The Oil Connection. Key Takeaways. What It May Mean for Investors WEEKLY GUIDANCE FROM OUR I NVESTMENT STRATEGY COMMITTEE

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1 WEEKLY GUIDANCE FROM OUR I NVESTMENT STRATEGY COMMITTEE John LaForge Head of Real Asset Strategy The Oil Connection August 14, 217 Key Takeaways» Oil prices have an impact on other commodities, and on stocks, bonds, and inflation. What It May Mean for Investors» We continue to expect West Texas Intermediate (WTI) oil prices to remain rangebound in 217, between $4 and $5 per barrel. Oil never seems too far from the mainstream headlines, and it often is on our minds at Wells Fargo Investment Institute. We frequently are asked why. The main reason is that oil is the most-produced commodity in the world. Each day, the world consumes about 96 million barrels of petroleum. Take those 96 million daily barrels, multiply them by last week s $49 WTI price, and you get $4.7 billion spent daily on oil. Turn that $4.7 billion into a yearly consumption number, and we get $1.7 trillion. Only nine countries in the world have a yearly gross domestic product (GDP) greater than $1.7 trillion. Asset Group Overviews Equities... 7 Fixed Income... 8 Real Assets... 9 Alternative Investments... 1 Oil touches so many aspects of our daily lives. If you are sitting in your office reading this, nearly everything around you was produced with energy, and quite likely with oil or a derivative of it (gasoline, diesel, heating oil, etc.). Why oil why not some other energy source? Pound for pound, oil is the most efficient fossil fuel we have found, especially when converted into gasoline or diesel for use in transportation. Over the past 1 years, many countries have learned this some with dire consequences. World War I and II were both influenced heavily by oil. Winston Churchill, as an example, understood oil s superiority (ships could stay at sea longer, and move more quickly than a coal-powered ship), and gambled heavily on it at a time when Welsh coal was cheap and abundant (while the same could not be said of oil). The conversion to oil, in the end, helped the Allies. On the flip side, it has been argued persuasively that Hitler lost World War II because he ran out of oil looking for more oil. 217 Wells Fargo Investment Institute. All rights reserved. Page 1 of 12

2 The Oil Connection Back to today s investing landscape because of oil s sheer amount of production, it tends to dominate commodity indices. About 28 percent of the Bloomberg Commodity Index (BCOM), the blue line shown in the top panel of Chart 1, comes from oil and its energy derivatives. The bottom panel in Chart 1 highlights the persistently tight connection between the price of oil and other commodity prices. The horizontal dashed yellow line shows an average.7 correlation over the past 25 years. This connection is why we often write on oil, and why it influences our general commodity recommendation. Chart 1. Oil versus Commodities Oil Price (U.S. Dollars/Barrel) Correlation WTI Oil Commodity Index Rolling Two Year Correlations of Weekly Returns.9 Average Index Value Sources: Bloomberg, Wells Fargo Investment Institute. Weekly data: 1/3/1992-8/4/217. Commodity Index is the Bloomberg Commodity Index Total Return. WTI is a grade of crude oil used as a benchmark in oil pricing. The Bloomberg Commodity Index is calculated on an excess return basis and reflects commodity futures price movements. An index is unmanaged and not available for direct investment. Correlations represent past performance. Past performance is no guarantee of future results. There is no guarantee that future correlations between WTI and BCOM will remain the same. 217 Wells Fargo Investment Institute. All rights reserved. Page 2 of 12

3 The Oil Connection Oil Important for the Commodity Investment Outlook For added perspective on the importance of oil in our general commodity recommendation, take a look at Chart 2. Chart 2 highlights the connection between gold and other commodity prices. Gold, like oil, is a very popular commodity topic. However, gold does not hold the same sway in our investment minds as oil, precisely because of what we see in the bottom panel of Chart 2. Gold does not have the same persistently tight connection to other commodity prices, like oil does. Chart 2. Gold versus Commodities Gold Price (U.S. Dollars/oz) Correlation 2 18 Gold 16 Commodity Index Rolling Two Year Correlations of Weekly Returns.7 Average Index Value Sources: Bloomberg, Wells Fargo Investment Institute. Weekly data: 1/3/1992-8/4/217. Commodity Index is the Bloomberg Commodity Index Total Return. Gold is represented by XAU, a currency unit used to denote one troy ounce of gold. The Bloomberg Commodity Index is calculated on an excess return basis and reflects commodity futures price movements. An index is unmanaged and not available for direct investment. Correlations represent past performance. Past performance is no guarantee of future results. There is no guarantee that future correlations between gold and BCOM will remain the same. 217 Wells Fargo Investment Institute. All rights reserved. Page 3 of 12

4 The Oil Connection Oil and Stock Prices Oil s connection to the stock market is another question we often receive. The common thought is that, if oil prices go up, then stock prices must come down, and vice versa. Chart 3 argues against this thought. The bottom panel of Chart 3 shows that about half of the time, oil prices and the stock market (in this example, the S&P 5 Index) go up and down together (positive correlation) and the other half of the time, they move opposite one another (negative correlation). This does not mean that oil, and its derivatives, are irrelevant to how stock prices move. Our research shows that historically, when gasoline prices swing aggressively and quickly, stock prices were heavily influenced. When gasoline prices rose by 2 percent or more, after six months, stock-price gains tended to slow. When gasoline prices rose by 3 percent or more over a full year, stock prices frequently turned negative. Fortunately for stock investors, these events have not occurred too often. Over the past 4 years, gasoline prices have risen by 3 percent or more in one year, only 13 times. Chart 3. Oil versus Stocks Oil Price (U.S. Dollars/Barrel) WTI Oil S&P 5 Index Index Value Correlation Rolling Three Year Correlations of Monthly Returns Average Sources: Bloomberg, Wells Fargo Investment Institute. Monthly data: 1/31/1984-7/31/217. WTI is a grade of crude oil used as a benchmark in oil pricing. The S&P 5 Index is a market capitalization-weighted index composed of 5 widely held common stocks that is generally considered representative of the US stock market. An index is unmanaged and not available for direct investment. Correlations represent past performance. Past performance is no guarantee of future results. There is no guarantee that future correlations between WTI and the S&P 5 Index will remain the same. 217 Wells Fargo Investment Institute. All rights reserved. Page 4 of 12

5 The Oil Connection Oil and Inflation We receive a fair number of questions on oil s impact on inflation. Chart 4 shows that consumer inflation and oil prices do tend to move together through time. This is evident in the bottom panel of Chart 4, which shows a persistently positive correlation between the Consumer Price Index (CPI) and oil prices. Chart 4. Oil versus Inflation Oil Price (U.S. Dollars/Barrel) WTI Oil CPI YoY Index Index Value Correlation Rolling Three Year Correlations of Monthly Returns Average Sources: Bloomberg, Wells Fargo Investment Institute. Monthly data: 1/31/1984-7/31/217. WTI is a grade of crude oil used as a benchmark in oil pricing. The Consumer Price Index (CPI) measures the price of a fixed basket of goods and services purchased by an average consumer. It is a key indicator to measure inflation and changes in purchasing trends. Correlations represent past performance. Past performance is no guarantee of future results. There is no guarantee that future correlations between WTI and the CPI will remain the same. 217 Wells Fargo Investment Institute. All rights reserved. Page 5 of 12

6 The Oil Connection Oil and Bond Prices Lastly, today, we ll take a look at oil prices and bond prices. The historical connection has generally been what an investor would come to expect. The bottom panel of Chart 5 emphasizes that oil prices and bond prices do tend to have a negative correlation, through much of time. This makes sense: as oil prices rise, so does inflation (generally), and higher inflation tends to eat away at the fixed (income) returns in bonds. Chart 5. Oil versus Treasury Bonds Oil Price (U.S. Dollars/Barrel) WTI Oil Bloomberg Barclays Long Treasury Index Index Value Correlation Rolling Three Year Correlations of Monthly Returns Average Sources: Bloomberg, Wells Fargo Investment Institute. Monthly data: 1/31/1984-7/31/217. WTI is a grade of crude oil used as a benchmark in oil pricing. The Bloomberg Barclays US Long Treasury Index (the Index) measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. An index is unmanaged and not available for direct investment. Correlations represent past performance. Past performance is no guarantee of future results. There is no guarantee that future correlations between WTI and the Index will remain the same. 217 Wells Fargo Investment Institute. All rights reserved. Page 6 of 12

7 EQUITIES Ken Johnson, CFA Investment Strategy Analyst 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 What We See Ahead for International Equities More than 91 percent of the companies in the MSCI EAFE (Developed Market ex-u.s.) Index have reported second-quarter earnings. We have seen positive revenue and earnings surprises for 6 percent and 63 percent of companies, respectively. Year-overyear revenue and earnings growth also has been strong, at 6.7 percent and 24 percent, respectively. In aggregate, forward earnings have been trending higher this year. Strong earnings figures, coupled with improving growth in Europe and Japan, have helped translate into more compelling gains relative to the United States. However, should the European Central Bank begin tapering this year, developed international equity markets could experience some weakness. For the MSCI Emerging Markets (EM) Index, nearly 6 percent of companies have reported second-quarter earnings. So far, 53 percent have exceeded revenue expectations, while 46 percent have topped earnings expectations. Second-quarter revenue and earnings have risen by 7.7 percent and 2.8 percent, respectively, versus the same quarter last year. Overall, forward earnings have been relatively flat in 217; yet earnings are less of a factor for EM equities. Sentiment, geopolitics and currency movements carry more weight all of which appear to be improving. We recently have seen EM currency appreciation and strengthening global growth. The major EM-equity risks would be a strengthening dollar or disappointing global economic growth. Key Takeaways» We expect developed-market earnings to increase modestly this year. We also anticipate some stabilization in emerging-market earnings.» We remain evenweight emerging and developed-market equities. We prefer international equity markets over U.S. markets when putting new cash to work today. Forward Earnings per Share (EPS): Developed and Emerging Markets MSCI EAFE (Earnings per Share) MSCI Emerging Market (Earnings per Share) MSCI EAFE - Forward EPS MSCI Emerging Market - Forward EPS Sources: Wells Fargo Investment Institute, Bloomberg; 8/9/17. The MSCI EAFE (DM) and Emerging Markets (EM) Indices are equity indices which capture large- and mid- cap representation across 21 DM countries and 23 EM countries around the world. An index is unmanaged and not available for direct investment. 217 Wells Fargo Investment Institute. All rights reserved. Page 7 of 12

8 FIXED INCOME Brian Rehling, CFA Co-Head of Global Fixed Income Strategy 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 Overweight U.S. Taxable Investment Grade Fixed Income Overweight U.S. Intermediate Term Taxable Fixed Income Bond-Market Volatility At an All-Time Low The bond market is currently in a consolidation period that has lasted most of the year. In fact, the Merrill Lynch Option Volatility Estimate (MOVE Index) implies that U.S. bond-market volatility is not just at a low for the year but at an all-time low. While this low-volatility environment in the bond market could persist for some time, history shows that it will not last indefinitely. Significant volatility in the fixed-income market is not uncommon and often comes with little warning. The 1-year Treasury note typically trades in a fairly wide yield range over the course of a year. Since 2, the average calendar year trading range (the difference between the year s highest and lowest yield) for the 1-year U.S. Treasury note is 14 basis points or 1.4 percent. Interestingly, the lack of significant Federal Reserve (Fed) rate moves over the past seven years has not significantly changed what investors experience in annual yield movements. We do not expect the current low-volatility environment to persist. It is likely that investors will be subject to meaningful yield volatility at some point in the coming months. History supports our expectation. Key Takeaways» Periods of bond-market calm can often lull investors into taking added risk in their bond portfolios. High-yield debt investments have produced double-digit returns over the past 18 months. We recommend that investors use this opportunity to take profits in lower-rated debt securities and move to an underweight allocation. We also favor raising average credit quality in bond portfolios today.» By understanding that interest-rate volatility is a normal part of bond-market trading patterns, investors can be less emotional when the inevitable periods of volatility occur. Merrill Lynch Option Volatility Estimate (MOVE Index) MOVE Index Value Source: Bloomberg, 8/8/17. The Merrill Lynch Option Volatility Estimate (MOVE) Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options which are weighted on the 2, 5, 1, and 3 year contracts. It is a market-based measure of uncertainty about the future course of interest rates. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. 217 Wells Fargo Investment Institute. All rights reserved. Page 8 of 12

9 Austin Pickle, CFA Investment Strategy Analyst REAL ASSETS The essence of strategy is choosing what not to do. --Michael Porter MLPs Oil Prices Remain Key Underweight Commodities Private Real Estate Overweight Public Real Estate Oil gets a lot of attention from the news cycle, from investors, and from us. And it should. Oil is the most economically important and relevant commodity in the world. In recent reports, we have reiterated our view on oil prices; that they will remain rangebound for the next few years (likely between $3 and $6) and within a tighter range for the remainder of 217 (between $4 and $5 for WTI). Master limited partnerships (MLPs) get comparably little attention (but are inextricably tied to the fate of oil prices). MLPs own pipelines and storage facilities and charge tolls for others to use their infrastructure. The toll-payers are typically Exploration and Production (E&P) companies. The relatively steady toll-taking business has allowed MLPs to consistently be the least sensitive energy-related industry to oil price moves (purple line in the chart below). But this dynamic changed when oil prices crashed from a level above $1 in 214 to $26 in 216. Nearly 22 percent of all E&P companies went bust during this time, and MLPs suffered. The scar from this event is still fresh in investors minds and, as a result, MLPs are still unusually sensitive to the price of oil. This sensitivity may provide trading opportunities as oil prices bounce between the low end of our forecast range to the high. We believe high quality mid-stream MLPs would be a buying opportunity should oil prices dip to the low-$4s or below. Key Takeaways» Currently, MLPs are unusually sensitive to oil-price moves.» We believe that high quality mid-stream MLPs could offer a buying opportunity should oil prices dip to the low $4s or below. Energy-Related Industries' Sensitivity to Oil Price Moves Sources: Bloomberg, S&P, Alerian, Wells Fargo Investment Institute. Weekly Data: 1/1/1998-7/28/217. Sensitivity based on a two-year rolling beta of weekly returns to WTI crude oil spot. Upstream Index includes the S&P Supercomposite Oil & Gas Exploration & Production and the S&P Supercomposite Oil & Gas Drillers Sub Industry Indexes. Market Cap weighted Downstream Index = S&P Supercomposite Oil & Gas Refining & Marketing Sub Industry Index Integrated Index = S&P Supercomposite Integrated Oil & Gas Sub Industry Index. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. Please see the end of this report for the definitions of the indices. 217 Wells Fargo Investment Institute. All rights reserved. Page 9 of 12

10 ALTERNATIVE INVESTMENTS Justin Lenarcic Global Alternative Investment Strategist Crude Behavior: Are Hedge Funds Correlated to Oil? Private Equity Private Debt Hedge Funds-Macro Hedge Funds-Event Driven Overweight Hedge Funds-Relative Value There are a multitude of factors believed to influence hedge fund performance. These include volatility, interest rates, inflation, correlation, performance dispersion, and monetary policy (to name only a few). In fact, we spend a significant amount of time isolating and analyzing the drivers of hedge fund performance, which then helps us to forecast hypothetical expected returns and develop strategy and fund conviction levels. In a recent review of the factors driving hedge fund returns, we found it interesting that crude oil was a significant driver of performance not only for the Macro strategy which is intuitive but also for Relative Value, Event Driven, and Equity Hedge. (We used the first futures contract on West Texas Intermediate, or WTI, crude oil in our analysis.) Our conclusion is that large swings in crude-oil prices, similar to what we saw in 28 and again in 215, can have a lasting impact on active management, with crudeoil prices influencing everything from long and short opportunities in equities and credit, to distressed opportunities within Event Driven strategies. In the chart below, we show the 24-month rolling correlation of crude oil and hedge funds (represented by the HFRI Fund Weighted Composite Index) and compare that to the price of the first crude-oil futures contract. For much of the 199s and 2s, the correlation was low-to-negative. However the correlation spiked during the 28 financial crisis, retreated during the recovery, and remains at around.4 today. Regardless of the direction of crude-oil prices, we anticipate that they will continue to have a meaningful impact on hedge funds. Key Takeaways» Crude oil has become a key driver of hedge fund returns, especially post-crisis.» In the alternative investment class, we believe that the direction of crude-oil prices is not as important as their impact on security selection and thematic opportunities. Hedge Funds Are Modestly Correlated to Crude Oil Overweight 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 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Crude Oil First Futures Price 24-Month Rolling Correlation Sources: Bloomberg, Hedge Fund Research, Global Alternative Investments, 8/9/17. Futures contracts, including crude oil futures, are contractual agreements to buy or sell a given commodity at a predetermined price in the future. The contract with the closest settlement date is called the nearby (first) futures contract. The HFRI Fund Weighted Composite Index (Index) is a global, equal-weighted index of over 2, single-manager funds that report to HFR Database. An index is unmanaged and not available for direct investment. Correlation represents past performance. Past performance is no guarantee of future results. There is no guarantee that future correlations between Crude Oil First Futures Price and the Index will remain the same. 217 Wells Fargo Investment Institute. All rights reserved. Page 1 of 12

11 Risk 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. 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. Investment in securities of Master Limited Partnerships (MLPs) involves certain risks which differ from an investment in the securities of a corporation. MLPs may be sensitive to price changes in oil, natural gas, etc., regulatory risk, and rising interest rates. A change in the current tax law regarding MLPs could result in the MLP being treated as a corporation for federal income tax purposes which would reduce the amount of cash flows distributed by the MLP. In addition, there are certain tax risks associated with an investment in MLP units and conflicts of interest may exist between common unitholders and the general partner, including those arising from incentive distribution payments. 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 Net Asset Value and other material risks. 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 Energy-Related Indices Alerian MLP Index is a composite of the 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. S&P Supercomposite Oil & Gas Exploration & Production. S&P Supercomposite Industry Indices are designed to measure the performance of narrow GICS sub-industries. The index comprises stocks in the S&P 15 Index that are classified in the GICS oil & gas exploration & production sub-industry and is a capitalization-weighted index. S&P Supercomposite Oil & Gas Drillers. S&P Supercomposite Industry Indices are designed to measure the performance of narrow GICS sub-industries. The index comprises stocks in the S&P 15 Index that are classified in the GICS oil & gas drillers sub-industry and is a capitalization-weighted index. S&P Supercomposite Oil & Gas Refining & Marketing. S&P Supercomposite Industry Indices are designed to measure the performance of narrow GICS sub-industries. The index comprises stocks in the S&P 15 Index that are classified in the GICS oil & gas refining & marketing sub-industry and is a capitalization-weighted index. S&P Supercomposite Integrated Oil & Gas. S&P Supercomposite Industry Indices are designed to measure the performance of narrow GICS sub-industries. The index comprises stocks in the S&P 15 Index that are classified in the GICS oil & gas integrated sub-industry and is a capitalization-weighted index. 217 Wells Fargo Investment Institute. All rights reserved. Page 11 of 12

12 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 12 of 12