Portfolio Manager Commentary

Overview, strategy, and outlook: As of February 28, 2014

Credit update

The Consumer Analyst Group of New York (CAGNY) held its 50th-annual conference February 17–21, where some of the most well-known consumer goods and food/beverage brands and leaders presented. While each presenting company was unique in its prognosis of and approach to the current environment, a few general themes emerged.

Operating margin growth

The first area of focus was on growing overall operating margin, particularly through productivity initiatives. Currency volatility and a general consensus that global economic conditions will continue to be weak were identified as headwinds going into 2014. Several presenters focused on the necessity of growing operating margin to serve as a buffer to these headwinds as well as fund business reinvestment. Product innovations and brand extensions were noted as a means for margin gain, but the focus for many speakers was on driving increased productivity. In the past, these productivity announcements typically carried specific dollar and time targets; this year it was generally broader, with productivity becoming a longer-term operating objective within the corporate culture. However, some focused on specific initiatives designed to increase productivity, such as redesigning supply chains through major market manufacturing consolidation, making technology investments, and increasing localization of developing market manufacturing and distribution.

Emerging markets

Although growth in emerging markets is expected to continue to slow, emerging markets remain the drivers of growth relative to developed markets. In these markets, margins are generally lower than those in the developed world because companies compete to establish their core brands and develop an efficient supply chain. Therefore, growing market share is the primary objective, with the hope that increased scale will support margin gains along with volume growth. Significant investments are being made to localize marketing and supply chain resources.

Financial flexibility and returns

Company balance sheets are in good shape relative to precrisis levels. However, higher cash and cash flow in a low-growth environment naturally invites calls for increased capital to be returned to shareholders in the form of dividends and share repurchases. Furthermore, several companies noted that they had capacity to add debt without threatening their current ratings. Together, as we have already seen at a few large industrial companies this year, this combination is likely to yield increased debt-funded shareholder-friendly actions during 2014. Acquisition opportunities were also noted but generally will be limited to smaller acquisitions that further specific strategic goals and enhance value.

Increased and smarter marketing

And finally, the drive to support core brands in gaining share while reducing costs to grow operating margin are competing forces affecting marketing budgets. Many companies highlighted the increased focus on using customer insights to better target marketing efforts, particularly pulling back from traditional media sources in favor of digital media. Companies have found digital media to carry a much higher return on investment, allowing them to manage costs while remaining competitive.

Rates for sample investment instruments
Current month-end % (February 2014)

Sector 1 day 1 week 1 month 2 month 3 month 6 month 12 month
U.S. Treasury repurchase agreements (repos) 0.05 0.05 0.04 0.05
U.S. Treasury bills 0.04 0.04 0.06 0.10
Agency discount notes 0.02 0.02 0.02 0.02 0.03 0.05 0.10
LIBOR 0.09 0.12 0.16 0.20 0.24 0.33 0.55
Asset-backed commercial paper—First Tier 0.13 0.14 0.16 0.18 0.21
Dealer commercial paper—First Tier 0.10 0.11 0.16 0.17 0.20 0.28
Municipals—First Tier 0.03 0.03 0.06 0.07 0.09 0.12 0.15

Sources: Bloomberg L.P., Wells Capital Management
Past performance is no guarantee of future results.

Government sector update

Years of quantitative easing and the attendant expansion of the Federal Reserve’s (Fed’s) balance sheet, coupled with myriad regulatory changes that have sparked demand for high-quality assets while driving supply lower, have gradually reshaped the U.S. government money markets. There now appears to be a wall of cash that seems sufficient to block any moves higher in yield that one might have expected, absent these influences. Activity to date in 2014 has tested the resilience of the wall several times.

The repurchase agreement (repo) market has usually responded to increases in collateral supply by moving yields higher, but that effect has recently been largely absent. Previously, yields increased as dealers digested the mid- and end-of-month Treasury auctions, with repo rates moving roughly 1 basis point (bp; 100 bps equals 1.00%) higher for each $10 billion of new collateral. While this may have resulted in somewhat more volatility, it typically subsided after a few days. What had formerly been a multiday pop of 5 bps or 6 bps has become a one-day speed bump of perhaps 1 bp or 2 bps in 2014.

This phenomenon has also occurred over longer seasonal periods and never more reliably than in the first quarter each year when the U.S. Treasury ramps up its Treasury bill (T-bill) supply in order to pay tax refunds, then shrinks issuance just as rapidly when it receives large tax payments in mid-April. The extra T-bills that usually lead to elevated repo yields during February and March ran into the wall of cash in February 2014, and yields barely budged. The very modest uptick in repo levels that has occurred is more likely a result of the Fed increasing the rate on its reverse repo (RRP) facility from 3 bps to 5 bps during the last half of the month. The difference between the market’s responses to first-quarter supply in 2013 and 2014 is clear in the chart below.

Treasury bills outstanding and repo rates

Chart: Treasury bills outstanding and repo rates

Sources: Bloomberg L.P., U.S. Treasury, Wells Capital Management
Past performance is no guarantee of future results.

Also apparent in the chart is the degree to which repo levels are clinging to the Fed’s RRP facility rate. It seems like a dream environment for the Fed—the RRP facility rate is setting a floor, albeit a slightly porous one, while the wall of cash is setting a ceiling, conveniently at just about the same rate as the floor. Now that’s optimal control! Based on only a few months of experience in 2014, and with the Fed RRP facility still officially in test mode, it’s perhaps too early to reach the conclusion that the government money markets have permanently changed. However, it’s easy to imagine this becoming the norm, as the Fed’s great big balance sheet isn’t shrinking anytime soon.

Rate reactions on other products in the government space have been similarly muted, with T-bill and agency discount note yields hovering in the same ranges as during the light supply period preceding the auctions. These products could experience pressure for higher rates at the very short end of their issuance curve when T-bill supply normalizes at the end of the tax season because investors may move further out the curve to capture any incremental yield over the Fed’s RRP rate.

Prime sector update

As is typically the case at year-end, the amount of commercial paper (CP) outstanding fell as issuers’ short-term borrowing needs decreased. However, the amount of CP outstanding has picked up again during the first two months of 2014 in a fairly broad-based way, with most sectors experiencing an increase. Both financial and nonfinancial CP outstanding are up 16% and 27%, respectively, which is a little more unusual, as nonfinancial paper historically has not shown such a large increase. It appears that corporate issuers may be taking advantage of extremely low rates by increasing their borrowing in the CP market. The only sector to experience a decline in the amount outstanding was asset-backed commercial paper, which has been steadily declining since 2007 and is now less than $250 billion total outstanding.

U.S. commercial paper outstandings
(not seasonally adjusted)

Chart: U.S. commercial paper

Source: Federal Reserve
Past performance is no guarantee of future results.

As investors, we tend to expect an increase in supply to lead to higher rates, but despite the increase in supply and an overall decline in prime institutional money market fund assets, the total demand for term paper has kept a lid on rates.

Persistently low repo and bank deposit rates have induced investors to purchase somewhat longer securities in order to capture the incremental yield offered by a slightly positive yield curve. As a result, with the Fed effectively setting a floor on overnight rates and absent a material credit event, money market yield curves should continue to flatten until the Fed decides the time has come to officially raise its target rate. LIBOR (London Interbank Offered Rate) rates have decreased by 1–2 bps across the curve since the beginning of the year, as have CP yields. The A-1+/P-1 dealer-placed CP scale in six months declined from 0.19% at the end of December to 0.17% today. High-quality names are easily able to sell six-month term paper in this environment, and we would not look for that to change near term.

LIBOR yield curve

Chart: LIBOR yield curve

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

Municipal sector update

Demand for investments has remained consistently strong during the first two months of the year. Municipal money market funds have been flush with cash due to seasonally heavy inflows, the result of elevated levels of bond interest payments and maturities. The combination of steady asset levels and sluggish supply has resulted in depressed levels on high-grade paper throughout the municipal money market space. This supply/demand dynamic is particularly acute in the short end of the curve, where the demand for daily and weekly variable-rate demand notes (VRDNs) and tender option bonds (TOBs) has remained exceptionally strong. The Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index1 has languished in the 0.03% to 0.04% range through the first two months of the year based primarily on steady demand from traditional buyers. Further out on the curve, rates on high-grade municipal CP and notes have also continued to compress. Yields on CP in the 30- to 90-day range have sunk to the single digits, while the one-year high-grade benchmark yields fell to 0.15% at the end of February from 0.17% at the end of 2013.

1-week U.S. Treasury repo vs. 7-day SIFMA

Chart: 1-week U.S. Treasury repo vs. 7-day SIFMA

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

With tax-exempt yields trapped in the low single digits, VRDNs and TOBs have lost some of their relative appeal to nontraditional investors as their yields have converged with those available on comparable taxable alternatives. However, with forecasted supply levels expected to remain moribund, it is reasonable to expect that demand from traditional municipal buyers will remain strong enough to constrain rates on tax-exempt floaters in the near future.

Since the beginning of the year, municipal markets issuance has recently been weak due to a combination of factors. For the municipal money market space, in particular, issuance of seasonal cash-flow notes is expected to continue to contract as municipal finances slowly continue their recovery and cash-flow borrowing needs continue to diminish. While this leaves us with a lower overall level of supply, improving credit conditions have given us the opportunity to lengthen our time horizons and broaden our investment portfolios, with little added risk.

 

View current money market fund performance.
View a list of complete holdings for the money market funds.

1. The SIFMA Municipal Swap Index, produced by Municipal Market Data (MMD), is a seven-day high-grade market index composed of tax-exempt variable-rate demand obligations from MMD’s extensive database. You cannot invest directly in an index.

Foreign investments are especially volatile and can rise or fall dramatically due to differences in the political and economic conditions of the host country. These risks are generally intensified in emerging markets.

A portion of the municipal money market fund’s income may be subject to federal, state, and/or local income taxes or the Alternative Minimum Tax (AMT). Any capital gains distributions may be taxable. For the government money market funds, the U.S. government guarantee applies to certain underlying securities and not to shares of the fund.

The views expressed and any forward-looking statements are as of 2-28-14 and are those of the fund managers and the Money Market team at Wells Capital Management, subadvisor to the Wells Fargo Advantage Money Market Funds, and Wells Fargo Funds Management, LLC. Discussions of individual securities, or the markets generally, or any Wells Fargo Advantage Fund are not intended as individual recommendations. Future events or results may vary significantly from those expressed in any forward-looking statements; the views expressed are subject to change at any time in response to changing circumstances in the market. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.