Investment Strategy

Asset allocation in vogue

After the rhapsodic performance of the U.S. S&P 500 Index in 2023 and 2024, equity investors reversed course at the beginning of 2025. Between January 1, 2025 and March 21, 2025 the S&P 500 Index staged one of the quickest corrections (defined as a 10% price decline) in history since World War II as investors withdrew from U.S. equity markets due to uncertainties from the tariff and growth scare news.

The new administration’s America First Investment Policy¹ may have contributed to foreign investors’ sentiment change, as well. Meanwhile, European and Asian markets have gained more investor interest as policy, innovation, and improving economic expectations in those regions have taken a positive turn alongside comparatively attractive forward price-to-earnings multiple valuations (15 for the MSCI EAFE Index vs 21 for the S&P 500 Index)². We believe asset allocation is in vogue again.

We remain skeptical that this apparent shift in market sentiment is an indication of the end of U.S. Large Cap equity outperformance and the onset of a burgeoning secular trend in international markets. If fact, tactically, we continue to favor U.S. Large Caps and Mid Caps over international equities. We believe the shift in investor sentiment so far can be attributed to both rational and emotional reasons. To navigate today’s volatility, in our view, investors may benefit from a long-term asset allocation strategy.

Table 1: Asset-class returns

	Actual year-end 2024 returns	Actual_year-to-date_2025_returns
U.S Long Term Taxable Fixed Income	-4.1%	2.6%
U.S Large Cap	25.0%	-1.5%
International Developed Equities	4.3%	10.5%
Emerging Market Equities	8.1%	5.6%
Commodities	5.4%	7.5%

Sources: Morningstar Direct and Wells Fargo Investment Institute. Actual return data is as of December 31, 2024 and March 25, 2025. WFII = Wells Fargo Investment Institute. U.S. Long Term Taxable Fixed Income returns are measured by the Bloomberg U.S. Aggregate 10+ Year Index. U.S. Large Cap return is measured by the S&P 500 Index. International Developed Equities return is measured by The MSCE EAFE Index in U.S. dollars. Emerging Market Equities return is measured by the MSCI EM Index in U.S. dollars. Commodities return is measured by the Bloomberg Commodity Index. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

In 2024, the performance of the S&P 500 Index led other equity asset classes by a wide margin. So far this year (through March 21), it has lagged. Diversified investors likely underperformed the S&P 500 Index in 2024, but a disciplined investment approach with regular rebalancing would likely have helped offset losses from U.S. large caps so far in 2025 as international markets have rallied.

So why should investors consider rebalancing portfolios back to target allocations?

As the euphoric sentiment has shifted away from the U.S. markets to offshore ones like Germany and China, we see a similar pattern in how unexpected, good news tends to draw investors’ attention. The German government’s turn from a tight fiscal stance to one now willing to increase infrastructure and defense spending helped convince investors that the once-stagnant market may finally be revived. The DAX Index has generated a total return of 15% between December 31, 2024 and March 21, 2025.³ China’s artificial intelligence (AI) companies surprised the world by showing that devoting a large amount of capital spending on expensive computer chips may not be the only solution for AI development. The MSCI China Index has gained almost 18% in total return over the same period.

How long can these rallies continue? It depends on many factors, such as international companies’ earnings, governmental fiscal policies, and central banks’ monetary policies. But many countries face an additional constraint ― elevated debt levels.

Chart 1: Global debt levels are highSources: International Monetary Fund (IMF) and Wells Fargo Investment Institute. Data as of Dec. 31, 2023.

Chart 1 offers a comparison of general government debt to gross domestic product (GDP) for nine developed and emerging markets. Besides Germany and a handful of emerging-market countries, the debt-to-GDP ratio for most countries, including the U.S., remains above 100%. An investor might expect that any additional stimulus and debt issuance aiming to support growth would be restrained by these debt levels. Despite Germany’s relatively sound fiscal position, high debt levels in France and Italy raise the question of how the European Union can influence a unified economic policy. Thus, regional risks remain.

In our view, instead of following the market euphoria across global regions, investors may be better served by rebalancing portfolios and potentially taking profits, while maintaining an overall diversified allocation to help prepare for the ebbs and flows of today’s choppy markets. We currently remain neutral on Developed Market Ex-U.S. Equities and unfavorable on Emerging Market Equities. Besides equities, investors are compensated 4% or more for holding money in short-term fixed-income assets (based on the Bloomberg 3-month Treasury Bill Index) . We believe that diversifying allocations into fixed income may provide income potential and maintain dry powder for future opportunities.

¹ “America First Investment Policy,” The White House, February 21, 2025.

² Bloomberg, March 27, 2025.

³ All start and end dates for year-to-date performance are between December 31, 2024 and March 21, 2025. Bloomberg, data as of 3/21/2025.

U.S Small Cap Equities struggle to keep afloat

The Russell 2000 Index fell 18.36% from November 25, 2024, to March 13, 2025, before staging a slight rebound. We believe the sharp decline is due to still-high short-term interest rates, a cooling U.S. economy and consumption, and now a global trade war. The Russell 2000 Index is at levels seen last summer, which means we have reversed gains spurred by optimism about the new administration’s pro-business policies.

Our assumption that the Trump administration would focus first on trade and immigration, as those policies are easier to drive from the executive branch, has largely proven right. However, we expect that attention will shift to tax cuts and deregulation next as the Republican Congress settles on a legislative framework and Cabinet positions get filled. As we transition from less market-friendly initiatives to more market-friendly initiatives, we believe that U.S. Small Cap Equities should recover. We also believe the economy and job growth are downshifting to sustainable levels and remain healthy enough to support consumption and corporate profitability.

While we favor U.S. Large and Mid Cap Equities, we believe small caps now discount much of the bad news. In our view, investors should use the weakness to add exposure in-line with our neutral guidance on U.S. Small Cap Equities and maintain full asset allocation weightings in portfolios.

The chart shows the Russell 2000 Index (2109) is in a downtrend, with the 50-day moving average (2195) now trading below the 200-day moving average (2203). It should find support at the recent low (1994) and resistance at the 50-day moving average (2195).

U.S. Small Cap Equities experiencing a break lowerSources: Bloomberg and Wells Fargo Investment Institute. Daily data from March 24, 2022, through March 24, 2025. RTY = Russell 2000 Index. SMAVG (50) = 50-day simple moving average. SMAVG (200) = 200-day simple moving average. RSI = relative strength index. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Are changes coming to the tax-exempt status of Munis?

Over the past several months, reports have increasingly been commenting on the potential for change to the tax-exempt status of municipal bonds. A document from the United States House Committee on Ways and Means that circulated back in January 2025 contained potential Tax Cuts Jobs Act (TCJA) extension offsets, which included a 50-page list of possible budget reconciliation options, along with two items related to the elimination of the municipal tax exemption and one item suggesting the elimination of nonprofit status for hospitals.⁴

The report included a savings estimate of $250 billion over 10 years for eliminating the tax-exempt status of municipal bonds and $114 billion of savings tied to cutting private activity bonds (PABs). The Trump administration appears determined to cut government expenditures and reduce the government’s fiscal deficit; and given that there are not many big discretionary line items that will help them reach their target, it seems that lots of smaller cuts are on the table, including removing the tax-exempt status of municipal bonds. However, broad municipal bond market participants are not willing to go down without a fight⁵ and are already displaying a push back by lobbying to Congress on the importance of keeping municipal bonds tax exempt — especially as they argue that communities would eventually see an increase in the cost of capital for many of their projects.

Potential investor implications

In our view, the potential elimination of tax exemption would have wide-reaching and significant impacts for municipal bond investors. However, we continue to believe it would be unlikely to be applied broadly to all outstanding municipal bonds given that the reaction from state and local governments would be substantial, and the revenue from the municipal exemption is small compared to the overall federal budget. We believe the greater probability would be a proposed cap on tax exemption on future bonds or certain private-activity and other non-municipal bonds.

We believe that if the market anticipates realistic upcoming policy limitations to tax-exempt financing, supply could increase before any tax action is taken. Also, PABs (for example, stadiums and convention centers) are likely most at risk, potentially impacting future new-issue supply. However, in our opinion, previously issued PABs could be grandfathered.

The tax-exempt status of municipal bonds has had strong political support in the past, and we believe that eliminating the exemption entirely would be politically very difficult. But in an aggressive scenario where the tax exemption on municipal bonds was eliminated and current bonds were not grandfathered in, we would expect a period of market price dislocation and liquidity challenges, especially when compared to corporate bonds with similar terms and credit ratings. However, this is not our base case at the moment, and we believe that there is still much debate ahead on this topic.

⁴ The Bond Buyer, “Tax-exempt bonds axed in menu of options floated by Ways and Means,” January 17, 2025.

⁵ Bloomberg, “Bankers flood DC to protect tax-free debt for states and cities,” February 6, 2025.

Expensive beef prices could stick around in 2025

Commodities continued to show positive performance, with the Bloomberg Commodity Index (BCOMTR) up 7.4% year to date (YTD) as of March 24. While sectors such as Precious Metals and Energy have garnered much of the attention, lesser weighted groups like livestock have also experienced positive returns. Specifically, live cattle is up 6.2% YTD as of March 24, and unfortunately for consumers we suspect that prices could remain elevated in 2025.

Despite accounting for a small weighting in the BCOMTR, prices of cattle and other food-related commodities are still important to everyday consumers, especially considering that in 2022 the average American consumed roughly four times more beef annually than the global average.

We believe cattle prices are likely to remain elevated in 2025, which in our view is driven by resilient demand and a record-low cattle herd population. Notably, changes in the herd population is a strong driver of cattle prices. The herd typically goes through eight- to 12-year cycles, marked by expansions and contractions of the population in response to prices, as shown in the chart.

Today, we are in year 11 of the current cycle with the herd population contracting and prices rising. However, despite nearing the end of an average cycle, we are not seeing signs that ranchers are looking to expand the herd yet. In fact, we are actually seeing the opposite as more heifers are being sent for processing. This indicates that ranchers are not retaining as many heifers for breeding purposes to meaningfully expand the herd.

Given the low retention of heifers and slow-moving nature of raising cattle, we believe that price relief through stronger supply growth is not likely to materialize in 2025, and relatively high beef prices could linger.

The cattle cycleSources: Bloomberg, USDA, and Wells Fargo Investment Institute. Annual data is from 2001 –2024. The cattle cycle is an eight- to 12-year cycle marked by the expansion and contraction of cattle herd populations in the U.S. The cycle is driven by the producer response to prices, input costs, and profitability.

Direct Lending seems resilient, yet caution is warranted

While the growth in Direct Lending strategies over the past decade has been remarkable, the performance of the strategies over time leaves little doubt as to the category’s appeal. Direct loans have outperformed high-yield bonds, bank loans, and the U.S. Aggregate Bond Index in five of the past nine calendar years (see chart).

While floating-rate Direct Lending investors were insulated from the rise in interest rates, the borrowers that consist of small to mid-sized businesses are subject to higher debt-service costs as loan terms reset to reflect the current environment. These businesses have been able to navigate the higher interest-rate regime with seemingly minimal impact as traditional default rates remain in check. Yet, a growing number of borrowers are attempting to restructure their debt prior to default (often termed distressed exchanges) or convert to payment-in-kind (PIK) loans. Converting to a PIK loan allows the borrowers to pay interest in the form of non-cash principal, thereby increasing the principal amount of the loan. While cash-saving tools such as PIK loans may buy time in the hope that lower rates lie ahead, we continue to monitor activity that may signal further deterioration (or improvement) in borrower creditworthiness.

We believe the yields generated by Direct Lending can cushion potential losses in loans in the event of a moderate rise in stress. However, the longer interest rates remain elevated, the greater the likelihood that stress levels rise among the lowest-quality segment of the borrower universe. While we are cautiously optimistic, we continue to maintain our neutral guidance on Direct Lending strategies until we get further confirmation that economic growth is accelerating, or lower interest rates in the future provide relief to the overly indebted subset of private borrowers.

Private Credit – Direct Lending strategies have performed well relative to other fixed-income categories

2015	2016	2017	2018	2019	2020	2021	2022	2023	Through 3Q 2024	Average	Inception
Direct Lending 5.5%	High Yield Bond 17.1%	Direct Lending 8.6%	Direct Lending 8.1%	High Yield Bond 14.2%	Aggregate Bond 7.5%	Direct Lending 12.8%	Direct Lending 6.3%	High Yield Bond 13.5%	Direct Lending 8.5%	Direct Lending 8.8%	Direct Lending 9.5%
Aggregate Bond 0.6%	Direct Lending 11.2%	High Yield Bond 7.5%	Leveraged Loan 0.5%	Direct Lending 9.0%	High Yield Bond 7.1%	High Yield Bond 5.3%	Leveraged Loan -0.8%	Leveraged Loan 13.3%	High Yield Bond 8.2%	High Yield Bond 5.5%	High Yield Bond 6.4%
Leveraged Loan -0.7%	Leveraged Loan 10.1%	Leveraged Loan 4.1%	Aggregate Bond 0.0%	Aggregate Bond 8.7%	Direct Lending 5.5%	Leveraged Loan 5.2%	High Yield Bond -11.2%	Direct Lending 12.1%	Leveraged Loan 3.2%	Leveraged Loan 4.7%	Leveraged Loan 4.8%
High Yield Bond -4.5%	Aggregate Bond 2.7%	Aggregate Bond 3.6%	High Yield Bond -2.1%	Leveraged Loan 8.7%	Leveraged Loan 3.1%	Aggregate Bond -1.5%	Aggregate Bond -13.0%	Aggregate Bond 5.5%	Aggregate Bond 1.3%	Aggregate Bond 1.5%	Aggregate Bond 3.1%

Sources: Cliffwater, third quarter 2024 report on U.S. Direct Lending, as of September 30, 2024. Additional 2024 data from Bloomberg and Morningstar as of September 30, 2024. Inception returns represent average annual returns from calendar years 2005 through 2023. Annual returns from 2015-2023, and 2024 through three quarters. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not appropriate for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.

Cash Alternatives and Fixed Income

Equities

Real Assets

Alternative Investments**

Source: Wells Fargo Investment Institute, March 31, 2025.

*Tactical horizon is 6-18 months

**Alternative investments are not appropriate for all investors. They are speculative and involve a high degree of risk that is appropriate only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. Please see end of report for important definitions and disclosures.

Forecasts and targets are based on certain assumptions and on views of market and economic conditions which are subject to change.

Asset allocation and diversification are investment methods used to help manage risk. They do not guarantee investment returns or eliminate risk of loss including in a declining market.

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Bank loans are subject to interest rate and credit risk. They are generally below investment grade and are subject to defaults and downgrades. These loans have the potential to hedge exposure to interest-rate risk but they also carry significant credit and call-risk. Call risk is the risk that the issuer will redeem the issue prior to maturity.

Investing in a Business Development Company (BDC) involves economic, credit and liquidity risks in addition to the special risks associated with investing in a portfolio of small and developing or financially trouble businesses. BDCs are exposed to high credit risk amplified through leverage. The use of leverage can magnify any price movements resulting in high volatility and potentially significant loss of principal.

Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is appropriate only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.

Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.

An index is unmanaged and not available for direct investment.

Aggregate Bond - Bloomberg U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.

Bloomberg U.S. Aggregate 10+ Year Bond Index is composed of the Bloomberg U.S. Government/Credit Index and the Bloomberg U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 10 years or more.

Bloomberg Commodity Index is comprised of 22 exchange-traded futures on physical commodities and represents 20 commodities weighted to account for economic significance and market liquidity.

High Yield Bond - Bloomberg High Yield Bond Index measures the market of USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds.

Direct Lending - The Cliffwater Direct Lending Index (the “CDLI”) seeks to measure the unlevered, gross of fees performance of U.S. middle market corporate loans, as represented by the underlying assets of Business Development Companies (“BDCs”), including both exchange-traded and unlisted BDCs, subject to certain eligibility requirements. The CDLI is an asset-weighted index that is calculated on a quarterly basis using financial statements and other information contained in the U.S. Securities and Exchange Commission (“SEC”) filings of all eligible BDCs. Cliffwater believes that the CDLI is representative of the direct lending asset class. The CDLI is owned exclusively by Cliffwater, and is protected by law including, but not limited to, United States copyright, trade secret, and trademark law, as well as other state, national, and international laws and regulations. Cliffwater provides this information on an "as is" and "as available" basis, without any warranty of any kind, whether express or implied.

DAX German Stock Index represents 30 of the largest and most liquid German companies traded on the Frankfurt Stock Exchange.

Leveraged Loan - Morningstar LSTA U.S. Leveraged Loan Index is designed to deliver comprehensive, precise coverage of the US leveraged loan market.

MSCI China Index captures large and mid-cap representation across China H shares, B shares, Red Chips and P Chips. With 140 constituents, the index covers about 85% of the China equity universe.

MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.

MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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