Investors peek beyond the boom

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Global Macro spotlight

by Gary Schlossberg, Global strate

• We believe investors looking beyond this year’s expected economic boom can expect a shift to more moderate, sustainable growth plus steadier inflation and interest rates during the latter part of 2022. Slowing economic growth has been typical during the second full year of an economic growth cycle without ongoing support from fiscal stimulus.
  
• We believe that more moderate growth plus steadier inflation and interest rates later in 2022 will encourage a rotation from economically sensitive stocks to technology and more defensive market sectors. Bond strategy could tilt from yield-enhanced securities to a duration strategy keyed to long-term Treasury securities (duration is a measure of interest-rate sensitivity).

A second wind. The economy has entered stage two of a V-shaped recovery that began with its freefall a year ago and is now moving beyond a make-do rebound propelled by spending on merchandise and services keyed to stay-at-home activity. We believe that the economy now is set to piggyback on mass vaccinations, propelling travel and other close-contact services to the leading edge of their strongest growth in over 35 years. Support from the economy’s reopening is being reinforced by aggressive fiscal and monetary stimulus, the release of pent-up demand, and the drawdown of sizable household savings.

What comes after that will likely provide important insights to asset market performance and portfolio strategy. This hasn’t been a typical, deep economic cycle like those in 1981-1982 and 2008-2009. The pandemic’s unexpected shock produced a slump more like the economy’s short but deep recession tied to credit controls in early 1980. Then, like now, the economy expanded rapidly from a deep recession as the disruption subsided. The strong recovery back then contributed to its own early end by adding to the pressure on inflation and higher interest rates, ultimately touching off a long, deep recession in 1981-1982.

Is powerful economic growth set to lose steam in 2022?

Sources: U.S. Commerce Department, Wells Fargo Investment Institute (WFII), April 27, 2021. *Cycles based on recessions ending in Q4 1960, Q4 1970, Q1 1975, Q3 1982, Q1 1991, Q3 2001. GDP = Gross Domestic Product. f = WFII forecast. 

Neither boom nor bust. Another flare-up of the pandemic is the most visible threat to growth this year and next. Enduring wage-price pressure ranks second, threatening to send interest rates higher and to squeeze the economy in much the same way it did in 1981. Now, unlike then, accelerating wage and price increases will likely have more to do with temporary dislocations and bottlenecks from a wrenching, V-shaped recovery than with fundamental changes perpetuating increases in both. Structural restraints, including globalization and a weak labor movement, still are potent enough to prevent a sustained rise of wages and inflation as temporary bottlenecks ease. Subdued inflation expectations add to inertia against rising price pressures, too.

We view more likely is a shift from rapid to more sustainable economic growth over the course of 2022. First, we believe steadying inflation will allow the Federal Reserve (Fed) to maintain easy credit conditions, even as it slowly retreats from ultra-accommodation. The mismatch between historically low interest rates and a strengthening economy is large enough to allow a prolonged shift to less stringent monetary policy before Fed-engineered rate increases threaten economic growth.

Second, proposed increases in government spending aren’t likely to be as front-loaded as they were in March from the $1.9 trillion stimulus bill, easing bottlenecks that would otherwise risk higher inflation. We believe added fiscal headwinds will come from proposed corporate and individual tax increases. Lastly, we expect one-time support to be winding down by mid-2022 from the economy’s reopening, the release of pent-up demand, and from the drawdown in savings supporting it. 

Growth has typically slowed to a more sustainable rate late in the second year of a growth cycle without ongoing support from fiscal policy. Export-led strength can do only so much for an economy like the U.S. that is driven by domestic spending. And any ripple effect from this year’s increased spending and hiring on added job growth and investment likely will be countered by the loss of one-time support from fiscal stimulus, pent-up demand, and excess savings. 

What it means for investors. Fundamental changes in portfolio strategy could follow any shift to more moderate economic growth during the latter part of 2022. Broadly, slowing economic growth risks undercutting the reflation trade that has been in place since late last year. More moderate, sustainable economic growth and the steadier inflation we expect to accompany it also should limit the rise in bond yields and the gap between them and short-term interest rates more tightly controlled by the Fed. For stocks, we believe the tilt from reflation as economic growth slows will encourage a move from economically sensitive sectors of the stock market toward higher-quality segments, including large-cap technology and more defensive stocks. Investment by U.S. residents in other developed-country markets will likely benefit from stronger economic growth abroad later this year and from a weaker dollar’s support to currency-related gains on overseas investments.

Bond strategy could tilt from yield-enhanced sectors of the market back to a duration strategy in Treasury securities as increases in longer-term interest rates moderate. We expect the municipal (or muni) bond market to be an exception to the rule. Muni demand should be boosted by a likely increase in the top personal tax rate, increasing the value of a tax exemption. We also believe that added support could come from the proposed increase in the top capital gains tax rate large enough to dampen demand for stocks. By contrast, we view proposed corporate and personal tax increases as unfavorable for the bond market’s taxable sector. Demand in this part of the market could suffer from reduced after-tax returns associated with the higher top rate on personal taxes. Moreover, the effect of higher capital gains taxes on the cost of equity financing and greater interest-related write-offs from the higher corporate tax rate could boost debt supply by encouraging a shift from equity to debt financing.

Equities

by Krishna Gandikota, Investment Strategy Analyst

• Small caps (as measured by the Russell 2000 Index) are the best-performing asset class year-to-date (as of April 27, 2021) with a 16.7% return.
• Small caps have tended to have a positive correlation with U.S. gross domestic product (GDP) growth. We anticipate that GDP growth will be in the mid- to upper- single digits for the second half of 2021, leading us to remain favorable on small caps.

Reiterating our favorable guidance on small caps

We are reiterating our favorable guidance on U.S. Small Caps and view the recent pullback as a buying opportunity relative to the broader equity markets. Revisiting our initial upgrade back in January (please see the Institute Alert titled “Revising guidance, targets for stronger 2021 growth”, January 19, 2021), we upgraded the asset class in an effort to take advantage of the Russell 2000 Index’s greater exposure to cyclical sectors as they have tended to be closely tied to economic recoveries.

U.S. Small Caps (as measured by the Russell 2000 Index) are the best-performing asset class year-to-date with a 16.7% return compared to the S&P 500 Index’s 11.4%.  Cheap borrowing costs, record amounts of fiscal stimulus, and a declining percentage of non-earning firms within the Russell 2000 Index keep us bullish for the equity class. In addition, small caps have tended to outperform their large-cap counterparts over a three-year period following a recession as investors allocate to riskier assets.

From a price-to-earnings valuation perspective, the Russell 2000 Index remains elevated relative to historical valuations, but is more attractive relative to the S&P 500 Index. The Russell 2000 Index continues to witness improving next 12 months earnings-per-share estimates, which shows a recovery to pre-pandemic levels.

Historically, U.S. Small Caps have tended to have a positive correlation with U.S. GDP growth. We anticipate that a robust recovery in services and consumer spending will propel economic growth to the mid- to upper-single digits in the second half of 2021. With the reflation trade likely still in the early innings, we believe U.S. Small Caps have more room to run, and we remain favorable.

U.S. GDP growth versus Russell 2000 return

Sources: Wells Fargo Investment Institute and Bloomberg. Data as of April 28, 2021. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. 

Fixed Income

by Luis Alvarado, Investment Strategy Analyst

Rising U.S. Treasury yields likely to resume

Most major fixed-income classes managed to recover and display positive performance in April as U.S. Treasury yields declined slightly from the strong yield hike experienced in the first quarter. It is important to highlight that in the first quarter, U.S. Treasury yields climbed at the fastest pace over the past 60 years. Looking back at history, we can observe that there has been some consolidation in yield levels after strong spikes have occurred, and it seems like this period has not been the exception.

However, our belief is that U.S. Treasury yields will continue to climb higher throughout the rest of the year, supported by stronger economic growth and higher inflation expectations. Our year-end 10-year Treasury yield range currently stands between 1.75% and 2.25%. We are not expecting the yield hike to be a straight line because there will most likely be periods of consolidation and even pullbacks influenced by macroeconomic conditions or by technical adjustments, which we believe is the case on this occasion.

With so many positive U.S. economic figures being reported, investors may ask why the yield rise has not resumed yet. We have observed that technical consolidation between supply and demand has been driving the recent decline in yields along with hedging from institutional investors and some short covering from speculators. Referring to the 10-year Treasury yield specifically, our momentum-driven model is signaling that yields currently remain near fair value. However, we think the stage is set for a pickup in inflation in the near term which should help push intermediate-term real yields higher..

Consolidation has occurred during rising 10-year yield periods

Sources: Wells Fargo Investment Institute and Bloomberg, April 30, 2021. Weekly data from January 2, 1990 to April 30, 2021. Rising yield periods highlighted in orange color. Yields represent past performance and fluctuate with market conditions.  Current yields may be higher or lower than those quoted above.  Past performance is no guarantee of future results.

Real Assets

by John LaForge, Head of Global Real Asset Strategy

“The dearer a thing is, the cheaper as a general rule we sell it.”  — Samuel Butlern

• Gasoline prices have surged higher and are approaching $3 per gallon. 
• The silver lining is that Americans spend a much smaller portion of their income on gasoline than they used to. 

Gas prices on the move

During 2020, we were rarely asked about gasoline prices. And rightfully so, as talk of travel took a back seat to health and safety. The gas questions are making a comeback in 2021, however. Thanks to $60 per barrel (West Texas Intermediate) oil prices and key refinery outages in Texas, gasoline prices have risen 25% in 2021. After seeing gas prices slip below $2 in 2020, drivers are now faced with a $2.87 average price.  And it may not stop there. Summer driving is nearly here, the economy is getting lively again, and gasoline inventories sit near five-year lows. Our advice is to go fill up under $3, while you still can. 

Rising gasoline prices typically hit lower-income households harder than higher-income households. For those making $33,000 a year or less, gasoline accounts for roughly 8% of yearly spending. For those making more than $200,000 a year, spending on gasoline is closer to 1%.  If there is a silver lining, it is that energy spending does not hit most pocketbooks like it once did. The red dashed line in the chart below highlights that energy consumption, as a percentage of the average American’s disposable income, has slipped from a high of 8% in 1980 to about 3% today..

Gasoline prices versus energy expenditures as a % of disposable income

Sources: Bloomberg, Bureau of Economic Analysis, U.S. Department of Energy (DOE), Wells Fargo Investment Institute. Monthly data: January 31, 1976 – March 31, 2021. Real gasoline price is adjusted for inflation by Consumer Price Index (CPI). Energy expenditures as a percent of disposable income takes U.S. personal consumption expenditures on energy goods and services divided by U.S. disposable personal income both as reported by the Bureau of Economic Analysis.

Alternatives

by Justin Lenarcic, Senior Global Alternative Investment Strategist

• Several broad themes have influenced hedge fund positioning and returns over the last 12 months.
• We anticipate the next theme to be centered on pricing power and the ability of companies to pass on higher input costs to maintain margins.

Re-opening trade shifting to pricing power trade

Over the last year, hedge fund positioning has been linked to several broad and well-known themes. Beginning with the recovery and re-opening theme, managers have tried to capture the twin tailwinds of monetary and fiscal stimulus with vaccine development and deployment. Fortunately, many hedge fund managers have benefited from these themes, and we have seen strong resulting performance. But now, some managers are questioning how much runway is left on the re-opening trade and have shifted into the next iteration of the post-pandemic era, focusing on a pricing power trade.

We are particularly interested in how this theme plays out for equity hedge managers. Though returns have been quite strong for this favorable strategy over the past 12 months, they have struggled so far this year, and we would like to see a return of short alpha (excess return), which may come via dispersion in pricing power. The chart below shows the relationship between inflation and a custom index (Pricing Power Dispersion Index) comparing companies with strong pricing power to those that lack pricing power.  That differentiation has increased significantly alongside the year-over-year increase in inflation, which is providing a catalyst for sector and stock selection..

Inflation could be the next driver for active equity selection

Sources: Bloomberg, Goldman Sachs, Wells Fargo Investment Institute. Data as of April 27, 2021. YoY = year-over-year. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

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