Key Takeaways. What it may mean for investors WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS. Luis Alvarado Investment Strategy Analyst

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1 Luis Alvarado Investment Strategy Analyst WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS December 12, 2017 The Mystery of Inflation and What Lies Ahead Key Takeaways» As most investors know, inflation is a widely followed barometer of economic activity and consumer (and business) purchasing power. Yet, for some followers of this indicator, consumer inflation (or lack thereof), remains a mystery today.» Although we agree with the Federal Reserve s (Fed) view that inflation will rise slightly next year, we believe that some of the near-term causes of higher inflation will be related to growing household demand, government spending, and credit usage. We foresee a more muted impact from wage increases. What it may mean for investors» In 2018, we expect moderate economic growth and inflation, and two additional Fed rate hikes, which could raise short-term rates by more than long-term rates. The flattening yields across the interest-rate curve likely favors equities over bonds. In September, outgoing Fed Chair Janet Yellen alluded to the lack of inflation in 2017 as being more of a mystery (than inflation developments in earlier years). In today s report, we seek to dispel some of the mystery of inflation today. We will discuss our views on recent inflation trends and describe factors that we believe will contribute toward higher inflation next year. Inflation is one of the most commonly followed economic indicators by economists and market participants alike, since it serves as a barometer on the economy and the purchasing power of consumers (and/or businesses). According to the Bureau of Labor Statistics, the Consumer Price Index (CPI) is the most widely cited inflation measure in the U.S. (the CPI measures the average change in prices of a basket of goods and services purchased by households). Monitoring and maintaining price stability is one of the Fed s two mandates. When the Federal Open Market Committee (FOMC) meets this week, it is widely expected to raise short-term interest rates for the fifth time since the Great Recession, to a fed funds target range of 1.25% to 1.50%. The FOMC recently has been concerned about inflation remaining below the Fed s target, but market expectations are for a December rate hike as the job market continues to improve potentially leading to higher wage growth, spending and somewhat higher inflation Wells Fargo Investment Institute. All rights reserved. Page 1 of 5

2 What can cause inflation? There are several factors that cause prices to rise. At times, these driving forces can occur concurrently. Overall, economists have tended to explain the major causes of inflation by organizing them into two main groups (Table 1), depending upon whether each factor pushes production costs higher or sparks demand or spending that pulls prices higher. Table 1: Major causes of inflation Cost-Push Demand-Pull 1) Shocks in Supply Stronger Consumption 2) Higher Wages Government Spending 3) Imported Inflation Weaker Exchange Rate 4) Higher Taxes Monetary Growth 5) Higher Inflation Expectations Source: Wells Fargo Investment Institute, November 27, Table components extracted from Principles of Macroeconomics, N. Gregory Mankiw, Ninth Edition. Since 1914, the CPI has been a common measure of inflation in the U.S. Historically, when the U.S. experienced elevated levels of inflation (above 5%), it was due to costpush inflation as supply of key commodities and resources became scarce (which often was attributed to war). The Fed reacted to the global financial crisis and the eventual U.S. recession by implementing several monetary policies. As investors know, these included reducing interest rates, and injecting money supply into the system through the purchase of Treasury and mortgage securities, with the intent to increase the amount of money available for spending (and to enhance credit conditions). Yet, the Fed has begun normalizing monetary policy by raising the fed funds rate (four times since December 2015) and by beginning to reduce its balance sheet (beginning in September 2017) as fears of potential inflation caused by wage growth began to surface. Yet, is that really the cause of higher consumer inflation? Chart 1: CPI changes year-by-year since World War I World War II World Oil and Grain Price Shocks 10 5 Korean War Vietnam War Gulf War Global Financial Crisis (GFC) YoY % 0-5 Fed Target after GFC Sources: Bloomberg, BLS; Monthly data: January 31, 1914, to October 31, Wells Fargo Investment Institute. All rights reserved. Page 2 of 5

3 Near-term inflation: origins and expectations In January of 2012, the Fed announced a 2% inflation target, saying that it is most consistent over the longer run with the Federal Reserve s statutory mandate. Since then, however, the Fed has consistently undershot that target. The Fed has cited weak wage growth as a key reason behind its cautious interest-rate policy outlook, and the current trend in data does suggest that this source of inflation is slow to materialize. As of late, inflationary expectations (the path that market observers expect inflation to follow) have been less affected by swings in compensation and wages than by other factors. Instead, we expect that near-term inflation will most likely be caused by 1) stronger consumption, as consumer and business confidence continues to increase and tax reform (leading to lower tax rates) potentially becomes effective in the first half of 2018, and 2) increased government spending, as fiscal policies and possible infrastructure spending from the Trump administration are implemented. Looking ahead and investor implications Our year-end 2018 CPI inflation target is 2.4%, up from the 2017 year-to-date average of 2.1%. We believe that the U.S. economy will grow slowly and produce only modest cost and demand pressures on inflation. The main risk to this view is that the broadening of economic growth and continued job gains could use more and more of the economy s productive capacity, until cost pressures finally push inflation up faster than our expectations. In an environment of moderately positive economic growth and inflation, we expect Fed policy makers to increase rates the fed funds rate twice next year. In addition, fixedincome investors are likely to see low expected inflation as a benign development and our 10-year Treasury yield target range is 2.50%-3.00% for year-end 2018, up marginally from our 2017 target range of 2.25%-2.75%. We have a favorable view of intermediate bonds within well-diversified fixed-income holdings, but as the yield curve continue to flatten, the benefit of moving out the curve is diminishing. We also see value in Treasury Inflation-Protected Securities (TIPS), which appear undervalued as inflation gradually recovers. TIPS could provide an inflation hedge to portfolios if inflation is unexpectedly strong. Equities should benefit from muted inflation, to the extent that long-term rates remain low and short-term rates rise only gradually. Solid earnings growth amid more consistent interest rates across the range of maturities (as the yield curve flattens) tends to support near-term earnings and attract investors to equities. Most of our equity-sector preferences are targeted in those sectors that should benefit the most from low inflation and steady growth namely, Financials, Industrials, and consumer cyclicals (the Consumer Discretionary sector) Wells Fargo Investment Institute. All rights reserved. Page 3 of 5

4 Economic Calendar Date Report Estimate Previous 12/12/2017 NFIB Small Business Optimism /12/2017 PPI Final Demand MoM 0.40% 0.40% 12/12/2017 PPI Ex Food and Energy MoM 0.20% 0.40% 12/12/2017 PPI Ex Food, Energy, Trade MoM 0.20% 0.20% 12/12/2017 PPI Final Demand YoY 3.00% 2.80% 12/12/2017 PPI Ex Food and Energy YoY 2.40% 2.40% 12/12/2017 PPI Ex Food, Energy, Trade YoY % 12/12/2017 Monthly Budget Statement -$135.0b -$63.2b 12/13/2017 MBA Mortgage Applications % 12/13/2017 CPI MoM 0.40% 0.10% 12/13/2017 CPI Ex Food and Energy MoM 0.20% 0.20% 12/13/2017 CPI YoY 2.20% 2.00% 12/13/2017 CPI Ex Food and Energy YoY 1.80% 1.80% 12/13/2017 CPI Core Index SA /13/2017 CPI Index NSA /13/2017 Real Avg Weekly Earnings YoY % 12/13/2017 Real Avg Hourly Earning YoY % 12/13/2017 FOMC Rate Decision (Upper Bound) 1.50% 1.25% 12/13/2017 FOMC Rate Decision (Lower Bound) 1.25% 1.00% 12/14/2017 Initial Jobless Claims 239k 236k 12/14/2017 Continuing Claims k 12/14/2017 Retail Sales Advance MoM 0.30% 0.20% 12/14/2017 Retail Sales Ex Auto MoM 0.70% 0.10% 12/14/2017 Retail Sales Ex Auto and Gas 0.30% 0.30% 12/14/2017 Retail Sales Control Group 0.30% 0.30% 12/14/2017 Import Price Index MoM 0.80% 0.20% 12/14/2017 Import Price Index ex Petroleum MoM 0.10% 0.10% 12/14/2017 Import Price Index YoY % 12/14/2017 Export Price Index MoM 0.30% 0.00% 12/14/2017 Export Price Index YoY % 12/14/2017 Markit US Manufacturing PMI /14/2017 Markit US Services PMI /14/2017 Markit US Composite PMI /14/2017 Bloomberg Consumer Comfort /14/2017 Business Inventories -0.10% 0.00% 12/15/2017 Empire Manufacturing /15/2017 Bloomberg Dec. United States Economic Survey 12/15/2017 Industrial Production MoM 0.30% 0.90% 12/15/2017 Capacity Utilization 77.20% 77.00% 12/15/2017 Manufacturing (SIC) Production 0.20% 1.30% 12/15/2017 Total Net TIC Flows -- -$51.3b 12/15/2017 Net Long-term TIC Flows -- $80.9b 12/18/2017 NAHB Housing Market Index Source: Bloomberg as of 12/8/ Wells Fargo Investment Institute. All rights reserved. Page 4 of 5

5 Risk Considerations Targets and forecasts are not guaranteed and are subject to change. 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. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities. An investment that is concentrated in a specific sector may be subject to a higher degree of market risk. Investments in fixed-income securities are subject to interest rate, credit/default, liquidity, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond s price. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity. Although Treasuries are considered free from credit risk they are subject to other types of risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate. 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. Disclosures The Consumer Price Index (CPI) produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services. 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 Securities is the trade name for the capital markets and investment banking services of Wells Fargo & Company and its subsidiaries, including Wells Fargo Securities, LLC, member NYSE, FINRA and SIPC and Wells Fargo Bank, National Association. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company. 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 5 of 5