Cyclical Asset Allocation Quarterly

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1 Global Investment Strategy Cyclical Asset Allocation Quarterly April 2, 2018 Our cyclical asset allocation process is based on a rolling three-year outlook which means that the Global Investment Strategy Committee evaluates how the portfolios are expected to perform over the next 36 months based on asset valuations as well as economic and market outlooks. This is different than a tactical or momentum-driven allocation process, which constantly adjusts to changing shortterm conditions. The cyclical approach is very much driven by fundamental valuations, which can lead to entering and exiting positions as potential opportunities arise. Over time, this approach may help investors avoid chasing unsustainable, wild market swings driven by fear and greed near the end of cyclical declines or advances. Overview» We continue to expect economic activity to expand modestly in the United States. We are projecting 2.9 percent Gross Domestic Product (GDP) growth in the U.S. this year, which is stronger than our 2.3 percent forecast for The U.S. economic cycle is likely in the final third of its run, but we believe momentum will extend driven by ongoing gradual gains in consumer spending and housing.» Our analysis suggests the Consumer Price Index (CPI) will rise 2.4 percent in 2018, up from 2.1 percent in Note that core Personal Consumption Expenditures (PCE) is the Federal Reserve s (Fed) preferred inflation gauge, not CPI. Our central bankers are targeting a 2 percent longer-run level for core PCE. The most recent measure of core PCE showed a 1.6 percent increase over the last 12 month period. CPI is well below the longer-term average (since 1914) of approximately 3.3 percent.» Small business optimism and consumer sentiment continue to be supportive of the domestic economy. Business owners remain optimistic about sales and are increasingly looking to expand their business, which appears to be bolstering capital spending. Consumers assessment of their present situation is favorable; encouraging labor-market conditions along with a steady housing market should bode well for future household spending. Rising confidence has been an important factor in our positive equity outlook for most of the past six years.» Over the past year, we have experienced positive domestic equity earnings, but we still believe that the U.S. bull market remains in its final third, in large part because of valuations. The combined benefits of tax reform should modestly impact earnings per share (EPS) before interest and taxes, but materially increase after-tax margins and income. We expect to see S&P 500 Index earnings growth of 18 percent next year as the economy slightly improves.» In terms of international equities, improving earnings have continued to support markets. We expect to see earnings growth of 7% in developed markets and 15% in emerging markets. Our valuation assumption, however, calls for little multiple expansion in these markets in We continue to see steady economic data and positive earnings growth which should contribute to gains in international equities markets this year.» Interest rates will likely increase only modestly from current levels throughout the year. Given our outlook for economic growth, our Fixed Income strategy team expects the yield on the 10-year Treasury note to trade in the 2.75 to 3.25 percent range at the end of next year. Relative to the strategic benchmarks, we are currently neutral U.S. investment grade taxable fixed income and are neutral duration. Duration measures how sensitive a bond or bond portfolio is to interest rate moves. Investment and Insurance Products: NOT FDIC Insured NO Bank Guarantee MAY Lose Value Page 1 of 8

2 Economic and Market Considerations Based on current economic policy and market conditions, the Global Investment Strategy Committee has used the following themes in its asset allocation decisions. Debt markets The divergence in global central bank policies continues to play out. We expect the Fed to continue tightening monetary policy slowly and deliberately in 2018; we look for three fed funds rate increases this year. Additionally, we do not believe the Fed balance-sheet normalization will be a disruptive event in the fixed income markets. As the Fed continues to reduce its balance sheet, in 2018, it will repurchase $420 billion less in fixed-income securities (mainly U.S Treasury securities) than the maturing debt that rolls off. Also, the U.S. central bank has long argued that fiscal policy will need to do some of the heavy lifting to boost economic growth and the new administration and many in Congress appear ready to oblige. On the other side, the European Central Bank, the Bank of Japan and the People s Bank of China have all initiated policy changes over the course of the last four years aimed at increasing growth and inflation in their respective economies. We continue to believe it would be a mistake to doubt the resolve of these major global central banks to do what they believe is necessary to avoid recession and deflation. We believe most major central banks will likely still be providing large amounts of liquidity to their economies in coming years. As fiscal stimulus begins to run through the U.S. economy, it should fuel additional economic growth, which likely will increase inflation. Signs are emerging that inflation may be picking up slightly, with recent upticks in wage, consumer and producer price inflation indexes. If inflation continues to increase moderately in 2018, it will likely lead to moderately higher interest rates as well. As the Fed slowly raises rates, we look for the Treasury yield curve to continue its flattening trend. However, our 2018 rate targets still project a positively sloped yield curve at year end-suggesting that more gas remains in the economic tank. We expect the U.S. economy to grow at a 2.9 percent pace this year. The yield on the 10-year Treasury note currently stands at approximately 2.7 percent. We expect the yield on the 10-year Treasury note to finish 2018 in the 2.75 percent to 3.25 percent range. For longer-dated maturities, we are looking for the yield on the 30-year Treasury bond in the 3.25 percent to 3.75 percent range. If interest rates appear ready to modestly increase over the next few years, some investors may question the need to own any bonds at all. Remember, as interest rates rise, bond prices tend to fall. But we encourage investors to consider the total return of this asset class. Bonds pay interest and this potentially helps to offset negative price movement. In addition, we expect a well diversified fixed income portfolio to outperform cash alternative allocations over time. Bonds can also help diversify a portfolio as the future is quite frequently uncertain. While our opinion is that interest rates will slowly move higher over time, there are no guarantees. Of course, one of the primary reasons to own fixed income investments is that this asset class is typically less volatile than stocks. Bonds, when used properly as part of a diversified investment strategy, may help smooth out a portfolio s overall performance. This quarter, we reduced the intermediate and long term fixed income allocation and increased the short term fixed income allocation. We will continue to monitor risk across all portfolios as we are factoring a higher probability of a recession three to five years out. We still remain at least slightly overweight fixed income versus the strategic allocations in all of our models. Fixed income remains an important asset class in portfolios despite the low interest rate environment and our outlook for the future. In our opinion, investors should diversify their fixed income holdings. We currently favor short-term bonds over long-term fixed income and maintain a neutral position on intermediate term bonds.. We maintain an unfavorable view on U.S. high yield corporate bonds and international developed market bonds. We also recommend that investors adjust the duration of their portfolios to be shorter than their strategic benchmarks. Page 2 of 8

3 Equities Volatility in equity markets picked up in the first quarter of this year after an extended period of low volatility. This volatility was triggered by uncertainty surrounding higher inflation and interest rates. New political developments and geopolitical concerns may also contribute to higher volatility than investors have become accustomed to in recent years. We advise investors to remain vigilant and focus on the positive fundamentals supporting equity markets. In the first quarter, we have seen the S&P 500, Dow Jones Industrial Average and NASDAQ Composite correct from all-time record highs, but we expect them to back upward. Valuation is not compelling (or cheap), and the perceived safety net of lower valuation isn t there to cushion the market impact if earnings and the economy were to start to falter. Based on our analysis, the S&P 500 is currently trading above levels we would consider fair value for this point in time. We believe the modest growth/modest inflation environment we have been living with for the last six years will likely continue through Although economic growth is below the longer term trend, investors around the globe have largely viewed the U.S. economy as dependable and our domestic stock market as somewhat of a relative safe haven in an uncertain world. Next year we expect the domestic economy to grow 2.9 percent versus our projection of 2.3 percent in Our analysis suggests 2018 S&P 500 revenue and EPS growth of 5.5 and 18 percent, respectively. Our year-end 2018 S&P 500 index target range is alongside $152 in EPS. Somewhat stronger global growth should favorably impact cyclically-sensitive industries revenues and earnings in 2018, even as energy comparisons become more difficult. Multinational companies should find additional support from the broader economic expansion and modest dollar weakness that we expect. This quarter, we added to the U.S. small cap equity allocations as they could stand to benefit the most from tax reform. The small cap allocations are still slightly below strategic recommendations. We remain favorable on U.S. large cap equities in the cyclical portfolios. We continue to keep a close eye on the performance and outlook for developed economies. Improved earnings growth supported developed equity markets in 2017, and we expect that trend to continue this year, albeit at a slower pace. We believe that international equities offer an attractive return potential and globalization can benefit portfolios. This is partly related to more compelling equity valuation abroad, but also stems from the fact that the business and earnings cycle for many international markets is at a different point than the U.S. cycle. We also expect that major foreign central banks will continue to attempt to stimulate their economies through easy money policies over the course of the next couple of years. We remain neutral in developed and emerging markets (EM). We foresee higher earnings growth in EM than in developed markets (DM), but improving earnings and global economic growth continue to support EM and DM equities. In addition, we also see balanced risks between faster earnings growth and political risk, especially if interest rates rise. Therefore, we will continue to monitor earnings stabilization in EMs over the next 12 months. Page 3 of 8

4 Style Our cyclical work (3 to 5 year time horizon) suggests that allocations should be balanced in terms of value versus growth. At this point in the cycle a neutral approach is desirable in our opinion. As a result, we continue to carry a 50%/50% value versus growth weighting across large, mid and small-cap equity classes. The Models We have five cyclical asset allocation models, which are described on the following pages. For investors with income as a primary objective, our allocations attempt to limit market risk and price volatility, as income investors tend to favor preservation of principal. However, maintaining purchasing power over a long period of time is also an important investment objective, and we also include what are perceived as more risk-oriented assets even in our income portfolios towards that goal. For those investors with growth objectives, our allocations are weighted more toward stocks, which usually have a fair amount of volatility and risk. Across all models, we stress diversification. We pay attention to the longer term strategic Capital Market Assumptions (CMAs) when allocating among the various asset classes.1 Our goal is to make cyclical adjustments around the long term CMAs based on where we are in the economic cycle. We continue to carry a more cyclical view in terms of equity sector exposure. We want to position the equity portion of the models to take advantage of our belief that the domestic and global economic recoveries are still under way. In fixed income, note that we still remain neutral duration versus the benchmark. Capital market assumptions are estimates of how asset classes and combinations of classes may respond during various market environments. The assumptions are not designed to predict actual performance. They are based on estimates and assumptions that may not occur. Page 4 of 8

5 Moderate Income Moderate Growth High Yield Taxable Fixed Income 3% Develpoed-Market ex. U.S. Equities 4% U.S. Small Cap Equities 2% Equities 2% U.S. Large Cap Equities 14% U.S. Long-Term Taxable Fixed Income 6% Fixed Income 6% Public Real Estate 4% U.S. Short-Term Taxable Fixed Income 27% U.S. Intermediate Taxable Fixed Income 30% U.S. Small Cap Equities 11% Fixed Income 3% Public Real Estate 4% High Yield Taxable Fixed Income 2% Equities 10% Developed-Market ex. U.S. Equities 10% Equities 13% U.S. Short-Term Taxable Fixed Income 10% U.S. Intermediate-Term Taxable Fixed Income 3% U.S. Long-Term Taxable Fixed Income 2% U.S. Large Cap Equities 30% Conservative Growth & Income Aggressive Growth High Yield Taxable Fixed Income 3% Equities 4% Developed-Market ex. U.S. Equities 5% U.S. Small Cap Equities 5% Equities 7% Fixed Income 5% U.S. Large Cap Equities 19% Public Real Estate 5% U.S. Short-Term Taxable Fixed Income 15% U.S. Intermediate Taxable Fixed Income 20% U.S. Long-Term Taxable Fixed Income 10% Equities 12% Developed-Market ex. U.S. Equities 12% U.S. Small Cap Equities 10% Fixed Income 2% Public Real Estate 5% Equities 15% U.S. Short-Term Taxable Fixed Income 8% U.S. Large Cap Equities 30% Moderate Growth & Income Fixed Income 5% High Yield Taxable Fixed Income 4% Equities 5% Developed-Market ex. U.S. Equities 6% U.S. Small Cap Equities 6% Equities 9% Public Real Estate 5% U.S. Short-Term Taxable Fixed Income 12% U.S Large Cap Equities 23% U.S. Intermediate Taxable Fixed Income 16% U.S. Long-Term Taxable Fixed Income 7% Source: Wells Fargo Investment Institute, 3/30/18 Page 5 of 8

6 Cyclical Asset Allocation models (First-quarter 2018) For more information on the Cyclical Asset Allocation Portfolio Plus (CAAP Plus) program, please ask your Financial Advisor. Moderate Income Conservative Growth & Income Moderate Growth & Income Moderate Growth Aggressive Growth Current Change Current Change Current Change Current Change Current Change none 2% none 2% none 2% none 2% none U.S. Short-Term Taxable Fixed Income 27% 6% 15% 5% 12% 6% 10% 5% 8% 5% U.S. Intermediate Taxable Fixed Income 30% (6%) 20% (3%) 16% (4%) 3% (3%) (2%) U.S. Long-Term Taxable Fixed Income 6% (2%) 10% (2%) 7% (2%) 2% (2%) (3%) High Yield Taxable Fixed Income 3% none 3% none 4% none 2% none none Fixed Income 6% none 5% none 5% none 3% none 2% none U.S. Large Cap Equities 14% 2% 19% none 23% none 30% none 30% none Equities 2% none 7% none 9% none 13% none 15% none U.S. Small Cap Equities 2% 2% 5% 3% 6% 3% 11% 3% 12% 2% Dev. Market e.x U.S. Equities 4% none 5% none 6% none 10% none 14% none Equities none 4% none 5% none 10% none 12% none Public Real Estate 4% (2%) 5% (3%) 5% (3%) 4% (3%) 5% (2%) Total 100% 100% 100% 100% 100% Source: Wells Fargo Investment Institute. Risk Considerations Asset allocation and diversification are investment methods used to help manage risk. They do not ensure a profit or protect against a loss. All investing involve risk, including the possible loss of principal. There can be no assurance any investment strategy will be successful or that the portfolios will meet their investment objectives. Investors should be aware of, and understand, all risks associated with an advisory product s underlying holdings before investing. Some of the risks associated with the asset classes discussed in this report include: Equity Investments are subject to market risk which means their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. The prices of small and mid-company stocks are generally more volatile than large company stocks. They often involve higher risks because smaller companies may lack the management expertise, financial resources, product diversification and competitive strengths to endure adverse economic conditions. Growth stocks may be more volatile than other stocks and growth may not be realized. There are no guarantees that value stocks will increase in value or that their intrinsic values will eventually be recognized by the overall market. Foreign/Emerging Markets investing involves greater risks than those associated with investing domestically including political, economic, currency and the risks associated with different accounting standards. These risks are heightened in emerging markets. 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. High yield fixed income securities are considered speculative, involve greater risk of default, and tend to be more volatile than investment grade fixed income securities. All fixed income investments may be worth less than their original cost upon redemption or maturity. There are special risks associated with an investment in real estate, including the possible illiquidity of the underlying properties, credit risk, interest rate fluctuation and the impact of varied economic conditions. Definitions The Consumer Price Index (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services. Dow Jones Industrial Average is an unweighted index of 30 blue-chip industrial U.S. stocks. NASDAQ Composite Index measures the market value of all domestic and foreign common stocks, representing a wide array of more than 5,000 companies, listed on the NASDAQ Stock Market. S&P 500 Index is a market capitalization-weighted index generally considered representative of the U.S. stock market. Page 6 of 8

7 General Disclosures Wells Fargo and its affiliates are not legal or tax advisors. Tax laws or regulations are subject to change at any time and can have a substantial impact on an individual s situation. The Cyclical Asset Allocation program is not designed for excessively traded or inactive accounts and may not be suitable for all investors. Please carefully review the Wells Fargo Advisors advisory disclosure document for a full description of our services. The minimum account size for these programs is $50,000. The information in this report was prepared by the GIS division of WFII. Opinions represent GIS opinion as of the date of this report and are for general informational 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. Global Investment Strategy (GIS) and Global Alternative Investments (GAI) are divisions 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. Page 7 of 8

8 The Global Investment Strategy Team Paul Christopher, CFA Head of Global Market Strategy Darrell Cronk, CFA WFII President, WIM CIO Stuart Freeman, CFA Co-Head of Global Equity Strategy Chris Haverland, CFA Global Asset Allocation Strategist John LaForge Head of Real Asset Strategy Mark Litzerman Head of Global Portfolio Management Sean Lynch, CFA Co-Head of Global Equity Strategy Tracie McMillion, CFA Head of Global Asset Allocation Strategy Brian Rehling, CFA Co-Head of Global Fixed Income Strategy George Rusnak CFA Co-Head of Global Fixed Income Strategy Sameer Samana, CFA Global Equity and Technical Strategist Greg Sigmund, CFA Head of Investments and Operations Adam Taback Head of Global Alternative Investments Peter Wilson Global Fixed Income Strategist Scott Wren Senior Global Equity Strategist Cyclical Asset Allocation models Cyclical Asset Allocation models provide a rolling three-year outlook and are based not only on past performance of various asset classes but, more important, on future expectations. The Global Investment Strategy Committee focuses on yield for income accounts, return for growth accounts and risk exposure for all accounts by using quantitative research and qualitative experience. Because the committee continually looks forward, the recommended allocations may change in periods of less than three years, if market conditions warrant. The charts in this report illustrate the various allocations based on investor type. Changes to the models may be made quarterly. Additional information is available upon request. The material contained herein has been prepared from sources and data we believe to be reliable, but we make no guarantee as to its accuracy or completeness. Wells Fargo Advisors is registered with the U.S. Securities 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 Wells Fargo Investment Institute. All rights reserved Page 8 of 8