Current corporate debt environment

Ken Johnson, CFA Investment Strategy Analyst WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS May 30, 2018 Rising Corporate Debt What It May Mean for Equities Key takeaways» Our expectation for gradually rising interest rates suggests that U.S. companies, overall, remain well positioned to service current debt levels, making a recession triggered by excessive corporate debt a minimal threat in the near term.» We anticipate increased capital expenditures, solid consumer demand, high levels of corporate balance-sheet cash, and a continuation of historically modest longer-term rates this year. This should be supportive of U.S. corporations financial health. What it may mean for investors» Yet, we do expect U.S. interest rates to rise in 2018. We believe that some equity sectors are better positioned than others to absorb the cost associated with rising rates. These sectors include Information Technology, Materials, and Industrials. Investors have become more aware and concerned about rising debt levels in the U.S. ranging from corporate and government debt to household and student borrowing. They have been wondering if any of these trends will trigger the next recession. Last month, we discussed household debt trends. 1 In today s report, we consider U.S. corporate debt levels from a macroeconomic perspective and offer our insights on how today s debt levels influence our current U.S. equity-sector guidance. Next month, we will cover the student loan situation. Additionally, this week s Fixed Income Strategy report provides an in-depth look at investment-grade (and high-yield) corporate debt trends. Current corporate debt environment Since the 2008 financial crisis, U.S. companies have been enjoying low borrowing costs. Low rates have led to a dramatic rise in the amount of debt domestic firms have incurred. Yet, Chart 1 shows that companies ability to service debt remains generally healthy. (Still, it is estimated that more than $4 trillion in corporate debt will need to be refinanced in the next five years.) 2 As the Federal Reserve (Fed) raises policy rates and inflation rises, much of this debt will be refinanced at higher rates. Yet, we foresee a low probability of a U.S. recession in the next 12-18 months as a result of increased corporate leverage, along with rising rates and inflation. 1 Global Perspectives, Rising Household Debt Canary in the Coal Mine?, April 24, 2018. 2 Bloomberg, Corporate America is Staring Down a Trillion Dollar Wall of Refinancing in 2018, May 9, 2018. 2018 Wells Fargo Investment Institute. All rights reserved. Page 1 of 7

Chart 1. Debt servicing ratio remains below recession levels 48 Pre-recessionaverage: 43 Current recovery average: 38 46 Debt servicing ratio 44 42 40 38 36 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 Recession U.S. nonfinancial corporations Source: Bank for International Settlements, May 2018. Debt servicing ratio is the ratio of interest payments plus amortization to earnings. As noted, leverage has risen in the U.S., and companies will need to refinance much of this debt at higher interest rates as the Fed normalizes monetary policy and inflation rises. On the surface, this might create a concern for U.S. corporate profitability levels overall. Yet, we do not see this as an immediate U.S. economic (or firm profitability) threat across the board, for three primary reasons: The Tax and Jobs Act of 2017 will help curb some of the stress of the corporate debt load by saving companies billions of dollars in tax expense. This has been helpful to earnings and cash flow, which is supportive of U.S. companies financial health and the U.S. equity market. Further, for much of the economic recovery, many companies have used cash and debt to increase shareholder wealth by issuing dividends, buying back stock, and conducting mergers and acquisitions. Going forward, we anticipate tax reform savings, and newly issued corporate debt, to be used for more capital investments and to enhance corporations financial standing. The most recent CFO Survey conducted by the Duke Fuqua School of Business shows that managers expect to increase capital spending 11% over the next 12 months. 3 An increase in business capital expenditures should help to boost productivity and corporate earnings. Large companies still have a sizable amount of cash on their balance sheets, estimated at roughly $1.9 trillion. 4 This could be used to pay down debt. As corporate debt matures or loans are refinanced, we should expect companies to refinance some new debt at longer maturities. We anticipate that short-term interest rates will continue to rise faster than longer-term rates. This should allow some companies to lock in debt at relatively low longer-term rates for an extended period of time. 3 As of March 2018. 4 S&P Global, May 25, 2017. 2018 Wells Fargo Investment Institute. All rights reserved. Page 2 of 7

Not all sectors are created equal Chart 2 shows the net debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio and the debt-to-assets ratio for a selection of S&P 500 Index sectors over a 20-year period (1998-2017). (Net debt is debt minus cash and short-term investments.) The higher these ratios, the more sensitive a sector s earnings are likely to be to an interest-rate increase. Some equity sectors will see the rising cost of servicing corporate debt hurt profits more than others (and some should be less affected). Materials and Industrials are two sectors that score well on both measures (net debt to EBITDA and debt to assets) as their current ratios are in line with the 20- year median. In addition, both sectors are supported by sustained global growth, and historically, they tend to outperform late in an economic cycle. Chart 2. Debt ratios for U.S. nonfinancial equity sectors (1998-2017) 6.00 4.00 Net Debt to EBITDA 45.00 35.00 Debt to Assets 2.00 0.00-2.00 25.00 15.00 5.00 High-Low Today Median High-Low Today Median Sources: Bloomberg, Wells Fargo Investment Institute. The Energy sector was omitted from the chart due to its extreme figures compared to the remaining sectors. Our real estate guidance is tracked by the FTSE EPRA NAREIT index, so the sector was omitted from the charts above. At first glance, Information Technology (IT) may not appear attractive when reviewing its currently high debt-to-assets ratio with the historical median. Yet, this historical comparison doesn t work well for the IT sector, because, in decades past, IT firms were debt-adverse and more volatile than other companies. Therefore, they tended to finance their operations through cash or equity issuance. In this recovery, with interest rates as low as they have been, debt became a very cheap source of financing, and firms capitalized upon that positive environment. The net debt to EBITDA ratio paints a more complete (and attractive) picture for the IT sector. In general, large IT companies are cash-rich today. In fact, some could easily pay off their debt entirely with the cash on their balance sheets. This makes them appealing, particularly if consumer demand for goods and services were to slow while inflation and interest rates accelerated (an unlikely scenario in the near term). Essentially, when it comes to debt, not all equity sectors are created equal. Most sectors debt ratios in Chart 2 appear reasonable today. Yet, high leverage and weaker debt servicing capability does add stress to sectors that we view unfavorably today, such as Consumer Staples, Telecom Services, and Utilities. Healthy balance sheets and reasonable (not overextended) leverage adds support for some of our already favorable and neutral sectors. These include Materials, Industrials, and Information Technology. 2018 Wells Fargo Investment Institute. All rights reserved. Page 3 of 7

These sectors recent sales and capital expenditure growth also reinforces their attractiveness (in our view). Capital spending (or capex ) as a percent of sales has shown substantial improvement across the board, and sales numbers for 2018 were revised higher after a strong first quarter. Sales (and revenue) growth historically has been a strong driver of capital spending leading to a virtuous cycle in which capital spending can drive topline (revenue) growth. A sustained level of capital spending also would help to fuel earnings growth as revenue flows down to the bottom line. We expect capital spending to accelerate further in the second half of this year. We see Consumer Staples, Telecom Services, and Utilities as poorly positioned sectors in the coming quarters. They face stretched debt ratios and fundamental concerns that include competitive pricing pressures and narrowing profit margins (profit as a percent of sales). Additionally, these sectors are more defensive in nature, which means that they often underperform in times of economic expansion, like the current macroeconomic environment. Recently rising U.S. corporate debt levels may appear concerning on the surface. And we believe that they are of concern for certain companies with below-investment-grade debt in the coming quarters. Yet, U.S. firms ability to service their corporate debt overall along with robust consumer spending and our expectation for only modest increases in interest rates and inflation leads us to believe that corporate leverage is not an imminent risk to the U.S. economy. Furthermore, as companies invest more heavily in capex and technology, we would expect a boost in sales and earnings growth. We are neutral on Materials and Information Technology and favorable on Industrials. These sectors reasonable debt profile further supports our guidance. On the other hand, the Consumer Staples, Telecom Services, and Utilities sectors could see additional strain ahead from their higher current leverage ratios. 2018 Wells Fargo Investment Institute. All rights reserved. Page 4 of 7

Economic Calendar Date Report Estimate Previous 5/29/2018 S&P CoreLogic CS 20-City MoM SA 0.70% 0.83% 5/29/2018 S&P CoreLogic CS 20-City YoY NSA -- 6.80% 5/29/2018 S&P CoreLogic CS 20-City NSA Index -- 206.67 5/29/2018 S&P CoreLogic CS US HPI NSA Index -- 197.01 5/29/2018 S&P CoreLogic CS US HPI YoY NSA -- 6.34% 5/29/2018 Conf. Board Consumer Confidence 128 128.7 5/29/2018 Conf. Board Present Situation -- 159.6 5/29/2018 Conf. Board Expectations -- 108.1 5/29/2018 Dallas Fed Manf. Activity 24.5 21.8 5/30/2018 MBA Mortgage Applications -- -2.60% 5/30/2018 ADP Employment Change 180k 204k 5/30/2018 Wholesale Inventories MoM -- 0.30% 5/30/2018 GDP Annualized QoQ 2.30% 2.30% 5/30/2018 Personal Consumption -- 1.10% 5/30/2018 GDP Price Index 2.00% 2.00% 5/30/2018 Core PCE QoQ -- 2.50% 5/30/2018 Advance Goods Trade Balance -$71.0b -$68.0b 5/30/2018 Retail Inventories MoM -- -0.40% 5/30/2018 U.S. Federal Reserve Releases Beige Book 5/31/2018 Challenger Job Cuts YoY -- -1.40% 5/31/2018 PCE Core YoY 1.80% 1.90% 5/31/2018 Personal Income 0.30% 0.30% 5/31/2018 Initial Jobless Claims 230k 234k 5/31/2018 Personal Spending 0.40% 0.40% 5/31/2018 Continuing Claims -- 1741k 5/31/2018 Real Personal Spending -- 0.40% 5/31/2018 PCE Deflator MoM 0.20% 0.00% 5/31/2018 PCE Deflator YoY 2.00% 2.00% 5/31/2018 PCE Core MoM 0.10% 0.20% 5/31/2018 Chicago Purchasing Manager 58 57.6 5/31/2018 Bloomberg Consumer Comfort -- 55.2 5/31/2018 Pending Home Sales MoM 1.00% 0.40% 5/31/2018 Pending Home Sales NSA YoY -- -4.40% 2018 Wells Fargo Investment Institute. All rights reserved. Page 5 of 7

6/1/2018 Change in Nonfarm Payrolls 188k 164k 6/1/2018 Two-Month Payroll Net Revision -- 30k 6/1/2018 Change in Private Payrolls 185k 168k 6/1/2018 Change in Manufact. Payrolls 20k 24k 6/1/2018 Unemployment Rate 3.90% 3.90% 6/1/2018 Underemployment Rate -- 7.80% 6/1/2018 Average Hourly Earnings MoM 0.30% 0.10% 6/1/2018 Average Hourly Earnings YoY 2.70% 2.60% 6/1/2018 Average Weekly Hours All Employees 34.5 34.5 6/1/2018 Labor Force Participation Rate -- 62.80% 6/1/2018 Markit US Manufacturing PMI -- 56.6 6/1/2018 Construction Spending MoM 0.90% -1.70% 6/1/2018 ISM Manufacturing 58.1 57.3 6/1/2018 ISM Employment -- 54.2 6/1/2018 ISM Prices Paid 77 79.3 6/1/2018 ISM New Orders -- 61.2 6/4/2018 Factory Orders -- 1.60% 6/4/2018 Factory Orders Ex Trans -- 0.30% 6/4/2018 Durable Goods Orders -- -- 6/4/2018 Durables Ex Transportation -- -- 6/4/2018 Cap Goods Orders Nondef Ex Air -- -- 6/4/2018 Cap Goods Ship Nondef Ex Air -- -- 6/5/2018 Markit US Services PMI -- 55.7 6/5/2018 Markit US Composite PMI -- 55.7 6/5/2018 JOLTS Job Openings -- 6550 6/5/2018 ISM Non-Manf. Composite 57 56.8 Source: Bloomberg, as of May 25, 2018. 2018 Wells Fargo Investment Institute. All rights reserved. Page 6 of 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. 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 0518-05353 2018 Wells Fargo Investment Institute. All rights reserved. Page 7 of 7