Anika R. Khan, Senior Economist October 20, 2015 2015 Economic Outlook Anika R. Khan, Senior Economist October 20, 2015

Five Key Themes U.S. Economic Growth Slow Global Growth Overall economic growth is improving at a steady pace. The household sector is seeing strong gains and the housing market is advancing. However, capital investment has been lackluster and net exports will continue to be drag on real GDP growth Slow Global Growth Global real GDP growth is gradually increasing, but remains below its long-run average. Although economic growth in the U.S. is strengthening, activity in other advanced economies are lagging in the recovery Risks to U.S. Outlook The U.S. dollar has strengthened significantly since last summer due to the divergence in the outlook for monetary policy. As a result, the U.S. manufacturing sector is showing weakness. The renewed drop in the price of oil has also been a headwind and unresolved fiscal issues will continue to add uncertainty Data-Dependent Federal Reserve The Fed is looking at an array of data and will need to continue to see strengthening labor market conditions, inflation moving toward its target and improvement in emerging economies China China’s economic growth continues to slow bringing much of the commodity export-dependent world down with it. The manufacturing sector is weak and construction is also showing marked declines. Foreign excess reserves have likely peaked

Real Private Final Sales Economic Growth We are now six years into the recovery and economic growth is increasing at a steady pace. Despite a slow start to the year, activity is expected to improve in the coming quarters Real GDP Forecast Real Private Final Sales Source: U.S. Department of Commerce and Wells Fargo Securities, LLC 3 3

Business Fixed Investment GDP Components Businesses still have a considerable amount of cash on the sidelines. We expect some of this money to be redirected into capital spending, but there are downside risks due to the recent drop in oil prices Business Fixed Investment Cash on Sidelines Source: U.S. Department of Commerce and Wells Fargo Securities, LLC 4 4

Residential Investment Spending Residential investment spending has made only a marginal contribution to real GDP growth. However, growth in the household sector is gradually improving Residential Investment Spending Household Formations Source: U.S. Department of Commerce and Wells Fargo Securities, LLC 5 5

Consumer spending is driving overall economic growth Real Consumer Spending Retail Sales Source: U.S. Department of Commerce and Wells Fargo Securities, LLC

Household Finances Although consumer leverage remains elevated relative to historical norms, it is well off its prerecession high and debt service has returned to more sustainable levels Debt to Income Debt Service Source: Federal Reserve Board and Wells Fargo Securities, LLC

Revolving credit is beginning to come back Consumer Credit Revolving credit is beginning to come back Source: Federal Reserve Board and Wells Fargo Securities, LLC

Percent change in real GDP by state 2013-2014 AR AZ CA CO FL GA IA ID IL IN KS KY LA ME MI MN MO MS MT NC ND NE NH NM NV NY OH OK OR PA SC SD TN TX UT VA VT WA WI WV WY 0.7 0.8 1.4 2.8 4.7 CT 0.6 DC 1.6 DE 1.2 2.7 2.3 0.4 1.8 1.0 1.9 MA MD 0.2 0.9 -1.2 6.3 NJ 2.5 2.1 3.6 RI 2.2 1.7 5.2 3.1 0.02 3.0 5.1 HI 0.8 U.S. = 2.2% 2.7% - 6.3% (-1.3)% - 0.7% 1.8% - 2.7% 1.2% - 1.8% 0.7% - 1.2% AK -1.3

Economic Policy Uncertainty The Index of Economic Policy Uncertainty reached its highest level on record during the debt ceiling debate, but remains well above its long-run trend Source: Economic Policy Uncertainty and Wells Fargo Securities, LLC

U.S. Budget Gap The federal government faces some significant fiscal challenges—the current path is not sustainable Source: Congressional Budget Office and Wells Fargo Securities, LLC

Treasury Fundamentals Net Treasury issuance and international capital flows remain the key drivers of price dynamics in the market Source: IHS Global Insight and Wells Fargo Securities, LLC

The composition of federal spending has shifted dramatically. Federal Fiscal Policy The composition of federal spending has shifted dramatically. The CBO projects that the debt-to-GDP ratio will reach nearly 80 percent by 2025. Composition of Federal Spending Federal Debt Continues to Rise Source: Congressional Budget Office and Wells Fargo Securities, LLC 13 13

What to watch for in the 114th Congress Fiscal Policy Outlook What to watch for in the 114th Congress Key Issues Oct. 29th - Funding for Highway Trust Fund expires How will the gap be filled? November 5th - Re-establishment of debt ceiling How will Congress increase the borrowing limit? December 11th - FY 2016 budget debate Current funding runs out Corporate tax reform Both sides agree action is needed, but what will be done? International trade agreements (TPP, TTIP) Don’t expect immediate action, but progress is being made

Fed Balance Sheet Operations Five Key Themes Lift-Off We continue to believe the Fed is on course to begin to raise short-term interest rates later this year. Lift-off in December is still on the table, but the risks have shifted Yield Curve & Term Premium Decomposing the yield curve into the risk-neutral yield and the term premium, we find longer-dated U.S. Treasuries have been lower, principally due to a lower term premium Fed Balance Sheet Operations Fed balance sheet operations have had substantial effects on longer-term Treasury Yields, by reducing the term premiums on longer-dated Treasury securities Data Dependent The Fed is looking at an array of data and will need to continue to see strengthening in global and labor market conditions. Safe-Haven Flows & Policy Divergence The divergence between monetary policies of large economies will continue to put upward pressure on the dollar with continued flows into U.S. assets and longer-term U.S. Treasuries

Past Tightening Cycles There have been five tightening cycles in the past 25 years In the 2004 cycle, the Fed stayed on hold for 12 months and hiked rates 425 bps from 1.00% Source: Federal Reserve Board and Wells Fargo Securities, LLC

Lift-Off: Pace of Policy Firming The FOMC Committee downshifted its expectations for the Federal Funds rate path in its recent meeting The FOMC has steadily reduced its projections and the market is currently discounting the possibility of a rate hike this year Source: Federal Reserve Board and Wells Fargo Securities, LLC

Fed Balance Sheet Although the Fed is largely expected to begin increasing its target short-term interest rate this year, the Fed will remain accommodative due to its balance sheet holdings Source: Federal Reserve Board and Wells Fargo Securities, LLC

Employment Situation Slack in the labor market is steadily diminishing and wage growth is beginning to show some signs of picking up Unemployment Rate Unemployment Rate Source: U.S. Department of Labor and Wells Fargo Securities, LLC 19 19

Inflation Members of the FOMC expect inflation to rise over the course of the year and approach its long-run target this year as the economy gradually strengthens and inflation expectations remain stable Source: U.S. Department of Commerce, Federal Reserve Board and Wells Fargo Securities, LLC

Inflation Expectations Survey-based inflation expectations remain stable, while market-based measures have fallen Market-Based Inflation Expectations Survey-Based Inflation Expectations Source: Bloomberg, LP, University of Michigan and Wells Fargo Securities, LLC 21 21

A Divergence in Central Bank Policy Over the next year, central bank policies will continue to diverge Source: Bloomberg LP and Wells Fargo Securities, LLC

Global Outlook

Global Real GDP Growth Global real GDP growth has grown slightly below its long-run average in recent years. Although we look for global GDP to increase somewhat next year, we do not expect to see the robust pace of growth seen in the previous expansion Source: IHS Global Insight and Wells Fargo Securities, LLC

Eurozone GDP Forecast The Eurozone has emerged from its double-dip recession, but the recovery will lag the U.S. Source: IHS Global Insight and Wells Fargo Securities, LLC

The Euro We expect the dollar to strengthen against the euro on stronger US growth and higher interest rates Source: IHS Global Insight and Wells Fargo Securities, LLC

China

Chinese GDP Forecast Growth in China is not expected to return to the double-digit rate seen earlier in the decade Source: IHS Global Insight and Wells Fargo Securities, LLC

China Manufacturing & Reserves Manufacturing activity in China continues to weaken and is also starting to weigh on the markets. China has begun whittling down its war chest of foreign exchange reserves Manufacturing Activity vs. S&P 500 Foreign Exchange Reserves Source: Bloomberg LP and Wells Fargo Securities, LLC

Chinese GDP vs Industrial Metals A weakening Chinese economy has weighed heavily on prices, specifically industrial metals Source: IHS Global Insight, Bloomberg LP and Wells Fargo Securities, LLC

China Household Assets Equities play a limited role in the allocation of Chinese financial wealth Source: CEIC and Wells Fargo Securities, LLC

American banks are not overly exposed to China Bank Exposure American banks are not overly exposed to China Source: Bank for International Settlements and Wells Fargo Securities, LLC

Chinese Trade Although Chinese trade has clearly weakened over the past few years, part of the recent decline can be attributed to price effects. Moreover, the direct effects to the U.S. appear to be minimal. China accounts for just 7 percent of U.S. exports and less than 1 percent of real GDP Source: IHS Global Insight and Wells Fargo Securities, LLC

Construction Started in China Residential and nonresidential construction have slowed markedly Source: CEIC and Wells Fargo Securities, LLC

U.S. Forecast 35

Appendix

Wells Fargo Economics Group Publications A Sampling of Our Recent Special, Regional & Industry Commentary To view any of our past research please visit: http://www.wellsfargo.com/ economics To join any of our research distribution lists please visit: http://www.wellsfargo.com/ economicsemail Recent Special Commentary

Wells Fargo Securities, LLC Economics Group Diane Schumaker-Krieg ………………… ……….diane.schumaker@wellsfargo.com Global Head of Research & Economics Global Head of Research and Economics Azhar Iqbal, Econometrician………………… ……………azhar.iqbal@wellsfargo.com Tim Quinlan, Economist …………………… ……………. .tim.quinlan@wellsfargo.com Eric J. Viloria, Currency Strategist eric.viloria@wellsfargo.com Sarah House, Economist …………… ………… sarah.house@wellsfargo.com Michael A. Brown, Economist ……………… … michael.a.brown@wellsfargo.com Economists Chief Economist John E. Silvia … ....................... … john.silvia@wellsfargo.com Mark Vitner, Senior Economist……………....………. . mark.vitner@wellsfargo.com Jay H. Bryson, Global Economist …………………....…… ….jay.bryson@wellsfargo.com Sam Bullard, Senior Economist sam.bullard@wellsfargo.com Nick Bennenbroek, Currency Strategist ……nicholas.bennenbroek@wellsfargo.com Eugenio J. Alemán, Senior Economist… …………eugenio.j.aleman@wellsfargo.com Anika R. Khan, Senior Economist … . anika.khan@wellsfargo.com Senior Economists Economic Analysts Erik Nelson, Economic Analyst erik.f.nelson@wellsfargo.com Alex Moehring, Economic Analyst alex.v.moehring@wellsfargo.com Misa Batcheller, Economic Analyst misa.n.batcheller@wellsfargo.com Michael Pugliese, Economic Analyst michael.d.pugliese@wellsfargo.com Donna LaFleur, Executive Assistant. donna.lafleur@wellsfargo.com Cyndi Burris, Senior Administrative Assistant cyndi.burris@wellsfargo.com Administrative Assistants Wells Fargo Securities Economics Group publications are produced by Wells Fargo Securities, LLC, a U.S broker-dealer registered with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority, and the Securities Investor Protection Corp. Wells Fargo Securities, LLC, distributes these publications directly and through subsidiaries including, but not limited to, Wells Fargo & Company, Wells Fargo Bank N.A., Wells Fargo Advisors, LLC, Wells Fargo Securities International Limited, Wells Fargo Securities Asia Limited and Wells Fargo Securities (Japan) Co. Limited. Wells Fargo Securities, LLC. ("WFS") is registered with the Commodities Futures Trading Commission as a futures commission merchant and is a member in good standing of the National Futures Association. Wells Fargo Bank, N.A. ("WFBNA") is registered with the Commodities Futures Trading Commission as a swap dealer and is a member in good standing of the National Futures Association. WFS and WFBNA are generally engaged in the trading of futures and derivative products, any of which may be discussed within this publication. Wells Fargo Securities, LLC does not compensate its research analysts based on specific investment banking transactions. Wells Fargo Securities, LLC’s research analysts receive compensation that is based upon and impacted by the overall profitability and revenue of the firm which includes, but is not limited to investment banking revenue. The information and opinions herein are for general information use only. Wells Fargo Securities, LLC does not guarantee their accuracy or completeness, nor does Wells Fargo Securities, LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. Wells Fargo Securities, LLC is a separate legal entity and distinct from affiliated banks and is a wholly owned subsidiary of Wells Fargo & Company © 2015 Wells Fargo Securities, LLC. SECURITIES: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE Important Information for Non-U.S. Recipients For recipients in the EEA, this report is distributed by Wells Fargo Securities International Limited ("WFSIL"). WFSIL is a U.K. incorporated investment firm authorized and regulated by the Financial Conduct Authority. The content of this report has been approved by WFSIL a regulated person under the Act. For purposes of the U.K. Financial Conduct Authority’s rules, this report constitutes impartial investment research. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive 2007. The FCA rules made under the Financial Services and Markets Act 2000 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available. This report is not intended for, and should not be relied upon by, retail clients. This document and any other materials accompanying this document (collectively, the "Materials") are provided for general informational purposes only. 38 38 38