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The Tell: Investors should favor U.S. assets as markets reach ‘crossroads’ in 2022, says Wells Fargo

With markets at a “crossroads” in 2022, investors should favor U.S. assets in their portfolios, particularly higher-quality equity classes, according to Wells Fargo Investment Institute. 

Markets will be in transition as central banks globally seek to balance supportive policies with the threat of high inflation, Wells Fargo Investment Institute strategists said in a report Monday. The global economic recovery from the pandemic will probably be uneven and led by the U.S., where stocks should outperform, according to their note. 

Read: Failed China ‘zero-COVID’ policy tops list of 2022 geopolitical risks: Eurasia Group

The strategists said they prefer moving up in quality while incrementally reallocating or putting new cash to work, as opposed to waiting for significant market pullbacks to invest. Major U.S. stock indexes saw big gains in 2021, with the S&P 500 rising about 27%. 

“We expect the global recovery to continue in 2022, but we believe the economic, earnings, and currency picture continues to favor the U.S. over international,” they wrote. “On the domestic front, we favor higher-quality equity classes such as U.S. large cap equities, followed by U.S. mid cap equities.”

See: U.S. small-cap stocks will probably lag the S&P 500 next year, says DataTrek. Here’s why.

Within fixed income, Wells Fargo also prefers the U.S. over other developed markets while favoring a defensive strategy as the Federal Reserve may begin raising rates this year to tame high inflation, according to the report. 

“Look for investor focus in 2022 to be on the Fed, which will have the difficult task of trying to keep policy rates low while economic growth and inflation rates remain at above-average levels,” the strategists said. “To this end, we expect the Fed to hike its target federal funds rate sometime in the second half of 2022.”

Rising rates can lead to low returns or losses in fixed-income, they said, “but for risk mitigation, a bond allocation is generally appropriate for most investors.”

The strategists said that “exposure in intermediate maturities may provide some opportunity against a backdrop of rising yields” while also suggesting preferred and municipal securities as ways to maintain fixed-income holdings. 

Amid concerns over the spike in the cost of living in the pandemic, some investors may be considering Treasury inflation-protected securities, or TIPS, for protection. But “we caution against investing heavily in this asset class given that we view it as overvalued and TIPS yields have historically tended to rise (and prices fall), along with other fixed-income yields, while economic growth is strong,” the Wells Fargo strategists wrote. 

With the cost of living rising at a high pace, they said commodities may serve as a hedge and that U.S. cyclical stocks, including in the financial and industrials sectors, should also benefit from above-average economic growth and inflation. 

“Although small-cap equities generally also have historically outperformed in rising inflationary environments, we remain neutral for now, primarily due to the strong gains already experienced in this asset class,” the strategists said. 

The Russell 2000 index RUT, +1.08%, which measures the performance of U.S. small-cap stocks, gained about 14% in 2021, according to FactSet data. The Russell 2000 was trading about 1% higher Monday afternoon while the S&P 500 SPX, +0.64% was up about 0.5%.

The Wells Fargo strategists favor equities over bonds as they expect interest rates will rise “modestly” this year from currently low levels. The yield on the 10-year Treasury note TMUBMUSD10Y, 1.635% rose to about 1.63% Monday, according to Dow Jones Market Data. When bond yields rise, prices of the debt fall. 

“Within equities, we remain unfavorable on yield-sensitive assets, such as the utilities sector, and neutral on REITs,” the Wells Fargo strategists wrote. They prefer real estate investment trusts in the U.S. over international REITs on “strong demand, improving business conditions, and a continued recovery.” 

Check out: Will U.S. REITs beat the S&P 500 next year?

Most REITs will probably see “higher property values, asking rents, and occupancy in 2022,” the strategists said. 

Their neutral rating on REITs overall breaks down into “a favorable rating on apartment, single family home, self-storage, infrastructure (cell towers), and industrial REITs,” they said, “and an unfavorable rating on office, health care, and lodging REITs.” 

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