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What to Do With a Neutral Outlook

Wells Fargo Investment Institute - April 29, 2019

Key takeaways

  • We believe that a U.S. economic recession is unlikely in the next 12 months, and potentially longer—while somewhat stronger growth seems set to emerge in the second half of 2019. International economic growth remains slow, however, and recent data suggest a delayed growth rebound in Europe and Japan.
  • We find many asset classes that appear to have upside opportunities over the next 12 months but that seem extended in the near term. Consequently, we have adopted a neutral position for many asset classes.

What it may mean for investors

  • This report offers guidance on steps that investors can consider when the tactical  (6-18 months ahead) outlook is neutral.

So far this year, we have taken guidance to neutral for a variety of equity, fixed income, and real asset classes1.  One point of emphasis is that neutral is not a negative outlook, and we believe there are steps investors can take to manage portfolios under neutral conditions.

Q: Recession or no recession? Have the odds changed significantly? 

The U.S. economy has slowed from last year, but we view the probability of a recession as below 50% in the next 12 months. After a weak start to the year, the labor market and consumer spending are recovering. We expect these factors—along with low inflation—to support moderate growth into 2020. We also believe that the Federal Reserve (Fed) has ended its rate-hiking cycle, a move that should add support to the economy. 

With this combination of slow growth, low inflation, and low long-term interest rates, it is tempting to say that 2019 is like 2016 to 2017. But this comparison has a glaring weakness. Unlike 2017, global economic growth today is not synchronized, especially in Europe and Japan, where contracting global trade restrains manufacturing and capital spending. The timing of these countries’ economic recovery is uncertain and depends on still-incomplete U.S.-China trade negotiations. The main risk might be that trade fails to gain new momentum, pushes European and Japanese economies into recession, and dents U.S. overseas earnings. A rapid strengthening of the U.S. dollar could presage this risk. 

Q: What should investors make of the strong equity rallies so far this year?

Global equities rose by more than 13% in the first quarter of 2019, led by Information Technology, Real Estate, Industrials, Energy, and Consumer Discretionary, even as broader economic growth decelerated. A combination of factors lifted investor sentiment, including relief that a recession does not appear imminent, the Fed’s move to stop raising interest rates, and new hope for positive outcomes from U.S.-China trade talks and Brexit negotiations.

Our April 24, 2019 report, noted above, discussed in detail why we expect steady 2019 profit margins for most U.S. firms, and why positive global earnings growth and somewhat higher valuations are likely by year-end. Nevertheless, we are neutral on the S&P 500 Index, because the index has returned to fair value amid significant near-term risks. Market volatility remains likely if: (i) the weak international data persist and suggest a spillover to other regions, or (ii) U.S.-China trade negotiations disappoint investors. 

Q: How is a neutral equity view consistent with a sector bent toward cyclicals? 

Our recent equity sector weighting changes align with the outlook for moderate U.S. economic growth—but volatility from sluggish international growth. As the U.S. economy steadies after a difficult start to the year, we favor increasing allocations to growth-oriented cyclical sectors. Our recent guidance upgrades emphasize the sectors with the highest forecasted 12-month forward earnings growth, while our downgrades reflect less favorable fundamentals. Still, our outlook for moderate U.S. growth—and the risk from sluggish growth and policy disappointments overseas—have led us to a greater emphasis on quality considerations among sectors, including low leverage, high profitability, and low earnings volatility. Stronger liquidity and debt management should soften the portfolio impact of the anticipated global equity market volatility.

Q: We are neutral on large- and mid-cap equities, neutral on intermediate- and long-term fixed income, and neutral on commodities. What is there for investors to do with so many neutral ratings?

We believe that investors should consider taking several steps:

As U.S. large caps move higher or lower, adjust holdings to maintain a neutral position. A neutral equity position does not mean liquidating equity holdings but, instead, taking steps to maintain one’s strategic or long-term target allocation in the face of market volatility. A neutral position accommodates rebalancing, which is a proactive strategy to manage risk. Rebalancing means taking some profits as equity prices exceed targets, and then reinvesting the proceeds in favored markets or sectors. Investors can reallocate cash to more favored markets or sectors in increments, either at regular intervals or as prices fall by designated percentages. In this environment, cash managed in this disciplined way can be a useful tool. 

Exploit the gradations in our asset class guidance. U.S. large- and mid-cap equities look neutral as a group, but we have a most favorable view on emerging market equities and an unfavorable view on U.S. small caps. An investor could rebalance toward neutral in U.S. large- and mid-cap equities, in order to increase diversification and exposure toward emerging markets. 

Even within the universe of large-cap equities, investors can follow our sector preferences. Specifically, we recently upgraded Information Technology and Energy, at the expense of Financials, Materials, and Health Care. This combination allows for rebalancing to the more favored sectors from the less favored. We also believe that the upgrades reinforce the quality of an equity position (see below).  

We recently upgraded intermediate- and long-term fixed income from unfavorable to neutral. Managing these neutral positions depends on the investor’s objective but, in broad strokes, some adjustments over time can help to target a more neutral position in intermediate and longer-term bonds:

  • Rather than selling individual bonds (a potentially expensive proposition) to buy those with longer maturities, an investor who owns individual bonds can simply look to buy longer-term bonds with existing cash, or as holdings mature. 
  • An investor that owns managed investments, such as mutual funds, exchange-traded funds, or separately managed investments with a short-term duration profile could target a manager with a neutral duration profile (our current position).  

Focus on quality. Corporate cash and healthy debt levels become especially important as an economic expansion matures, and rising debt levels become a risk to the economy. In equities, we favor reallocating between sectors based on quality factors. In fixed income, currently low interest rates may drive investors to assets with compelling yields—but which also have greater risk of sharp price declines and market losses. We favor increasing credit quality, and we remain unfavorable on high-yield debt.

Q: What could lead us to be more favorable on the broad S&P 500 Index? 

In order to move from neutral back toward favorable, we need to see better value in markets and more alignment between sentiment and the economic backdrop. That is, we would need to see the eventual stabilization in global economic growth that we expect—and also a pullback in equities that enables meaningful appreciation toward our 12-month targets.

View a PDF version of this report

1 Please see Institute Alert, “Adjusting for the Gap between Sentiment and Growth”, April 24, 2019; Institute Alert, “Lower Growth Expectations and Portfolio Implications”, April 4, 2019; Institute Alert, “Changing Guidance and Exposure for an Evolving Slowdown”, March 7, 2019; and Institute Alert, “Reducing Portfolio Risk”, January 31, 2019.

2 Duration is a measure of a bond's or bond portfolio's sensitivity to interest rates.