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Investment Strategy Report

Wells Fargo Investment Institute - October 11, 2021

Equities Spotlight

Doug Beath, Global Investment Strategist

  • Stock market volatility has re-emerged and we expect this trend to continue.
  • Absent a recession or excessive valuation, history suggests that equity-market downturns rebound relatively quickly, providing investors with an opportunity to rebalance portfolios.

Review of stock market corrections and rebounds

Volatility returned to equity markets during September, with the benchmark S&P 500 Index registering the worst month since March 2020. While the problems surrounding China’s largest real estate company were probably a catalyst, equity investors have also been concerned about future Federal Reserve (Fed) policy and decelerating economic data due to the highly contagious Delta variant and supply-chain bottlenecks worldwide.

To some extent, a pullback was inevitable given the unusual tranquility of markets; the S&P 500 Index had not experienced a decline of 5% in nearly a year, and major U.S. stock indices were producing record highs on a regular basis. In addition, the CBOE Volatility Index (VIX) has been hovering at very low levels of around 15 to 25. Nevertheless, the recent stock market drop coupled with the likelihood of additional volatility heading into 2022 provides a good opportunity to review the history of stock market plunges, rebounds, and how they relate to corrections, bear markets, and the economy.

Correction versus Bear Market

To be sure, the 5% drop that occurred last month does not qualify as an official stock market correction at this point (decline of 10-20% from peak to trough), but it’s never too early to mentally prepare for additional volatility. Historical data of market corrections since 1979 indicate that there were 11 corrections. What’s significant to investors is how quickly stocks rebounded after the market bottomed. On average, the S&P 500 recaptured all of the lost ground in approximately 10 months. In this scenario, we believe “buying on the dips” can be rewarding to investors during equity market corrections.

In terms of bear markets, defined as equity declines of 20% or more, there have been 5 such episodes since 1980 prior to the market collapse associated with the COVID pandemic. As expected, the duration of the bear-market period and the rebound phase are significantly longer than market corrections. On average, the S&P 500 took approximately 3.4 years (pre-COVID) to recapture lost ground, with the previous two bear markets prior to the pandemic requiring 7.2 and 5.5 years respectfully to rebound. Under these circumstances, a strategy of reducing risk assets early in the turbulent period would be more effective than aggressive rebalancing.

Further examination of bear market periods demonstrates that 4 of 5 aforementioned episodes were associated with a recession in the U.S. There was only one exception: October 19th, 1987, which was an issue of valuation, as the equity risk premium turned negative with the spike in long-term Treasury yields rising from 7% to 10%.

Next, we examine today’s situation to assess the probability of whether the recent turbulence or potential volatility in the future could morph into something more serious. Consider the following:

  1. In our view, the U.S. is unlikely to enter a recession in the near future. The deceleration of COVID-19 cases, improving foot traffic in sectors most affected by the pandemic, along with narrow corporate bond spreads and solid purchasing managers’ surveys point to accelerating growth in the current quarter.
  2. While the Fed is expected to begin raising short-term interest rates in 2023 or earlier, market-implied indicators suggest that interest rate normalization will be very gradual and take years to complete.
  3. Valuations measured on both trailing and forward earnings (20.7x and 18.9x, respectively) are now above their historical averages, but do not appear expensive relative to fixed income. The equity-risk premium is currently around 350 basis points (100 basis points equal 1 percent), above previous norms.

In our view, the current environment, including market-based indicators and surveys, do not portend a recession or bear market at this moment. Consistent with historical data regarding equity-market corrections and rebounds, we favor investors taking advantage of any significant market pullback to rebalance portfolios and invest in equities at more attractive prices.


Ken Johnson, CFA, Investment Strategy Analyst

  • Strong commodity prices and attractive valuations provide tailwinds for some commodity-producing emerging markets.
  • Headlines out of China have overshadowed bright spots in emerging markets. We remain neutral, but investors should be selective within emerging markets.

China has issues but all emerging markets are not the same

True to history, emerging market (EM) equities exploded at the start of the recovery. Performance later waned as the reflation trade paused and China racked up negative headlines reflecting regulatory challenges and slower growth. In consideration of these tumultuous events and China’s weighting within the MSCI EM Index (currently 33.7%), we lowered our MSCI EM target range for year end 2021 to 1200-1400. Subsequently, the index rallied to our new target midpoint, prompting us to lower our tactical guidance to neutral.

The events in China represent only part of the EM equities story. Commodity prices have been on a tear with oil and natural gas prices reaching levels not seen in years. We believe these prices are likely to remain elevated throughout the winter months, which supports energy-producing emerging regions and firms. Iron ore took a nose dive as steel producers cut production, but the pain may be starting to subside. This provides a boost for producers in South American countries such as Brazil.

Valuations for emerging markets are mixed. MSCI EM Asia represents countries with some of the richest valuations. The region currently trades at a 7.1% premium to its 10-year average. Alternatively, MSCI EM ex-Asia currently trades at a 25.9% discount to its history. When you exclude China and other EM Asia countries, the EM story switches from one of weakness to one of resilience and opportunity (see chart below).

The bottom line is that the structure of the MSCI EM Index shrouds bright spots for investors. We remain neutral, but we believe investors should be selective within emerging markets.

MSCI Emerging Markets ex-Asia outperforming broader MSCI EM index

MSCI Emerging Markets ex-Asia outperforming broader MSCI EM index

Sources: Wells Fargo Investment Institute, Bloomberg, 10/6/2021. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. Please see the end of the report for index definitions.

Fixed Income

Peter Wilson, Global Fixed Income Strategist

  • Norway became the first developed market to raise interest rates post-COVID-19 on September 23. It is fair to say we are likely past the trough in developed market policy rates.
  • Emerging markets passed this point more than a year ago, and the weighted-average EM policy rate is now clearly rising, with central banks in Latin America, Europe, and Asia raising rates.

Global interest rates – past the trough

Unless the economic outlook worsens dramatically, the U.S. Federal Reserve (Fed) looks set to begin reducing its quantitative easing bond purchases by the end of the year. The European Central Bank (ECB) has already slowed the pace of purchases, and will soon discuss whether to end its Pandemic Emergency Purchase Program (PEPP). On September 23, the Bank of Norway became the first developed market (DM) central bank to raise rates since the onset of the COVID-19 pandemic (from 0.00% to 0.25%), and the Reserve Bank of New Zealand quickly followed suit (hiking from 0.25% to 0.50%). After the September monetary policy meeting of the Bank of England, the market now sees three rate increases in the U.K. by the end of 2022.

In this context it is fair to say that we have likely passed the peak of bond purchases and the trough of interest rates for this cycle (although with a Gross Domestic Product, or GDP, weighting of just over 1%, compared to an almost 84% combined weight for the U.S., the eurozone, and Japan, Norway’s and New Zealand’s rate hikes are not yet visible on the chart). The chart does clearly show that the trough in emerging market (EM) policy rates was more than a year ago, in the third quarter of 2020. So far in 2021, at least 10 EM central banks, as diverse as Brazil, Russia, and South Korea, have raised interest rates. We will delve deeper into the implications of this next stage in the monetary policy cycle in future reports.

Global central bank rates have bottomed out: EM lead the way

Global central bank rates have bottomed out: EM lead the way

Sources: International Monetary Fund (IMF), Bank for International Settlements, national central banks, Bloomberg, Wells Fargo Investment Institute. Latest data as of October 6, 2021. The DM series is a weighted average of 11 DM central bank policy rates, using gross domestic product (GDP) at purchasing power parity (PPP) as weights. The EM series is a weighted average of 26 EM central bank policy rates, using GDP at PPP as weights. Purchasing Power Parity is the measurement of prices in different countries that uses the prices of specific goods to compare the absolute purchasing power of the countries' currencies. The IMF produces data on PPP that is commonly used to compare the size of economies across countries.

Real Assets

Austin Pickle, CFA, Investment Strategy Analyst

“If you want to lift yourself up, lift up someone else.” — Booker T. Washington

  • OPEC+ agreed to a 400 thousand barrels per day (Mbdp) oil production increase last week.
  • Barring meaningful price or political pressure, expect OPEC+ to stick to its plan to increase production 400 Mbpd each month. The next meeting is November 4.

OPEC+ : Another meeting, another 400k

On October 4, OPEC+ agreed to stick with its predetermined plan to increase oil production by 400 thousand barrels per day (Mbpd). Oil prices surged on the news as some market participants anticipated that the group would announce a larger production increase. Why did OPEC+ not deviate from their plan? In short, we believe a lack of pressure.

Oil prices that are too low could crimp revenues for OPEC+ members and create pressures for the group to cut production to buoy prices. In our opinion, prices that are too high are problematic as well, as they could stunt growth and demand outlooks and prompt political pressures from major customers to boost production.

What price levels are “too low” and “too high” for OPEC+ members is open to speculation but we suspect that today’s prices are currently near the group’s sweet spot. Prices have rebounded and appear well-supported, oil revenues are at multiyear highs (see chart below), demand is robust and growing, and the economic recovery appears to be on solid footing. In other words, there is currently little to no pressure on OPEC+ to change course.

But that can change quickly. Any number of scenarios could increase the pressure on OPEC+ to deviate from their plan: another COVID-19 wave (knock on wood that we have seen the last of these), an intensifying European and Asian energy crunch, production interruptions, etc. If pressures materialize to the point of action, we should find out in short order as OPEC+ is scheduled to meet monthly, with the next being November 4.

Saudi Arabia oil export revenues at multiyear high

Saudi Arabia oil export revenues at multiyear high

Sources: Bloomberg, General Authority for Statistics Kingdom of Saudi Arabia, Wells Fargo Investment Institute. Monthly data: January 31, 2019 – July 31, 2021.


Justin Lenarcic, CAIA, Senior Global Alternative Investment Strategist

  • The Equity Hedge strategy has delivered strong returns over the past two- and three-year periods, exemplifying the broader improvement in security selection that we have highlighted previously.
  • Even though fundamental drives of security selection remain in place, we anticipate modestly lower returns for Equity Hedge in 2022, especially if the backdrop for equity beta deteriorates.

Moderating return expectations for Equity Hedge

One of our favorite strategies for most of the era after the Global Financial Crisis has been Equity Hedge. While performance for this popular strategy has ebbed and flowed, the rolling two- and three-year returns have – on average – exceeded our capital market assumptions. As shown in the chart below, the current rolling two-year and three-year returns are nearly 40%, which not only surpasses recent peaks, but also highlights our view that a “new era” for hedge funds began back in the fourth quarter of 2018. While we certainly did not anticipate the pandemic, nor the fiscal and monetary stimulus that would propel asset prices higher, we did envision a better environment for equity security selection and active management.

We find ourselves now at an interesting crossroads for Equity Hedge. On one hand, fundamental drivers of dispersion such as inflation, supply chain disruptions, potentially higher corporate taxes, and higher interest rates should continue to foster a supportive stock picking environment. But it is possible that we also see a further decline in upward earnings revisions from peak levels, which could put pressure on funds that have more beta, or market exposure. In other words, though the environment remains conducive to Equity Hedge, and we continue to anticipate cyclical returns that exceed our capital market assumptions, we doubt that returns will be as robust as they have been over the past few years. This also means that we may begin shifting our guidance away from higher-beta, more directional strategies and back into the lower-net, low beta defensive Equity Hedge strategies that we prefer in the middle to later stages of the cycle.

Equity Hedge Returns are hovering near the cycle peak

Equity Hedge Returns are hovering near the cycle peak

Sources: HFRI, Wells Fargo Investment Institute. Chart shows the rolling two-year and three-year return of the HFRI Equity Hedge (Total) Index. Data as of August 31, 2021. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

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