Investing in a New Normal - Wells Fargo Advisors Advice & Research 2021 Equity Sector Outlook
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2021 Equity Sector Outlook: Investing in a New Normal Wells Fargo Advisors Advice & Research December 2020
Overview Even when one believes they know how the chess board is set, an exogenous variable like a pandemic can emerge and flip the board over. As we prepare to turn the page on what has certainly been an interesting (we could have chosen many different adjectives) year in many ways for both investors and society as a whole, it is worth exploring some of the key items we are watching into 2021. Let’s start with what we do know. Aggressive monetary easing and a thirst for yield and returns have kept capital markets active. Generous fiscal support and rapid adaptation to the pandemic have resulted in a relatively short-lived hit to corporate earnings. It should not go unnoticed that the changing nature of the economy and composition of U.S. equity markets toward tech-based platforms and services that was already occurring prior to COVID-19 has been a key factor in the relative durability of earnings at the index level. Meanwhile, debt has expanded further in most areas of the global economy. Many sectors and businesses that were secularly challenged prior to the outbreak of COVID-19 have seen the stress on their balance sheets grow. For others, the pandemic has proven to be a uniquely acute strain on activity simply due to the nature of how they operate. Rising government involvement and increasing investor focus on non-financial factors (i.e., environmental, social, and governance) has driven increasingly intense discussions on the future of certain businesses. On the other hand, some sub-industries (we’re looking at you, packaged food) have actually benefitted from changing consumption patterns. The question we ask ourselves is how permanent are these changes to consumer behavior? Are they structural in nature, or will consumers generally resort back to how we lived our lives prior to the pandemic? We would anticipate this “New Normal” to remain in place at least for the first half of 2021. Further, some of the same macro factors mentioned above will likely remain in place depending on when fears of the global pandemic subside. Through all of this, certain things have remained truisms. The U.S. is still a consumer-driven economy, American corporates (as a whole) have been quite efficient at managing through various economic environments, and global monetary authorities have been accommodative when necessary. It is also worth noting that the pandemic accelerated growth in mega-trends we have been following for quite some time: namely cloud computing, e-commerce, personal connectivity, and streaming entertainment. Hence while the strong gains for equities from their March lows may seem remarkable, given this context, investors should not be overly surprised. Turning to the unknowns. As we write this, we do not know the outcome on several key variables including potential policy changes post elections, additional U.S. fiscal stimulus negotiations, the forward path of COVID-19 infections and the related economic impact, and the outcome of vaccine trials. It does appear likely that we will see divided government in the U.S. with yet to be determined outcomes on near and medium term fiscal, tax, and regulatory policy. We have also seen encouraging, albeit early, data, on the vaccine front, even as the number of coronavirus infections reaches new heights. We continue to monitor these factors as key determinants for the pace of recovery in corporate earnings. Investment and Insurance Products: u NOT FDIC Insured u NO Bank Guarantee u MAY Lose Value 2
3
4
Comments on specific equity sectors
How would we invest with this as a backdrop? We may Turning to cyclicals, within which we would generally
sound like a broken record, but we would stick with quality. include Consumer Discretionary, Energy, Financials,
The impacts of COVID-19 (both the good and the bad) on Industrials, and Materials. We continue to preach selectivity
many businesses are likely to sustain for quite some time. in these areas. Many have called 2020 the year of ‘haves
At a macro level, consensus forecasts for persistently weak and have-nots’, and this is abundantly clear in how changing
growth and inflation are likely to continue to favor consumer spending patterns have impacted Consumer
businesses that can ‘make their own luck’. It is important to Discretionary. We continue to favor internet retail, home
note that this is not a pure growth vs. value distinction. We improvement, and general merchandise—all of which have
wrote in our 2020 Midyear Outlook that we believed benefitted from increased traffic and proven adept at
COVID-19 had likely resulted in even wider moats for growing their share of wallet during an uncertain time.
mega-cap tech companies and accelerated growth Within the last four sectors noted above, we have generally
opportunities for certain areas of the economy that were recommended investors remain ‘up in quality’ and by that
already quite ‘growthy’. We believe this remains true, we mean concentrating heavily on balance sheet capacity
although one could argue that valuations are increasingly and cash flow generation. A selection of our favored sub-
reflective of these fundamentals. In the same piece, we industries would include the integrated oil companies,
argued for allocating capital selectively toward cyclicals universal banks, railroads, and industrial gases. These
with favorable industry dynamics. We would again repeat sub-industries can be generally characterized as having
the broad outlines of this advice. multiple revenue streams (i.e. sensitivity to various areas of
the economy), favorable industry structure (high levels of
On the growth side of the ledger, our various thematic lists consolidation), and disciplined capital allocation (at least
include several of the ‘mega-cap’ tech-oriented companies relative to the sectors in which they fall). We would still
(recall that the five largest companies by market advise against being overly aggressive in these areas.
capitalization in the S&P 500 actually fall across
Information Technology, Communication Services, and Last but not least, we look at the defensive sectors of
Consumer Discretionary). Each has its own nuances, but Consumer Staples, Real Estate, and Utilities. We continue to
generally speaking, this class of companies has significant favor beverages and household products due to the highly
net cash positions, free cash flow (net cash from operations consolidated nature of these end markets. Within Real
less capital expenditures) margins well in excess of the S&P Estate, two favorable sub-industries of note (industrial and
500 average, and the potential for numerous organic cell towers) continue to benefit from secular growth trends
growth opportunities in fields including personal (e-commerce and data consumption respectively), while
connectivity, cloud computing, e-commerce, social our less favorable sub-industry (hotels/lodging) has seen a
networking, and streaming media. If we broaden the lens material negative impact from the pandemic. On the
and move up to a sector level in Information Technology, Utilities side, we would note the further growth of
Communication Services, and Health Care, we believe there renewables as a potential opportunity for electric utilities
are numerous high quality franchises in cutting-edge in particular.
semiconductor suppliers, enterprise software, interactive
media and services, and life sciences and medical devices.
Our favored sub-industries in these sectors remain largely
unchanged entering 2021 as most of the secular growth
‘winners’ of the last several years that have benefitted from
digital transformation and scientific advances have actually
seen net positives from the current environment.
5Communication Services
Sector drivers/themes
A handful of themes have been developing within the Communication Services
sector, including increased cord-cutting, a shift away from traditional cable television
subscriptions, heightened streaming video consumption, potential antitrust threats
on big technology companies, evolution of the fifth generation (5G) wireless network,
and transformation of the gaming industry, among others. In our view, the pandemic
has fast-tracked this digital transformation, including the acceleration of widespread,
Thomas Christopher
and potentially structural, changes to consumer habits around video and data
Equity Sector Analyst
consumption. Rather than being tied down to contracts, expensive equipment,
or schedules, consumers prefer to view content whenever and wherever they want—
typically through over-the-top (OTT) subscriptions on mobile devices. This ongoing
development may disrupt company business models within the sector, feeling the
need to adapt to reach the ever-changing end-user.
U.S. cable subscribers start to fall after peaking in 2012
105 3%
After peaking in 2012, the
Multichannel Subscribers (Millions)
100 2%
Multichannel Subscriber Growth
number of U.S. cable
subscribers has declined
95 1% annually. Nearly one-third
of U.S. households do not
have a traditional pay-tv
90 0% subscription. In fact, the
number of broadband-only
85 -1% homes continues to grow,
necessitated by the need
for increased bandwidth
80 -2%
on home networks.
'04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 '19 '20E '21E '22E
Multichannel Subscriber (Left Axis) Multichannel Subscriber Growth (Right Axis)
Source: Historical and estimated data from S&P Global Market Intelligence LLC, Wells Fargo Advisors. Estimated years are denoted with “E”.
Where to invest in 2021
For income investors, we continue to favor the telecommunication services industry group,
as these firms have offered attractive and generally stable dividends. Conversely, we believe
growth investors should focus on the interactive media & services and entertainment
industries, characterized by companies growing earnings at a faster pace than the broader
market. Further, the pandemic will likely continue weighing on the advertising and
broadcasting industries into at least the first part of 2021, but headwinds may dissipate as
we progress through the year.
6Despite the pandemic, the rollout of the 5G wireless network should remain a high Favorable
priority. We believe carriers will continue investing large amounts of capital to enhance • Integrated Telecom Services
the current infrastructure. In our view, government-sponsored auctions should help
• Interactive Home
the carriers acquire spectrum, filling gaps to densify and expand the network. Carriers
Entertainment
should also benefit from handset upgrades to new models with advanced 5G capabilities.
• Interactive Media and
Although promotional activity may dictate profitability, upgrades to higher-margin
Services
wireless plans may offset the reduction.
• Movies and Entertainment
The pandemic has influenced the shift toward streaming driven by the large number of
people working, playing and learning from home. Cord cutting is gaining momentum as
consumers reduce non-essential spending, including traditional cable subscriptions. Neutral
Streaming options have become more appealing, given the flexibility, convenience, and • Advertising
growing amount of free content. We prefer companies with strong distribution channels, • Broadcasting
offering a diverse library of original and legacy content. Additionally, many households
• Cable and Satellite
have upgraded their home broadband connections, or gone “broadband only”, to support
the heightened at-home usage—a trend that will likely accelerate. • Wireless Telecom Services
The gaming industry has experienced significant growth during the pandemic, driven by
Unfavorable
increased player engagement, in-game spending, and a shift toward digital downloads. The
release of new gaming consoles should also act as a tailwind for the industry. Companies • Alternative Carriers
with valuable gaming titles, engaged user base and exposure to e-sports should help expand • Publishing
the addressable market.
Valuation
The Communication Services sector currently trades at 22.7x, the next twelve months (NTM)
consensus earnings per share (EPS) estimate of $9.41; a premium to the sector’s average
5-year historical valuation of 15.7x. Relative to the S&P 500, the Communication Services
sector is trading at 1.0x times relative to its historical level of 0.9x. Historical valuations are
skewed and not directly comparable due to the fact that only the Telecommunications
industry is accounted for prior to September 21, 2018.
Risks
The way people communicate and consume data is continuously evolving, which could
lead to disruption among incumbent business models. Within the telecom, interactive
media, and cable industries, cord cutting is weighing on traditional TV services and affecting
how media firms approach customers. Telecom companies are subject to extensive
regulation, and an adverse regulatory environment could possibly hinder innovation while
adding heightened levels of uncertainty and risk.
7Consumer Discretionary
Sector drivers/themes
The 2021 outlook for consumer spending is quite a bit murkier than in previous years given
the uncertainty, longevity, and depth the COVID-19 pandemic will take during winter
months. No matter the situation, we see one of the most lasting impacts of this pandemic
being an accelerated consolidation of retail space—ranging from store closures to complete
liquidations – leaving the healthiest retailers positioned for improving long-term returns.
On the contrary, while physical retail will likely take the brunt of the carnage, we expect
Brian Postol
e-commerce to come out the biggest winner. The longer this pandemic goes, the deeper
Equity Sector Analyst
e-commerce will likely penetrate into everyday lives of consumers. Whether a consumer
was a seasoned or novice online shopper prior to this period, this pandemic has proven the
growing importance that online shopping can portray within consumers daily lives. We see
companies delivering the best customer service—quickest in-home delivery, curbside
pickup, pay-online/pick-up at store, etc.—distancing themselves from competition.
Global Crisis and the impact on U.S. retail sales
120
The previous two crises—9/11
Retail sales indexed to 100 at peak
110 and Global Financial Crisis—
saw an immediate contraction
100 within consumer spending,
similar to that shown in the
current COVID-19 crisis. The
90 initial stimulus program
resulted in a quick rebound in
80 retail sales, but risks of
another COVID-19 induced
Months before retail sales peak Months after retail sales peak slowdown could slow this
70
recovery absent another round
-24 -18 -12 -6 0 +6 +12 +18 +24 +30 +36 +42 +48
of economic stimulus.
Months
9/11 Great Financial Crisis COVID-19
Source: U.S. Census Bureau, FactSet, Wells Fargo Advisors. Monthly retail sales (total U.S. dollars) peaked on the following dates: 9/11 (10/31/2001),
Great Financial Crisis (11/30/2007), and COVID-19 (1/31/2020). Data through 9/30/2020.
Where to invest in 2021
The coronavirus pandemic is proving to be not only a public health crisis but also an
economic one. To-date, the pandemic has had a widespread negative impact on business
activity with the greatest impact falling on service-oriented industries such as retail,
restaurants, hotels, and child-care services. While some of these industries are adapting to
the new economic reality for survival—restaurants moving to take-out orders and
8contactless delivery, retail offering more home-delivery or curbside pickup—many others, Favorable
including entertainment-related businesses such as sports arenas and movie theaters, are • Automotive Retail
presently closed, either voluntarily or due to government mandates. The resulting end to
• General Merchandise Stores
these means is new habits are being formed and as these habits become new norms, this
will most likely result in increased risk to service jobs—jobs that won’t be needed at levels • Home Improvement Retail
experienced pre-COVID-19. • Internet Retail
A short-term offset to these job losses could be any, and all, forms of stimulus. The first
round of stimulus payments resulted in a benefit to consumer pocketbooks resulting in a Neutral
quick rebound in retail sales. Now that those funds have been exhausted, and with • Apparel, Accessories, and
heightened risks of additional layoffs/furloughs, another round of stimulus would likely be a Luxury Goods
welcome sign for spending. Even with another round of economic stimulus, the reality is • Apparel Retail
that the current pandemic is having both a financial—job/income lost with the fear of
• Footwear
long-term instability across business acumens—and psychological—comfort of being
around others with the fear of contracting the disease—impact on consumer psyche. • Restaurants
In light of the uncertainty, magnitude, duration and lingering effects of the COVID-19 crisis,
we continue with our defensive posture within the Consumer Discretionary sector. As such, Unfavorable
we view discounters, mass-merchants and off-price retailers as our favored Consumer • Automotive Manufacturers
Discretionary sub-industries for calendar year 2021. In addition, we believe online retailers • Casinos and Gaming
will benefit disproportionately near-term as consumers will want to limit the amount of
• Department Stores
person-to-person contact until a proven vaccine becomes available.
• Hotels, Resorts, and
Cruise Lines
Valuation • Leisure Products
The Consumer Discretionary sector currently trades at 33.4x the NTM consensus estimate • Motorcycle Manufacturers
of $38.14. The current price-to-earnings (P/E) ratio is above the five-year historical
valuation of 23.2x. Relative to the S&P 500, the Consumer Discretionary sector is trading
at 1.5x, above historical levels of 1.3x. Historical valuations are skewed by the fact that the
Media and Digital Streaming & Internet Services industries left the Consumer Discretionary
sector and moved into the Communication Services sector as of September 21, 2018.
Risks
A strong job market generally provides consumers more financial comfort and increased
disposable income. Yet, rising wages can bring both headwinds and tailwinds. On one hand,
higher wages are positive tailwinds for consumer spending. However, sub-industries with a
high labor component (Restaurants, Hotels/Resorts/Cruises, and Retail) will likely receive
less incremental benefit given the increased operating expense impact on profits.
Additionally, rising logistics, gas prices, and interest rates coupled with potentially lower
federal tax refunds are headwinds to consumer spending trends.
9Consumer Staples
Sector drivers/themes
The Consumer Staples sector turned in a respectable total return performance in what was
a volatile 2020. Investors gravitated toward defensive sectors early in the year due to
uncertainties attributable to the COVID-19 crisis. As monetary and fiscal stimulus packages
were announced in addition to progress on vaccines, the group underperformed as risk-on
assets became investors’ main focus. In good times and bad, investors have come to
appreciate the merits of the staples group which include relative safety, diversified earnings
Jack Russo, CFA®
growth in terms of products and geography and finally the rising income stories Consumer
Equity Sector Analyst
Staples stocks can provide.
We believe long-term sector performance will be driven by two factors in particular: the
relative financial stability of the group and attractive total returns, including the generous
dividend yields these companies generally offer. We expect firms within the sector to
continue to offer relatively steady earnings growth opportunities across economic cycles
and create excess free cash flows after funding operations. Consumers are staples
purchasers regardless of the state of the economy (as currently exhibited with consumers’
stock up mentality) making the Consumer Staples sector minimally cyclical.
Consumer Staples sector underperformed the S&P 500 through mid-November 2020
145
Performance indexed to 100 as of 1/1/2018
The Consumer Staples sector
130 slightly underperformed
versus the S&P 500 year to
date through November 15,
115 2020. This was due to risk-on
assets being favored over
Nov 2020 defensive assets as progress
100 was made on vaccines and
economic stimulus packages.
85
Jan 2018 Jul 2018 Jan 2019 Jul 2019 Jan 2020 Jul 2020 Jan 2021
S&P 500 Consumer Staples Sector Index S&P 500 Index
Source: Morningstar Direct, Wells Fargo Advisors. Data through 11/15/2020. Performance data indexed to 100 starting on 1/1/2018. Past
performance is no guarantee of future results. An index is unmanaged and not available for direct investment. The S&P 500 Sector Indices
measure the performance of the widely-used Global Industry Classification Standard (GICS®) sectors and sub-industries. Each index comprises
those companies included in the S&P 500 that are classified as members of their respective GICS® sectors. The S&P 500 is a market capitalization-
weighted index generally considered representative of the U.S. stock market.
10Where to invest in 2021
Broadly speaking, we remain selective in our views across the Consumer Staples sector. Favorable
Our cautious view overall is due to two factors; valuations are above historical averages • Beverages
using any metric but especially on a price to earnings basis. And we worry about a
• Household Products
potentially more cautious consumer longer-term due to the economic fallout from
COVID-19. While the impact of the coronavirus in the near term has pulled forward
demand and helped sales growth in most staples categories as consumers stayed more at Neutral
home, this demand pull forward and the economic impact from the coronavirus (job losses, • Packaged Food
etc.) could affect consumers’ ability and desire to spend on many consumer categories as
we go through 2021. But we do like the group’s defensive attributes and this should serve
investors well if market volatility remains above average in 2021 as we deal with lingering Unfavorable
effects of the coronavirus. • Tobacco Products
Our ranking of sub-industries from most favorable to least are in this order, household
products, beverages, packaged food and lastly tobacco. We favor sub-industries with
stronger sales growth potential and whose products could benefit more in a world geared
toward “staying at home.” We believe the beverage industry could benefit given its
emphasis in growing noncarbonated beverages (water, teas, sports drinks, and juices) that
represent healthy choices over carbonated sodas. Household product companies should
continue to see vibrant sales growth particularly those in the paper goods and personal care
categories. Tobacco stocks have struggled lately due to the popularity of ESG (environmental,
social and governance) investing and heightened Food and Drug Administration (FDA) focus
on nicotine reduction. These trends may continue into the new year. We upgraded the
packaged food sub-industry from unfavorable to neutral in 2020 given consumers’ desire
to stay more at home and their stock-up mentality. However, packaged food stocks could
struggle longer-term due to consumers’ desire for healthier foods.
Valuation
The Consumer Staples sector currently trades at 21.2x the NTM consensus estimate
of $32.68. The current P/E ratio is above the five-year historical valuation of 19.1x. Relative
to the S&P 500, the Consumer Staples sector is trading at 1.0x, in line with historical levels
of 1.1x.
Risks
Risks to companies within the Consumer Staples sector include intense competitive
conditions, geopolitical risk, and rising interest rates causing additional dollar strength
hurting multinationals reported sales and earnings. Other risks could include fluctuating
commodity costs, labor cost pressures, and potential pricing compression from private
label competition. Higher interest rates could make staples less valuable as bond proxies
with their above average dividend yields.
11Energy
Sector drivers/themes
The Energy sector has vastly underperformed all other sectors in 2020, primarily driven by
the impact of COVID-19-related demand destruction within an already oversupplied
commodity environment. There are also several external factors at play—the election cycle
has driven uncertainty for U.S. Energy companies around the future of the regulatory
environment, momentum in global capital investment towards alternative energy
infrastructure has raised questions around the long term viability of fossil fuels, and both
Ian Mikkelsen, CFA®
institutional and retail investors seem to be increasingly in favor of adopting
Equity Sector Analyst
environmentally conscious investing mandates which often exclude the Energy sector. The
combination of these factors has driven investor sentiment to an all-time low, with the
Energy sector now comprising just 2.4% of the S&P 500 Index at the end of November,
down from over 4% at the beginning of the year.
U.S. Refining Margins
$30 Refining margins are well
outside of their historic ranges,
$25
as COVID-19 related lockdowns
$20 and restrictions have weighed
$15 on demand for gasoline, jet
fuel, and diesel. This
$10
environment has forced
$5 refiners to operate at reduced
$0 capacity utilization levels, which
is a negative read through for
-$5
Nov-19 Jan-20 Mar-20 May-20 Jul-20 Sep-20 Nov-20 oil demand. We expect most of
Months these dynamics to remain out
of balance until there is clear
2015–2019 Range 2015–2019 Average Gulf Coast/Cushing 3:2:1 Crack Spread
visibility towards a vaccine or
Source: Bloomberg, Wells Fargo Advisors. Weekly data from 11/15/2015 through 11/15/2020 was used to create the 2015-2019 range and average other remedy that can allow
series. The Gulf Coast/Cushing 3:2:1 Crack Spread is a commonly used benchmark for U.S. Refining margins which measures the difference in spot the world to move past the
prices between a barrel of West Texas Intermediate (WTI) crude oil and the prices of refined products, assuming a typical product yield of two
barrels of gasoline and one barrel of distillate fuel for every three barrels of oil processed. pandemic.
Where to invest in 2021
Looking ahead, we can expect demand recovery (likely against a tighter commodity supply
backdrop) on the other side of the pandemic, yet for now most Energy market
fundamentals remain far out of balance. The timing of this recovery remains highly
uncertain and the capital-intensive nature of the industry continues to erode the financial
health of most Energy companies.
12With so much uncertainty abound, our relative preference for sector positioning remains Favorable
with the major integrated oil companies (IOCs) which we believe are best positioned to • Integrated Oil Companies
navigate the challenging environment due to their scale, diversification, and financial
flexibility. We have become more cautious around downstream fundamentals in the near
term, as global product inventories remain elevated and refining margins are currently well Neutral
below historic averages, forcing refiners to operate with idle capacity. • Midstream (including MLPs)
Midstream companies (including Master Limited Partnerships/MLPs) may be exposed to
counterparty risk as well as declining volume based cash flows. We view midstream as a Unfavorable
maturing industry as most energy basins have sufficient infrastructure in place with little • Exploration and Production
need for new pipelines and the outlook for U.S. oil and gas production volumes in the (E&Ps)
coming years remains pressured. Within midstream, we favor the larger diversified • Oilfield Services
companies that generate the majority of their cash flows from contracted long distance
• Refiners
transportation pipelines, as opposed to gathering and processing assets that are more
vulnerable to declining volumes. We also maintain a relative preference for midstream
companies that are structured as corporations rather than MLPs.
Independent oil and gas producers (also known as exploration and production companies,
or E&Ps) and oilfield services companies have direct proximity to commodity prices and
declining U.S. production. While production declines should eventually lead to
improvement in commodity prices, the benefit of higher realized prices for independent
producers is partially offset by their restrained ability to grow production against global
competition for market share from larger scale players.
Valuation
The Energy sector is currently trading at a price-to-book value (P/B) of 1.1x. The current P/B
ratio is below the five-year average for the group of 1.7x. Relative to the S&P 500, the
Energy sector has been trading at 0.3x P/B, below the five-year historical average of 0.5x.
Risks
Risks include commodity price exposure, the potential for structurally lower future
commodity demand due to permanent COVID-19-related social changes, additional shelter
in place restrictions from another round of COVID-19 infections, a slow pace of global
economic recovery, a reescalation of global trade tensions, international competition from
foreign government owned entities, misrepresentation of asset quality, regulatory risks at
both the State and Federal government levels, and environmental concerns. Additionally,
MLPs can be exposed to volumetric risk, commodity price exposure, potential customer
concentration risks, and economically stranded assets.
13Financials
Sector drivers/themes
The Federal Reserve’s (Fed’s) actions to keep credit flowing have supported debt and equity
markets this year and lessened the pandemic’s effects on consumers and businesses. Some
companies in the sector, such as those engaged in capital markets activities, have
benefitted, but for many Financials, market conditions remain difficult. That goes double
for the sector’s largest industry group, banking. Future intervention in the markets by the
Fed, or decisions by it as regulator, are difficult to foresee. Likewise, historical relationships
Michael Ruesy, CFA®
between key measures like unemployment and charge-offs have decoupled, making
Equity Sector Analyst
judgements for this credit cycle especially challenging, given the uncertain duration to the
pandemic. That said, we do not see the credit cycle as repealed, but extended.
Total U.S. Credit to private non-financial sector as a percentage of GDP
180%
Following the exceptional
160% fiscal and monetary support
from governments, and
140% forbearance activity from
governments and lenders alike
in response to the pandemic,
120%
we think investors should
prepare for an extended
100% restructuring cycle.
’90 ’92 ’94 ’96 ’98 ’00 ’02 04 ’06 ’08 ’10 ’12 ’14 ’16 ’18 ’20
Recession Total U.S. Credit to Private Non-Financial Sector as a Percentage of GDP
Source: Federal Reserve Economic Database, Federal Reserve of St. Louis, Bank for International Settlements, Wells Fargo Advisors.
Data as of 3/31/2020. GDP=gross domestic product.
14Where to invest in 2021
We think investors should respond to the nearly year-long draw-down in Financials by Favorable
upgrading the quality of their holdings, even if, in the near-term, there are sharp rallies in • Insurance Brokers
lower-quality issuers. When loss cycles come, the worth of the underwriting is revealed.
• Property and Casualty
Over the long haul, we think stronger underwriters can produce competitive returns
Insurance
regardless of whether the institution is classified as a bank, insurance company, or asset
• Universal Banks
manager. By industry, we like the universal banks, which have multiple revenue streams
that may help them weather the present economic and market conditions better than
some financials whose business lines are more dependent on interest income. There is Neutral
optimism that improving conditions for loan demand, interest rates, and loss cycles, can
• Asset Management and
help banks recapture some of their equity appeal in the year ahead. Loan growth is
Custody Banks
presently a struggle, with pre-payments, tepid demand, and elevated deposit balances.
• Credit Card Issuers
Even so, bank managements believe net interest income (NII) is bottoming. The consensus
view that interest rates remain low for a protracted period of time looks ripe for a surprise • Financial Exchanges
to us, should further progress be made on the pandemic and economic activity become less and Data
uneven. Lastly, though there is still plenty of uncertainty on how credit ultimately unfolds, • Investment Banking and
the universal banks believe they are adequately reserved, so we may have seen the peak in Brokerage
reserve build for this cycle. Along with the universal banks, we also favor select property • Regional Banks
and casualty (P&C) insurers that look to underwrite for a profit. Insurance brokers may be
worthy of consideration, despite their recent elevated valuations, and modest rates of
organic revenue growth. Consolidation in the insurance brokerage industry is a positive Unfavorable
trend that is still intact. We would be quite selective in bargain-hunting among regional • Business Development
banks, preferring those with very strong records on credit. Companies
• Mortgage Real Estate
Investment Trusts
Valuation
The Financials sector currently trades at 14.2x the NTM consensus EPS estimate of $31.78.
The P/E ratio is above the 5 year historical valuation of 12.9x. Relative to the S&P 500, the
Financials sector is trading at 0.6x which is slightly below historical levels of 0.7x.
Risks
Key risks to the Financials sector include an end to the accommodating period for credit,
deterioration in underwriting conditions, higher credit losses, tight lending spreads,
financial leverage, loss of liquidity, changes in regulation, and weak asset or capital markets.
Some firms, which are dependent on external financing, may not be able to access the
capital markets on favorable terms, or at all.
15Health Care
Sector drivers/themes
The Health Care sector has held up reasonably well through the COVID-19 pandemic,
remaining one of the best performing sectors during most of 2020. The direct impact of
the pandemic on health care companies has varied dramatically, as elective procedures
were disrupted, doctor visits decreased significantly, and tele-medicine has become
significantly more popular. With the election over and possible light at the end of the
pandemic tunnel, the macro risks for the group appear to have decreased further. Needless
Greg Simpson, CFA®
to say, 2020 was a particularly challenging year, though the sector held up quite well on a
Equity Sector Analyst
relative basis, and the future looks favorable looking ahead to 2021.
Health Care sub-industry performance vs. S&P 500
130
Performance indexed to 100 as of 1/1/2020
120 Health Care equities have
110 outperformed the S&P 500
during 2020, though sub-
100 industry performance has
remained mixed. We continue
90
to prefer health care
80 equipment and supplies overall
as we enter 2021, specifically
70
medical device and life
60 sciences companies.
Jan. 2020 Mar. 2020 May 2020 Jul. 2020 Sep. 2020 Nov. 2020
S&P 500 S&P 500 Health Care - Equip. & Supplies
S&P 500 Health Care - Pharmaceuticals S&P 500 Health Care - Managed Care
Source: Morningstar Direct, Wells Fargo Advisors. Data through 11/15/2020. Data indexed to 100 starting 1/1/2020. Past performance is no
guarantee of future results. An index is unmanaged and not available for direct investment. The S&P 500 Sector Indices measure the performance
of the widely-used Global Industry Classification Standard (GICS®) sectors and sub-industries. Each index comprises those companies included in
the S&P 500 that are classified as members of their respective GICS® sectors. The S&P 500 is a market capitalization-weighted index generally
considered representative of the U.S. stock market.
Where to invest in 2021
We continue to believe the outlook for the Health Care sector remains favorable for long-
term investors. Recent disruptions related to the pandemic proved to be temporary for
most companies in the sector, and we believe the sector should return to a state of
16normalcy in 2021, and the longer-term outlook appears to be quite favorable. Sector- Favorable
specific risks such as Medicare for All and drug pricing reform efforts have moderated • Health Care Technology
considerably, given the apparent election outcome, with the Republicans appearing to
• Life Sciences Tools and
retain control of the Senate. We believe health care investors prefer “gridlock” with respect
Services
to health care policy, and though we believe the potential for some bipartisan legislation
• Medical Devices and
with respect to health care is possible in 2021, though the risk of more dramatic actions
Equipment
such as Medicare for All appear limited.
Looking at sector positioning as we move into 2021, we continue to favor the Medical
Neutral
Device/Life Sciences sub-industry, as long-term fundamentals remain favorable. While the
pandemic has caused severe, short-term disruption for many companies, we expect the • Biotechnology
issues to be temporary, with procedures and overall demand rebounding in the latter stages • Health Care Distributors
of 2020. Meanwhile, we continue to suggest a neutral stance on pharmaceutical stocks, • Health Care Services
which have generally underperformed in 2020 in response to ongoing drug pricing
• Managed Care
concerns. With respect to Managed Care, we view this sub-sector more favorably on a
post-election basis, given that Republicans likely retained a majority in the Senate, though • Pharmaceuticals
pending the planned run-off elections in Georgia in early January. The lack of a “Blue Wave”
in the election has reduced the possibility of significant health care reform legislation, and Unfavorable
thus reduced the risk for the managed care sub-industry.
• Generic Pharmaceuticals
• Health Care Facilities
Valuation
The Health Care sector is currently trading at 16.7x the NTM consensus EPS estimate of
$78.41. The current P/E ratio is above the five-year average for the group of 15.7x. Relative
to the S&P 500, the Health Care sector has been trading at 0.8x, modestly below the 0.9x
five-year historical average level.
Risks
Risks to companies within the Health Care sector include competition on branded
products, sales erosion due to cheaper alternatives (such as generic pharmaceuticals and/or
biosimilar products), research and development risk, and dependence on regulators such as
the Food & Drug Administration (FDA) to approve products anticipated to enter the market.
Additionally, companies can be exposed to cuts in Medicare reimbursements (either based
on yearly review or due to sequestration) as well as uncertainty surrounding healthcare
reform efforts in the U.S.
17Industrials
Sector drivers/themes
Simply put, investors appear to be anticipating a broad-based recovery in industrial
markets during 2021 and are valuing stocks in the Industrials sector somewhat
homogenously. Global industrial production is well off its lows and purchasing managers’
indices indicate further improvement is possible in the medium term. We remain of the
view that the recovery from COVID-19 will be uneven as certain areas languish (aircraft
and oil and gas) while others flourish (home improvement and logistics). In the very near
Lawrence Pfeffer, CFA®
term we believe that the sequential pace of improvement for broad industrial activity
Equity Sector Analyst
could moderate and that further multiple expansion could prove challenging against
this backdrop.
We also believe government policy is likely to play an increasingly large role in the
fortunes of this sector as tariffs/trade, procurement rules, taxation, infrastructure
investment and energy transition are just a few factors that could help certain
companies while harming others.
Global industrial activity
70 15%
Forwarding-looking indicators
65 suggest global industrial
10%
Global industrial production
activity could continue to
Global Manufacturing PMI
60
5% improve into year-end,
55
however we believe it is likely
50 0% that the pace of sequential
45 gains will moderate as the
-5% calendar turns.
40
-10%
35
30 -15%
2008 2010 2012 2014 2016 2018 2020
Global manufacturing PMI – Advanced 3 months (left axis)
Global Industrial Production – 3 Month Moving Average (Right Axis)
Source: FactSet, Wells Fargo Advisors. Data through 10/31/2020. Purchasing Managers’ Indices (PMIs) are surveys of purchasing
managers that are used to measure sentiment and predict demand in the near future. 50 represents the breakeven between
expansion and contraction in overall conditions.
Where to invest in 2021
With the vast majority of Industrials sub-industries trading at all-time high valuation multiples
and broad forecasts of meaningful earnings growth, we see minimal differentiation within the
sector. Widespread valuation expansion in Industrials stocks over the course of 2020, as well as
18the negative impact of COVID-19 on certain end markets led us to remove a number of Favorable
sub-industries from our list of favorables during the year, including multi-industrials, • Building Products
industrial distributors, air freight and logistics, and commercial aerospace.
• Defense Contractors
Thus we favor a selective approach to the sector entering 2021. We retain our positive • Railroads
stance on railroads and defense contractors and are adding building products to our list of
favorable sub-industries. We continue to be less favorable on airlines and are now adding
Neutral
commercial aerospace to this category due to expectations for a more protracted recovery.
• Agricultural Machinery
Railroads remain our favored sub-industry for those investors looking to express a positive
• Air Freight and Logistics
cyclical bias as they have leverage to improving trends in consumer spending, industrial
production, and global commodities demand. In addition, the sub-industry has now broadly • Commercial Services
and Supplies
embraced the well-tested margin improvement philosophy of Precision Scheduled
Railroading. We see valuations for this group as reasonable compared to other cyclically- • Construction and
oriented sub-industries in Industrials. Engineering
• Construction Machinery
We acknowledge that risk exists for defense contractors due to rising budget deficits. That
said, we believe the current geopolitical threat environment and shape of the current budget • Industrial Distributors
argue against material budget cuts. Although top-line growth could moderate, defense • Multi-Industrials
contractors continue to score reasonably well on our favored quality metrics and we believe • Professional Services
scope exists for some valuation recovery in the medium term.
• Truck Machinery
We are adding building products to our list of favorables as we believe the group should • Trucking
benefit from strong spending trends in home improvement, rising temperatures and hence
demand for cooling, efforts to reduce emissions from existing heating and cooling
Unfavorable
equipment, and a desire to improve indoor air quality post COVID-19.
• Airlines
• Commercial Aerospace
Valuation
The Industrials sector currently trades at 25.5x the NTM consensus estimate of $29.48.
The current P/E ratio is above the five-year historical valuation of 18.0x. Relative to the
S&P 500, the Industrials sector is trading at 1.2x, above historical levels of 1.0x.
Risks
The Industrials sector is heavily influenced by underlying conditions in the global economic
environment. Many companies in the sector are also heavily tied to government policy in
multiple jurisdictions, covering topics such as trade, taxes, interest rates, and fiscal
spending. The pace of technological change also appears to be accelerating, which could
make incumbent business models more challenging in the future.
19Information Technology
Sector drivers/themes
We expect the secular trends that were evident prior to the coronavirus such as the digital
transformation of companies with the shift to cloud computing, online e-commerce
penetration, online gaming, remote everything from work to learning to telemedicine, as
well as the ongoing transition to digital payments to show firm growth dynamics as we
work through the pandemic.
We believe we are likely in the early stages of a multi-decade progression of enterprise Amit Chanda
workloads to the cloud. We believe most enterprises will adopt a hybrid cloud and multi- Equity Sector Analyst
cloud architecture.
In our view, 5G is another favorable long term multi-year investment theme. Despite the
ongoing pandemic, most semiconductor companies expect healthy growth in 5G handset
and infrastructure deployments to occur in 2021.
We expect U.S. and China trade tensions to escalate as the need for greater intellectual
property protection becomes paramount.
Information Technology sector performance vs. S&P 500
145
Year-to-date through
Performance indexed to 100 as of 1/1/2020
November 15, the S&P 500
130
Information Technology
Sector Index increased 33.6%,
115
which compared favorably to a
12.8% return for the S&P 500
100
Index. During this time frame,
technology hardware and
85
equipment led the way with
approximately 57% growth,
70
while semiconductors and
semiconductor capital
55
Jan. 2020 Mar. 2020 May. 2020 Jul. 2020 Sep. 2020 Nov. 2020 equipment increased 33% and
software and services
S&P 500 Information Technology Index S&P 500 Index
gained 39%.
Source: Morningstar Direct, Wells Fargo Advisors. Data through 11/15/2020. Data indexed to 100 starting 1/1/2020. Past performance is no
guarantee of future results. An index is unmanaged and not available for direct investment. The S&P 500 Sector Indices measure the performance
of the widely-used Global Industry Classification Standard (GICS®) sectors and sub-industries. Each index comprises those companies included in
the S&P 500 that are classified as members of their respective GICS® sectors. The S&P 500 is a market capitalization-weighted index generally
considered representative of the U.S. stock market.
20Where to invest in 2021
The U.S. and China trade conflict has been going on for a few years now and has morphed into Favorable
a technology war with concerns over national security. We believe tense U.S. and China trade • IT Services
relations will continue to impact trade and foreign policy decisions over the near to
• Semiconductors and
intermediate term. The semiconductor industry has largely shrugged these concerns. From
Semiconductor Equipment
2010-2019, the Philadelphia Semiconductor Index returned 619%, ahead of the S&P 500
Index return of 270%.1 • Software
Despite ongoing trade concerns, digital transformation remains a key strategic priority for
enterprises to compete more effectively in today’s digital economy. Despite the ongoing Neutral
uncertain COVID-19 environment, we believe opportunities for digital transformation remain • Communications Equipment
abundant. Ongoing work-from-home and remote learning initiatives should continue to
• Electronic Equipment
support cloud computing and data center demand through mid-year 2021.
Instruments and
Many industries are still in the early innings of digital transformation. We believe the long- Components
term shift toward a hybrid cloud environment remains intact. Furthermore, as more • Technology Hardware
employees access their corporate networks and more students access their online lessons
from a home environment, Information Technology budget allocations focused on enterprise
Unfavorable
network security spending should potentially benefit. In addition, as enterprise workloads
migrate to a hybrid cloud environment, we believe this poses additional cyber security • Storage and Peripherals
threats. Lastly, we expect the semiconductor capital equipment manufacturers to benefit
from ongoing foundry and logic investments in cutting edge manufacturing.
Our expectation for the multi-year 5G network buildout should provide the infrastructure to
support many long-term technology trends, including industrial automation, smart cities,
autonomous driving, telehealth, cloud gaming and various commercial and consumer
applications. 5G is designed to be a significantly faster network than 4G (fourth generation),
with higher capacity and lower latency. Although we are in the early stages of the 5G rollout,
most semiconductor companies expect 5G handset and 5G infrastructure deployments to
continue into 2021.
Valuation
The Information Technology sector currently trades at 26.4x the NTM consensus EPS
estimate of $80.92. The P/E ratio is above the 5-year historical valuation of 19.5x. Relative to
the S&P 500, the Information Technology sector is trading at 1.2x, which is modestly above
historical levels of 1.1x. Historical comparisons are skewed as a result of the Internet Services
and Home Entertainment & Software industries which left the Information Technology
sector and moved into the Communication Services sector as of 9/21/18.
Risks
Risks for the Information Technology sector include increased competition from domestic
and international companies, unexpected changes in demand, regulatory actions, technical
problems with key products, and the departure of key members of management.
1. Philadelphia Semiconductor Index is a capitalization-weighted index composed of companies primarily involved in the design, distribution, manufacture, and sale of semiconductors.
An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.
21Materials
Sector drivers/themes
The Materials sector continues to be one driven by disparate factors, but remains highly
cyclical and thus subject to evolving global growth conditions. Volumes and earnings have
recovered to various degrees depending on the sub-industry but the recovery in global
growth and commodity prices generally have benefitted most areas of Materials. We
believe 2021 will be a ‘recovery’ year for most companies in the sector and we would expect
spending on durable consumer goods to be the largest swing factor.
Lawrence Pfeffer, CFA®
We also frequently remind investors that that the different sub-industries within Materials Equity Sector Analyst
have exposure to different commodity prices both in terms of selling prices and input costs.
For instance, we would note the ratio of oil to natural gas prices compressed over the course
of 2020, which, if sustained, could have a potential negative impact on U.S.-based chemical
and fertilizer producers.
S&P 500 Materials sector composition
Steel 2%
Commodity Chemicals 7%
Industrial Gases 26%
Other Chemicals 10%
We believe it is critical to
Other Mining 3%
distinguish the various
Construction Materials 4% sub-industries within Materials
as there is significant disparity
Agriculture/Fertilizer 7% in the levels of quality and
Coatings 12% cyclicality therein. Our more
favorable sub-industries
Gold 7%
(industrial gases and coatings)
are generally higher quality in
Other Consumer 9% Containers/Packaging 13%
nature.
Source: S&P 500 Materials sector constituent company reports, Wells Fargo Advisors. Data as of 9/30/2020.
Where to invest in 2021
We will start our thoughts on where to invest within Materials with a brief reminder of
what’s in the sector. The space is split into roughly three parts. First, there are high quality
sub-industries like industrial gases and specialty chemicals. Second, there are ‘garden
variety’ cyclicals like packaging and commodity chemicals. Last, there are extractive/
22commodity-centric sub-industries like metals and mining, fertilizers, and aggregates. We Favorable
have been relatively consistent over the last several years in favoring the first group and we • Coatings
maintain that preference into 2021. We continue to be more favorable on industrial gases
• Industrial Gases
and coatings.
We are attracted to these two areas largely due to industry structure. These are heavily
Neutral
consolidated end markets with only a handful of scale players on a global basis. They are
• Construction Materials
generally able to price for the value of the products and services they provide rather than
being tethered to commodity price movements. We would also note that these sub- • Containers and Packaging
industries have greater exposure to end markets that generally showcase lower cyclicality • Diversified Chemicals
and stronger long-term growth characteristics compared to other sub-industries in the
• Fertilizers
Materials sector.
• Mining
In terms of incremental catalysts over the medium term, both industrial gases and coatings • Paper and Forest Products
would likely see volumes benefit form a gradual industrial recovery. In the case of industrial
• Specialty Chemicals
gases, we would note that companies in the sub-industry could see significant long-term
(excluding Coatings)
revenue opportunities from the expanding usage of hydrogen in industrial and power
generation applications. On the coatings side, a persistent ‘stay-at-home’ theme could
continue to drive above normal growth trends in home improvement spending. Unfavorable
• Commodity Chemicals
We remain less favorable on commodity chemicals and steel. These sub-industries have
been plagued by overcapacity on a global basis in recent years and are quite sensitive to • Steel
fluctuations in commodity prices.
Valuation
The Materials sector currently trades at 21.3x the NTM consensus EPS estimate of $20.52.
This P/E ratio is above the average 5-year historical valuation of 17.5x. Relative to the S&P
500, the sector is trading at 1.0x in line with historical levels of 1.0x.
Risks
The sector is sensitive to fluctuations in and relationships among commodity prices,
particularly crude oil, natural gas and liquid natural gas, metals, and agricultural products.
China has been a major factor in driving demand for commodities in the Materials sector
and therefore has been a volatility factor in pricing for many commodities. A global
economic slowdown would likely weigh on the Materials sector’s performance. Many
materials companies have significant operational exposure to foreign currencies.
Additionally, many commodities are priced in U.S. dollars. Strength in the U.S. dollar could
negatively impact reported results within the sector.
23Real Estate
Sector drivers/themes
Given the significant impacts on real estate investment trusts (REITs) resulting from the
COVID-19 pandemic, we believe a meaningful influence on 2021 REIT total returns will be the
timing and pace of an economic recovery given a number of REIT sub-sectors are viewed as
economically sensitive. We also believe significant progress towards a medical solution to the
COVID-19 pandemic could have positive impact on a number of REIT sub-industries,
particularly industries related to retail and hospitality. The interest rate environment can also
John Sheehan, CFA®
be a factor in REIT total returns. Another major influence will likely be the ability of REITs to
Equity Sector Analyst
access attractively priced capital, especially in light of the weaker equity returns from certain
REIT sub-sectors during the first ten months of 2020. Finally, we believe the common
dividend reductions implemented by certain REITs in sub-industries significantly influenced
by COVID-19 have likely lowered investor confidence in the stability of REIT common
dividend income. Should the REIT industry return to consistent common dividend growth
during 2021, we believe REIT valuations would likely improve.
Year-to-date REIT total returns by property sector
Data Centers 26.1% REIT sub-industry
Self-Storage 14.5% performance through
November 15, 2020 was quite
Infrastructure (Cell Towers) 14.1%
dispersed, with sectors
Industrial 13.2%
considered to be potential
Single Family Homes 4.5% beneficiaries from various
Timber -3.8% trends related to COVID-19
Manufactured Homes -4.7% (data centers, infrastructure
(cell towers), industrial,
FTSE NAREIT All Equity REITs -5.5%
self-storage, single family
Specialty -11.0% home rental, timber, and
Free Standing Retail -13.0% manufactured housing)
Health Care -13.3% generating stronger relative
total returns. On the opposite
Apartments -13.6%
end of the spectrum, REIT
Office -22.8%
sub-industries that have been
Diversified -24.4% negatively impacted by
Strip Shopping Centers -31.2% COVID-19 or are viewed as
Lodging/Resorts -33.2% potentially at risk from the
coronavirus were weaker
Regional Malls -45.3%
performers; these sub-
industries included retail (free
-60% -45% -30% -15% 0% 15% 30%
standing, shopping centers,
and regional malls), health
Source: FTSE™, FactSet, Nareit®, Wells Fargo Advisors. Data through 11/15/2020. Past performance is no guarantee of future results. An index is
unmanaged and not available for direct investment. The FTSE NAREIT All Equity REITs Index is a free-float adjusted, market capitalization- care, apartments, office,
weighted index of U.S. equity REITs. Constituents of the index include all tax-qualified REITs with more than 50% of total assets in qualifying real specialty, diversified, and
estate assets other than mortgages secured by real property.
lodging/resorts.
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