Where Demand Meets Supply Changing Fixed Income Markets

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1 WEEKLY GUIDANCE FROM OUR I NVESTMENT STRATEGY COMMITTEE George Rusnak, CFA Co-Head of Global Fixed Income Strategy Asset Group Overviews Equities... 3 Fixed Income... 4 Real Assets... 5 Alternative Investments... 6 Where Demand Meets Supply Changing Fixed Income Markets December 4, 2017 Key Takeaways» Monetary and fiscal policy changes, including the potential for U.S. tax reform, are likely to impact supply and demand in fixed-income markets both in the U.S. and abroad.» While these changes may create some near-term headwinds for fixed-income securities, we believe that these supply and demand forces are likely to be met with increased individual and institutional demand for fixed income in the longer term. What It May Mean for Investors» We recommend that investors retain exposure to fixed-income assets at strategic targets, but that they consider the unique impacts to fixed-income markets resulting from changing supply/demand dynamics. The fixed-income landscape is likely to be impacted by policy changes in Washington, D.C., and abroad made by central banks and fiscal policymakers, such as those focused on tax reform in the U.S. These are important forces for fixed-income investors to consider today and they are ones that we are closely monitoring. We expect tax reform, and monetary-policy changes, to have a meaningful impact on supply and demand in fixed-income markets. In today s report, we discuss these changes and their possible impacts on the bond markets. Monetary Policy Impacts As central banks begin reducing their asset purchases and security holdings, while raising interest rates, they will be decreasing or shifting demand for securities they once purchased more aggressively. For example, the Federal Reserve (Fed) will be reducing its demand for Treasury and mortgage securities as its trims its balance sheet by allowing a portion of these securities to roll off monthly without repurchasing them. Keep in mind that the pace of this balance-sheet reduction is expected to increase into the third quarter of While the Fed has begun to decrease the size of its balance sheet by $10 billion monthly, it plans to increase that number by $10 billion each quarter until it reaches $50 billion. Separately, the European Central Bank (ECB) will be reducing its demand for new sovereign debt, along with mortgage and corporate securities, as it cuts the size of its 2017 Wells Fargo Investment Institute. All rights reserved. Page 1 of 8

2 Where Demand Meets Supply Changing Fixed Income Markets monthly asset purchases next year. The ECB will be decreasing its quantitative easing asset purchases from 60billion ($71.4 billion) monthly to 30billion ($35.7 billion) monthly at the beginning of 2018 and plans to keep it that way for at least nine months. We expect the ECB to proceed cautiously in reducing its security purchases and to retain flexibility should market conditions change. Finally, the Fed may shift investor demand for short-dated fixed income securities by raising short-term interest rates. As the yield curve has flattened this year, we would expect to see investor sentiment shifting toward the shorter end of the yield curve where there now is a more favorable risk/reward equation, with the possibility for less volatility. Yet, ultimately, monetary-policy impacts are transitioning toward lower demand from central banks for fixed-income securities. It will be important for other market participants to make up this demand or for supply to decrease for markets to remain in equilibrium. Fiscal Policy Impacts As U.S. policymakers evaluate their latest tax policy proposals, the reduced federal revenues (from tax cuts) likely will lead to an increased supply of Treasury-security issuance. Conversely, more detailed components of the tax proposal, in its current form, could decrease the supply of securities in both the corporate and municipal markets as the ability of issuers to issue debt in these markets may be changed (and the benefits of issuing debt may be more limited). Specifically, corporate-bond supply may decrease in the coming years due to the current proposed limit on interest deductibility, which would make issuing debt less favorable for corporations. Additionally, new tax proposals may affect the issuance of securities for pre-refunded municipal (and stadium financing) bonds, and the ability for issuers of private activity bonds to issue debt or tighten their standards. This change could reduce the supply of municipal debt in a market that s already challenged for new issuance. (These changes could reduce 2018 municipal issuance by as much as 25 percent). Overall, the fiscal impacts of the latest tax proposal likely will have meaningful effects on the supply of Treasury, corporate and municipal bonds. It will be important for investors to be aware of these impacts and to invest with a forward-looking mindset. Investment Implications We believe that recent shifts in both monetary and fiscal policy may create some nearterm headwinds (and volatility) for fixed-income securities as central banks decrease demand and market dynamics shift with the expected changes to U.S. tax policy. Yet, some fixed-income sectors, such as the corporate and municipal market, may benefit from decreased supply as a result of the plan details. More importantly, we believe that demand for fixed-income securities will continue to increase for both individuals and institutions in the U.S, and that this increased demand likely will offset the reduced demand at the central-bank level. While we forecast a rising-rate environment, we believe that these rate increases will not be so significant in either pace or magnitude so as to deter investors from allocating to fixed-income assets in their portfolios Wells Fargo Investment Institute. All rights reserved. Page 2 of 8

3 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 Bull Has Room to Run Emerging equity markets are up 35.0 percent year to date on top of last year s respectable 11.6 percent return. After studying past bull-market cycles in emerging markets, we believe that we are slightly through the average length of a bull market, but that we still have significantly more room (and time) for the total return to increase. We looked at bull markets over the past 30 years for the MSCI Emerging Markets Index. The current bull market is the fifth bull market that the group has experienced. This bull market, which began in January 2016, is now 22 months old and has returned 55 percent. The average bull market in emerging markets over the past 30 years has lasted 32.8 months and returned 177 percent. We also looked at the bull-market cycles for the S&P 500 and MSCI EAFE indices. Compared to those cycles, the MSCI Emerging Markets cycles have been shorter but have had the highest average annualized returns. 1 We continue to believe that investors should maintain a full strategic allocation toward emerging-market equities. From a tactical standpoint, the December to January time frame can be a volatile one and should we get a pullback, we may look to assume more aggressive positioning for this equity group. We currently are evenweight emergingmarket equities. The last time we upgraded emerging-market equities was last December, following a quick 10-percent decline. Key Takeaways» We are slightly through the average length of a bull market for the emerging markets but we still believe that there is significantly more room for the total return to move upward.» We continue to believe that investors should maintain a full strategic allocation to emerging-market equities. Cumulative Total Return: MSCI Emerging Markets Index Emerging Market Equities Sources: Wells Fargo Investment Institute, Bloomberg; 11/29/17. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment. 1 Sources: FactSet, Wells Fargo Investment Institute, November 29, Wells Fargo Investment Institute. All rights reserved. Page 3 of 8

4 FIXED INCOME Brian Rehling, CFA Co-Head of Global Fixed Income Strategy Stressing Our Intermediate Recommendation 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 We continue to recommend intermediate-term fixed income, but the short-term fixed income class is quickly closing the gap as the yield curve flattens. Two years ago, the Bloomberg Barclays U.S. Aggregate 1-3 Year Bond Index yielded 1.25 percent. On Tuesday, November 28, the yield on this short-term index had increased to 1.92 percent (an increase of 67 basis points). 2 This compares with a yield increase of just 0.14 percent for the (intermediate-term) Bloomberg Barclays U.S. Aggregate 5-7 Year Bond Index to a 2.71 percent yield on this date. The yield gap clearly is closing. We have stress tested both the Bloomberg Barclays U.S. Aggregate 1-3 Year Bond Index (short-term) and the Bloomberg Barclays U.S. Aggregate 5-7 Year Bond Index (intermediate-term). Our stress test looked at performance over the next 12 months under a number of scenarios in which the Treasury yield curve shifts in a parallel fashion both higher and lower. Should we unexpectedly see a significant shift in the Treasury yield curve, we still would expect overall returns for intermediate fixed-income investors to be positive over a 12-month time horizon. Yet, the yield benefit that intermediate-term fixed income has over short-term fixed income is shrinking as short-term rates continue to increase. Given our relatively benign interest-rate forecast, we still see value in moving out the yield curve to intermediate fixed income (within a well-diversified fixed income portfolio). However, if the flattening yield-curve trend continues (as we expect), we could look to reduce exposure to intermediate maturities in the future as the benefit is shrinking. Bear in mind yield is only one consideration when investing in fixed income securities. Key Takeaways» We continue to favor intermediate maturities, but short-term issues are closing the yield gap as short-term interest rates rise.» High quality, longer-term fixed income continues to offer good diversification potential in the event of a significant unexpected risk-off market move. Total Return Under Treasury Interest Rate Hypothetical Shock Scenarios 5.00% U.S. Taxable Investment Grade Fixed Income Total Return 4.50% 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% Short Term Bloomberg Barclays U.S. Aggregate 1-3 Year Bond Index Intermediate Term Bloomberg Barclays U.S. Aggregate 5-7 Year Bond Index U.S. Intermediate Term Taxable Fixed Income 0.50% 0.00% Change in Interest Rates (Basis Points) Sources: Bloomberg, Wells Fargo Investment Institute, 11/29/17. Chart shows total return (including both price and income return), and it assumes that: (1) the yield curve shifts in a parallel fashion, and (2) the return period is 12 months. This information is hypothetical and is provided for illustrative purposes only. It is not intended to represent any specific return, yield, or investment, nor is it indicative of future results. The results are based on shock analysis which measures the risks to bond investors should interest rates rise by the stated percents and takes into account maturity, price, effective duration, yield to worst and other factors of the individual bonds in the portfolio. Results are estimates and are derived from a mathematical model. The actual impact on a portfolio of a rise in interest rates may be different than what is shown here. 2 FactSet, 11/28/17. One hundred basis points equal one percent Wells Fargo Investment Institute. All rights reserved. Page 4 of 8

5 REAL ASSETS John LaForge Head of Real Asset Strategy Underweight Commodities Private Real Estate Public Real Estate Top Three Potential Real Asset Surprises for 2018 It is our choices that show what we truly are, far more than our abilities. --J.K. Rowling We re sailing into 2018 pretty much on the same path as we started 2017 for real assets. Real assets, as a reminder, are based on hard or tangible investment assets. The real assets group is a very large investment arena, comprised mainly of commodities (oil, gold, copper, etc.), Real Estate Investment Trusts, or REITs (real estate, land, etc.), and Master Limited Partnerships, or MLPs (natural gas pipelines, oil storage facilities, etc.). As we begin 2018, we favor REITs (overweight), do not favor most commodities (underweight), and are more or less ambivalent on MLPs. Over the next few weeks, we ll be writing on each of these areas giving the background behind our 2018 advice. In the coming weeks, we ll also detail three possible surprises for 2018; today is a sneakpeak of these potential surprises. To be clear we re not necessarily expecting these things to happen. And talking to other real asset investors and strategists neither do they. It is these types of events, though, that would upset the real assets applecart, so to speak, should they occur. Only #1 (below) has a realistic chance of happening in 2018 (in our opinion). Yet, they all are worth watching. Potential (Unexpected) Surprises for ) MLPs gain more than 20 percent become the best-performing real asset and beat most other major assets (stocks, bonds, etc.). The main driver: Investors forget about poor MLP fundamentals, and rush to buy relatively cheap high-yielding assets. Chart 1 highlights that MLPs are the cheapest they ever have been versus high-yield bonds. 2) West Texas Intermediate (WTI) crude oil retests its $26 February 2016 low. The main driver: OPEC (Organization of the Petroleum Exporting Countries) loses its grip on oil prices. 3) Copper prices hit the low $2s. The main driver: Chinese metal demand falls off a cliff. MLPs versus High Yield Bonds 25 Alerian MLP Index Yield Yield (%) Bloomberg Barclays U.S. Corporate High Yield Index Yield Spread (%) Spread (Alerian MLP Index Yield - Bloomberg Barclays U.S. Corporate High Yield Index Yield) Median Sources: Wells Fargo Investment Institute, Bloomberg; monthly data 1/31/ /31/2017. Yields represent past performance and fluctuate with market conditions. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investing Wells Fargo Investment Institute. All rights reserved. Page 5 of 8 MLPs Expensive MLPs Cheap

6 ALTERNATIVE INVESTMENTS Jim Sweetman Senior Global Alternative Investment Strategist As Correlations Collapse Alpha Rises 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. Correlations have tumbled across the board this year a phenomenon that analysts have termed The Great Correlation Collapse. Stock pickers in the hedge fund universe have benefited during the first 10 months of this year as correlations between sectors and stocks have fallen significantly from last year s levels. This has benefited the Equity Hedge strategy, which is having its best year-to-date (YTD) return since Equity Hedge has gained 10.7 percent YTD through October while holding approximately 50 percent net long exposure and generating positive performance in 12 consecutive months. 3 As we approach year-end, stock correlations are at their lowest levels since the 2008 financial crisis resulting in a more favorable market backdrop for Equity Hedge managers. As the chart below depicts, until last year, there were long periods of high correlations between returns of global equities and the Equity Hedge strategy. 4 This highlights the challenges faced by active managers seeking to provide diversification and alpha 5. Yet, over the past 12 months, correlations between global equities and Equity Hedge have fallen to levels not seen since the 12-month period ending in May These are the lowest correlation levels in more than 21 years. While correlations have fallen, alpha has increased to levels not seen since the 12-month period ending in January 2010 almost eight years ago. When coupled with heightened dispersion of returns, we believe that this provides a more favorable environment for the Equity Hedge strategy heading into Key Takeaways» The decline in correlations between sectors has led to improved fundamentals and rising dispersion across stocks and sectors. In our view, this has created a more favorable environment for Equity Hedge strategy.» We believe that allocating assets to the Equity Hedge strategy may help to diversify portfolios and dampen volatility while offering access to idiosyncratic alphageneration opportunities that are independent of broader equity directionality. Rolling 12-Month Correlation and Alpha: HFRI Equity Hedge to MSCI World Index Sources: HFR, Bloomberg 11/29/17. Chart represents rolling 12-month data, December 1990 through October Correlation represents past performance. Past past performance is no guarantee of future results. An index is unmanaged and not available for direct investment. There is no guarantee that future correlations between the indices will remain the same. 3 HFRI Equity Hedge (Total) Index, November 29, MSCI All Country World Index, November 29, Alpha represents the difference between actual performance and expected performance based on market sensitivity, as measured by Beta Wells Fargo Investment Institute. All rights reserved. Page 6 of 8

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. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds, including municipal 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 securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. 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. Master Limited Partnerships (MLPs) are not appropriate for all investors. MLPs involve risks that differ from investments in common stock including risks related to limited control and limited rights to vote on matters affecting the MLP, risks related to potential conflicts of interest between the MLP and the MLP's general partner and cash flow risks, Other risks include the volatility associated with the use of leverage; volatility of the commodities markets; market risks; supply and demand; natural and man-made catastrophes; competition; liquidity; market price discount from NAV and other material risks. An MLP is not required to make distributions and distributions may represent a return of capital as detailed in the K-1 delivered to the unitholder. Unlike regular dividends, a `return of capital' is typically tax-deferred for the unitholder of an MLP and each distribution may reduce the unitholder's cost-basis. 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 Alerian MLP Index is a composite of the 50 most prominent energy Master Limited Partnerships (MLPs) that provides investors with an unbiased, comprehensive benchmark for this emerging asset class. The index, which is calculated using a float-adjusted, capitalizationweighted methodology, is disseminated real-time on a price-return basis and on a total-return basis. Bloomberg Barclays U.S. Aggregate 1-3 Year Bond Index is composed of the Barclays U.S. Government/Credit Index and the Barclays U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 1-3 years. Bloomberg Barclays U.S. Aggregate 5-7 Year Bond Index is composed of the Barclays U.S. Government/Credit Index and the Barclays U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 5-7 years. Bloomberg Barclays U.S. Corporate High Yield Index covers the universe of fixed-rate, noninvestment-grade debt. HFRI Equity Hedge (Total) Index. Equity Hedge: Investment Managers who maintain positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. EH managers would typically maintain at least 50 percent exposure to, and may in some cases be entirely invested in, equities, both long and short Wells Fargo Investment Institute. All rights reserved. Page 7 of 8

8 MSCI (ACWI) AC World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Index consists of 46 country indices comprising 23 developed and 23 emerging market country indices. The developed market country indices included are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States. The emerging market country indices included are: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. MSCI EAFE Value Index is a market capitalization-weighted index that monitors the performance of value stocks from Europe, Australasia and the Far East. MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. An index is unmanaged and not available for direct investment. 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 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 8 of 8