Investment Insights | 2019 - Expand views on debt Adapt to changing discount rates - Wells Fargo Asset Management
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Investment Insights | 2019 Expand views on debt Adapt to changing discount rates Adjust portfolio duration
Expand, adapt, and adjust: Managing risk in an aging recovery
The past 10 years featured generally declining interest rates, rising investor
confidence, and a restoration of balance sheet health for most households
and businesses. Yet the tailwinds of the past decade look to be turning into Table of contents
headwinds. Interest rates have been rising, making long-duration assets
Portfolio positioning 2
underperform shorter-duration assets. Discount rates have been rising,
making assets with riskier cash flows underperform higher-quality assets. Expand views on debt 4
Debt levels have reached points where they are raising concerns. In this
aging recovery, we believe there are concrete steps investors can consider Adapt to changing
to manage risks: discount rates 8
Adjust portfolio duration 11
1
Expand views on debt Conclusion 13
Open questions about rising rates, the pace of economic growth,
and corporate and government debt levels will likely require About the authors 13
nuance to identify the right investment opportunities.
2 Adapt to changing discount rates
Shifting risk premia (or the amount that investors expect in
compensation for taking on various risks) and widening credit
spreads should cause credit quality and fundamental security
selection to play a critical role in helping drive returns.
3 Adjust portfolio duration
Duration, security price movement as a result of interest rate
movements, is more than just a fixed-income concern. Knowing
when to adjust duration across asset classes is often one benefit of
active management.
1Portfolio positioning
U.S. equities Taxable domestic fixed income
Notable overweights: In an overall environment of scarce Notable overweights: Corporate debt has grown, but not
growth, our U.S. growth equity teams continue to favor evenly across all sectors. Banks and financials have been
companies with secular tailwinds. These opportunities have exhibiting lower leverage levels than prior to the financial crisis,
been and continue to be found within disruptive information due largely to regulatory changes. Many teams are overweight
technology and communication services companies. They credit, but with valuations in many credit sectors stretched
remain disciplined on valuations for this growth, differentiating and spreads near the lower end of the range, those teams are
their strategy from momentum strategies. Our U.S. core and finding it prudent to build dry powder and favor an up-in-
value equity teams are finding more opportunities within the quality bias in portfolios. Fundamentals in the high-yield market
industrials and materials sectors in companies that may continue to be supportive and default rates remain low, lending
be experiencing transitory cost pressures amid continued teams an opportunity to find positions here, though valuations
global growth. remain rich. Our U.S.-focused teams are generally moving closer
to a more neutral interest rate duration positioning with the
Notable underweights: U.S. growth equity teams are
view that the majority of market participants have priced in the
underweight consumer staples, where earnings and revenue
remaining Federal Reserve (Fed) rate hikes.
growth have been challenging. Our U.S. core and value equity
teams are underweight real estate investment trusts (REITs) Notable underweights: U.S. nonfinancials and industrials
and utilities. Such stocks tend to be pressured in a rising rate remain underweights given their higher levels of leverage late
environment, given higher financing costs and competition in the cycle. Underwriting and credit quality of the leveraged
from higher-yielding U.S. Treasury securities. loan market have deteriorated, potentially leaving investors less
protected when the credit cycle turns.
Non-U.S. equities
Notable overweights: Although fundamentals are a bit less
Taxable non-U.S. fixed income
favorable due to slowing global growth, higher oil prices, Notable overweights: The speed and magnitude with which
and ongoing trade wars, our international managers that developed nations have issued debt, as measured by debt
also manage global portfolios are finding more opportunities to gross domestic product (GDP), is concerning and has left
outside of the U.S. Internationally, our managers are also smaller developed/developing and emerging markets with less
finding opportunities to overweight information technology. relative debt. As central banks look to normalize their policies
They are also adding self-help restructuring opportunities around the world, the focus on fundamentals should help
within Europe. Our managers believe that emerging market differentiate credits. European investment-grade spreads are
valuations look attractive in the intermediate to long term, seeing more dispersion and we expect this to continue as the
particularly within Asia. cycle matures, offering relative-value opportunities. We also
believe moving up in quality and maintaining liquidity will be
Notable underweights: As sovereign interest rates and
important as the influence from exchange-traded funds, asset
yield curves rise, our international equity teams are also
managers, and the broader shadow banking system has grown.
underweight REITs and utilities.
Notable underweights: Teams are underweight developed
nations whose debt levels have increased rapidly or which
remain elevated to historical levels. Currency valuations and
hedging costs are leading teams to look for value in local
currencies around the world and underweighting U.S.-dollar-
denominated debt.
2Portfolio positioning
Tax-exempt fixed income Multi-asset
Notable overweights: After having positioned portfolio Notable overweights:
durations short relative to their benchmarks for much of the • A multi-asset perspective on investing is about focusing on
past two years, the team has been moving closer to neutral risk premias and risk allocation, letting the capital allocation
levels of interest rate duration. Given that we are in the later follow the risk allocations. Traditional asset allocation puts
stages of the cycle, the team has been opportunistically capital allocation first. For example, allocating toward
improving credit quality and taking advantage of the steeper economic growth can be done via high-yield bonds or
municipal yield curve by purchasing higher credit-quality equities, albeit with different risk/return properties. Within the
bonds in key rates along the curve. Highly rated securities multi-asset strategies focused on growing wealth, the team is
within Texas and select securities within Illinois remain leaning cyclically, although less so than it did last year.
notable overweights. The strategies have maintained an
• Within the strategies focused on generating income, the
overweight to lower-quality credits, but the exposures have
team continues to favor more economically growth-linked
been reduced.
sources of income, like global dividend-paying stocks, high-
Notable underweights: Changes to federal tax laws enacted yield bonds, contingent convertible bonds (or CoCos), and
in late 2017 have created relative-value differences across emerging market debt.
municipalities leading to underweight positions in California
• For those strategies that are geared toward protecting
debt and prerefunded bonds.
wealth, the team continues to favor long-short strategies
to capture alternative risk premias, as well as the use of
systematic futures and options strategies to provide
Quantitative dynamic risk hedging.
Notable overweights: Analytic and Golden are the two Notable underweights:
Wells Fargo Asset Management quantitative teams. • For a few years, the multi-asset strategies focused on growth
Analytic takes a pure quantitative disciplined approach have favored the momentum factor in the U.S., but they
to maintain exposures across quality, value, momentum, reduced exposure to that factor over the course of 2018,
small size, and low-volatility factors. Golden takes a similar shifting attention to the value opportunities outside the U.S.
disciplined “quantamental” approach but also seeks to Our multi-asset strategies have been underweight duration
identify those companies with strong and improving risk across portfolios because the team anticipated a rise in
company fundamentals, strong balance sheets, experienced interest rates. Now that the Fed is closer to neutral than it has
management, and attractive valuations. Currently, this has led been in a decade, the strategies are still underweight duration
to an overweight positioning in health care. but not nearly to the extent they were even a year ago.
Notable underweights: Golden’s underweight to consumer
staples is driven by revenue and earnings growth challenges,
along with fuller valuations.
3Expand views on debt
Debt is rising—but not everywhere
Whether it’s the Bank for International Settlements or the International
Monetary Fund, organizations are issuing warnings about rising debt levels. A
Alison Shimada nuance that is often omitted is the distribution and concentration of that debt.
Senior Portfolio Manager
Many governments have increased their debt levels to the point that they equal
“ Despite China’s slower economic growth, their GDP, and some nongovernment sectors have also increased their leverage.
we do not expect nonperforming However, across and within geographies and sectors, not everyone has levered
loans to materially increase for the up to concerning levels. Nuance will likely make all the difference if and when
following reasons—the continuation of rates rise further or economic growth slows faster than many expect.
the country’s deleveraging campaign,
stable earnings growth in an economy
growing at ~6%, an interest coverage
ratio (earnings before interest and Portfolio positioning
tax/interest expense) in the 3.5–8.0
Multi-asset solutions
times range, the implicit guarantee
of state-owned enterprise debt, and Nuance is important. Government debt has grown, but corporate balance
a more accommodative interest rate sheets look pretty healthy. Through the lens of debt growth and valuations, the
policy. Our outlook has been confirmed multi-asset managers think there are places investors can ride out any market
by the banks as they report results storms that may hit.
and guide toward stable credit costs
for 2019. Additionally, I believe the Equity
continuing shift away from infrastructure Our equity managers think about debt from a few angles. As an example, have
investment, which is capital intensive, the companies incurred too much debt such that if growth slows they will have
toward technology sectors with higher a hard time servicing the debt? There may be cases of that in any country or
return potential, as well as reforms to any sector, but a focus on quality (Alison Shimada) or balance sheet flexibility
enhance capital efficiency, are long-term (Bryant VanCronkhite) should help navigate around those potholes.
solutions to China’s high debt problem.”
Fixed income
Our fixed-income managers have a lot of perspectives on this from a sector and
country level. Again, a focus on quality and bottom-up credit analysis is their
tactic for threading the needle of high debt loads and rising debt-servicing cost.
4Expand views on debt
Global government debt has generally grown faster over the past decade than corporate debt
The data below shows the change in corporate leverage versus the change in government debt burdens. The bubble size represents forward price/earnings
multiples from Bloomberg estimates.
15
15
Brazil
10
10
Change in MSCI Index debt-to-assets from 2008 to 2018 (percentage points)
Turkey
55 India
Change in MSCI Index debt-to-assets (percentage points)
Germany Canada
00
Mexico South
Africa
Australia
Russia
-5
-5 Hong Kong South
Korea United States Japan
Portugal Greece
Italy
-10 Britain
-10
Spain
-15
-15
-20
-20
-25
-25 France
-30
-30
-30 -20 -10 0 10 20 30 40 50 60 70 80
-30 -20 -10 0 10 20 30 40 50
Change in government debt-to-GDP from 2008 to 2018 (percentage points)
60 70 80
Change in government debt-to-GDP from 2008 to 2018 (percentage points)
Source: Bloomberg. Price/earnings (P/E) is the price of a share of a stock divided by earnings per share, using Bloomberg estimates for next twelve months’ earnings per share.
5Expand views on debt
A rising tide of leveraged loans
While many governments have increased their debt-to-GDP ratios since 2008,
the corporate sector is looking much healthier, with many companies having
Janet Rilling, CFA
Senior Portfolio Manager reduced their debt-to-asset levels. There is also a wide variety of valuations
“
across the globe, creating potential opportunities for investors. A global search
While broad generalizations about rising for quality should uncover opportunities for investors who may be nervous
debt levels are not to be ignored, they
about rising debt levels and the possibility of peaking economic activity.
don’t necessarily apply to all parts of the
credit market. Within the investment- Although aggressive borrowing is occurring, the majority of deals are being
grade bond universe, there are several financed by a combination of the syndicated loan and private debt worlds.
sectors that are defying the rising debt Issuers are finding more generous terms in those markets. The positive is that
narrative. Banking is a good example of
high-yield issuers, fundamentally, are well positioned at this point in the cycle
a sector that is exhibiting lower leverage
levels than prior to the financial crisis,
relative to history. There are fewer issues rated CCC (the lowest-rated tier) and a
largely as a result of regulatory changes.” higher percentage of BBs than average. The negative is the deterioration in the
Moreover, it might surprise some to
quality of the loan market.
learn that leverage metrics for the U.S.
high-yield corporate bond market have Corporate loans are increasingly issued at the
been declining, while interest coverage expense of bonds
metrics, an indicator of how much cash New issue volumes ($ billions)
flow a company has to service its interest 450
expense, are at cycle-high levels.” 400
350
300
$ billions
250
200
150
100
50
0
Niklas Nordenfelt, CFA 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Senior Portfolio Manager
“
U.S. high yield U.S. institutional loans
Typically, at this point in the cycle,
one would expect to see a significant Par amount outstanding ($ billions)
growth of the high-yield bond market 1,200
as companies engage in aggressive
borrowing and/or merger and 1,000
acquisition activity. However, the
800
high-yield bond market, in contrast to
$ billions
the investment-grade corporate bond 600
market, has actually declined in size.”
400
200
0
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
U.S. institutional loans U.S. high yield bond European Union Emerging Markets
high yield high yield
Source: ICE BofA Merrill Lynch Global Research, data as of September 30, 2018
6Expand views on debt
The seemingly insatiable demand for floating-rate debt and the creation
of collateralized loan obligations has resulted in a significant increase in
both lower-rated loans and loan-only structures. It seems that investors are
trading interest rate risk for credit spread risk. As investors, this is important to
understand. In an eventual downturn, we expect lower recovery rates for loans Bryant VanCronkhite, CFA, CPA
Senior Portfolio Manager
than most investors have modeled based on historical measures. We prefer
“
higher-quality loans (generally BB rated), which have experienced less erosion A lot of investors have lived for 10
in structure. years in a world where cash earnings
have grown and interest costs have
Lower-quality loans now account for a greater proportion fallen. That cocktail typically allows for
of the market very high leverage ratios. However,
the true variability of cash flows is far
Loan market ratings mix greater for many industries than we’ve
experienced over the past 10 years.
55 What looks today like a safe leverage
Par based, excluding nonrated and defaulted loans
ratio could quickly turn into a debt tail
50 that wags the equity dog.”
45 Aug 2018:
BB-/B+ = 28.0%
B/B- = 38.1%
40
35 Jan 2013:
BB-/B+ = 44.6%
Percent (%)
30 B/B- = 20.3%
Alex Temple
25 Portfolio Manager
20
15
“ Nuance will be meaningful.
Considerations include the mix of
a country’s local and hard currency
debt, the term structure of debt, and
diversification of funding sources. In this
10
latter stage of the credit cycle, liquidity
might trump leverage and fundamentals
5
as the greatest concern in a period of
heightened volatility, which one might
0 expect at the end of the cycle. While
Jan. 2012 Jan. 2013 Jan. 2014 Jan. 2015 Jan. 2016 Jan. 2017 Jan. 2018 general leverage in the system might be
lower than pre–global financial crisis,
BB+/BB BB-/BB+ B/B- Below B-
there has been a risk transfer from banks
Sources: LCD and Wells Fargo Securities to asset managers and exchange-traded
funds and the wider shadow banking
system. This could have implications
for liquidity.”
7Adapt to changing discount rates
Risky cash flows should not be discounted by risk-free interest rates. Instead,
investors should use discount rates that reflect shifting risk premia. If economic
activity slows, credit spreads and risk premia can widen, even absent a
recession. Rising discount rates lowers the present value of a security. For this
Alison Shimada reason, many of our fixed-income managers are moving up in credit quality
Senior Portfolio Manager
and focusing on those issues where their bottom-up analysis lends stronger
“ We often hear from investors that rates confidence in the issuer’s credit quality than what may be reflected in market
are going up and that is bad for emerging prices or credit ratings. Our equity managers are looking for areas where their
markets, especially higher-yielding names. expectations differ from the consensus, based on confidence arising from their
However, the numbers are not supportive investment processes. This means focusing more on security selection than on
of that assertion as the correlation between sector allocation for possible outperformance.
changes in the U.S. 10-year Treasury and
emerging market equity performance over
Discount rates have recently risen off their lows
three-year periods has been quite low—in
the single digits. Emerging market equity The historical option-adjusted spread represents changing discount rates.
markets rallied in 2017 as the Fed raised
rates four times during the year. Emerging 20
markets are down so far in 2018, but that
can’t be attributed only to the three Fed rate
Option-adjusted spread (%)
hikes this year. Thus far, we have not seen 15
and do not expect to see a disproportionate
negative impact in the portfolio for the
aforementioned reasons. With our dividend-
focused strategy, there’s also the fact that 10
90% of companies in the MSCI Emerging
Markets Index pay a dividend, allowing
us to rotate out of names that may be 5
disproportionately hurt by rising rates.”
0
12/31/2007
12/31/2008
12/31/2009
12/31/2010
12/31/1201
12/31/2012
12/31/2013
12/31/2014
12/31/2015
12/31/2016
12/31/2017
9/29/2018
Jeffrey Weaver, CFA Bloomberg Barclays U.S. Bloomberg Barclays Bloomberg Barclays
Senior Portfolio Manager Corporate High Yield Bond Pan-European High Yield Emerging Markets High Yield
“ We remain concerned around the level Source: Bloomberg
of nonfinancial corporate leverage. Many
merger and acquisition agreements leave A decent amount of portfolio gains since 2008 have come from falling interest
little room for operational challenges and rates, tightening credit spreads, or rising valuations. All three of these factors
we find concerning the leverage levels may be in the early stages of making a turn. That’s where strong fundamentals
being taken on by issuers. While leverage for
in the form of cash flow growth and a company’s ability to pay dividends will
BBB-rated issuers is marginally higher than
likely become more important over the next few years.
precrisis levels, the aggregate leverage for
A-rated issuers is significantly higher. In many
instances, BBB-rated issuers are better able to
manage their leverage levels within existing
ratings, but a deteriorating macroeconomic
backdrop could lead to a large number of
downgrades out of A ratings.”
8Adapt to changing discount rates
The decomposition of equity returns
Recently, P/E multiple expansion has heavily influenced S&P 500 Index returns. Whereas …
Dividend Earnings Valuation/PE Annualized Cumulative
+ + = Janet Rilling, CFA
yield growth changes return return
Senior Portfolio Manager
“
S&P 500 2.3% 7.7% 5.6% 15.6% 130%
While it is always important to practice
MSCI EAFE 2.9% 1.6% 2.1% 6.6% 44% careful security selection, it is especially
crucial to do your homework in the later
MSCI EM 2.5% -0.9% 0.7% 2.3% 14% stages of a credit cycle. Fundamental
1/1/2013 to 9/30/2018 analysis can help uncover credit stories
that buck the trend—such as companies
generating a more geographically
... Longer term, dividends and earnings growth, not valuation, are the drivers. diversified revenue stream, resulting
in less sensitivity to a U.S. downturn.
Dividend Earnings Valuation/PE Annualized Cumulative Another attractive place to focus could
+ + =
yield growth changes return return be sectors that are less correlated with
U.S. GDP growth, either because they
S&P 500 2.2% 6.5% 0.1% 8.8% 220%
are less cyclical or because they are
MSCI EAFE 2.9% 2.6% -0.7% 4.8% 90% benefiting from a larger secular trend.
Companies that provide productivity
MSCI EM 2.6% 4.1% 0.8% 7.5% 169% improvements to their customers, such
as in the technology industry, could be a
1/1/2005 to 9/30/2018 third place to look. In any case, attention
to financial flexibility and liquidity
Sources: FactSet, Bloomberg, USD, S&P 500 Index, MSCI EM (Emerging Markets Net Return) Index, MSCI EAFE (Europe Australasia, Far East
Net Return) Index, cumulative and annualized returns calculated monthly. position should help an investor better
Dividend yield for MSCI EM (Emerging Markets Net Return) Index, MSCI EAFE (Europe Australasia, Far East Net Return) Index is estimated assess a company’s ability to weather
using net dividends. economic headwinds that could be on
Earnings growth and valuation to P/E changes components are U.S.-dollar estimated total return percentages, using next 12 months.
the horizon.”
Past performance is no guarantee of future results.
Portfolio positioning
Multi-asset solutions Equity Fixed income
Multi-asset’s bread and butter is The return decomposition chart above For fixed income, credit spreads have
examining risk premias. Discount rates— shows how much of total return tends to widened, but they’re still narrow. This
which include various risk premias—have come from fundamentals versus valuation credit cycle could end with more of a
been rising across asset classes, but the changes. In the U.S., the story in recent fizzle than a burst. Spreads might
turn looks to be in the early stages. We’ve years has been one of valuations rising gradually rise as economic growth looks
been overweight domestic equities to drive returns. A focus on fundamental good, and there seems to be only pockets
and growth. With rising risk premias but earnings growth should uncover of craziness in the credit market.
differentials across countries, we think it’s opportunities. Outside the U.S., there
prudent to adapt portfolios by reducing hasn’t been the same surge in valuations,
that home bias and growth bias. which should bode well for non-U.S.
exposure.
9Adapt to changing discount rates
As shown in the graphics below, spreads have tightened significantly between
CCC-rated and B-rated bonds. Lower-quality bonds benefited from multiple
factors, including improving overall credit quality and investors’ search for
yield. Moreover, although equity volatility spiked in October, stock market
Niklas Nordenfelt, CFA volatility has been muted for most of 2018, further supporting lower-rated
Senior Portfolio Manager
debt. Despite the strong performance of the credit markets in general and
“ Spreads on CCC-rated bonds have lower-quality debt in particular, concerns about the levels of leverage at some
declined to 2018 tights in response to companies is not going away.
the strong U.S. economy and, mostly, low
equity volatility. We anticipate that a rise In the high-yield bond market, lower-rated bonds had yields
in the equity risk premium will negatively come in relative to mid-rated debt
affect this segment of high yield the
most, in spite of a still-projected low CCC-B spread differential
default rate in the coming year.”
Basis points (bps: 100 bps = 1.00%)
2,500
2,000
1,500
1,000
500
0
Alex Temple
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
16
17
19
19
19
19
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
Portfolio Manager
“
CCC-B spread Long-term average Average in periods
Investors are increasingly focusing on
corporate fundamentals as central
banks normalize policy. We are already
seeing increased dispersion in European
investment-grade corporate bond Past 12 months
spreads and only expect this to increase 650
as the interest rate cycle matures. An 600
expectation that assets are subject to
550
revaluation risks—for example, the value
Basis points
of commercial property backing REITs 500
or the secondhand car values for leasing 450
companies—could have a negative
400
impact on credit spreads as investors
demand higher compensation for lower 350
implied recovery rates. To this end, we 300
are generally moving up in quality across
er
er
r
r
ry
ry
h
l
y
e
y
ust
er
ri
be
be
Ma
Jul
Jun
rc
mb
tob
mb
ua
rua
Ap
our portfolios, with a significant focus
Ma
g
vem
cem
Au
Jan
Feb
pte
pte
Oc
De
No
Se
Se
from analysts on asset valuations.” CCC-B spread Long-term average
Source: ICE BofA/ML Constrained Indices. Data as of September 30, 2018.
10Adjust portfolio duration
Fixed-income investors are familiar with adjusting duration, or the interest
rate sensitivity of portfolios. Most investors worry only about fixed-income Portfolio positioning
duration, but even equities have duration—whether it’s due to how changes Multi-asset solutions
in interest rates affect valuations or how changes in interest rates affect the Our multi-asset portfolios have generally
profitability of firms. Defensive sectors tend to be high-dividend-yielding ones, maintained a short duration in fixed income,
which makes them interest rate sensitive. Yet even growth stocks can have balancing that with a longer duration in
high duration exposure because their expected cash flows are often in the equities (growth overweight). With the recent
distant future. Shortening duration in equities typically means underweighting rise in yields and increase in risk premias, the
the classic interest-rate-sensitive defensive sectors and moderating allocations team has shifted both fixed-income and equity
to go-go-growth stocks. durations toward neutral.
Everything else equal, growth stocks can have a high
Equity
sensitivity to changes in interest rates Growth is a long-duration equity exposure,
Although investors often discuss the effect of interest rate changes on fixed income, changes though there’s a lot more to equity returns
in the yield curve can also have an effect on stocks. This chart shows the historical relationship
than just interest rate sensitivity. A rapid rise in
between a one percentage point increase in the slope of the yield curve (difference in yields
between the 10-year and the 2-year Treasury) and the total return of various indices. valuations—and occasional hiccup in prices—
has been more a function of exposure to
0 momentum than growth.
(0.96) (0.62) (1.22)
(2) (2.66) (2.53) Fixed income
Fixed-income portfolio managers have a
(4) number of tools to manage duration while
Total return (%)
maintaining exposure to the higher-yielding
(6) parts of the market that they favor.
(7.26)
(8)
(10)
(11.58)
(12)
Global Bloomberg ICE BoAML S&P 500 Russell 2000 S&P 500 S&P 500 Pure
Financial Barclays U.S. U.S. High Yield Index Index Pure Value Growth Index
Data 10-Year Corporate Constrained Index
Treasury Total Bond Index Index
Return Index
Sources: Global Financial Data and WFAM calculation from regression model for each index where the explanatory variables
are the level of two-year yield, the slope of the yield curve, and the change in the slope over the next six months.
11Adjust portfolio duration
Not all growth, but mostly momentum
The interest rate sensitivity of growth stocks is not uniform. There are many
different flavors of growth stocks. Firms whose cash flows are expected
Tom Ognar in the distant future tend to be stocks with the highest durations. Our
Senior Portfolio Manager
managers focus on finding companies with substantial, sustainable, and
“ Don’t confuse momentum investing underappreciated abilities to generate cash flows, reducing their effective
with growth investing. As the duration exposure. Most of the almost meteoric rise in growth stocks—in
embedded chart indicates, and which areas that may be most vulnerable—tend to be more momentum plays than
is reflected in our portfolio positioning, genuine growth stories. Momentum—the tendency for rising asset prices to
relative to history, the momentum continue rising—often occurs among growth stocks, but not all growth stocks
factor or positive price behavior is display the same degree of momentum.
expensive, while the growth factor
defined as predictable earnings growth
is not. Our style at its core has a growth
Q1–Q5 forward P/E spread: Momentum has been a more
focus that is executed with a disciplined significant factor than growth in explaining relative
eye on how much growth is being performance over the past few years
priced into a stock’s valuation. The key
is to be disciplined on the buy and, as U.S. momentum
important, the sell decisions.”
14
Q1–Q5 forward P/E spread
12
10
8
6
4
2
0
-2
Janet Rilling, CFA
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Senior Portfolio Manager
.2
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“
Ma
Fixed-income managers have a range
of tools to address duration. A blunt U.S. growth
and effective instrument to help protect
against interest rate increases is the 14
Q1–Q5 forward P/E spread
outright reduction of portfolio duration. 12
A manager can also favor less interest 10
8
rate sensitive sectors such as high-yield
6
bonds or those foreign bonds that are
4
exposed to a different interest rate cycle.
2
Floating-rate securities can be another
0
way to avoid interest rate risk because
-2
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No 201
No 201
Ju 201
No 201
01
No 200
Ma y 20
Ma y 20
the investor to benefit from rising rates.”
y2
rch
Ma
Sources: FactSet and MSCI Barra, as of September 30, 2018
The Q1–Q5 forward P/E spread shows the difference between consensus projected P/E for one quarter
ahead (Q1) and consensus projected P/E for five quarters ahead (Q5). The gray area represents the
first standard deviation. Standard deviation is the square root of the average squared deviations from
the mean. It is often used as a measure of volatility, variability, or risk. Standard deviation is based on
historical performance and does not represent future results.
12Conclusion
For what seems like at least six years now, people have been saying the economic and market
expansion is in the seventh or eighth inning. As viewers of the 2018 World Series can attest,
some innings can be short and some can be long and some pivotal games can go into many
extra innings, exhausting fans. Our portfolio managers think that instead of trying to call the end
of the game, or even predict when it might happen, a more prudent approach is to manage the
newly emerging risks as the game goes on. For this part of the market and economic cycle, we
think investors across asset classes can manage the risks of debt, discount rates, and duration to
better align their portfolios with their long-term investment goals.
• Debt loads are rising but still manageable and affordable for many issuers. Slowing but
continued economic growth shouldn’t undermine the fundamentals of most issuers. That’s
why an expanded view on debt may help investors navigate equity and fixed-income
markets over the next year.
• Discount rates are what investors typically use to value future cash flows. When risks increase,
these discount rates usually rise. Many of our portfolio managers are upgrading the quality of
their portfolios in an attempt to dampen the effects of rising discount rates.
• Duration is the measure of an asset price’s sensitivity to changes in interest rates. All assets
have at least some sensitivity to interest rates. Our fixed-income managers have a number
of levers to pull to adjust duration to targeted levels while generating acceptable levels of
coupon income. Equity managers can adjust the duration risks of their holdings by shifting
toward those areas that are less sensitive to interest rates. For growth managers, this means
looking for sustainable growth rather than mistaking momentum for growth. For value
managers, this means shying away from those areas (such as REITs or utilities) that tend to
serve merely as bond proxies for investors. Individual investors can help manage the duration
risk in their portfolios through broad, global diversification, taking advantage of the different
growth and interest rate cycles around the world.
About the authors
Wells Fargo Asset Management’s investment professionals offer their views on the economy,
equities markets, and fixed-income markets in the U.S. and abroad. Their combined view of the
investment landscape gives investors a comprehensive perspective on recent market activity.
F. Jon Baranko Lyle Fitterer, CFA Brian Jacobsen,
Chief Equity Officer Co-Head of WFAM Ph.D., CFA, CFP®
Global Fixed Income, Senior Investment Strategist,
Managing Director, Multi-Asset Solutions
Head of Municipal Fixed Income
13The views expressed and any forward-looking statements are as of November 20, 2018, and are those of Chief Equity Officer F. Jon Baranko, Co-Head of Wells Fargo Asset Management Global Fixed Income and Managing Director, Head of Municipal Fixed Income Lyle Fitterer, Senior Investment Strategist, Multi-Asset Solutions Brian Jacobsen, and Wells Fargo Asset Management. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Asset Management and its affiliates disclaim any obligation to publicly update or revise any views expressed or forward-looking statements. Mutual fund investing involves risks, including the possible loss of principal. Consult a fund’s prospectus for additional information on risks. Asset allocation and diversification do not ensure or guarantee better performance and cannot eliminate the risk of investment losses. The Bloomberg Barclays Emerging Markets High Yield Index is a market capitalization weighted index that consists of the high yield bonds in the Bloomberg Barclays Emerging Markets USD Aggregate Bond Index, which includes fixed and floating-rate US dollar-denominated debt issued from sovereign, quasi-sovereign, and corporate emerging markets issuers. Country eligibility and classification is reviewed annually and based on the World Bank income group (low/middle income) or International Monetary Fund country classifications (non-advanced country). At the security level, there must be at least US $500 million par outstanding. The Bloomberg Barclays Pan-European High Yield Index measures the market of non-investment-grade, fixed-rate corporate bonds denominated in the following currencies: euro, pounds sterling, Danish krone, Norwegian krone, Swedish krona, and Swiss franc. Inclusion is based on the currency of issue and not the domicile of the issuer. You cannot invest directly in an index. The Bloomberg Barclays U.S. Corporate Bond Index is an unmanaged market-value-weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more. You cannot invest directly in an index. The Bloomberg Barclays U.S. Corporate High Yield Bond Index is an unmanaged, U.S.-dollar-denominated, nonconvertible, non-investment-grade debt index. The index consists of domestic corporate bonds rated Ba and below with a minimum outstanding amount of $150 million. You cannot invest directly in an index. The Global Financial Data’s 10-Year Treasury Total Return Index measures the 10-year Treasury note’s total rate of return, including changes in the prices of 10-year Treasuries, as well as interest income. You cannot invest directly in an index. The ICE BofAML U.S. High Yield Constrained Index is a market-value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment- in-kind securities. Issues included in the index have maturities of one year or more and have a credit rating lower than BBB-/Baa3 but are not in default. The ICE BofAML U.S. High Yield Constrained Index limits any individual issuer to a maximum of 2% benchmark exposure. You cannot invest directly in an index. Copyright 2018. ICE Data Indices, LLC. All rights reserved. The ICE BofAML U.S. High Yield Index is a market-capitalization-weighted index of domestic and Yankee high-yield bonds. The index tracks the performance of high-yield securities traded in the U.S. bond market. You cannot invest directly in an index. Copyright 2018. ICE Data Indices, LLC. All rights reserved. The Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) (Net) is a free-float-adjusted market-capitalization-weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI (Net) consists of 46 country indices comprising 23 developed and 23 emerging market country indices. The developed market country indices included are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. The emerging markets country indices included are Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, the Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates. You cannot invest directly in an index. The Morgan Stanley Capital International (MSCI) Emerging Markets (EM) Index (Net) is a free-float-adjusted market-capitalization-weighted index that is designed to measure large- and mid-cap equity market performance of emerging markets. The MSCI EM Index (Net) consists of the following 24 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, the Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates. You cannot invest directly in an index. The Morgan Stanley Capital International (MSCI) Europe, Australasia, Far East (EAFE) Index is a free-float-adjusted market-capitalization-weighted index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 21 developed markets country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. You cannot invest directly in an index. Source: MSCI. 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. The 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. You cannot invest directly in an index. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value-weighted index with each stock’s weight in the index proportionate to its market value. You cannot invest directly in an index. The S&P 500 Pure Growth Index measures the performance of the pure growth stocks from the S&P 500 Index, which represent approximately 33% of the total market capitalization of the S&P 500 Index. You cannot invest directly in an index. The S&P 500 Pure Value Index measures the performance of the pure value stocks from the S&P 500 Index, which represent approximately 33% of the total market capitalization of the S&P 500 Index. You cannot invest directly in an index. Carefully consider a fund’s investment objectives, risks, charges, and expenses before investing. For a current prospectus and, if available, a summary prospectus, containing this and other information, visit wellsfargofunds.com. Read it carefully before investing. 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