Markets at a Crossroads

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1 WEEKLY GUIDANCE FROM OUR I NVESTMENT STRATEGY COMMITTEE Paul Christopher, CFA Head of Global Market Strategy Sameer Samana, CFA Senior Global Market Strategist Asset Group Overviews Equities... 3 Fixed Income... 4 Real Assets... 5 Alternative Investments... 6 Markets at a Crossroads March 18, 2019» We believe that capital markets are at an inflection point that could lead to a move in either direction.» The recent strength in equities amid continued economic uncertainty may reflect some investor complacency. We recently lowered our guidance on select U.S. equity classes to capitalize upon recent equity strength while also aiming to reduce the overall portfolio risk profile. What it may mean for investors» Capital markets appear to be at a crossroads. We believe investors can position their portfolios to address economic uncertainty by increasing their allocations to Cash Alternatives in line with our tactical allocations, which are currently above our strategic allocations to this asset class.» Investors also can consider aligning their equity exposure with our current tactical guidance on U.S. Large Cap and Mid Cap Equities (neutral or in line with strategic targets) and with our unfavorable guidance on U.S. Small Cap Equities (underweight versus the strategic target). We believe that capital markets may be at a crossroads, given the softness in recent economic data. So far, the global equity rally has dismissed recession fears, but the economic and earnings fundamentals remain uncertain. Such is the nature of retracements after indiscriminate sell-offs like the one we saw late last year. Put another way, we see the global capital markets today at a potential inflection point a level from which prices could pivot higher or lower. The pivot direction ultimately should depend upon how the economic uncertainties resolve in the coming weeks and months. To us, this disconnect between fundamentals and equity markets may represent some complacency, and we continue to make guidance changes to reflect this fact (as we also seek to capitalize upon the recent market rally). As a reminder, in January, we reduced our U.S. Small Cap Equities guidance and also reduced their allocations. More recently, with the U.S. equity market continuing to grind higher, we took the opportunity to reduce our guidance on U.S. Large Cap Equities and Mid Cap Equities. We also moved capital out of U.S. Large Cap Equities and into Cash Alternatives Wells Fargo Investment Institute. All rights reserved. Page 1 of 8

2 Markets at a Crossroads As in January, our focus remains cautious, but it does not imply a negative equity outlook. If the economic data continue to weaken, we may further (and selectively) reduce portfolio exposure to economic risk; alternatively, if the data strengthen, we could favor taking more risk in equities. We reiterate a critical point that we touched on in the 2019 Outlook report s main theme, the end of easy. The asset-price trends that advanced easily and without much interruption until 2018 were unusually long, but they may now be over. Looking ahead, we expect muted equity market gains, as political events, and the possibility of rising interest rates, and concerns about the aging economic expansion could disrupt sentiment periodically. Above all, risk and reward are now changing more quickly, and investors may need to adjust portfolio positioning more often. Given the current level of uncertainty against the backdrop of high equity market valuations, we now view Cash Alternatives as an attractive asset class. We have upgraded Cash Alternatives from neutral to favorable. On a return basis, Cash Alternatives have usually provided a similar yield to U.S. Short Term Taxable Fixed Income (a most favorable asset class), and a yield that is above the comparable total return we foresee for U.S. Long Term Taxable Fixed Income. 1 Above all, in an environment characterized by uncertainty, volatility, and higher valuations, the reallocation of funds from U.S. Large Cap Equities into Cash Alternatives (now favorably rated) gives us flexibility to potentially reallocate assets back into equity, fixed income, and real asset markets when opportunities arise. 1 Cash alternatives can include money market funds, short-term CDs, short duration bonds; deposit accounts, Treasury bills; savings accounts. Please see the end of this report for important risk considerations associated with this asset class Wells Fargo Investment Institute. All rights reserved. Page 2 of 8

3 EQUITIES Craig P. Holke, Investment Strategy Analyst Audrey Kaplan, Head of Global Equity Strategy U.S. Large Cap Equities U.S. Mid Cap Equities U.S. Small Cap Equities Developed Market Ex-U.S. Equities Most Emerging Market Equities Our emerging market view Adjusting our guidance on Emerging Europe, Middle East, and Africa We have adjusted our equity guidance on the Emerging Europe, Middle East, and Africa (EMEA) region from most favorable to favorable. While our view remains most favorable on emerging market (EM) equities overall, we believe that Emerging Asia and Latin America offer better near-term prospects than the EMEA region today. Fundamentals remain mostly sound across the EMEA region, and we have seen some recent positive economic surprises across the region. There also have been meaningful year-to-date returns. Our currently favorable view stems from the fact that we see reasons for slightly more caution in EMEA than we see in other regions. Economic growth has slowed somewhat, particularly in emerging European countries, such as Russia and Turkey. Earnings expectations among the region s banks and exporters have deteriorated recently, especially for countries with exposure to developed Europe (specifically, Germany, Italy, and the U.K.). Recent price gains also leave valuations somewhat less attractive than they were at year-end While our outlook remains positive; it compares less favorably to our expectations for other EM regions. As growth continues to slow in developed economies, we expect more resiliency and return potential from EM equities. We decreased our eurozone gross domestic product growth forecast on March 7. This decline, along with slowing U.S. economic growth, reflects a further slowdown in the developed market economic cycle. As such, we believe that the best equity opportunities are in EMs today as we believe they have brighter growth prospects over the three-to-five year horizon.» We have a favorable view on the EMEA region and are most favorable on EM equities as a whole. The move from most favorable to favorable is on a relative basis (when compared to most favorable opportunities in Emerging Asia and Latin America).» Our March 15, 2019, Asset Allocation Strategy report provides details on our regional equity market strategy and guidance on the developed and emerging markets Wells Fargo Investment Institute. All rights reserved. Page 3 of 8

4 Peter Wilson Global Fixed Income Strategist FIXED INCOME U.S. Taxable Investment Grade Fixed Income Most U.S. Short-Term Taxable Fixed Income U.S. Intermediate Term Taxable Fixed Income U.S. Long-Term Taxable Fixed Income High Yield Taxable Fixed Income Developed Market Ex.-U.S. Fixed Income Eurozone inflation expectations and negative rates Ten-year German bund yields declined in late 2018; that decrease continued in the first quarter driven mainly by data disappointments, suggesting a sharp slowdown in activity. For example, the Markit Manufacturing Purchasing Managers Index (PMI) had fallen below 50 by February a rapid decline from the third-quarter level of approximately 55. The European Central Bank s (ECB) dovish turn at its March meeting validated market concerns as the ECB cut its 2019 inflation forecast from 1.6% to 1.2%. The chart shows that market expectations mirrored private-sector and ECB economists inflation outlook downgrade. 2 A key indicator has fallen below 1.50%, edging into a range last seen in 2016, during a period that coincided with an ECB policy rate cut to -0.40%, along with 10-year German bund yields trading as low as -0.20%. We cannot rule out a new German bund move into negative yield territory since the economic outlook is uncertain; the ECB is still reinvesting cash flows into German bunds; and the supply/demand balance remains tight. Further, risk events such as Brexit and European parliamentary elections in May raise the possibility of renewed flight-to-quality flows into bunds. But a bottoming out of the eurozone economic slowdown could quickly move sovereign yields in the opposite direction, and negligible coupon income would mean virtually no cushion against capital losses in that event. We remain unfavorable on developed market (DM) fixed income (ex-u.s.) for now.» Weakening growth and falling inflation expectations have driven 10-year bund yields close to 0%. A fall into negative territory is possible, given the supply/demand balance and risk events, including Brexit and European parliamentary elections.» Even if further yield declines generate modest capital gains, DM bond returns are vulnerable, as negligible coupon income offers no cushion against capital and currency losses. We retain our unfavorable DM debt view for now. Falling inflation expectations are driving 10-year bund yields back toward zero Euro 5-year, 5-year forward inflation swaps European Central Bank deposit facility rate Ten-year German bund yield Rate (%) 1.00 Emerging Market Fixed Income Sources: Bloomberg, Wells Fargo Investment Institute; March 12, Yields represent past performance and fluctuate with market conditions. Current yields may be higher or lower than that shown above. Past performance is no guarantee of future results. 2 As measured by the five-year, five-year forward inflation swap rate. An inflation swap is a derivative used to transfer inflation risk from one party to another through an exchange of cash flows. The Euro five-year, fiveyear forward inflation swap rate is a common measure used by central banks and market participants to gauge the market s future inflation expectations Wells Fargo Investment Institute. All rights reserved. Page 4 of 8

5 REAL ASSETS Austin Pickle, CFA Investment Strategy Analyst Commodities Private Real Estate Public Real Estate The U.S. trade deficit is nearly gone. What I spent, is gone; what I kept, I lost; but what I gave away will be mine forever. --Ethel Percy Andrus The title above is missing the word petroleum. The U.S. petroleum trade deficit is nearly gone. The total U.S. goods trade balance is still at record deficits. Yes, it is a clickbait title, but you are here now so you might as well read on. The improvement in the petroleum trade balance is a truly remarkable feat. As recently as 2011, petroleum accounted for more than 50% of the total U.S. goods deficit. Today, it represents less than 2% (orange line in the chart below). The shale effect (i.e., historic levels of U.S. petroleum production; removal of export restrictions; and a build-out of petroleum infrastructure and export capacity) has driven the improvement. And this trend is expected to continue the Energy Information Administration forecasts that the U.S. will be a net petroleum exporter by 2021 and a net energy exporter (petroleum, natural gas, etc.) next year for the first time since the 1950s. With mounting concern over the historic total trade deficit, energy is one of the few bright spots. If the administration wants to foster this strength, we would caution to not push hard for lower oil prices. Oil prices that are too low could cause production to slow, infrastructure spending to collapse, and exports to stagnate. But too high, and the consumer and economy generally would be negatively impacted. Given current breakeven levels, a range of $55-$70 seems to be the sweet spot for West Texas Intermediate crude that should encourage production, investment, and exports without crimping economic growth.» The U.S. is poised to become a net petroleum and energy exporter.» Oil prices that are too low could stunt production and exports. U.S. petroleum trade balance % U.S. petroleum trade balance (as % of total) Billion U.S. dollars U.S. petroleum trade balance Sources: Bloomberg, U.S. Census Bureau, Wells Fargo Investment Institute. Monthly data: January 31, 1994 December 31, Wells Fargo Investment Institute. All rights reserved. Page 5 of 8

6 ALTERNATIVE INVESTMENTS Justin Lenarcic Global Alternative Investment Strategist Low default rates don t equal low stressed and distressed debt opportunities Private Equity Hedge Funds-Macro Hedge Funds-Event Driven Private Debt Hedge Funds-Equity Hedge Hedge Funds-Relative Value Headline corporate default rates continue to hover near historical lows, likely aided by the Federal Reserve s dovish pivot and by a rebound in high-yield (HY) debt issuance. Further, the year-to-date volume of fallen angels stands just below 9% of rising-star volume. 3 But beneath the surface, the picture is increasingly murky. Credit downgrades from rating agencies outnumbered upgrades by a ratio of 2:1 in February. This coincided with a slowdown in adjusted and unadjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) for HY debt issuers that was reflected in fourth-quarter earnings. Moreover, distress ratios across several sectors are at least as high (or higher) than at this time last year (see chart). Our views on the distressed opportunity set for hedge funds and private capital do not rely upon a specific default-rate projection. In fact, we believe that much of these strategies opportunities come at this point in the cycle, when defaults are low, yet companies are beginning to show signs of stress. Hedge funds can capitalize upon a growing list of catalysts, such as downgrades, refinancings, bankruptcies, and defaults. Private capital strategies can lend to challenged companies at very attractive rates, or opportunistically take control, restructure debt, and exit holdings at an attractive premium. Although low default rates suggest that credit-market conditions may be benign, the reality for hedge fund and private capital strategies is that there is no shortage of opportunities to lend to (and trade) companies facing fundamental challenges.» Default rates remain near historically low levels, yet we continue to see signs of stress under the surface.» Much of the hedge fund and private capital opportunity comes when defaults are low and there are catalysts for trading and lending-based strategies. Among 18 sectors, 10 have higher year-over-year distress ratios Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not suitable for all investors and are only open to accredited or qualified investors within the meaning of U.S. securities laws. Distress ratio (%) February 2019 distress ratios February 2018 distress ratios Sources: Bank of America, Wells Fargo Investment Institute; March The distress ratio is defined as the percentage of high-yield corporate bonds with spreads that are higher than 1,000 basis points, and investment-grade bonds with spreads that exceed 500 basis points. (One hundred basis points equal 1%.) 3 Bank of America, High Yield Credit Chartbook, March Fallen angels are companies that experience ratings downgrades that move their debt from investment grade to high yield Wells Fargo Investment Institute. All rights reserved. Page 6 of 8

7 Risk Considerations Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions. Cash Alternatives: Each type of cash alternatives, such as bank certificates of deposits, Treasury bills, ultra-short bond mutual funds, variable rate demand notes and money market funds, has advantages and disadvantages. They typically offer lower rates of return than longer-term equity or fixed-income securities and may not keep pace with inflation over extended periods of time. While government savings bonds, U.S. Treasury bills, and other U.S. government securities are backed by the full faith and credit of the federal government if held to maturity, other cash alternatives carry higher default risk. Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing. Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund. Distressed Debt: Private debt strategies seek to actively improve the capital structure of a company often through debt restructuring and deleveraging measures. In private debt investments, an investor acts as a lender to private companies and loans have specific contractual interest rate terms and repayment schedules. Such investments are subject to potential default, limited liquidity, the creditworthiness of the private company, and the infrequent availability of independent credit ratings for them. Because of their distressed situation, private debt funds may be illiquid, have low trading volumes, and be subject to substantial interest rate and credit risks. These funds often demand long holding periods to allow for the end of the debt's term or an exit strategy via the secondary market which is not guaranteed to exist or develop. Definitions The MSCI EAFE (DM) and Emerging Markets (EM) Indices are equity indices which capture large and mid cap representation across 21 developed market (DM) countries and 23 emerging market (EM) countries around the world. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. An index is unmanaged and not available for direct investment. 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, 2019 Wells Fargo Investment Institute. All rights reserved. Page 7 of 8

8 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 8 of 8