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Weekly market insights from the Global Investment Strategy team
What it may mean for investors
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
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.
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.
All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security. Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments.
Dividends are not guaranteed and are subject to change or elimination.
Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.
Investments in fixed-income securities are subject to market, interest rate, credit/default and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond's price. Because bond prices generally fall as interest rates rise, the current low interest rate environment can increase the bond's interest rate risk. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.
Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. These bonds are subject to interest rate and credit/default risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer.
A rating: Upper-medium grade and subject to low credit risk.
Global Investment Strategy is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.
The information in this report was prepared by the Global Investment Strategy division of WFII. 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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