Global Investment Strategy Global Investment Strategy Report February 1, 2016 Paul Christopher, CFA Head Global Market Strategist Weekly market insights from the Global Investment Strategy team» Falling oil prices and disappointing news out of China repeatedly have cycled through global markets and created pessimism.» While we see risks from these two sources, the negative sentiment seems exaggerated. What it may mean for investors» We think the current market pessimism offers potential opportunities for investors with a disciplined approach to meeting their financial objectives. How Oil Prices, China, and Equity Markets Intersect and What to Do About It Since the beginning of the year, global markets have been riding a roller coaster. Unfortunately, when pessimism is unusually strong, some worries seem to come around again and again like a merry-goround. China s problems and tumbling oil prices repeatedly have seized the headlines this month and weighed heavily on the equity markets. Clearly these factors present risks, but we think revolving concerns have been exaggerated and may obscure the long-term vision that investors need to stick with their investment plans. Here, we consider the intersection of these three dynamic market forces and briefly review risks and opportunities for each, until this wild ride ends. What are the risks? Oil prices and equity markets: Oil prices have not moved closely with equity prices historically, but the recent drop in oil prices poses two related risks for equities. First, the imbalance in the oil market comes from an oversupply. The process of rebalancing global oil markets may fall heavily on U.S. energy producers, triggering layoffs and spending cuts to the detriment of an already-weak U.S. manufacturing sector. Second, the latest slide in commodity prices pushes near-term inflation expectations closer to zero and towards deflation risk. If prices in the economy fall (deflation), consumers may be tempted to delay their large purchases until prices stop falling. Of course, this behavior damages revenues, hiring, and confidence throughout the economy. Although crude oil prices could slide further, we think a bottom is close. Global supply and demand rebalancing are underway, and today s low prices may accelerate the adjustment. We believe oil prices appear to be forming a bottom, and with it, the correlation with equity prices should return to a more historically (lower) average. 1 China: China is in a government-managed transition from a manufacturing economy to a services economy. We see risks in China but not a crisis. For example, countries historically have devalued their 1 For more details on why we think oil prices are near a bottom, please see our Global Investment Strategy, Why we are no longer a super-commodity bear, January 19, 2016. For a discussion of the historically low correlation between the oil and U.S. equity markets, please see our Global Investment Strategy, The investment upside to sinking oil prices, January 28, 2016. 2016 Wells Fargo Investment Institute. All rights reserved. Page 1 of 5
currencies during periods of extreme economic stress, but China s economy seems stable to us (more on that below). Moreover, devaluation is part of the government s stated long-term strategy to open China s financial markets to global trade. Chart 1 illustrates that China s currency is weakening against the U.S. dollar, not against a broad basket of currencies. Put differently, the yuan is depreciating to realign with the dollar; it is not weakening against a broad group of currencies. Chart 1. China s Currency Depreciation Has Been Narrow and Mainly Against the U.S. Dollar 130 $0.17 Exchange Rate Index 125 120 $0.16 $0.15 Dollar per Yuan 115 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 JP Morgan nominal broad exchange rate (index, left axis) U.S. dollars per yuan (right axis) $0.14 Sources: Bloomberg and Wells Fargo Investment Institute, 1/27/16 The J.P Morgan nominal broad effective exchange rate for the yuan is a trade-weighted average of the yuan s exchange rate against the U.S. dollar, the euro, the British pound, the Japanese yen, the Mexican peso, and smaller weights to other European, Asian, and Latin American trading partners of China. Another source of market concern is China s corporate debt level. Government-owned companies assumed most of the debt in the post-2008 government stimulus program, but private Chinese companies collectively lowered their debt as a percentage of their total assets, according to a study by the Hong Kong Institute for Monetary Research. 2 Despite the build in debt, bond yields do not suggest a crisis, in part because China (and other Asian economies) has a high savings rate. Chart 2 shows that the yields across a variety of Chinese corporate bond maturities have declined since the second half of 2015, despite a nearly 50-percent decline in China s equity market, as reflected by the performance of the Shanghai Stock Exchange Composite Index. 2 For more information, please see Corporate Leverage in China: Why Has It Increased Fast in Recent Years and Where do the Risks Lie?, Hong Kong Institute for Monetary Research, April 2015. Link: http://www.hkimr.org/uploads/publication/416/wp-no-10_2015-final-.pdf 2016 Wells Fargo Investment Institute. All rights reserved. Page 2 of 5
Chart 2. Chinese Corporate Bond Yields Have Declined During Recent Financial Disruption (Yield-to-Maturity at Various Maturities and at Selected Dates, in Percent) 9 8 Yield to Maturity 7 6 5 4 1 2 3 4 5 6 7 8 9 10 15 20 30 Years to Maturity 1/27/16 12/31/15 6/30/15 Sources: Chinabond via Bloomberg, and Wells Fargo Investment Institute, 1/27/16. Notes: The yields shown are for local-currency corporate bonds rated AAand that are traded on the China Interbank Exchange. The yield values shown on the curves are contributed by China Government Securities Depository Trust & Clearing Co Ltd. Past performance is no guarantee of future results. As China moves through its economic transition, debt and unemployment remain the main risks to watch, but we see no reason for alarm. The government will have to facilitate the write-off of large loans at construction and processing firms that will be closed in the transition. Some of those bankruptcies could disrupt certain bank operations and create unemployment. If China mismanages the tasks of retiring the bad debt and finding new jobs for the displaced workers, the economy could suffer a significant disruption. Such a disruption is the hard landing scenario that some investors worry about. Still, it is very important to remember that the largest part of China s economy is healthy and growing. The service sector is now the principal source of Chinese economic and job growth, and wages are rising. Households appear to be taking advantage of these developments. Now, many market watchers (ourselves included) treat Chinese government statistics with caution, but we see a broad array of evidence that China s consumer and service industries are financially healthy, and that the overall economy appears stable. Table 1 provides a sample. 2016 Wells Fargo Investment Institute. All rights reserved. Page 3 of 5
Table 1. How much longer will the risk aversion continue? Worries about oil prices and China may linger for a matter of days or weeks, but sentiment should improve while the U.S., European, and Japanese economies continue showing solid (albeit slow) growth, and while China s economy slows but remains stable. Here are the factors we are watching: Supply-demand adjustments in oil markets: Once supply cuts accelerate (possibly by spring), oil prices should stabilize and defuse deflation fears. Some additional years may be needed to weed out additional producers and prompt a new oil price rally. China s policies regarding its currency exchange rate: Chinese officials are aiming for the yuan to depreciate but this month confused currency traders by abruptly changing the yuan s depreciation pace. Sentiment should improve if the yuan maintains a steady depreciation. The U.S. dollar: The dollar has been strengthening globally, but the yuan may face less depreciation pressure, if the dollar pauses or consolidates. The dollar may consolidate if Federal Reserve officials signal no new rate hike this spring. Keep perspective, take action Times like these can be upsetting for investors. This is why we strongly recommend identifying your financial goals, investment time frame, and risk appetite. Your investment professional can help you build a portfolio that looks past today s emotional selling and sets a long-term strategy to align our expected returns and your long-term goals. From that strategic perspective, we see potential opportunities for a focused investment plan to buy selectively those markets that have sold off in recent months. In particular, investors should consider that equity market valuations are attractive at approximately 15 times the 2016 consensus estimate. Even in the balance of the year, our historical market research indicates that the six-month period following an equity-market correction often can 2016 Wells Fargo Investment Institute. All rights reserved. Page 4 of 5
reward patient investors. 3 In addition, more than half of the S&P 500 Index constituent companies currently pay dividends that exceed the current 10-year U.S. Treasury note yield. Risk Factors All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security. Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. Currency risk is the risk that foreign currencies will decline in value relative to that of the U.S. dollar. Exchange rate risk between the U.S. dollar and foreign currencies may cause the value of the portfolio's investments to decline. Investing in commodities is not suitable for all investors. Exposure to the commodities markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Products that invest in commodities may employ more complex strategies which may expose investors to additional risks. Definitions An index is unmanaged and not available for direct investment. 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. The Shanghai Stock Exchange Composite Index is a capitalization-weighted index. The index tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. The Corporate Bonds with the AA- rating are considered to be in the upper-medium grade and subject to low credit risk. Disclaimers Global Investment Strategy is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company. The information in this report was prepared by the Global Investment Strategy division of WFII. 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. This report is not intended to be a client specific suitability 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. Wells Fargo Advisors is registered with the U.S. Securities Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Brokerage products and services are offered through Wells Fargo Advisors. Wells Fargo Advisors is the trade name used by two separate registered broker-dealers: Wells Fargo Advisors, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, non-bank affiliates of Wells Fargo & Company. CAR 0216-00143 3 Since 1970, the S&P 500 Index gained in 15 out of 22 six-month periods (median gain of 10.9 percent) following episodes of six-month losses of between 9 percent and 11 percent. Please see our Global Equity Strategy Weekly, History Shows Frequent Recovery from Similar Downturns, January 21, 2016. 2016 Wells Fargo Investment Institute. All rights reserved. Page 5 of 5