A less-than-august August?

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Words are interesting, especially when they leave a lot of room for interpretation. For example, on July 26, Mario Draghi, European Central Bank (ECB) president, said the ECB would support the euro. Market participants seemed to think that meant the ECB would step in to buy up government debt. What seemed to be missed, or de-emphasized, by investors was that he also said the ECB’s support would fall, “within its mandate.”

Similarly, in the most recent Federal Open Market Committee (FOMC) statement, the committee said it would “closely monitor” incoming information and act as needed. Some interpreted this to be a secret phrase that meant the FOMC would be willing to jump into the market—even, if necessary, between regularly scheduled meetings.

Perhaps investors should stop reading too much into such simple words. The ECB is legally constrained as to what it can do to intervene in the government bond market. The Fed is always on the lookout, but maybe in an election year it wants to make it clear that any policy move it makes will be driven by concerns about the economy, not the election. If investors come around to this way of thinking, August could prove to be a lot like the year so far: not bad, but not great. We’re OK with that.

> The economy
> Equities
> Bonds
> Asset allocation
> The bottom line

The economy

The first look at second-quarter real gross domestic product (GDP) paints an ugly picture of the economy. It’s still growing at 1.5%, but it’s slowed from the first quarter and doesn’t show signs of picking up speed. From 1990 to 2007, nonfarm payrolls grew by 1.4% per year on average, while GDP grew 3%. In the second quarter, payrolls only grew by 1.0% (note: that’s still positive payroll growth). (See Chart 1.)

The end of June marked the third anniversary of the recovery. The recovery has been led by spending on equipment and software (good for long-term growth) and exports (a sign of improved competitiveness). Increased inventories have also been a big contributor to growth, but that can only last for so long—eventually, that inventory needs to get sold.

When it comes to GDP and jobs, the relationship isn’t always clear-cut. While real GDP advanced 3% on average from 1990 to 2007, payrolls expanded by 1.4% on average during the same time period. Growth in payrolls was primarily driven by spending on nonresidential structures, equipment and software, and expanding state and local governments.

Chart 1: Contributions to GDP growth don’t point to rapid job gains

Source: Bureau of Economic Analysis and authors’ calculations

The political environment in the U.S. is doing nothing to help the jobs picture—or the economy overall. The Senate passes a bill that is all but dead on arrival in the U.S. House of Representatives, and then the U.S. House passes something that’s doomed to fail in the Senate. It’s a lot like how peacocks fan their tails to show off their plumage: an interesting spectacle, but one that doesn’t fix anything. It’s this lack of progress on the political front that will likely doom the economy to sluggish growth for the balance of the year.

Equities

Any recapitulation of the stock market’s performance in July 2012 must start with the last week of June. The S&P 500 Index jumped 2.5% on the last trading day of the second quarter on “news” that European leaders had reached an agreement to “deal” with the continent’s banking crisis. Most of this gain was given up within 10 days, as early second-quarter results raised fears of impending profit declines within the U.S. However, once earnings results took on a better tone, the market gains fell back (once more) as European bond spreads widened and fears of financial and sovereign problems resurfaced. Luckily, ECB President Draghi announced on July 26 that he had both the will and the ability to deal with the issues in Europe, which contributed to positive gains at the end of the quarter in the domestic equity market.

I did not make this stuff up. I could not have invented it, and no one would have believed me if I did. In the end, the S&P 500 Index gained 1.3% in July (the 15.6% day-to-day price change it traversed to do so will remain in parentheses) and is now up 9.7% for the year. The Dow Jones Industrial Average gained 1.0% in the month and 6.5% year to date. Both market measures are down slightly in the past three months.

Growth slightly outperformed value in July, as it has so far in 2012. The Russell 3000 Growth Index was up 1.0% and 10.3% for the month and year, respectively. Over the same period, the Russell 3000 Value Index gained only 0.8% and 8.1%, respectively. We continue to believe that investors’ need for dividend growth in the long term and the slowing of profit growth in the short term will continue to favor the outperformance of growth over the rest of this year.

Large-capitalization stocks significantly outperformed small-capitalization stocks in July. The Value Line Composite Indexes both declined in the period: the arithmetic by 0.8% and the geometric by 1.3%. For the year, they are up only 6.6% and 3.3%, respectively. We continue to favor the large-cap area. Large-cap companies, while more exposed to dollar strength than small caps, generally have a greater ability to maintain earnings and dividend growth in an environment of slowing sales growth than smaller, leaner companies. They also appear to have larger cash positions. Over the next six months, we believe these attributes will prove to be important.

Among the sectors, last month was dominated by two themes: yield and recovery. The best-performing sector in July was telecommunication services, with a 5.5% return. In the past year, this sector has risen almost 24%, as investors sought high current yield and an oblique play on the “smartphone” boom. While the area clearly has been a pleasant surprise, we remain neutral because of its competitive landscape and high relative valuation on metrics other than yield.

The second best performer was energy, a sector we favor. Energy rose 4.1% in July yet is still down 7.0% in the past year. While oil prices seem depressed to us after their recent tumble, the most recent impetus behind our recommendation is valuation. At its bottom last month, the sector’s forward price/earnings ratio (P/E) was at a 35% discount to the S&P 500 Index. In the past 12 years, a 35% to 40% discount has proven to be a good buying opportunity. Also outperforming last month was the consumer staples sector, with a 2.6% advance. We favor the sector’s large-cap names as a means to “play” the emerging middle class in the “emerging markets.” While we do not believe that this theme is entirely exhausted, we note that valuations in the emerging markets are no longer as attractive as they were a year ago.

Cyclical areas continued to lag. Materials dropped 1.3% in the month to cap a 7.4% decline in the past year. We are not believers in the imminent return of inflation and find little interest in that area. The consumer discretionary sector also posted a decline in July (down 0.3% but up 10.0% over the past year). While the “American consumer” is quite a robust individual, we do not believe that he or she will be the main driver in the current recovery. We are neutral on the area.

Finally, the financials sector, our largest underweight, was flat in July and down a scant 0.9% over the past year. Those numbers mask a strong 12.7% advance year to date. While we believe the sector is depressed, we do not find its P/E versus the market to be compelling. Moreover, even if current fundamentals were to stabilize and loan quality were to improve, we would still be wary of the effect on the industry’s potential profitability of pending or possible regulation.

Bonds

The investment-grade corporate bond market was the best-performing sector of the fixed- income markets in July, outpacing even high-yield corporates by a substantial margin. In a departure from previous months, the AA and A credits performed as well as the BBB issues. Throughout the first half, the highest-yielding sectors—high yield, BBB, and bank paper—performed best. While bank paper performed well in July, the industrials and utilities sectors performed somewhat better. Within high yield, returns from the CCC and weaker-quality grades were substantially less than returns from the BB and B credits. Ongoing turmoil in Europe kept investors somewhat more cautious in July, but the need for income continued to attract them to the corporate markets. The relatively poor performance of the equity markets in July prevented the weaker credits from performing as well as they did in June and in the first half of 2012.(See Table 1.)

The flight to safety occasioned by events in Europe helped all sectors of the Treasury market in July, while weak domestic economic indicators apparently prompted investors to buy longer-duration notes and bonds. Maturities of 10 years and longer rebounded strongly from negative returns in June. The longer-duration corporates also outperformed the short-to-intermediate corporates by substantial margins.

The municipal market has not seen a flight away from the weaker credits, despite well-publicized bankruptcy filings by several California cities. Returns from A and BBB sectors were once again better than those from AAA and AA sectors in July. Thus far in 2012, the A/BBB sectors have outperformed the AAA/AA sectors by 300 basis points (bps; 100 bps equals 1.00%). That has been the pattern for the past three years, thanks to the unusually wide quality spreads that emerged during the financial crisis and have persisted since then. Steep municipal yield curves continue to reward investors in the intermediate maturities. The seven- to 12-year index has outperformed the one- to three-year index by almost 700 bps thus far in 2012.

Table 1: Year-to-date bond market total returns in a period of unusually volatile global markets are remarkable (%)

Market	2010	2011	Q1 2012	Q2 2012	July	YTD
Broad market index	6.80	7.80	0.37	2.17	1.41	3.99
Corporate	9.52	7.51	2.44	2.37	2.81	7.81
Treasuries	5.88	9.79	-1.29	3.00	1.07	2.75
Agencies	4.61	5.27	-0.02	1.38	0.69	2.06
Mortgages	5.67	6.14	0.60	1.11	0.79	2.52
Asset-backed	5.02	1.43	0.76	0.70	0.35	1.83
High-yield	15.24	4.50	5.15	1.83	1.92	9.13
Municipal	2.25	11.19	2.08	1.98	1.61	5.77
2-year Treasury	2.28	1.45	-0.10	0.10	0.20	0.21
5-year Treasury	6.76	9.20	-0.52	1.94	0.76	2.17
10-year Treasury	7.90	17.15	-2.23	5.81	1.66	5.16
30-year Treasury	8.65	35.50	-7.57	12.60	4.06	8.30

Source: Bloomberg
Past performance is no guarantee of future results.

Year-to-date total returns of approximately 4% for the broad taxable market index and approximately 5.5% for the municipal market index are remarkable for a period in which the global markets have been unusually volatile and, by some measures, extremely risky. To many investors, that volatility has been an excuse to stay in cash. Cash equivalents, such as Treasury bills, have returned 0.05% year to date. For the past three years, the opportunity cost of holding large amounts of cash has been substantial, and that is likely to remain true over the next 12 months.

Asset allocation

Investment horizons

Equities

Value versus growth

Large caps versus small caps

Fixed income

Asset allocation summary table¹

Equity recommendations

Strategic		Tactical
Developed equities/emerging markets equities
Balanced, with 30% emerging and 70% developed. We prefer strategies that are bottom-up, especially those tracking the benchmarks, which tend to be dominated by Chinese financials.		Balanced, though we prefer a 20% allocation to emerging because we are concerned about the trajectory of the Chinese, Brazilian, and South Korean markets. With capital controls, we fear global investors could be disappointed.
U.S. equities/non-U.S. developed equities
Heavily overweight U.S. equities, which will likely grow faster than other developed countries. Europe and Japan are likely in for a tough journey, though Japan may surprise to the upside as it pursues its new monetary easing.		Heavily overweight U.S. but with selective European industrials and IT exposure. The U.S. will likely grow faster than other developed countries, but industrials appear to have attractive valuations in non-U.S. equities.
Value/growth
Heavily overweight growth, only because financials tend to dominate the value indexes and financials could underperform with the enhanced regulatory scrutiny they face. This could create significant uncertainty about the sector’s outlook. We also think investors will pay up for real growth, which could be hard to find.		Unbiased between value and growth, provided the value portion of a portfolio is not benchmarked to the financials sector. There are short-term opportunities in the traditionally “defensive” sectors like consumer staples and health care.
Large/small
Overweight large-cap stocks because they tend to have the dominant market share and cash to survive a volatile environment.		Large-cap stocks are attractive, but some large-cap companies may be tempted to overpay for acquiring small-cap companies.

Fixed-income recommendations

Strategic		Tactical
Intermediate-term, although we think yields could rise after June 2013, despite the Fed's statement that it projects conditions will warrant keeping rates exceptionally low until late 2014. We do need to remind investors that "exceptionally low" does not necessarily mean zero. Even 2% would be exceptionally low.		Intermediate-term, because rates won’t likely rise until the middle of June 2013, but abating fear could push Treasury yields higher. There seems to be a decent cushion in corporate and municipal spreads to withstand a move up in Treasury yields.
Credit risk exposure
High yield. Default rates appear to be low. We believe they will dip lower as the global economy slowly improves.		High yield. Clip coupons while you can, considering default rates are low and likely to remain low.
Fixed rate/floating rate
Fixed rate. Rates will likely rise, but when? Sitting on floating-rate notes for a year or so seems to be overly cautious to us. Floating-rate notes involve paying for insurance that is probably not needed.		Fixed rate. With floating-rate securities, investors are paying for a feature they probably don’t need. It’s unlikely that short-term rates will rise significantly, any time soon.

The bottom line

While developed market governments seem to be caught in a trap of indecision or inaction, emerging economies, such as Mexico, are going through important political changes that could be beneficial in the long term. Others—such as Argentina, which is adopting protectionist and nationalistic policies—are experiencing setbacks. There’s a lot of good and a lot of bad no matter where you look, so we think now is a good time to be working with the pros. It’s not a time to be investing blindly.

¹The asset allocation summary table is in no way intended to offer individualized advice about which investments to choose or how much to allocate to any particular investment option. The table is provided for illustration purposes only and does not predict or guarantee the performance of any Wells Fargo Advantage Fund. When applying an asset allocation strategy to your own situation, variables such as your investment objectives, time frame, income requirements and resources, inflation, and potential rates of return should be considered when you determine which investments will best suit your risk profile. Please consult a financial advisor for advice on your specific facts and circumstances.

The 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. You cannot invest directly in an index.

The Russell 3000^® Growth Index measures the performance of those Russell 3000^® Index companies with higher price-to-book ratios and higher forecasted growth values. The stocks in this index are also members of either the Russell 1000^® Growth Index or the Russell 2000^® Growth Index. You cannot invest directly in an index.

The Russell 3000^® Value Index measures the performance of those Russell 3000 Index companies with lower price-to-book ratios and lower forecasted growth values. The stocks in this index are also members of either the Russell 1000^® Value Index or the Russell 2000^® Value Index. You cannot invest directly in an index.

The Value Line Composite Index is an equal-weighted stock index that contains 1,700 companies from the NYSE, American Stock Exchange, Nasdaq, and over-the-counter market. You cannot invest directly in an index.

The Dow Jones Industrial Average is a price-weighted index of 30 "blue-chip" industrial U.S. stocks. You cannot invest directly in an index.

The views expressed are as of 8-7-12 and are those of Chief Portfolio Strategist Brian Jacobsen, Chief Equity Strategist John Manley, Chief Fixed-Income Strategist James Kochan, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the authors and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.