Late-Cycle Investment Positioning

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1 WEEKLY GUIDANCE FROM OUR I NVESTMENT STRATEGY COMMITTEE Tracie McMillion, CFA Head of Global Asset Allocation Strategy Late-Cycle Investment Positioning December 17, 2018 Key takeaways» Although some economic data has softened recently, we do not expect a recession in In our view, the risk of a recession will rise in 2020.» U.S. equities historically have performed well in the years preceding a recession, with large caps generally outperforming with less variation in returns in the 12 months before recessionary periods. What it may mean for investors» We caution investors to weigh risk and return carefully. We favor areas of the market such as large- and mid-cap U.S. stocks and emerging market equities where the risk/return tradeoff is attractive. We also believe that investors should reduce risk in their bond portfolios by emphasizing shorter-term and higher-quality bond holdings. We do not expect a recession in 2019, but we do believe that the likelihood of a recession will increase in As the risk of recession rises, so does the risk of a bear market. Our research has shown that historically recessions typically have accompanied bear markets. Therefore, economic conditions warrant a close watch by investors. Asset Group Overviews Equities... 4 Fixed Income... 5 Real Assets... 6 Alternative Investments... 7 While the U.S. economy remains broadly positive, we have seen some softness in recent economic data. Retail sales growth, for example, slowed in November; the future expectations component of consumer confidence slipped; and housing data has been mixed as higher mortgage rates have dampened the housing market s recovery. Another indicator to watch is higher market interest rates on shorter-term government bonds than on longer-term government bonds, but we have not seen enough evidence of a lasting change in the interest-rate structure (yield curve) to be overly concerned. Forward-looking survey data has remained very strong and small business confidence is near its high point for this cycle. Leading economic indicators typically turn negative ahead of a recession, yet recent indicators remain mostly positive. Taken as a whole, we believe that the strength in the U.S. economy is outweighing any weakness in the current numbers. While recessions are difficult to predict, they are a normal part of an economic cycle. Relative to history, the last recession was unusually deep and somewhat longer than average and the recovery also has been extended. Absent a recession in the next six months, the current recovery will become the longest recovery since Wells Fargo Investment Institute. All rights reserved. Page 1 of 9

2 Late-Cycle Investment Positioning The longevity of this expansion is starting to worry some investors. Yet equities have been among the top performers of the expansion, and they may continue to lead most other asset classes for the next year (and perhaps longer). Our research shows that late in a cycle, equity performance can be quite strong. We are continuing to overweight equities relative to bonds in many of our portfolio allocations. We prefer large- and mid-cap stocks to small-cap stocks and higher-quality bonds over lower-quality bonds. The historical performance records for large-cap stocks versus small-cap stocks and investment-grade bonds is longer than the performance records for most other asset classes. As such, we analyzed small-cap stock returns versus large-cap stock returns and government bonds for the 14 recessionary periods from 1928 to the present as defined by the National Bureau of Economic Research (NBER). We found that average returns for small caps were higher than returns for large-cap stocks in the months preceding recessions and in the months before recessions, but slightly lower in the 12 months preceding recessions. On average, equities outpaced government bonds in the periods studied. The variation in returns that is, the difference between the highs and the lows was wider for small-cap stocks than for large-cap stocks. When we looked the median returns (the middle points in the series), small caps had lower median returns than large-cap stocks did for the 12 months preceding recessionary periods, and median returns were nearly the same for small and large caps in the months preceding recessionary periods (see Chart 1). Chart 1. In years leading up to recession stocks generally gain but capitalization performance is mixed Percentage 120.0% 100.0% 80.0% 60.0% 40.0% 20.0% 0.0% -20.0% -40.0% 15.4% 2.6% 70.0% 62.9% 66.5% 6.0% Sources: Morningstar Direct and Wells Fargo Investment Institute, November 30, Monthly data from August 31, 1928, to September 30, All returns are for one-year intervals 12 months prior to recessionary periods, months prior to a recessionary period, and months prior to a recessionary period recessionary periods are defined by the National Bureau of Economic Research. Performance results are for illustrative purposes only and do not represent the performance of any investment, nor should they be interpreted as a forecast or as an indication of how the asset classes may perform in any future recession period. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. Index returns represent general market results; assume the reinvestment of dividends and other distributions; and do not reflect deduction for any fees, expenses, or taxes applicable to an actual investment. Intermediate-term government bonds are represented by the Ibbotson Associates Stocks, Bonds, Bills and Inflation Series (IA SBBI) U.S. Intermediate-Term Government Bonds TR Index. Large-cap equities are represented by the Ibbotson Associates Stocks, Bonds, Bills, and Inflation Series (IA SBBI) U.S. Large Stock TR Index. Small-cap equities are represented by the Ibbotson Associates Stocks, Bonds, Bills, and Inflation Series (IA SBBI) U.S. Small Stock TR Index Wells Fargo Investment Institute. All rights reserved. Page 2 of % 13.0% 4.4% -0.4% -6.1% -3.4% -1.7% -14.0% -1.0% -28.2% 3.2% 7.7% 89.0% 23.9% 23.8% U.S. Small-Cap Equities U.S. Large-Cap Equities Intermediate-term government bonds Median returns 84.5% 46.9% 16.0% 18.3% -12.5% -25.7% 12 months months prior months prior

3 Late-Cycle Investment Positioning Investment implications Large-cap stocks appear to post higher returns deeper into the cycle more consistently than small caps do, but the historical picture is mixed. For that reason, we believe that it is important to pay attention to the factors that characterize the present cycle and how they may influence the tactical market-capitalization decision. The passage of tax reform and increased government spending late in this cycle likely has front loaded gains for small-cap stocks. As rates rise and tax benefits decrease in the coming year, small-cap companies could face higher debt servicing costs that may reduce their free cash flow and impede significantly higher valuations from here. While the next recession may not hit the U.S. economy for quite some time, it is important to remember that timing recessions is very difficult and timing the market response to a future recession is even more difficult. As we depart from some longstanding market trends, we believe that now is a good time to weigh risk and return carefully. We believe that equities have the greatest return potential for the level of risk we anticipate in the coming year. However, we still favor holding some fixed income in most allocations. We suggest lowering exposures to longer-term bonds in favor of shorter-term bonds, lowering high yield fixed income in favor of investment grade and lowering exposure to developed market bonds outside of the U.S. In our view, these portfolio adjustments move away from areas of the market where we believe the expected return is insufficient for the amount of potential downside risk. We believe that staying fully invested and using volatility to your advantage is a good way to approach the market conditions we expect in We suggest rebalancing by buying asset classes that have fallen below your long-term allocations and selling those that are higher than your long-term allocations to manage through expected rising volatility Wells Fargo Investment Institute. All rights reserved. Page 3 of 9

4 EQUITIES Scott Wren, Senior Global Equity Strategist Ken Johnson, CFA, Investment Strategy Analyst U.S. Large Cap Equities U.S. Mid Cap Equities U.S. Small Cap Equities Developed Market Ex-U.S. Equities Our view on the Utilities sector During the first half of this year, the Utilities sector underperformed the S&P 500 Index by nearly 2.5% (+0.3% versus +2.6%). Yet, so far in the second half of 2018, this sector has been the second best-performing sector, beating the S&P 500 by 12.5% (+10.4% versus - 2.1%). 1 What changed from the first half of 2018 to the second half? Our analysis still suggests that the U.S. bull market has more upside and our sector preferences largely lean toward those that would continue to benefit from the economic expansion we expect in We still hold an unfavorable view of the Utilities sector. The Utilities sector is typically a late-cycle outperformer. It is normally a defensive sector where investors hide as the economy slows and, possibly, falls into recession. This sector s earnings stream is not as closely tied to the economy as, for instance, the Consumer Discretionary sector s earnings stream is. In addition, the Utilities sector currently carries an attractive dividend yield, which also can help to cushion the sector when the economy and stock market stumbles. The chart illustrates how Utility sector performance relative to the S&P 500 frequently has been tied to the 10-year Treasury yield over the past year. As illustrated, the Utility sector s performance has been negatively correlated to the 10-year Treasury yield. This relationship is not perfect but it helps to explain why Utilities outperformed as Treasury yields fell. The compelling sector yield has attracted attention, along with the defensive nature of the earnings stream. Key takeaways» Despite the Utilities sector s outperformance year to date, we hold an unfavorable view of this sector. We prefer more cyclically focused sectors, along with Health Care.» This sector often is a late-cycle outperformer, but its returns are negatively correlated with the 10-year Treasury yield. We expect this yield to rise in 2019 a possible Utilities performance headwind. S&P 500 Utilities sector s performance versus the 10-year Treasury yield Most Emerging Market Equities Index level Yields Utilities/S&P 500 Index U.S. 10-year Treasury yield Sources: Wells Fargo Investment Institute, FactSet; December 12, Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment. 1 Second-half 2018 return data was through December 11, Wells Fargo Investment Institute. All rights reserved. Page 4 of 9

5 FIXED INCOME Brian Rehling, CFA Co-Head of Global Fixed Income Strategy U.S. Taxable Investment Grade Fixed Income U.S. Short-Term Taxable Fixed Income U.S. Intermediate Term Taxable Fixed Income U.S. Long-Term Taxable Fixed Income High Yield Taxable Fixed Income What is the yield curve signaling? In recent weeks, investors have focused on the two-year Treasury yield moving above the five-year Treasury yield. When shorter-term rates move above longer-term rates, we refer to the event as yield curve inversion. Yet, not all yield curve inversions are created equal. We do not believe that investors should be overly concerned with an inversion in the belly of the yield curve (5-year to 2-year maturities), but the increased pace of yield-curve flattening is worth monitoring. Should 2-year Treasury yields move above 10-year Treasury yields, we would expect increased market and media attention that may weigh on markets. Our level of concern would rise if we saw the 1-year Treasury yield to 10-year Treasury yield curve invert. If this indicator turns negative for at least 4 weeks or inverts by more than 25 basis points (100 basis points equal 1 percent), we believe that it would be an indication that a recession is likely within the next 18 months. Focusing on other indicators could provide an early warning, but it also increases the risk of a false positive. Further, acting too early could lead to missing out on potential late-cycle gains for risk assets. For now, the Treasury yield curve remains positively sloped in key areas, but the margin is shrinking. We look for added yield-curve volatility in 2019, but we urge investors to wait for a definitive signal before they become overly concerned. For a more in-depth yield curve discussion, please ask your investment professional for our report titled Power in the Yield Curve. 2 Key takeaways» There recently has been increased focus on the yield curve, including concern that a future yield-curve inversion could signal U.S. economic weakness ahead. The Treasury yield curve has been a powerful predictor of recession in past economic cycles.» We expect the U.S. economy to remain healthy in the near term, and see the economic expansion continuing in Yet, we believe that the yield curve merits close monitoring. U.S. Treasury yield curve: Current versus one year ago 4.00 Developed Market Ex.-U.S. Fixed Income 3.00 Emerging Market Fixed Income Yield (%) Current Treasury yield curve Treasury yield curve one year ago 0.00 Source: Bloomberg; December 12, Wells Fargo Investment Institute, Fixed Income Strategy Report, Power in the Yield Curve, July 26, Wells Fargo Investment Institute. All rights reserved. Page 5 of 9

6 REAL ASSETS John LaForge Head of Real Asset Strategy I have never in my life learned anything from any man who agreed with me. --Dudley Field Malone Is oil calling for a recession? Commodities Private Real Estate Public Real Estate Oil s 30% drop, since the start of October, has investors asking the dreaded recession question Is oil s fall from grace a sign of an imminent recession? Our answer is: we doubt it. If oil s price cliff dive, since October, was calling for a recession, we would expect to see global oil demand cliff diving too. And we re not seeing that. Based on the green line in the chart below, global oil demand growth is running at roughly 3%, year-over-year. This is down a bit from the start of 2018, but not by much and it is a relatively healthy level. And this little bit of weak oil demand growth, since the start of 2018, is nowhere close to the declines we witnessed heading into the past two recessions, during 2001 and 2008 (see shaded areas in the chart). As for why oil prices have cliff dived in recent months, we blame supply, not demand. The ugly fact is that the world has been producing far too much oil for what demand is available. It is this reality, we believe, that investors have finally grasped. The blue line in the chart below shows the spike in global supply growth, which now sits at its highest level since For more on why oil has been behaving so badly, please see our Real Assets In Depth report titled $50 Oil Too Low Upgrading Oil and MLPs. 3 Key takeaways» Oil s 30% drop since October likely was due to accelerating supply growth and not collapsing demand.» We do not believe that this drop is a sign of an imminent recession. Global oil supply growth versus demand growth 8 6 Global supply growth (YoY%) Global demand growth (YoY%) Year-over-year growth (%) Sources: U.S. Energy Information Administration, Bloomberg, Wells Fargo Investment Institute. Monthly data: January 31, November 30, Global demand growth is the year-over-year real-oil-consumption-weighted gross domestic product growth. 3 Wells Fargo Investment Institute, $50 Oil Too Low Upgrading Oil and MLPs, November 30, Wells Fargo Investment Institute. All rights reserved. Page 6 of 9

7 ALTERNATIVE INVESTMENTS Justin Lenarcic Global Alternative Investment Strategist Private Equity Hedge Funds-Macro Hedge Funds-Event Driven Hedge Funds-Relative Value Hedge Funds-Equity Hedge Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not suitable for all investors and are only open to accredited or qualified investors within the meaning of U.S. securities laws. Distress ratios are showing signs of green shoots One of our key views for 2019 is centered on the growing opportunity set for alternative investments within global credit markets. We analyze a number of metrics to gauge the environment for active management within credit with the distress ratio being one of the more important measures. Simply put, the distress ratio illustrates the percentage of bonds in a specific credit index with an option-adjusted spread (OAS) greater than 1,000 basis points (or 10%). 4 In the chart below, we highlight distress ratios for U.S., European, and emerging market (EM) high-yield debt. Although these ratios are rising from a low base, we have noticed a material increase since the end of the third quarter. While the distress ratio for U.S. high-yield credit has not increased significantly this year, the same cannot be said for European and EM high-yield distress ratios, which have risen by 145% and 97%, respectively, year to date. We pay attention to distress ratios because they are considered a leading indicator for corporate defaults and a coincident indicator for credit dispersion. Both of these areas are critical to our expectations for Relative Value and Event Driven investing over the next 3-5 years. While defaults are still near historically low levels, the growing percentage of bonds trading at distressed levels supports our view that credit markets are likely to face challenges from rising interest rates and a maturing credit cycle. Credit selection is becoming increasingly important. Key takeaway» Distress ratios are beginning to increase, with European and EM high-yield distress ratios reflecting material changes in This helps to support our view of a dynamic opportunity set developing for Relative Value and Event Driven strategies. Global high-yield credit distress ratios are ticking up Distress ratio (% of bonds with spreads greater than 1,000 basis points) Nov-99 Nov-01 Nov-03 Nov-05 Nov-07 Nov-09 Nov-11 Nov-13 Nov-15 Nov-17 U.S. high yield credit distress ratio Emerging market high yield credit distress ratio European high yield credit distress ratio Sources: Bank of America Merrill Lynch, Wells Fargo Investment Institute; December U.S. high yield credit is represented by the Bank of America Merrill Lynch U.S. High Yield Master II Index. European high yield credit is represented by the ICE BofAML Euro High Yield Index. Emerging market high yield credit is represented by the ICE BofAML High Yield Emerging Markets Corporate Plus Index. 4 One hundred basis points equal 1% Wells Fargo Investment Institute. All rights reserved. Page 7 of 9

8 Risk Considerations 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 suitable 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. Definitions BofA Merrill Lynch U.S. High Yield Master II Index is a market capitalization-weighted index of domestic and Yankee high-yield bonds. The Index tracks the performance of high-yield securities traded in the U.S. bond market. Ibbotson Associates (IA) SBBI U.S. Small Stock Index is a custom index designed to measure the performance of small capitalization U.S. stocks. Ibbotson Associates SBBI U.S. Large Cap Stock Index tracks the performance of the S&P 500 Index stocks. Ibbotson Associates (IA) SBBI U.S. Intermediate-Term Government Bond Index is an unweighted index which measures the performance of five-year maturity U.S. Treasury Bonds. The ICE BofAML Euro High Yield Index tracks the performance of Euro denominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets. Qualifying securities must have a below investment grade rating (based on an average of Moody's, S&P, and Fitch). Qualifying securities must have at least one year remaining term to maturity, a fixed coupon schedule, and a minimum amount outstanding of Euro 100 million. Original issue zero coupon bonds, "global" securities (debt issued simultaneously in the eurobond and euro domestic markets), 144a securities and pay-in-kind securities, including toggle notes, qualify for inclusion in the Index. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. Defaulted, warrant-bearing and euro legacy currency securities are excluded from the Index. The ICE BofAML Emerging Markets Corporate Plus Index tracks the performance of US dollar (USD) and Euro denominated emerging markets non-sovereign debt publicly issued within the major domestic and Eurobond markets. To qualify for inclusion in the index, the issuer of debt must have risk exposure to countries other than members of the FX G10 (US, Japan, New Zealand, Australia, Canada, Sweden, UK, Switzerland, Norway, and Euro Currency Members), all Western European countries, and territories of the US and Western European countries. Each security must also be denominated in USD or Euro with a time to maturity greater than 1 year and have a fixed coupon. For inclusion in the index, investment grade rated bonds of qualifying issuers must have at least 250 million (Euro or USD) in outstanding face value, and below investment grade rated bonds must have at least 100 million (Euro or USD) in outstanding face value. The index includes corporate and quasi-government debt of qualifying countries, but excludes sovereign and supranational debt. Other types of securities acceptable for inclusion in this index are: original issue zero coupon bonds, global securities (debt issued in the US domestic bond markets as well the Eurobond Market simultaneously), 144a securities, pay-in-kind securities (includes toggle notes), callable perpetual securities 2018 Wells Fargo Investment Institute. All rights reserved. Page 8 of 9

9 (qualify if they are at least one year from the first call date), fixed-to-floating rate securities (qualify if the securities are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security). Defaulted securities are excluded from the Index 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. An index is unmanaged and not available for direct investment. General Disclosures 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. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR Wells Fargo Investment Institute. All rights reserved. Page 9 of 9