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Faster, further, and fragile
Wells Fargo Investment Institute (WFII) believes the economic cycle will run faster, interest rates will rise further, and the economy and capital markets will remain fragile in the second half of 2022.
Against this backdrop, WFII strategists think that the economy’s current rate of slowing likely points to a mild recession later in 2022 and into early 2023.
In its 2022 Midyear Outlook, WFII encourages investors to face risk not strictly as an unknown, but also as something to measure as part of a disciplined decision process.
We believe that this economic expansion ultimately will prove to be one of the fastest and hottest in almost a century.
The Federal Reserve’s aggressive tightening should help cool inflation, but that has a side effect of undermining borrowing, spending, and economic growth.
We believe that sticky inflation and the outlook for rising short-term interest rates will outweigh support from solid job growth and erode consumer spending in the months ahead.
And now, after the economic data are deteriorating faster, and we expect inflation and interest rate increases to go further, the U.S. economic outlook looks fragile. As we think about what faster, further, and fragile means, we conclude that the economy is now likely to have a mild contraction or recession late in 2022 and into early 2023. So far, the data indicate a recession that could be similar to that of 1990-1991, not 2008, and our outlook is for lower inflation and stronger economic growth later in 2023.
Recessions are a normal part of the business cycle, and typically patience is one of an investor’s most valuable tools when a recession looks likely. For long-term investors, we favor working with one of our investment professionals to make a disciplined plan to put cash to work, because we believe financial markets are likely to turn higher as investors anticipate an economic recovery.
For shorter-term investors, patience may mean holding cash as needed for near-term expenses, or, for investors looking for opportunities, we favor patiently looking for quality. Our various preferences may help with that process.
We favor playing defense in fixed income portfolios. While interest rates continue to rise moderately — we prefer short-term maturities and municipal securities.
In equities, we expect earnings to weaken through 2023 as revenue growth moderates, production costs remain high, and margins contract from record levels. We favor high-quality, U.S. Large Cap and Mid Cap equities over international and U.S. small-cap stocks, and prefer sectors that have good cash flow and strong balance sheets, such as Information Technology, Health Care, and Energy.
In real assets, as the world struggles to balance energy, metals, and food demand against limited supply, we believe many commodity prices will remain near current levels through year end and rise in 2023.
We favor a broad-based allocation to commodities.
And finally, we believe late-cycle can be an opportune time to allocate to alternative investment strategies that typically have low correlation to equities and fixed-income. We favor Macro and Relative Value, but qualified investors may want to consider adding to Event Driven as we approach a recession.
For more on these recommendations and our top five portfolio ideas for the second half — download our Wells Fargo Investment Institute special report: 2022 Midyear Outlook: Faster, Further, and Fragile.
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. 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. 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. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income. 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. Investing in gold, silver or other precious metals involves special risk considerations such as severe price fluctuations and adverse economic and regulatory developments affecting the sector or industry.
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 appropriate 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 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.
The opinions expressed reflect the judgment of the speaker as of the recording date and are subject to change without notice. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results. Additional information is available upon request.
The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client‐specific suitability or best interest analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.
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Although many equity and fixed-income classes may underperform our long-term assumptions as rates potentially rise further and growth continues to wane, diversifiers such as commodities and alternative investments historically have served as a useful portfolio hedge against losses.
The potential diversification benefits of commodities can make them an appealing addition to a portfolio allocation. Hedge fund strategies with low or negative correlations to stocks and bonds may help bolster a portfolio’s resilience through access to strategies that do not rely solely on positive markets for gains.
Be defensive on equity exposure late in an economic cycle
Against the backdrop of a fast-moving business cycle and global central bank tightening, we favor an equity exposure with a bent toward the higher-quality segments of the asset group.
Specifically, we believe that the U.S. is better positioned to weather the global economic slowdown and rising interest rates than international or U.S. small-cap companies are. These factors likely will affect larger U.S. companies less than smaller ones, and less than European, Japanese and many emerging-market companies.
Thus, we prefer U.S. over international equities, and we prefer large-cap and mid-cap stocks over small-cap stocks. Within U.S. equity sectors, we prefer Health Care, Energy, and Information Technology for their potential to post stable, high-quality earnings.
Add to fixed-income holdings judiciously in a rising-rate (and inflationary) environment
Looking ahead, we expect high-quality bonds to provide traditional diversification attributes both for income — particularly given that yields have risen — and to help reduce downside participation during periods of heavy equity market volatility.
We believe that investors should continue to position fixed-income allocations somewhat defensively by favoring investment-grade intermediate- and short-term fixed income. Most of the increase in investment-grade fixed-income yields and the associated price declines likely occurred during the first half of 2022. As such, we suggest that investors consider incrementally adding back to U.S. Long Term Taxable Fixed Income to strategic target levels.
Match cash allocations to time horizon
The unusual market environment so far this year has led to declining values in most asset classes with very few exceptions. Depending on the investor’s risk tolerance, a modest cash allocation may be appropriate during this period of continued market volatility.
For investors with short-term cash needs and time horizons, we believe a higher cash level or short-term bond allocation is prudent to help ensure funding of those near-term goals.
For investors with a long time horizon, we prefer to invest excess cash by dollar cost averaging into the markets over the course of several months to several quarters.*
*A periodic investment plan such as dollar cost averaging does not assure a profit or protect against a loss in declining markets. Since such a strategy involves continuous investment, the investor should consider his or her ability to continue purchases through periods of low price levels.
Seek to mitigate downside risk with alternative investments, including hedge funds
Given our expectations for higher market volatility due to slower growth, persistent inflation, and rising interest rates, investments that can mitigate risk and even provide upside potential under these challenging market conditions warrant consideration for an allocation in a diversified portfolio.
Hedge fund strategies, such as Global Macro and Relative Value, offer diversification benefits through lower correlations to traditional stocks and bonds. Global Macro strategies have often performed well when there is a dominant macro trend such as rising inflation and commodities prices. Relative Value strategies seek to take advantage of arbitrage opportunities that are independent of market direction.
For qualified investors with longer time horizons, Private Capital investments with longer lock-up periods may offer additional upside potential. Private Debt strategies, such as Direct Lending strategies, can help insulate portfolios against rising interest rates while offering potentially attractive income streams.
Alternative investments, such as hedge funds, are not appropriate for all investors. They are speculative and involve a high degree of risk that is appropriate 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.
As we try to make sound decisions and keep boundless anxiety at bay, it will help to keep perspective — to be neither an optimist nor a pessimist but a realist.
Darrell L. Cronk, CFA, President, Wells Fargo Investment Institute, Chief Investment Officer, Wealth and Investment Management
A mild recession is now our base case for the end of 2022 and into early 2023. As inflation and monetary tightening ease more perceptibly later in 2023, we expect a nascent economic recovery that markets may project into 2024.
We expect U.S. macroeconomic and interest rate advantages to push the dollar higher against developed market currencies. Emerging market currencies may find more support but are unlikely to broadly outperform the dollar.
A more challenging economic environment calls for a more defensive stance within and across asset classes, in our view.
Wells Fargo Investment Institute U.S. GDP growth forecast for 2022 is 1.5% and for 2023 is -0.5%. Wells Fargo Investment Institute U.S. CPI inflation forecast for 2022 is 7.7% and for 2023 is 3.5%.
Source: Wells Fargo Investment Institute, June 14, 2022. GDP = gross domestic product; CPI = Consumer Price Index. The CPI produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services. Forecasts, targets, and estimates are based on certain assumptions and on our current views of market and economic conditions, which are subject to change.
We expect uncertainties and market volatility to increase in the second half of 2022 while the Federal Reserve (the Fed) struggles to tame inflation and avoid an economic recession.
We believe that the technical imbalance between municipal supply and demand will serve as a strong backdrop for municipal performance.
We favor playing defense in bond portfolios today. We prefer short-term and intermediate-term maturities while interest rates continue to rise modestly. We prefer not to increase allocations or extend down the credit spectrum into high-yield fixed income at this time.
Wells Fargo Investment Institute targets
10-year U.S. Treasury yield
3.25% – 3.75%
2.75% – 3.25%
Federal funds rate
3.50% – 3.75%
4.00% – 4.25%
Source: Wells Fargo Investment Institute, June 17, 2022. Forecasts, targets, and estimates are based on certain assumptions and on our current views of market and economic conditions, which are subject to change.
We expect earnings growth to slow in 2022 and shrink in 2023. However, we believe valuations will rebound in 2023 to lift equity markets by year-end.
As the cycle matures, our preferences have moved away from cyclicals. Instead, we favor higher-quality asset classes and sectors.
We believe quality and selectivity today will at least partially offset near-term headwinds and potentially benefit from positive structural forces we expect in the coming years.
Wells Fargo Investment Institute targets
S&P 500 Index
4,200 – 4,400
4,500 – 4,700
Source: Wells Fargo Investment Institute, June 14, 2022. 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. Forecasts, targets, and estimates are based on certain assumptions and on our current views of market and economic conditions, which are subject to change. An index is unmanaged and not available for direct investment.
2022 commodity rally likely to slow, reaccelerate in 2023
Commodity prices are unlikely to repeat the stellar performance they’ve had since mid-2020, yet we do expect more upside through 2023 and favor holding a full allocation in a broad-based commodity position.
Real estate investment trust (REIT) fundamentals appear solid, yet higher interest rates may weigh on relative performance; therefore, 2022 opportunities and risks appear balanced.
Among Midstream energy companies, we prefer C-Corporations for their strong corporate governance and their ability to attract institutional fund flows.
Wells Fargo Investment Institute targets
WTI crude oil
$90 – $110
$100 – $120
Brent crude oil
$95 – $115
$105 – $125
Source: Wells Fargo Investment Institute, June 14, 2022. WTI = West Texas Intermediate. Forecasts, targets, and estimates are based on certain assumptions and on our current views of market and economic conditions, which are subject to change.
Late cycle can be an opportune time to allocate to alternative investment strategies that have low correlation to equities and fixed income.
For the near future, we favor strategies to help enhance equity and credit market diversification, as well as inflation-adjusted yield, both of which are available through Relative Value and Global Macro hedge fund strategies.
For investors with longer-term investment horizons, we foresee Private Equity opportunities among small- and mid-cap buyouts.