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Manage Portfolios More Proactively


by Paul Christopher, CFA, Head of Global Market Strategy

Key takeaways

  • Good and bad news about trade and manufacturing appear to be cycling more quickly as the economy gradually loses forward momentum.
  • We believe now isn’t the time to be drastic in portfolios—the risks and rewards may not favor abandoning a diversified allocation for concentrated positions in cash and gold—but we do favor being more proactive as investors during these times.

What it may mean for investors

  • We favor taking opportunities to rotate equity exposure, focusing on quality in equities and fixed income, and using cash as a tool in an attempt to promote higher returns and manage volatility.

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Financial market pessimism about global trade in August has given way to more optimism in September. Investors have seen this sequence before—between December 2018 and April 2019, between May 2019 and July 2019, and most recently, between August and September of 2019. 

Each cycle began with pessimism over the escalating U.S.-China trade dispute and the ongoing global manufacturing slowdown. After a few weeks of escalating the dispute, the U.S. and China agreed to new talks. Optimism and hopes for lower interest rates drove the S&P 500 Index higher. However, the cycles are getting shorter, and we believe that the trade dispute will get worse before it gets better.

Looking beyond the news cycles, the growing, negative tariff impact and a concomitant slowdown in the global economy are developing. Chart 1 applies each tariff from 2018 and 2019 to its relevant imports as measured by their 2018 volumes. In a $21-trillion U.S. economy, this direct impact is not large yet, but it is increasing. There also are indirect effects as, in some cases, consumers switch to other goods—while, in others, companies absorb the tariff costs and look for other suppliers. In the meantime, slowing global trade is weighing on global manufacturing activity. This, in turn, slows corporate spending on plant and equipment. The global economy may lose more momentum in 2020.

Chart 1. The rising cost of the trade war

(Annualized cost of goods based on value of goods times the tariff rate, using 2018 import levels, in billions of U.S. dollars)


Chart 1. The rising cost of the trade war

Sources: Wells Fargo Securities and U.S. Dept. of Commerce, August 29, 2019. Light-colored bars for October-December 2019 are forecasts based on tariffs known or threatened as of August 29, 2019.

Should investors prepare for an economic recession?

Recessions are difficult to predict, because the triggers are disruptions that may be difficult to foresee and are sometimes sudden. Many of the potential disruptors are political—e.g., some combination of trade disputes, Brexit, the 2020 elections, or a central-bank policy mistake. Yet, no one can predict how slow the economy has to be for any shock (or shocks) to spark a recession. So, predicting a recession is like predicting the next earthquake, lightning strike, or flat tire. 

One way to face the unpredictable is to take steps as they make sense to take along the way. So, for example, a homeowner may install a lightning rod on a sunny day, for protection when a storm comes. Once a storm approaches, the owner may take more steps—staying out from under trees—and if need be, filling sandbags or going to an interior room or the basement. But the owner may wait to evacuate the house until the risk exceeds the benefits of staying. 

When it comes to a portfolio, diversification, rebalancing, and hedging can be the portfolio’s lightning rods—steps against an unpredictable recession. A diversified portfolio might have gained during the first half of 2019, and we anticipate further equity gains through mid-2020 (although with some risk of heightened volatility). However, the slowing economy may shift risk and reward across financial markets. Thus, we also favor rotating positions in response. Portfolios may need to be checked more often in 2020. That’s why we favor a roughly neutral stance between stocks and bonds, but why we have made more frequent changes so far this year.

The bottom line is that we do not believe that it is time to be drastic—the risks and rewards don’t favor “going to cash and gold”—but we do favor being more proactive as investors in these times. We favor three broad steps:

  1. Take opportunities to rotate equity exposure. In August, we downgraded emerging market equities from favorable to neutral, and we moved toward a neutral position between growth- and value-oriented equities. But we also took the large-cap Industrials and Energy sectors from favorable to neutral, and we lifted the Utilities and Real Estate (including REITs, or real estate investment trusts) sectors to neutral from unfavorable.
  2. Focus on quality in equities and fixed income. As this cycle matures, we view quality as tilted toward companies with strong cash positions, especially in the Information Technology and Consumer Discretionary sectors. In fixed income, we favor high-quality, investment-grade corporate bonds, municipal bonds, preferred stock, and residential mortgage-backed securities. Also, dividend-paying equity strategies still appear to be attractive ways to generate income. When the end of the cycle comes, quality instruments also may decline but potentially by less than other stocks and bonds.
  3. Use cash more tactically. We prefer pruning large-cap positions as the S&P 500 Index retests its all-time highs—and looking to put the cash back to work if equity markets pull back again. Sometimes it is emotionally difficult to buy when the S&P 500 is pulling back. Yet, a disciplined approach to pruning and then reinvesting—even as equity prices are weakening—can be a successful tool to increase return potential when political and other uncertainties create equity market swings. The goal is not to let cash alternative positions accumulate indefinitely, but to use cash as a tool. 

Equities

by Scott Wren, Senior Global Equity Strategist 

Large-cap stocks—meeting the test of time 

We frequently talk about asset allocation and the benefits of diversification. In our opinion, portfolios need exposure to asset classes that are not perfectly correlated.1 In other words, we believe that investors should try to smooth out returns over time by not putting all their eggs into one (or very few) baskets. We recommend investors hold some investments that will be able to weather economic and market downturns—just as we recommend allocation to asset classes, like stocks (overall), that tend to perform best when the economy is expanding.

Saying that, we believe that investors should have a healthy allocation to U.S. large-capitalization stocks. We track the performance of this asset class using the S&P 500 Index. As the chart below shows, over the past 108 years, the S&P 500 has posted positive annual returns 78 times through 2018. The index has recorded gains slightly more than 72% of the time over this time frame. The index also has notched positive returns in every year but one (2018) during the long post-financial-crisis expansion (this includes 2009, the year that the last recession ended).

The lesson here is that U.S. large-cap stocks are an important part of most long-term investors’ portfolios. Of course, no asset class is likely to deliver gains year in and year out, without stumbling from time to time. That is why we recommend diversification through exposure to a variety of asset classes.

Key takeaways

  • U.S. large-cap stocks have delivered a positive return over the longer term.
  • In our view, U.S. large-cap equities should be an important part of long-term investors’ portfolios.

S&P 500 Index total returns—108 years ended on December 31, 2018


S&P 500 Index total returns—108 years ended on December 31, 2018

Source: Bloomberg, December 31, 2018. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment.

Fixed Income

by Brian Rehling, CFA, Co-Head of Global Fixed Income Strategy

A closer look at preferred stock

There are a number of features that investors may embrace when adding higher-yielding securities to their portfolios. These can include longer maturities, lower credit quality, less liquidity, and a loss of structural protections. Preferred securities contain most, if not all, of these qualities. These qualities also can enhance the volatility of this sector during times of market stress.

Since the beginning of this year, the S&P U.S. Preferred Stock Index has had a total return of almost 14.8%.2 This is among the best year-to-date returns of all the fixed-income sectors and asset classes that we track. We urge investors to not anticipate a repeat performance in the quarters ahead. Investors should be prepared for preferred securities to be one of the more volatile fixed-income classes, given increased market uncertainty. This volatility must be accepted as a trade-off for the higher yields inherent in the sector.  

We believe that investors purchasing preferred securities should not be focused on price appreciation at this time, given what we view as full valuations in this sector. Rather, the focus should be on income generation. Despite the low-yield environment, yields near 5.25% remain available in a well-diversified portfolio of preferred securities. While we believe that the yield potential in the preferred sector remains attractive, this yield opportunity brings with it meaningful risks to investors. We recommend that investors focus on long-term income generation when purchasing preferred securities and strongly encourage investors to consider a professional manager to oversee their preferred allocations.

Key takeaways

  • Given the higher volatility of preferred securities, we believe that exposure to this sector should be diversified among a variety of issuers, sectors, and structures. We strongly recommend that investors consider a professional manager to oversee their preferred allocations. 
  • As the credit cycle continues to mature, the potential for a credit-based correction in the preferred sector is likely to increase.
  • We currently have a favorable view of the preferred-security sector.

Real Assets

by Austin Pickle, CFA, Investment Strategy Analyst

“What lies in our power to do, it lies in our power not to do.” - Aristotle 

A hawk flies and oil falls

President Trump’s national security adviser, John Bolton, left the administration last week. John Bolton, widely considered to be a foreign-policy hawk, had consistently taken a hard line against Iran. During his time as national security adviser, crippling U.S. sanctions reduced Iranian oil exports by more than 2 million barrels per day (see chart). Oil prices dropped on the news of his departure. The thought was that—with Bolton gone—President Trump might be more likely to ease sanctions and quickly bring those lost barrels back to market. Does this news change our oil forecast? 

We believe that the proper supply/demand balance for the West Texas Intermediate (WTI) oil price is $40-$50 per barrel. Our 2019 year-end price target of $50-$60 includes a $10 premium for geopolitical concerns like those involving Iran. If Iran is removed as a major geopolitical concern, should that $10 premium be reduced and the target range lowered? Not necessarily. Nothing occurs in a vacuum—and currently—there are a number of competing considerations. These include the inability of OPEC (Organization of the Petroleum Exporting Countries) members to cover budgets at current prices, recent bullish inventory reports, flat U.S. oil-production growth (despite prices being above breakeven levels), exploration and production companies increasingly going bust, high-yield energy credit spreads widening—not to mention a little matter of the ongoing U.S./China trade dispute and related global growth angst—just to name a few.

While it is notable, John Bolton leaving is just one force in the tug-of-war over the future direction of oil prices. Our oil targets remain unchanged.

Key takeaways

  • John Bolton’s departure could open the door for easing Iran sanctions.
  • Our 2019 year-end targets remain $50-$60 per barrel for WTI crude oil and $55-$65 for Brent.

Iran crude-oil exports by country and region


Iran crude-oil exports by country and region

Sources: Wells Fargo Investment Institute, Bloomberg; September 11, 2019. Monthly data: July 31, 2015-August 31, 2019.

Alternative Investments

by Ryan McWalter, CAIA, Global Alternative Investment Strategist 

Recent performance and positioning of Trend Following Macro strategies

Volatility was elevated in August as trade tensions and global-growth concerns led to equity and commodity market declines. While the Bloomberg Barclays Global Aggregate Bond Index rose last month during the risk-off environment (+2.03%), the multiple return streams of Trend Following Macro strategies produced outsized gains (+4.50%), providing reduced downside exposure—as the HFRI Macro Systematic Diversified Index posted its second best monthly return in the post-financial-crisis era. Notable performance drivers included long exposure to fixed income, precious metals, and the Japanese yen, along with short euro and British pound positioning.

We have been unfavorable on Trend Following Macro strategies, because of the headwinds from the abrupt trend reversals that have occurred across asset classes. In recent years, there have been many instances in which equity and commodity markets have had V-shaped recoveries, limiting Trend Following managers’ ability to fully capture trends and crystalize returns. Additionally, the market’s focus on central-bank policy decisions created sharp reversals within bond and currency markets as expectations and decisions moved markets. Yet, months like August help to illustrate why we recommend that investors maintain a long-term, strategic allocation to Trend Following Macro strategies. These strategies can be an important complement to traditional long-only stock and bond exposure, especially during times of sustained volatility and trends across asset classes.  

While we do not believe that a market correction, recession, or hard Brexit are imminent, we believe that these strategies are currently positioned to perform well in such scenarios (particularly with regard to a hard Brexit, given currency positioning).

Key takeaways

  • During a volatile August, Trend Following Macro strategies outperformed, providing valuable diversification benefits to traditional long-only stock and bond exposure.
  • Given the strategy’s current positioning, we believe that it could perform well in the event of a sustained market correction or recession (and, in particular, a hard Brexit).

Reducing downside exposure with Trend Following Macro Strategies


Reducing downside exposure with Trend Following Macro Strategies

Source: Bloomberg; September 12, 2019. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment.

1Correlation measures how two asset classes or investments move in relation to each other.  

2Return is year to date through September 9, 2019.