What Are Consumer and Investor Confidence Signaling?

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1 Veronica Willis Investment Strategy Analyst WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS What Are Consumer and Investor Confidence Signaling? September 19, 2017 Key Takeaways» Consumer and investor confidence do not always move in the same direction. Investor confidence started to decline amid concerns surrounding global economic growth in 2015, but consumers were able to look past these concerns and have remained confident in the current state of the U.S. economy.» Institutional investor confidence in the U.S. has started to improve (along with consumer confidence) as investors have become more confident in the future economic outlook. What It May Mean for Investors» We expect that improving economic conditions and investor confidence will continue to support global equities. Lower inflation than anticipated could keep global yields low, but we expect that the improving domestic economy will result in yield advantages for U.S. bonds over developed-market bonds and attract global asset flows. While consumers and investors are both focused on economic growth, labor and housing markets, and financial-market conditions, their levels of confidence may differ. Investors appear to be driven by expectations for future economic growth, while consumers are willing to place more importance in the current state of the economy. Two-thirds of U.S. economic activity is driven by consumer spending. Furthermore, much of this spending relies on the level of confidence that consumers have in the current state of the economy (reflected in their expectations for job stability, income prospects and changes in the cost of living). Consumer spending and confidence indicators tend to move in sync with one another, as was the case for much of the economic recovery over the past eight years, when strength in consumer spending, along with rising consumer sentiment, supported growth. Investor confidence also tends to move in conjunction with consumer confidence. Although consumers have been gaining confidence throughout the recovery, investor behavior has not always followed the same trend. While this report is focused on the U.S., a similar relationship between investor and consumer confidence can be seen in other economies. We are starting to see that consumer confidence is improving in other parts of the world. We believe that this development could provide more support to the global economic recovery, particularly in the Eurozone and in Asia, and eventually lead to improved investor confidence in these regions as well Wells Fargo Investment Institute. All rights reserved. Page 1 of 7

2 Why Might Consumer Confidence and Investor Confidence Diverge? Although they are related, consumer and investor confidence can be influenced by different factors. Consumer sentiment is driven by how confident consumers feel about the overall economy and their financial state for a given period of time. A high level of consumer confidence indicates that consumers believe that economic growth will be good and that their financial situation is stable. One such measure of confidence in the U.S., the University of Michigan Consumer Sentiment Index, surveys consumers on four key points: 1) their financial condition now versus one year ago, 2) their expectations for their financial situation one year from now, 3) their expectations for business conditions, and 4) present market conditions for large household purchases. Answers to these questions may be based on the recent performance of financial markets, the state of the housing and labor markets, and economic uncertainty. Similar to consumer confidence, investor confidence reflects how investors perceive the underlying economic conditions and other factors that may drive corporate fundamentals (and, in turn, influence markets). Yet, it is likely that investor confidence relies more heavily on investor expectations for the future of financial markets and the economy. While consumers and investors are both focused on the state of housing, labor and financial markets, consumers often are willing to spend while current conditions are good, but investors may be looking further into the future. The State Street Investor Confidence Index tracks the composition of institutional investment portfolios and measures the changes in holdings of risky assets (such as equities). Investor confidence should increase as the level of riskier assets held rises. Chart 1. U.S. Investor Confidence Is Starting to Catch Up to Consumer Sentiment (Indexed to as of 7/31/1998) /98 7/00 7/02 7/04 7/06 7/08 7/10 7/12 7/14 7/16 University of Michigan Consumer Sentiment Index State Street Investor Confidence Index Sources: Bloomberg, State Street, University of Michigan, 9/6/ Wells Fargo Investment Institute. All rights reserved. Page 2 of 7

3 While consumer and investor confidence have shown notably positive correlations, they do not always move in the same direction. Chart 1 shows that consumer and investor confidence in the U.S. historically have tracked closely together. In mid-2015, however, investor confidence began to decline while consumer confidence remained high. This divergence alludes to investors reluctance to take on riskier positions despite consumers healthy expectations for the economy and their financial conditions. Investor confidence has started to close the gap this year, but what has contributed to a divergence between the two in recent years? We decided to look further into the data. According to a component of the consumer sentiment index that focuses on future expectations (Chart 2), the disparity between consumer future expectations and investor confidence is not as large as with overall consumer sentiment. We believe that institutional investors had become more pessimistic about future economic prospects than consumers had. Despite the fact that there still was a divergence between consumers future expectations and institutional investor sentiment, this disconnect was short-lived. This suggests that investors holdings (and their confidence) in riskier assets may be driven more by future expectations than the current state of the economy or consumer financial conditions. Less confidence in the future economic outlook could contribute to building a portfolio with more conservative holdings, and thus, reflect lower investor confidence. Chart 2. U.S. Investor Confidence Follows Future Expectations More Closely 120 (Indexed to as of 7/31/1998) /98 7/00 7/02 7/04 7/06 7/08 7/10 7/12 7/14 7/16 University of Michigan Consumer Expectations Index State Street Investor Confidence Index Sources: Bloomberg, State Street, University of Michigan, 9/6/ Wells Fargo Investment Institute. All rights reserved. Page 3 of 7

4 Investment Implications In general, financial markets benefit when consumer and investor confidence improves. Despite the dip in institutional investor confidence, and its divergence from consumer confidence at times, global equities continue to perform well. Investor confidence appears to track future consumer expectations more closely than current conditions, which is important, because it relates to the potential for higher corporate earnings in the future. Chart 3. Equity Markets Continue to Move Higher S&P 0 MSCI Europe /05 1/07 1/09 1/11 1/13 1/15 1/17 S&P 0 Index State Street Investor Confidence Index /05 1/07 1/09 1/11 1/13 1/15 1/17 MSCI Europe Index State Street European Investor Confidence Investor Confidence Investor Confidence MSCI Asia Pacific Index Level /05 1/07 1/09 1/11 1/13 1/15 1/17 MSCI Asia Pacific Index State Street Asian Investor Confidence Investor Confidence Sources: Bloomberg, State Street, 9/8/17 Strength in consumer confidence and underlying economic fundamentals remain supportive of equities, both in the U.S. and abroad. Despite political uncertainties in the U.S., strength in consumer confidence and the turn in investor confidence are both supportive of the economy. We do not believe that we are at the end of the cycle yet and we expect stronger economic growth later this year, which should benefit cyclical sectors (more than defensive sectors). We currently recommend that investors overweight the Consumer Discretionary, Industrials, Financials, and Health Care sectors of the U.S. equity market Wells Fargo Investment Institute. All rights reserved. Page 4 of 7

5 International markets have benefited from improved earnings, better-than-expected economic growth, and rising consumer sentiment. While investor confidence is still lagging in Europe and Asia, we keep a balanced view of these equity markets. Earnings growth is improving, but investor sentiment is not yet showing an anticipation of improvement. The balance between these two factors leaves us evenweight (neutral) international developed ex-u.s. equities and emerging-market equities. Evenweight implies that investors should hold their long-term target allocations in these international markets. Yet, we recommend that investors whose portfolios have less than this target allocation begin taking allocations up to these long-term target levels. In the fixed-income markets, even as consumer and investor confidence build and economic conditions improve, low levels of inflation could remain a concern for bond investors (because a rise in inflation may negatively impact bond-market prices). Government bond yields have fallen from highs set earlier this year as fixed-income markets around the world have priced in lower-than-anticipated inflation. With that said, we expect bond yields in the U.S. to rise gradually from current levels. U.S. Treasury security yields remain attractive on a global scale, despite the recent rise in developed-market bond yields abroad. Furthermore, our outlook for the U.S. dollar calls for moderation of the currency s recent losses against the euro and yen, which could reduce developed-market fixed-income performance for the dollar-based investor. We recommend that investors remain broadly and globally diversified. We continue to recommend underweighting international developed-market fixed income Wells Fargo Investment Institute. All rights reserved. Page 5 of 7

6 Economic Calendar Date Report Estimate Previous 9/19/2017 Housing Starts 1174k 1155k 9/19/2017 Housing Starts MoM 1.% -4.80% 9/19/2017 Building Permits 1220k 1223k 9/19/2017 Building Permits MoM -0.80% -4.10% 9/19/2017 Current Account Balance -$116.0b -$116.8b 9/19/2017 Import Price Index MoM 0.40% 0.10% 9/19/2017 Import Price Index ex Petroleum MoM 0.20% 0.00% 9/19/2017 Import Price Index YoY 2.20% 1.% 9/19/2017 Export Price Index MoM 0.20% 0.40% 9/19/2017 Export Price Index YoY % 9/20/2017 MBA Mortgage Applications -- 9.% 9/20/2017 Existing Home Sales 5.46m 5.44m 9/20/2017 Existing Home Sales MoM 0.40% -1.30% 9/20/2017 FOMC Rate Decision (Upper Bound) 1.25% 1.25% 9/20/2017 FOMC Rate Decision (Lower Bound) 1.00% 1.00% 9/21/2017 Initial Jobless Claims 300k 284k 9/21/2017 Continuing Claims 1975k 1944k 9/21/2017 Philadelphia Fed Business Outlook /21/2017 FHFA House Price Index MoM 0.40% 0.10% 9/21/2017 Bloomberg Consumer Comfort /21/2017 Bloomberg Economic Expectations /21/2017 Leading Index 0.30% 0.30% 9/21/2017 Household Change in Net Worth -- $2347b 9/22/2017 Markit US Manufacturing PMI /22/2017 Markit US Services PMI /22/2017 Markit US Composite PMI /25/2017 Chicago Fed Nat Activity Index /25/2017 Dallas Fed Manf. Activity Source: Bloomberg as of 9/18/ Wells Fargo Investment Institute. All rights reserved. Page 6 of 7

7 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. 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. Definitions An index is unmanaged and not available for direct investment. University of Michigan Consumer Sentiment Index is a survey of consumer confidence conducted by the University of Michigan. The Michigan Consumer Sentiment Index (MCSI) uses telephone surveys to gather information on consumer expectations regarding the overall economy. State Street Investor Confidence Index is an index that measures investor confidence by looking at actual levels of risk taken by investors in their portfolios. University of Michigan Consumer Expectations Index is a subset of the University of Michigan Consumer Sentiment Index. The Index of Consumer Expectations (ICI) is a survey of consumer confidence conducted by the University of Michigan. The ICI uses telephone surveys to gather information on consumer expectations regarding the overall economy. State Street European Investor Confidence Index is an index that measures investor confidence for European institutional investors by looking at actual levels of risk taken by investors in their portfolios. State Street Asian Investor Confidence Index is an index that measures investor confidence for Asian institutional investors by looking at actual levels of risk taken by investors in their portfolios. S&P 0 Index consists of 0 stocks chosen for market size, liquidity, and industry group representation. It is a market-value-weighted index with each stock s weight in the index proportionate to its market value. MSCI Europe Index captures large and mid-cap representation across 15 Developed Markets (DM) countries in Europe: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the UK. MSCI AC Asia Pacific Index captures large and mid-cap representation across 5 Developed Markets countries and 9 Emerging Markets countries in the Asia Pacific region. Developed Markets countries in the index include: Australia, Hong Kong, Japan, New Zealand and Singapore. Emerging Markets countries include: China, India, Indonesia, Korea, Malaysia, Pakistan, the Philippines, Taiwan and Thailand. 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. 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