Investment Strategy Report - Is the business cycle dead? - Wells Fargo Investment Institute

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Investment Strategy

Wells Fargo Investment Institute - March 1, 2021

Is the business cycle dead?

Global Macro spotlight

by Gary Schlossberg, Global Strategist

  • During recent decades, the economy’s pace has lost much of the ebb and flow — the swings higher and lower — that characterized past business cycles. Yet, we view talk of the business cycle’s death as premature.
  • With the economic cycle still very much alive, we believe that growth, inflation, and other economic forces will be central to portfolio strategy in coming years. The outlook for strong economic growth and a moderate rise in interest rates this year favors cyclically sensitive stocks, in addition to old-favorites Information Technology and Communication Services, along with yield-advantaged sectors of the bond market.

Is the business cycle dead? An odd question during the economy’s recovery from the worst recession since the 1930s depression. Still, policymakers’ success in heading off a credit crunch and preventing an even deeper economic slump has revived an ongoing debate over their ability to control future economic cycles.

Eliminating economic booms and busts has been the Holy Grail for economists since at least the 1960s, when hope first emerged for corralling the economic cycle. Inflation’s more recent wind down was instrumental to the “Great Moderation” of economic stability that took hold in the 1990s and largely prevailed until the pandemic triggered major swings in economic activity after 2019 (see chart below).

From steadier growth to the economic cycle's demise?

From steadier growth to the economic cycle's demise?  

Sources: U.S. Commerce Department, Wells Fargo Investment Institute, February 24, 2021. As measured by the standard deviation of quarter-to-quarter returns in real GDP over a rolling 10-year period.

The stakes for investor

We believe that ending the business cycle would be as important for portfolio strategy as it would be for the economy. Just how important was apparent from declining S&P 500 Index volatility during the economy’s Great Moderation period, particularly in the decade before the onset of the 2020 pandemic. Steadier economic-growth and stock-market volatility ultimately was led by economically sensitive industrial, materials and consumer discretionary stocks, ultimately pulling the volatility of those sectors from 2010 to 2020 below that of traditionally more stable defensive sectors.

Our view is that taming the economic cycle might blur distinctions between the stock market’s defensive and cyclically sensitive sectors — reducing the importance of macroeconomic factors driving performance. Active investing could get a lift as the focus would shift from a rising macroeconomic tide lifting all ships to a renewed focus on standout companies supported by financial and management quality. We believe that changes could carry over to the bond market, where lower inflation and reduced interest-rate volatility could make the current focus on more yield-oriented sector strategies more enduring.

Reports of its death…

Like Mark Twain, however, we believe that reports of the business cycle’s death are premature. We see three reasons why efforts to fine-tune policy aren’t likely to eliminate the swings in activity that make the business cycle.

Problem one, for us, is overestimating policymakers’ effectiveness to avoid the same human errors and data misinterpretation that have dogged all forecasters.

Second, the same cushioning effect of low inflation and subdued interest rates creates its own stresses and strains in the financial market and, ultimately, the economy. Successfully subduing both inflation and interest rates encourages the kind of borrowing and rising asset prices that left markets vulnerable to financial and economic disruptions over a decade ago. In this way, we believe, efforts to stabilize the economy and the financial market have left both sensitive to interest-rate changes when inevitable disturbances do occur.

Risks from ultra-low inflation and interest rates have been aggravated in the past year by the Fed’s massive injection of money into the financial markets, partly to purchase Treasury securities to fund the government’s rapidly expanding debt. Financial distortions created by aggressive government intervention also have undercut the role of interest rates in allocating capital and of asset prices in accurately measuring securities’ quality and risk. There is also the incentive for excessive risk taking if businesses and investors come to expect government support to bail them out of difficult economic circumstances.

Third, we view policy fine-tuning to steady the economic cycle as largely irrelevant when the economy is confronted by a massive “unknown unknown” — like the pandemic or the big increases in oil prices during the 1970s. Policy also has had a mixed record in countering more slowly developing, identifiable problems due to any combination of political pressure, unexpected changes abroad, weather events, and other economic shocks. Economic reforms aimed at providing flexibility to absorb outside shocks often have been a double-edged sword, generating unintended market volatility, as we learned in the years following the shift from fixed to floating exchange rates in the early and mid-1970s.

Staying the course

For investors, we believe that an economic cycle alive and well means favoring markets and sectors that tend to outperform at the beginning of a business cycle. That strategy is influenced, at the moment, by an unusual economic cycle providing potential post-pandemic opportunities for technology and social media platforms nearly as great as those investors saw in 2020.

Likewise, our view is that the economically sensitive Industrials, Materials, and Consumer Discretionary sectors are likely to be propelled by what we believe could be the strongest economic growth in over 35 years. We also expect a moderate rise in interest rates to favor several yield-enhanced sectors of the bond market, including high-quality corporate, preferred and municipal securities over Treasury debt, which tend to be more susceptible to price declines if interest rates move higher as we expect.


by Chris Haverland, CFA, Global Asset Allocation Strategist

  • With longer-dated interest rates rising, some investors are questioning equity market valuations.
  • While higher interest rates can have a modest impact on equity valuations, in most rising-rate environments, both yields and equities have moved higher.

Interest rates and equity valuations

With longer-dated interest rates rising, some investors are questioning equity market valuations. Since the beginning of the year, the U.S. 10-year Treasury yield has climbed approximately 50 basis points to 1.4% (100 basis points equals 1%). While this is a sizable move on a percentage basis, the absolute level remains low, relative to history. Prior to COVID-19, the 10-year yield was near 2.0%, and the average in the decade leading up to the pandemic was 2.4%.

Equity investors shouldn’t fear rising interest rates as long as the move is supported by an improving economic backdrop. In 2021, we expect one of the best years for economic growth in decades. We anticipate this to likely lead to modestly higher inflation and longer-term interest rates. While this could cause short-term disruptions in the stock market, we look for accommodative monetary policies and well-behaved credit markets should dampen the impact.

Upward movements in rates can impact equity valuations. However, historically, price/earnings (P/E) multiples have not declined meaningfully until rates reach significantly higher levels. The chart below shows only modest deterioration in trailing P/E multiples as rates rise above 2.0%. Our forecast is for the 10-year yield to increase but stay below 2.0% this year.

In most rising-rate environments, both yields and equities have moved higher. A good example is in 2013, when the 10-year yield rose from 1.77% to 3.04% while the S&P 500 Index surged 30% (January 1, 2013 – December 31, 2013). Our favored sectors have historically performed well when rates rise in Information Technology, Consumer Discretionary, Materials, Industrials, and Financials.

S&P 500 Index median P/E multiples during different interest-rate regimes

S&P 500 Index median P/E multiples during different interest-rate regimes

Sources: Bloomberg, Wells Fargo Investment Institute, February 26, 2021. Data range: 1/1/1962-1/31/2021.

Fixed Income

by Peter Wilson, Global Fixed Income Strategist

  • The move higher in U.S. Treasury yields in late 2020 through early February 2021 was clearly driven by rising inflation expectations. The latest jump reflects a rise in real yields.
  • In itself, this need not be a major concern for the economy or risk asset markets. Much will depend on the speed of any yield rise and on how the Federal Reserve (Fed) reacts to the market’s challenge to its short-term interest-rate guidance.

How worrisome is the latest surge in U.S. (real) yields?

The rise in U.S. Treasury securities yields was initially driven by a rise in inflation expectations, but this has changed — with 10-year real yields moving higher faster than nominal yields and surging to seven-month highs last week. In the short term, there are reasons to be cautious. For the first time, the market is seriously challenging the Fed commitment to keeping rates low, with market indicators now suggesting the first rate hike as soon as late 2022 — compared to the Fed’s December “dot plot” median expectation of rates on hold at least until 2024. Also, there are signs of supply concerns – the spike in yields was caused by a very poor 7-year auction – and of other market dislocations.

However, we remain relatively sanguine about the impact of the move on risk assets and the broader economy. Inflation expectations and real yields are two sides of the positive reflation narrative — the former rising in anticipation of demand-driven price rises, the latter reflecting a brighter outlook for real economic growth. Secondly, it is the speed of the move, rather than the level of yields, that is disturbing the equity markets. While we do expect yields to continue to rise and the curve to steepen in 2021, we do not expect rates — nominal or inflation-adjusted — to rise to levels that would damage government financing or derail the recovery. Finally, if short-term rates markets continue to bring forward their expectations of the first rate rise, we would anticipate more aggressive pushback from the Fed to counter this view.

Driver of bond sell-off shifts from inflation expectations to real yields

Driver of bond sell-off shifts from inflation expectations to real yields

Sources: Bloomberg, Wells Fargo Investment Institute, latest data as of February 25, 2021. TIPS are Treasury Inflation-Protected Securities. The breakeven inflation rate is the difference between the yield on the nominal (regular) U.S. Treasury and the inflation-adjusted security of the same maturity, and is one measure of the market’s expectations for annual inflation over the period. Current performance may be higher or lower than the performance quoted above. Yields and returns will fluctuate as market conditions change. Past performance is not a guarantee of future results.

Real Assets

by Austin Pickle, CFA, Investment Strategy Analyst

“Never be limited by other people’s limited imaginations.” — Dr. Mae Jemison

  • U.S. oil production has held flat since May 2020 despite an 80% bounce in oil prices.
  • U.S. supply restraint as well as coordinated OPEC+ production cuts have been integral in driving oil prices to pre-pandemic highs, even though demand has yet to fully recover.

Oil supply strategy shift

Prior to 2020, the shale oil revolution had been characterized by impressive oil production gains that had consistently outpaced even the most optimistic forecasts (see chart). There had been a “maximize production” mindset across U.S. oil-producer C-suites. But that may be changing. Investors have called for a shift in strategy to focus more on capital discipline and less on production. Are the oil-producer C-suites listening?

C-suites seem to be. “Capital discipline,” “deleveraging,” “boosting cash flow,” and “supporting dividends and buybacks” have been repeated ad nauseam on recent earnings calls. Evidence does support that the group is following through on this talk. U.S. oil production has flat-lined around 11 million barrels per day since May — despite the fact that West Texas Intermediate (WTI) oil prices have increased 80% since then. In fact, the current WTI price is over $60, which is significantly higher than the average shale oil well breakeven cost of around $40. In the pre-pandemic “pump at will” regime, we would have expected producers to open the spigots in this environment. Yet, the oil supply flood has not come. It seems that oil producer C-suites — at least for now — are talking the “supply restraint” talk and walking the “supply restraint” walk.

This supply restraint shown by U.S. producers — as well as historic coordinated OPEC+ production cuts — have been integral in driving oil prices to pre-pandemic highs, even though demand has yet to fully recover.

U.S. oil production: Actual versus forecasts

U.S. oil production: Actual versus forecasts

Sources: Energy Information Administration (EIA), Bloomberg, Wells Fargo Investment Institute. Monthly data: January 31, 2016 - December 31, 2022. Forecasts taken from the EIA's monthly Short-Term Energy Outlook report. Forecasts are not guaranteed and based on certain assumptions and on views of market and economic conditions which are subject to change.


by James Sweetman, Senior Global Alternative Investment Strategist

  • Structured credit markets were generally unfazed by the volatility exhibited at the end of January, and trading conditions appear favorable to generate alpha through active trading of mispriced securities.
  • Investor appetite in the search of income remains strong in this low interest rate environment, and — for investors that qualify — an allocation to Structured Credit may be prudent.

Structured credit — A source of alternative income

The COVID-19 crisis has compounded the challenge for investors seeking income. With interest rates likely to remain near historic lows for even longer than expected, investors will need to broaden their perspective to seek durable income without taking outsized risks. We believe the expanding global universe of credit will be critical to delivering income and helping investors meet their investment objectives. To address this theme, qualified investors should consider allocations to Relative Value hedge fund strategies with a focus on securitized credit. The Structured Credit strategy can combine trading expertise with credit analysis to take advantage of higher yields and market inefficiency while targeting a durable income yield of approximately 6%-8%.

So far in 2021, we have seen an increased appetite for exposure to residential and consumer credit. New issuance has been met with robust demand while secondary trading activity has remained strong. We continue to see an extension of two primary themes — relative value and ongoing embedded value. And increased likelihood of an additional, substantial stimulus package could further benefit residential and consumer debt products.

In addition to market dynamics, borrower profiles have also improved as U.S. consumers meaningfully reduced their leverage, U.S. household debt-to-GDP declined by more than 20% since 2008, and debt-to-income ratios and consumer credit scores for residential mortgages improved. Despite these improved fundamentals, the COVID-19 crisis caused a dislocation. While prices have somewhat recovered, yields have not been distorted by central bank buying (not part of the Fed purchase program) and remain elevated compared to pre-pandemic levels, creating a potentially compelling opportunity.

U.S. household debt-to-GDP declining post-2008-2009 financial crisis

U.S. household debt-to-GDP declining post-2008-2009 financial crisis

Sources: International Monetary Fund (IMF), Wells Fargo Investment Institute. Data through Third Quarter 2020.

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