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Market Risks That May Lie Ahead In 2021

By Laurie KingJohn Hockers And Brandon Brouillard

Today’s podcast features an update about risks that investors may face in 2021. With us to discuss the implications is John Hockers, CFA®, PRM, Co-Head of Investment Analytics at Wells Fargo Asset Management (WFAM).

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Laurie King: I’m Laurie King and you are listening to On the Trading Desk®.

Today we’ll be talking about risks that investors may face in 2021. With me today to discuss is John Hockers, Co-Head of Investment Analytics here at Wells Fargo Asset Management. And since we’re recording just days after President Biden’s inauguration, I hope we’ll have time to revisit the risk outlook your team developed for the Democratic sweep. Our listeners may remember that we discussed that scenario in detail just prior to the November elections last year. Welcome back to the program, John.

John Hockers: Thank you for having me, Laurie.

Laurie: I’d also like to welcome my colleague Brandon Brouillard, who will be joining me as co-host of On the Trading Desk. Brandon joins us from Menomonee Falls, Wisconsin and is a 12-year veteran of Wells Fargo Asset Management. Brandon, welcome to On the Trading Desk.

Brandon Brouillard: Yeah, thanks, Laurie. I’m really happy to be a part of the On the Trading Desk team.

Laurie: Well, let’s begin today with a question for you, John. You head up the independent investment risk group here at Wells Fargo Asset Management and this group works closely with the firm’s portfolio management teams. Can you tell us how you determine the risks that we’ll talk about? And do you always look for non-consensus, market-related risks?

John: At Wells Fargo Asset Management, we think it’s important to understand all of the risks within our portfolios, both intended and unintended. One of the best ways to uncover unintended risks is to brainstorm events that could derail markets and then use our analytics and risk reports to uncover which portfolios would be impacted the most by those exogenous events. We collectively refer to that list of hypotheticals as our “Market Risk Monitor” list.

The “how” part is actually quite fun. We ask all of our analysts to brainstorm ideas that have some level of uncertainty, usually items with a probability of occurring below 50%. We then debate the ideas in monthly meetings and assign different analysts on the team to be experts on specific topics.

When published, the Market Risk Monitor lists market risks in one of three categories: significant market concerns, emerging risks, and long-term market risks.

We define significant market risks as items that have a reasonable probability of moving markets, in either a positive or negative fashion, over the next 12 months.

Emerging risks are typically risks that are not at the top-of-mind of most investors but could surprise the market at some point over the next year.

And long-term market risks are items that probably won’t move markets in the next year, but could be really significant for an investor looking at a 5- or 10-year time horizon.

Laurie: Well, thanks for explaining that. So what are the biggest changes you’ve seen in potential risks over the past month or so?

John: As you mentioned, we monitored risks preceding the U.S. elections in November. Our main concern was a strong “blue wave” that could usher in higher taxes on capital gains and corporate earnings.

With the election results in for Georgia’s two Senate races, we now know that the Dems will control the Oval Office, the House, and the Senate, but the blue wave that investors were fearing in early November ultimately turned into a “blue ripple” that will make significant tax reform very challenging.

The other big change from our list occurred across the pond in the United Kingdom. Negotiators for the U.K. and the EU finally reached a deal on what Brexit actually means for U.K. citizens. That deal reduced fears of chaos in the region and helped overt a potential sell-off in the British pound.

Laurie: So what did you mean by blue ripple versus blue wave? Because I thought that Democrats had the presidency, the House, and now the Senate with the vice president having the tie vote.

John: Sure. I think a lot of people thought that there be a blue wave, meaning that the numbers in the Senate that the Democrats would win would be know quite a bit higher, 55 seats, 56 seats. They would have a pretty substantial majority in the House and, of course, they’d win the presidency.

So what I meant by a blue ripple is that the Democrats only won 50 seats in the Senate, which means that’s a 50-50 tie and that the tie-breaking vote is enacted by the new vice president, Kamala Harris. So really it’s more of a blue ripple in that it’s not going to be a way that’s going to be able overcome a lot of opposition. Even one Democrat senator can really derail the process.

Laurie: Okay. Well, thanks for explaining that. As you look forward, what are some significant risks that you are watching now?

John: Our number one risk right now for the markets is the extreme valuation levels for securities related to the work-from-home environment that so many of us find ourselves in today. Cloud computing and SaaS, or software as a service, names have experienced incredible revenue growth as technology became an essential service for hundreds of millions of people.

The other dynamic in markets is that growth is hard to find right now as many traditional companies are either treading water or struggling to stay solvent during the pandemic.

Once a COVID vaccine is broadly distributed and all sectors of the economy are growing again, there is a significant risk that investors will rotate out of the technology winners of 2020.

Laurie: And another risk?

John: Now that we have a Brexit deal between the U.K. and the EU, we’re watching how Scotland and Northern Ireland accept the deal.

A few years back, Scotland pursued a referendum on whether they should stay in the United Kingdom. The measure failed with only around 45% support, but more recent polls show that Scots are more likely to vote for a separation from England now. We think there is a very real possibility that Scotland and maybe Northern Ireland could leave the “kingdom” in the next 12 to 24 months in favor of membership in the EU. A break-up of the United Kingdom could be extremely negative for the British pound and would leave England and Wales even more isolated from the rest of Europe.

Brandon: Well, thanks for that, John. And I’d like to shift gears slightly now toward emerging risks that you’re tracking. Is unexpected inflation a risk that investors need to worry about?

John: Great question, Brandon. A number of economists are currently expecting tame inflation and a very dovish Fed for the years to come. Based on their outlooks, short-term rates in the U.S. may stay near zero until 2025. But an unexpected spike in inflation could change that sentiment and derail both equity and fixed income markets.

What might cause that spike in inflation? Well, how about a durable COVID vaccine that eradicates the virus by summer time? I don’t know about you, but I’m tired of eating the same take-out, vacationing in my basement, and talking to people over Zoom. The experiences that everyone was loving pre-COVID could come roaring back later this year. If they do, I suspect lines for restaurants, bars, movies, and Disney World will be quite long. Long lines usually give businesses pricing power, and pricing power can certainly turn into inflation. Low mortgage rates have already created upward pressure on home prices in the suburbs.

Brandon: Yeah, that’s interesting. And another emerging risk that I’ve heard you talk about concerns Russia. Can you tell us more on that?

John: The Obama administration instituted a series of technology and investment sanctions on Russian companies in response to Russian actions in the Ukraine. With the recent SolarWinds cyberattack, which has been attributed to Russian intelligence operations, the Biden administration may follow suit and enact expanded sanctions that seek to deprive Russian companies from western capital investments. While the global impact of such actions would be low, it could create some anxiety for investors in the emerging market space.

Brandon: And that’s fantastic information and insight, and staying with the topic of emerging risks abroad, how does your team evaluate the risks of repealing policy instituted under the prior administration? We know that China has been in the cross hairs of U.S. politics over the last few years, so what happens now?

John: Correct. For the last four years, the Trump administration has been focused on sanctions against companies affiliated with the Chinese military. The most severe sanctions, enacted through an Executive Order last November, banned U.S. persons from buying blacklisted Chinese names after a certain date and, more significantly, require U.S. persons to divest from those names within a year of their inclusion on the sanctions list.

While it’s unlikely that the Biden administration will immediately move to undo this Order, they could hit the pause bottom and signal to the Chinese government that they are willing to ease up on the sanctions in exchange for assistance elsewhere. The same thing could be said for the tariffs that still remain on Chinese goods being sold into the U.S.

Laurie: Well, I would like to ask now about long-term risks. I’ve been working with the Global Fixed-Income team here at WFAM on a paper about how to position for dollar weakness. You also see dollar weakness as a long-term risk. So why is that and what will it mean for investors?

John: Our dollar weakness market concern is focused on the long-term budget deficits that the U.S. government is ringing up to fight COVID.

The fiscal-year 2020 federal budget deficit came in at $3.1 trillion, more than triple the shortfall recorded in 2019. These types of massive deficits and the borrowing that comes with it are not sustainable in the long run. At some point, foreign bond vigilantes could come back into the market, selling their U.S. Treasury positions in protest. That could lead to increased yields in the U.S. and weakness in the value of the U.S. dollar.

The best defense that investors have against a weak dollar is a well-diversified global portfolio that includes investments in both developed and emerging market equities and bonds. Emerging market securities tend to perform quite well when the dollar is weak because they are priced in the foreign currencies that are rising in value and because many of their economies are leveraged to the price of basic materials like oil and copper that tend to also rally with a weak dollar.

Laurie: Well, we only have a minute or so left and I wondered if you could share a parting thought with our listeners?

John: You know, former heavyweight boxing champ Mike Tyson’s most famous quote is that “everyone has a plan until they get punched in the mouth.” COVID-19 surprised nearly everyone last year. While it’s important to hypothesize about unexpected risks that could impact various market segments, no one can really ever anticipate all of them. Because of that, it’s important to have an investment plan that you can stick with, even if someone like Mike Tyson punches you in the face. Wells Fargo Asset Management has a number of great products that can be key building blocks in such a plan.

Laurie: Brandon and I appreciate you talking with us today and sharing your insights, John.

John: Thank you, Laurie, and thank you, Brandon.

Brandon: Thanks again.

Laurie: Well, that wraps up this episode of On the Trading Desk. If you’d like to read more market insights and investment perspectives from the investment teams at Wells Fargo Asset Management, you can find them at our AdvantageVoice® blog, as well as by visiting http://on.wf.com/6127HbfzJ.

To stay connected to On the Trading Desk and listen to past and future episodes of the program, you can subscribe to the podcast on iTunes, Stitcher, Overcast, or Google Podcasts. Until next time, I’m Laurie King; take care.

Originally Posted on January 27, 2021 – Market Risks That May Lie Ahead In 2021

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