Breaking Out is Hard to Do

WEEKLY GUIDANCE FROM OUR I NVESTMENT STRATEGY COMMITTEE Sameer Samana, CFA Global Equity and Technical Strategist Breaking Out is Hard to Do May 21, 2018» We believe that observing market movement and investor behavior over the past year may be helpful in anticipating the U.S. equity market s next move.» While the S&P 500 Index has been trading in an ever-narrowing range, which has led to some investor confusion, we believe that a technical breakout is near. What it may mean for investors» We expect U.S. equity markets to break out to the upside and resume their uptrend, but we also believe that more normal levels of volatility are here to stay. We suggest that investors remain nimble and well-diversified. U.S. equity markets have been trading in an ever-narrowing range in recent months. Given the history of market corrections (defined as a decline from the peak of at least 10%), and markets tendency to take some time to heal by trading sideways, it could take a while for markets to break out to the upside. We believe that it is worth looking back to see if there may be lessons to learn from the market s recent twists and turns. In today s report, we focus on the past 12 months to see if technical market trends over this period may signal what the U.S. equity market s next move might be. Phase 1: Low volatility and shallow pullbacks Asset Group Overviews Equities... 4 Fixed Income... 5 Real Assets... 6 Alternative Investments... 7 The first phase of the equity market s movement over this 12-month time frame (much of which took place last year) was a period of low volatility and shallow pullbacks. None of these pullbacks came close to reaching the 200-day moving average, and each conditioned investors to buy on dips. This phase culminated late in January 2018 with a market melt-up when confidence in the economic and market outlook became more widespread and valuation multiples expanded. We spent much of this time warning about crowded bullish positioning and cautioning investors to avoid the market euphoria. Although many market participants didn t know exactly when markets would stumble, it was clear that the ingredients for a correction were in place. 2018 Wells Fargo Investment Institute. All rights reserved. Page 1 of 8

Phase 2: The correction The second phase was marked by deflating of the overconfidence bubble, and it happened over several weeks. It started in mid-january with an interest-rate increase as the 10-year Treasury yield broke above its 2017 highs, which led to investor reassessment of whether equity valuation multiples might be impacted more significantly by yields than was originally anticipated. The breakout in yields was followed by a rise in the VIX (CBOE Volatility Index) to a level above 15 for the first time since August 2017. The straw that broke the camel s back was on February 2, when year-over-year (as of January) average hourly earnings growth was reported at 2.9%, well ahead of consensus expectations for 2.6%. These three events called into question the consensus investor view that rates would remain lower for longer, inflation would not be an issue, and markets would experience only marginally higher volatility. The crowded and stretched positioning in strategies such as those shorting volatility (and risk-parity) made the subsequent unwinding of positions more severe. In the sell-off that followed, the S&P 500 Index experienced its first correction in more than two years, the VIX saw its largest daily percentage increase (116%) on record since it began in 1993 (as it jumped from a February 2 close of 17 to a February 5 close of 37), and investor positioning and sentiment turned from optimistic to pessimistic. The current phase This brings us to the current phase, during which markets have been consolidating within a tighter range, but have failed to make much progress (Chart 1). We have been saying for some time that we did not see an easy (or quick) recovery following the February market breakdown. History tells us that recovering from corrections is sometimes akin to healing from a broken leg. Following the correction (or leg injury), the leg is placed inside a cast, which resembles the narrow range that we have seen in markets. This phase typically can t be hurried; it can take anywhere from months to years as the leg (or in this case, the market) heals. In this phase, it is important not to overreact to every market move higher and lower, and it is more valuable to confirm that buyers continue to engage at important support levels. Chart 1 shows that the S&P 500 Index has tended to bounce each time it has gotten close to its 200-day moving average or to the trend-line that sits just below that. 2018 Wells Fargo Investment Institute. All rights reserved. Page 2 of 8

Breaking Out is Hard to Do Chart 1: Technical levels and trading range for S&P 500 Index: 12 months ended May 16, 2018 Source: Bloomberg, May 16, 2018. Past performance is no guarantee of future results. The last step is the market breakout (akin to reemergence from the leg injury, as the cast is removed). In the market s case, we expect it to break out of this range but even then, the recovery could be slow, as the market tends to return to test the breakout. If U.S. equity markets continue to follow the path that we expect, then in the coming months, they should break out of this range decisively, with the only question being which direction they will move. It is also important to note that the volatile swings and symmetry in the market s recent movement, where we have simultaneously seen lower highs and higher lows, has led to plenty of confusion over what the market s next move might be. Our view on the market s future direction With respect to future market direction, we believe that the technical breakout often turns to a resumption of the trend that was in place before the correction. That is why we expect U.S. markets to break higher. As that occurs, we also expect investors to feel a sense of missing out on the market s gains. They should come back into equity markets with additional assets, if history is any guide. We also believe that the odds of resolution to the upside are increased by the continued positive indicators on our macroeconomic, fundamental, and valuation dashboard. While our outlook is bullish, it is worth noting that the volatility we have seen year to date was both expected and normal. We see it remaining for the foreseeable future. This is an element that generally has been missing for the past few years. Investors will need to dust off their playbooks for choppier equity markets, if they hope to capitalize upon them. 2018 Wells Fargo Investment Institute. All rights reserved. Page 3 of 8

EQUITIES Sameer Samana, CFA Global Equity and Technical Strategist How much are markets tracking versus historical seasonality? U.S. Small Cap Equities U.S. Large Cap Equities U.S. Mid Cap Equities Developed Market Ex-U.S. Equities Emerging Market Equities Sell in May and go away is an old saying, which claims that investors should exit stocks in May and return in the fall. We reviewed historical S&P 500 Index data from 1928 to today to see how 2018 is playing out thus far and whether we can glean any insights about the remainder of this year. The table below shows that history suggests the six best months for the market are the October through January period and the months of May and July (when ranked by the median monthly return, which takes out extreme outliers). The table also shows that 2018 has been a pretty typical year from a seasonality standpoint (to date) as January was quite strong and the period from February to April has been quite weak. If 2018 continues along this normal path, then we already have experienced three of the worst six months of the year. History suggests that the period from May through July should be positive for investors (the S&P 500 Index already has gained 2.5% month-to-date through May 15) with a breather in June and a more concerning stretch that could occur in August and September. Given that U.S. midterm elections are likely to attract investor focus as we approach November, it would not be a surprise to see choppier markets late in the summer, and our historical analysis suggests that seasonality might be a further performance drag. With that being said, history also suggests that any weakness during those months sets the stage for arguably the best stretch of the year from October through January.» This year has been a fairly typical year from a historical seasonality standpoint.» We expect some U.S. equity-market choppiness as we approach the midterm elections, but we believe that the S&P 500 Index will end this year above last week s levels. Median monthly S&P 500 Index returns from 1928 to today Seasonality Performance January February March April May June Median 1.55% 0.27% 0.94% 0.91% 1.06% 0.08% 2018 5.62% -3.89% -2.69% 0.27% 2.51% July August September October November December Median 1.43% 0.81% -0.42% 1.03% 1.11% 1.48% 2018 Top 50% Bottom 50% Sources: Bloomberg, Wells Fargo Investment Institute, May 16, 2018. Past performance is no guarantee of future results. 2018 Wells Fargo Investment Institute. All rights reserved. Page 4 of 8

FIXED INCOME Brian Rehling, CFA Co-Head of Global Fixed Income Strategy U.S. Taxable Investment Grade Fixed Income U.S. Short Term Taxable Fixed Income U.S. Intermediate Term Taxable Fixed Income Most U.S. Long Term Taxable Fixed Income High Yield Taxable Fixed Income Long-term fixed income price declines continue On March 29, 2018, we moved long-term fixed income from evenweight to underweight. When we released our new guidance nomenclature on April 16, 2018, we rated longterm fixed income as most unfavorable (our lowest rating). The chart below shows the price performance of Treasury securities since March 29, 2018. We expect a continued abatement of factors that had previously limited a rise in longerterm rates, such as low global rates, a slow-growth economy, and inflation that has persisted below Federal Reserve (Fed) targets. We look for low global bond yields to continue to moderate (rise) throughout the year as international developed economies strengthen further. Higher hedging costs for foreign investors have made the trade into higher-yielding U.S. securities less attractive. We look for continued improvement in gross domestic product (GDP) growth in the coming quarters. Better growth domestically and abroad should allow the yield curve to maintain its steepness or even steepen in the near term. Additional yield curve steepening would continue to impact the long-term fixed income class negatively. Our projections call for near term survey-based inflation measures to increase throughout 2018. We also have observed a meaningful rise in longer term market-based inflation measures as the near-term inflation risk has increased.» Higher short-term interest rates offer an opportunity for increased income potential in lower-risk asset classes.» While curve flattening is the trend, the curve remains sufficiently steep to suggest that the slow-growth environment will continue.» We have a favorable view on (and recommend higher exposure to) short-term fixed income. We also recommend reducing exposure to long-term fixed income while targeting below-benchmark duration portfolio positioning. 1 Generic Treasury security price decline since March 29, 2018 Developed Market Ex.-U.S. Fixed Income 0.0% -1.0% -2.0% Two-year Treasury Ten-year Treasury Thirty-year Treasury Emerging Market Fixed Income Percent -3.0% -4.0% -5.0% -6.0% Sources: Bloomberg, Wells Fargo Investment Institute, May 15, 2018. 1 Duration measures a bond s price sensitivity to interest-rate changes. 2018 Wells Fargo Investment Institute. All rights reserved. Page 5 of 8

REAL ASSETS Austin Pickle, CFA Investment Strategy Analyst Commodities Private Real Estate Public Real Estate Whether you think you can or whether you think you can t, you re right. --Henry Ford Oil-price perfect storm may dissipate Oil has been in a strong uptrend since June of last year. And the short-term trend and momentum point higher still. Yet, we would caution investors against jumping on the bull bandwagon as the upside potential from these levels likely is limited. There has been a near-perfect storm of supply, demand, and geopolitical factors that contributed to this bullish trend. The initial supply response to higher prices was muted due to hesitant U.S. oil production and the surprising resolve of OPEC (Organization of the Petroleum Exporting Countries) to over-comply with its self-imposed oil production quota. Demand increased along with the accelerating domestic and global economy. And geopolitical risks increased due to Middle East tensions, Iranian sanctions, Venezuela s accelerating economic and oil production collapse, and potential Venezuelan sanctions. In short, the stars aligned to drive oil prices to their currently lofty levels. Such a perfect storm rarely lasts long, and it may be starting to dissipate. U.S. oil production levels are setting new records week after week, the Iran decision has come and gone, and higher oil and gas prices are starting to hit demand all at a time when the acceleration of economic growth may have peaked. We expect lower prices by yearend. With that being said, if softening fundamentals don t gain traction over oil prices soon, our current crude-oil price targets may be too low. Stay tuned.» Oil prices benefited from a near-perfect storm of a hesitant supply response, increased demand, and escalating geopolitical risks.» We see evidence that this perfect bullish scenario is unraveling, and we expect lower oil prices by year-end 2018. West Texas Intermediate (WTI) oil price WTI oil price (U.S. dollars per barrel) 110 100 90 80 70 60 50 40 30 WTI oil Two standard deviations above 21-Day SMA Two standard deviations below 21-Day SMA 20 2014 2015 2016 2017 2018 Sources: Bloomberg, Wells Fargo Investment Institute. Daily Data: January 2, 2014 May 16, 2018. SMA stands for simple moving average. 2018 Wells Fargo Investment Institute. All rights reserved. Page 6 of 8

ALTERNATIVE INVESTMENTS Justin Lenarcic Global Alternative Investment Strategist Reading the tea leaves with recovery rates Private Equity Hedge Funds-Macro Hedge Funds-Event Driven Hedge Funds-Relative Value Most Hedge Funds-Equity Hedge Much of our alternative investment commentary in the past 12 months has focused on preparing for late-cycle opportunities. While the immediate opportunity set may be more focused on Equity Hedge strategies, where we maintain a most favorable view on a tactical basis, we are increasingly constructive on opportunities within corporate credit and the implications for Relative Value, Event Driven, and Private Debt strategies over the next two to three years. Traditional indicators, such as default rates, distress ratios, and even CCC-rated (below-investment-grade credit) issuance all remain sanguine and are not foretelling of immediate credit market stress. Yet, we have seen a steady deterioration in underwriting due to both institutional and retail investor demand for high-yielding loans. This has led to weaker loan covenants, which ultimately should affect recovery rates. Recovery rates reflect the amount of principal and accrued interest recovered after an issuer restructures its defaulted debt. In other words, recovery rates reflect the permanent loss of capital expected in the event of a default for example, a recovery rate of 60% implies that investors will lose 40% of their investment. While the current recovery rate for U.S. senior unsecured debt is well above the historical average, it may be showing early signs of deterioration. Along with credit default rates and distress ratios, this will be an important indicator for us to watch as the credit cycle matures and we frame our guidance on the Long/Short Credit and Event Driven opportunity set.» Although the current recovery rate for U.S. senior unsecured debt is above the historical average, it may be showing early signs of deterioration.» As recovery rates decline, investors will face the potential for higher losses if defaults increase. This could lead to trading opportunities for Long/Short Credit strategies. High yield credit recovery rates may be poised for a reversal 90 80 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. Recovery rate 70 60 50 40 30 20 10 0 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 Jan-16 Jan-18 Recovery rate for U.S. senior, unsecured debt Average Sources: Wells Fargo Investment Institute, Bank of America Merrill Lynch, May 2018. 2018 Wells Fargo Investment Institute. All rights reserved. Page 7 of 8

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. Definitions Chicago Board Options Exchange Volatility Index (VIX) reflects a market estimate of future volatility, based on the weighted average of the implied volatilities for a wide range of strikes. 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. 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. 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 0518-03720. 2018 Wells Fargo Investment Institute. All rights reserved. Page 8 of 8