Ten Issues in a Two-Percent Economy Los Angeles John E. Silvia, Chief Economist February 2018

Five benchmarks for good decision making Where Are We Now? Five benchmarks for good decision making Interest Rates Inflation Growth Profits The Dollar Source:

Wells Fargo vs. Consensus, Vote for Change How do we compare to consensus? Expectations for the Future Above trend growth, no recession in the forecast Employment—cyclical and structural change Consumer solid—key support to growth In line with consensus on strong housing starts and auto sales Trade will be a drag on economic growth in the U.S. Unsustainable long-run fiscal policy Europe growth remains steady 2 percent plus post-Brexit China growth slower for 2018, 2019 Continued Growth in Canada with BoC continuing to hike rates

Sustained Growth—The Anchoring Bias Above growth at 3 percent in the year ahead. A more balanced composition of domestic growth should prevail, but trade will be a drag going forward. Source: U.S. Department of Commerce and Wells Fargo Securities

Supply-Side Challenges

Potential Growth—Little Help From Productivity Productivity growth has downshifted over the past cycle Source: U.S. Department of Labor and Wells Fargo Securities

Potential Growth—Little Help from Labor Participation Labor supply growth is slowing, particularly for prime-age workers. Labor force participation has improved but remains historically low. Working Age Population Labor Force Participation Source: U.S. Department of Labor and Wells Fargo Securities 7

The Consumer: Health Care, Rents, Restaurants Food away from home, rental housing, and health care spending have improved as the economy has picked up Source: U.S. Department of Labor and Wells Fargo Securities

Workers’ Earnings Drift Upward Average hourly earnings growth has picked up modestly but remains limited by lower-skilled workers entering the workforce and Baby Boomers beginning to retire—the Atlanta Fed measure tracks individuals over time, eliminating compositional effects on wage growth Source: U.S. Department of Labor, Federal Reserve Bank of Atlanta and Wells Fargo Securities

Beveridge Curve Implications The shift outward in the Beveridge curve provides evidence of a break in the link between job vacancies and available workers, as measured by the unemployment rate. Source: U.S. Department of Labor and Wells Fargo Securities

Small Business Optimism Business owners have become much less worried about the regulatory environment. Sales and earnings trends also look more positive. Small Business Optimism Small Business Concerns Source: National Federation of Independent Business (NFIB) and Wells Fargo Securities 11 11

Core Orders Firming Core capital goods orders and shipments, a good proxy for equipment spending, are running at multi-year highs. Source: U.S. Department of Commerce and Wells Fargo Securities

Divergence in Commercial Real Estate

Property Prices: CBD, Suburbs Differ High valuations have caught the Fed’s attention Source: RCA and Wells Fargo Securities

Property Prices: Major/Non-Major Market Splits Valuations have grown the fastest in major markets Los Angeles New York City Boston San Francisco Source: RCA and Wells Fargo Securities

Unsustainable Fiscal Policy

Federal Fiscal Policy Outlook Key Tax Law Changes Individual Tax Code Changes Bill slashes marginal tax rates across the board Limits state & local income and property tax deductions to $10,000 Pass-throughs would be allowed to deduct up to 20 percent of income Doubles the standard deduction and the child tax credit Caps mortgage interest deduction at $750K Doubles the estate tax exemption Keeps the Alternative Minimum Tax (AMT) but lifts the threshold to $500K Maintains several deductions including medical expenses, student loans and private activity bonds (PABs) Repeals Obamacare individual mandate Individual cuts expire on December 31, 2025 Business Tax Code Changes Permanently reduces the corporate tax rate to 21% from the current 35% federal rate starting in 2018 Corporate AMT repealed Business interest expense deductions are capped at 30 percent of EBITDA for 4 years and 30 percent of EBIT thereafter The bill allows for full and immediate expensing of business capital investments. This provision expires in five years. Ends the current worldwide corporate tax system by switching to a territorial system. Existing profits held abroad are taxed at 15.5 percent for cash and cash equivalents and 8 percent for reinvested foreign earnings.

Tax Legislation: A Look Through History Projected figures come from CBO and JCT

Size of the Tax Cuts The new tax plan cuts taxes on businesses and corporations by about $600 billion, plus frees up profits previously being held abroad for tax reasons. Source: Joint Committee on Taxation and Wells Fargo Securities

Effective Corporate Tax Rate Previously, the United States had the highest statutory corporate tax rate in the G20. Source: CBO and Wells Fargo Securities

Federal Fiscal Policy: Tax Cuts for Taxpayers Corporate income tax receipts accounted for less than 10 percent of federal revenues in FY 2016. The top income quintile pays an outsized share of federal taxes. Composition of Federal Revenues Federal Taxes Paid by Income Quintile Source: Congressional Budget Office and Wells Fargo Securities 21

Major Regulatory Changes: New Administration The number of new regulations put in place in the first year of the Trump administration is the lowest among the last four administrations Source: Office of Information and Regulatory Affairs and Wells Fargo Securities

Federal Fiscal Policy – Long Run Debt Problem The composition of federal spending has shifted dramatically. The CBO projects that the debt-to-GDP ratio will surpass 91 percent by 2027. Composition of Federal Spending Federal Debt Continues to Rise Source: Congressional Budget Office and Wells Fargo Securities 23

Leverage: A Government Issue Since 1982, the growth in debt has been a greater issue for the government sector than for the nonfinancial corporate sector. Source: Federal Reserve Board and Wells Fargo Securities

Inflation: Bifurcation

Inflation & Interest Rates Core Inflation Interest Rates Inflation Growth Key Drivers Yield Curve The Dollar Profits Wage-Price Spiral Market Expectations

Inflation: Rising Toward the Two Percent Target Inflation has retreated from the FOMC’s target – mean reverting at 2.3 percent from 1984-2017: Long period of adjustment. Source: U.S. Department of Commerce and Wells Fargo Securities 27

Inflation: A Divide in Goods vs. Services Inflation for services has been much firmer than for commodities Source: U.S. Department of Labor and Wells Fargo Securities

Inflation Expectations…or Lack thereof Inflation expectations, influenced by the recent trend in inflation are still at historically low levels. Source: University of Michigan and Wells Fargo Securities

Interest Rate Path

Pace of Policy Firming: We Say Three Hikes in 2018 FOMC members’ target for the Fed funds rate continues to overshoot market expectations Source: Federal Reserve Board, Bloomberg LP and Wells Fargo Securities

Unwinding of the Balance Sheet As the Fed tapers its reinvestment of maturing assets, its balance sheet will gradually shrink Source: Federal Reserve Board and Wells Fargo Securities

Inflation and the Fed Funds Rate: Narrowing the Gap Inflation has lost momentum. Will the Fed adjust its policy path? Source: Federal Reserve Board, U.S. Department of Labor and Wells Fargo Securities

Household Debt Delinquencies: Autos the Exception Tighter credit standards and a strengthening economy have helped to improve the credit position of households over the past few years—with the exception of student debt. Source: FRBNY and Wells Fargo Securities

Auto Loan Finance An increasingly larger share of auto purchases are being financed with debt. Source: Federal Reserve Board and Wells Fargo Securities

Foreign Purchases of U.S. Securities: Still Solid Capital flows and asset allocation by global investors play a strong role in rate determinations Standard inst Source: U.S. Department of the Treasury and Wells Fargo Securities

Business Lending

Cracks in Bank Lending Market? Demand for commercial real estate loans has eased from its peak Source: Federal Reserve Board and Wells Fargo Securities

Cracks in Bank Lending Market? Lending standards for these types of loans have tightened Source: Federal Reserve Board and Wells Fargo Securities

Bank Market Share As a slowdown in loan demand occurs for businesses and consumers, it is no surprise that bank loans as a share of credit market financing has declined. Weakening Demand Declining Share Source: Federal Reserve Board and Wells Fargo Securities 40

Global Profits and Shrinking Profit Margins

S&P Revenues Earned Abroad by Sector IT and Materials earn the highest share of their revenues abroad, making those industries positioned to benefit the most from a weaker dollar Source: Bloomberg LP and Wells Fargo Securities

Corporate Profit Margins Corporate profits as a share of gross value added remains historically high but is now past its peak Source: U.S. Department of Commerce and Wells Fargo Securities

Encouraging Trend in Profits Corporate balance sheets are in good shape and profits are improving Source: U.S. Department of Commerce and Wells Fargo Securities

Net Interest Expense Net interest expense as a percentage of operating surplus has steadily declined as is typical as the economic expansion ages Source: U.S. Department of Commerce, Bloomberg LP and Wells Fargo Securities

P/E Ratio: Not Mean Reverting The P/E ratio is not independent of the economic cycle. Instead it is a product of the many forces of the economic cycle. Source: Bloomberg LP and Wells Fargo Securities

Financing Capex For nonfinancial corporations, the financing gap between capital expenditures and internally generated funds move together over time Source: U.S. Department of Commerce and Wells Fargo Securities

Dollar Appreciation and Trade Deficit

Dollar Appreciation: Bias Downward We expect the dollar to depreciate as central bank policy convergence replaces policy divergence Source: Federal Reserve Board and Wells Fargo Securities

Dollar Appreciation: Bias Downward The dollar has depreciated against all of our large trading partners over the past year, but movements have varied significantly Source: Federal Reserve Board and Wells Fargo Securities

Dollar and Short-Term Rates We expect the divergence between expected short-term rates and the Fed’s dollar index to continue Source: Federal Reserve Board, U.S. Department of the Treasury and Wells Fargo Securities 51

Global Central Bank Outlook Global central banks appear to be on a gradual path toward monetary policy convergence Source: Bloomberg LP and Wells Fargo Securities 52

International Trade The U.S. trade balance with Canada and Mexico is modest compared to the rest of the world—particularly China Source: U.S. Department of Commerce and Wells Fargo Securities

Export Forecast We look for exports to accelerate in the coming quarters and become additive to real GDP in 2019 Source: U.S. Department of Commerce and Wells Fargo Securities

Retaliatory Tariff Implications Possible trade policy changes could pose downside risks to export growth Source: IHS Global Insight and Wells Fargo Securities 55

International Outlook: Improving Global Growth?

We expect global economic growth will remain near its long-run trend Global Forecast We expect global economic growth will remain near its long-run trend Source: International Monetary Fund and Wells Fargo Securities 57

Global Exports: Upswing Global trade has clearly downshifted compared to past expansions, however the recent trend is encouraging Standard inst Source: IHS Global Insight and Wells Fargo Securities

Developing Markets Signal their Significance Developing markets have become increasingly important for U.S. exporters Developing Markets Gaining Share Trend Likely to Continue Source: IHS Global Insight and Wells Fargo Securities 59

The Eurozone will likely continue to expand at a solid pace Eurozone GDP Forecast The Eurozone will likely continue to expand at a solid pace Source: IHS Global Insight and Wells Fargo Securities 60

U.K. GDP Forecast The U.K. economy continues to expand, however Brexit uncertainties have likely been a drag on growth Source: IHS Global Insight and Wells Fargo Securities 61

Chinese GDP: Soft Landing Growth in China will likely continue to downshift to a more sustainable pace Source: Bloomberg LP and Wells Fargo Securities 62

Chinese Debt: NFCs and SOEs Debt problems in China are concentrated in the business sector Source: Bloomberg LP and Wells Fargo Securities 63

Five Takeaways Growth Continued moderate growth led by domestic consumer Inflation Moving upwards. Will this influence the Fed’s policy path? Interest Rates Rising short rates, but relatively flat long rates as capital flows favor the U.S. Dollar Central bank policy convergence will drive dollar lower Profits A late cycle slowdown

U.S. Forecast Source: U.S. Department of Commerce, U.S. Department of Labor, Federal Reserve Board, Freddie Mac and Wells Fargo Securities

International Forecast Source: International Monetary Fund and Wells Fargo Securities

Appendix

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Wells Fargo Securities Economics Group Diane Schumaker-Krieg ………………… ……….diane.schumaker@wellsfargo.com Global Head of Research, Economics & Strategy Global Head of Research, Economics & Strategy Sarah House, Economist sarah.house@wellsfargo.com Michael A. Brown, Economist michael.a.brown@wellsfargo.com Jamie Feik, Economist jamie.feik@wellsfargo.com Erik Nelson, Currency Strategist erik.f.nelson@wellsfargo.com Economists Chief Economist John E. Silvia john.silvia@wellsfargo.com Economic Analysts Senior Economists Michael Pugliese, Economic Analyst michael.d.pugliese@wellsfargo.com Harry Pershing, Economic Analyst harry.pershing@wellsfargo.com Hank Carmichael, Economic Analyst john.h.carmichael@wellsfargo.com Ariana Vaisey, Economic Analyst ariana.b.vaisey@wellsfargo.com Abigail Kinnaman, Economic Analyst abigail.kinnaman@wellsfargo.com Shannon Seery, Economic Analyst shannon.seery@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 Azhar Iqbal, Econometrician azhar.iqbal@wellsfargo.com Tim Quinlan, Senior Economist tim.quinlan@wellsfargo.com Eric J. Viloria, Currency Strategist eric.viloria@wellsfargo.com Administrative Assistants Donna LaFleur, Executive Assistant donna.lafleur@wellsfargo.com Dawne Howes, Administrative Assistant dawne.howes@wellsfargo.com 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 Clearing Services, 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 © 2018 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. 69 69 69