Perspective. Economic and Market. Some Thoughts on 2016

Transcription

1 Wells Capital Management Economic and Market Perspective January 4, 2016 Some Thoughts on 2016 Bringing you national and global economic trends for more than 30 years James W. Paulsen, Ph.D Chief Investment Strategist, Wells Capital Management, Inc. Welcome to 2016! Because of its persistent subpar growth rate, the contemporary economic recovery is universally considered disappointing. However, if it continues until March, it will represent the fourth longest in U.S. history. The stock market bull is already the fifth longest and its gain is the fifth best (about a three-fold rise) in U.S. history. Both U.S. nominal GDP and nominal personal income are currently about 25% above their respective levels at the end of the last recovery. There are more people currently employed in this country than ever before and the unemployment rate recently returned to 5%, a level which is lower than two-thirds of the time since WWII. Finally, both corporate profits and household net worth (at about $85 trillion) are at all-time record highs about 25% above their previous respective peaks reached in the last recovery. While this may be the most disappointing recovery ever, it is also likely the most successful disappointing recovery ever. While overall economic growth this year will likely remain subpar by historic standards, our guess is the global economy will enjoy its first synchronized bounce in real economic activity of the recovery. This probably will be led by a recovery in the materials, energy, and manufacturing sectors due to a lagged response from powerful economic stimulus introduced about the globe during the last year. While better economic growth should be supportive for most stock markets, it may prove conflicting for the U.S stock market. After a widespread obsession about the potential for a global deflationary abyss, most inflationary indicators may lift in The first synchronized global economic bounce since the U.S. has returned to full employment, a surprisingly weak U.S. dollar, a revival in commodity prices, and worsening wage pressures may combine to accelerate the Fed s exit strategy and pressure fixed-income markets around the globe. Here are the details of several guesses for A synchronized global economic bounce? Not only has global economic growth been persistently subpar, it has never been synchronized. Early in the recovery, while the U.S. chose quantitative easing aimed at improving economic growth, the eurozone chose fiscal austerity pushing the region back near recession. Moreover, in late 2010, Chinese officials decided to moderate their recovery and emerging world growth has been slowing ever since. Japan has been up and down throughout the recovery and in the last couple of years, resource-based economies like Canada and Australia have slowed as oil prices collapsed. This could be the year when all economic boats finally rise together. During the last 12 to 18 months, powerful economic stimulus has been implemented nearly everywhere. First, the collapse in most commodity markets including energy prices is similar to a major fiscal tax cut. Globally, there are many more consumers than producers of commodities and an almost 50% reduction in broad-based commodity price indexes since 2014 will likely prove to be a major economic stimulant. Monetary accommodation has also been evident. Long-term sovereign bond yields have declined significantly in the U.S. and Canada, throughout Europe, in Japan, and across the emerging world. Finally, relative to the U.S., many foreign currency rates have recently been cheapened by about 20%. Overall, most economies have enjoyed a powerful trio of policy accommodation the equivalent of a major fiscal tax cut (lower commodity prices), a significant monetary boost (lower bond yields), and a large currency devaluation. Rather than anticipate further global weakening this year, the lagged impact of these aggressive economic policies suggest better economic growth. Unlike most economies, the U.S. faces a stiff headwind from a substantial rise in the U.S. dollar. However, this negative force should be buffered by a deep drop in commodity costs and by lower long-term bond yields. Moreover, the U.S. economy is likely to benefit from other private sector forces during First, until 2014, the U.S. economy had little or no credit creation. In the last year, though, U.S. bank lending has risen by

2 more than 8%! Perhaps some leveraged economic activity will allow the recovery to grow a bit faster? Second, the U.S. household sector is in far better shape compared to any other time in this recovery. When the recovery began, the unemployment rate was over 10%, job creation was paltry, household net worth had declined by about 20%, and consumer confidence was near a post-war low. Today, the unemployment rate is only 5%, annual job growth has consistently been close to 2%, household net worth has risen by more than 50% from its recession low, and consumer confidence measures are much closer to post-war highs. Moreover, real wages have risen faster this past year (by about 1.6%) than at any other time in this recovery. Lastly, since the Fed has begun to raise interest rates, savers should finally be rewarded with rising interest income. Third, expect a greater contribution from the housing industry during the balance of this recovery. Normally, the housing market is an early cycle contributor often weakening again long before the recovery ends. In this cycle, however, housing was a no-show early in the recovery and may oddly prove to be an outsized late cycle contributor. Due to the severity of the last recession, many home plans were postponed but perhaps not canceled. Now that the job market is much improved, consumer confidence has recovered, household formation is finally rising again, and the Fed is signaling homeowners need to act soon to beat mortgage rate hikes. U.S. housing activity may prove stronger than most anticipate. Finally, capital spending may help boost U.S. growth this year. Throughout this recovery, corporations have been sitting on considerable cash hoards which have been used primarily to boost dividends, increase stock buybacks, or for mergers and acquisitions. There has been little incentive for capital spending when most global economies were often struggling. However, if there is a global synchronized economic bounce in 2016, it could finally awaken the animal spirits of cash rich companies. We do not anticipate booming economic growth. Aging demographics in the developed world and poor productivity performance are the two primary obstacles likely to keep growth subdued. However, if most economies simultaneously improve even marginally, the overall global recovery may appear broader, healthier, and more sustainable than ever. Closing the global gap and reversing the U.S. dollar! The U.S. dollar has played a crucial role in both the financial markets and in the economy during the last couple years. We expect it will again be a central driver of events in Most seem to believe the U.S. dollar has strengthened because of the difference in economic policies between the U.S. and the rest of the world. Indeed, with the Fed already beginning to raise interest rates while most foreign officials are intensifying easing efforts, a strong consensus expects the U.S. dollar will continue to advance. However, the economic growth differential, rather than policy differentials, is likely more important in driving currency valuations. In 2014, while U.S. economic growth improved slightly, growth abroad mostly slowed. The widening growth gap between most foreign economies and the U.S. pushed the U.S. dollar considerably higher during the last half of Since last February, however, the dollar has trended sideways against most developed economy currencies as U.S. economic growth slowed slightly while growth in some developed countries like Japan and the eurozone improved. U.S. dollar strength during 2015 was mainly limited to emerging currency rates as growth in China and most emerging economies continued to slow. We expect a synchronized global economic bounce to close the foreign growth gap relative to the U.S. and force the U.S. dollar lower this year against both developed and emerging currencies. While U.S. growth should improve slightly, we think it will bounce less than most foreign economies for a couple of reasons. First, the U.S. did not slow as much as most international economies in recent years and therefore probably has less rebound potential. Second, the U.S. economy is closer to full employment limiting growth potential relative to foreign economies with more resource slack. Most importantly, foreign policy officials have recently been much more accommodative compared to domestic economic policies (e.g., the Fed stopped quantitative easing in 2014 and just began raising short-term interest rates last month), and finally, the U.S. bounce is likely to be muted in part due to the lagged impact of a strong dollar. 2

3 One last comment about the U.S. dollar. Many believe since the Fed has begun to raise interest rates while most other foreign policy officials remain highly accommodative, the U.S. dollar can only rise. However, in contrast to conventional wisdom, since at least 1970, when the Fed funds interest rate has increased, the U.S. dollar has typically declined. Moreover, if global economic growth improves, interest rates will likely rise everywhere. Quantitative easing does not ensure bond yields will stay low. The U.S. was employing quantitative easing in 2013 when improved U.S. economic growth boosted the 10-year Treasury bond yield that year from about 1.5% to 3%. A weaker U.S. dollar and a recovery in commodity prices? Commodity markets are poised to have a good year in The two major factors responsible for the decline in commodity prices since mid-2014 weaker global economic growth and a strong U.S. dollar should reverse this year. Nearly every major decline in the commodity markets since 1970, rather than persisting at lows for an extended period, experienced a sharp V-shaped recovery once a low was reached. We suspect this will happen again this year and although commodity prices are not to likely recover to the 2014 summer levels, their bounce may be much steeper than most now anticipate. For example, we would not be surprised if crude oil prices reach as high as $65 to $70 sometime in Core inflation to rise about the globe? Primarily because of the collapse in energy prices, overall inflation has slowed significantly. However, core consumer price inflation has already increased more broadly than most appreciate. Awakening core pricing pressures are most pronounced in the U.S. being at least somewhat bolstered by a return to full employment. The annual rate of core consumer price inflation rose from about 1.5% to 2% this past year. Annual U.S. wage inflation (based on a 3-month moving average) recently rose to its highest level of the recovery to about 2.5%. Finally, the U.S. core services inflation rate spiked to a new recovery high this past year near 3%. Core pressures have also quietly become more noticeable about the globe. In the eurozone, the core consumer inflation rate declined steadily between 2012 through the end of However, the annual core inflation rate this year has risen from about 0.5% to about 1%. In Japan, core consumer prices were chronically deflating during this recovery until However, they have risen by about 1% in the last year. Even in China, the core consumer price inflation rate has accelerated by about 0.5% since late We are not suggesting nor are we concerned about the risk of a significant sustaining burst of inflation in the U.S. or about the globe. We do believe, however, that widespread worries about deflation will lessen this year and perhaps for the first time in this recovery, the cultural mindset (particularly within the U.S.) will start to recognize and accept that the inflation environment is beginning to turn higher. The U.S. crossed over into some semblance of full employment this past year with the unemployment rate falling to 5%. Consequently, economic growth will now likely aggravate cost-push pressures including wages and core consumer prices. Moreover, these pressures could intensify should the U.S. dollar decline, should commodity prices including energy prices recover, and should global economic growth experience a synchronized bounce. We anticipate the annual rate of U.S. wage inflation to reach about 3.25% this year and for core consumer price inflation to reach about 3%. While this level of inflation is not frightening by historic standards, it would likely have considerable impact on the mindsets of investors, consumers, businesses, and policy officials which have grown complacent in a recovery seemingly absent of any inflation risk. It is also an inflation rate probably inconsistent with a 0.25% to 0.5% Fed funds interest rate, a 2.25% 10-year Treasury yield and with an 18 to 19 times trailing stock market price-earnings multiple. A challenging Fed tightening cycle? Many believe lifting interest rates off zero should not be that negative for either the economy or the financial markets. After all, interest rates are still very low by historical standards and this is more about normalizing monetary policy than it is about tightening credit conditions. For a couple of reasons, however, we expect the normalization of interest rates to prove more challenging than most anticipate. First, because the Fed has started the tightening process so much later compared to past recoveries many of the buffers that traditionally have mitigated the negative impact of rising yields have expired. Usually, when the Fed first begins tightening, the U.S. earnings cycle is much younger than it is today. Typically, profit margins are far from cycle highs, company earnings are still recovering from the last recession, and solid earnings growth buffers early interest rate hikes. Today, the Fed faces an old earnings cycle with profit margins already near post-war highs. That is, the earnings buffer has already expired. 3

4 Similarly, the Fed usually initiates tightening against solid gains in the job market. Job growth is strongest when the unemployment rate can be reduced. Once full employment is reached, job gains typically slow. Today, as the Fed begins to lift interest rates, job creation is likely to slow because the unemployment rate is already back to 5%. For comparison, during the last three initial Fed tightenings in April 1983, January 1991, and in May 2004, the unemployment rate was 7.9%, 6.6%, and 5.6% respectively. Consequently, today, because the Fed has delayed the tightening process, it has lost the opportunity to lift interest rates against the most robust job gains of the recovery. Finally, former Fed Chairman Alan Greenspan was considered the Maestro of monetary policy primarily because he was able to use a massive productivity miracle as the exit ramp (and fabulous buffer against higher interest rates) for his monetary normalization process. Fed Chair Janet Yellen, however, begins the process of lifting interest rates against the worst productivity performance of any recovery in post-war history. We are also concerned that the premise behind this tightening cycle may become stagflation. Indeed, wasn t this essentially why the Fed finally began to raise interest rates in December? It certainly wasn t because real growth was surging. The Fed started to raise interest rates last month despite a recession in the manufacturing sector because at full employment, concerns about emerging wage pressures forced the decision. Sluggish real economic growth has been a chronic problem in this recovery but it has yet to be combined with inflation worries. However, since the U.S. has now reached full employment, even sluggish economic growth may produce cost-push pressures resulting in wage and core price hikes. Typically, when the Fed begins to tighten, although inflation pressures may be intensifying, real economic growth is also usually firming and much stronger than it is today. Could real economic growth remain subpar while inflationary evidence strengthens? That is, could the Fed be forced to quicken its exit path because of stagflation fears? A bad year for bonds? Throughout this recovery, a majority of prognosticators (author included) have frequently anticipated an imminent rise in bond yields. After all, a 10-year Treasury bond yield often only about one-half the pace of nominal GDP growth hardly seems an equilibrium interest rate. However, bond yields have mostly either stayed low or moved even lower about the globe. Will 2016 finally be the year when bonds quit being priced solely by fears and yields actually begin to reconnect with the economic recovery? Could the normalization of interest rates initiated by the Fed last year broaden to include the overall bond market? Dare we say (again), we think so? As we begin the new year, a dominant interest rate mantra is lower for longer. This reflects a consensus that has come to expect bond yields will never rise significantly again. The global economy is very weak, inflation is nonexistent, and deflation is a much bigger risk. However, we think several things are changing which increases yield risk. First, since the 2008 crisis, perhaps for the first time since global inflation peaked in the early 1980s, the entire world has thrown inflation concerns to the sidelines and is universally focused on ending deflationary pressures. Even the historic global epicenter of inflationary hypochondria, Germany, is now fighting deflation. Chancellor Angela Merkel is no longer demanding fiscal austerity but rather is standing down while Mario Draghi employs full out quantitative easing. After facing more than two decades of chronic deflation in Japan, Abenomics has fully embraced the Benanomics playbook. And China is no longer attempting to moderate its recovery. Even the U.S. Fed was dragged only very reluctantly toward monetary tightening and ensures all who want to listen that they intend to move only very slowly. When the world universally fought inflation in the early 1980s, they succeeded. Perhaps the recent global war on deflation will indeed mark the low in bond yields? Second, the synchronized policy stimulus delivered about the globe in the last year (massive decline in commodity prices, major declines in sovereign bond yields and widespread currency devaluations) will likely produce a global economic bounce this year when most investors are braced for weaker economic growth. Third, the U.S. economic recovery has returned close to full employment. Until now, economic growth has not aggravated inflationary pressures. As the U.S. dips into a four-handle unemployment rate, even continued subpar real growth will now likely produce cost-push pressures and higher wage and price inflation. Finally, inflation concerns could be excited this year if commodity prices bounce more than most expect and if the U.S. dollar experiences a surprising decline. Should wage and core consumer price inflation rise to about 3% as we expect, the 10-year U.S. Treasury yield may reach about 3.25% by year-end. 4

5 Another violently flat year for U.S. stocks? It is tempting to suggest the stall in the stock market last year is either a precursor to a bear market or that the bull market will regain its footing and have another solid year in Our guess though, similar to 2015, is for the U.S. stock market to exhibit another year of considerable volatility while essentially ending flat. The stock market faces several challenges it will likely struggle to navigate in First, while the stock market did pause in 2015, it was not a refreshing pause. A year ago, the stock market entered 2015 with a relatively high historic valuation, with bullish or at least complacent investor sentiment, with a rapidly aging earnings cycle and with an imminent need to reset interest rates. As we begin this year, many of these same challenges are still evident. Since earnings were also essentially flat last year, the pause in the stock market did little to improve its valuation. While investor optimism may be somewhat less compared to the start of last year, it seems mostly complacent. Indeed, the brief correction last summer followed by a sharp recovery did not generate much fear. Rather, it probably reinforced buy on the dip mentalities and that any decline is simply an opportunity rather than a risk. Like last year, the best earnings performance for this recovery is already past. The U.S. earnings cycle got one year older, corporate profit margins near postwar highs have no room for additional improvement and since the U.S. has reached full employment, margins may be pressured this year. Finally, while the long overdue U.S. interest rate reset has finally begun, it is only about one month underway. In 2015, the stock market constantly struggled with when the Fed will begin to raise interest rates. In 2016, it will likely constantly struggle with how fast interest rates will be raised. It may be a new year, but the factors that essentially flattened the stock market last year still appear equally daunting and yet unaddressed here in Second, with the U.S. economy now back close to full employment, what economic growth rate is good for the stock market? Until now, most companies have been able to augment sluggish sales performance with chronically rising profit margins. Now, however, if the pace of economic growth remains weak, since profit margins are already near record highs and can no longer be lifted, earnings growth will likely match disappointing sales results. Alternatively, should the pace of economic growth accelerate forcing the unemployment rate towards 4%, rising cost-push pressures are likely to erode profit margins, offset sales gains, and keep earnings performance subpar. What economic growth rate are the bulls expecting? With the U.S. economy now near full employment and with record high company profit margins, is there really a goldilocks economic growth rate for stocks? Third, as we detailed in a report last year (see the Economic and Market Perspective from October 13, 2015), history suggests the character of the financial markets is typically far less rewarding once the U.S. economy reaches full employment (i.e., reaches about a 5% unemployment rate). Indeed, in the post-war era, the U.S. economy has been at or below a 5% unemployment rate about one-third of the time. When it has been at full employment, average annualized stock returns have been nearly half what they were when the unemployment rate was above 5%. Moreover, both stocks and bonds have tended to suffer more frequent monthly declines in fully employed economies. Finally, on average during the post-war era, once the unemployment rate reaches 5%, the next recession has been less than two years away. The bull market may yet last for several more years. However, since the U.S. economy has returned to full employment, history suggests investors should prepare for a much more challenging financial market risk and reward environment during the balance of this recovery. Fourth, we do think stagflation is a risk for the financial markets in Until now, the stock market has constantly had to deal with a subpar real growth recovery but not one with any inflation overtones. Could 2016 be the first year of this recovery when the financial markets face continued sluggish growth with some inflationary worries? What if commodity prices bounce, the U.S. dollar weakens, and wage inflation accelerates toward 3% but U.S. real GDP growth remains subpar near 2.5%? Because the U.S. is now near full employment, even slow growth could intensify inflation evidence. So far, the stock market has done well in this recovery with very sluggish real economic growth. Will it continue to do well even if real growth remains subpar but inflation finally increases? That is, how would the stock market deal with mild stagflation? Lastly, has the U.S. stock market already used up much of its capacity to rise? It has risen about three-fold from its low in 2009 and in March it will enter the eighth year of its bull run. Thus far, it has performed well primarily because it had so much capacity for improvement in the wake of the last recession including a massive rise in its P/E multiple, a big decline in the competitive bond yield, a huge improvement in the economy registered by a large drop in the U.S. unemployment rate, and a substantial recovery in corporate earnings. Now, however, because of its success in reducing excess capacity, room for further improvement is becoming limited. The P/E multiple is in the upper quartile of historic norms, the unemployment rate is back to 5% and can t go 5

6 financial market fallout (e.g., cost-push pressures, inflation and higher yields), bond yields are already at all-time record lows, and profit margins are at post-war highs. Where is the capacity for stocks to continue to move significantly higher? Refreshing the bull? Since 1870, the U.S. stock market has rarely risen above or sustained at a trailing 12-month P/E multiple much above the 18 to 19 times the market is priced near today. The few times when the P/E multiple rose above today s level were mainly periods when the P/E rose primarily because earnings collapsed, rather than due to a true rise in the valuation of trend earnings. The single notable historical exception was the 1990s when the P/E multiple on trend earnings soared and sustained between 20 to slightly more than 30 for several years. This unprecedented valuation period was associated with a massive leap forward in technological expertise (i.e., the new-era tech boom). It produced a surge in productivity dampening inflation and cost-push pressures and neutralizing the negative impact of rising interest rates allowing stock market valuations to climb. If this single exception from the last 150 years of U.S. stock market valuations can be repeated than the contemporary bull market does indeed still have considerable potential. However, the other 140 years of U.S. history suggest the current market s P/E multiple is quite high and this valuation level may be difficult to sustain in an economy now at full employment. Until recently, the primary premise of this bull market has been the ability of the economy to grow (even though at a disappointingly sluggish pace) without creating negative financial market fallout. Because of excessive slack, this recovery has grown without creating labor cost pressures, without raising the inflation rate, and without forcing a hike in interest rates. If the economic recovery can continue to grow without raising any challenge to record high profit margins, with a perpetually accommodative Fed, without raising the overall inflation rate, and while continuing to maintain a zero short-term interest rate, then the stock market s P/E multiple could be maintained near historic highs. Indeed, perhaps the valuation could even expand further. However, last year as the unemployment rate declined back to 5%, the recovery reached the threshold of full employment. Further growth in the economy now will only be achieved with some negative consequences for the financial markets. Increasingly, economic growth will likely aggravate wage and price pressures, curtail corporate profit margins, and force interest rates higher. Consequently, the U.S. stock market may continue to struggle this year until it finds a lower valuation level more appropriate and sustainable for an economic recovery which has returned to full employment. What P/E multiple would be sustainable in a fully employed economy? We are not sure but would probably become much more bullish on the prospects again for the U.S. stock market should the P/E multiple decline to about 16 times. This P/E multiple leaves room for a rise in competitive interest rates, for the negative earnings impact of some erosion in profit margins, and for a less hospitable Fed. The stock market could revalue quickly similar to the August correction last year. Currently, with trailing 12-month earnings per share for the S&P 500 Index of about $112, a violent break to about 1800 would reach a 16 P/E multiple. Alternatively, it could simply prove to be another flat year for the stock market, but unlike last year, a year when earnings increase. For example, if the S&P ended this year essentially flat at 2050 while earnings rose to about $125, the P/E multiple would be 16.4 heading into If the stock market is revalued (e.g., if the P/E multiple is reduced again toward the 16ish level), perhaps the buy-and-hold bull market could resume. That is, from a more sustainable valuation level, the U.S. bull market could simply follow earnings higher. Assuming a modest 5% annualized earnings growth rate during the rest of this recovery and adding the current dividend yield of about 2% suggests the possibility of a buy-and-hold total return of about 7% once and should the valuation of this bull market be refreshed. Longer-term returns could even prove better if the U.S can resurrect some solid productivity growth. Healthy productivity gains would dampen inflation and interest rate pressures and could allow the P/E multiple to expand again as it did during the last great productivity era in the late-1990s. Admittedly, there is nothing scientific about 16 times earnings. Perhaps, the stock market will find good support at 17 times or maybe it will need to adjust to 15 times? Who knows? As this entire note, it is guesswork at best. However, as we begin the new year, the U.S. stock market still faces some formidable challenges and until it achieves a better fundamental footing (i.e., reaches a 6

7 lower valuation level), it is not likely to sustain a meaningful advance. Some investment recommendations for the new year!?! We anticipate another volatile but essentially flat year for U.S. stocks but would not be surprised if the S&P 500 establishes a new record high sometime during the year. Our guess is for about a 20% trading range between about 1800 and 2200 ending the year at U.S. and global bond yields are likely to rise significantly this year resulting in disappointing fixed-income returns. Commodities and other real assets may provide the best investment returns in Finally, hedge fund strategies may also experience a good year. Thinking not only about the next year but also the next few years, we offer a few investment recommendations. First, while the U.S. stock market correction may not yet be over, we would not tilt significantly away from equities. Cash offers a near zero return and bonds also exhibit significant risk during the balance of this recovery. Moreover, we continue to believe the bull market is most likely pausing but not ending. While buy-and-hold may prove difficult in the coming year, it may also still prove profitable during the next few years (particularly if U.S. productivity is resurrected). Second, some modest cash reserves seem warranted. While near zero returns are not necessarily attractive, we would have some dry powder to take advantage of opportunities should the U.S. stock market experience another correction this year. Third, stock portfolios should be maximally tilted toward international equities both developed and emerging stock markets. The U.S. is in an almost unique position facing the crossroads of full employment. Most other economies across the globe are still in full policy accommodation mode. Should global economic growth soon bounce as we expect, while the U.S. stock market may struggle with escalating inflation and interest rate pressures, improved economic growth would be bullish across the emerging world, Europe, Japan, and Canada. We find the international equity markets attractive for many reasons. After four years of underperformance relative to the U.S., international investing is under-owned and most overseas markets represent a better relative value. Moreover, while U.S. policy officials are turning hostile, international policy officials will mostly remain hospitable toward the financial markets. Additionally, unlike the U.S., most foreign markets are not likely to experience negative financial fallout from being at full employment. Finally, because their economic recoveries trail the U.S., most foreign companies are still in a much younger part of the earnings cycle. Fourth, we recommend using contemporary stock market volatility to slowly position portfolios for the next leg of this bull market. As discussed in a recent note (see the September 17, 2015 Economic and Market Perspective), we think a shift in economic pricing power from consumers to producers is likely to unfold during the balance of this recovery. This suggests a leadership change in the stock market may be forthcoming from U.S. stocks to foreign stocks (since the U.S. economy is much more consumer-centric relative to most foreign economies) and from consumer stock sectors to industrial or producer sectors. Relative stock price performance tends to follow relative economic pricing power. Consequently, we would use periods of strong stock market rallies to lessen the portfolio exposure toward U.S. stocks and toward consumer sectors (e.g., consumer discretionary, consumer staples, and health care). Similarly, periods of significant market weakness should be used to add overseas exposure and to accumulate the industrial and capital goods sectors (e.g., industrials, materials, energy, and technology). Fifth, we favor both mid and small cap stocks over large cap stocks. In the U.S., the large cap marketplace has not yet experienced any meaningful correction and is probably more extended on a valuation basis. Moreover, disinflation historically tends to favor large company stocks. Larger companies tend to operate with fluff and wider profit margins and are therefore better able to deal with tough top line pricing competitiveness that often results during periods of disinflation. Large companies can more easily cut costs, promote efficiencies, and achieve economies to scale to more effectively prosper in falling inflation eras. Smaller entrepreneurial companies tend to run lean and mean and do not have as much flexibility to widen margins. However, when the inflation rate accelerates, small companies tend to have much greater operating leverage to better top-line pricing. 7

8 Should inflation finally rise in this recovery as we expect, profit growth among small and mid cap companies should do much better relative to large companies. Sixth, we believe the U.S. dollar is peaking and will likely move lower in the next year. Last year, the U.S. dollar strengthened significantly against emerging market currencies but was essentially flat since January against most developed world currencies. We expect a bounce in global economies to close the growth gap between the U.S. and the rest of the world resulting in a bid for foreign currencies and a sell of the U.S. dollar. While U.S. yields will likely rise, better economic growth abroad should also increase foreign yields, keeping yield spreads from widening materially. The likelihood of a weaker U.S. dollar is another reason investors should consider lifting exposure toward international assets. Seventh, consistent with a weaker U.S. dollar is an expectation that we are near a bottom in commodity prices (see the August 25, 2015 Economic and Market Perspective). After collapsing in 2014, commodity prices have trended more sideways this past year. A bounce in global economic growth combined with a decline in the U.S. dollar could produce the best year in commodities since early in this recovery. Overall, if foreign economies finally experience a synchronized recovery (even if growth is still only modest) while the U.S. crosses over into full employment, real assets in general may do much better during the rest of this recovery. Eighth, a flat but volatile stock market and a challenging bond market probably favor hedge fund strategies in Finally, investors should remain underweighted in fixedincome assets. With most global policy officials now simultaneously and robustly attempting to boost economic activity, with the U.S. finally in policy tightening mode and with bonds currently priced for expected weak growth with deflationary overtones, the upside risk for global bond yields remains elevated. We would focus bond allocations away from the U.S. and toward lower credit quality, which has recently become much more attractively priced. 8

9 Final conclusions Most likely 2016 will prove to be a year which refreshes an ongoing bull market by lowering stock valuations to more sustainable levels. It also may finally begin to reconnect interest rates more appropriately to an economy now at full employment, with about a 2.5% to 3.0% real GDP growth rate and about a 2.5% to 3.0% core consumer price inflation rate. It is likely to further check and refresh investor complacency built up over the last several years of mostly good markets. And, it may rebalance some financial trends which have moved to far out of line including the U.S. dollar, foreign stock markets, and commodity prices. The potential for this bull market to continue depends primarily on two factors. The first is productivity. Better productivity is not absolutely required to continue this bull market, but it would certainly help. Without any meaningful rise in productivity, full employment pressures are likely to accelerate and eventually end this economic recovery much sooner. Alternatively, some pickup in productivity would buffer the need to raise interest rates, stretch the labor market beyond full employment, and help dampen inflationary pressures which would likely elongate both the recovery and the bull market. While we do not expect any productivity miracle like the 1990s, we do expect productivity to do better in the next few years. The primary reason we have not yet turned outright bearish despite the many challenges currently faced by the stock market is because we believe the risk of recession in 2016 remains quite low. Without a recession, a sustained bear market is not likely. The normal excesses for recession are not evident. Balance sheets among consumers and businesses are mostly healthy and banks are the most strongly capitalized ever. Very few sectors seem overextended including housing, capital goods, manufacturing, technology, or retailing. Finally, yields have not risen aggressively, the yield curve is still very positively sloped and liquidity is more than ample. The stock and bond markets may be headed for a refreshing year but the chance of some better productivity gains and a still low probability of recession keeps us bullish longer-term. I hope you have a sturdy fortitude to withstand what may prove to be a challenging year but probably within the context of an ongoing bull market. Happy New Year!!! Written by James W. Paulsen, Ph.D. An investment management industry professional since 1983, Jim is nationally recognized for his views on the economy and frequently appears on several CNBC and Bloomberg Television programs, including regular appearances as a guest host on CNBC. BusinessWeek named him Top Economic Forecaster, and BondWeek twice named him Interest Rate Forecaster of the Year. For more than 30 years, Jim has published his own commentary assessing economic and market trends through his newsletter, Economic and Market Perspective, which was named one of 101 Things Every Investor Should Know by Money magazine. Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. WFAM includes Affiliated Managers (Galliard Capital Management, Inc.; Golden Capital Management, LLC; Nelson Capital Management; Peregrine Capital Management; and The Rock Creek Group); Wells Capital Management, Inc. (Metropolitan West Capital Management, LLC; First International Advisors, LLC; and ECM Asset Management Ltd.); Wells Fargo Funds Distributor, LLC; Wells Fargo Asset Management Luxembourg S.A.; and Wells Fargo Funds Management, LLC. Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at or refer to our Form ADV Part II, which is available upon request by calling