus holdings of liquid debt securities—essentially, assets that can be turned into cash quickly. Liabilities include all borrowing. Household liquid assets have outpaced liabilities since June 2015. While household debt trails savings, household liquidity is growing, even as the Fed raises interest rates. Rising household cash is still a significant support for household finances and a potential cushion against future shocks.

Household liquid assets are growing faster than household financial liabilitiesSources: Federal Reserve, Bloomberg, and Wells Fargo Investment Institute; quarterly data; June 1, 1983-June 30, 2018. Household liquid assets include checking, savings, and money market deposits, plus holdings of liquid debt (U.S. Treasury and agency bonds, municipal bonds, corporate bonds, and foreign bonds).

If the Fed interest-rate hikes choke off the U.S. economic expansion, or if China fails to add economic stimulus to offset the restrictions that arise from Beijing’s reforms, then we believe global liquidity conditions could truncate incomes and quickly drain reserves. In addition, if the U.S. and China head toward cutting off mutual trade, then the financial flows that pay for trade also would decline, and this could adversely affect the liquidity available for markets.

None of these is our base case. The fact that corporate and household liquidity is still significant should help to extend the U.S. economic expansion. Our economic outlook is for solid growth through 2019. We do not see a contraction in the coming 12 months—and probably through 2019 as well—and do not anticipate that monetary policy will change that outlook. Moreover, China is already stimulating its economy to counterbalance its reform program, and we expect an eventual trade pact. In an environment of solid economic growth and benign inflation, favorable household and we believe corporate liquidity should extend the U.S. expansion and help insulate the economy from another 2008-style crisis. We still see a favorable environment for equities generally, and particularly for growth-oriented equity sectors (notably Consumer Discretionary and Industrials), as well as for the Health Care and Financials sectors.

History has set an interesting benchmark on U.S. equity-market direction after midterm elections. Yet, much will depend on market fundamentals and economic confidence measures going forward. Today, we will highlight four observations, based upon prior midterm elections and their market impact:

1. After the past 22 midterm elections, the S&P 500 Index typically has gained ground in the final seven weeks of the year.⁴
2. After the midterms, the president often has adjusted policy to strengthen the base for the next presidential election. These changes have included increasing federal spending, reducing taxes, and raising social security payouts. While this may not occur in 2019, it has been observed historically.
3. Since 1926, in the 12-month period following the midterms, the S&P 500 Index gained 13.8%, on average.⁵ In the 12-month period following presidential elections or following years when there were no midterms, the S&P 500 Index rose by 6%, on average.⁶
4. Midterm elections historically have represented buying opportunities over the 3-, 6-, and 12-month periods that follow, with average S&P 500 Index returns of 6.5%, 11.8%, and 13.8%, respectively.⁷

In addition to the average market uptrend that has followed midterms, fundamentals and economic outcomes typically have improved. Historically, economic activity, earnings growth, and valuations (such as the price paid for a dollar of expected earnings), have improved in the 12 months following midterms. Cyclical sectors also have tended to outperform in these periods. We have a favorable view of the Consumer Discretionary and Health Care sectors, and we are most favorable on Industrials and Financials.

• U.S. midterm elections typically have preceded positive 12-month S&P 500 returns.
• Historically, cyclical sectors have tended to outperform in the 12 months following midterms.

S&P 500 Index has performed better in periods after midterms than following years without midtermsSources: Bloomberg, Wells Fargo Investment Institute. Data reflects S&P 500 Index returns from November 1927 through October 2018. Price return prior to 1988 and total return from 1998 to present. Table shows data from periods following 22 midterms and for periods following presidential election years and years with no elections. Data is from market close on election day for a 12-month period (for election years). It starts in early November for nonelection years. For 2018, data ends in October. For illustrative purposes only. There is no certainty that the S&P 500 Index will perform similarly in the 2018 midterm election year as it has in past midterm election cycles or in future midterm elections or produce similar returns as shown above. Index returns are not fund returns. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

The latest round of volatility in the Italian government bond market started in May, when 10-year yields soared above 3.0% after inauguration of a populist government. Following choppy summer trading, a new phase began with the presentation of the government’s draft budget for 2019. The proposed deficit of 2.4% of gross domestic product (GDP) was far higher than preliminary suggestions of 1.6%, and this seems likely to trigger confrontation with the European Union. Predictably, the euro has weakened toward this year’s lows versus the dollar (below 1.15) and 10-year bond yields have risen above 3.5% for the first time since 2014.

The Italian government projects that the deficit will fall back to 1.8% of GDP by 2021—and that the 130% debt/GDP ratio (one of the world’s largest) will not rise. But these forecasts are based on economic growth assumptions that are seen as highly optimistic (1.6% growth in 2019). When the draft budget is formally presented to the European Commission, it is hard to see how a near-term compromise will be found. Tough rhetoric on both sides generally means that markets may remain under pressure for a while.

Italian yields may remain high and the euro relatively weak in coming weeks. Moody’s and Standard & Poor’s may decide to downgrade Italy’s credit when their analysts review it in late October. But markets are taking the view—we believe correctly—that the standoff will not result in an existential threat to the euro’s existence. In contrast to previous episodes, contagion to other eurozone bond markets (such as Spain’s) has not occurred (see chart).

• It is hard to see a quick resolution to the current standoff over the Italian budget. We expect both Italian bond yields and volatility to remain high.
• Italian government bonds now yield above 3%, but they represent less than 12% of the ex-U.S. developed market bond index.⁸ With other components yielding much closer to zero, the average index yield remains near 1%. Thus, we maintain our unfavorable opinion on developed market (ex-U.S.) fixed income.

This time—Italian spreads may not be warning of a broader euro crisisSources: Bloomberg, Wells Fargo Investment Institute, October 9, 2018. Bund = German government bonds. BTP = Italian government bonds. Bono = Spanish government bonds. One hundred basis points equal 1%.For illustrative purposes only. Yields represent past performance and fluctuate with market conditions. Current yields may be higher or lower than those shown above. Past performance is no guarantee of future results.

“Daring as it is to investigate the unknown, even more so it is to question the known”
--Kasper

October has been a tough month so far for stocks and bonds. Commodities, on the other hand, have generally emerged unscathed month to date.⁹ Thirteen of 22 commodities in the Bloomberg Commodity Index (BCOM) have been positive over this period, while the index itself has risen by 2%.¹⁰ If nothing else, this is one more example of the benefits of portfolio diversification.

Part of the reason why commodities have not sold off month to date is that there appears to be limited downside for the asset class overall (in our view). 2018 already has been a tough year for most commodities, save oil, thanks to constant global tariff chatter. In fact, prices had become so cheap that we turned favorable on commodities on September 7. We consider this a pretty big deal, as we had been unfavorable on commodities for nearly two years. While the BCOM has rallied 5% since our upgrade, we still are expecting more upside in the coming months.

A second reason why commodities have largely sidestepped October’s equity sell-off can be explained by the chart below. It highlights correlations between the equity markets and the three major real asset groups (commodities; real estate investment trusts, or REITs; and master limited partnerships, or MLPs). Notice that commodities (yellow line) generally have the lowest correlation to equities.

• Unlike most equity and bond classes, commodities have had positive returns to date in October.¹¹
• Commodities’ low correlation to U.S. equities has helped them to sidestep the recent market carnage, and this is a good example of their diversification benefits.

Real assets’ correlation to stocksSources: Bloomberg, Wells Fargo Investment Institute. Monthly data: December 31, 1998 -September 30, 2018. Global REITs represented by the FTSE EPRA/NAREIT Developed Index; MLPs by the Alerian Index; and Commodities by the Bloomberg Commodity Index. Correlation is the rolling three-year correlation of monthly returns between each real asset class and the S&P 500 Index. Correlation represents past performance. Past performance is no guarantee of future results. Index returns are not fund returns and are not forecasts of expected gains or losses an investment 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 nor do they constitute a recommendation to invest in any particular fund or strategy. An index is unmanaged and not available for direct investment. Please see the end of this report for the definitions of the indices and a description of the asset class risks.

As we examine the opportunity set for hedge funds in corporate credit, there are several important metrics that bear watching. Fundamental ratios such as interest coverage, leverage, and EBITDA (earnings before interest, taxes, depreciation, and amortization) are generally important signposts for the overall credit cycle. Trends in distress ratios and default rates will help pinpoint the speed and magnitude of credit market weakness—along with the breadth of the opportunity set for stressed and distressed debt strategies. Moreover, the growing proportion of investment-grade credit that is rated BBB, or only one level above high-yield debt, helps to highlight credit-quality trends and the potential for large-scale credit downgrades, should fundamentals weaken.

Another metric that we have been watching closely is the difference between bid-ask spreads for BB-rated (high yield) and BBB-rated (investment-grade) credit. As the chart shows, this differential has increased from its mid-July low, and it could be poised to move higher as the cycle matures. Though this differential clearly remains below the long-term average, a widening of bid-ask spreads normally coincides with an increase in volatility—and in severe instances—with a lack of liquidity.

Periods such as these can be challenging for passive credit investors. Yet, they have the potential to provide tactical trading opportunities for hedge funds. The ability to be a buyer when others are selling is a key reason why we are optimistic about the Long/Short Credit strategy in the current environment.

• Though corporate bid-ask spreads have been trending downward for most of this year, a recent reversal in the trend could be a precursor to more volatility within corporate credit.
• As bid-ask spreads widen, the corporate credit market tends to become less liquid. This could provide opportunities for patient investors (particularly, hedge funds) that can be buyers when others are selling.

Wider bid-ask spreads could lead to higher corporate-credit volatilitySources: Bank of America Merrill Lynch, Wells Fargo Investment Institute, October 2018. The data represented in the axis is in annual increments beginning in April 11. The bid-ask spread is the difference between the bid price at which an investor would sell shares and the ask price at which the investor would buy shares expressed as a percentage. The moving average is an indicator used in technical analysis. It looks at the average price of a particular security over a rolling time period. Credit ratings are not intended to indicate the value, suitability, or merit of an investment. They are opinions of credit quality and, in some cases, the expected recovery in the event of default. An index is unmanaged and not available for direct investment. Please see the end of this report for the definitions of the indices, bond ratings and for the risks associated with long/short credit strategies.

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.

¹Federal Reserve Flow of Dunds Data base, October 12, 2018.

²Ibid.

³Ibid.

⁴The S&P 500 Index gained in the last seven weeks of the year following 16 of the 22 midterms over the period.

⁵The 12-month period began after market close on election day (in election years) and ended 12 months later. In years with no elections, the period ran from early November for 12 months to early November of the next year. For the 2017-2018 period, the period ended in October, as data was not available for early November.

⁶Ibid

⁷Ibid

⁸The developed market bond index is the JP Morgan Government Bond Index (GBI) Global, ex-U.S.

⁹Data is based on returns of the Bloomberg Commodity Index month to date through October 10, 2018.

¹⁰Ibid.

¹¹Ibid.

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.

Investment in Master Limited Partnerships (MLPs) involves certain risks which differ from an investment in the securities of a corporation. MLPs may be sensitive to price changes in oil, natural gas, etc., regulatory risk, and rising interest rates. A change in the current tax law regarding MLPs could result in the MLP being treated as a corporation for federal income tax purposes which would reduce the amount of cash flows distributed by the MLP.

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.

Long/short credit strategies seek to mitigate interest rate and credit risks regardless of market environment through investment in credit-related and structured debt vehicles. These strategies involve the use of market hedges and involve risks such as derivatives, fixed income, foreign investment, currency, hedging, leverage, liquidity, short sales, loss of principal and other material risks.

Credit Ratings

Ratings assess default and credit risk. The ratings shown are not a forecast or guarantee of investment results. They are assigned by Standard and Poor's at the time of their analysis and subject to change based on economic, issuer or other factors. The issue ratings definitions are expressed in terms of default risk. The ratings should only be considered as an opinion by the rating organization as to the credit quality of investment. Investment grade bonds pertain to bonds rated BBB or better. The rating represents a relatively low-risk bond or investment that is judged by the rating agency as likely to meet payment obligations. A BBB-rated bond is judged to have speculative elements and is subject to substantial credit risk.

Alerian MLP Index is a composite of the 50 most prominent energy Master Limited Partnerships (MLPs) that provides investors with an unbiased, comprehensive benchmark for this emerging asset class. The index, which is calculated using a float-adjusted, capitalization-weighted methodology, is disseminated real-time on a price-return basis and on a total-return basis.

The BofA Merrill Lynch US High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.

BofA Merrill Lynch U.S. Corporate Index is comprised of U.S. dollar denominated investment grade corporate debt securities publicly issued in the U.S. domestic market with at least one year remaining term to final maturity.

Bloomberg Commodity Index is a broadly diversified index comprised of 22 exchange-traded futures on physical commodities and represents 20 commodities weighted to account for economic significance and market liquidity.

FTSE EPRA/NAREIT Developed ex US Index is designed to track the performance of listed real estate companies in developed countries worldwide other than the United States.

JPMorgan Global Ex United States Index (JPM GBI Global Ex-US) is a total return, market capitalization weighted index, rebalanced monthly, consisting of the following countries: Australia, Germany, Spain, Belgium, Italy, Sweden, Canada, Japan, United Kingdom, Denmark, Netherlands, and France.

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.