Opportunities in challenging times

Transcription

1 2011 Economic and Market Outlook Opportunities in challenging times Contents Economy... 2 Equities... 5 U.S. fixed income International equity...15 International fixed income Currencies Commodities...20 Asset allocation...24 Conclusion Economy and market forecasts...26 Prepared by the Advisory Services Group 2011 forecasts All market comments are as of Dec. 10, 2010 Year-end S&P 500 1,250-1,300 S&P 500 EPS $89 Real GDP 3.0%* 10-year U.S. Treasury 3.5% Source: Wells Fargo Advisors * Gross domestic product growth (fourth-quarter 2010 to fourthquarter 2011) 2011 year-end target Past performance is not an indication of future results. An index is not managed and is unavailable for direct investment. There can be no assurance that any of the target objectives will be met. Executive summary The U.S. economy is slowly recovering from the deep recession. We expect the recovery to continue at a 3.0% annual rate in 2011, fueled by modest consumer spending and business investment. Unfortunately, the unemployment rate is likely to decline only slightly in 2011, ending the year around 9%. We expect consumer price inflation to be 2.0% in the 12 months ending in December The Federal Reserve (Fed) is pumping more money into the economy with a second round of quantitative easing (QE2); however, there is still a lot of excess production capacity and high unemployment limiting upward pressure on prices. In the current global economic recovery, the United States is following the lead of stronger growth in Asia, particularly in China. Consequently, the economic and market outlook depends more on foreign developments than it has in previous cycles. In a slow-growth-low-inflation environment, U.S. equity markets are likely to appreciate at a moderate rate. Our base-case year-end 2011 target range for the S&P 500 stock index is 1,250-1,300. If the stock market increases only modestly, as we expect, it will be important to hold the better-performing sectors. We continue to favor those equity sectors that would benefit from continued economic growth, such as Industrials and Materials. We look for interest rates to remain low during the first half of the year while the Fed is implementing the QE2 program. However, interest rates are likely to move moderately higher in the second half of the year, following the program s completion. Our year-end target yield for the 10-year Treasury is 3.50%. We favor corporate debt and recommend an underweight to long-term U.S. government debt as we anticipate interest rates to rise over the next few years. On the international front, diverging economic performance, rebalancing trade patterns and moderating global growth are likely to affect investment opportunities. The greatest risk to the U.S. economy in the year ahead could come from unexpected global developments. We believe the dollar will continue to decline over the long-run because of the large U.S. trade deficit and the easy money Fed policy. However, the dollar could have pockets of strength during periods of risk aversion.

2 Economy Is the economic recovery likely to continue in 2011? Yes. We believe the U.S. economy is positioned for further economic growth in The economy still faces many headwinds, but there are more positive factors boosting growth than there are negative factors restraining it. We look for inflation-adjusted gross domestic product (GDP) to increase at an average 3.0% annual rate in This would be slightly better than in 2010 but still slower than normal. The accompanying chart shows that economic growth has been weaker than average during both the decline of the recession and the increase of the recovery. Figure 1 Economic growth has been weaker than average Quarterly growth of inflation-adjusted GDP vs. average of previous 10 cycles 8% 6 Average of previous 10 cycles The economy still faces many headwinds, but there are more positive factors boosting growth than there are negative factors restraining it. We look for inflation-adjusted gross domestic product (GDP) to increase at an average 3.0% annual rate in Percent change at annual rate 4 2 This cycle ? -6? Source: Commerce Dept., Haver Analytics, Wells Fargo Advisors Which areas of the economy are likely to be strong and which are likely to be weak? Consumer finances are slowly improving as families save more money and pay down debts. This hurts the economy now but creates more favorable conditions for the future when consumer finances should be in better shape. In the months ahead, we expect consumer spending to be one of the main drivers of economic growth, accounting for about two-thirds of the growth in the economy in Fortunately, job growth is likely to improve during the next 12 months, generating more income for consumers to spend. However, unemployment is likely to decrease only modestly, ending the year near 9%. Businesses are also improving their financial conditions. Profits continue to grow, and many companies have increased cash reserves. Consequently, we look for business spending on new facilities to turn slightly positive after two years of decline. In addition, business spending on equipment and software is also likely to increase but at a more moderate rate than We also look for businesses to build inventories further, although at a slower rate than during the past year Economic and Market Outlook

3 Economy Housing activity is likely to remain depressed but begin to stabilize and then turn up slightly in the year ahead. Government spending is also likely to contribute less to growth in 2011 than in Federal government stimulus programs are winding down, and state and local government spending continues to contract because of deteriorating finances. Finally, on the positive side, the trade deficit is likely to be less of a drag on U.S. economic activity in the year ahead. Will the outcome of the 2010 elections affect the economy s direction? Yes, potentially. The extension of the Bush-era tax cuts was the first test of the willingness of the weakened Democratic leadership to compromise with the strengthened Republican leadership. Fortunately, an agreement was reached to extend current tax rates for a couple of years. Looking ahead, many investors worry about gridlock. But it is too early to say that political differences will prevent Congress from getting things done. Rather, we are likely to see more efforts to restrain governmental spending and create a credible plan to balance the federal budget as the economy gradually improves during the next year. In addition, the new Republican-controlled House of Representatives could reduce funding for many government departments, restraining government regulation. What is the outlook for inflation? We look for consumer price inflation to be approximately 2.0% in 2011 after dipping to only 1.2% during the 12 months ended in October Food and energy prices have increased recently as the Fed adds liquidity to the U.S. economy, pushing the dollar down and commodity prices up. Moreover, the housing market is beginning to stabilize, which could cause housing inflation to increase slightly in the year ahead. The Fed appears to favor consumer price inflation around the 2.0% level and is pumping a lot of extra liquidity into the system to boost economic growth and lift inflation slightly. The window of opportunity for such a policy is limited to periods like today when there are no major resource shortages. As a result, we do not look for QE2 to significantly boost inflation in the year ahead. Nevertheless, people may worry about inflation while the Fed is pumping money into the economy. The chart on page 4 shows how inflation expectations have fluctuated during the past several years. When inflation expectations dropped sharply in 2008, the Fed added liquidity through its first quantitative easing program (QE1). When inflation expectations rebounded, the Fed talked about removing the excess liquidity. However, when fears of deflation resurfaced in mid 2010 and inflation expectations declined again, the Fed initiated its QE2 program. If inflation expectations increase too far in 2011, the Fed could stop QE2. We do not look for the Fed s renewed quantitative easing program to significantly boost inflation in the year ahead. We expect consumer price inflation to be 2% in the 12 months ending December What could cause inflation to be higher or lower than anticipated? Inflation could be higher than we anticipate if the Fed pumps too much money into the economy, causing the dollar to drop sharply while sending commodity prices significantly higher. Inflation could also exceed our expectations if geopolitical events turn negative and commodity prices move dramatically higher. On the other hand, many investors still worry about deflation rather than inflation. Inflation could be less than we expect if housing problems worsen and lending declines further instead of improving modestly, as we anticipate Economic and Market Outlook 3

4 Economy Figure 2 Quantitative easing programs (QE1, QE2) have targeted inflation expectations Implied expected inflation over 10 years 3.0% Fed talked about exiting QE The economy still faces many problems, including mortgage foreclosures, high unemployment, high energy costs and continued geopolitical risks from terrorism or war. As long as sentiment remains depressed, the economy is vulnerable to weakness if there are any unexpected negative shocks that depress confidence and spending even more QE QE 0 1/5/2007 1/5/2008 1/5/2009 1/5/2010 Source: Bloomberg, Wells Fargo Advisors If job creation is better than we expect and sentiment improves significantly, economic growth could exceed our projections. What could cause the economy to do worse than expected? The U.S. economy is not in the same perilous position that it was before the recession, and a new recession, though possible, seems unlikely. If the housing market deteriorates significantly further or if foreign economic growth slows too much and global equity markets drop sharply, consumers could cut spending as their wealth declines. In addition, if geopolitical events take a turn for the worse, causing energy prices to spike, the economy might also fall back into recession. We continue to put the probability of a double-dip or renewed recession at only 20%. The economy still faces many problems, including mortgage foreclosures, high unemployment, high energy costs and continued geopolitical risks from terrorism or war. As long as sentiment remains depressed, the economy is vulnerable to weakness if there are any unexpected negative shocks that depress confidence and spending even more. In particular, with the global economic recovery being led by Asia, global economic growth (including U.S. growth) depends on the pace of growth overseas. If the fast-growing foreign economies get sick, the illness could spread to the U.S. What could cause the economy to do better than expected? For the economy to do better than we anticipate, consumers and businesses probably need to feel that economic prospects are improving significantly, leading to more spending. For example, an unexpected drop in energy prices could give the economy a shot in the arm. After all, there is some pent-up demand in the economy after several years of restrained spending. Unfortunately, low levels of sentiment are keeping consumers and businesses from spending more freely. Finally, if job creation is better than we expect and sentiment improves significantly, economic growth could exceed our projections Economic and Market Outlook

5 Equities How will the S&P 500 perform? Looking ahead, there are reasons to be optimistic about equity returns, although there will be many challenges. On the positive side, the breadth of economic growth is favorable, and the Fed has been quite diligent in offering liquidity to the economy as the banks work to reliquefy and make more loans to businesses and consumers. As for additional Fed stimulus, whether the Fed truncates QE2 or increases the initial amount of liquidity applied could materially impact the equity markets in coming quarters. Also, an ongoing QE2 program could have an unintended consequence of further worrying bondholders about inflation. In that case, longer-maturity bond yields could move upward as some investors sell Treasury bonds. These various risks suggest the forward-looking target range for equities should be a little wider than normal. Post-World War II history suggests second- and third-year returns in a bull market average a modest 10%. However, the return during the third year in the mid-70s recovery was negative (and that bull market was one of those that progressed most similarly to the current one). Finally, the third year of a four-year election cycle (2011) historically tends to be the best year of the four for stocks. That return has averaged 14.9% since Past performance is not an indication of future results. Given the particular uncertainty of the above factors (particularly the Fed action variable), we believe the S&P 500 level range should be relatively wide and consider 1,250-1,300 to be reasonable. This range represents between a 14x multiple and a 14.6x multiple on our 2011 earnings estimate of $89 for the S&P 500 (up roughly 12.7% from our 2010 earnings estimate) S&P 500 forecasts Earnings $89 Year end Trading range 1,250-1,300 Source: Wells Fargo Advisors We expect the revenue and earnings recoveries to be most aggressive in the more cyclically sensitive segments of the market. We also expect a declining dollar and growth abroad should benefit the Industrials and Materials segments. Which market sectors are most likely to outperform over the next 12 months? It remains relatively early in this recovery, and the Fed is still pumping liquidity into the system. Interest rates remain low, and the Fed appears committed to hold them there for an extended period of time. Under such conditions, we expect the revenue and earnings recoveries to be most aggressive in the more cyclically sensitive segments of the market (although correction periods in those stocks are likely to occur from time to time). We also expect a declining dollar and growth abroad should benefit the Industrials and Materials segments. We continue to suggest an overweight to these two sectors for the 12-month time frame opportunities in equities Equity sector allocation recommendations Overweight Evenweight Underweight Industrials Materials Telecom Services Utilities Consumer Discretionary Energy Consumer Staples Information Technology Financials Health Care Source: Wells Fargo Advisors 2011 Economic and Market Outlook 5

6 Equities The lion s share of earnings growth has come through margin expansion as companies reduced costs and slowed capital expenditures during and immediately after the recession. We also see a healthy sign in the fact that earnings growth is being generated by a variety of industries, not just a few. We continue to underweight the Consumer Staples and Health Care sectors, both of which we expect to show moderate earnings expansion relative to that available from more cyclically sensitive sectors. Overall, we remain neutral regarding the growth versus value styles. We anticipate we will lean more toward value as the recovery continues. While value portfolios generally carry more cyclically sensitive issues, growth portfolios tend to own a greater balance of defensive issues that tend to be less leveraged to the economic cycle. What do the current equity market fundamentals look like? Overall, S&P 500 fundamentals have shown a strong rebound. S&P 500 revenues are running roughly 9% above the low in first quarter of 2009, and margins are almost 94% of the last cycle s highs significantly boosted by margins in the Consumer Discretionary and Technology sectors. Operating earnings now represent 92% of the last cycle s high in the second quarter of 2007 and are up roughly 80% from the recession s earnings low in the fourth quarter of Corporations were quite successful in their efforts to reduce costs and slow capital expenditures during and immediately after the recession, so the lion s share of earnings growth has come through margin expansion. In addition, although GDP growth has been more sluggish than the average of the last 10 economic cycles, the job growth we have experienced has occurred in a wide breadth of industries (rather than just a few). We also see a healthy sign in the fact that earnings growth is being generated by a variety of industries, not just a few. In Figure 3, we have plotted the ratio of up versus down earnings for quarters back to early We have circled the last two recessions. Note that the ratio or breadth of earnings has lifted from 0.5:1 at the recession low to more than 3.5:1 in the last two quarters. Figure 3 Corporate earnings are rebounding Ratio, up-to-down earnings of S&P 500 companies Ratio, up-to-down EPS (year-over-year) recession recession Q2-98 Q1-00 Q4-01 Q3-03 Q2-05 Q1-07 Q4-08 Q3-10 Source: Bloomberg, Wells Fargo Advisors Q Economic and Market Outlook

7 Equities How has the market performed when compared to the first few years of historical recoveries? The equity market s performance in this recovery represents one of the strongest over many cycles. This is partially due to the depth of the recent bear market but also to the rapid rebound of corporate margins. Historically, during post-world War II years, the first four years of a bull market have shown average annual returns of roughly 26% in the first year and 10%, 10% and 4% in the following three years, respectively. In this recovery, the first year produced roughly a 71% increase, and the second has thus far offered 8.1% appreciation (priced as of December 9, 2010). To compare historical returns, we have included Figure 4, which shows the progress of the current cyclical bull market versus those of the prior six recoveries. All cycles are indexed to 1 at bear-market bottoms. Note that this cycle has thus far outperformed that of the strongest cyclical recoveries. After the ˇ73-ˇ74 recession, the next 12 months from this point in the recovery brought a decline in stocks. On that basis alone, it would not be out of line to expect only modest returns from stocks over the next year. The equity market s performance in this recovery represents one of the strongest over many cycles. Figure 4 Equity prices are performing better than previous recoveries S&P 500 cyclical market performance indexed to bear-market bottoms 80% recovery Source: FactSet Data Systems, Baseline, Wells Fargo Advisors Cyclical market progress (months) How are small-capitalization stocks positioned at this point of the cycle? We are cautiously positive on small- and mid-cap stocks for They performed well in 2010, and we believe many analyst projections for 2011 are still too low, on balance. Markets are still treating smaller companies with a healthy dose of caution. As the economy and capital markets improve, investors could see a higher proportion of earnings surprises in small- and mid-cap stocks. As the economy and capital markets improve, investors could see a higher proportion of earnings surprises in smalland mid-cap stocks Economic and Market Outlook 7

8 Equities We are leaning toward small- and mid-cap issues versus large-cap. In our view, an improving economy and capital markets should support an upward bias to small- and mid-cap stock prices. As we move into mid-2011, we believe more money will flow into stocks compared to bonds as the worldwide recovery continues. In our opinion, a flow of money into stocks could serve to limit the frequency of temporary stock market corrections during The fundamentals of small- and mid-cap stocks are recovering at a slower pace than larger-cap companies overall. We studied estimates for the underlying small- and mid-cap companies to get a clearer picture of what is beneath the headline numbers. We compared analysts estimates for earnings, revenues and margins to their peak values from the last cycle. In analyzing the Russell 2000, three key points emerge: Only approximately 40% of 2011 EPS (earnings per share) estimates are above the previous peak. More than half of 2011 revenue estimates are still below peak sales. EBITDA (earnings before interest, taxes, depreciation and amortization) margins for only about half of the companies have improved beyond average margins from With estimates still below their previous peaks, there is room for positive surprises and upward revisions in the small- and mid-cap space. A slow but improving economy should support a trend of small- and mid-cap earnings outperformance. In addition, capital has not yet started to flow to smaller businesses despite the rise in equity prices. Outside of the public markets for large liquid assets, there exists an abundance of capital but a shortage of credit. We are leaning toward small- and mid-cap issues versus large cap, as we expect fundamentals to play catch-up over the next few years as the capital availability improves for companies in these spaces. A key risk is that small- and mid-cap stock valuations may look rich on current, still depressed earnings numbers. This makes the stocks more vulnerable to any near-term sentiment shifts or earnings misses. In our view, however, an improving economy and capital markets should support an upward bias to small- and mid-cap stock prices and the risk of a major downward revision of small- and mid-cap company estimates is moderate and manageable. What is the stock market s outlook from a technical perspective? Measured from the March 2009 lows, the stock market enters 2011 still in a long-term up-trending channel (see Figure 5 on the following page). From a quality standpoint, the rise has been very orderly to this point and interrupted only by one large correction during the summer of 2010 when the S&P 500 declined 16%. We believe one reason for the orderly advance is the large amount of skepticism that has accompanied the rally. In addition, stock mutual fund outflows and the corresponding inflow into bond funds have signaled an underlying doubt or disbelief in the rally. This is a positive from a contrarian basis as it prevents the market from building up excess optimism, which historically has often exposed the market to longer, deeper corrections. According to the Investment Company Institute (ICI), stock mutual funds experienced $40 billion of outflows in 2009; in 2010 through November 23, the net outflow was $75 billion. During the same periods, bond funds experienced record inflows of $376 billion and $268 billion. We believe that as we move into mid-2011, the tide will turn and we will see more money flow into stocks as the worldwide economic recovery continues. In our opinion, a flow of money into stocks could serve to limit the frequency of temporary stock market corrections during In the momentum category, the stock market is short-term extended after its rally from the late August 2010 low to the November 5 high. The S&P 500 extended its rally in the late-november to early-december period and reached its highest level since September It is also noteworthy that the market did not have so much as even a 4% pullback since August. Investors are focusing on the shift in power in Washington, D.C., to a more even balance of Republicans and Democrats. In addition, investors were anticipating the Fed to announce their QE2 plans, and third-quarter earnings came in stronger than investors expected. All of these factors combined to keep an underlying bid to the market, and investors were quick to buy on the slightest pullbacks in stocks Economic and Market Outlook

9 Equities In the sentiment category, as stock prices rose during the August through early November period, so did complacency. As measured by the American Association of Individual Investors (AAII) survey, the weekly percentage of bulls rose to a peak of 57% on November 11. Likewise, bears had fallen to just 21% as of October 28 and stood at 28% on November 11. Similarly, by November 17 the Investors Intelligence weekly survey of investor optimism had also risen to extremes. These surveys are all contrary indicators. Historically, a high degree of bullishness has been associated with short-term and sometimes even major stock market pullbacks. Figure 5 Equity prices are trending upward S&P 500 three-year chart 1,500 1,400 1,300 6 Resistance levels 1,200 1,100 1,000 area,,, Support levels /07 03/08 06/08 09/08 12/08 03/09 06/09 09/09 12/09 03/10 06/10 09/10 Source: Bloomberg, Wells Fargo Advisors The fear gauge or VIX indicator, the label given to the Chicago Board Options Exchange (CBOE) Volatility Index, measures how much investors are willing to pay for options to help protect against declines in the marketplace. This gauge recently fell to a low level similar to April 2010 before the spring 2010 correction in stock prices. This is another indicator that has reached a level that historically has accompanied periods of sideways to declining prices that remove some excesses from the marketplace. As previously mentioned, some very positive historical patterns for stocks coincide with the third year (2011) of the presidential cycle. History has shown the average price appreciation during the third year to be the strongest of the four years with a 14.9% average increase since Not only is the third year typically the best performing, but the margin of outperformance versus the other three years has been substantial. Unfortunately, stock market appreciation or depreciation has not exactly conformed to the annual calendar. The Stock Trader s Almanac points out that the strongest period for stocks during the presidential cycle is not specifically within the third calendar year but actually from the low in the second year (2010) to the high in the third year (2011) Economic and Market Outlook 9

10 Equities The following possibilities could spell a bearish scenario for stocks: new asset bubbles in emerging markets, gold and commodities and/or foreign debt issues; a slowdown in the recovery of the real estate market and banking sector; an inability to slow U.S. deficit spending and major geopolitical events that reduce consumer or investor confidence. A bullish scenario for stocks would be one in which the Fed continues to supply liquidity into the economy until we begin to see some firming of consumer prices and even broader signs of employment growth. What would cause the equity markets to perform worse than we expect? A bearish scenario could include a broad range of possibilities. For example, the Fed s QE2 program could create dangerous bubbles if the funds do not end up moving into the general economy through spending and job growth but instead sit idle or create asset bubbles in emerging markets, gold and other commodities. Alternatively, no continuation or only partial continuation of tax cuts could place an additional drag on the economy. At this time, it appears that a two-year extension is on tap. Looking overseas, sovereign debt issue contagion could worsen. In addition, if the current concerns over U.S. default processes result in questions over who legally owns homes, the impact could be a slowdown in the healing of the real estate market as well as the banking sectors of the economy. Here in the United States, the inability of Congress to make headway on programs to slow deficit spending or a major geopolitical event that might reduce consumer and investor confidence would also restrict the potential for growth in the economy. Furthermore, if China increases its interest rates too aggressively, thus reducing its own growth rate too much, the result could be even slower worldwide economic growth. Corporate margins have already pushed toward historical highs. Under the bear case, we would be more concerned that GDP growth could come in below 2.5% and that operating earnings potential might only be in the $83 range. Under such a scenario and a 13.5x multiple, the S&P 500 could be extremely volatile throughout the year and perhaps close 2011 in the 1,120 area. This is not our target, but such a market level would certainly fall into a moderate bear case. If all of these negatives discussed above were to occur simultaneously, the downside for equities could be even greater. Given signs of this scenario, we would likely reduce our overweight recommendation in the Industrial and Material sectors and upgrade our underweight recommendations in the Consumer Staples and Health Care sectors. Overall, such a scenario would best be navigated through the use of very defensively positioned equity portfolios, in our opinion. What would cause the equity markets to perform better than expected? The bullish scenario for stocks would be one in which the Fed continues to supply liquidity into the economy until we begin to see some firming of consumer prices and even broader signs of employment growth. Under this scenario, the Fed would be able to discontinue its QE2 program before it causes disruptions in other countries economic recoveries and before easing becomes inflationary. This scenario, in our opinion, would also not include a contagion of any of the sovereign debt problems abroad. Under the best circumstances, we would see policy shifts begin to move in a favorable direction for businesses and employment as well as tax policies that would benefit corporate and consumer spending. The bullish scenario would also include a permanent extension of tax cuts for all. If all these features were to exist together in this economy, and if major geopolitical events could be thwarted, the environment should offer better consumer, business and investor confidence. Stronger consumer confidence could lead to more spending, stronger business confidence to more hiring, and stronger investor confidence to somewhat more risk-taking in the marketplace. Under such a scenario, we might see GDP growth above 3%, and we would expect earnings next year to move closer to $93 versus $89, and there may be potential for more P/E multiple expansion. Valuations of stocks versus bonds are currently quite attractive. A bull case for year-end 2011 could put the S&P 500 closer to 1,400 (roughly 15x a $93 estimate), and a 1,400 target would represent roughly a 12.9% (priced as of Dec. 10, 2010) increase for the S&P 500 in The midyear level shows the potential to be higher than year end in this scenario as well. Given signs of this scenario, we would expect to downgrade our overweight recommendation in both the Utility and Telecom Services sectors and upgrade our underweight recommendations in both the Technology and Financial sectors, especially if more banks are allowed to start paying dividends Economic and Market Outlook

11 U.S. fixed income What is the current outlook for interest rates? We expect that the Fed will continue to keep the benchmark federal funds target rate (the interest rate at which banks lend to other member banks) unchanged at 0% to 0.25% throughout 2011 and into The Fed remains concerned about high unemployment and low inflation, conditions that we expect will slowly improve during The Fed operates under a dual mandate of maximum employment and price stability. Given that short-term interest rates are already at 0% to 0.25%, the Fed s ability to reduce rates further is limited. Therefore, the Fed must rely on other, more nontraditional methods to drive long-term interest rates lower. Currently, the Fed is actively engaged in quantitative easing in an attempt to move rates lower, further out on the curve. While the lower rates effect on economic growth or employment may be modest at best, the Fed has successfully lowered rates below levels than we would have seen otherwise. What can we expect from Fed quantitative easing? While the prospects of quantitative easing is a short-term positive, much if not all of future Fed Treasury purchases may already be priced into the market. We expect the Fed to end the expansion of its balance sheet through quantitative easing during 2011, and we anticipate that the market will begin pricing in an eventual end to the program several months in advance of its termination. In our view, this will lead to rates trending higher during the year. However, we expect the Fed will be unwilling to let rates move substantially higher in 2011 as that would threaten any positive economic momentum that has been built. We are concerned that as the Fed engages in quantitative easing there may be unintended consequences. While we do not view any of the scenarios outlined below as the most likely scenario, we are concerned that the unprecedented easing campaign from the Fed could lead to unexpected risks. Reputation effects: Additional easing may end up having little effect on the economy, and the market may question the Fed s ability to manage a future crisis. Stagflation: If the Fed is successful in moving inflation higher but economic growth does not follow, we could be headed for a stagflation-type scenario. Historically, the Fed has a track record of leaving easing in place longer than necessary. As a result, one must question whether the Fed will be able to effectively manage the tremendous amount of stimulus they are introducing into the market. Given all of the new tools the Fed has employed during the past couple of years, managing liquidity and rates may be harder in the future than it ever was in the past, and while inflation may not be a major problem to investors at present, the yield curve is beginning to highlight investor concerns. The spread differential between 10-year Treasury notes and 30-year Treasury bonds is near its all-time high (see Figure 6 on next page). If investors were worried about deflation, we would expect to see a rally on the long end of the curve, and this spread would decrease. The fact that we are seeing the opposite suggests that investor attention is turning toward inflation. Asset price bubbles: Asset bubbles may form and be difficult to detect. As the Fed floods the market with dollars, investors must allocate the added liquidity. While the Fed prefers that the added liquidity be used to expand lending and increase hiring, some of the money may be building bubbles in various asset classes. In recent months, we have seen strong flows into bonds, emerging markets, commodities and gold. But precisely where or when a bubble may develop and then pop can be difficult to detect until it is too late fixed income forecasts Year end Target federal funds rate 0.00% % 10-year Treasury yield 3.50% Source: Wells Fargo Advisors Range Target federal funds rate 0.00% % 10-year Treasury yield 2.75% % We expect the Fed to end the expansion of its balance sheet through quantitative easing during 2011, and we anticipate that the market will begin pricing in an eventual end to the program several months in advance of its termination. In our view, this will lead to rates trending higher during the year. However, we expect the Fed will be unwilling to let rates move substantially higher in 2011 as that would threaten any positive economic momentum that has been built Economic and Market Outlook 11

12 U.S. fixed income Figure 6 Investors attention appears to be turning toward inflation Treasury/yield spread differential: 30-year bond vs. 10-year note 200% 150 While we do not expect a rapid rise in interest rates over the next six to 12 months, investors purchasing longer-dated bonds may potentially face a period of significantly higher yields and lower bond prices over the next several years Source: Bloomberg, Wells Fargo Advisors Past performance is not an indication of future results. We look for the benchmark 10-year Treasury yield to trade in a range of 2.75% to 3.75% during 2011, with a year-end target in the 3.50% area. While we do not expect a rapid rise in interest rates over the next six to 12 months, investors purchasing longer-dated bonds may potentially face a period of significantly higher yields and lower bond prices over the next several years. The U.S. Treasury will need to continue selling large amounts of debt on a regular basis to fund the U.S. debt and future budget deficits for the foreseeable future. As global economies improve, market participants may demand higher yields to buy and hold U.S. Treasury debt, which is a particular concern with foreign investors currently holding more than 50% of Treasury securities. We see a strong likelihood that investors will face a period of higher rates in the next one to four years. Please ask your Financial Advisor for our report, Preparing for a Rise in Interest Rates, in which we offer a variety of strategies for investors to reduce interest rate risk. How should fixed-income investors be positioned? In 2011, we believe fixed income investors will continue to face low short-term rates and modestly higher long-term rates. We think the Fed will keep short-term rates low through 2011, which in turn will likely help contain longer-term benchmark rates. We anticipate that the Fed will end its QE2 program in mid We look for the benchmark 10-year Treasury yield to trade in a range of 2.75% to 3.75% during 2011, with a year-end target in the 3.50% area. This type of rate environment requires investors to make choices or trade-offs in their fixed income portfolio. Short-term, high-quality fixed-income securities can preserve capital and liquidity, but it comes at a cost: little-to-no yield or return. To achieve incremental yield or return, fixed income investors face the decision of either extending their time horizon Economic and Market Outlook

13 U.S. fixed income (longer maturities) or lowering their quality parameters (lower quality bonds), or some combination of the two. In the current environment, we recommend overweighting exposure to credit-sensitive sectors. We also believe investors should resist the temptation to become too aggressive in long-duration securities or below-investmentgrade bonds. As we look into 2011, we believe that credit-sensitive sectors offer the best relative value for fixed income investors. We recommend an overweight position in investmentgrade corporate bonds as well as a slight overweight to municipal bonds and high-yield securities. Furthermore, we recommend a slight underweight to Treasury securities and an underweight to agency and mortgage-backed securities opportunities in fixed income Fixed income sector allocation recommendations Overweight Corporate bonds Slight overweight High-yield securities Municipal bonds Neutral Emerging-market debt Slight underweight U.S. Treasuries Underweight Mortgage-backed securities Agency securities International developed-market debt Duration Slightly short* As we look into 2011, we believe that credit-sensitive sectors offer the best relative value for fixed income investors. We recommend an overweight position in investment-grade corporate bonds as well as a slight overweight to municipal bonds and high-yield securities. We also believe investors should resist the temptation to become too aggressive in longduration securities or belowinvestment-grade bonds. Source: Bloomberg, Wells Fargo Advisors * We recommend a duration slightly short of an investor s target duration. If an investor does not have a target duration, we recommend a duration approximately 2½ to four years. Duration, stated in years, can be used to estimate the percentage change in a bond s value that results from a 1% change in interest rates. The longer (higher) the duration, the more prices will fluctuate as interest rates rise and fall. Investment-grade corporate bonds and high-yield securities Given the significant spread compression we have seen over the last couple of years, it would be hard to imagine a scenario in which corporate or high-yield bonds replicate recent returns. While investors need to pare back their expectations for the sector, we still think that the corporate and high-yield sectors will outperform other fixed income sectors in U.S. companies continue to reduce or refinance debt and build cash reserves. Corporate profitability and earnings also continue to show improvement. We expect the rate of default on outstanding corporate debt will continue to fall and investors will be drawn to sectors that provide incremental yield. We continue to recommend that investors add to corporate credit exposure within individual risk tolerances for Agency and mortgage-backed securities We recommend that investors underweight both agency and mortgage-backed securities in the current environment. Moreover, we are concerned that investors are not being adequately compensated for the uncertainty around future government policy. Mortgage-backed security spreads have widened recently, but we would like to see more clarity on future foreclosure policy before recommending additional exposure to the sector. In addition, a move higher in rates may extend the average life of currently held securities and lead to more price volatility. While we doubt that there is material credit risk in agency securities, the increased rhetoric surrounding the restructuring of Fannie Mae and Freddie Mac during the coming years may pose some volatility and headline risk. Considering the historically tight credit spreads for agency securities, we do not see much upside for investors to purchase agency securities Economic and Market Outlook 13

14 U.S. fixed income While state and local municipal issuers continue to face significant budgetary challenges from prolonged declines in their municipal tax revenue sources, we continue to believe that the primary risk will be ratings downgrades rather than actual default risk. We continue to recommend investors focus on accumulating positions of single A -rated or better generalobligation and essential-service revenue bonds. Should the economy deteriorate or inflation expectations fall, we would expect to see benchmark yields fall below our year-end target. As a general rule, when interest rates fall, bond prices increase. Should the economy improve more than expected or inflation expectations increase, we would expect to see benchmark yields rise above our year-end target. Municipal bonds We continue to like valuations in the municipal sector but are increasingly concerned about prospects for a changing supply-and-demand dynamic that would likely occur if Congress extends the current tax cuts while letting the Build America Bond (BAB) program expire. The BAB program has funneled a significant amount of new municipal debt issuance into the taxable market, a supply that the tax-exempt market would have had to absorb. Should the BAB program expire, investors may face a significant increase of traditional tax-exempt municipal market supply. At the same time, an extension of the Bush-era tax cuts may reduce overall demand. An environment of increased supply and reduced demand could push municipal yields higher. While state and local municipal issuers continue to face significant budgetary challenges from prolonged declines in their municipal tax revenue sources, we continue to believe that the primary risk will be ratings downgrades rather than actual default risk. We continue to recommend investors focus on accumulating positions of single A -rated or better (by Standard and Poor s) general-obligation and essential-service revenue bonds. A -rated bonds are considered in the upper-medium grade category, subject to low credit risk. Please ask your Financial Advisor for our report, The Municipal Bond Roadmap, which gives a municipal sector overview and looks at investment opportunities for today s market. What would cause yields to fall more than expected? A bear case for the economy would represent a bull case for bonds. Interest rates are often influenced by changes in the long-term outlook for the economy. Should the economy deteriorate or inflation expectations fall, we would expect to see benchmark yields fall below our year-end target. As a general rule, when interest rates fall, bond prices increase. In addition to rising prices, investors would likely gravitate to the perceived safety and liquidity of U.S. Treasury securities, and we could see Treasury, agency and mortgage-backed securities outperform the more credit-sensitive corporate and high-yield sectors. What would cause yields to rise more than expected? A bull case for the economy would represent a bear case for bonds. As economic conditions improve, investors often anticipate that higher interest rates may be needed in the future to cool off the economy and keep inflation under control. Should the economy improve more than expected or inflation expectations increase, we would expect to see benchmark yields rise above our year-end target. In such a scenario, investors would likely seek out additional exposure to credit-sensitive sectors. In a rising-rate environment, the corporate bond and high-yield markets would likely give investors the potential for better returns than less credit-sensitive sectors such as Treasury, agency and mortgage-backed securities Economic and Market Outlook

15 International equity What international themes do we see playing out in 2011, and how does this outlook impact what international equities are recommended? Diverging economic growth prospects across countries has been a principal trend for the world economy since the financial crisis, and we believe this should continue in The trend is clear in the chart below, which illustrates the share of world output accounted for separately by the emerging- and developed-market economies during the past 30 years. For most of those three decades, emerging-market economies gained share because they grew faster than the world average. Some smaller developed-market economies matched the world average pace, while the largest developed-market economies underperformed. Beginning with the financial crisis in 2007, however, the emerging-market share surpassed the G7 share (G7 includes Canada, France, Germany, Italy, Japan, United Kingdom and United States), and the gap widened as some Latin American and Asian emerging-market economies led the world out of recession for the first time in history. This divergence seems set to continue in 2011 and leads us to favor those countries with relatively low debt burdens and strong export orientation. Exports continue to drive growth in a world where consumers and businesses remain cautious. Figure 7 Emerging and developing economies are leading the recovery Share of world output by country groupings 60% Diverging economic growth prospects across countries has been a principal trend for the world economy since the financial crisis. This divergence seems set to continue in 2011 and leads us to favor those countries with relatively low debt burdens and strong export orientation Major advanced economies (G ) Emerging and developing economies Other advanced economies (excluding G and euro zone) Source: International Monetary Fund (IMF), Wells Fargo Advisors Data sample: Annual data, (2010 is an IMF forecast) Gross domestic product (GDP) based on purchasing-power-parity valuation of country GDP Even as divergence continues, overall global economic growth may slow somewhat in With the global expansion now well-established, many governments with fastgrowing economies are slowly withdrawing the economic stimuli that supported their economies and markets in 2009 and In addition, inventory restocking is slowing in many countries, implying slowing international trade flows. These developments are typical for economies in mid-cycle and may even extend investment opportunities by cooling inflation pressures. Consequently, while divergence remains our principal investment theme in 2011, a salutary moderation in global economic activity makes a second theme for Even as divergence continues, overall global economic growth may slow somewhat in Economic and Market Outlook 15

16 International equity While divergence amid a solid economic expansion should remain the main themes, moderating growth should draw increasing attention toward a third and rising trend: global rebalancing. Rebalancing is an emerging trend and may take a decade or longer to develop into the dominant trend. While divergence amid a solid economic expansion should remain the main themes, moderating growth should draw increasing attention toward a third and rising trend: global rebalancing. Asian economic development strategy since the end of World War II has emphasized export growth over domestic spending. Going forward, slowing exports should yield rebalancing from trade toward domestic spending. Meanwhile, the U.S. and European economies are slowly rebalancing from spending and debt accumulation toward saving, investment and exports. Signs of this rebalancing emerged in 2010 as U.S. households and businesses saved more, cut debt and boosted exports. In Asia, households lifted spending, and the Chinese government adopted a new five-year plan to reduce exports role and promote domestic spending. Rebalancing is an emerging trend and may take a decade or longer to develop into the dominant trend. Policies in China to encourage greater domestic consumption may require that long to implement. The chart below shows that China s household spending as a share of total spending fell sharply from while the country channeled its growing wealth into production and exports. In fact, 2009 was the first year since 2000 that China s household spending grew as much as the overall economy. We expect that further gains for household spending will favor infrastructure and service-sector development along with small-capitalization firms that serve local consumers. Regional trade eventually may create more economic growth and investment opportunities than U.S.-Asian trade and is off to a quick start: Since the recovery began, Asia s exports to China have risen about three times faster than China s exports to the developed-market economies. Figure 8 The tide may be turning on China s household spending China s household expenditure as a share of total spending in the economy 80% Source: Bloomberg, Wells Fargo Advisors Data sample: Annual data, Economic and Market Outlook