Market Welcomes Fed News What s Next?

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1 WEEKLY GUIDANCE FROM OUR I NVESTMENT STRATEGY COMMITTEE Brian Rehling, CFA Co-Head of Global Fixed Income Strategy Asset Group Overviews Equities... 4 Fixed Income... 5 Real Assets... 6 Alternative Investments... 7 Market Welcomes Fed News What s Next? November 6, 2017» We expect the nomination of Jerome Powell as the next chair of the Federal Reserve (Fed) to solidify the Fed s gradual pace of interest-rate increases.» We look for a December rate hike and reiterate our expectation of just two Fed rate hikes in A continuation of current Fed policies should help to support ongoing U.S. economic growth. What It May Mean for Investors» While the continuation of current policies should allow fixed-income investors to clip coupons, we still favor upgrading portfolios fixed-income credit profiles in the face of rather expensive valuations. Last week, the Fed held a meeting of the Federal Open Market Committee (FOMC), and President Trump nominated Jerome Powell as chair of the Fed (and FOMC) when Janet Yellen s term expires in February It would not be unusual for either of these events to lead to significant market movements yet markets took both events in stride with barely a reaction. New Fed Chair Jerome Powell is a moderate and a consensus builder who is likely to continue the monetary policies of Janet Yellen. His selection should soothe market participants who were concerned that a new Fed chair could implement more aggressive Fed tightening. The Powell nomination allows the president to appoint his Fed chair, while (at the same time), providing a continuation of the supportive monetary framework that is currently in place. We would expect Powell to favor the low interest rate, easy-money policies that align with the president s economic agenda. Perhaps most importantly, Powell is a seasoned veteran and is likely to continue the Fed s long history of political independence that is critical to the central bank s market credibility. With Powell leading the Fed and likely continuing current monetary policies, we do not see a material change in our interest-rate expectations and reiterate that we expect three Fed rate hikes between now and year-end We look for the Fed to continue its measured pace of balance-sheet reduction, with little deviation from the previously 2017 Wells Fargo Investment Institute. All rights reserved. Page 1 of 9

2 Market Welcomes Fed News What s Next? announced plan. In a June speech, Jerome Powell stated that he believed the Fed balance sheet was unlikely to decline below $2.4 trillion (or even $2.9 trillion) once normalized which further supports an easy monetary stance. Fed Rate Hikes Given that we expect Powell to continue current monetary-policy direction, let s look at where the Fed stands in regard to monetary policy and the difficulties the FOMC may face in implementing policy going forward. The Fed has two mandates; full employment and price stability. There is near-universal agreement that the Fed has met its full-employment mandate. Inflation, however, continues to run below the Fed s goal and the lack of inflationary pressure puts the Fed in a bit of a quandary. Raising rates in the face of below-goal inflation runs the risk of bringing the current economic expansion to a premature conclusion. Yet, if inflation pressure truly is building below the surface, a delay in raising rates could lead to a more meaningful pickup in inflation that the Fed would need to quash. These competing factors make the life of a central banker difficult. Under Jerome Powell, we look for the Fed to err on the side of fewer rate hikes at least until inflation pressure becomes evident. As a result, we remain committed to our expectation of just two rate hikes next year rather than the Fed s expectation of three rate hikes. Not only do current inflation indicators suggest that inflation remains below target levels market-based forward looking inflation indicators also suggest inflation will remain subdued. The Fed compiles forward inflation expectations that are implied by trading in Treasury Inflation-Protected Securities (TIPS). The Fed s five-year forward breakeven inflation rate is a good indicator of the market s expectation for inflation pressure five years into the future. Rather than using this indicator to project exactly where inflation rates will be in the future, we find this data useful in monitoring market trends. Inflation Expectations Remain Depressed Fice-Year Forward Breakeven Inflation Rate Sources: Bloomberg, Federal Reserve, 11/2/ Wells Fargo Investment Institute. All rights reserved. Page 2 of 9

3 Market Welcomes Fed News What s Next? The trend in inflation remains weak, with little change in market expectations over the past several months. We believe that the currently muted inflation level along with our expectation that inflation will remain well-contained helps to explain why modest fed funds rate increases should not send longer-term rates materially higher. In fact, if the Fed unexpectedly moves forward with a faster pace of rate hikes, we could see longterm rates actually fall. The market would likely view a faster pace of rate hikes as premature, which could lead to slower future economic growth than might have been experienced otherwise Wells Fargo Investment Institute. All rights reserved. Page 3 of 9

4 EQUITIES Sean Lynch, CFA Co-Head of Global Equity Strategy Underweight U.S. Small Cap Equities U.S. Large Cap Equities U.S. Mid Cap Equities Developed Market Ex-U.S. Equities Emerging Market Equities Mega-Cap Stocks Carry the Day The five largest companies in the S&P 500 Index (based on market capitalization) have a combined valuation equal to that of the 250 lowest-market-cap S&P 500 companies. 1 This staggering statistic illustrates how much these mega caps have gained versus their U.S. large-cap peers. This week, we compare equal-weighted indices versus market-cap-weighted indices in order to gauge market breadth (how the level of participation of all stocks in the market is contributing to returns). Typically, if equity trends are improving, and investors are taking more risk, smallercap stocks start to show more relative strength. This has not been the case this year across the three indices that we reviewed. In all cases, including the S&P 500, Russell 2000 (small cap), and MSCI EAFE (developed markets) indices, performance of the equal-weighted index falls short of the market-cap-weighted index return year to date (YTD). The first chart below shows the YTD S&P 500 Index performance. The equalweighted index has underperformed this year, and that trend has been worsening during earnings season (second chart). Yes, top-market-cap names have been key drivers of strong equity-market gains in Yet, the equal-weighted benchmarks also have experienced double-digit gains. We do not view the narrowness of strong gains by the largest market caps as a sign that markets are excessively overextended.» To date in 2017, top market-cap names have been the key drivers of strong equitymarket gains.» Yet, equal-weighted benchmarks have experienced double-digit gains as well. We would not consider the narrowness of market breadth to be a sign that markets are excessively overextended. YTD S&P 500 Index Performance: Market-Cap-Weighted Index versus Equal-Weighted Index S&P 500 Index Value (indexed at ) S&P 500 (Market Cap Weighted) S&P 500 (Equal Weighted) 95 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Sources: Wells Fargo Investment Institute, Bloomberg; 11/2/17. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. 15.0% 11.5% S&P 500 Market Cap and Equal Weight Price Difference Equal Weight Outperform Market Cap Outperform -4 Jan Feb Mar Apr May Jun Jul Aug Sep Oct 1 Source: Wells Fargo Investment Institute. On November 1, the five largest companies (by market capitalization) in the S&P 500 Index had a $3.28 trillion market value, while the bottom 250 had a market valuation of approximately $3.42 trillion Wells Fargo Investment Institute. All rights reserved. Page 4 of 9

5 FIXED INCOME George Rusnak, CFA Co-Head of Global Fixed Income Strategy Even Headwinds Can Be Tailwinds for Municipals Underweight High Yield Taxable Fixed Income Underweight Developed Market Ex.-U.S. Fixed Income U.S. Short Term Taxable Fixed Income U.S. Long Term Taxable Fixed Income Emerging Market Fixed Income Recent events, such as new tax proposals, hurricanes, and increased supply, have not led to a pullback in the municipal market (to date) in In fact, municipals have outperformed Treasury securities since late July as interest rates have been rising. Municipal-to-Treasury yield ratios even have moved close to one-year lows highlighting recent outperformance by this fixed-income class (see chart below). Why have municipal bonds performed so well recently? The focus on the potential for fewer tax deductions, longer-term benefits of infrastructure rebuilding proposals, and improved price discovery have fueled demand for municipals, despite initial headline concerns. 2 We believe that this outperformance will give way to uncertainty toward year-end. We also anticipate that investors will find a more opportune time to enter the municipal market in the months ahead. For investors considering initial investment in municipals at current levels, we recommend some caution as we favor a more conservative approach to credit, coupon structure, and yield-curve positioning. The municipal market is very diverse, and we believe that any new individual tax policy will result in winners and losers within the municipal market (rather than, solely, a broad market impact). Specifically, current tax proposals could increase demand for municipals in states with higher tax brackets and for municipals that have been subject to the alternative minimum tax (AMT). We believe that it is too soon to speculate on outcomes, and we would expect volatility to rise as tax-policy negotiations progress.» Recent municipal outperformance has come despite challenging headlines. We expect volatility to rise, and we see any pullbacks as a potential buying opportunity.» We recommend a defensive approach to municipal investing today, with a focus on raising credit quality and favoring premium-coupon bonds and short-tointermediate maturities. AAA Municipal / Treasury Yield Ratios 200 I High / Low Range - Current 200 U.S. Taxable Investment Grade Fixed Income U.S. Intermediate Term Taxable Fixed Income AAA-Rated Municipal/Treasury Yield Ratio Source: Thomson Municipal Market Monitor, 10/31/17. Past 12 Month Range to Comparable Maturity Treasury Securities: High - Low Current. Yields represent past performance and fluctuate with market conditions. Past performance is no guarantee of future results Year 5 Year 10 Year 15 Year 20 Year 30 Year Price discovery is the process of determining a security s market price (which depends on supply and demand). When demand is higher than supply, prices typically rise (and vice versa). For municipals, there recently has been high demand and constrained supply. Thus, a small supply increase has offered greater liquidity and firmer prices. (Longer-term and larger supply increases often have the opposite effect flooding the market and causing price declines.) 2017 Wells Fargo Investment Institute. All rights reserved. Page 5 of 9

6 REAL ASSETS John LaForge Head of Real Asset Strategy Our most important thoughts are those which contradict our emotions. --Paul Valery Oil Costs Still Dropping Underweight Commodities Private Real Estate Public Real Estate Investors are asking the question is it time to buy oil? Prices have had a nice run, since the springtime lows of about $43 per barrel. Also, many investors remember $ prices quite clearly (2014 was not that long ago), and pine for those good old days. While we understand the temptation, we are still skeptical that the rally in West Texas Intermediate (WTI) oil prices can extend much beyond $. Last week s publication, This Oil Bear Has Room to Run, goes into detail behind our skepticism. 3 One of the more interesting charts from last week s publication is shown below. It outlines how drilling costs have dropped since 2014 (the last time WTI prices topped $) similar to what happened during the last commodity bear super-cycle which ran from roughly 19 to The red line highlights drilling costs from , while the blue line highlights drilling costs so far this cycle, since Lower costs mean that more producers can afford to stick around, even as oil prices fall. As oil prices rise, the temptation to overproduce is overwhelming for companies and countries alike. The net effect; oil prices can rally during commodity bear super-cycles, but they have a hard time holding on to the higher, post-rally levels. We re expecting the recent WTI rally to $55 to be met with additional oil supply soon which should cap the oil-price rally.» We expect the West Texas Intermediate oil-price rally (to $55) to be met with increased supply and eventually a cap on the price rally.» In our view, this is not the time to be aggressively buying oil or energy names. U.S. Cost Per Drilled Well 19s Bear versus Today Cost Per Drilled Well ( ) Cost Per Drilled Well ( Today) 110 Indexed Cost Value Sources: Energy Information Administration (EIA), Bureau of Labor Statistics (BLS), Wells Fargo Investment Institute. Yearly data: 12/31/19-12/31/1998 and 12/31/2011-Today. Costs indexed to at 19 and West Texas Intermediate (WTI) is a grade of crude oil used as a benchmark in oil pricing Real Assets Report, This Oil Bear Has Room to Run, November 2, 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. A Multi-Year Opportunity Developing in Credit As we look ahead to 2018, we continue to expect a strong environment for security selection that should benefit Long/Short Equity strategies. As long as equity correlations remain low, we anticipate that the performance of these strategies will remain above the post-crisis average. But, in addition to equities, we see multi-year opportunities developing within global credit sectors. These opportunities are largely the result of a maturing credit cycle, combined with weaker lending requirements in recent years. We believe that Relative Value strategies focused on Long/Short Credit, and Event Driven strategies focused on both Stressed and Distressed Debt, may be able to capitalize on these opportunities in 2018 and With corporate credit spreads at or near historically tight levels, shorting credit has been difficult. But we are beginning to see greater dispersion among high-yield bonds as the market is discerning strong (versus weak) fundamentals. We believe that this will eventually lead to an increase in the high-yield distress ratio, which represents the percentage of high-yield bonds with spreads greater than 1,000 basis points. (One hundred basis points equal one percent.) As the proportion of those bonds increases, the ability of Relative Value managers to capitalize on long and short credit selection historically has improved. Furthermore, an increase in the distress ratio is typically a precursor to defaults, which provide opportunities for Event Driven managers to purchase stressed and distressed bonds at compelling (cheap) prices that potentially recover after the company has been restructured.» Long/Short Credit and Distressed Debt investing is expected to improve as the credit cycle matures. We believe this is an appropriate time for investors to prepare for these changes.» Although the high-yield distress ratio is currently low, it often increases one or two years prior to recession, and is generally a good barometer for security selection within credit. Pay Careful Attention to Distress and Default Ratios Distress Ratio (Percent of High-Yield Bonds with Spreads Exceeding 1,000 Basis Points) Recession 0 Jan-98 Jan-01 Jan-04 Jan-07 Jan-10 Jan-13 Jan High Yield Default Rate U.S High Yield Credit Distress Ratio (LHS) U.S High Yield Credit Default Rate (RHS) Source: Bank of America Merrill Lynch, 10/31/ Wells Fargo Investment Institute. All rights reserved. Page 7 of 9

8 Risks 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. Municipal bonds are subject to interest rate, credit/default, liquidity, duration, call, potentially AMT and other risks. 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 MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 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. AAA rating: The highest quality debt, with minimal credit risk. 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 2017 Wells Fargo Investment Institute. All rights reserved. Page 8 of 9

9 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