Paul Christopher, CFA®
by
Head Global Market Strategist
Sameer Samana, CFA®
by
Global Quantitative Strategist

Weekly market insights from the Global Investment Strategy team

  • The substantial rise in domestic equities and bond yields since November 9 has been attributed to the Republicans' election victories, but we believe that's only partly true.
  • Trends in equity, fixed income, and currency markets anticipate economic improvement and policy changes, but these expectations seem to be extrapolated beyond what is likely to happen in 2017.

What it may mean for investors

  • We offer specific suggestions on how to remain invested for a market environment featuring modest growth and inflation, along with limits to further dollar strength.
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Investing When Market Trends Outrun Fundamental Support

The rise in domestic equities and bond yields since November 9 has been attributed to the U.S. election results, but we believe that this reason does not fully explain these market developments, nor is it likely to sustain current market trends. To be accurate, the economy started to improve even before the election. Weak points—manufacturing, trade, and business investment spending on plant and equipment—all have shown some modest recovery since midyear.

We also do not expect significant economic benefit from new government policies in 2017. The incoming administration seems intent on notching some relatively quick successes in the first few months. Yet, the more substantive proposals for the economy are likely to advance over years and only after significant compromise. In particular, if congressional leaders want to avoid long filibusters over tax reform, procedural rules will force reductions in federal tax deductions to leave the budget neutral under lower tax rates. Even more, before debating tax reform, Congress needs a 2017 budget resolution. And difficult battles over the debt ceiling, the next Supreme Court nominee, and health-care reform are in the wings.

Even deregulation is potentially complex. Overturning environmental rules, for instance, requires new legislation or executive decisions that could prompt court challenges. Also, many businesses have already adapted by investing significantly in the direction of clean energy, driven partly by low prices for natural gas and wind power, but also under pressure from investors, activists and customers.

Current Trends Appear to Be Ahead of Fundamentals

We advise investors not to extrapolate the post-election market trends straight through to the end of 2017. Investors typically try to anticipate as much of a trend-changing event as quickly as possible. For example, over the past 20 years, fixed-income yields have adjusted higher during a number of periods. Such adjustments typically take only a few months to complete, as shown in the table below, but most of the yield increase occurs early in the adjustment period.

Table 1. U.S. Treasury Yields Can Complete a Change in Trend in Just a Few Months' Time


Table of chnages in Treasury yields trends over a short duration of time. Contact your Relationship Manager for more information.

Sources: Bloomberg and Wells Fargo Investment Institute, 12/16/2016. Past performance does not guarantee future results.

We believe that the strengthening U.S. economy should raise domestic interest rates faster than international rates and thereby support the dollar. Yet, the U.S. economy's strength could work to limit dollar appreciation in two ways. First, if the dollar were to appreciate by another five percent, the cost of U.S. exports to overseas buyers could again reach a level that previously dented U.S. exports, corporate earnings, and economic growth. Second, a healthier U.S. economy also is driving consumer spending, including purchases of imported goods. Growing U.S. borrowing from suppliers overseas should moderate and even limit the dollar's 2017 gains.

Moreover, wide dollar exchange-rate swings are possible, given the uncertain foreign-policy priorities of the incoming U.S. administration. The low end of that range is likely close to the dollar's current value, thanks to support from relatively attractive U.S. interest rates. On the upper end, the level from the late 1990s seems to be a reasonable possible limit.

As for equity markets, the U.S. economy is still growing, and we expect further earnings expansion, even beyond 2017. Improving earnings represent a competitive return factor for stocks that bonds lack, but rising bond yields have narrowed the advantage. For example, a few months ago, more than 200 of the individual companies within the S&P 500 Index carried dividend yields exceeding the 10-year U.S. Treasury note yield. Currently, with the Treasury yield at roughly 2.60 percent, that proportion has halved.

Investment Implications

The fundamental changes in earnings, economic growth and inflation are likely to take years to play out, not months. We believe that investors should continue to allocate investments for modest growth and inflation and diminishing dollar strength:

Consider a more defensive fixed-income posture: Current yields show much of the interest-rate rise we are expecting but could drift a little higher. While risks remain for higher U.S. bond yields, we favor domestic investment-grade bonds with maturities of five to 10 years, and we also favor raising average credit quality. Among municipal bonds, we prefer holdings with ratings of single-A or higher, especially from essential-service revenue issuers. We also favor premium bonds offering higher coupons. We believe that international developed-market ex-U.S. bond yields should remain significantly below U.S. yields on comparable maturities. We would not add to these positions, nor do we expect the dollar to strengthen enough to make hedging worthwhile.

Rising volatility should provide tactical equity opportunities: U.S. equity yields may be somewhat less competitive today versus bond yields than in the past several years. However, we expect continued low inflation and a cautious Federal Reserve to preserve equities' relative attractiveness. New government policies may not raise economic growth appreciably in 2017, but earnings growth should be sufficiently strong to post increases of six or seven percent, even with the headwind from the dollar's accumulated gains since 2014. We favor tactical investment in cyclical equity sectors that can benefit from economic growth and the new administration's policies. Volatility can provide opportunities to invest in quality issues and high-potential sectors.

Maintain international equity exposure: International equities are generally cheaper than U.S. equities based on price-to-earnings comparisons. Looking ahead, international markets could cheapen further, but economic growth has recovered close to its long-term trend in Western Europe—and is stabilizing in Asia and Latin America. Meanwhile, Japan's large exporters should benefit from rebounding global trade and from yen depreciation, which makes Japanese exported products cheaper.

Be an active investor: Our outlook is for flatter returns in 2017 than in 2016. Meanwhile, U.S. policy uncertainties may spark market volatility. We believe that investors can benefit from being more active or nimble in financial markets next year—and capitalizing upon volatility to realign assets to investment classes with the most future potential. Specifically, we favor regularly rebalancing portfolios and strategically reallocating profits from asset classes that have appreciated into other investments that have a more attractive difference between potential risk and reward.