Investment Strategy

A sustainable Developed Market rally? We are skeptical

Perhaps lost in the noise of tariff headlines, a chorus of U.S. economic growth concerns, and the 10% correction of the S&P 500 Index has been the impressive 12% rally (as of March 17) in Developed Market ex U.S. Equities (DM) off its January 2025 low, as of 1/13/25. Is this the start of a sustained period of DM outperformance? We are skeptical.

Skeptical for a reason

Over the past nearly two decades, there have been seven similar periods where the skies appeared to clear for DM, and they outperformed —for a moment. Each time, calls that the bounce was the beginning of sustained DM outperformance were proven false within months. Will the current iteration follow the same pattern shown in Chart 1, or will it be different this time? No one knows for sure, but history has not been kind to investors betting on the latter.

Chart 1. Every DM outperformance bounce since 2007 has been short-livedSources: Bloomberg and Wells Fargo Investment Institute. Daily data. Indexed to 100 as of the short term peaks in the MSCI EAFE Index / S&P 500 Index ratio including October 21, 2009; October 14, 2010; December 28, 2012; April 27, 2015; May 17, 2017; January 4, 2021; January 18, 2023; and March 13, 2025. An index is unmanaged and not available for direct investment. Maximum amount of relative performance versus S&P 500/Minimum amount of relative outperformance versus S&P 500. Past performance is no guarantee of future results.

What sparked the DM rally?

Stifling regulation, high energy costs, a lackluster economy, and 17-plus years of practically nonexistent earnings growth and returns (Chart 2) had depressed DM sentiment and valuations going into 2025. With the pessimistic pendulum swung so extremely negative, DM was primed to react to positive surprises. A string of modestly better-than-expected European economic data prints, an upward turn in consensus earnings expectations, and optimism over increased fiscal spending provided the surprise and the rally spark.

Chart 2. DM earnings per share (EPS) and price growth practically nonexistent for nearly 20 yearsSources: Bloomberg and Wells Fargo Investment Institute. Monthly data: December 31, 2007 – February 28, 2025. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Markets like the fiscal shift

Last week, the German parliament voted to lift restrictions on government spending, to allocate 500 billion euros ($540.8 billion) to infrastructure spending, and to release defense spending from debt restrictions. In doing so, Germany is leading the continental economies in dramatically increasing government spending for the first time since before 2008. Outside of Germany, additional fiscal spending is expected to focus on defense outlays.

While the fiscal news has been welcomed by investors, we still have concerns: 1) Defense spending increase is a cost; what is the sustainable economic benefit that could meaningfully change the economic — and earnings — outlook? And the military hardware spending will not help the eurozone economy, to the extent that it imports U.S. weapons. 2) The extra expenditure on infrastructure is helpful, but how productive will the German infrastructure spending be? It’s only 500 billion euros — a useful down payment but not a promise of more to come. 3) Could increased spending reverse the disinflation progress and force higher short-term rates? 4) Are the countries with large government deficits (which now includes France) able to shoulder their share of the spending increase?

Focusing in on the impact to equities, an increase in defense spending certainly improves the earnings outlook of the likely beneficiaries, namely the Aerospace and Defense industry, but that industry is only 3% of the broad DM benchmark (the MSCI EAFE Index). Increased German infrastructure spending is also a welcome development, especially for the Germany Industrials sector, but that is a mere 2% of the DM benchmark. In short, the announced fiscal spending does little to move the needle on our overall DM earnings-per-share forecast.

Putting it all together

We are comfortable at neutral and a full allocation to DM. We believe the asset class offers decent quality at attractive valuations, and we suspect that sentiment is likely past its nadir. However, a lack of consistent growth, a resilient U.S. dollar, and tariff and trade uncertainty are headwinds. For investors who find themselves overweight the asset class, we suggest using this rally to trim DM exposure back to market weights and reallocate into U.S. Large Cap Equities or U.S. Mid Cap Equities, both currently favorable asset classes.

Reiterating our recent guidance changes

Last December, when we published our interest-rate outlook for 2025, we had anticipated an increase in U.S. Treasury yield volatility as new policies from the Trump administration began to get implemented. The combination of several catalysts has already caused 10-year U.S. Treasury yields to decline from their yearly high of 4.79% on January 14, 2025, to 4.28% as of March 18, 2025, as markets have anticipated a potential slowdown in economic growth and investors have rotated into high-quality fixed income.

This rotation has led to not only a pullback in equity prices but also an increase in high-quality longer-term fixed-income prices. At this time, we believe U.S. Treasury yields will continue to trade in a range near current levels. With our recent guidance changes, Adjusting fixed-income and equity positions published on March 11, 2025, we moved to a neutral stance in duration and U.S. Intermediate Term Taxable Fixed Income and to unfavorable on U.S. Short Term and Long Term Taxable Fixed Income, supporting our view that this was a good opportunity to take some gains in longer-term fixed income and move some capital toward U.S. Mid Cap Equities.

We still believe that 10-year U.S. Treasury yields will end the year between 4.50% and 5.00%. Our rate outlook is consistent with our expectation of higher growth and higher inflation, especially as we move through the second half of the year. In our view, the yield (income return) remains one of the biggest benefits of bonds at the moment, and we believe most U.S. fixed-income sectors are still displaying attractive starting yields.

Yield comparison amongst fixed-income sectorsSources: Bloomberg and Wells Fargo Investment Institute, as of March 18, 2025. Data from March 18, 2015, to March 18, 2025. Please see back of the report for definitions of Bloomberg Indexes used. An index is unmanaged and not available for direct investment. Min, Max are the minimum and maximum index yield observed within in the 10-year period. Past performance is no guarantee of future results.

Commodities — time for a breather

2025 started on a hopeful note with investors looking forward to business-friendly tax cuts and deregulation from the new administration. Unfortunately, markets have, thus far, been mainly greeted by headlines regarding tariffs — which can put upward pressure on prices and downward pressure on the economy — business investment and consumer spending. Other factors that have boosted the appeal of commodities include policy (liquified natural gas prospects have boosted natural gas), geopolitics (the war in the Middle East has probably boosted both oil and gold), and a falling U.S. dollar (tends to be a positive for all commodities, but especially gold).

The Bloomberg Commodity Total Return Index (BCOMTR) is up 7.68% year-to-date through March 17, besting the total return on both the S&P 500 Index (-3.23%) and the Bloomberg U.S. Aggregate Bond Index (2.21%)¹. While we remain favorable on Commodities, we believe it is time for a breather and most, if not all, of these factors should reverse to some degree. We suggest investors look for allocations that have grown larger-than-desired and rebalance toward other asset groups, like equities and fixed income. In addition, we believe that there is an opportunity to rebalance between our favorable sectors, from precious metals, which has been the standout in 2025, to energy, especially oil, which has lagged and may have room to catch up.

The chart suggests that the BCOMTR (258) remains in an uptrend. It should find support next at the 50-day moving average (253) followed by the 200-day moving average (239). Resistance sits at the recent high (261).

Commodities are close to overbought levelsSources: Bloomberg and Wells Fargo Investment Institute. Daily data from March 18, 2022, through March 18, 2025. BCOMTR = Bloomberg Commodity Total Return 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.

¹ All numbers are year-to-date. 12/31/2024 to 3/17/2025.

Long-term drivers for infrastructure investments remain

Infrastructure assets are the networks and systems that provide essential services, ranging from roads and bridges to ports and airports, utilities, and power transmission, as well as pipelines, telecommunication towers, and data centers. The developed world generally enjoys more established, yet aging, infrastructure. According to the American Society of Civil Engineers, the average age of U.S. electric grids and water systems is over 40 years old, and 43% of roads and over 46,000 bridges in the U.S. are in poor conditions and deemed structurally deficient.

In addition, the growth and adoption of new technologies, including cloud computing and artificial intelligence, as well as the transition to clean and renewable energy will also require significant capital outlays. The World Bank’s Global Infrastructure Hub estimated that $51 trillion will be needed by 2040 to modernize aging systems and to accelerate energy transition and support the digital economy.

With the growing government budget deficits and increasingly constrained public finances, we expect that private capital will play a greater role in infrastructure investments. According to Preqin, from 2020 to 2024, private infrastructure has raised $625 billion in capital and has accumulated $350 billion in dry powder that is ready to be invested. Furthermore, in the second quarter of 2024, private infrastructure reached nearly $1.5 trillion in assets under management (see chart). We believe this growth will continue and can offer attractive opportunities for long-term qualified investors seeking potential for consistent returns to provide a hedge against rising inflation.

Private infrastructure investments have grown to nearly $1.5 trillion (from 2000 – 2024)Sources: Preqin and Wells Fargo Investment Institute. Data as of June 30, 2024. The assets under management is calculated based on all private infrastructure funds that Preqin sourced and classified as infrastructure funds.

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 24, 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.

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.

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.

Bloomberg Commodity Total Return Index reflects the returns that are potentially available through an unleveraged investment in the futures contracts on 19 physical commodities comprising the Index plus the rate of interest that could be earned on cash collateral invested in specified Treasury Bills. The Index is a rolling index rebalancing annually.

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

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.

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.

Short Term Taxable Fixed Income (Short Term). Bloomberg U.S. Aggregate 1-3 Year Bond Index is the one to three year component of the Bloomberg U.S. Aggregate Bond Index, which represents fixed-income securities that are SEC-registered, taxable, dollar-denominated, and investment-grade.

Intermediate Term Taxable Fixed Income (IntermTerm). Bloomberg U.S. Aggregate 5-7 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 5-7 years.

Long Term Taxable Fixed Income (Long Term). 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.

U.S. Investment Grade Corporate Fixed Income (IG Corp Bonds). Bloomberg U.S. Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers.

High Yield Taxable Fixed Income (US HY Corps). Bloomberg U.S. Corporate High-Yield Index covers the universe of fixed-rate, non-investment-grade debt.

Securitized (US Securitized). Bloomberg U.S. Securitized: MBS/ABS/CMBS and Covered TR Index covers the universe of securitized debt.

U.S. Municipal Bond (Municipals). Bloomberg Municipal Index is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least one year.

An index is unmanaged and not available for direct investment.

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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