Economic forces behind the equity-market correction

WEEKLY GUIDANCE FROM OUR I NVESTMENT STRATEGY COMMITTEE Paul Christopher, CFA Head of Global Market Strategy February 26, 2018 Perspectives on Inflation, Interest Rates, and Equities» The expanding U.S. economy, supported by the administration s recent fiscal policies, has raised expectations for inflation and interest rates.» For this year, we continue to anticipate that inflation and interest rates will rise only modestly and remain low by historical standards. What it may mean for investors» Investors may need additional time and data to establish a consensus on the extent of inflation and interest-rate increases, and this uncertainty could produce additional equity-price pullbacks. On balance, we continue to expect new highs in equity markets, especially in the U.S., but with more swings in prices than in 2017. Economic forces behind the equity-market correction A combination of investor complacency and somewhat faster wage and price data might have triggered the equity-market selling, but these are symptoms of broader economic changes that are typical later in an economic expansion. Inflation is still modest but is starting to rise from near cycle lows. Bond yields are sensitive to and tend to rise with inflation expectations. Asset Group Overviews Equities... 4 Fixed Income... 5 Real Assets... 6 Alternative Investments... 7 Rising rates also respond to the demand for credit to invest in expanding economic capacity. Historically, rising economic growth in the final half of an economic expansion tends to induce more investment in plant and equipment. We believe the new tax rules provide attractive incentives that will also encourage new spending. We see anecdotal evidence in fourth-quarter earnings reports that many companies are planning additional equipment spending. The immediate implications of stronger corporate equipment spending are greater efficiencies and greater corporate demand for credit. The additional efficiencies from new equipment in workplaces across the U.S. should increase worker productivity and, in turn, raise both wages and profits while restraining inflation s increase. However, the greater demand for credit likely will put upward pressure on the interest rates that corporate borrowers pay to finance their spending projects. Meanwhile, the tax overhaul and higher wages should induce greater household spending and borrowing. Taken together, greater business and household spending should generate the faster U.S. inflation pace that current surveys and market data are 2018 Wells Fargo Investment Institute. All rights reserved. Page 1 of 9

Perspectives on Inflation, Interest Rates, and Equities beginning to anticipate. Washington s latest budget deal could add some inflationary pressure, given that the spending increases will arrive just as corporate and household spending are increasing and as low unemployment fuels upward wage pressure. Separately from inflation s impact on interest rates, the greater demand for credit appears to be raising domestic borrowing costs and yields. This also is significant for markets. Interest payments on debt have been very low throughout this economic expansion, both for households and for businesses. Rising interest rates also will raise the interest cost on variable-rate debt and, in turn, reduce the cash available to businesses and households that finance their spending activity. Keep perspective on inflation and interest rates The upward pressure on domestic inflation is likely to be moderated by several shortand long-term factors. First, prices in some U.S. industries are still weak and even falling. This is particularly true of durable goods, which include appliances and other products with multi-year service lives. We believe that these falling prices (or deflation) are unlikely to end soon. Falling prices of goods are largely the result of technology and trade trends, which translate into low production and transportation costs. A longerterm factor is that aging populations in many countries including the U.S. point to slower spending in the years ahead. Finally, as we mentioned above, any efficiency gains from adding or replacing equipment generally reduce production costs and, thereby, final-goods inflation. If we are correct, inflation s gains should be limited this year, and this should allow the Federal Reserve to remain gradual as it raises short-term interest rates toward historically more average levels. Regarding interest rates, we note that interest costs on debt remain at low levels, especially for households (Chart 1). Moreover, many businesses are still accumulating cash, although this is less so for households, which have lowered their saving rates. For now, businesses and consumers seem able to make monthly and quarterly debt payments. Still, as available cash is increasingly diverted to debt payments, corporate earnings and consumer spending may remain sensitive to rising interest rates and possible inflation surprises. Household debt service as a percentage Nonfinancial U.S. corporate debt service of personal disposable income (%) as a percentage of corporate income (%) 14 13 12 11 10 9 8 48.0 46.0 44.0 42.0 40.0 38.0 36.0 34.0 32.0 30.0 9/1/1981 9/1/1984 9/1/1987 9/1/1990 9/1/1993 9/1/1996 9/1/1999 9/1/2002 9/1/2005 9/1/2008 9/1/2011 9/1/2014 9/1/2017 06/01/99 06/01/00 06/01/01 06/01/02 06/01/03 06/01/04 06/01/05 06/01/06 06/01/07 06/01/08 06/01/09 06/01/10 06/01/11 06/01/12 06/01/13 06/01/14 06/01/15 06/01/16 06/01/17 Sources: Federal Reserve Bank of St. Louis and Bank for International Settlements. Quarterly data through September 2017 (for households) and June 2017 (for corporations). As of February 23, 2018. Personal disposable income is income after taxes. 2018 Wells Fargo Investment Institute. All rights reserved. Page 2 of 9

Perspectives on Inflation, Interest Rates, and Equities Investment implications The economy is still growing, supported by economic expansion in key parts of the world, and inflation should rise only moderately this year. U.S. interest rates are rising, but debt payment requirements are still very low. The U.S. economy is unlikely to fall into recession in 2018. The economic expansion, with low inflation and interest rates still below historically average levels, remains positive for equities, and we expect new highs in equity prices later this year. However, the ride may be bumpier than in 2017, thanks to evolving inflation and interest-rate trends. 2018 Wells Fargo Investment Institute. All rights reserved. Page 3 of 9

EQUITIES Sean Lynch, CFA Co-Head of Global Equity Strategy U.S. Small Cap Equities U.S. Large Cap Equities U.S. Mid Cap Equities Developed Market Ex-U.S. Equities Emerging Market Equities 2018 Year of the Dog (Not a dog of a year ) Many of China s financial markets were closed last week due to the Chinese Lunar New Year. 2018 ushers in the Year of the Dog. Dogs have been a valued part of the Wells Fargo culture for decades, traveling on stagecoaches and protecting assets. Clearly, Chinese equity markets have not been dogs in investment speak, as stocks in the Hong Kong Hang Seng Index were strong performers last year and started 2018 with modest increases. Valuations for Chinese equities are fairly reasonable, with a forward price/earnings multiple of approximately 12 times earnings. Financial stocks, including many stateowned banks, are heavily represented in the major indices in China. This can keep valuations artificially low. The key drivers for growth in these indices lie with technology and consumer stocks. Those indices that were more heavily exposed to these sectors (like the Hang Seng Index) outperformed in 2017. While Chinese valuations are reasonable and earnings are improving, there are risks arising in this Year of the Dog. The first risk is that trade protection rhetoric could increase. This recently happened around aluminum and steel tariffs. Secondly, China President Xi Jinping may capitalize upon the strong economic growth and financial markets to more energetically tackle long-term problems like the growing debt burden and pollution, and by instituting other reforms that could temper growth. Wells Fargo Investment Institute estimates that China s economy will grow 6.2 percent this year, which is below the consensus growth forecast. Our view on emerging equity markets and Chinese equities is neutral for the coming year. Investing in China is no longer a binary option; all equity portfolios need some exposure to this country.» The key drivers for growth in the Chinese equity indices lie with technology and consumer stocks.» The risks are that trade protection fears may increase and that reforms may slow growth. Valuations in Chinese equity markets remain reasonable today 19 17 Forward P/E valuations 15 13 11 9 7 2013 2014 2015 2016 2017 2018 Shanghi Composite Index Hong Kong Hang Seng Index Source: Bloomberg, February 21, 2018. P/E = price/earnings ratio. The P/E ratio is a valuation ratio of a company's current share price compared to its per share earnings. The forward P/E ratio takes into account a company's expected earnings. 2018 Wells Fargo Investment Institute. All rights reserved. Page 4 of 9

FIXED INCOME Brian Rehling, CFA Co-Head of Global Fixed Income Strategy Underweight High Yield Taxable Fixed Income Underweight Developed Market Ex.-U.S. Fixed Income U.S. Short Term Taxable Fixed Income U.S. Long Term Taxable Fixed Income Emerging Market Fixed Income U.S. Taxable Investment Grade Fixed Income U.S. Intermediate Term Taxable Fixed Income When rates rise deconstructing duration Most investors are likely to see negative year-to-date performance in their fixed income portfolios after the recent rise in interest rates (at least in the unrealized capital loss/gain column). 1 For some, the losses will be relatively minor, while others may see losses in the mid-single-digits. The variance in investor returns is most likely due to differences in portfolio duration. Generally speaking, if interest rates move higher, bonds market prices fall, and the opposite occurs as interest rates fall. Duration is one measure of the sensitivity of a bond s price to a change in interest-rate movements. Rather than simply looking at a bond s maturity, we recommend that investors understand duration as a tool to gauge interest-rate risk and the approximate impact that rate movements may have on a fixedincome investment. The duration calculation can be broadly used by investors to approximate the percentage change in market price for an instantaneous one percent parallel shift in the yield curve. For example, the price of a bond with a five-year duration would be expected to rise or fall 5% in price for every 1% change in market interest rates. The longer (higher) the duration, the more market prices will fluctuate as interest rates rise and fall. Long-term bonds tend to have longer duration, and prices can rise and fall quickly during periods of significant interest-rate movements.» We recommend that investors refrain from favoring any particular spot on the interest-rate curve, but take care to own allocations across the maturity spectrum.» Given the current low-yield environment, fixed-income investors are likely to experience lower returns in the future than they have experienced over the past decade.» We favor a neutral duration profile within fixed-income allocations across the yield curve. For reference the Bloomberg Barclays U.S. Aggregate Bond Index which is considered representative of the U.S. dollar denominated, fixed-rate taxable bond market currently has a duration of 6.12 years. Impact of duration (and changing yields) on fixed-income prices 30-Year U.S. Treasury 10-Year U.S. Treasury 2-Year U.S. Treasury Hypothetical yield on February 22, 2018 Duration Market value after instantaneous 100 basis point increase in the yield curve (Loss) 3.15% 19.62 $82.93-17.07% 2.90% 8.75 $91.78-8.22% 2.25% 1.97 $98.08-1.92% Source: Wells Fargo Investment Institute, February 21, 2018. This is a hypothetical example used for illustrative purposes only. It does not reflect the rates currently available on any investments available for purchase, nor are they predictive of future rates. 1 Note that a bond held to maturity typically will not realize capital losses, but its market price can rise and fall during the bond term. 2018 Wells Fargo Investment Institute. All rights reserved. Page 5 of 9

REAL ASSETS John LaForge Head of Real Asset Strategy Underweight Commodities Private Real Estate Overweight Public Real Estate China is not helping gold A great man is always willing to be little. --Ralph Waldo Emerson Some of you may be wondering why gold prices seem to be hard pressed to break above $1,350 per ounce. Some have argued that prices should be much higher, due to a persistently weak U.S. dollar and global inflationary concerns. We see these gold bullish points, but we still feel that they are not enough to push gold prices above $1,400 per ounce. The main reason that we feel gold prices should struggle to exceed $1,400 is that pesky commodity bear market super-cycle that we like to discuss. There is a second reason, though, that we don t write about often China. China is the largest buyer of gold in the world, and what China does matters. As we begin 2018, Chinese demand continues to fall. In the past 12 months, mainland China imported roughly 700 tonnes of gold through Hong Kong. This number is represented by the blue bars in the top panel of the chart below. For perspective, world gold demand in 2017 was almost 4,100 tonnes. This places Chinese gold demand at nearly 17% of total global demand. Yet, the chart shows that Chinese demand has been cut in half, since 2014. For gold to move above $1,400, and stay there, we believe that it needs a few trends to reverse. One, of course, is the end of the commodity bear super-cycle. Second, China needs to buy more gold. We don t see either of these trends reversing in 2018, which has us gold bearish to start the year.» Gold s largest buyer, China, continues to buy less.» We expect gold prices to struggle in 2018. China s gold imports Metric tons 1600 1400 1200 1000 800 600 Chinese gold imports gross (metric tons - trailing 12 months) Chinese gold imports net (metric tons - trailing 12 months) 12-month change (%) 400 200 0 700 600 Chinese gold imports gross 12-month % change 500 Chinese gold imports net 12-month % change 400 300 200 100 0-100 2010 2011 2012 2013 2014 2015 2016 2017 Sources: Bloomberg, Census and Statistics Department, Wells Fargo Investment Institute. Monthly data: January 31, 2010 - December 31, 2017. 2018 Wells Fargo Investment Institute. All rights reserved. Page 6 of 9

ALTERNATIVE INVESTMENTS Justin Lenarcic Global Alternative Investment Strategist Private Equity Hedge Funds-Macro Hedge Funds-Event Driven Overweight Hedge Funds-Relative Value Overweight Hedge Funds-Equity Hedge 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. Hedge funds regain Sharpe ratio advantage Risk-adjusted returns form the foundation of modern portfolio theory, and are often an integral component to asset allocation decisions. In an effort to build the most efficient portfolio, investors often compare the Sharpe ratio of various asset classes, strategies, and funds to determine which one offers the highest return per unit of risk. 2 As seen in the chart below, for most of the historical analysis period, hedge funds have offered a higher Sharpe ratio than the S&P 500 Index has, largely due to similar annualized returns but with a lower annualized standard deviation (volatility), made possible by both long and short exposure. While this analysis includes the 1990-2017 period, it is worth highlighting that from October 2011 through November 2017, the rolling two-year Sharpe ratio of hedge funds has been less than that of the S&P 500 Index. We believe this can be attributed to several factors, but perhaps most importantly, to the difficult environment for shorting equities combined with historically low volatility both largely driven by quantitative easing. Recently, however, we have seen a significant increase in the rolling two-year Sharpe ratio for hedge funds (alongside an equally notable increase in the Sharpe ratio for the S&P 500 Index), that we believe further substantiates our view that the environment for active management has changed for the better. While it is unlikely that the recent Sharpe ratio trajectory will remain in place, we do anticipate that hedge funds will offer better risk-adjusted returns relative to long-only equities, driven by higher interest rates, higher volatility, and a maturing economic cycle.» Hedge funds have historically provided better risk-adjusted returns than the S&P 500 Index, but that relationship reversed for much of the post-crisis period.» Hedge funds recently have begun producing a higher Sharpe ratio than the S&P 500 Index. We expect this trend to continue as volatility increases. Current hedge fund Sharpe Ratio is above the long-term average Sharpe Ratio 6 5 4 3 2 1 0-1 -2 Jan-90 - Dec-91 Sep-90 - Aug-92 May-91 - Apr-93 Jan-92 - Dec-93 Sep-92 - Aug-94 May-93 - Apr-95 Jan-94 - Dec-95 Sep-94 - Aug-96 May-95 - Apr-97 Jan-96 - Dec-97 Sep-96 - Aug-98 May-97 - Apr-99 Jan-98 - Dec-99 Sep-98 - Aug-00 May-99 - Apr-01 Jan-00 - Dec-01 Sep-00 - Aug-02 May-01 - Apr-03 Jan-02 - Dec-03 Sep-02 - Aug-04 May-03 - Apr-05 Jan-04 - Dec-05 Sep-04 - Aug-06 May-05 - Apr-07 Jan-06 - Dec-07 Sep-06 - Aug-08 May-07 - Apr-09 Jan-08 - Dec-09 Sep-08 - Aug-10 May-09 - Apr-11 Jan-10 - Dec-11 Sep-10 - Aug-12 May-11 - Apr-13 Jan-12 - Dec-13 Sep-12 - Aug-14 May-13 - Apr-15 Jan-14 - Dec-15 Sep-14 - Aug-16 May-15 - Apr-17 Jan 16 - Dec 17 HFRI Fund Weighted Composite Index 24 month rolling Sharpe ratio Historical average since January 1990 S&P 500 Sources: Hedge Fund Research, Inc. Bloomberg, Wells Fargo Investment Institute, February 2018. For illustrative purposes only. Index returns do not represent fund returns. The HFRI Fund Weighted Composite Index is an equal weighted index while the S&P 500 is a market capitalization-weighted index. Please see index definitions for complete definitions of these indices. An index is unmanaged and not available for direct investing. Past performance is no guarantee of future results. 2 Sharpe ratio measures the additional return that an investor could expect to receive for accepting additional risk. 2018 Wells Fargo Investment Institute. All rights reserved. Page 7 of 9

Risks 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. 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. Chart Index Definitions HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database. Unlike most asset class indices, HFR Index returns reflect deduction for fees and expenses. S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market. Returns assume reinvestment of dividends and capital gain distributions. Other Index Definitions Hong Kong Hang Seng Index is a market capitalization-weighted index of 40 of the largest companies that trade on the Hong Kong Exchange. The Hang Seng Index is maintained by a subsidiary of Hang Seng Bank, and has been published since 1969. The index aims to capture the leadership of the Hong Kong exchange, and covers approximately 65% of its total market capitalization. The Hang Seng members are also classified into one of four sub-indexes based on the main lines of business including commerce and industry, finance, utilities and properties. Shanghai Stock Exchange Composite Index is a capitalization-weighted index. The index tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. 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, 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. 2018 Wells Fargo Investment Institute. All rights reserved. Page 8 of 9

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 0218-04224. 2018 Wells Fargo Investment Institute. All rights reserved. Page 9 of 9