Investment Strategy
Can Productivity Drive Equity and Fixed Income Returns?
by Paul Christopher, CFA, Head of Global Market Strategy
Key takeaways
- Worker productivity probably will not support the economy much in this economic expansion.
- Slow productivity growth implies equity and fixed income market volatility in the coming months.
What it may mean for investors
- We favor rebalancing portfolios—taking profits when market valuations are high—but reallocating the cash proceeds as valuations decline to more attractive levels.
Worker productivity refers to a worker’s average output per hour of work, and it can help to drive equity and bond returns late in a long economic expansion. The more an average worker can produce per hour, the more the business typically can distribute in wages and profits.1 Greater efficiency also helps to hold down overall production costs, and thereby, can limit consumer price inflation. Stronger profits and low inflation, in turn, support higher equity and fixed income returns. Meanwhile, the extra share of proceeds to workers supports wage growth, consumer confidence and spending.
Chart 1. Productivity growth has slowed during this economic expansion
Sources: Federal Reserve Bank of St. Louis, Wells Fargo Investment Institute, May 14, 2019. Annual data, 1988-2018. Productivity is measured as labor productivity, which is average output per hour of labor in private, nonfarm businesses. The green line measures the average annual growth from 1988-2009 and from 2010-2018.
Productivity growth historically has arisen from three sources: more machines per worker, better-educated workers, and new technologies. Unfortunately, U.S. productivity growth has been low throughout this economic expansion (2010-2018; see Chart 1)—and the outlook is not encouraging for its three main supports. We consider that outlook in this week’s report.
Capital per worker: These are the tools that workers use. As an expansion ages, qualified workers are harder to find. Businesses respond with more (or better) tools, to improve the efficiency of their current workforce. Capital spending growth in this expansion has been slow, however, and recent improvement in capital expenditures has been focused narrowly in the Energy and Information Technology sectors.
Worker education and the mix of new job openings: From 1940 to 1970, U.S. Census Department data show that median educational attainment (the highest number of years of education that an individual reaches) rose by roughly one year per decade, and contributed significantly to economic growth.2 The median educational attainment has risen little since then.3 Another problem is that most of the new U.S. jobs are in services, especially in leisure, retail trade, and transportation. These industries tend to hire low-productivity, younger workers.
Technology: The U.S. economy is always innovating, but multi-year productivity gains historically require innovations that widely change how people live and work. The electric light and motor, internal combustion engines, and the telephone were revolutionary and raised productivity well into the middle 20th century. What’s more, it often is only with a lag that innovations sustain productivity growth. For example, World War II introduced computers, along with heavy trucks and cargo planes. Yet, only with new, larger airports—and the interstate highway system in the 1950s and 1960s—could the new transportation vehicles carry large volumes of goods across the country. Likewise, computers only transformed work and home life after the internet and easy-to-use software arrived in the 1990s.
Artificial Intelligence (AI) is technology that programs machines to perceive, learn, plan, and process language—and it is the next transformational hope. AI has developed the most in industries that feature very specific, repetitive practices (e.g., health care, transportation, automobile manufacturing, and consumer goods packaging). In these areas, computers learn from data that follow patterns—e.g., driving a tractor trailer on mapped roads; reading x-rays and diagnosing tumors; and warning when an assembly line is about to break down. But until it can handle more general tasks—such as a robot that can enter any home and make a cup of coffee—AI still has great promise, but limited application, today.
Actions for investors to consider now
First-quarter productivity rose in the U.S., but this likely was only temporary. Much of the extra output went into inventory accumulation, because sales growth is slowing. Looking ahead, we expect businesses to slow production to reduce the undesired stockpiles. Inventory adjustments frequently account for much of the economy’s ebb and flow during an economic expansion. This variability—and the sparse support from the three productivity factors that we have discussed—imply that persistent improvement in productivity growth is unlikely.
We expect no U.S. recession in the coming 12 months, but low productivity growth probably means that the economy will fluctuate with the inventory cycle and create volatile equity and bond prices. When equity and fixed income markets pull back, we will be looking for opportunities to put cash back to work, starting in global equities. When markets rise steadily—as they did earlier this year—we will look to trim equity and bond positions toward long-term target allocations. This is rebalancing, and it is a way to maintain those allocations, which are the foundation for the investor’s long-term plan.
EQUITIES
by Scott Wren, Senior Global Equity Strategist
Trade friction—likely an issue for first-quarter emerging markets earnings
Companies in the MSCI Emerging Markets Index tend to report their earnings later than U.S., European, and Japanese firms do (such as those in the S&P 500 and MSCI EAFE indices). For example, more than 91% of companies in the S&P 500 Index have reported first-quarter earnings, while less than 60% of emerging market companies have posted results. Last week, we reported on U.S. large-cap earnings, so we thought an emerging market update would be appropriate this week. We continue to hold a most favorable view on emerging market equities.
Overall, the earnings reporting season in the emerging markets has been negatively impacted by the ongoing U.S.-China trade frictions. We had expected first-quarter results for the emerging markets to show the worst comparisons of any quarter in 2019 (much like our expectations for U.S. large-cap companies). So far, it appears that our expectations have been correct—but emerging market earnings actually are coming in below our projections for the first quarter. In parsing the data, one can see that countries with large exports of technology and high-end industrial goods to China have posted meaningful year-over-year earnings declines (see table). Specifically, companies in South Korea and Taiwan are registering earnings declines of 42.8% and 26.1%, respectively, so far in this earnings reporting season.
We believe that trade frictions have played a role in these earnings declines. Uncertainties over tariffs and the resulting potential for slowing global growth have dampened Chinese demand for high-tech equipment from these two major exporters.
Key takeaways
- We believe that U.S.-China trade frictions have impacted emerging market earnings results.
- We retain our most favorable rating on emerging market equities over the tactical time frame (6-18 months).
First-quarter 2019 earnings results for MSCI Emerging Markets Index and select countries
Sources: FactSet, Wells Fargo Investment Institute, May 15, 2019. Not all countries included in the MSCI Emerging Markets Index are shown. * In order of performance from best to worst. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.
FIXED INCOME
by Brian Rehling, CFA, Co-Head of Global Fixed Income Strategy
China threatens more U.S. Treasury security sales
Hu Xijin, the editor of a Chinese state-owned newspaper, suggested that Chinese scholars had discussed selling the country’s Treasury securities in retaliation against the United States in the trade dispute. In our opinion, it is very unlikely that China would pursue such a strategy—as it would be self-defeating. In the unlikely event that China did decide to dump its Treasury holdings on the market, we expect that any bond-market impact would be short-lived.
Selling Treasury securities would hurt China. This action would weaken the dollar at least temporarily—making the U.S. a more competitive manufacturer on the world stage. If China sold its dollar currency reserves (Treasury securities), it would have few alternative investment choices. It is unlikely that there is sufficient liquidity in other nations’ securities, many of which offer rates that are close to zero or negative. In addition, many believe that no country’s sovereign debt offers the safety and security that U.S. Treasury securities have.
If China decides to sell its Treasury portfolio, it likely would happen over time. China has already been slowly selling its Treasury portfolio that peaked in July 2011 at just over $1.3 trillion, which represented 12.98% of Treasury debt held by the public at the time. Today, China owns $1.12 trillion. Given the increase in Treasury debt outstanding—this represents just over 7% of the Treasury debt held by the public.
We believe that the market could easily absorb additional Treasury supply over time, and we recommend that investors continue to hold fixed-income portfolio duration at benchmark levels.
Key takeaways
- We recommend that investors maintain a neutral benchmark duration target in their high-quality fixed income portfolio.
- We expect the Federal Reserve (Fed) to end its balance sheet roll-off in October. As a result, the Fed will purchase Treasury securities once again to maintain a stable portfolio, which should be supportive of the Treasury market.
- We do not expect interest rates to move materially high over the next 12 months.
U.S. Treasury debt held by the public—percent owned by China
Sources: Federal Reserve Bank of St. Louis (FRED), U.S. Treasury, May 14, 2019.
REAL ASSETS
by John LaForge, Head of Real Asset Strategy
“You must have long-range goals to keep you from being frustrated by short-range failures.” - Charles C. Noble
Oil prices and the Middle East
Tensions between the U.S. and Iran are back, and they likely are here to stay through 2019. On May 2, the U.S. stepped up its efforts to block Iran from selling its oil around the world. It appears that President Trump is pressuring Iran to stop its nuclear program altogether.
Iran is not likely to accept President Trump’s conditions, at least not without a fight. Two weeks ago, Iranian–backed rebels attacked two Saudi Arabian tankers as they approached the Strait of Hormuz. Last week, a key Saudi oil pipeline was attacked by Yemeni rebels—known to be linked to the Iranian government.
Tensions have risen enough that the U.S. pulled its embassy staff from Iraq last week. This makes sense as rumblings about a potential war are brewing. While we are not expecting it, a war is possible. Since the 1970s, wars in the Middle East have happened with regularity. After all, the region holds significant energy resources. The Middle East exports 42% of the world’s crude oil, and holds 54% of the world’s crude-oil reserves.
When turmoil has struck the Middle East in the past, the history on crude-oil prices is mixed. In the short term, oil prices have tended to spike with tensions. With that said, the chart below indicates that these price spikes often have been short-lived. Our year-end 2019 oil targets already include a $10 premium to account for elevated oil geopolitics. War or no war, our 2019 target midpoints remain $65 for West Texas Intermediate (WTI), and $70 for Brent crude oil.
Key takeaways
- U.S.-Iranian tensions have returned, and they could affect oil prices in the short term.
- Our year-end 2019 targets include a $10 premium for elevated oil geopolitics. Our target midpoints remain $65 for WTI and $70 for Brent crude oil.
Oil prices and Middle East events
Sources: Bloomberg, Wells Fargo Investment Institute, May 16, 2019. Oil prices from 1861 to 1950 are taken from BP statistical review. Prices from 1951 to April 1983 are Bloomberg Arabian Gulf Light Crude Spot prices, and prices from May 1983 to date are Bloomberg West Texas Intermediate Cushing Crude Spot price.
ALTERNATIVE INVESTMENTS
by James Sweetman, Senior Global Alternative Investment Strategist
Hedge fund strategies have continued their strong performance
In April, hedge funds extended their gains from the strongest first quarter since 2006—with positive returns across all main strategies, led by Event Driven and Macro. Positive risk-on sentiment fueled gains, although performance drivers expanded from equity beta to include credit; merger and acquisition (M&A) activity; and commodity and currency exposure. Performance drivers were distributed across a broad range of strategies, including Distressed, Activist, Discretionary Macro, and Systematic.
Hedge fund returns were positive for the fourth consecutive month as global equity markets rose. In April, equity positions that were widely held by hedge funds continued to outperform the broader equity markets. Year to date, the Goldman Sachs VIP Index (comprised of the top 50 long positions of fundamentally driven hedge funds) outperformed the S&P 500 and MSCI World indices by 461 and 615 basis points, respectively.4
As markets recovered from a difficult fourth quarter, hedge funds’ gross and net leverage rose from year-end 2018 levels across most regions and strategies, but they remained significantly below first-half 2018 highs. As global equity markets sold off this month on renewed fears over a U.S.-China trade war, hedge funds aggressively increased gross exposure (adding to downside protection via index puts) and reduced net exposure. This should help to limit losses in what has been a difficult environment for long-only portfolios—and it reinforces the benefits of hedge funds as a complement to traditional long-only asset classes.
Key takeaways
- Hedge funds continued their recovery from a difficult fourth quarter, extending gains in April after the strongest first quarter since 2006, with positive returns across all main strategies.
- Hedge funds added to gross exposure over the first four months of 2019—but aggressively added to downside protection in May as global equity markets sold off.
Hedge fund performance in April and year to date
Sources: Wells Fargo Investment Institute, Bloomberg; May 14, 2019. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.
1This statement abstracts from changes in the prices of other inputs, such as raw materials. However, compared to other U.S. economic cycles, producer price inflation has been low during this economic expansion.
2For more details on these measurements, please see Fernald, John G. and Jones, Charles I. "The Future of U.S. Economic Growth”, American Economic Review, May 2014, 104 (5), pages. 44-49.
3U.S. Census Bureau, CPS Historical Tables, “Years of School Completed by People 25 Years and Over, by Age and Sex, selected years 1940 to 2018”, table A-1; accessed on May 13, 2019.
4One hundred basis points equal 1%. Top 50 long hedge-fund position data was based upon 13-F filings.
Risk Considerations
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.
Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.
Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.
Definitions
Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.
Bloomberg Barclays U.S. Corporate Bond Index includes publicly issued U.S. corporate and Yankee debentures and secured notes that meet specified maturity, liquidity, and quality requirements.
Bloomberg Commodity Index is calculated on an excess return basis and reflects commodity futures price movements.
Goldman Sachs Hedge Fund VIP index consists of hedge fund managers’ “Very-Important-Positions,” or the US-listed stocks whose performance is expected to influence the long portfolios of hedge funds. Those stocks are defined as the positions that appear most frequently among the top 10 long equity holdings within the portfolios of fundamentally-driven hedge fund managers.
HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2000 single-manager funds that report to HFR Database. Constituent funds report monthly net-of-all-fees performance in U.S. dollars and have a minimum of $50 Million under management or a 12-month track record of active performance. The HFRI Fund Weighted Composite Index does not include Funds of Hedge Funds.
HFRI Equity Hedge (Total) Index maintains positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations, and valuation ranges of typical portfolios.
HFRI Event-Driven (Total) Index consists of Investment Managers who maintain positions in securities of companies currently or prospectively involved in corporate transactions of a wide variety, including but not limited to: mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. ED exposure contains a combination of sensitivities to equity markets, credit markets and idiosyncratic, company specific developments. Investment theses are typically predicated on fundamental characteristics (as opposed to quantitative), with the realization of the thesis predicated on a specific development exogenous to the existing capital structure.
HFRI Macro Index: Investment Managers which trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets. Managers employ a variety of techniques, both discretionary and systematic analysis, combinations of top down and bottom up theses, quantitative and fundamental approaches and long and short term holding periods. Although some strategies employ RV techniques, Macro strategies are distinct from RV strategies in that the primary investment thesis is predicated on predicted or future movements in the underlying instruments, rather than realization of a valuation discrepancy between securities. In a similar way, while both Macro and equity hedge managers may hold equity securities, the overriding investment thesis is predicated on the impact movements in underlying macroeconomic variables may have on security prices, as opposes to EH, in which the fundamental characteristics on the company are the most significant are integral to investment thesis.
HFRI Relative Value (Total) Index consists of Investment Managers who maintain positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities Manager employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivative or other security types. RVA position may be involved in corporate transactions also, but as opposed to ED exposures, the investment thesis is predicated on realization of a pricing discrepancy between related securities, as opposed to the outcome of the corporate transaction.
HFRI Fund of Funds Composite Index tracks fund of funds that invest with multiple managers through funds or managed accounts. The strategy designs a diversified portfolio of managers with the objective of significantly lowering the risk (volatility) of investing with an individual manager. The Fund of Funds manager has discretion in choosing which strategies to invest in for the portfolio. A manager may allocate funds to numerous managers within a single strategy, or with numerous managers in multiple strategies. The minimum investment in a Fund of Funds may be lower than an investment in an individual hedge fund or managed account. The investor has the advantage of diversification among managers and styles with significantly less capital than investing with separate managers.
MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.
MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of 23 developed market countries including the United States.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.
S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.
An index is unmanaged and not available for direct investment.
General Disclosures
Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.
The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.
The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.
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