And the bear has arrived

Asset Allocation Spotlight

by Global Asset Allocation Strategy Team

• 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.

…And the bear has arrived

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 the novel coronavirus (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).

Table 1. A history of bear markets

Sources: Bloomberg and Wells Fargo Investment Institute, as of March 17, 2020. Data January 1929 through March 11, 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.

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 11.3 months in duration and have been reflected in an average S&P 500 Index decline of just over 35%.

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

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

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 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 and index definitions.

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 three-asset group, Moderate Growth and Income allocation) 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

Sources: Morningstar Direct and Wells Fargo Investment Institute. Data: December 31, 1989-December 31, 2018. Moderate Growth and Income Four Asset Group portfolio: 3% Bloomberg Barclays U.S. Treasury Bill (1–3 Month) Index, 16% Bloomberg Barclays U.S. Aggregate 5–7 Year Bond Index, 6% Bloomberg Barclays U.S. Aggregate 10+ Year Bond Index, 6% Bloomberg Barclays U.S. Corporate High Yield Bond Index, 5% JPMorgan EMBI Global Index, 20% S&P 500 Index, 10% Russell Midcap Index, 8% Russell 2000 Index, 6% MSCI EAFE Index, 5% MSCI Emerging Markets Index, 3% HFRI Relative Value Index, 6% HFRI Macro Index, 4% HFRI Event Driven Index, 2% HFRI Equity Hedge Index. Performance results for the Moderate Growth and Income Four Asset Group portfolio model 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 index definitions.

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

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. Composition of the portfolios provided at the end of the report. Note: Corrections are declines of 10% or more. Bear markets are declines of 20% or more.

Attempting to reduce downside volatility is 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

Source: Wells Fargo Investment Institute, March 12, 2020.  Please see text below Chart 2 for the composition of the Moderate Growth and Income Three Asset Group (MGI 3AG) portfolio. 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. Composition of the portfolios provided at the end of the report. Note: Corrections are declines of 10% or more. Bear markets are declines of 20% or more.

Although downside events have typically been short-lived, how investors react (or don’t react) is 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 will 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 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.

Equities

by Ken Johnson, CFA, Investment Strategy Analyst

• We recently reduced our guidance on Developed Market ex-U.S. Equities to unfavorable and lowered our 2020 earnings and price targets for this equity class.
• Developed markets face strong economic and earnings headwinds in the wake of the coronavirus outbreak. We favor U.S. equity markets over international markets today.

Our reduced targets and guidance for Developed Market ex-U.S. equities

We recently lowered our guidance on Developed Market ex-U.S. Equities to unfavorable from neutral and reduced our 2020 earnings and year-end price targets for this equity class.² As the coronavirus has seriously impacted countries from China to Italy and Japan, the economic and market headwinds have risen quickly.

In this environment, with lingering unknowns, we are regularly assessing the impact that the coronavirus may have on equity fundamentals. Developed markets have faced particular strain as global supply chains have been challenged and consumer demand has declined. There has been some implementation of fiscal and monetary stimulus across these regions, particularly in Europe and Asia, but it remains unclear to what extent this stimulus will improve economic growth and company earnings. In fact, some of these economies are already contracting and could enter a technical recession in early 2020, which would have a meaningful impact on corporate profits. Chart 1 illustrates the deterioration in the MSCI EAFE earnings revision ratio as the virus has spread.³

We prefer U.S. equity markets over international markets today. We also favor large- and mid-cap stocks over small-cap equities—and believe that investors should focus on quality portfolio holdings.

MSCI EAFE earnings have deteriorated as the coronavirus has spread

Source: Wells Fargo Investment Institute, Bloomberg, March 11, 2020. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment.

Real Assets

by Austin Pickle, CFA, Investment Strategy Analyst

“Everyone has a plan until they get punched in the mouth.”  —Mike Tyson

• Coronavirus-associated demand destruction and the Saudi Arabia/Russia spat have been a “one-two punch” for oil prices.
• We expect cratering U.S. oil production and more constructive OPEC+ politics to help stabilize oil prices—and to help them move higher soon.

Oil’s one-two punch

The coronavirus pandemic and the efforts to contain it have decimated the oil-demand outlook and prices. The price of West Texas Intermediate oil fell from a high of $63 per barrel on January 6 to $41 on March 6. But then oil prices received a gut punch that sent prices tumbling 25% in one trading day. The coalition between the Organization of the Petroleum Exporting Countries and Russia (OPEC+) unraveled. Saudi Arabia and Russia—as the world’s number 2 and number 3 largest oil producers—reneged on their commitments to curtail production and instead promised to open their oil taps to flood the market. This was a knockout blow to oil prices already reeling from the coronavirus-associated demand destruction. What happened, what are the consequences, and where do we go from here?

As for what happened, Saudi Arabia got fed up with shouldering the majority of production cuts while other countries, like Russia, consistently pumped more than their agreed-upon allowance. Additionally, Saudi Arabia had wanted OPEC+ to agree to an additional, substantial production cut, while Russia dissented. As it is for a boxer knocked to the mat, the consequence is pain. U.S. shale producers, Saudi Arabia, Russia, and all other oil producers will feel it. No oil producer wins with a $30 per barrel oil price. Saudi Arabia’s own 2020 budget assumes $60 per barrel, but it would need $80 per barrel for revenue to equal expenses. Estimates suggest that Russia needs prices in the $40s, and the median breakeven price for U.S. shale oil is $45 per barrel. In the U.S., we can expect production to slow and oil bankruptcies to rise.

Going forward, we do not believe that oil prices will stay in the high $20s and low $30s for long. Severe 50% oil-price drops, like we have seen so far in 2020, are rare and typically do not last. Historically we have seen that within months, a bottom is usually found, and a bounce follows. We’re expecting the same in the coming months, with a bounce likely into the high $30s to low $40s. The high $20s and low $30s was the pain point in February 2016 that forced the world’s major oil producers to work together to push oil prices higher. We believe a similar “reality check” will happen in 2020. We expect the combination of cratering U.S. oil production and more constructive OPEC+ politics to help stabilize oil prices and help them move higher soon.

Alternatives

by Nicholas Sprague, CFA, Global Alternative Investment Strategist

• Despite strong growth in private capital secondary market volume, average pricing across strategies declined by 400 basis points in 2019.¹
• We look for increased supply and a relatively limited capital overhang should foster a favorable pricing environment for buyers of private assets in the secondary market.

A potential buyers’ market in private capital secondaries

Secondary market transaction volume set another record in 2019, increasing by 19% year over year to $88 billion.⁴ Despite continued strong volume growth, the average high bid across all secondary strategies in 2019 was 88% of net asset value (NAV)—a 400 basis point decline relative to 2018.⁵ Softening prices indicate a shifting dynamic between buyers and sellers as supply growth outpaces demand. 

Active portfolio management among private capital investors continues to drive a diverse supply of secondary opportunities across strategy, vintage, and geography. Additionally, as private capital funds reach the end of their life–amid rich private market valuations–general partners are looking to the secondary market to extend the holding period of certain assets while offering liquidity to limited partners and resetting fee structures. As a result, secondary buyer deal flow is at record levels, providing buyers with the ability to be selective when deploying capital in the face of high valuations and an aging business cycle. 

The chart illustrates that 2019 price weakness was evident across strategies, with average high bids for buyout and venture capital assets as a percentage of NAV declining by 400 and 600 basis points year over year, respectively. Furthermore, the secondary capital overhang multiple (the ratio of secondary market dry powder to the last 12 months, or LTM, secondary volume) compressed to 1.8x in 2019—the lowest level since 2013. Plenty of supply and a relatively limited capital overhang we believe should continue to foster a favorable pricing environment for secondary buyers.

Secondary market capital overhang and pricing

Source: Greenhill Global Secondary Market Trends & Outlook, January 2020. Greenhill is an investment bank that provides capital advisory services to institutional investors on private equity secondary transactions. Dry powder is near-term available capital dedicated to the secondary strategy. Capital overhang multiple is near-term available capital dedicated to the secondary strategy divided by the last 12 months secondary transaction volume. Purchase price for private asset(s) on the secondary market expressed as a percentage of the net asset value. 

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¹ One hundred basis points equal 1.00%.

² Our 2020 year-end price target for the MSCI EAFE Index is now 1730-1870, and our 2020 earnings forecast is $115. We also have downgraded Developed Market ex-U.S. Small Cap Equities to unfavorable.

³ Earnings revision ratio calculated based on Bloomberg earnings consensus estimates. The earnings revision ratio takes the difference between the number of analyst upgrades and analyst downgrades and divides it by the total number of analyst revisions on a monthly basis.

⁴ Private equity secondaries are preexisting investor commitments bought in the secondary market.

⁵ Greenhill Global Secondary Market Trends and Outlook, January 2020.