Investment Strategy Report

Investment Strategy

Weekly guidance from our Investment Strategy Committee November 9, 2020

Global Economy spotlight: China, U.S., and the dual reflation trade ...... 2 • Despite several attempts, asset reflation has largely failed to take hold this year. • But recent price action in several “reflationary assets,” coupled with existing and expected fiscal stimulus in both China and the U.S., could be enough to jumpstart the reflation trade in 2021. Equities: Third quarter was a pandemic-fueled earnings blow-out ...... 4 • Third-quarter S&P 500 Index earnings growth is tracking much better than expected, -9.9% compared to -21.5% consensus. • Improving earnings revisions keep us favorable with U.S. Large Cap Equities. Fixed Income: Currencies unimpressed by U.S.-Eurozone yield decoupling ...... 5 • Recent decoupling of U.S. and German bond yields can be explained by expectations of fiscal stimulus and stronger recovery in the U.S., while a COVID-19 “second wave” undermines the eurozone economy • But the euro’s continued firmness against the dollar tells us that other factors besides growth and rate differentials are at work in currency markets. We still expect the euro to strengthen in 2021. Real Assets: EM energy transition trails DM ...... 6 • We suspect that emerging markets (Ems) will prove much more difficult and time-consuming to ween off of fossil fuels. • While we believe developing markets (DMs) should get to the “green promised land” sooner than EMs, both are likely many decades away. Alternatives: Is the slow recovery for distressed debt a canary in the (high-yield credit) coal mine? ...... 7 • Distressed high-yield names have recovered some from the March dislocation, but not with the same speed as fallen angels — which is a departure from the post-2008 Global Financial Crisis (GFC) recovery. • While spreads may tighten from here, a lagged recovery in distressed high-yield names indicates the market remains concerned with the fundamentally weakest balance sheets.

Global Economy spotlight Justin Lenarcic Senior Global Alternative China, U.S., and the dual reflation trade Investment Strategist Asset reflation and the “reflation trade” have slowly tucked their way into investment parlance over the last decade. The goal of reflation is to counteract economic weakness and stimulate spending, which can be accomplished through monetary policy (increasing the money supply, lowering borrowing costs and exchange rates) or through fiscal policy (tax cuts, increased spending, and — more recently — direct cash injections through government income payments and central-bank credit facilities). Reflation trades typically favor cyclical sectors like materials and industrials as well as base metals, real estate, and even inflation-linked securities like treasury inflation-protected securities (TIPS). That’s why the price action of some of these reflationary assets in recent weeks has led to speculation on the return of the reflation trade. But given several “false positives” on reflation this year, it’s prudent to wonder whether this time is different. Though admittedly early, we think this time could, in fact, be different — largely due to existing and expected fiscal policy from China converging with reflationary policies here in the United States.

Chart 1: Material increases in fiscal deficits should support the reflation trade

0.0%

-2.0%

-4.0%

-6.0%

-8.0% Fiscal deficit of (percent GDP) -10.0%

-12.0% World United States China

Average historical deficit (2012-2019) Average projected deficit (2020-2025)

Sources: International Monetary Fund, Fiscal Monitor, October 2020.

U.S. interest rates are already at their lower bound, and the financial system is flush with liquidity. Despite a massive fiscal stimulus package unveiled earlier this year to combat COVID-19, we anticipate an additional $3.0-3.5 trillion package next year. Meanwhile, China unveiled a fiscal stimulus package earlier this year worth more than 4.5% of its GDP to support social and economic COVID-19 recovery. From a monetary policy perspective, the Peoples Bank of China (PBoC) has lowered lending rates and increased liquidity. The policy seems to have worked, as real economic indicators point to an accelerating recovery for China. Much of the workforce has returned to normal levels of activity, and consumers are beginning to spend again. Furthermore, the manufacturing sector continues to improve, evidenced by a rebound in industrial profits. Reflationary policy is indeed alive and well in the two most important global economies.

It is important to note, however, that even though these measures are reflationary, they have largely been reactionary to the economic damage caused by the pandemic. For the reflation trade to take hold, we need policies to remain in place long after COVID-19 abates. In other words, the reflation trade needs to be much bigger than just a “COVID- 19 recovery trade.” And we think it will, especially considering that Chinese President Xi Jinping’s five-year “Dual Circulation” model was born not out of the pandemic, but from China’s overarching desire to better position itself to global uncertainty (i.e. trade disputes and re-shoring).

The Dual Circulation model has two main goals: 1. Facilitate domestic demand, and 2. Support domestic development by attracting foreign capital and further opening the door to financial reform. While both objectives are reflationary, we are paying particular attention to the measures taken by China to open up its $45 trillion financial industry to the world. Better access to capital, plus the desire of President Xi to strengthen China’s presence in the industries of the future (artificial intelligence, biotechnology, and microchips), may provide a strong tailwind to Chinese equity valuations that are cheap, relative to the US.

The ramifications of the U.S. elections will likely dominate investors’ attention in the near term, but eventually we need to consider the impact of existing (and anticipated) fiscal and monetary stimulus on global asset prices. The reflation trade has been allusive this year, but it’s very possible that the lagged impact of reflationary policy is beginning to show up. Perhaps an even more important question is whether the historical hand-in- hand relationship between reflation and inflation breaks down in this environment of low inflation. If so, not only would cyclically sensitive assets likely continue to benefit from reflationary policy, but so too would value stocks, financials, and longer-dated fixed income and credit sectors.

Equities Ken Johnson, CFA Investment Strategy Analyst Third quarter was a pandemic-fueled earnings blow-out With the Presidential election behind us, we expect investors to revert their attention back to fundamentals. Analyst anticipated third quarter earnings would decline by 21.5%, however with 72% of S&P 500 companies reporting, earnings growth is tracking at -9.9%, which is well above expectations. Favorable Furthermore, a record 87.6% of companies have posted positive surprises. U.S. Large Cap Equities

Health Care and Communication Services have been the standouts, with double-digit earnings growth from a year prior. Communication Services benefitted from stay-at-home orders, as consumers turned to more virtual means of entertaining and staying social. Health Care earnings were supported by a return to elective surgeries and continued U.S. federal government spending Favorable to combat the coronavirus. U.S. Mid Cap Equities

As earnings season closes out, the path forward will depend on policies passed by newly-elected government officials, continued improvement in U.S. economic growth, and further advancements on COVID-19 treatments and vaccines. Earnings expectations have continued to improve, and we continue to Neutral favor high-quality large- and mid-cap companies with ample cash and broad U.S. Small Cap Equities earnings power.

Earnings outlook continues to improve

100% Unfavorable 90% Developed Market 80% Ex-U.S. Equities

70%

60%

50%

40% week revision ratio revision week -

1 Unfavorable 30% Emerging Market Equities 20%

10%

0% 2015 2016 2017 2018 2019 2020

Sources: Wells Fargo Investment Institute, Factset, November 4, 2020. Data represents S&P 500 Index. The circled area highlights the improving trend. Revision ratio is calculated as the number of firms upgrading earnings estimates divided by the number of firms upgrading and downgrading. Past performance is no guarantee of future results.

Fixed Income Peter Wilson Global Fixed Income Strategist Currencies unimpressed by U.S.-Eurozone yield decoupling Ahead of the U.S. elections, the 10-year yield differential between U.S. Treasury securities and German government bonds (“bunds”) widened consistently from 100 to 150 basis points (see chart).1 This was driven by a “decoupling” of the Unfavorable two markets — as U.S. yields rose, bund yields moved lower. This can be U.S. Taxable Investment Grade Fixed Income explained by expectations of more fiscal stimulus and stronger growth in the U.S., while the eurozone faced a COVID-19 second wave, new lockdowns, and an economic double dip.

However, the euro hardly gave back any of its gains. This tells us that U.S. Unfavorable growth outperformance and interest rate differentials are not the key drivers of U.S. Short Term Taxable the euro/dollar rate right now. More important may be longer-run Fixed Income considerations such as relative fiscal strength — the rising fiscal deficit in the U.S. may weigh on the dollar, while Germany’s still very low debt to GDP ratio underlines bunds’ status as a genuinely low-risk asset. The U.S. Federal Reserve (Fed) is also more credibly able to target a higher rate of inflation than the Neutral European Central Bank. U.S. Intermediate Term Taxable Fixed Income Irrespective of the U.S. election result, we expect an ultra-accommodative Fed and the fiscal deficit to carry more weight than potential U.S. growth outperformance in the future direction of the dollar. We also believe that improved policy coordination within the eurozone and the apparent elimination Neutral of euro break-up risk should continue to support the euro. We expect the euro U.S. Long Term Taxable to rise to around 1.25 dollars per euro by the end of 2021. Fixed Income

Decoupling of U.S. Treasury and German bund yields – little impact on the euro

2.0 Favorable 10-year German bund yield 1.5 High Yield Taxable 10-year US Treasury note yield 1.0 Fixed Income

0.5

Yield (percent) Yield 0.0 -0.5 -1.0 Neutral 10-year government bond yield spread, U.S. minus Germany Developed Market Ex.-U.S. 2.0 Fixed Income 1.5

1.0 Percentage points Percentage 0.5

0.0 Jan-20 Feb-20 Mar-20 Apr-20 May-20 Jun-20 Jul-20 Aug-20 Sep-20 Oct-20 Nov-20 Neutral Emerging Market Sources: Bloomberg, Wells Fargo Investment Institute. Latest data as of November 3, 2020. Fixed Income

Real Assets Austin Pickle, CFA Investment Strategy Analyst “The way to get started is to quit talking and begin doing.” — Walt Disney EM energy transition trails DM

The “energy transition” away from fossil fuels has received increasing amounts of attention recently. Many companies, countries, and regions have laid out aggressive plans that aim to reduce fossil fuel use and emissions. Progress has Favorable been made over the past decades towards a greener future and should accelerate Commodities as these plans play out. Much of the progress to date and many of the plans recently announced impact developed markets (DMs) only. Where do emerging markets (EMs) stand on the transition timeline?

We suspect that EMs will prove much more difficult and time consuming to ween off of fossil fuels. Why? Not only do EMs consume vastly more energy and Unfavorable fossil fuels in total than DMs, but also that appetite for energy is still growing. Private Real Estate Contrast that with DMs where energy consumption has peaked (see chart). For renewables to unseat fossil fuels in EMs, they effectively have to do “double time” to replace both existing and future consumption. This likely will prove a tough task and one should expect a longer runway to a green energy future than in DMs. The EM green movement did receive a surprise boost in September, though, when President Xi Jinping pledged that China — the world’s largest carbon emitter — would be carbon neutral by 2060.

We believe fossil fuels will likely be a key part of the world’s energy future for decades to come. While we believe DMs should get to the “green promised land” sooner than EMs, both are likely many decades away.

Energy and fossil fuel consumption growth: DMs versus EMs

140 Emerging markets' total energy consumption Emerging markets' fossil fuel consumption 135 Developed markets' total energy consumption Developed markets' fossil fuel consumption 130

125

120

115

110

105 Consumption indexed to 100 to indexed Consumption 100

90 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Sources: Energy Information Administration, Wells Fargo Investment Institute. Developed markets include all OECD countries except Mexico, Chile, Colombia, and Turkey. Emerging markets include all other countries. Yearly data: 2007 – 2017. Indexed to 100 as of 2007.

Alternatives Justin Lenarcic Senior Global Alternative Is the slow recovery for distressed debt a canary in the (high- Investment Strategist yield credit) coal mine? Two conflicting views appear to be brewing in the credit markets. On one hand, with expectations of a gradual economic recovery coupled with fiscal and monetary stimulus, high-yield credit spreads are expected to tighten from here Neutral as trends in defaults slow. On the other hand, as a result of historically high debt Private Equity issuance in recent months, many balance sheets are even more leveraged than they were before COVID-19, and concerns are mounting about if companies in troubled sectors will be able to “earn” their way out an eventual default.

With the Federal Reserve (Fed) backstopping fallen angels, it is no wonder those Neutral names have rallied similar to what happened in the 2008 GFC. But unlike a Hedge Funds – Macro decade ago, distressed names are missing out so far, which begs the question: are the high-yield credit markets as healthy as the current spreads indicate? This is one key reason why we maintain our favorable view on long/short credit heading into 2021. Neutral Why are distressed high yield names recovering much slower now than after Hedge Funds – Event Driven the 2008 Global Financial Crisis?

130 120

110 100 Favorable 90 Private Debt 80 70 60

Index (normalized to 100) (normalizedIndex 50 40 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Favorable ICE BofA US Distressed High Yield Index ICE BofA US Fallen Angel High Yield Index Hedge Funds – Equity Hedge

110

100

90 80 Neutral Hedge Funds – Relative Value 70

60 Alternative investments, such as hedge funds, Index (normalized to 100) (normalizedIndex private equity, private debt and private real 50 estate funds are not suitable for all investors Dec-19 Jan-20 Feb-20 Mar-20 Apr-20 May-20 Jun-20 Jul-20 Aug-20 Sep-20 Oct-20 and are only open to “accredited” or “qualified” ICE BofA US Distressed High Yield Index ICE BofA US Fallen Angel High Yield Index investors within the meaning of U.S. securities laws. Sources: Greywolf Capital, Bank of America Merrill Lynch. Data as of October 31, 2020. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

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. Treasury Inflation-Protected Securities (TIPS) are subject to interest rate risk, especially when real interest rates rise. This may cause the underlying value of the bond to fluctuate more than other fixed income securities. TIPS have special tax consequences, generating phantom income on the “inflation compensation” component of the principal. A holder of TIPS may be required to report this income annually although no income related to “inflation compensation” is received until maturity. Currency risk is the risk that foreign currencies will decline in value relative to that of the U.S. dollar. Exchange rate movement between the U.S. dollar and foreign currencies may cause the value of a portfolio's investments to decline. Sector investing can be more volatile than investments that are broadly diversified over numerous sectors of the economy and will increase a portfolio’s vulnerability to any single economic, political, or regulatory development affecting the sector. This can result in greater price volatility. 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 An index is unmanaged and not available for direct investment. BofA Merrill Lynch U.S. Fallen Angel High Yield Index is comprised of below investment grade corporate debt instruments denominated in U.S. dollars that were rated investment grade at the time of issuance. Qualifying securities must be issued in the U.S. domestic market and have a below investment grade rating (based on an average of Moody’s, Standard & Poor’s Rating Services, or Fitch International Rating Agency BofA Merrill Lynch U.S. Non-Distressed High Yield Index is a subset of the BofA Merrill Lynch US High Yield Index including all securities with an option-adjusted spread less than 1,000 basis points. The BofA Merrill Lynch US High Yield Index tracks the performance of below investment grade U.S. Dollar-denominated corporate bonds publicly issued in the U.S. domestic market. 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. 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.

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