Investment Strategy
Finding Yield in a Low-Yield Environment
by George Rusnak, CFA, Co-Head of Global Fixed Income Strategy
Key takeaways
- The Federal Reserve (Fed) lowered rates three times in 2019, and investors may be wondering when or if rates will rise again.
- Fixed-income yields have dropped significantly this year. We believe this era of lower yielding fixed-income assets is due to high global demand, extraordinary low/negative rate policies globally, and lower long-term growth and inflation expectations.
What it may mean for investors
- Seeking more income requires accepting more risk, and we believe investors should consider which risks they are willing to accept. In our view, there are opportunities within sectors and liquidity risks, and investors seeking extra yield may want to consider diversifying income streams across asset classes.
Fixed-income assets have performed well this year as yields have declined globally. However, lower yields present a challenge for many fixed income investors—primarily for the income stream. The dramatic reversal of both the Fed’s position on interest rates and global rates has caught many investors off guard, leading some to wonder when or if rates will rise again. If interest rates do not rise, investors may struggle with how to meet their income needs in this low interest-rate environment.
The difference a year can make
This time last year, the 10-year Treasury yielded 3.24% on November 8, 2018 (see Chart 1), and the expectation was that the Fed would raise short-term rates another 25 basis points at year-end and continue raising rates well into 2019.1 This view reversed in late 2018 and into 2019 as the economic landscape was weaker than previously believed. This led the Fed to reverse course and lower rates three times this year—rather than raise them. Although interest rates can certainly move higher from current levels, we do not believe rates will move materially higher in the foreseeable future as the global landscape has changed in terms of demand, policy, and expectations.
Chart 1. The 10-year Treasury yield’s decline
Source: Bloomberg, November 6, 2019. 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.
Why lower rates?
We believe that strong demand for high-quality fixed-income assets will continue to grow as developed market demographics shift and retiring baby boomers face living on a fixed income (see Chart 2). Additionally, we believe that many developed market central bank policies featuring lower (and sometimes negative) rates may present challenges for the Fed to significantly raise rates. As the U.S. is currently experiencing, it is easier to lower interest rates than to raise them, since raising rates can cause challenges for equity market discount rates and overall growth prospects. Finally, global growth and inflation prospects have been shifting down as we reach our long-term potential and possibly near the limits to what monetary policy stimulus can provide. Putting this together, we feel that interest rates may rise a little or fall, but a significant rise in rates does not appear likely given these changing forces.
Chart 2. Fixed-income flows (YTD)
Source: Investment Company Institute data, November 6, 2019. YTD = year to date.
Increasing risk to increase yield
This low-yield environment has left investors struggling with how to maintain their income levels despite falling yields worldwide. The saying in the bond market is that “there’s no such thing as a free lunch,” meaning if you want more income or yield, you need to be willing to accept more risk. However, which risk is the right risk for investors to take given today’s markets and the current business cycle?
Credit risk – The extra yield received for purchasing weaker rated credits does not seem to offer value at current levels, which is why we are unfavorable on high yield. Current credit spreads for high yield are close to credit cycle tights (i.e., the lowest credit spreads of the economic cycle), and therefore, are not compensating holders for the increased credit risk. Additionally, there’s been a split in high yield where the yield spreads on the lower rated credits and sectors have increased dramatically, typically a sign of late-market cycle behavior.
Interest-rate risk – Accepting more price volatility by moving out on the yield curve does not seem to offer much value at current levels. Given the flatness of the yield curve, an investor may receive about 70% of the income in a 2-year versus 30-year Treasury, with only about 9% of the interest-rate volatility. This is one of the reasons we are favorable on the short-end of the yield curve.
Sector risk – We believe there are opportunities within some sectors to gain more yield. Specifically, we are favorable on investment-grade corporates, preferreds, and mortgage-backed securities. We believe investment-grade corporates offer additional income over Treasuries without as much credit risk as high yield. We particularly like the financial sector given favorable risk/reward characteristics versus utilities and industrials and improved fundamentals. Preferreds offer additional income for investors willing and able to handle increasing duration and concentration risk in the financial sector. 2 Mortgage-backed securities have underperformed this year; yet, we believe they may offer good opportunities for investors able to withstand increased price volatility due to changing average lives and pay downs.
Liquidity risk – We also believe that patient capital can be rewarded within fixed income, and that volatility and uncertainty in the private debt market can offer opportunities from experienced portfolio managers.
What to do?
It’s important that investors understand that all methods to gain extra yield or income within fixed income assume a higher level of risk. We currently view credit risk as unfavorable and interest-rate risk as favorable on the short-end, and we believe there are opportunities within sectors and liquidity risks. Within sectors, we are favorable on investment-grade corporates, preferreds, and mortgage-backed securities. Additionally, we believe investors that seek extra yield may want to consider a more comprehensive view of income including multiple asset classes such as equities, real assets, and alternatives where possible.
Equities
by Audrey Kaplan, Head of Global Equity Strategy; Ken Johnson, CFA, Investment Strategy Analyst
U.S. earnings season update: Wall Street converged to our EPS forecasts
Across the U.S. large-cap, mid-cap, and small-cap asset classes, the Wall Street consensus has revised its full-year 2019 earnings lower as actuals came in during the quarter—despite the fact that reported figures are better than expected for S&P 500 third-quarter results for 76% of the companies reported so far. Since the first quarter, we have had a conservative stance on earnings growth. As the table illustrates, the S&P 500 consensus has moved down and is now below our estimate of 2.1%. Mid-cap equities have converged to our estimate, while small caps have remained too high, in our opinion.
With approximately 80%, 75%, and 60% of firms reported for the S&P 500, Russell Midcap, and Russell 2000 respectively, third-quarter earnings are negative across the board and show similarities to the prior two earnings slowdowns in this 10.5-year economic cycle. Meanwhile, revenue growth remains positive. In fact, 2019 revenue growth for the S&P 500 is projected to be over 100 basis points higher than the 10-year average of 3.1%. Buoyant revenues have provided fundamental support to the S&P 500 Index, year to date. Although earnings results are coming in below the Street consensus for mid- and small-cap equities, our full-year forecast was already below consensus. With revenues holding up despite geopolitical headwinds, such as U.S.-China trade tensions and extreme market uncertainty, we believe this revenue growth bodes well for overall firm profitability as we approach year end.
Key takeaways
- We believe the risk-reward balance favors large caps over small caps, given the Russell 2000 muted earnings per share (EPS) and revenue growth versus its own history.
- Revenue growth remained more robust in the third quarter (Q3) versus EPS growth, which we believe provides fundamental support for continued modest equity gains this cycle.
Wells Fargo Investment Institute targets compared to full-year consensus EPS and revenue growth in Q3 2019
Sources: Wells Fargo Investment Institute (WFII), FactSet, as of November 6, 2019. FY = full year. An index is unmanaged and not available for direct investment. Forecasts and estimates are not guaranteed and are based on certain assumptions and views of market and economic conditions which are subject to change.
Fixed Income
by Brian Rehling, CFA, Co-Head of Global Fixed Income Strategy
Positive yield curve trends
Historically, the yield curve has followed fairly predictable long-term trends: steepening early in an economic recovery before flattening and inverting, followed by an eventual economic downturn. This summer the yield curve meaningfully inverted, and investors expressed concern that a recession may be forthcoming. In recent weeks, the yield curve has steepened and is no longer inverted at any of the key points. In fact, the 3-month versus 10-year Treasury curve is positively sloped by 32 basis points after being inverted by as much as 50 basis points in August of this year.
The significant change in the slope of the yield curve may be interpreted as a positive development, but in our view, does not yet confirm that the U.S. will avoid a recession. Historically, it has been as long as 18 months after initial inversion before recessionary conditions materialized. We are hopeful that this time will be different, and we believe recent yield curve developments are a positive sign. We expect to see a slowdown in economic growth in the U.S. but not a recession. However, if the yield curve once again flattens and inverts, our concern would increase. For a more in-depth discussion of the yield curve, ask your investment professional for a copy of our report “Power in the Yield Curve.”
Key takeaways
- There had been concern that this summer’s yield curve inversion could signal impending U.S. economic weakness ahead. The Treasury yield curve has been a powerful recession predictor in past economic cycles.
- Yields on longer-maturity Treasury securities have increased over the past two weeks as investors have become more confident that the economic recovery will remain intact.
Ten-year versus three-month yield curve slope
Sources: Bloomberg, November 5, 2019. 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 Real Asset Strategy
“History is the best textbook.” —Xi Jinping
What trade has to do with the price of food in China
Much has been made of the recent trade truce/deal between the U.S. and China. And rightfully so. Resolving the trade dispute between the world’s two largest economies could go a long way to help jumpstart global trade and gross domestic product (GDP) growth in 2020.
Deal or no deal, China faces some stiff economic headwinds as it sails into 2020. And we’re not only talking about trade. Chinese consumers are being hit with an inflation storm of sorts—the likes of which they haven’t seen in nearly a decade. Food costs have swelled 11%, year-over-year (chart, green line), which is the highest level in nearly a decade. At the same time, wage inflation has dropped to one of its lowest readings ever. This combination of higher food costs and less pay potential is squeezing Chinese pocketbooks.
Food inflation is an interesting beast—if it goes untamed, it may fuel social unrest. We’re not necessarily arguing for investors to expect social unrest inside China, but it is something to watch. While not all individual food commodity prices are rising, some high-profile ones are. Pork prices, as an example, are up 70% year-over-year (chart, blue line), as a result of a herd-decimating African swine fever. Pork is key because it is a meat consumed like no other inside China. China consumes more pork than any other country, and its citizens consume more pork per person than nearly every other country. Be on the lookout for Chinese leadership to begin addressing rising food inflation, especially pork prices.
Key takeaways
- Food costs are soaring in China. Pork prices, as an example, are up 70%.
- Be on the lookout for Chinese leadership to begin addressing rising food inflation.
China pork and food CPI
Sources: Bloomberg, National Bureau of Statistics of China, Wells Fargo Investment Institute. Monthly data: January 31, 2014 – October 31, 2019. CPI=Consumer Price Index.
Alternative Investments
by Ryan McWalter, CAIA, Global Alternative Investment Strategist
Changing dynamics beneath the surface of credit markets
Stellar performances at index levels have not fully illustrated the changing dynamics that occurred over the past year—in particular to distress ratios within high-yield credit markets. The chart below shows the year-over-year change (September 2018 to September 2019) in distress ratios across the 18 sectors in the Bank of America Merrill Lynch US High Yield Bond Index.
What is telling to us is the number of sectors that have experienced material increases in distress ratios (bonds with spreads greater than 1,000 basis points). Nine of the eighteen sectors have had a 5% or more increase in the percentage of bonds trading at distressed levels. Notable increases have occurred in Energy (5.75% to 31.06%), Food (4% to 15.38%), and Health Care (3.75% to 13.51%). This reiterates our view that troubled corporate credits exist throughout the course of a market cycle, even when headline high-yield credit indices are performing well.
These opportunities can provide distressed managers with attractive entry points and the ability to overweight certain sectors/credits, which can enhance returns over the long term. Since January 1990 through September 2019, the HFRI Event Driven: Distressed Restructuring Index has generated a 10.05% annualized return versus the Bank of America Merrill Lynch US High Yield Bond Index’s 8.37% annualized return.
While the distressed strategy will have sensitivity to broader credit markets and can feel the initial effects of widening credit spreads, this strategy has rewarded patient investors over multiple distressed cycles by consistently taking advantage of dislocations in credit markets. Of course, past performance is no guarantee of future results.
Key takeaways
- Though headline indices have performed well over the past year, there have been large increases in distress ratios across sectors, enhancing the opportunity set for distressed managers.
- While the distressed strategy has sensitivity to broader credit markets, over time the strategy has compensated patient investors throughout the course of credit cycles.
Pockets of increased distress
Source: Bank of America Merrill Lynch, September 2019.
1 100 basis points equals 1%.
2 Duration is a measure of a bond's sensitivity to interest rates.
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. In addition to the risks associated with investment in debt securities, mortgage-backed securities will be subject to prepayment, extension and call risks. Changes in prepayments may significantly affect yield, average life and expected maturity. Extension risk is the risk that rising interest rates will slow the rate at which mortgages are prepaid. Call risk is the risk that If called prior to maturity, similar yielding investments may not be available for the Fund to purchase. These risks may be heightened for longer maturity and duration securities. 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. Preferred securities have special risks associated with investing. Preferred securities are subject to interest rate and credit risks. Preferred securities are generally subordinated to bonds or other debt instruments in an issuer's capital structure, subjecting them to a greater risk of non-payment than more senior securities. In addition, the issue may be callable which may negatively impact the return of the security. 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
The Consumer Price Index (CPI) produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services.
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.
Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. The Russell 3000 Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.
Russell Midcap Index measures the performance of the 800 smallest companies in the Russell 1000 Index.
Bank of America Merrill Lynch U.S. High Yield Bond Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market.
HFRI Event Driven Distressed/Restructuring Index: Strategies focus on corporate fixed-income instruments, primarily corporate credit instruments of companies trading at significant discounts to their value at issuance or obliged (par value) at maturity as a result of either formal bankruptcy proceedings or financial-market perception of near-term proceedings. Managers are typically actively involved with the management of these companies; they are frequently involved on creditors’ committees in negotiating the exchange of securities for alternative obligations, either swaps of debt, equity or hybrid securities. Managers employ fundamental credit processes focused on valuation and asset coverage of securities of distressed firms; in most cases portfolio exposures are concentrated in instruments that are publicly traded, in some cases actively and in others under reduced liquidity but in general for which a reasonable public market exists. Strategies employ primarily debt (greater than 60 percent) but also may maintain related equity exposure.
An index is unmanaged and not available for direct investment.
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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.
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