Seeing Equity Risk through a Cash-to-Debt Lens

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1 WEEKLY GUIDANCE FROM OUR I NVESTMENT STRATEGY COMMITTEE Audrey Kaplan Head of Global Equity Strategy Ken Johnson, CFA Investment Strategy Analyst Seeing Equity Risk through a Cash-to-Debt Lens February 19, 2019 Key takeaways» Following the financial crisis, corporate cash balances rose as U.S. companies raised their cash buffer in case the recovery was unsustainable and some firms held cash abroad. Debt levels also increased as low interest rates helped to fuel more borrowing.» Following tax reform and cash repatriation, we have taken a fresh look at the cash versus debt picture 10 years after the financial crisis. How has the corporate liquidity landscape changed? What credit risks could lie ahead? What it may mean for investors» We see a growing bifurcation between cash-rich companies in the S&P 500 Index and those with smaller cash balances on the liquidity and debt landscape. This may signal a need for greater sector and company selectivity based on credit quality in the coming quarters. U.S. borrowing conditions have been favorable for some time as rates have remained relatively low. Yet, leverage is rising, and debt burdens may become too large for some companies as this economic cycle extends. The Great Recession was precipitated by a housing credit crisis. Despite historically high total debt today, corporate cash levels remain generally strong, following tax reform. While leverage measures bear monitoring, it is unclear whether today s debt level is too high or just right. Asset Group Overviews Equities... 5 Fixed Income... 6 Real Assets... 7 Alternative Investments... 8 Nevertheless, we believe that the bifurcation between cash-rich S&P 500 companies and those with less cash may offer some useful insights for equity investors. In this week s report, we answer the question: does the corporate cash-to-debt (CTD) ratio pose market risks for U.S. large-cap companies? How does the landscape vary by cash position and sector? The cash versus debt landscape As of last week, financial reports showed that corporate cash balances of S&P 500 Index companies (excluding financial firms) exceeded $1.6 trillion late in Yet corporate debt at these firms was $5.3 trillion late last year, or 3.3 times the cash balance. 2 Further, the CTD ratio was at a post-financial-crisis low. 1 With more than 70% of S&P 500 companies having reported year-end 2018 (and fourth-quarter) results, this data includes late 2018 balances of cash and short-term liquid investments for these firms. The total cash balance reported here also reflects September 30, 2018 cash balances for those S&P 500 firms that had not yet reported fiscal 2018 results. 2 Debt includes debt issued to fund long-term operations (this includes bonds, bank loans, mortgages, notes payable, etc.). This also includes the short-term portion of that debt expected to be paid off within the given year. An index is unmanaged and not available for direct investment Wells Fargo Investment Institute. All rights reserved. Page 1 of 10

2 Seeing Equity Risk through a Cash-to-Debt Lens In this economic cycle, there has been a growing CTD imbalance between S&P 500 Index nonfinancial companies with large cash holdings and all other index firms. 3 The 25 most cash-rich companies which represent 5% of the S&P 500 universe hold 55% of total cash for large-cap companies (more than half). The remaining S&P 500 Index firms (95% of the S&P 500 universe, excluding Financials) hold 45% of the cash. Clearly, not all large-cap companies are created equal on the corporate cash front. The debt breakdown between these two groups is more striking. The 5% most cash-rich companies in the S&P 500 Index had just 27% of the $5.3 trillion in S&P 500 company debt (for nonfinancial firms). This means that their CTD ratio was 61% (Chart 1). Obviously, the cash-rich, top 5% of S&P 500 nonfinancial companies have a comfortable cash position. S&P 500 company cash (as a percent of debt) peaked in 2016, but it still remains fairly high with the top cash holders showing a healthy level relative to the cash position before the last recession. Meanwhile, 95% of S&P 500 nonfinancial companies hold 73% of the index s debt putting their CTD ratio at just 18%. For this, more cash-poor group of S&P 500 companies (the bottom 95%), the current debt level may pose a credit risk in an environment of rapidly rising interest rates. The CTD ratio generally declined after reaching a peak in The federal government implemented tax reform in 2018 partly to encourage companies to repatriate cash held offshore which could have been used to pay down debt. Yet, this repatriated cash appears to have been used mostly for share repurchases, dividend increases, or acquisitions or it is still sitting on balance sheets. In addition to lackluster business investment levels, there have been limited signs of S&P 500 company debt being paid down (Chart 2). In other words, large-cap companies debt has risen steadily during this cycle (aside from the most cash-rich companies). Thus, monitoring companies CTD ratio may help us to identify a U.S. credit risk event in the future. Chart 1: Top 5% of S&P 500 Index company cash holders (excluding Financials) Cash and debt (in billions) $1,800.0 $1,600.0 $1,400.0 $1,200.0 $1,000.0 $800.0 $600.0 $400.0 $200.0 $ % 65% 60% 55% 50% 45% 40% 35% 30% Cash as a % of debt Total cash and equivalents (in billions) Total debt (in billions) Total cash/total debt ratio (%) Sources: Wells Fargo Investment Institute, FactSet, February 14, For illustrative purposes only. 3 S&P Global Insights, U.S. Corporate Cash Reaches $1.9 Trillion But Rising Debt and Tax Reform Pose Risk, May 25, Wells Fargo Investment Institute. All rights reserved. Page 2 of 10

3 Seeing Equity Risk through a Cash-to-Debt Lens Chart 2: Bottom 95% of S&P 500 firms for cash balances (excluding Financials) $4, % Cash and debt (in billions) $4,000.0 $3,500.0 $3,000.0 $2,500.0 $2,000.0 $1,500.0 $1,000.0 $500.0 $ % 25% 23% 21% 19% 17% 15% Cash as a % of debt Sources: Wells Fargo Investment Institute, FactSet, February 14, For illustrative purposes only. How do S&P 500 Index sectors rank based on cash and the CTD ratio? Among the 25 S&P 500 companies with the highest cash balances (the most cash-rich 5%), the Communication Services, Information Technology (IT), and Health Care sectors lead all other sectors, with CTD ratios exceeding 50% (Chart 3). IT and Health Care companies, especially large-cap pharmaceutical firms, have been building their cash positions within the U.S. and overseas because they often have strong patent protection. Even among the 95% of companies with lower cash balances, the IT sector appears to be best positioned to weather rising rates (from a debt perspective). Chart 3: Top 5% of S&P 500 companies based on cash balances sector profile Cash and debt (in billions) $500.0 $450.0 $400.0 $350.0 $300.0 $250.0 $200.0 $150.0 $100.0 $50.0 $0.0 Total cash and equivalents (in billions) Total debt (in billions) Total cash/total debt ratio (%) Consumer Discretionary Consumer Staples Health Care Industrials Information Technology Materials Total cash and equivalents (in billions) Total debt (in billions) Total cash/total debt ratio (%) Sources: Wells Fargo Investment Institute, FactSet, February 14, Communications Services CTD ratio was 3,618%; it was excluded from this chart. For illustrative purposes only. Where are the concerns? We believe that the important story to monitor is among those large-cap companies that have lower cash balances relative to debt level. By removing the largest cash hoarding companies, we can see that the CTD ratio has deteriorated since the middle of this cycle (Chart 4). Companies in some sectors have been rapidly building their debt levels while debt has been available at low rates. These firms higher debt levels have been at the cost of increased leverage ratios. This is somewhat similar 2019 Wells Fargo Investment Institute. All rights reserved. Page 3 of 10 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Cash as a % of debt

4 Seeing Equity Risk through a Cash-to-Debt Lens to the housing crisis, during which homeowners took on increasing debt, and leverage ratios rose. During the past 10 years, credit conditions have been favorable with historically low rates. But, leverage is now near-post-financial-crisis highs. With our expectation for rising rates, this raises the question of when, or where, we may see signs of a credit-risk event. What sectors are most vulnerable? In Chart 4, we show the 95% of S&P 500 Index companies with the lowest cash balances, along with their CTD ratio by sector. Based on the late-2018 CTD ratio, sectors that may be more at risk from rising rates include: Utilities (3% CTD ratio), Real Estate (7% CTD ratio), and Consumer Staples (11% CTD ratio). Companies profitability generally has remained strong, and 2018 earnings were better than was expected. The operating margin for S&P 500 companies reached a record level at year-end. 4 We see most U.S. large-cap companies generating enough cash flow to cover interest expenses. Additionally, many companies have been able to pass along higher prices while rates have risen over the past two years. Yet, debt levels bear watching as this cycle moves into its latter innings. Chart 4: Bottom 95% of S&P 500 companies based on cash balances sector profile Cash and debt (in billions) $800.0 $700.0 $600.0 $500.0 $400.0 $300.0 $200.0 $100.0 $0.0 80% 70% 60% 50% 40% 30% 20% 10% 0% Cash as a % of debt Total cash and equivalents (in billions) Total debt (in billions) Total cash/total debt ratio (%) Sources: Wells Fargo Investment Institute, FactSet, February 14, Investment implications Corporate debt levels have been rising, and there is clear bifurcation between cash-rich large cap companies and cash-poor firms (in terms of CTD ratios). We believe that the CTD ratio and other leverage ratios (such as debt-to-equity, debt-to-cash, debt-toincome, etc.) bear monitoring as the U.S. economic cycle progresses. While the U.S. corporate debt situation has not yet hit crisis level, it should be watched, especially with rising rates. Speculative-grade (high-yield) companies, and smaller firms, are likely to be the most vulnerable to debt service challenges as the cycle matures. We believe that this is a time to be selective and well-diversified by asset class, geography, and sector. 4 FactSet, Wells Fargo Investment Institute, February 14, Wells Fargo Investment Institute. All rights reserved. Page 4 of 10

5 EQUITIES Ken Johnson, CFA, Investment Strategy Analyst Audrey Kaplan, Head of Global Equity Strategy U.S. Large Cap Equities U.S. Mid Cap Equities U.S. Small Cap Equities Neutral Developed Market Ex-U.S. Equities Trading in the sweet spot U.S. equity markets have rebounded this year, partly due to better-than-expected 2018 earnings and the Federal Reserve s (Fed) rate-hike pause at its January meeting. This surge brought the S&P 500 Index to a point just above its 200-day moving average last week and returned many individual companies to their recent sweet spot trading range. Today, more than 56% of S&P 500 companies are trading above their 200-day moving average. This is slightly below the long-term average of about 63%, yet it remains above the lower end of the 200-day moving average range. Historically, when the number of firms trading above their 200-day moving average is within this range, the S&P 500 Index has returned more than 13% that year. We touched the lower end of the 200-day moving average threshold in December, when global companies were faced with record uncertainty from the Fed, global trade and economic jitters, and concern over political events. Yet, companies earnings resilience and a solid U.S economy buoyed the markets. The S&P 500 Index only tends to trade outside of the 200-day moving average range just before and after U.S. recessions. We do not anticipate a U.S. recession this year, and we believe that U.S. equity markets still have room to appreciate further. We forecast a record-high $173 for S&P 500 earnings this year. Nevertheless, we don t expect the ride to be smooth. The Fed s pause have given investors something to cheer about, but geopolitical and growth concerns linger and markets are likely to remain sensitive to related headlines. Key takeaways» Corporate earnings resiliency, the Fed, and a solid U.S. economy have fueled higher year-to-date S&P 500 returns.» In our view, market breadth (around the 200-day moving average) signals a healthy S&P 500 return in S&P 500 market breadth remains in a healthy range % Most Emerging Market Equities Number of members above 200 day moving average % 40.0% 30.0% 20.0% 10.0% 0.0% -10.0% -20.0% -30.0% -40.0% S&P 500 total return (YoY) % Recession Average No. of S&P 500 firms with prices > 200-day moving avg. Lower threshold Sources: Wells Fargo Investment Institute, Bloomberg, February 13, For illustrative purposes only. The moving average looks at the average price of a particular stock (or sector, market or asset class) over a rolling time period. There is no assurance that these movements or trends can or will be duplicated in the future. Technical analysis is only one approach used to analyze stocks. The S&P 500 is a market capitalization-weighted index composed of 500 stocks generally considered representative of the US stock market. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results Wells Fargo Investment Institute. All rights reserved. Page 5 of 10

6 FIXED INCOME Brian Rehling, CFA Co-Head of Global Fixed Income Strategy Investment TIPS U.S. Taxable Investment Grade Fixed Income Most 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 Developed Market Ex.-U.S. Fixed Income One of the risks of owning bonds especially for investors locked into a longer-term stream of payments is that inflation will be higher-than-expected, so the stream of payments buys less than it otherwise would have. While TIPS (Treasury Inflation Protected Securities) can help an investor to protect their purchasing power against unexpected changes in inflation, TIPS market value is impacted by changes in real interest rates. This factor is often misunderstood by investors. TIPS have a defined coupon rate at issue. While the income that an investor receives will change as the underlying TIPS principal value adjusts, based on CPI (Consumer Price Index) changes, the actual coupon rate of the security never changes. This is just like the scenario for an ordinary bond when interest rates increase, the market price of the bond typically decreases and when interest rates fall, the market price of the bond increases. These interest-rate movements often help to explain how the TIPS market value sometimes increases even as inflation expectations fall, and it can explain how TIPS market value can fall when inflation expectations increase. The benefits of TIPS are fairly straightforward; the real purchasing power of the security (the value of the bond adjusted for inflation) keeps pace with inflation until maturity. TIPS mitigate credit risk, as they are backed by the full faith and credit of the U.S. government. A TIPS allocation can offer enhanced sector diversification to a portfolio providing returns that are not highly correlated with the other fixed-income market sectors. Key takeaways» At current valuations, we believe that TIPS are fairly valued. We currently have a neutral rating on this sector.» Investors may consider including a nominal allocation to TIPS as part of a welldiversified portfolio.» The TIPS market generally has a longer duration profile than the traditional bond market. This can amplify price movements based on interest-rate changes. Emerging Market Fixed Income 2019 Wells Fargo Investment Institute. All rights reserved. Page 6 of 10

7 REAL ASSETS John LaForge Head of Real Asset Strategy Commodities Private Real Estate Public Real Estate Why $65 oil There are no shortcuts to any place worth going. --Beverly Sills Oil prices have started 2019 on fire, and we are expecting even higher prices by yearend. West Texas Intermediate (WTI) oil began the year near $45, and it now sits roughly 20% higher, closing at $54 last Tuesday. A 20% two-month gain is a big move for WTI so some price churning in the $51-$56 area over the coming months makes sense to us. With that said, keep in mind our higher, $60-$70 year-end WTI price range. There are numerous inputs that are baked into our $65 midpoint WTI target. Simply put, we believe that $55 WTI oil can be attributed to the supply/demand balance, and we have added a $10 premium for geopolitical uncertainties that could impact the oil market ($55 + $10 = $65). This reflects the fact that some of the world s largest oilproducing countries are either in turmoil, and/or are in the crosshairs of the U.S, such as Venezuela, Iran, Saudi Arabia, and even OPEC (Organization of Petroleum Exporting Countries), more generally. While the U.S. is now the world s largest individual oilproducing country, OPEC remains formidable, producing 36% of total global supplies (see chart). Venezuela has received lots of attention this year, but we are most concerned with the potential impacts from Iran and Saudi Arabia. President Trump is likely to revisit Iranian oil sanction waivers soon which expire in May. As for Saudi Arabia, leadership questions, and the Khashoggi murder, have muddied its relationships with the West. In the end, we expect higher-than-normal oil volatility, and higher prices, in Key takeaways» Oil prices have surged roughly 20% in 2019.» We expect some price churning for a few months. Yet, we believe that geopolitical issues will eventually drive oil prices higher by year-end. U.S. and OPEC oil production versus global oil production Global production (right scale) OPEC production as % of global (left scale) U.S. production as % of global (left scale) Oil production as % of global production Million barrels per day Sources: EIA, Wells Fargo Investment Institute. Yearly Data: For illustrative purposes only. WTI is a grade of crude oil used as benchmarks in oil pricing Wells Fargo Investment Institute. All rights reserved. Page 7 of 10

8 ALTERNATIVE INVESTMENTS Justin Lenarcic Global Alternative Investment Strategist Comparing European and U.S. implied volatility Neutral Private Equity Neutral Hedge Funds-Macro Neutral Hedge Funds-Event Driven Hedge Funds-Relative Value Hedge Funds-Equity Hedge One of the common concerns expressed at this month s Wells Fargo Wealth and Investment Management Alternative Investments Symposium was the slew of challenges facing Europe. With mounting evidence of slowing economic growth, coupled with U.K. Brexit concerns and Italian budget issues, it is easy to see why many speakers focused their global concerns and their view of alternative investment opportunities on the Eurozone. Yet, we find it interesting that European financial markets continue to show a relatively high level of complacency, despite the present and future challenges facing Europe. This can be seen in the chart, which compares the implied volatility of the EURO STOXX 50 Index (V2X Index) with implied volatility of the S&P 500 Index (reflected in the CBOE Volatility Index, or VIX ). Despite robust U.S. economic growth and generally strong equity markets in recent years, implied volatility has been higher in the U.S. than in Europe since early 2018 (evident in the downward trending line shown in the chart). Further, the current V2X/VIX ratio is well below the historical average. This cheap European volatility in the face of a more challenging backdrop is being noticed by both equity and Macro strategy traders, who are considering European index and single-stock options as a cheap hedge or directional opportunity. Key takeaways» Europe faces several significant challenges in the near and medium term.» Despite these challenges, the implied volatility of European stocks is below that of U.S. stocks, offering traders what we believe is a relatively cheap option for hedging or directional opportunities. Despite concerns European implied volatility remains cheap 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 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Jan-17 Jan-19 V2X / VIX Ratio Average Sources: Bloomberg; February For illustrative purposes only. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. Please see Index Definitions for important information on the indices Wells Fargo Investment Institute. All rights reserved. Page 8 of 10

9 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. Treasury Inflation-Protected Securities (TIPS) are subject to interest rate risk, especially when real interest rates rise. This may cause the underlying value of the bond to fluctuate more than other fixed income securities. TIPS have special tax consequences, generating phantom income on the inflation compensation component of the principal. A holder of TIPS may be required to report this income annually although no income related to inflation compensation is received until maturity. 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. Index Definitions The VIX shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the investor fear gauge. The VSTOXX indices aim to measure the volatility of the EURO STOXX 50 Index over a future time horizon as implied by the option contracts available on the Eurex Exchange (Eurex) on the Index. The EURO STOXX 50 options are among the products of Eurex with the highest trading volume. EURO STOXX 50 Index, Europe's leading Blue-chip index for the Eurozone, provides a Blue-chip representation of supersector leaders in the Eurozone. The index covers 50 stocks from 12 Eurozone countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. 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 2019 Wells Fargo Investment Institute. All rights reserved. Page 9 of 10

10 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 10 of 10