The Divided Recovery

How the innovative and efficient adapt

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What Is a “Divided Recovery?”

The prolonged recovery has had a distinct set of winners and losers, as benefits have accrued unevenly to different groups of investors, workers, and countries. This disparity has increased certain economic and geopolitical risks. Yet where there’s risk, there’s often opportunity for investors. This recovery has divided along several fault lines:

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Geography: In developed economies, the recession and recovery have been difficult on the lower-to-middle income segment. Emerging economies are struggling to maintain their growth rates as global trade slows.

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Education level: Jobs created since the recession overwhelmingly have gone to college-educated workers.

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Skill level: Workers with sought-after skills are in high demand, but companies are struggling to find qualified workers.

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Company size: Small private businesses were hit harder than larger companies during the recession and took longer to recover.

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Governments: Political Risk on the Rise

One developed market after another seems to be contending with the fallout of a divided recovery, and the political landscape remains unsettled in 2017. A rise in global political tensions could lead to market volatility. The following chart shows an overview of key political events that have taken place or will take place in the coming year.

Businesses: Confidence Rising

Small businesses were hit harder during the Great Recession and took longer to recover. For the economy to grow more quickly, both large and small businesses will need to recover.

The Return of Confidence

Small-business confidence lagged large-company sentiment (represented by the ISM index) throughout the recovery, but is rapidly trending higher.

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Sources: National Federation of Independent Businesses, “Small Business Economic Trends” Monthly Survey (December 2016). Institute for Supply Management, “Manufacturing ISM Report on Business.”

Note: The National Federation of Independent Businesses’ Optimism Index is comprised of mostly small businesses, while the Institute for Supply Management’s Manufacturing Index tracks mostly large businesses.

What Happened

  • Large businesses used workforce reduction to help contain costs and increase productivity and efficiencies, and were able to cut capital expenses.
  • Smaller firms had challenges accessing credit, which affected sales, inventories, and short-term debt.
  • New business formation and job growth in the recovery has been concentrated in about 20 counties out of more than 3,000 in the U.S.

What’s Ahead

  • If labor costs rise as we approach full employment, productivity will become an increasingly important component of corporate profitability.
  • It will be vital for businesses to innovate and automate to compete globally.
  • The new U.S. administration’s stated commitment to lower corporate tax rates and fewer regulatory policies could improve the environment for both large and small businesses.
  • Over time, corporations may use a leaner core organizational structure and rely on a loose network of contractual workers.

Workers: Labor Market Changes Bring Opportunities

Real income stagnated for many American workers over the past few decades, while workers in many emerging markets made sizable income gains.

What Happened

  • Globalization has conferred benefits to U.S. consumers in the form of more plentiful choices and lower prices, but advances in technology and communications have allowed companies to decrease labor costs by outsourcing work to lower-cost regions.
  • During the recovery, job gains were broad-based across many different sectors, from lower-wage hospitality jobs to higher-wage jobs in health care, business, and management.
  • Gains for most of America’s workers stagnated as jobs moved to more cost-effective areas of the globe, contributing to higher growth rates in those parts of the world.

What’s Ahead

  • Technology continues to exacerbate job displacement, but automation is not a synonym for worker extinction.
  • Challenges include training workers to meet employer demands and matching available workers with available jobs.
  • The proliferation of non-standard jobs may offer greater flexibility and autonomy for workers.
  • Millennials are optimistic about the prospects of starting new businesses.

U.S. Median Household Income

Although U.S. median household income remains below its pre-recession levels, it climbed by 5.2% in 2015.

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Source: U.S. Census Bureau, Current Population Survey, Income and Poverty in the United States: 2015. Data as of 2015. Report Issued September 2016.

Investment Outlook: Opportunities in a Recovering World

The divided recovery creates opportunities for investors, especially those who can find growth opportunities in unfamiliar places and place a premium on high-quality assets.

Equities

  • Consumer Discretionary stocks may outperform because of their ability to generate earnings growth in a recovering economy.
  • In a volatile market, owning stocks that pay dividends can help offset price losses and support total return.
  • European equity valuations remain attractive relative to those of other global equities.
  • Emerging market equities still face significant challenges, yet earnings growth appears to be stabilizing.

Fixed Income

  • Higher inflation beyond 2017 could cause further risks to long-term bond yields.
  • Lower-quality securities may face more downgrades and defaults in the latter stages of the credit cycle.
  • We favor intermediate-term U.S. corporate bonds and are underweighting high-yield corporate bonds.

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Real Assets

  • Agricultural commodities may fare better than crude oil and gold, but gold may rise on volatility spikes.
  • Fundamentals in Public Real Estate remain supportive, and valuations became more attractive due to underperformance in late 2016.

Alternatives

  • Strategies with low-net equity exposure, such as Relative Value and Equity Hedge, should perform well.
  • In times of rising inflation and modest economic growth, investors may find opportunities in Equity Hedge and Macro strategies that may also help them mitigate risk.
  • Structured credit should also perform well as inflation picks up but interest rates remain relatively low.
  • Private capital may offer compelling opportunities for qualified investors.

Investment Expertise and Advice That Can Help You Succeed Financially

Wells Fargo Investment Institute is home to more than 100 investment professionals focused on investment strategy, allocation, portfolio management, manager reviews, and alternative investments. For additional information on Wells Fargo Investment Institute, visit our website.


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