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September 2016 Three areas of expertise, one source of investor guidance Steady as she goes? A lot of people went into August thinking that it would be a rough month. People were trying to go on vacation, which creates lighter trading volumes, and the equity markets were at record highs. Instead, August was relatively dull. As measured by the standard deviation of daily returns, the S&P 500 Index for August had the fourth-lowest volatility out of the 255 months since June 1995. The Russell Midcap® Index had the 10th lowest. Small-cap stocks, as measured by the Russell 2000® Index, had the 27th lowest. Fixed-income markets had a bit more excitement, mainly due to talk out of central bankers, but that volatility was just run of the mill. The BofA Merrill Lynch High Yield Index’s volatility was nearly smack-dab in the middle of its historical volatility (127 out of 255). The Barclays U.S. Aggregate Bond Index had slightly lower volatility than its median (117 out of 255). John Manley, CFA Chief Equity Strategist James Kochan Chief Fixed-Income Strategist Brian Jacobsen, Ph.D., CFA, CFP® Chief Portfolio Strategist Our strategists offer their view on the economy, the equities markets, and the fixed-income markets, both in the U.S. and abroad. Their combined view of the investment landscape gives investors a comprehensive perspective on recent market activity and clear guidance for allocating their investment portfolios going forward. Will September be steady as she goes? Probably not. We think it’s prudent to expect volatility and just be delighted when it doesn’t show up. Given the focus on the September 21 announcements from the Bank of Japan (BOJ) and the Federal Open Market Committee (FOMC), there’s certainly the seed of volatility. But given how many people are just waiting for volatility to surge, often what’s widely expected doesn’t materialize. In markets, expectations of drops or pops tend to be self-destroying. If it’s steady as she goes for the markets, it should be steady as she goes for your portfolio. Key themes we are seeing 1. The economy: Talk is cheap 2. Equities: Maybe a stutter, but not a full stop 3. Fixed income: Interest is driving total returns View investment guidance for today’s markets 1. The economy: Talk is cheap One of the highlights of the summer for economists is the Kansas City Federal Reserve’s Economic Symposium in Jackson Hole, Wyoming. The meetings are a chance to hear from central bankers and academics about hot topics in monetary policy. As you can imagine, when central bankers talk, investors listen. This year’s theme was “Designing Resilient Monetary Policy Frameworks for the Future.” Most participants argued that negative rates can be effective in helping central banks stoke the flames of inflation, but there are limits to how effective negative rates can be. They tend to cause distortions in the credit markets and sometimes banks aren’t willing or able to pass those low rates through to depositors or borrowers. There also seemed to be agreement that central banks should use their balance sheets to conduct monetary policy through purchasing a wide variety of assets. Finally, the finger was pointed squarely at fiscal policymakers for not doing enough to help stoke growth or inflation. In other words, the symposium was a chance to talk about how maybe what’s needed for areas like Japan and the eurozone is just a little bit more of what they’ve been doing, especially if the headwind of austerity (tax increases and spending cuts) is abating. Governor Kuroda of the BOJ took the opportunity to talk about how the BOJ could cut rates further into negative territory and do more with asset purchases. The yen responded by weakening relative to the dollar, but there is the danger that Kuroda may be raising expectations for action too high. Talk is cheap, especially after the BOJ disappointed investors in June and July. September will be a critical month for Kuroda to—quite literally—put his money where his mouth is. While the BOJ is talking up more action, Federal Reserve (Fed) officials were talking about action in the opposite direction: raising rates. Fed Chair Janet Yellen—who is the most important one to listen to—struck an optimistic tone on the economy. Vice Chair Stanley Fischer talked about how the Fed could still hike twice this year. Other voting members of the FOMC also talked about hiking. Will they, or won’t they? It depends on the data. If we see wages rising and payrolls expanding like they have been, measures of manufacturing activity improving, housing activity staying robust, and consumer spending proving to be resilient, two rate hikes this year is a distinct possibility. Those are some pretty big ifs, though. Business investment is still sluggish and manufacturing is early in recovering from the April–May slowdown. A Fed that isn’t in a hurry to hike may wait until November rather than jump the gun and go in September. 2. Equities: Maybe a stutter, but not a full stop Equities have rebounded smartly since the Brexit scare and some pretty smart investors are looking for a correction. That’s always possible but 4%–6% pullbacks are notoriously hard to profit from. U.S. equities seem fairly valued at 17 times forward earnings expectations. After two years of stagnation, earnings expectations appear to be rising again. This is more pronounced in mid-cap stocks, which tend to be less affected by a strong dollar. Outlook | September 2016 | 2 Chart 1 Large-cap earnings estimates are rising Source: FactSet, July 28, 2016. Past performance is no guarantee of future results. Chart 2 Mid-cap earnings estimates are rising as well Source: FactSet, July 28, 2016. Past performance is no guarantee of future results. Outlook | September 2016 | 3 The Fed seems ready to nudge rates higher but, in our opinion, not likely to tighten. Chair Yellen seems encouraged by growth but unlikely to try to stifle it. Investor sentiment is far from giddy. We still wince at every loud economic noise we hear. Financials have done better in August and we find that encouraging. Investors seem to be sensing that better growth and slightly higher short-term rates are not the poison they were perceived to be in the days of the taper tantrum, that period in 2013 when rates began to rise and both stock and bond markets had short-term overreactions. Economically sensitive stocks are also outperforming as signs of U.S. economic improvement seem to percolate into view. We think that appetite for risk has been piqued but not yet satisfied. Investors are less fearful than two years ago but have not yet developed enthusiasm. After so many mini panics, we may be getting ready to substitute hope for fear and appreciation potential for up-front income. 3. Fixed income: Interest is driving total returns Interest income was the key to better performance in the bond markets during August. The best total returns came from those segments that offer higher interest income. In the high-yield market, credits rated CCC and weaker outperformed credits rated BB by 200 basis points (bps; 100 bps equals 1.00%). Among investment-grade corporates, the BBB-rated segment outperformed the AA-rated segment by 50 bps. The BBB-rated municipals outperformed the AAA-rated munis by 40 bps. International markets exhibited the same patterns. Emerging markets debt outperformed the developed markets by 150 bps. Treasuries and agencies—fixed-income sectors with the lowest yields—recorded negative total returns in August. Those markets are most sensitive to the outlook for Fed policy, and that outlook darkened somewhat during August. With the economy performing better, the Fed’s hints of one or two rate increases before year-end seem credible. The yield on the 2-year note, which is the most sensitive to the outlook for the funds rate, rose 15 bps in August. Because yields have declined and yield curves have flattened, the longer maturities show the best year-to-date returns. This relative performance would not be expected to prevail if the federal funds rate were to rise. The August experience, in which only the very short Treasury maturities produced positive returns, could be repeated in the months ahead. Durations are so extended that even relatively small yield increases can result in negative returns for the longer maturities. Outlook | September 2016 | 4 Table 1 At a glance: Year-to-date bond market total returns (%) Index name 0.60 -0.63 0.83 0.99 1.46 -4.64 3.55 Q2 2016 2.28 3.50 2.24 1.34 1.12 5.89 2.72 August 2016 -0.14 0.27 -0.57 -0.20 0.11 2.23 0.23 Year to date (8-31-16) 5.96 9.42 5.50 3.58 3.43 14.58 4.59 9.21 4.84 1.26 1.13 2.62 4.44 -0.09 1.42 6.50 12.25 2.93 10.72 29.43 1.49 0.91 -3.20 1.38 3.02 7.33 -0.62 -0.97 -0.78 3.72 7.37 19.34 2014 2015 Broad Market Index Corporate Treasuries Agencies Mortgages High yield Municipal 6.27 7.51 6.02 4.04 6.07 2.51 9.78 International bond (ex U.S.) Emerging markets ($ den.) 5-year Treasury 10-year Treasury 30-year Treasury Source: Bloomberg L.P. Past performance is no guarantee of future results. Outlook | September 2016 | 5 Investment thoughts for today’s markets Action items • Don’t be afraid to buy on the dips if the market falls on good economic data. That could just be the market repricing a rate hike by the Fed. If the Fed is hiking into economic strength, not weakness, that’s nothing to be afraid of. • Consider stocking up on mid caps. Greater investor risk tolerance and better earnings growth could tilt the field toward mid caps. Earnings expectations are rising for mid caps in particular. • Consider opportunistic hedging of currency risk. • As the Fed warms to hiking, brace for higher yields by favoring credit risk over duration risk. • Try to go for yield. Fixed-income sectors with the greatest interest income are likely to have the best total returns. But avoid the weakest of high-yield corporate and muni credits. • Reduce exposure to long-duration securities. Investment themes • Valuations are now slightly above historical norms but not very extended. • A seasonally weak period lies before us, but seasonality hasn’t worked this year. • Individual investors may soon begin to shake off fears of another panic. • Durations should be conservative. What to watch • Watch the Fed. Chair Yellen will want to encourage, not discourage, growth, and it appears that the Fed is preparing to raise rates. • September 21 is the big day of the month with the BOJ and FOMC meetings. • Don’t forget to watch data out of Europe. The Brexit effect hasn’t been too bad. It’s not great, but things seem to be beating expectations. • Commodity prices can continue to be buffeted by the changing value of the dollar. We could see some dollar strength if it’s looking clear that the Fed will hike before Election Day. • Watch earnings expectations. A better economy usually brings better earnings. • Keep an eye on emerging markets. They were surprisingly resilient earlier this year. Valuations may be compelling. • Monitor economic indicators. Stronger data is likely to be bearish for Treasuries but bullish for junk bonds. Outlook | September 2016 | 6 Asset allocation guide For long-term investors with a time frame of three years or longer, we suggest the following strategic portfolio allocation, compared with a market-cap-weighted* portfolio: Summary portfolios Market-cap-weighted portfolio Our suggested portfolio Asset allocation breakdown Equities Fixed income Our suggested portfolio rationale for: Equities U.S. vs. non-U.S. developed equities: Forget going where growth is already good. Go where growth could be better than expected. Despite the Brexit shock, Europe’s growth looks to be getting better. Japan is a bit of a wildcard, but if the BOJ goes big in September, it should help short-term sentiment. Developed equities vs. emerging markets equities: We see some positive developments for emerging markets. India’s new head central banker could credibly fight inflation. Brazil just impeached President Rousseff and launched pro-business reforms. China is stabilizing growth and excess capacity. Large-cap vs. small-cap equities: Why choose? Why not both? And don’t overlook mid caps, with their slightly more domestic focus and stronger resilience against a strengthening dollar than large caps. Fixed income Credit risk exposure: In seeking income, it’s better to take on modest credit risk than duration risk. Lower-quality investment-grade credits and higher-quality junk may help cushion rising Treasury yields. Fixed-income duration: We’re not comfortable with a 10-year Treasury yield below 1.7%. If the Fed hikes this year, we think this yield will move higher. That can be painful for investors in longer-dated Treasuries. Shorter-dated Treasuries offer scant income, so we prefer short-term high yield for income. Alternative investment strategies Alternatives exposure: A diversified set of alternative investments can help reduce the risk of one particular style or strategy underperforming. With heightened uncertainty about the exact timing of a Fed rate hike, we see good value in adding 15% exposure to a diversified pool of alternative strategies. These tend to be global and flexible, which can be useful when there’s a lot of ambiguity in the outlook. *Portfolio allocations may not sum to exactly 100% due to rounding. Outlook | September 2016 | 7 Connect with us At Wells Fargo Asset Management, we know you’re always on the lookout for smart, relevant market and investing information. That’s why we offer timely access to commentary by our capital market strategists on economic indicators, Fed movements, and newsworthy events to help you make informed investment decisions. To subscribe to our monthly Outlook, please visit wellsfargofunds.com. The asset allocation positioning represented is in no way intended to offer individualized advice about which investments to choose or how much to allocate to any particular investment option. The asset allocation charts are provided for illustration purposes only and do not predict or guarantee the performance of any Wells Fargo Fund. When applying an asset allocation strategy to your own situation, variables such as your investment objectives, time frame, income requirements and resources, inflation, and potential rates of return should be considered when you determine which investments will best suit your risk profile. Please consult a financial advisor for advice on your specific facts and circumstances. Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value-weighted index, with each stock’s weight in the index proportionate to its market value. The S&P MidCap 400 Index measures the performance of the mid-size company segment of the U.S. market; this index is used by more than 95% of U.S. managers and pension plan sponsors. More than $25 billion is indexed to the S&P MidCap 400 Index. The S&P SmallCap 600 Index measures the performance of the small-cap segment of the U.S. equity market. It is a market-value-weighted index. The Bond Buyer 20 Index is a representation of municipal bond trends, based on a portfolio of 20 general obligation bonds that mature in 20 years. The index is based on a survey of municipal bond traders rather than actual prices or yields. The Bond Buyer 20 Index is published by The Bond Buyer, a daily financial publication. The BofA Merrill Lynch U.S. High Yield Master II Index is a market-capitalization-weighted index of domestic and Yankee high-yield bonds. The index tracks the performance of high-yield securities traded in the U.S. bond market. The BofA Merrill Lynch U.S. Corporate Index is an unmanaged index composed of U.S. dollar–denominated investment-grade corporate debt securities publicly issued in the U.S. domestic market with at least a one-year remaining term to final maturity. The BofA Merrill Lynch U.S. Municipal Securities Index is an unmanaged, market-value-weighted index composed of investment-grade, fixed rate, coupon-bearing municipal bonds. You cannot invest directly in an index. The ratings indicated are from Standard & Poor’s and/or Moody’s Investors Service. Credit-quality ratings: Credit-quality ratings apply to corporate and municipal bond issues. Standard & Poor’s rates the creditworthiness of bonds from AAA (highest) to D (lowest). Ratings from A to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the ratings categories. Moody’s rates the creditworthiness of bonds from Aaa (highest) to C (lowest). Ratings Aa to B may be modified by the addition of a number 1 (highest) to 3 (lowest) to show relative standing within the ratings categories. Duration is a measurement of the sensitivity of a bond’s price to changes in Treasury yields. A fund’s duration is the weighted average of duration of the bonds in the portfolio. Duration should be interpreted as the approximate change in a bond’s (or fund’s) price for a 100-basispoint change in Treasury yields. The views expressed are as of 8-31-16 and are those of Chief Portfolio Strategist Brian Jacobsen; Chief Equity Strategist John Manley; Chief Fixed-Income Strategist James Kochan; and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the authors and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management disclaims any obligation to publicly update or revise any views expressed or forward-looking statements. Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. Wells Fargo Funds Management, LLC, a wholly owned subsidiary of Wells Fargo & Company, provides investment advisory and administrative services for Wells Fargo Funds. Other affiliates of Wells Fargo & Company provide subadvisory and other services for the funds. The funds are distributed by Wells Fargo Funds Distributor, LLC, Member FINRA, an affiliate of Wells Fargo & Company. 245901 09-16 NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE © 2016 Wells Fargo Funds Management, LLC. All rights reserved. Outlook | September 2016 | 8