Investment Insights 2018

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1 Marketing Communication Investment Insights 2018 What s inside Watch for signs of economic change Wait patiently but not passively

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3 Portfolio positioning 2 Watch for signs of economic change 4 Central-bank policy remains on center stage 6 Don t think global, think specific 7 Wait patiently but not passively 8 Proactive waiting through liquidity 9 The advantage of diversification and patience 11 Watch and wait: The advantage of patience and positioning Our 2017 Midyear Investment Insights emphasized revising views on risk and pivoting toward emerging investment opportunities. In this 2018 Investment Insights, we look out over the next six months and share what our portfolio managers are thinking and how they re positioning their portfolios. With questions about an economic expansion and lack of clarity around interest-rate changes, we believe the best approach is to watch and wait. We believe the key thing to watch for in 2018 is evidence that this global environment of synchronized growth and low inflation might begin to fray around the edges. As Chief Equity Officer Jon Baranko says, Markets have gone from climbing a wall of worry to climbing a wall of disbelief that we can continue with this environment of moderate growth and inflation. As we watch and wait, we feel the most prudent approach is to stay diversified and stay patient. Hear from our portfolio managers about what they are watching, what they are waiting for, and what they are doing while they wait. 1

4 Portfolio positioning Wells Fargo Asset Management (WFAM) is known for its diverse offering of investment solutions. With 29 investment teams, WFAM is one firm with many perspectives across all asset classes and styles. The following represents the most common themes and ideas represented across WFAM s diverse teams. Equities Most teams still believe that decent opportunities exist within their areas of specialization. They tend to be neutral as it relates to market-capitalization exposure. The consensus view is that small-cap stocks which have a stronger domestic orientation than large-cap stocks are most vulnerable to any setback to proposed U.S. tax reform. While staying diversified, many managers have shifted toward slightly more concentrated portfolios (fewer names) or being more selective in higher-conviction names. Managers seem to have a cyclical bent, though a few expressed concerns that too rosy of a growth scenario is being priced into equities. The most-favored sectors are industrials, information technology (IT), materials, and certain parts of the diverse consumer discretionary space. Broadly, the managers are cautious about biotech, banks, and bond-proxy sectors like utilities and real estate investment trusts. Managers see more opportunities internationally, with banks and financials being particularly interesting. Banks and financials could be the prime beneficiaries of rate normalization and also should benefit from higher operating leverage after years of cost cutting. Fixed income Whether taxable, tax-exempt, domestic, or international, most of the WFAM fixed-income teams seem to be treading cautiously. The economic picture remains positive, but opportunities seem to be more at an issuer-by-issuer level rather than sector by sector. Many teams have said they tend to sell into rallies and lean into risk on pullbacks. In investment-grade credit, the teams believe investors are compensated to take on more duration risk, but, broadly speaking, the teams are positioned with slightly shorter duration exposures than their benchmarks. Within the longerduration portions of the tax-exempt market, the team is not seeing a compelling yield pickup by moving down in credit quality. On balance, the team is mildly underweight duration exposure and mildly overweight credit exposure. Internationally, core Europe looks expensive but some of the smaller countries offer opportunities. Although Italy will be the one having an election, Spain seems to carry more political risk, with the possible outcomes tilted toward the downside. The international portfolios strategically are positioned to benefit from a closing of the gap between developed and developing economies. 2

5 Asset allocation Looking at U.S. and non-u.s. equities, the Multi-Asset Solutions team believes that non-u.s. equities look more attractive from a valuation and momentum perspective. However, the opposite is true when considering fixed-income opportunities the team favors U.S. fixed income. Overall, the team continues to favor equities over fixed income but not to the same extent as it did at the midyear point. The team believes that economic fundamentals are sound enough to support valuations and spreads; however, it is concerned that the market is not properly pricing in the Federal Reserve s (Fed s) readiness to hike more quickly in 2018 than in 2017, especially as the vacancies on the Federal Reserve Board are filled. Fed policy affects not only the economic outlook but also the risk-free rate. A higher risk-free rate could compress risk premiums while marginally increasing risks. Factors In 2017, momentum and volatility were in favor while quality and value were not. Analytic Investors, LLC, takes a rules-based approach to allocating across factors. The team s rules allocate more to those factors that have higher trailing volatility than those factors with lower trailing volatility. The volatility factor has displayed low volatility, meaning the rules tend to favor overweighting assets with lower realized volatility versus those with higher realized volatility. Alternatives The Rock Creek Group, LP, manages a portfolio of alternative strategies. The team has diversified its sources of alpha by lowering its allocation to equity hedged and relative value strategies; relative value strategies tend to underperform in market sell-offs. The team also has tried to lower the interest-rate exposure of the portfolio because it is concerned that markets are underpricing the risk that the Fed may hike more quickly in 2018 than in Although global macro strategies tend to be trend-following strategies, The Rock Creek Group has steered toward global macro strategies that instead give exposure to non-u.s. equities, currencies, and long/short fixed-income strategies. The team continues to look through the labels on hedge fund strategies and focus on the themes the strategies invest in. Among the reoccurring sector themes are the consolidation of the community banking sector, the growth of the health care sector in the developing world, technology innovation in China, and the application of blockchain technology. Companies that have been dynamic, adaptive, nimble, disruptive, and innovative have performed well. One key feature is the ability of companies to navigate in a dynamic, fast-paced, and changing market environment. 3

6 Watch for signs of economic change The global economy seems to be firing on all cylinders. According to the International Monetary Fund s data, more than 96% of the world s gross domestic product (GDP) is growing. This is happening in a context where inflation has remained low. While we have seen broad growth, that growth is historically below average. Low growth and low yields have hung around for a while and formed a type of bittersweet spot for investors. CHART 1 Global growth with low inflation things have rarely been this good Let s face it, we are in a world of low growth. Interest rates, inflation, and spending are likely to remain low compared with past cycles. This environment has made two attributes particularly scarce in the investing world yield and growth. Investors insatiable desire for yield has been prevalent for years. Now, as the cycle matures, companies that can grow organically are becoming increasingly valuable. Value is created through scarcity, and leading growth stocks have scarce attributes. They are taking market share and growing earnings rapidly; they don t need policy changes, and they don t need valuation expansion to outperform. We build portfolios that are overweight in the companies of the future. By identifying long-term secular winners, we believe the opportunity to compound outsized returns is astounding. The FANG phenomenon of recent years the stock market dominance of Facebook, Amazon, Netflix, and Google (Alphabet) has shown us how powerful this approach can be. Technological advancements are creating transformative growth opportunities. For investors to reach their objectives, it s imperative to have exposure to companies on the right side of change. Michael Smith, CFA Managing Director and Senior Portfolio Manager 70 % of world GDP % of world GDP growing % of world GDP with <4% inflation Source: International Monetary Fund. Yearly data from 1982 through

7 For much of the period, the preponderance of world GDP was expanding. Synchronized global growth can remain synchronized for a while. Instead of thinking that things will fall apart simply as a result of the passage of time, we are looking at leading indicators of whether the global growth picture is beginning to fray. Here are a few indicators we are watching: Bank lending Residential investment The housing cycle generally coincides with the economic cycle, and I keep a close eye on residential investment as a result. It usually provides a nice 12- to 18-month preview of where the broader cycle is heading. Right now, residential investment is a bit soft but not enough to be concerning. There s some multifamily weakness at the moment, but there appears to be plenty of room for the single-family market to pick up the slack, which is what I expect in 2018 and beyond. If residential investment dipped significantly from here, then I would start to get more concerned. I tend to track a broader array of indicators in Europe and Japan, including Purchasing Managers Indices, consumption indicators like retail sales, and employment. The story with all of these remains positive as well. Noah Wise, CFA Portfolio Manager Wage growth Country-specific politics CHART 2 Business loan growth has slowed in the U.S. but has accelerated in Japan and the eurozone Bank lending can be a lagging rather than a leading indicator, but if the U.S. lending picture does not improve, we would take that as an indication that the global business cycle could be taking an adverse turn Euro-area loans to nonfinancial businesses U.S. commercial and industrial loans Japanese loans Year-on-year growth (%) Sources: Bloomberg and Federal Reserve Bank of St. Louis. European Central Bank euro-area monetary financial institution loans to nonfinancial corporations annual growth rates, total U.S. bank credit of all commercial banks, and Japan average amounts of loans and discounts outstanding at banks. Monthly data from October 31, 2001, through September 30,

8 Central-bank policy remains on center stage A change in central-bank activity can serve as a bit of an exogenous shock to global markets and economies. Since the mid-2000s, central banks have shifted from merely setting policies to communicating their policy intentions, a process known as forward guidance. If the Fed governors begin talking about hiking rates in the U.S. without inflation making a run toward 2%, and if the real economic data is pointing toward a slowdown, then we would begin to worry that the Fed is getting too anxious about snuffing out the economic flames rather than fanning them. Even though profit margins may get squeezed as wage growth accelerates, there are still equity investment opportunities around stronger wage growth, especially when focusing on consumer experiences rather than consumer goods. Risks come from surprises, and the big surprise could be how responsive the Fed is to wage pressure as an early warning of inflation. We are hearing from executives on earnings calls that wages are on the rise. That pressure might not be in the macroeconomic data yet, but it is emerging from company-by-company calls. The biggest risk is higher wages, which might push the Fed to hike faster. Garth Nisbet, CFA Senior Portfolio Manager CHART 3 The profit and wage cycle may have turned, but it can take a while for recession to set in The decline in unit profit per unit labor costs indicates that wages are growing more quickly than profits, which could be an early sign of an economic downturn Unit profit per unit labor costs Recession Unit profit per unit labor costs 6 Sources: Bloomberg and Federal Reserve Bank of St. Louis. Data from June 30, 1947, through June 30, 2017.

9 Don t think global, think specific Rather than thinking in terms of threats to the global outlook, we believe it is important to think in terms of threats to specific countries and sectors. Within the U.S., although debates about U.S. tax policy are capturing people s attention, we believe that failure to pass tax reform could make the market stumble but not necessarily enter a bear market. While the tax code is convoluted and inefficient, we believe that the U.S. economic backdrop is favorable despite the tax code. Domestically oriented and serviceoriented firms are most vulnerable if tax reform fails to pass, but we do not think that failure poses an existential threat to the global bull market. Outside of the U.S., there is almost a laundry list of issues that merit monitoring: The political situations in South Africa, Turkey, and Venezuela likely mean their markets will continue to CHART 4 The slowdown in China s debt growth merits watching due to its relationship with economic growth. Industrial production year-over-year growth (%) We keep a very close eye on the People s Bank of China balance sheet, Chinese credit growth, and the country s foreign currency reserves to see how much stimulus is getting provided to their economy and to see how jittery Chinese capital is or is allowed to be. This is particularly important for assessing the prospects for China s large trading partners and those emerging-market economies that are disproportionately dependent on commodity prices. Right now, it appears the stimulus spigots are still open and the capital controls remain functional. Noah Wise, CFA Portfolio Manager China industrial production growth (year-over-year) China social financing growth (year-over-year) Sources: Bloomberg and National Bureau of Statistics of China. Monthly data from February 28, 2006, through August 31, carry a volatile political premium although Venezuela does not have much of a market. Italy will face an election in 2018 in which the outcome seems too difficult to guess. Brexit continues to advance and retreat, buffeting the British pound. Mexico will have a general election on July 1, 2018, and it s possible that policies implemented under the incumbent President Peña Nieto could be reversed Total social financing year-over-year growth (%) China is dealing with its debt pile but so far seems to have things under control. This last point the way China is dealing with its debt pile is perhaps the most important story for the global macroeconomic picture. In terms of individual sectors, IT has dominated other sectors for Looking ahead, we believe that it is still important to focus on IT but to do so in a diversified and expansive way to capitalize on change. Our focus is to invest in companies on the right side of change. Emerging technologies are creating rapid change throughout the global economy. Like the buildout of railroads and highways from past generations, new infrastructures are being built today. They have the potential to affect virtually every industry. Examples include machine learning, robotics, artificial intelligence, virtual reality, cloud hosting, automation, e-commerce, digital currencies, and driverless vehicles. From an investing standpoint, what is especially powerful is how leading companies are seeing their competitive advantages accelerate as time goes by. This is distinctly unique from past technological cycles. Michael Smith, CFA Managing Director and Senior Portfolio Manager 7

10 Wait patiently but not passively Markets and the economy do not obey the clock or the calendar. As a result, it is impossible to say how long investors might have to wait things out in the current environment of rich valuations and low volatility. The Fed says it is data dependent when it comes to setting monetary policy, and we believe that is also a prudent approach to investing be data dependent. Across the board, our managers have been waiting for, and then pouncing on, opportunities. This latter part of the year has felt like the reverse of last year. People can t get enough of munis right now, whereas last year they couldn t sell fast enough. Our approach this year is the same as last year s, though. We haven t been structuring or restructuring our portfolios based upon anticipated tax changes. We would, however, fade or trade against any rally. Even if supply is going to be reduced, at some point valuations matter. We had been trying to extend duration slightly into the recent sell-off, but with muni yields moving tighter relative to Treasuries, we prefer to stay short. Generally, we have a bias toward moving up in quality as well. CHART 5 Lyle Fitterer, CFA, CPA Co-Head of WFAM Global Fixed Income Municipal bond yields are fair relative to Treasuries, but asset flows into municipal bond funds have been robust AAA muni yield as a % of 10-year Treasury Municipal bond fund flows AAA muni yield as % of 10 year Treasury Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 4,000 2, ,000-4,000-6,000-8,000 Weekly municipal bond mutual fund and ETF flow (millions of dollars) Source: Bloomberg and Investment Company Institute. Weekly data from January 9, 2013, through November 15,

11 Long-term Treasury yields in the U.S. have been oscillating between 2.70% and 2.95% since the middle of For the next six months, we believe long-term yields will continue to be rangebound. Any move up in longterm U.S. yields should be relatively contained; the U.S. bond market already offers relatively high yields versus other developed markets, and we see decent demand for investmentgrade fixed income by pension funds across the globe. First, foreign investors continue to extend their investment-grade maturity parameters in an effort to combat low and negative global interest rates. Second, due to the strength of the equity market, there likely will be a rebalancing out of equities and into long-duration fixed income by pension funds; specifically, their fixed-income allocations tend to be largely allocated toward long-duration investment-grade credit. We continue to forecast that the U.S. Treasury yield curve will flatten, with a narrower spread between short-term and long-term interest rates. Floating-rate notes that reset quarterly off of three-month LIBOR are a nice way to play a flattening of the yield curve. This also could be a good market space to hang out in if one is concerned about a significant rate backup. But we think yields will rise only modestly in 2018, with the 10-year Treasury continuing to trade under 3%. We need to see more evidence of inflation globally to be concerned about a significant rate rise. In the meantime, we believe that global central banks will continue to be protective of what little growth they currently have. Scott Smith, CFA Portfolio Manager Proactive waiting through liquidity When it comes to investing wild cards, such as geopolitical events, most investors tend to be reactive instead of proactive, selling in response to negative news. Yet markets tend to move a lot faster than individuals can. We think the most prudent way to be proactive is to remain diversified and make good use of liquidity. Managing cash balances such that cash flows are covered for a set period of time such as for six months to a year gives an investor the option to take advantage of sudden opportunities or to ride things out instead of being a forced seller. Investors have many different choices for managing liquidity needs. In 2016, a raft of regulatory changes introduced floating net asset values (NAVs) for prime money market funds, liquidity fees, and redemption gates. But after a year of transitioning to these new rules, investors have re-engaged with money market funds that invest in corporate securities, also known as prime funds. We have seen a steady return back to prime in 2017, both for the industry and for our strategies. Floating NAV changes have been small and infrequent, liquidity has been high and in excess of the 30% requirement, and yields increased by approximately 30 basis points (100 basis points equal 1.00%) compared with government funds. These observed characteristics have comforted many investors as they reconsider prime money markets since 2016 s implementation of floating NAVs, liquidity fees, and redemption gates. Jeffrey Weaver, CFA Head of Money Market Funds and Short-Duration Fixed Income 9

12 CHART 6 Attractive commercial paper yields help support prime money market fund flows The exodus from prime money market funds to government money market funds has stopped. One reason might be because yields on commercial paper are relatively attractive compared with those on U.S. Treasuries. 2,500 Commercial Paper three month yield 1.6 Assets in type of money market mutual fund (billions of dollars) 2,000 1,500 1, Treasury bill three month yield Prime money market fund assets Government money market fund assets Yield (%) 0 0 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Source: Bloomberg and Investment Company Institute. Weekly data from January 11, 2013, through November 17, Now that prime money market funds have yields in excess of 1% (as reported by Thomson Reuters Lipper), investors may feel as though their cash balances are at least beginning to keep pace with inflation. Those yields are likely to rise as the Fed continues its slow march toward a normal policy rate (federal funds rate) target of approximately 3%. Depending on how the U.S. president fills the vacancies on the Federal Reserve Board, the march toward normal could happen faster or slower. Broadly, our managers anticipate it should continue to be a steady and gradual ascent. The nomination of Jerome Powell for Fed chairman has markets believing he will follow the path started by Chair Janet Yellen. Increases in the federal funds rate likely will continue to be steady and gradual in nature, and the Fed s balance sheet should decrease over time. While Powell s nomination hasn t necessarily provided investment opportunities, a gradual trend toward higher rates is attractive to short-term investors. Such a gradual course should result in more-attractive yields without the disruptive effects of dramatic increases in interest rates, which could result in negative returns and increased volatility in risk markets. Jeffrey Weaver, CFA Head of Money Market Funds and Short-Duration Fixed Income 10

13 The advantage of diversification and patience The economic backdrop continues to look favorable, but many people tend to catastrophize, thinking, It can only get worse from here. While things may get worse, this may not happen for a while. One of the dangers with an environment where everyone knows that things look good is that a shock can shake up the system. First, it seems most of these positives are broadly understood and priced into the market, so unfortunately valuations already reflect a lot of this. Therefore, we ve dialed down the amount of risk we re taking so that we can act from a position of strength when the market starts to exhibit some weakness. No one knows when that ultimately will be, but fortunately the cost of waiting has rarely been lower. When implied volatilities are at their lowest, market risk is often at its highest because the cost of leverage declines as volatility declines. Confidence, especially of the unwarranted variety, usually goes up as prices go up. That has proven to be a dangerous combination since time immemorial. Second, we ve found good old-fashioned credit picking is the most consistent source of alpha generation through the cycle. Issuer selection never goes out of style! When the market isn t differentiating between the good and not-so-good companies, this can mean investing more in industry leaders with strong balance sheets and solid operating performance. However, good credit selection also means being willing to take smart risks when the market provides overlooked and misunderstood opportunities, which occur even in a bull market. Noah Wise, CFA Portfolio Manager We believe the cardinal rules of successful investing remain staying diversified and practicing patience, even as investors continue to watch and wait. 11

14 About the authors Wells Fargo Asset Management s investment experts offer their views on the economy, equities markets, and fixed-income markets in the U.S. and abroad. Their combined view of the investment landscape gives investors a comprehensive perspective on recent market activity. F. Jon Baranko Chief Equity Officer Lyle Fitterer, CFA Co-Head of WFAM Global Fixed Income, Managing Director, Head of Municipal Fixed Income Brian Jacobsen, Ph.D., CFA, CFP Senior Investment Strategist, Multi-Asset Solutions 12

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16 The views expressed and any forward-looking statements are as of November 15, 2017, and are those of Chief Equity Officer F. Jon Baranko, Co-Head of Wells Fargo Asset Management Global Fixed Income Lyle Fitterer, Senior Investment Strategist Brian Jacobsen, and Wells Fargo Asset Management. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. 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