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

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

3. 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

4. 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

5. Supply-Side Challenges

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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. Divergence in Commercial Real Estate

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

15. 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

16. Unsustainable Fiscal Policy

17. 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.

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

19. 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

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

21. Federal Fiscal Policy: Tax Cuts for Taxpayers
Corporate income tax receipts accounted for less than 10 percent of federal revenues in FY 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

22. 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

23. 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

24. 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

25. Inflation: Bifurcation

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

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

28. 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

29. 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

30. Interest Rate Path

31. 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

32. 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

33. 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

34. 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

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

36. 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

37. Business Lending

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

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

40. 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

41. Global Profits and Shrinking Profit Margins

42. 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

43. 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

44. 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

45. 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

46. 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

47. 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

48. Dollar Appreciation and Trade Deficit

49. 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

50. 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

51. 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

52. 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

53. 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

54. 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

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

56. International Outlook: Improving Global Growth?

57. 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

58. 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

59. 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

60. 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

61. 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

62. 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

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

64. 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

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

66. International Forecast
Source: International Monetary Fund and Wells Fargo Securities

67. Appendix

68. Wells Fargo Economics Group Publications
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69. Wells Fargo Securities Economics Group
Diane Schumaker-Krieg …………………
Global Head of Research, Economics & Strategy
Global Head of Research, Economics & Strategy
Sarah House, Economist
Michael A. Brown, Economist
Jamie Feik, Economist
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John E. Silvia
Economic Analysts
Senior Economists
Michael Pugliese, Economic Analyst
Harry Pershing, Economic Analyst
Hank Carmichael, Economic Analyst
Ariana Vaisey, Economic Analyst
Abigail Kinnaman, Economic Analyst
Shannon Seery, Economic Analyst
Mark Vitner, Senior Economist
Jay H. Bryson, Global Economist
Sam Bullard, Senior Economist
Nick Bennenbroek, Currency Strategist
Eugenio J. Alemán, Senior Economist
Azhar Iqbal, Econometrician
Tim Quinlan, Senior Economist
Eric J. Viloria, Currency Strategist
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