Investment Strategy

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

November 20, 2017

John LaForge, Head of Real Asset Strategy

Oil—Running into Year-End Headwinds?

Key Takeaways

  • Oil prices have rallied 30 percent, since mid-June. We are expecting to see extra global supplies soon.
  • We are currently underweight the commodities sector as we believe that commodities remain within a bear market super-cycle.

What it May Mean for Investors

  • With West Texas Intermediate (WTI) crude-oil prices near the high end of our long-term $30-$60 price range, we recommend being sellers of oil at these levels.

“I have a huge debt to pay. I have to produce oil, [and] I have to make money.” -Pedro Parente, Petrobras Chief Executive Officer

Oil prices have been on a great run since June—with the major U.S. oil benchmark, WTI crude oil, gaining more than 30 percent. Why exactly is anyone’s guess; and we have heard lots of guesses. Most cited is the new, more amicable, relationship between Russia and Saudi Arabia. These two countries together generate roughly 24 percent of world oil production. A more friendly and coordinated relationship could be the main reason why oil prices have finally moved higher.

We also have heard that oil prices have risen because, “…it is that time of the year.” We doubt that this is the reason for crude oil’s recent gains. Chart 1 highlights the typical monthly WTI price pattern. The dark blue bars represent the average monthly gains for WTI, since 1979. Notice that WTI prices typically rise in the third quarter of each year, but not in the fourth quarter. In other words, oil prices typically fade by now, starting in October. This has not been the case in 2017.

Chart 1. Seasonality of Crude Oil (4/30/83 – 10/31/17)Chart 1. Seasonality of Crude Oil (4/30/83 – 10/31/17) © Copyright 2017 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.

The fact that crude-oil prices are bucking their typical seasonal pattern likely stems from investors finally grasping the fact that the global demand/supply picture has improved. The green line in Chart 2 shows the global balance between growth in demand and supply. A rising green line means that demand growth is outstripping supply growth, which is typically a plus for oil prices. This can be seen in the blue line, which is the price of Brent, a major global crude-oil benchmark. Yet, the recovering demand/supply picture has stopped improving. This can be seen in the falling green line in recent months. We believe that this is largely a supply issue. In other words, the move into the $50s, since the summer, has incentivized countries and companies to produce more oil. If this dynamic continues, as we suspect that it will, investors should not expect global oil prices to hold onto their recent gains.

For some time, our stance has been that WTI oil prices would slip back into the $40s before year-end 2017, precisely because we believed that recent price gains would be met with more supply. Extra supply appears to be coming, but the price response has been slow. That is fine with us, as we are in this investment-advice game for the long haul. But for those of you who were counting on seeing WTI with a $40s handle by year-end; it probably won’t happen until 2018.

Chart 2. Global Oil Price versus Global Oil Demand/Supply BalanceChart 2. Global Oil Price versus Global Oil Demand/Supply BalanceSource: U.S. Energy Information Administration, Bloomberg, Wells Fargo Investment Institute. Monthly Data: 1/2002 - 10/31/2017.

Chart 3 shows another way to look at the supply side of the oil picture. It highlights the world’s top petroleum producers. Notice that most of the countries on the list have supply hooking up, not down. And most importantly, the world’s largest petroleum producer, the U.S. (Chart 3, blue line), is clearly producing more oil. In fact, the U.S. is producing more oil in 2017, with WTI prices in the $50s, than it was in 2014, the last time WTI prices were north of $100.

Chart 3. Top Petroleum ProducersChart 3. Top Petroleum ProducersSources: Energy Information Administration, Bloomberg, Wells Fargo Investment Institute. Monthly Data: 1/31/1981 - 10/31/2017.

Lastly, we want investors to keep in mind that recent oil-price moves need to be viewed in the bigger picture. We suspect that oil prices will remain range-bound for a few more years to come. Our best guess for this range is between $30 and $60 per barrel. The reason is that oil is part of the commodity family, and history tells us that the “family” moves together over long price cycles, which we call super-cycles. Chart 4 showcases commodity prices, since 1914, and how they typically move as a family. Oil is the black line, gold is the gold line, silver is the silver line, and the entire commodity family is the green line. Notice that they generally track one another over time.

As of 2017, the commodity family is six years into a price bear super-cycle, which began in 2011. The average bear super-cycle, since the year 1800, has lasted nearly 20 years. We are not expecting this bear to last the average 20 years, but we also believe that a six-year bear market is much too young to sprout a new bull market in commodity prices. At this point in a typical bear super-cycle, the big price declines likely have been seen (i.e. WTI falling from $110 per barrel in 2014 to $26 in 2016). That is the good news. The bad news for oil bulls is that this is also the point in the cycle at which prices become stuck in wide prices ranges. Money can be made in bear super-cycles, no doubt, but investors should not expect to see $100 oil anytime soon. Our bottom line is that we think investors in 2017-2018 should look to sell WTI near $60 per barrel, and buy it should it slip into the $30s.

Chart 4. Commodity Prices Have Tended to Run TogetherChart 4. Commodity Prices Have Tended to Run TogetherSources: Bloomberg, Kitco, Bureau of Labor Statistics, Federal Reserve Economic Research, Prices by Warren and Pearson. Monthly data: 1/31/1914 – 10/31/2017. Values shown in log scale. Indexed to 100 as of 1/31/1914. Gold, silver and crude oil (West Texas Intermediate) are based on spot prices.

Equities

Sean Lynch, CFA, Co-Head of Global Equity Strategy

With Fewer Rupees and a Better Market, India Is Outperforming

On November 8, 2016, India’s government surprised its citizens and global markets by removing from circulation the current series of 500 rupee ($8.00) and 1,000 rupee ($16.00) bank notes. This was done to curtail the “shadow economy” (unreported economic activity that would generally be taxable). Yet, it also posed a risk of slowing growth for an economy accustomed to hard currency. This was not the only major move undertaken by Prime Minister Modi as he sought to remove barriers to doing business. So far, equity markets have cheered his policy changes.

Year to date (YTD), India’s equity markets have shown impressive gains, as the major India equity indices (the NIFTY 50 and S&P BSE SENSEX 30) are up 23.6 and 23.0 percent YTD, respectively, in local-currency terms. A weaker dollar (USD) versus the rupee has enhanced returns for U.S. investors, as YTD returns in USDs are 28.5 and 27.9 percent, respectively. India’s risks include the need to create meaningful work for a young and educated workforce—and managing debt. The government recently injected capital into some of the state banks. Along with other factors, this pushed India’s 10-year sovereign debt yield to seven percent. Higher rates may start to affect businesses and negatively impact valuations.

India has emerged as one of the world’s fastest-growing economies. The country’s expanding middle class should continue to make it a consumption hub for multinational companies. Further, the improving business climate may continue to propel its equity markets higher. We believe that exposure to equities in India should be a core part of investors’ emerging-market holdings.

Key Takeaways

  • India’s expanding middle class should continue to make it a consumption hub for multinationals.
  • Major Indian equity indices such as the NIFTY 50 and S&P BSE SENSEX 30 are up 28.5 and 27.9 percent, respectively, YTD (in U.S. dollar terms).
India's Major Equity Indices Have Rallied in 2017India's Major Equity Indices Have Rallied in 2017Sources: Wells Fargo Investment Institute, Bloomberg;11/15/17.

Fixed Income

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

Fed and Bond Market Are Not In Sync

On December 13, 2017, the Federal Open Market Committee (FOMC) is likely to increase the federal funds rate by 25 basis points to 1.25 – 1.50 percent. The market already has priced in a rate hike, and we would expect little market reaction from a rate increase. The focus for the bond market is not on what rate hikes occur between now and year-end; the focus is on what will occur in 2018. Currently, the Federal Reserve (Fed) has different expectations than the market does.

The Fed has been stating that Fed members expect three rate hikes in 2018. The market has been skeptical that the Fed will hike more than just once next year. The Fed has been steadfast in projecting three rate increases in 2018—with no change in 2018 projections since December 2016. The Fed has a mixed record of projecting rate hikes over a 12-month period.

The fed funds futures market sees a greater than 50 percent chance of just one Fed rate hike next year. The futures market also sees just a 15-percent probability that the Fed will raise rates three times in 2018. We expect two rate hikes in 2018. The lack of market consensus on rate-hike expectations may lead to an increase in bond-market volatility, depending on who is right.

Key Takeaways

  • We expect the interest-rate curve to continue to flatten if short-term rates increase at a faster pace than longer-term rates.
  • We favor intermediate-term fixed income maturities that we believe should continue to provide investors with modest returns, coupled with limited downside volatility.
Fed Expectations for Rate Hikes Over the Next 12 MonthsFed Expectations for Rate Hikes Over the Next 12 MonthsSources: Wells Fargo Investment Institute, Bloomberg; 11/15/17. Chart shows Fed rate hike expectations for the following 12 months each year. It also shows actual rate hikes in that year. Expected bar reflects one additional Fed rate hike (anticipated for December 2017).

Real Assets

John LaForge, Head of Real Asset Strategy

Gold—Following the 1980s Script

“If you want what fate wants, then nothing can happen against your will.” --Chuang Tzu

Has anyone noticed that gold prices seem stuck near $1,280? Gold had a great first-half rally to $1,350, but it has faded, since September. We believe that this action is related to the U.S. dollar. Like most other commodities, gold is priced in U.S. dollars. When the U.S. dollar strengthens, gold prices typically decline, and vice versa. Since September, the U.S. dollar has been rallying versus a basket of other major currencies. This has pushed gold prices lower. For 2018, Wells Fargo Investment Institute is not expecting much in the way of U.S-dollar (USD) gains or losses. Should this “going nowhere fast” scenario play out for the dollar in 2018, we suspect that other factors will take the lead in influencing gold prices.

At the top of our list for gold-price influences in 2018 is that pesky commodity bear super-cycle we love to talk about. In our view, gold, like other commodities, is stuck inside a multi-year bear market. Prices should be range-bound for a few more years as commodities struggle to shake persistent oversupply. For gold, we see $1,050-$1,400 as the likely trading range over the next five years or so. Chart 1 shows the track we expect for gold to follow closely. The blue line shows how gold behaved during its last bear super-cycle, from its peak in 1980, to its bottom near 2000. The green line represents gold’s performance so far this bear super-cycle, which began in 2011.

The U.S. dollar heavily influenced gold’s price action in 2017. For 2018, we are expecting the commodity bear super-cycle to be the main factor impacting gold.

Key Takeaways

  • The U.S. dollar heavily influenced gold’s price action in 2017. For 2018, we are expecting the commodity bear super-cycle to be the main factor impacting gold.
  • We expect flat-to-down gold prices in 2018.
Gold Performance Today versus Gold in the 1980s CycleGold Performance Today versus Gold in the 1980s CycleSources: Wells Fargo Investment Institute, Bloomberg; 11/15/17.

Alternative Investments

Jim Sweetman , Senior Global Alternative Investment Strategist

Time for a Regime Change?

With an estimated October return of 2.53 percent, the HFRI Macro (Total) Index posted the strongest gain since December 2010 and pushed the rolling 12- and 24-month returns into positive territory. Yet, enthusiasm was tempered by the fact that the majority of the gain stemmed from highly leveraged long equity and energy (oil) positions. In fact, we continue to remind investors that the “risk-on” posture currently expressed by many Macro managers may actually exacerbate losses in a sharp correction, even though the Macro strategy historically has very low correlation to U.S. large-cap and global equities.

Since the inception of the HFRI Macro (Total) Index in January 1990, the rolling 12-month return has been negative in only 50 of 323 periods, or slightly more than 15 percent of the time. Remarkably, 42 of those 50 instances have occurred in the past six years. We believe that there are three distinct regimes of Macro returns: the early 1990s to the late 1990s, the late 1990s to the global financial crisis, and post-crisis through today. It is unlikely that we will return to the “heyday” of Macro investing seen in the early 1990s. We currently are forecasting low-single-digit annualized Macro-strategy returns next year, but we do anticipate an increase in these returns as volatility rises from its abnormally low base, and the impact of global monetary policy dissipates.

Key Takeaways

  • October was a strong month for Macro strategies, although returns were dependent on risky long equity and oil positions.
  • Historical strategy performance can be segregated into three regimes; we anticipate an improvement in returns as volatility rises and central banks tighten policy.
Macro Performance: Three Regimes in (Nearly) Three DecadesMacro Performance: Three Regimes in (Nearly) Three DecadesSource: Hedge Fund Research, Inc., Wells Fargo Investment Institute, 11/14/17. Index returns are for illustrative purposes only and do not represent the returns of an actual portfolio in existence during the time periods shown. The 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. Unlike most asset class indices, HFR index returns reflect fees and expenses. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

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 other 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

The NIFTY 50 Index is the National Stock Exchange of India's benchmark index. The S&P BSE SENSEX (S&P Bombay Stock Exchange Sensitive Index) is an index of 30 well-established Indian companies.

The S&P BSE SENSEX (S&P Bombay Stock Exchange Sensitive Index) is a free-float, market-weighted stock market index of 30 well-established Indian companies listed on the Bombay Stock Exchange. The 30 component companies are representative of various industrial sectors of the Indian economy. This index also is called the BSE 30 or the SENSEX.

An index is unmanaged and not available for direct investment.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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

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