The first part of a two part series, this episode discusses how some of the investment teams at Wells Fargo Asset Management have navigated the ups and downs of 2020 and how they plan on approaching the continued uncertainty for the rest of the year.
Brian Jacobsen moderates a conversation between Terry Goode, Senior Portfolio Manager with the WFAM Global Fixed Income Municipal team; Bryant VanCronkhite, Senior Portfolio Manager with the WFAM Special Global Equity team; and Harin de Silva, Portfolio Manager for the WFAM Analytic Investors team.
Brian Jacobsen: I’m Brian Jacobsen and you are listening to On the Trading Desk®. This is part one of a two-part series. Today we’ll be discussing how some of our investment teams at Wells Fargo Asset Management have navigated the ups and downs of 2020 and how they plan on approaching the continued uncertainty for the rest of the year.
With us, we have Terry Goode, Senior Portfolio Manager with the Wells Fargo Asset Management Global Fixed Income Municipal team; Bryant VanCronkhite, Senior Portfolio Manager with the Wells Fargo Asset Management Special Global Equity team; and Harin de Silva, Portfolio Manager for the Wells Fargo Asset Management Analytic Investors team. It’s great having you all on the program!
Terry Goode: Hello, Brian. Thank you for having me.
Bryant VanCronkhite: Thank you, Brian. Great to be here.
Harin de Silva: Thank you for the invitation, Brian. Happy to be here.
Brian: So to start off, for many, 2020 has been a year of losing balance, on a personal, social, and for many, a financial level. And hopefully, the rest of the year can be about finding balance. So Terry, let’s start with you. Are there any imbalances that you’re still seeing in your area of focus?
Terry: Yes, we are seeing imbalance in the municipal bond market. We actually have a supply/demand imbalance. It’s actually bolstering municipal bond prices in the face of some deteriorating credit fundamentals.
As a way of backdrop, we had record volatility and outflows in the municipal market in the first quarter. During the week of March 18, the market experienced a record $12 billion outflow. Year-to-date outflows, which once stood at almost $22 billion, have now reversed and we now have positive fund flows approaching $2 billion with over 10 straight periods of inflows.
If we combine the reversal of fund flows with significant July and August reinvestment, we see extremely strong demand for municipals.
Conversely, we see most of the supply in the municipal market being issued as taxable. Extremely low interest rates make it economic for municipal entities to issue taxable debt to advance refund tax-exempt bonds. And taxable issuance is actually nearing record levels, while tax-exempt is down compared to prior years.
So we have this strong technical backdrop for municipals driving bond prices higher and spreads tighter.
We also have deteriorating credit fundamentals in some sectors. The effects of the virus spread and the negative economic impacts has caused tax collections and revenues to be weaker. This leads to a disconnect–or imbalance–in which bond prices are going higher in the face of deteriorating credit fundamentals.
So how do we navigate this? By using active portfolio management and a disciplined investment process.
Brian: That’s some fantastic detail there. I really like that. Thank you. And so Bryant, how about you? How would you answer that question about any imbalances that you’re still seeing?
Bryant: Yeah, we’re definitely seeing imbalances remaining in the equity markets.
One of the greatest imbalances is in the value-versus-growth stock debate, where growth has trounced value for several years now, and that trouncing has only gotten more severe year-to-date. No matter what part of the market cap you look at—whether it’s small-cap, mid-cap, or large-cap—growth has beaten value by more than 20 percentage points year-to-date. So tremendous outperformance continues. And the valuations we’re seeing between value and growth are at all-time wides on a P/E basis.
For us, that makes a lot of sense right now. There’s a general lack of growth in the economy, which favors growth stocks where you see some certainty. Rates have moved lower, which favors cash flow streams that are further out in the future, again, mostly growth stocks. And in a time when people see uncertainty, they crave certainty, and in many ways, growth companies have greater visibility and greater certainty. And all that’s a great backdrop for growth stocks.
But at this point, the dislocation seems so extreme that it doesn’t take a whole lot to envision a time when that divergence begins to close. And as we see general GDP begin to increase, we’ll see more broad-based economic expansion and better growth across a wider array of companies. You’ll see rates at least stop moving lower, and you’ll see value stocks begin to reassert themselves. People will begin to consider what they’re paying for a unit of growth when growth is more visible and more widely available across the market cap spectrum and across the economic universe.
I think, furthermore, there is additional tailwinds that value could benefit from as we move forward, especially when it comes to sector exposure within the different indices. The value indices have a lot more exposure to the more cyclical components of our economy—think about industrials, materials—while the growth is more exposed to less cyclical areas, which now would be tech, for example. And so as that rotation happens, cyclical stocks should outperform, again, benefiting value.
What’s always uncertain with every dislocation, and ultimate reversion, is timing. And we’re not any better at picking the timing of that than anybody else, but I would tell you that the magnitude of dislocation argues for what likely might be a very quick and severe reversion when it does happen. So at this point, we’re really thinking about making sure we’re not tilting too far one direction when it comes to the growth-versus-value debate and making sure we give ourselves enough exposure to benefit when this ultimately does mean revert.
Brian: Well, that’s really helpful. That shows that you’re taking a very balanced approach to navigating this period of time, so thank you for that. And Harin, what are your thoughts on any imbalances that you’re seeing?
Harin: Yeah, the biggest imbalance we’re seeing is the discrepancy in the performance of the U.S. stock market versus the rest of the world.
As we all know the U.S. market is near all-time highs. The P/E’s around 24, so it’s high from a historical standpoint, but it’s high also in comparison to some of the other markets in the world, especially the developed markets, which have actually done a better job in terms of navigating the crisis. And what I mean by better job is more of the economy in some of these markets, like Germany, for example, or the Netherlands, is open. There’s more companies that are returned to work as normal, more businesses that have brought all their employees back, so it’s very hard to reconcile why we’re seeing so much optimism in the U.S. market versus some of these other markets.
Now there’s two things that you’ve got to keep in mind here. One is the U.S. is obviously one of the wealthier economies, so the level of stimulus we’ve been able to provide is really, really high and so maybe that’s what’s reflected in the high valuation. And also the valuation reflects the average stock and what we’ve seen is really that certain parts of the market have done really well—tech, in particular—and other parts of the market have really suffered.
So I think you can explain the high level of valuation by that to some degree, but I think as investors, you need to be aware that there’s lots of opportunity available on a worldwide basis and you don’t need to pay the high multiple that you’re going to pay if you invest just in the U.S. market.
Brian: Now that’s a really good point. Thank you and thank you all for that perspective. So moving on, we’ve all had to adapt to new ways of living during this tumultuous year. Are there any areas of your portfolios that have adapted, or changed significantly, since the beginning of the year? Maybe in terms of cash holdings, sector or factor exposures? So Bryant, why don’t we start with you?
Bryant: Yeah, we were very active in the time period between the middle of the first quarter and the middle of the second calendar quarter and probably our most active three-month time period in years, as far as I can recall.
And to your question, we did take cash down significantly to take advantage of the fear that entered the market. And I use “fear” intentionally because a lot of the reaction that we saw was emotional. Certainly, there was some fundamental reactions that made a lot of sense in some of the epicenter type areas, if you will, around airlines, cruise ships, even some restaurants and hotels, but a lot of the other sectors and other companies that were impacted negatively were truly moving on emotion. And so our job is to fight the emotion off and act with objectivity, and we think we did a good job of that.
We certainly increased exposure in areas of technology, industrials, consumer staples; reduced exposure in financials and energy. A lot of that work was done through swapping, trimming one name to add to another name that we already owned, so selling the outperformers to buy the underperformers, really optimizing reward-to-risk ratio.
But there were a lot of new ideas that popped up. I say “new ideas” in the sense that we’ve been following them for 5 to 10 years but never bought a share due to valuation, but all of a sudden, the emotions of the market gave us a chance to buy stocks at very attractive valuations.
And what we’re trying to do there is simply find the mismatch between the market price and the near-term risk and our ability to determine the long-term value based on what the company can control over the next one to three years.
The payback on these decisions, we think, will take about 12 to 24 months, so we’re really happy with that position today and the moves it can make during the pandemic.
In the last month, I would say, in July, some of the stocks did react very quickly and reward-risk ratios got less attractive so we have trimmed some exposure in a few names, bringing cash back up a touch from its lows in the portfolio. But I’d say that we’re still very fully invested and our activity levels throughout the crisis were higher than we’ve seen in quite a long time.
Brian: Excellent. Thank you for that. I guess it shows that patience is a cardinal virtue of investing. Harin, how about you? What are your views on this? Any major changes in the portfolios, almost like the pre-COVID and during-COVID period?
Harin: Yeah, this is probably the single biggest revision we’ve seen in our portfolios in the 30 years I’ve been at Analytic, so dramatic changes in the market. Dramatic changes in the risk profile of companies.
I tried to put the changes we’ve seen in historical context by going back to the early 1900’s and you’ve never seen this kind of rotation in terms of a company that’s been high-risk becoming low-risk and a company that’s being low-risk becoming high-risk. Because what’s happened is the ability of companies to respond to the stay-at-home factor was not priced into the way stocks are behaving.
So if you took a company like Disney, it was regarded as safe and you took a company like Netflix, it was regarded as very sensitive to the market. And what happened through this crisis was you realized that one of the companies, Netflix, had the ability to survive this and therefore, its beta—the systematic risk of the stock—fell dramatically.
And you’ve seen that happen to a great degree, even with certain parts of the tech sectors. If you look at semiconductors, as long as I can remember, the beta of the semiconductor industry has been greater than one, and now it’s close to one because everyone’s realized that these are companies that are going to survive this type of shock.
So huge turnover in the portfolios as we’ve migrated away from stocks that have more systematic risks to stocks that have less systematic risks. And huge turnover in also fundamentals, in the types of fundamentals that have been rewarded in the marketplace. So there’s been a lot of emphasis on return of assets as a factor as opposed to return on equity [ROE]. And the distinction between those two is subtle, except that ROE reflects leverage in a company and everyone’s been moving away from highly-leveraged companies.
So lots of opportunity in the market but also really, really high levels of turnover to exploit this really rapid change we’re seeing.
Brian: That’s really fascinating. Thanks for that detail. And Terry, let’s close with your thoughts on this. Any major changes in portfolios before coronavirus and now during the coronavirus crisis, and hopefully what’s emerging from it in the rocky road to recovery?
Terry: Yes, we’ve actually made changes in several areas: Credit quality and sector, security selection, and duration.
In the beginning of the year, credit spreads were extremely tight. We felt that investors were not being appropriately compensated for going down in credit quality. New purchases were primarily in the higher investment-grade categories.
During March, interest rates backed up and credit spreads widened. We began to see great opportunities in the secondary market as a primary market really shut down for months. We took the opportunity to add bonds in the airport, transportation, and hospital sectors at wider credit spreads. So compared to the beginning of the year, you will see a larger weighting toward the airport, transportation, and hospital sectors.
However, we are still very cautious regarding the high-yield and non-rated categories since we don’t believe some of the prices are truly reflective of the credit risk. The Federal Reserve has also signaled that it will continue to be accommodative, so we expect rates to be in this low range for the near to medium term, absent a significant unexpected event.
Lastly, most portfolios were slightly short the benchmark from a duration perspective. We’re now neutral to slightly long since we expect to be in this low rate environment for the medium term.
Brian: Wonderful insights, everyone. Thank you so much. Why don’t we stop here for today, and we’ll pick up the rest of our conversation in part two of this series? So Harin, Terry, and Bryant, thank you again for joining us today.
Harin: Always a pleasure. Thank you.
Terry: Thank you for having me.
Bryant: My pleasure.
Brian: And then for our listeners, you can find more of our perspectives about creating and managing resilient portfolios by visiting www.wellsfargoassetmanagement.com and navigating to the page called Confidence Starts with Portfolio Resilience. Until next time, I’m Brian Jacobsen; stay informed.