Investment Strategy Report - Asset Allocation Spotlight - Wells Fargo Investment Institute

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Investment Strategy

Wells Fargo Investment Institute - March 17, 2020
    

Asset Allocation Spotlight

by Global Asset Allocation Strategy Team

…And the bear has arrived

  • U.S. equity markets entered bear market territory last week as the novel coronavirus (COVID-19) fueled rapidly rising economic and market headwinds.
  • Historically, diversified portfolios have helped investors weather equity volatility and often have recovered to a recent market peak more quickly than individual asset classes (e.g., equities) have done.

Just two short months ago, our investment strategy committee was contemplating what risks could take down the enduring market climb that had led to the longest bull market on record—and then China reported a new virus strain that was sickening its citizens at an alarming rate. Not to worry, many investors reasoned, this new virus likely will die out before crossing the globe to more developed countries in Europe and the U.S., that most surely have the tools to deal with this type of menace.

But that thinking proved too optimistic as the rapid spread, coupled with the virulence of COVID-19, led to downgrades of 2020 global growth and market performance forecasts. Bond yields tumbled to their lowest rates on record, and on March 11, the World Health Organization announced that the COVID-19 virus had become a global pandemic. This announcement—while highly telegraphed—nevertheless led to a renewed round of selling in global markets. Moreover, uncertainty about the possible fiscal policy countermeasures that U.S. policymakers were contemplating also contributed to the sell-off.

On March 11, the Dow Jones Industrial Average closed with a decline of more than 20% from its all-time high on February 12, 2020, marking the start of a new bear market. The S&P 500 Index followed suit on March 12 (the S&P 500 Index reached its all-time high on February 19, 2020).

No one knows for sure how long and how deep this bear market may be, but a look back at previous bear markets gives us some historical context. Since 1929, bear markets have averaged about 20.1 months in duration and have been reflected in an average S&P 500 Index decline of just over 39%.

Table 1. A history of bear markets

Table 1. A history of bear markets

Sources: Bloomberg and Wells Fargo Investment Institute, as of March 17, 2020. Data January 1929 through March 17, 2020. For illustrative purposes only. The S&P 500 Index is a market-capitalization-weighted index that is considered to be representative of the U.S. stock market. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment.

It is important to note that Wells Fargo Investment Institute’s (WFII) investment objective allocations carefully weigh potential market volatility risk against the potential for long-term growth in the value of the portfolio. The goal is to construct a mix of asset classes that is designed to provide a path of expected returns calibrated to the volatility risk an investor is willing to assume. In other words, investment allocations are designed to match specified risk and return objectives.

As Chart 1 shows, our strategic allocations employ exposure to equities for the potential for long-term growth and exposure to fixed income for the potential for stability and income generation. Some allocations also may include hedge funds for the diversification benefits that they may provide to qualified investors. In today’s volatile market environment, asset allocations that favor fixed income have been faring much better than those that favor equities. This is in contrast to last year’s returns and the returns we expect for a full market cycle (a full bull market and a full bear market).

Chart 1. WFII’s asset allocation for a range of investment objectives

Chart 1. WFII’s asset allocation for a range of investment objectives

Sources: Wells Fargo Investment Institute; July 16, 2019. Chart is conceptual and does not reflect any actual returns or represent any specific asset classifications.

As Chart 2 illustrates, financial markets can be extremely volatile on a short-term basis, and some investors may be unable to tolerate sizable drawdowns in their portfolios. One way to participate in the financial markets, while potentially minimizing wild swings in investment portfolios, is through asset allocation. Having exposure to a diversified mix of asset classes that do not always move in the same direction historically has provided some downside risk mitigation.

Chart 2. Returns of a WFII diversified portfolio versus performance of individual asset classes

Chart 2. Returns of a WFII diversified portfolio versus performance of individual asset classes

Sources: Morningstar Direct and Wells Fargo Investment Institute, March 11, 2020. WFII portfolio returns are shown in the gold bars—individual asset classes are in the blue bars. Performance results for the WFII 3AG (three asset group) portfolios are hypothetical and presented for illustrative purposes only. Index returns do not represent investment performance or the results of actual trading. Index returns reflect general market results, assume the reinvestment of dividends and other distributions, and do not reflect deduction for fees, expenses, or taxes applicable to an actual investment. An index is unmanaged and not available for direct investment. Hypothetical and past performance does not guarantee future results. Please see the end of this report for portfolio compositions, index definitions, and risks associated with the representative asset classes.

Note that most fixed income and equity asset classes have performed very differently from one another in this environment. This is why diversification can help—holding a mix of assets has mitigated some of the downside risk from the equity markets in this environment.

As shown in Chart 3, while the year-to-year historical returns of a diversified allocation (represented by WFII’s Moderate Growth and Income 4AG Portfolio) have varied widely; yet the rolling 10-year returns have been far more consistent.

Chart 3. Annual returns of a diversified portfolio allocation are more volatile than 10-year returns

Chart 3. Annual returns of a diversified portfolio allocation are more volatile than 10-year returns

Sources: Morningstar Direct and Wells Fargo Investment Institute. Data: December 31, 1989-December 31, 2018. Performance results for the Moderate Growth and Income Four Asset Group Portfolio are hypothetical and for illustrative purposes only. Index returns do not represent investment performance or the results of actual trading. Index returns reflect general market results; assume the reinvestment of dividends and other distributions; and do not reflect deductions for fees, expenses, or taxes applicable to an actual investment. An index is unmanaged and not available for direct investment. Hypothetical and past performance is no guarantee of future results. Please see the end of this report for portfolio composition, index definitions, and risks associated with the representative asset classes.

Diversification also has allowed for shorter recovery times, meaning that historically it has not taken as long to get back to the previous peak after markets fall. Chart 4 highlights periods throughout the past 40 years in which the S&P 500 Index has entered a correction or bear market territory. The chart also shows how a diversified allocation generally has not experienced losses that are as sharp as those of an all-equity position during equity market drawdowns.

Chart 4. Diversification may reduce downside risk during a correction or bear market

Chart 4. Diversification may reduce downside risk during a correction or bear market

Sources: Morningstar Direct and Wells Fargo Investment Institute, as of March 11, 2020. Performance results for the Moderate Growth and Income 3AG Portfolio is hypothetical and is presented for illustrative purposes only. Index returns do not represent investment performance or the results of actual trading. Index returns reflect general market results, assume the reinvestment of dividends and other distributions, and do not reflect deduction for fees, expenses or taxes applicable to an actual investment. An index is unmanaged and not available for direct investment. Hypothetical and past performance does not guarantee future results. Please see the end of this report for portfolio compositions, index definitions, and risks associated with the representative asset classes. Note: Corrections are declines of 10% or more. Bear markets are declines of 20% or more.

Attempting to reduce downside volatility can be critical to long-term performance, as it can allow a portfolio to recover much more quickly after a negative market event. Using the same corrective periods from Chart 4 (with the exception of the current drawdown), we examined how long it took to recover to the prior peak. Table 2 shows that, on average, a diversified allocation recovered faster (at just under two years for a bear market) than the S&P 500 Index after corrections and bear markets (which recovered in about 3.5 years from a bear market).

Table 2. Corrections and bear markets—length of time to recover to previous peak

Table 2. Corrections and bear markets—length of time to recover to previous peak

Source: Wells Fargo Investment Institute, March 12, 2020.  Corrections are declines of 10% or more. Bear markets are declines of 20% or more. Performance results for the Moderate Growth and Income 3AG Portfolio is hypothetical and is presented for illustrative purposes only. Index returns do not represent investment performance or the results of actual trading. Index returns reflect general market results, assume the reinvestment of dividends and other distributions, and do not reflect deduction for fees, expenses or taxes applicable to an actual investment. An index is unmanaged and not available for direct investment. Hypothetical and past performance does not guarantee future results. Please see the end of this report for portfolio compositions, index definitions, and risks associated with the representative asset classes.

Although downside events have typically been short-lived, how investors react (or don’t react) can be extremely important in meeting long-term financial goals. We have offered guidance for shorter-term tactical adjustments to WFII’s strategic allocations that we believe can help to reduce risk and improve overall return. For fixed-income portfolio positioning, we were favorable on duration (a measure of a bond’s interest rate sensitivity) positioning last year and early in 2020, which benefited the allocations’ performance (we recently moved to a neutral duration position given the yield decline and we retain our high-quality bias in fixed income). In equities, we also have continued to stress our preference for quality equity classes and sectors. We currently favor U.S. over international equity markets and large- and mid-cap equities over small caps. We favor commodities at current levels. In addition to our unfavorable guidance on small caps, we are unfavorable on Emerging Market Equities and Developed Market (ex-U.S.) Equities today. From an equity sector standpoint, we hold an unfavorable view of Industrials, Energy, and Materials. We prefer Information Technology, Communication Services, Consumer Discretionary, and Financials at current prices.

We believe that the best investment approach is to set a strategic asset allocation that represents an investor’s goals, risk tolerance, and time horizon—and to rebalance back to those strategic targets on a regular basis. Trying to time the market during periods of heightened volatility is nearly impossible. Yet, investors may want to consider employing tactical asset allocation to make modest adjustments to portfolio allocations based on a nearer-term outlook. These actions may assist in reducing downside risk and could help a portfolio to recover more quickly after negative market-moving events.

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