The best thing about Wells Fargo’s midyear market outlook may be what it forecasts won’t happen rather than what will. For example, it doesn’t expect a recession in the next 12 months, which is supportive for financial markets, but it does expect the S&P 500 index to end the year below current levels — 4% to 8% lower — and short-term and long-term interest rates to finish higher.
Wells Fargo’s year-end target for the S&P 500 is between 2,230 and 2,330 and for the federal funds rate between 1.25% and 1.50%, up 50 basis points from the current range. It expects two more Fed rate hikes this year. It also has a year-end target for the 10-year Treasury bond yield at somewhere between 2.25% and 2.75%, up from 2.17% currently, which is near a seven-month low.
(Related on ThinkAdvisor: Gundlach: Get Ready for Higher Yields, Summer Selloff)
“We are most assuredly past the midpoint,” wrote Darrell Cronk, Wells Fargo’s chief investment officer of Wealth and Investment Management in his letter to investors, referring to the economic recovery cycle, now in its ninth year. “However, we see few signs today that this cycle is in danger of imminently ending.”
Wells Fargo is forecasting 2.3% GDP growth and 2.4% inflation (for CPI) by year end, with WTI crude oil priced between $40 and $50 a barrel. (It’s currently just over $47.)
Proposed policy initiatives such as tax reform or an infrastructure spending plan are not expected to have much impact on the economy or markets because neither is anticipated befor “late 2017 or early 2018 at the earliest.”
Wells Fargo’s midyear outlook, subtitled “Seize the Opportunities,” includes five portfolio recommendations for the second half of 2017, on top of the usual asset diversification and rebalancing, as follows:
1. Reduce exposure to U.S. equities, especially small-cap stocks, and high-yield bonds.
Stock valuations are likely to contract because of Fed rate hikes, which is a reason to lighten up on equities, especially small caps, are according to Wells Fargo. The firm also recommends against owning weaker bond credits, such as high yield, because of relatively tight yield spreads. “We prefer higher quality bonds at this point in the interest rate cycle, including U.S. taxable investment-grade bonds … [especially] intermediate-term bonds.
2. Increase exposure to non-U.S. stocks.
Many investors own large positions in U.S. stocks because they have outperformed international equities in four of the past five years, but that may not continue, according to the outlook. It recommends that investors increase exposure to overseas markets whose “fundamentals have improved,” such as developed markets in the Asia Pacific region and developing markets, also in Asia. These include Australia, Hong Kong, Japan and Singapore (developed markets) and China, India, Indonesia, Malaysia, Philippines, South Korea, Taiwan and Thailand (developing markets).
(Related on ThinkAdvisor: Equity Investors Rotate Out of US Into Eurozone: BofA Merrill Survey)
Wells Fargo is neutral on Europe and has an unfavorable view of emerging markets in Europe (Poland, Russia and Turkey), the Middle East, Africa (South Africa) and South America (Brazil, Chile, Mexico).
3. Add nontraditional investments.
Publicly traded real estate investment trusts (REITs) should benefit from increasing global demand for property, rising real estate prices and improving real estate investor confidence, according to the outlook. For financially sophisticated, qualified investors invest, it recommends investing with Relative Value managers, who can take advantage of retail-related distressed credit, and equity hedge fund managers, who use long and short strategies to take advantage of stock price dispersion and low correlations among asset classes.
4. Be agile with tactical shifts.
Given expectations for low returns through the balance of the year, Wells Fargo recommends that investors be nimble, to take advantage of market mispricings and reduce risk. To those ends, it suggests incorporating tactical shifts in holdings, lasting six to 18 months, within longer term allocations that last 10 to 15 years. The firm is currently slightly underweight risk assets because of forecasts for limited upside in several equity asset classes.
In the U.S., those assets include small-cap stocks as well energy, utilities and consumer staples shares. It’s overweight consumer discretionary, financials, health care and industrials and neutral on U.S. large-cap and midcap shares, developed markets excluding the U.S. and emerging markets.
5. Reconsider active/passive mix.
Given its mediocre outlook for financial markets in the second half along with the Fed plans to reduce reserves as it begins to unwind previous monetary stimulus, Wells Fargo stresses the importance of stock picking.
(Related on ThinkAdvisor: These 10 Actively Managed Funds Beat S&P 500 for 15 Years: Morningstar)
“Securities selection will be paramount to portfolio performance,” which favors active management over passive strategies.
The Risk Ahead
The Wells Fargo midyear outlook lists several risks that could upset its relatively mediocre outlook for financial markets in the second half. These include further flattening of the U.S. yield curve, which could reduce investors’ bond income as reflected by slower economic growth, or its opposite: faster than expected rate hikes, which would reduce demand for REITs. In addition, there are potential geopolitical risks and policy missteps such as tariffs on goods entering the U.S. and trade restrictions in Europe, especially Italy.
— Related on ThinkAdvisor:
- Markets Need a 30% Stock Drop or 50% Higher U.S. Yields, Or Not.
- Most Markets Have Made All Their Gains for the Year: Wells Fargo’s McMillion
- Gundlach: Get Ready for Higher Yields, Summer Selloff
- These 10 Actively Managed Funds Beat S&P 500 for 15 Years: Morningstar
- Equity Investors Rotate Out of US Into Eurozone: BofA Merrill Survey