Key Takeaways. What It May Mean for Investors WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS. Craig P. Holke Investment Strategy Analyst

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1 Craig P. Holke Investment Strategy Analyst Michael Taylor, CFA Investment Strategy Analyst WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS October 31, 2017 Consumer Debt Not Likely to Derail U.S. Economy Key Takeaways» Current debt payments pose little threat to consumer spending or U.S. economic growth. As credit card, auto, and student loan debt rise, some market observers are concerned that consumer spending could decline and impede economic growth.» While debt continues to rise in absolute terms, it is important to consider that low interest rates and higher household incomes make this debt more affordable. What It May Mean for Investors» We expect solid corporate earnings to support domestic equities and certain fixedincome classes. This environment also should benefit the housing sector, along with the Consumer Discretionary and Financials sectors. Today s headlines caution investors about rising consumer-debt levels, particularly credit card, auto and student loan balances, warning them that the size of U.S. consumer debt is now at all-time highs. What these articles tend to overlook is consumers capacity to manage the debt and maintain general spending levels. Chart 1. Many Types of Consumer Debt Are Reaching New Highs (Billions of dollars) $12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $ Mortgage (left axis) Auto (right axis) Credit Card (right axis) Student Loan (right axis) Sources: Federal Reserve, Wells Fargo Investment Institute. Notes: Spike in credit card debt in 2010 was due to implementation of new accounting rules (FAS 166/167 and FASB 46) regarding how banks measure credit card balances. Data as of June 30, $ Wells Fargo Investment Institute. All rights reserved. Page 1 of 6

2 Chart 1 shows that credit card, auto loan, and student loan debt are at all-time highs (mortgage debt is still off its all-time high). Yet, looking closer, we also notice that household incomes are at all-time highs. Higher household incomes, combined with low borrowing costs, can help to make debt payments more affordable for most borrowers. In fact, we do not foresee current debt levels derailing the consumer-led U.S. economy in the near term. Affordability Remains an Important Consideration As noted, Chart 1 shows that most types of domestic consumer debt are at or near historical highs. Mortgage debt, the largest component of consumer debt, is below the all-time high reached during the Great Recession, mainly due to refinancing, foreclosures, and a slower pace of real-estate purchases as consumers finances have improved. Although credit card debt initially declined after the last recession, it has picked up over the past several years. Auto loans have increased rapidly since 2010, but student loans have risen even faster and are now the second largest component of consumer debt, behind mortgages. Consumer spending is the largest component of the U.S. economy, and consumer borrowing helps to sustain economic growth. As consumer debt levels increase, the question arises whether increased borrowing costs will reduce consumers income that could be used to purchase other goods and services. Chart 2 depicts how much consumer income is used for debt payments, including principal and interest. This affordability measure indicates that the cost of paying the debt, which ultimately determines how much free cash flow is left to spend, remains near all-time lows. Chart 2. Consumer Debt Payments Remain Very Affordable (Total household debt service payments as a percentage of after-tax income) 13.5% 13.0% 12.5% 12.0% 11.5% 11.0% 10.5% 10.0% 9.5% Sources: Federal Reserve, Wells Fargo Investment Institute. Notes: Series represents consumer debt payments as a percent of income. Shaded areas indicate recessions as designated by the National Bureau of Economic Research. Data as of June 30, Wells Fargo Investment Institute. All rights reserved. Page 2 of 6

3 While the currently high debt levels remain affordable for most consumers, it is important to consider whether consumers are falling behind on their debt obligations. Delinquencies are a key indicator of consumer financial health. Rising delinquencies signal challenges in consumers ability to make debt payments (not to mention having money left over to make other purchases). As consumers have continued to improve their finances, serious delinquencies defined as payments delinquent for greater than 90 days also have improved significantly from levels observed during the recession. Chart 3 depicts the delinquency rates for the major types of consumer debt. In terms of borrowing levels, mortgage-loan growth has rebounded modestly after contracting for six years, while mortgage delinquencies have declined. Although credit card debt growth recently rose on a month-over-month basis, it generally has been trending lower. Credit-card delinquencies tend to peak during recessions as consumers increase borrowing and have difficulty making payments. Auto-loan growth has been mixed, but recently has shown signs of accelerating. Auto-loan delinquencies have picked up. Yet, the economic impact of auto loans is lower than for mortgages, because the smaller level of auto debt outstanding does not pose the same level of risk to the financial system as mortgages do. Student-loan growth continues at a solid pace, but it has slowed significantly from the rapid growth rates seen during the recession. Student-loan delinquencies, which increased greatly following the last recession, have stabilized, albeit at higher levels, alongside an improving economy and flexible repayment options. Chart 3. Delinquency Rates for Most Types of Consumer Debt are Stabilizing (Percent of outstanding balance 90+ days delinquent by loan type) 16% 14% 12% 10% 8% 6% 4% 2% 0% Recession Mortgage Auto Credit Card Student Loan Sources: Federal Reserve Bank of New York Consumer Credit Panel/Equifax, Wells Fargo Investment Institute. Note: Shaded areas indicate recessions as designated by the National Bureau of Economic Research. Data as of June 30, Wells Fargo Investment Institute. All rights reserved. Page 3 of 6

4 Investment Implications The U.S. economy continues on its trajectory through the latter stages of the current cycle, yet we do not believe that the cycle is coming to an end. As Chart 2 shows, U.S. consumer-debt payments (as a percent of income) have declined to near record lows in terms of affordability. This suggests that debt is manageable and any consumer-debt uptrend is sustainable in the near term. We conclude that the economy is likely past the midpoint of its current expansion, but that the expansion has further to run, at least through 2018 (and likely longer). The length depends, in part, on how quickly debt builds from here. Overall, the U.S. consumer remains in a much stronger financial condition today than prior to the recession. The robust labor market is supportive of higher household income, while low borrowing costs are keeping loan payments affordable. With household net worth also at record highs, it is this affordability factor, coupled with consumer sentiment at a cycle high, that is allowing consumers the capacity to spend and helping to sustain economic growth. Yet, risks do exist. Consumer debt payments can be influenced by changing interest rates. Mortgage rates are primarily determined by long-term rates; not by the fed funds rate the short-term rate the Federal Reserve (Fed) sets. Mortgage rates are more likely to rise with inflation and longer-term U.S. Treasury yields. Yet, inflation expectations remain modest, and we expect Treasury yields to remain relatively muted next year. As a result, real-estate borrowing costs could remain affordable for longer. Credit-card debt is usually the most expensive, and the floating credit-card interest rates will rise directly with short-term rates, such as the fed funds rate. Most auto loan rates are fixed; they are not likely to rise for existing borrowers, but rising interest rates could make future purchases more expensive. Rates on federal student loans are fixed for life; thus, they are not subject to rising payments as rates increase. They also are based upon a formula using long-term interest rates and should react similarly to mortgage rates. In this late-cycle environment, we believe U.S. equities should continue to be supported by the current level of consumer spending. As a result, even though we are expecting flat-to-modest total returns next year for the S&P 500 Index, we remain evenweight U.S. large-cap equities. Small-cap valuations remain high relative to fundamentals, and consensus earnings estimates appear overstretched, so we would recommend managing portfolio risk by reducing exposure to U.S. small-cap equities. Based on our expectations for higher consumer spending levels and an improving labor market (along with wage gains next year), we believe that the Consumer Discretionary sector will outperform the S&P 500 Index. Likewise, this trend also should benefit the housing sector and Financials as demand for consumer loans picks up. Taxable fixed-income markets, like their equity counterparts, also should continue to be supported by the current level of consumer spending. We believe the improving domestic economy should lead to yield advantages for U.S. bonds over other developedmarket bonds. We also see income opportunities for investors in investment-grade bonds, including securitized debt. Inflation, although showing signs of rising from higher wages, is still below expectations. All indications are that the Fed will remain committed to its current trajectory of interest-rate increases, which likely will provide a modest headwind for fixed-income returns Wells Fargo Investment Institute. All rights reserved. Page 4 of 6

5 Economic Calendar Date Report Estimate Previous 10/31/2017 Employment Cost Index 0.70% 0.50% 10/31/2017 S&P CoreLogic CS 20-City MoM SA % 10/31/2017 S&P CoreLogic CS 20-City YoY NSA % 10/31/2017 S&P CoreLogic CS 20-City NSA Index /31/2017 S&P CoreLogic CS US HPI YoY NSA % 10/31/2017 S&P CoreLogic CS US HPI NSA Index /31/2017 Chicago Purchasing Manager /31/2017 Conf. Board Consumer Confidence /31/2017 Conf. Board Present Situation /31/2017 Conf. Board Expectations /1/2017 MBA Mortgage Applications % 11/1/2017 ADP Employment Change 188k 135k 11/1/2017 Markit US Manufacturing PMI /1/2017 ISM Manufacturing /1/2017 ISM Prices Paid /1/2017 ISM New Orders /1/2017 ISM Employment /1/2017 Construction Spending MoM -0.50% 0.50% 11/1/2017 FOMC Rate Decision (Upper Bound) 1.25% 1.25% 11/1/2017 FOMC Rate Decision (Lower Bound) 1.00% 1.00% 11/1/2017 Wards Total Vehicle Sales 17.30m 18.47m 11/1/2017 Wards Domestic Vehicle Sales m 11/2/2017 Challenger Job Cuts YoY % 11/2/2017 Initial Jobless Claims k 11/2/2017 Continuing Claims k 11/2/2017 Nonfarm Productivity 2.00% 1.50% 11/2/2017 Unit Labor Costs 0.60% 0.20% 11/2/2017 Bloomberg Consumer Comfort /3/2017 Change in Nonfarm Payrolls 300k -33k 11/3/2017 Two-Month Payroll Net Revision k 11/3/2017 Change in Private Payrolls 240k -40k 11/3/2017 Change in Manufact. Payrolls 20k -1k 11/3/2017 Unemployment Rate 4.20% 4.20% 11/3/2017 Average Hourly Earnings MoM 0.20% 0.50% 11/3/2017 Average Hourly Earnings YoY 2.70% 2.90% 11/3/2017 Average Weekly Hours All Employees /3/2017 Labor Force Participation Rate % 11/3/2017 Underemployment Rate % 11/3/2017 Trade Balance -$43.5b -$42.4b 11/3/2017 ISM Non-Manf. Composite /3/2017 Factory Orders 1.00% 1.20% 11/3/2017 Factory Orders Ex Trans % 11/3/2017 Durable Goods Orders % 11/3/2017 Durables Ex Transportation % 11/3/2017 Cap Goods Orders Nondef Ex Air % 11/3/2017 Cap Goods Ship Nondef Ex Air % 11/3/2017 Markit US Services PMI /3/2017 Markit US Composite PMI /6/2017 Mortgage Delinquencies % 11/6/2017 MBA Mortgage Foreclosures % Source: Bloomberg as of 10/26/ Wells Fargo Investment Institute. All rights reserved. Page 5 of 6

6 Risks Considerations Estimates and targets are not guaranteed and are subject to change. 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. Small-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. 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