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Q&A—Where Markets May Go From Here

Wells Fargo Investment Institute - May 21, 2020

by Sameer Samana, CFA, Senior Global Market Strategist

Key takeaways

  • The recent run to levels above our year-end 2020 targets leaves equity markets trading close to what we believe to be fair value.
  • While monetary and fiscal stimulus have been the main drivers of the market’s rebound, we believe further gains will be harder to achieve.

What it may mean for investors

  • Investors should continue to maintain allocations in line with their investment plan and focus on higher quality areas, such as U.S. large- and mid-cap equities, and the Information Technology, Communication Services, Health Care, Consumer Discretionary, and Financials sectors.

What should investors do about equity markets trading above our year-end 2020 forecast targets?

Our year-end 2020 target prices have been surpassed, and we would anticipate more limited upside going forward, along with a bumpier road in the months ahead. While we expect the economy to improve in the second half of 2020 from the second-quarter shutdown, we believe a full recovery will prove long, slow, and uneven. This aligns with our tactical guidance to be overweight commodities and fixed income and underweight on equities.  For investors with equity allocations above recommendations, now may be a good time to consider trimming exposure, especially in areas we disfavor, such as U.S. small-cap, developed-market, and emerging-market equities and the Energy, Materials, Industrials, and Real Estate sectors.

Do we still expect a re-test of March lows? And if so, do we think investors should consider generating cash at these levels to potentially take advantage of an expected pullback?

Recent market action continues to track the past three recessions very closely in many ways. The S&P 500 Index rebounded 36% between March 23 and May 20 (its recent high). In the initial rebound rallies associated with the past three recessions, the S&P 500 rallied back 34% on average. Market breadth, while extremely narrow early in the current rebound rally, is slowly but consistently improving. We will need to see durability of expanding market breadth if markets are to move meaningfully higher from here.

While the immense amount of liquidity infused by the Federal Reserve (Fed), and the possibility of further fiscal measures, make a full retest of the March 23 lows (2192) less probable, we also take note of the expanding divergence between the market’s V-shaped recovery and the U.S. economy’s slower, more sanguine recovery path. Investors should prepare for equity markets that trade in a wide band without making much progress until there is greater clarity on COVID-19 related economic impact. Currently, we are closer to the upper end of that trading range, in our view, and we believe investors should rebalance back to recommended allocations, while preparing for the next bout of price weakness. Wells Fargo Investment Institute has a neutral rating on cash and would not recommend holding large allocations to low-yielding cash. We would favor Intermediate Fixed Income and Commodities as destinations for excess equity allocations. 

What factors do we expect to drive the market’s direction going forward in the near term?   

  • Fiscal and monetary stimulus. The size of stimulus and the degree of difficulty getting more support from Congress and the Fed will be important for the markets, in our opinion.
  • Reopening progression. Equity markets are beginning to build in positive assumptions for a “return to normal”. Data and activity levels would need to confirm this in coming weeks.
  • Vaccine hopes. Swift moves to the upside and disappointments to the downside on daily vaccine breakthroughs may be the norm for the near term as scientists race to accelerate testing and markets scrutinize plausible outcomes.
  • Signs of economic activity bottoming out. High-frequency data denoting any kind of near-term trends or themes in the data are watched more closely than ever before.
  • Expectations for a big earnings rebound in 2021. We believe earnings estimates for next year remain too high and need to come down—these potential revisions are not yet priced in.

What obstacles must be overcome in the intermediate term to continue the recent rally? 

  • Tighter lending standards
  • 36 million unemployed workers need to be able to seamlessly return to work
  • A growing spotlight on the November presidential and Congressional elections—with many key risks still looming large
  • Supply and demand questions: Simply reopening business—a supply push—does not ensure consumers return at the same consumption and confidence level—a demand pull. 

How can we be favorable on U.S. large and mid-cap equities, while current index values are above our 2020 year-end targets?

As mentioned above, we are currently underweight equities as an asset group, due to our expectations for further volatility in markets. Within the equities asset group, however, we favor higher quality U.S. large- and mid-cap equities and the Information Technology, Communication Services, Consumer Discretionary, Financials, and Health Care sectors. 

Do we still favor the U.S. over international markets? 

Yes. Our global macro team believes that the U.S. economy was the strongest global economy entering this recession and that it will emerge as the strongest coming out. Therefore, we believe the best opportunities remain in the U.S. at this point. Our equity strategy work suggests that sector composition and earnings prospects also favor U.S. large-cap equities over international developed and emerging market peers.

Why is Growth outperforming Value by so much?

Growth-style investments tend to have heavier concentrations in Information Technology, and Value-style investments tend to have higher concentrations to Financials. The outperformance of Information Technology stocks relative to Financials has been the main driver of Growth besting Value through this crisis. While we favor both sectors, we prefer Information Technology over Financials and believe Growth may continue to outperform over a tactical (6- to 18-month) horizon.

Why do we still like Financials?

The Financials sector has struggled due to concerns about a flat yield curve, which constrains the profitability of financial companies, and the possibility of a sharp rise in loan-related losses, which accompany recessions. But we believe Financials’ cheap valuations discount both of these issues. Interestingly, the yield curve has already started to steepen, thanks to the Fed’s rate cuts. The fast actions by the Fed and Congress may help soften the blow from an economic downturn, and the recent improvement in the absolute performance of Financials may suggest a bottom is near.

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