Key takeaways. What it may mean for investors WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS. Veronica Willis Investment Strategy Analyst

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1 Veronica Willis Investment Strategy Analyst WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS May 8, 2018 Monetary Policy Divergence Could Last a Little Longer Key takeaways» Recent economic improvement in Europe and Japan has sparked concern that central bankers in those regions will soon end accommodative monetary policy.» Expectations that European Central Bank (ECB) and Bank of Japan (BOJ) monetary policy will converge with the U.S. Federal Reserve s (Fed) policy may have run ahead of actual central-bank action. Some assets (particularly currencies), have begun to price in an expected convergence in monetary policy. What it may mean for investors» The potential for monetary policy convergence could cause some uncertainty in financial markets, but the ECB and BOJ have indicated that they are not finished easing yet. Over the next year, we expect the Fed s policy to continue to diverge from ECB and BOJ policy, both in terms of interest rates and balance-sheet levels. Since 2015, monetary policies across the U.S., Europe and Japan have been diverging, while the Fed was the first central bank to begin removing economic stimulus. Since then, the divergence has become more pronounced. The U.S. economy has been able to recover more quickly than the European and Japanese economies as those locales dealt with high unemployment (Europe only), low inflation, structural reforms, and elections. Chart 1. Central-bank assets now are declining in the U.S. and still growing overseas 100% 90% 80% Central bank assets as % of GDP 70% 60% 50% 40% 30% 20% 10% 0% Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17 Mar-18 U.S. Federal Reserve Bank of Japan European Central Bank Sources: Bloomberg, Wells Fargo Investment Institute, May 3, GDP = gross domestic product Wells Fargo Investment Institute. All rights reserved. Page 1 of 6

2 Yet, recent economic improvement in Europe and Japan has sparked concern that central bankers in those locales will soon end accommodative policy causing their policy approach to converge with that of the Fed. Chart 1 shows the rise in European and Japanese central-bank assets, while U.S. central-bank assets have begun to decline. Eurozone and Japan catching on? The U.S. and the eurozone have both shown solid economic growth (as measured by gross domestic product, or GDP), lower unemployment rates, and slowly improving inflation. This has fueled concerns that the ECB may start tightening monetary policy sooner rather than later. For now, the ECB s policy remains accommodative, and its deposit rate is still negative. In March, the central bank announced its decision to maintain asset purchases of 30 billion per month ($35.9 billion) through at least September of this year. Last year, the ECB started to taper its asset purchases due to improvement in economic activity, but market participants have been curious about when the ECB might end its asset-purchase program and whether it might begin raising interest rates sooner than expected. Improving economic growth in Japan also has increased speculation that the BOJ would alter its monetary policy toward tightening. However, both the ECB and BOJ have been unwilling to tighten monetary policy to date. Yet, they also have increased transparency to help manage expectations. The ECB has communicated that it expects to keep interest rates at current levels for an extended period of time after it ends its asset-purchase program, while BOJ governor Haruhiko Kuroda has suggested the central bank s yield target will not be changed until next year. Both the ECB and the BOJ would like to see greater consistency in economic improvement before moving to tighter monetary policy. Additionally, inflation, while slowly rising (shown in the right panel of Chart 2), remains below the central banks targets. Despite this higher transparency from these central banks, market participants continue to anticipate that policies may converge sooner rather than later (with the expectation that inflation will grow at a faster pace now that economic activity is improving in Europe and Japan). Chart 2. Eurozone and Japan: Improving economies, but inflation is running below the central banks 2% target Gross Domestic Product (quarter-overquarter %) Inflation (year-over-year%) U.S. GDP Eurozone GDP Japan GDP U.S. inflation Eurozone inflation Japan inflation Sources: Bloomberg, Wells Fargo Investment Institute, May 3, We expect the ECB to continue easing through the end of 2018 and to not start raising rates until Even with potentially tighter ECB monetary policy a year from now, 2018 Wells Fargo Investment Institute. All rights reserved. Page 2 of 6

3 interest-rate differentials should continue to widen as we expect the Fed to raise rates two more times this year. Similarly, the BOJ s yield target is likely to remain unchanged for at least another year. Over the next year, we expect the Fed s policy to continue to diverge from ECB and BOJ policy, both in terms of rates and balance sheet levels. Investment implications Expectations for monetary policy convergence may have run ahead of actual centralbank action. This has sparked some uncertainties in currency markets. The euro generally has strengthened versus the U.S. dollar over the past year, while the yen has been more range-bound. The euro appreciated due to stronger-than-expected economic growth in the eurozone, coupled with the expectation for tighter monetary policy. More recently, however, the dollar has strengthened versus the yen. The yen has been pressured by speculation over changes to trade policies and concerns about a trade war. We anticipate slight dollar weakness this year as investors balance these uncertainties. We currently do not favor hedging international fixed income or equity holdings as we anticipate further dollar depreciation this year. Chart 3. The U.S. dollar has been weakening versus the euro and yen since late 2016 Yen per dollar Dollar stronger Dollar per euro 95 Dollar weaker 90 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Yen per dollar (LHS) Dollars per euro (RHS, inverted axis) Sources: Bloomberg, Wells Fargo Investment Institute, May 3, The spreads between U.S. and German two-year sovereign bond yields and between U.S. and Japanese two-year sovereign bond yields (shown in Chart 4) have widened since monetary policies started to diverge in December They should continue to widen as U.S. short-term interest rates rise faster than their European and Japanese counterparts. Despite domestic yields being more attractive relative to yields on international developed-market bonds today, developed-market fixed income returns in dollar terms recently have risen due to dollar weakness, particularly versus the euro. While we expect some additional return benefit from euro appreciation, we remain unfavorable on international developed-market bonds due to expectations for low yields. Additionally, we favor shorter-term U.S. fixed income over longer-term bonds today to help mitigate interest-rate risk in a rising-rate environment. We recommend that investors position duration 1 below that of their individually selected benchmarks. 1 Duration measures a bond s price sensitivity to interest-rate changes Wells Fargo Investment Institute. All rights reserved. Page 3 of 6

4 Chart 4. Yield spreads continue to widen Basis points Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 U.S.-Japanese two-year government bond yield spread U.S.-German two-year government bond yield spread Sources: Bloomberg, Wells Fargo Investment Institute, May 3, basis points equals one percent. Global equity markets have benefited from easing measures taken by central banks globally, and international equities should continue to benefit from central-bank stimulus. Developed-market equities also could benefit from potential strength in the euro as markets anticipate future monetary policy convergence. In emerging markets, we expect currencies, on balance, to appreciate against the dollar. Yet, we remain unfavorable on emerging-market equities as investor sentiment has weakened on concerns surrounding earnings in the Information Technology sector and the impact of potential trade restrictions Wells Fargo Investment Institute. All rights reserved. Page 4 of 6

5 Economic Calendar Date Report Estimate Previous 5/7/2018 Mortgage Delinquencies % 5/7/2018 MBA Mortgage Foreclosures % 5/8/2018 NFIB Small Business Optimism /8/2018 JOLTS Job Openings /9/2018 MBA Mortgage Applications % 5/9/2018 PPI Final Demand MoM 0.20% 0.30% 5/9/2018 PPI Ex Food and Energy MoM 0.20% 0.30% 5/9/2018 PPI Ex Food, Energy, Trade MoM 0.30% 0.40% 5/9/2018 PPI Final Demand YoY 2.80% 3.00% 5/9/2018 PPI Ex Food and Energy YoY 2.40% 2.70% 5/9/2018 PPI Ex Food, Energy, Trade YoY % 5/9/2018 Wholesale Trade Sales MoM % 5/9/2018 Wholesale Inventories MoM 0.60% 0.50% 5/10/2018 CPI MoM 0.30% -0.10% 5/10/2018 CPI Ex Food and Energy MoM 0.20% 0.20% 5/10/2018 CPI YoY 2.50% 2.40% 5/10/2018 Initial Jobless Claims k 5/10/2018 CPI Ex Food and Energy YoY 2.20% 2.10% 5/10/2018 Continuing Claims k 5/10/2018 CPI Index NSA /10/2018 CPI Core Index SA /10/2018 Real Avg Weekly Earnings YoY % 5/10/2018 Real Avg Hourly Earning YoY % 5/10/2018 Bloomberg May United States Economic Survey 5/10/2018 Bloomberg Consumer Comfort /10/2018 Monthly Budget Statement -- -$208.7b 5/11/2018 Import Price Index MoM 0.50% 0.00% 5/11/2018 Import Price Index ex Petroleum MoM 0.20% 0.10% 5/11/2018 Import Price Index YoY 3.90% 3.60% 5/11/2018 Export Price Index MoM 0.30% 0.30% 5/11/2018 Export Price Index YoY % 5/11/2018 U. of Mich. Sentiment /11/2018 U. of Mich. Current Conditions /11/2018 U. of Mich. Expectations /11/2018 U. of Mich. 1 Yr Inflation % 5/11/2018 U. of Mich Yr Inflation % Source: Bloomberg, as of May 3, Wells Fargo Investment Institute. All rights reserved. Page 5 of 6

6 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. 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. Currency risk is the risk that foreign currencies will decline in value relative to that of the U.S. dollar. Exchange rate risk between the U.S. dollar and foreign currencies may cause the value of the portfolio's investments to decline. 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 6 of 6