Economics Group

2018 Annual Economic OutlookA cautious tale for an optimistic outlook

December 14, 2017

“Be sure to take your umbrella” is a prudent warning even on a bright morning. Today, the economic sunshine permeates our vision and expectations. But while our current economic view for the next two years is generally optimistic, in this annual report we focus on the signals of possible rain showers ahead.

Wells Fargo Securities Economics Group Table of Contents

1

I. Executive Summary 2

II. U.S. Outlook 4

III. Consumer 5

IV. Investment 7

V. Real Estate 8

VI. Inflation 10

VII. Fiscal Policy 12

VIII. Monetary Policy & Interest Rates 15

IX. Global Outlook & Dollar 17

X. Recession Outlook 20

XI. Forecast Tables 22

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Wells Fargo Securities Economics Group Executive Summary

2

Marian: “You're not the man I knew ten years ago.”

Jones: “It's not the years, honey; it's the mileage.”

-Marian & Indiana Jones played by Karen Allen & Harrison Ford in the 1981 film, Raiders of the Lost Ark.

“When will this horror show come to an end?” It was nine years ago that we wrote those words. There certainly has been a lot of mileage on the economic engine since then. If we count the months since the economy emerged from recession in July 2009, this January marks the 103rd month of the current expansion. The longest on record is 120; that was the expansion of the 1990s. Yet, this is no time for complacency.

It’s Time to Ask Yourself: What Do You Believe in? On the upside, economic expansions do not come with an expiration date. Our forecast of roughly 2.5 percent quarterly growth on an uninterrupted basis for 2018 and 2019 means that we are implicitly saying that this cycle will break the record for the longest expansion in U.S. history. Having said that, the average annual real GDP growth rate since mid-2009 is a rather tepid 2.3 percent. In addition to the possibility of being the longest, the current expansion is also the weakest of the post-war era. Perhaps somewhat counter-intuitively, this subpar pace of GDP growth is actually one of the most often cited rationales for this expansion to break the record in terms of duration.

For 2018 and 2019, our baseline forecast looks for growth of 2.5 percent (a bit above the trend for this cycle) with continued growth in consumer spending based on the gains in jobs and wages as well as a wealth effect given the gains in financial markets and home prices. Capital spending on business equipment is expected to continue to grow, albeit at a more moderate pace, while structures outlays should post some modest gains after declines in the second half of 2017. After boosting growth in 2017, net exports are expected to be a slight drag on overall growth.

In the real estate sector, the move back toward center cities by Millennials earlier in the decade appears to be topping out, and we are seeing renewed growth in the suburbs. Single-family development is heating up, while apartment construction is cooling off. Likewise, commercial real estate development is expected to expand off the relatively muted recovery observed in recent years. We foresee corporate profits exhibiting healthy growth, with the after-tax measure of profits receiving a boost on the assumption that congress can pass tax-reduction legislation.

But in the Latin alphabet, ‘Jehovah’ Begins with an ‘I’: Inflation and the Fed Around the world, central banks have struggled to stoke consumer price inflation. The inflation frustration for central banks has been felt in the United States as well. At one point in the middle part of this year, some policy makers remarked that rather than 2 percent being a target, it has more effectively been a ceiling on consumer inflation throughout this expansion. We look for a number of one-off factors that have been holding back inflation to fade away in 2018, which should result in gradual upward momentum for prices. Given the difficulty in achieving sustained inflation at or near 2 percent in this cycle, there has been a growing sentiment among some policy makers at the Fed to overshoot the target temporarily.

Despite the challenges with inflation, the unemployment rate is at its lowest level since 2001 and the number of job openings is at a record high, both of which indicate the Fed is delivering on the “maximum employment” portion of its dual mandate. On that basis, we expect the Fed to raise rates three times this coming year, bringing the fed funds rate to 2.25 percent by year-end 2018. On this assumption, we expect the 10-year Treasury yield to climb as well, albeit at a slower pace, resulting in a slight flattening of the yield curve.

Fly? Yes, Land? No. The Globally Synchronized Expansion For the first time in a long time just about every corner of the global economy is expanding at the same time. We are not bracing for recession in Europe as we were in 2010-2012 after the sovereign debt crisis there, nor are we expecting another great moderation in China and the associated knock-on effects for emerging markets as we have seen over the course of recent years. Instead, we are seeing slow, steady growth. There are no minus signs in our GDP forecasts for any of the foreign economies that we follow.

Inflation frustration for central banks has been felt in the United States as well.

The current expansion has the potential to be the longest and weakest expansion of the post-war era.

Wells Fargo Securities Economics Group Executive Summary

3

While global growth begins to firm, central banks around the world are beginning to dial back policy accommodation. As a result, we are entering a period of monetary policy “convergence” which will likely push the dollar downward. The extent of foreign currency strength will likely depend on the degree of monetary policy adjustment by foreign central banks.

Despite that admittedly sanguine assessment, we acknowledge a number of factors including high government debt levels in Japan and China, the potential for a hard Brexit and of course geopolitical risks, especially with North Korea.

Please, Sit Down Before You Fall Down As this economic cycle continues to approach records for duration, financial markets similarly extend uninterrupted gains. With major stock indices routinely breaking all-time highs, investors are positioned for economic perfection. That may not be what we get, but aside from asset prices themselves, it is difficult to point to a sector that has over-extended itself so much that recession is right around the corner. Our probit model suggests a relatively low 1.17 percent probability of recession in the next six months.

You’re going to get killed chasing after your damn fortune and glory!

Maybe…but not today.

It is difficult to point to a sector that has over-extended itself so much that recession is right around the corner.

Wells Fargo Securities Economics Group U.S. Outlook

4

On the Road of Life, Is It Better to Be a Tortoise, a Hare or Simply Avoid Getting Hit by a Truck? Real GDP growth picked up to better than a 3 percent pace during the second and third quarters of 2017, and with solid momentum going into the fourth quarter, we feel confident about our call for 2.7 percent growth in 2018. While it is comforting to see this improvement, just about any additional good news today is greeted with an unusual amount of trepidation. The past three business expansions lasted an average of only 94 months, a benchmark the current expansion surpassed six months ago.

Expansions do not die of old age; they tend to by killed off by policy blunders or exogenous shocks. Recessions typically come about due to a buildup of excesses within the economy and then some sort of event leads consumers, businesses and policymakers to suddenly become more risk averse.

The unusually slow pace of this economic recovery has left the economy in pretty good shape. There are few visible excesses present today. Inflation and interest rates remain low. Consumers do not strike us as overleveraged (Figure 1). Corporate balance sheets are in good shape and profits are improving now that global growth is reviving and commodity prices have rebounded (Figure 2). Housing, with the exception of some apartment markets, and commercial real estate, are in relative balance. Finally, fiscal policy appears set to become more expansionary. Given this policy mix, our forecast of 2.7 percent real GDP growth in 2018 and 2.5 percent in 2019 seems appropriate.

The lack of negatives is rather remarkable for this stage of the business cycle but is no reason for complacency. Whether growth is plodding along or hopping along, it can all quickly be undermined by forces beyond our control. There is also a risk that the Goldilocks-like economic recovery may have had a more symbiotic relationship that meets the eye. The one persistent theme of the past decade is that interest rates have remained near generation lows, setting off a search for yield by investors and dramatically lowering borrowing costs for households and businesses.

Lower interest rates have enabled homeowners and businesses to repair their balance sheets, while the search for yield has driven asset prices higher. For many decision makers, the soaring stock market, rebounding home prices, rising commercial property prices and surging valuations for privately held companies are music to their ears. For others, however, they have slowed economic mobility and pushed homeownership further out of reach. The reach for yield has also fueled a boom in private equity markets and alternative assets, which has helped drive the technology and energy booms. When you substitute the word ‘unicorn’ (privately funded firms with valuations of more than $1 billion) for ‘dotcom’ the similarties are eerie. Nothing is easy. A sudden and unexpected jump in interest rates could have far reaching consequences across the economy, slowing growth in the tech sector and the fastest-growing parts of the real estate sector. The implications would likely reach into every corner of the economy, even upending the boom in craft breweries.

The terrible “ifs” accumulate when you dwell on what might go wrong. Worrying about what might go wrong only ensures that you do not fully enjoy what is going right today. We are approaching the new year with more promise than any time since the Great Recession. Improvement is evident across nearly all sectors and regions of the country. As we tell our story, come close and lend an ear.

Figure 1

Figure 2

Source: Federal Reserve Board U.S. Department of Commerce and Wells Fargo Securities

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Household Debt Service RatioAs a Percent of Income Measures

Wages and Salaries: Q2 @ 13.9%

Disposable Income Less Transfers: Q2 @ 12.4%

Disposable Income: Q2 @ 9.9%

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Corporate ProfitsUSD Millions

Foreign Profits: Q3 @ $434.1 (Left Axis)

Domestic Profits: Q3 @ $1,781.0 (Right Axis)

Expansions do not die of old age; they tend to be killed off by policy blunders or exogenous shocks.

Lower interest rates have enabled homeowners and businesses to repair balance sheets.

Wells Fargo Securities Economics Group Consumer

5

The U.S. Consumer Needs Higher Wages and Salaries as Interest Rates Rise Real personal consumption expenditures (PCE) have provided the momentum for U.S. economic growth since the recovery from the Great Recession (Figure 3). This could change if Americans do not receive larger wage and salary gains during the next several years in the face of a tighter monetary policy regime. Real PCE growth has averaged 2.4 percent since the recovery from the Great Recession, while real disposable personal income growth has averaged 2.3 percent during the same period. However, for the past year and a half we have seen a large discrepancy between the growth rate of real PCE, up 2.6 percent, and the growth rate of real disposable personal income, up only 1.2 percent. This discrepancy creates tension for the consumer.

Figure 3

Figure 4

Source: U.S. Department of Commerce and Wells Fargo Securities

How Sustainable Is the Current Environment? The late stage of this economic cycle normally has decision makers trying to predict when a recession is coming. However, let’s review just the basic facts. The slow pace of growth of the U.S. economy since the recovery from the Great Recession and the increase in consumer confidence since the presidential election in November of last year have analysts trying to figure out how American consumers are going to monetize this newfound confidence in the future.

Americans have already reacted to this increase in confidence by drawing down the personal saving rate from 6+ percent of disposable personal income back in 2015 to just 3.2 percent in October 2017. Meanwhile, real disposable personal income, which was growing at a 4 to 5 percent rate in 2015, slowed down to a trickle in late 2016 (Figure 4). Only recovering some ground during the first 10 months of this year, real disposable personal income remains weak, up about 1.3 percent on a three-month moving average basis in October. Some of the deterioration in real disposable personal income has been due to higher inflation, especially during 2016, but the fact of the matter is that income growth has remained constrained.

If Americans do not see an increase in wages and salaries soon, the current rate of growth of real PCE will only be sustainable if consumers start to rely more on credit, therefore highlighting the rub with higher interest rates. While some credit dependency is rising today, it is probably not enough to push real PCE much higher than what it has been for the past several years. Credit card borrowing has been positive, but it has not gone back to the peak before the Great Recession, and even student loan and automobile loan growth have slowed down considerably since the heydays of 2014-2016. We saw a notably strong print for non-revolving credit in September of this year, possibly related to Hurricanes Harvey and Irma, and we have observed automobile demand remaining strong in October, which would probably show up in the non-revolving credit number for that month. In October, nonrevolving credit was up $12.2 billion versus $8.3 billion for revolving credit, i.e., mostly credit cards (Figure 5).

Meanwhile, student loan debt remains a topic of discussion for analysts since delinquency rates have increased to about 11 percent (Figure 6). However, for now the good news is that student loan delinquency rates have remained relatively constant for the past five years. Having said this, there may be more bad news for this market as the House Republican tax bill eliminates the interest deduction for student loans, which could put further pressure on this already overextended market.

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Real Personal Consumption ExpendituresBars = CAGR Line = Yr/Yr Percent Change

PCE - CAGR: Q3 @ 2.3%

PCE - Yr/Yr Percent Change: Q3 @ 2.6%

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Real Disposable IncomeBoth Series are 3-Month Moving Averages

Real Disposable Income, 3-Month Annual Rate: Oct @ 0.2%

Real Disposable Income, Yr/Yr % Change: Oct @ 1.3%

Personal consumption has been the main driver of economic growth in this cycle.

Some of the deterioration in real disposable personal income has been due to higher inflation.

Wells Fargo Securities Economics Group Consumer

6

One cautionary signal is the rise in automobile loan delinquency rates, which have been slowly increasing but have not gone back to the rates recorded during the Great Recession. Moreover, delinquency rates for home equity loans have continued to come down, but they remain notably high compared to the rates characteristic of the pre-Great Recession period, which could point to problems down the line for this type of loan if a recession hits. This is similarly true for mortgage loan delinquency rates, which have come down considerably from the near 9 percent highs of the Great Recession, but these delinquency rates still remain above the pre-recession levels. These credit issues likely point to the weak recovery in income since the Great Recession, and add urgency to the need for stronger wage and salary growth for American workers and consumers going forward to sustain the recent growth in spending.

Figure 5

Figure 6

Source: Federal Reserve Board, Federal Reserve Bank of New York and Wells Fargo Securities

For now, the positive news is that many of the indicators we watch are pointing to a potentially improving wage and salary environment for consumers. The unemployment rate is strikingly close to an all-time low, at 4.1 percent in November and nonfarm employment growth has continued at a relatively strong pace. As we mentioned before, inflation has recovered somewhat but remains low. However, these positive developments have been true for several years, and we have yet to see strong pressure on wages and salaries that would make a sustained recovery in real disposable personal income and real personal consumption expenditures. Of course, the proposed tax reform could provide some momentum to consumer demand next year if lower tax rates boost take-home pay.

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Revolving & Nonrevolving DebtChange in Billions of Dollars, 3-Month Moving Average

Revolving: Oct @ $6.5B

Nonrevolving: Oct @ $10.6B

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Household Debt DelinquenciesPercent of Balance 90+ Days Past Due

Credit Card: Q3 @ 7.5%Other: Q3 @ 6.7%Student Loans: Q3 @ 11.2%Mortgage: Q3 @ 1.4%Auto: Q3 @ 4.0%HELOC: Q3 @ 1.5%

Auto loan delinquency rates are slowly rising, but remain below rates recorded during the Great Recession.

The unemployment rate is strikingly close to an all-time low, at 4.1 percent in November.

Wells Fargo Securities Economics Group Investment

7

Equipment Spending, Current Expansion, Future Risks Business fixed investment spending was a key driver of growth in the first several years of the current expansion and that was particularly true for spending on equipment. As Figure 7 shows, both the quarterly and the year-over-year growth rates for equipment spending in 2010 and 2011 rivaled some of the fastest growth rates we have witnessed in the past 40 years.

Equipment spending hit a soft patch starting in the middle of 2014; not coincidentally, that was also roughly the time that oil and other energy prices peaked in this cycle. By 2015 and 2016, outlays on equipment had fallen for four straight quarters. We had never previously observed more than two consecutive declines in equipment spending outside of a recession. Indeed, many economists at the time talked about a manufacturing recession in the United States. We resisted, and held to the view that slow and steady growth would eventually take hold.

Figure 7

Figure 8

Source: U.S. Department of Commerce and Wells Fargo Securities

Our conviction was informed by the notion that some of the weakness was due to temporary pullbacks in energy-related spending, as well as the effect of the then strong dollar and only tepid pace of global growth. From the summer of 2009, when we first emerged from recession, until the peak in oil prices in the summer of 2014, energy-related spending climbed on everything from exploration/extraction to transport and delivery of crude oil and natural gas (Figure 8). Of course, the momentum in spending in these categories fell off a cliff when prices collapsed.

As oil prices have stabilized, so too has energy-related spending. Other headwinds in 2016 have become tailwinds more recently. Since the start of the current year, the trade-weighted dollar is down more than 7 percent and prospects for global growth have been firming. The U.S. dollar could see some further consolidation in the near term, although we still expect trend weakness in the greenback against most foreign currencies over the medium to longer term. Shipments of non-defense capital goods excluding aircraft (core capital goods) provide a reliable signal of future equipment spending. The latest print for this series came in at a 3-month annualized rate of 13.1 percent. Only the second double-digit reading for this barometer of business activity in three years.

Orders lead shipments, and core capital goods orders are growing at an even-faster 14.5 percent annualized rate. 2017 was a turnaround year after four consecutive quarterly declines; equipment spending is now up for four consecutive quarters. Survey data, like the NFIB index and ISM, indicate that the production pipeline is still full…for now, promised fiscal policy improvements need to follow.

Future Risks: I See Trouble on the Way In our view, one of the key challenges for the outlook for business spending is that tax reform comes in well short of expectations. The surge in business confidence earlier this year was in response to what many decision-makers interpreted as a “pro-business agenda” in Washington. However, with the first year nearly over, we have yet to see any enacted legislation. A trade shock is not out of the question either. Should President Trump walk away from NAFTA or slap tariffs on Chinese goods, it could engender a destructive trade war or at least a rise in the price of imported goods, many of them capital goods. Finally, there is the issue of rising interest rates and concerns surrounding the availability of funding for future capital investment.

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Real Business Fixed Investment, Equipment Bars = Compound Annual Rate Line = Yr/Yr % Change

Equipment Investment: Q3 @ 10.4%

Equipment Yr/Yr: Q3 @ 6.3%

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Fixed Investment Spending on EnergyAs Percent of Total BFI

Energy: Q3 @ 3.8%

Equipment spending has recently been gaining momentum.

As oil prices have stabilized, so too has energy-related spending.

Wells Fargo Securities Economics Group Real Estate

8

Residential Investment: Turning Point-Upside We have confidence that we are at a significant turning point in the housing recovery, where several factors that have been holding back single-family sales and new home construction since the financial crisis are beginning to unwind. One of the more prominent trends has been the movement back toward center cities, which has coincided with the millennial generation coming of age and contributed to an epic apartment boom. The trend has been most prominent in tech-driven markets like San Francisco, Seattle and Austin, but is also apparent in most rapidly growing major cities. Much of this new development has been confined to high-end units in a handful of submarkets, resulting in much higher rents. Just more than half of the nation’s multi-family permits for projects of five units or more since 2010 were confined to large MSAs, specifically New York City and Los Angeles, and the 20 most rapidly growing metro areas, as measured by net domestic migration.

The delivery of so many units in high cost metro areas and submarkets has sent rents soaring. Effective rents have risen nationally every quarter since the Great Recession, with growth peaking at nearly 6 percent year over year in Q4 2015 (Figure 9). The proportion of income spent on rent has risen dramatically in many major cities and now exceeds historical benchmarks relative to income, leading an increasing proportion of renters to seek lower cost alternatives in the suburbs or secondary metro areas (Figure 10).

Figure 9

Figure 10

Source: Reis Inc., Zillow Real Estate Research and Wells Fargo Securities

Vacancy rates appear to have bottomed out on a national basis. A deluge of apartments has come to market in San Francisco, New York City, Los Angeles and Washington, D.C., resulting in rising vacancy rates and some easing in effective rents there–but rents remain dramatically higher in all of these markets than at the start of the expansion, and have risen much faster than median income. In addition, since apartment construction has been concentrated in just a handful of markets, overall rental vacancy rates remain relatively low nationwide, allowing rents to easily outpace income in much of the country. Apartment construction should moderate further in 2018, as declines in many large markets offset increases in mid-sized markets and the suburbs. This should keep apartment construction close to its recent pace in the longer run.

Single-family construction appears poised for stronger gains in 2018. The leading edge of the Millennials will turn 37 in 2018 and more than half the cohort will be 29 or over. At this point in their lives, more Millennials are forming households and looking to purchase a home. While we expect the cities to hold onto a greater proportion of this cohort than prior generations, the overwhelming majority of Millennials are settling in the suburbs, which is helping revive suburban growth. Aging Baby Boomers are another potent driver, with retirees flocking to the Sun Belt and reigniting growth of retirement havens in Florida, Georgia, the Carolinas, Arizona and Nevada. Trade-up buyers are still largely missing in action, however, as homeowners are choosing to remain in their existing homes longer than they have previously.

The greatest challenges for the single-family market remain the overall lack of inventory in the existing home market, high land development costs, shortages of lots in desirable areas, and rising prices for building materials. In addition, modest income growth since the Great Recession and high debt

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Apartment Effective Rent GrowthQuarter-over-Quarter Percent Change

Quarter-over-Quarter: Q3 @ 0.9% (Right Axis)

Year-over-Year: Q3 @ 3.3% (Left Axis)

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Rental Affordablity Major Apartment MarketsMedian Rent as Share of Median Income, Zillow

Average 1985 - 1999Q2 2017

We have confidence that we are at a significant turning point in the housing recovery.

Vacancy rates appear to have bottomed out on a national basis.

Wells Fargo Securities Economics Group Real Estate

9

burdens by Millennial buyers continue to weigh on affordability. We look for home sales and new home construction to strengthen in coming years but only modestly so from their recent pace.

Non-Residential Construction Commercial real estate development is expected to expand off the narrow recovery witnessed in recent years. Nonresidential construction expenditures have rebounded 65 percent from its post-recession low, but remain modest relative to overall economic activity. Structures investment accounts for just 2.7 percent of GDP versus a post-war norm of 3.4 percent. Moreover, the recovery to date has been unusually narrow, with energy projects, data centers and industrial projects accounting for a disproportionate share of growth. Office and retail development has largely been limited to energy and technology-driven markets.

The paucity of new projects has left commercial development in a strong position this far into the business cycle. Occupancy rates have been steadily increasing for most property categories and there is little fear of overbuilding. The lone exception has been rental apartments, which has seen a torrent of new units come online over the past five years, with the bulk of new construction occurring in just a handful of major markets.

Demand for warehouse and industrial space remains a growth area. Development continues to be driven by the rapid growth for e-commerce and the resurgence in international trade. The revival in U.S. manufacturing is also playing a supporting role, as is growth is leisure and recreation, which is allowing older space to be repurposed as breweries, restaurants, sports and entertainment venues. Warehouse and industrial development should strengthen further in 2018.

Opportunities for office and retail development have been somewhat more limited. Demand for traditional office space remains strongest in technology-driven markets like San Francisco, Seattle and Austin but has been more modest in many other markets. Demand from creative industries is also the fastest growing component of many of the fastest growing major office markets, including New York City, Boston, San Francisco, Seattle, Atlanta and Los Angeles, which is fueling demand for renovated space or new space that has the edginess of renovated buildings. Rents and sales prices for new and renovated office space are commanding greater premiums relative to the overall market. Sales prices for trophy properties in globally-connected markets have also risen much faster than other markets.

Retail development remains challenged by the relentless growth in e-commerce and evolving demographics. Reports of the death of brick and mortar retailers, however, appear to be overdone. While store closings are likely to proliferate for quite some time, demand for well-located retail locations remains solid. Town center projects, industrial redevelopment and transit-oriented projects continue to lease-up quickly and command premium rents.

Risks to the Outlook-The Downside; Bad Moon Rising

While the lack of new construction has generally left the commercial real estate market in good shape

eight and a half years into the expansion, risks have also increased. With less new construction, rents

and property prices have increased well ahead of incomes. This leaves the market with less room to the

upside and possibly vulnerable to the downside if economic growth slows abruptly, interest rates rise

quickly, unemployment increases or credit conditions deteriorate. The high concentration of economic

growth in tech-driven metropolitan areas and the tech-driven submarkets of other metro areas also

creates some downside risks, as unproven business models are tested by the business cycle. The

strongest office, industrial, retail and apartment markets are often in areas of the economy where the

technology sector is growing rapidly. Many of these tech markets are being driven by rapidly growing

‘unicorns’. The flow of private equity, and the high valuations into unicorns, is at least partly a

byproduct of the low interest rate environment and global savings glut. If interest rates rise and the

hunt for yield diminish, many of these firms may face difficulty funding their rapid growth and the

ensuing slowdown might reverberate more broadly than currently discounted by decision makers.

CRE development is expected to expand off the narrow recovery witnessed in recent years.

With less new construction, rents and property prices have increased well ahead of incomes.

Wells Fargo Securities Economics Group Inflation

10

Optimistic about Reflation, Cautious about a Return to 2 Percent

Will inflation pick up alongside economic growth? The resolution to this question represents a significant challenge to the FOMC’s efforts to further normalize monetary policy in the year ahead. After coming out of the gate strong in 2017, headline and core inflation moved sharply lower in March and have struggled to turn around since. The slowdown has renewed concerns about whether the FOMC can meet its inflation mandate in the coming years, let alone in 2018. Eight and a half years into the expansion, core PCE inflation has been 2.0 percent or higher for only five months.

Our baseline scenario is that inflation will increase in 2018 (Figure 11). The pickup will be driven by the unwinding of what we believe were largely one-offs in 2017. Declines in wireless phone services and physician services shaved 0.18 percentage points off of the headline rate of CPI since the start of the year, but are once again rising. More broadly, higher labor costs, as the job market continues to tighten, should exert some modest upward pressure on inflation.

Higher energy prices as global oil demand has improved and producers remaining fairly disciplined should also generate a lift to overall inflation. At the same time, the improving global environment stands to translate into some support for inflation here at home. Not only will a weaker dollar generate higher import prices, but strengthening inflation abroad, including China, points to rising input costs around the world. The pass-through of these global factors will be fairly modest given that goods account for only a quarter of core CPI, but the Fed needs all the help it can get.

Figure 11

Figure 12

Source: U.S. Department of Commerce, University of Michigan, Bloomberg LP and Wells Fargo Securities

While higher inflation is likely in 2018, the pace of improvement is likely to remain disappointingly slow from the perspective of the FOMC and its 2 percent inflation target. Labor market tightening and the global backdrop support a cyclical pickup, but there is reason to remain cautious in believing core inflation will reach 2 percent in 2018. Inflation is highly correlated with recent past values, indicating the current below-target environment will remain difficult to exit. Although both headline and core PCE inflation are mean-reverting, each measure has averaged less than the Fed’s target since the early 1990s (1.9 and 1.8 percent, respectively), which illustrates the struggle in returning to 2 percent.

Inflation’s stickiness around its recent trend can lead to ingrained inflation expectations. Lower inflation expectations for 5-10 years out look increasingly entrenched as the sub-2 percent inflation environment has lingered (Figure 12). Both market and consumer measures of long-term inflation expectations experienced a structural shift downward during the recession that has not been reversed. We view low inflation expectations as a significant headwind to core inflation returning to 2 percent over the coming year. All told, we expect by the fourth quarter of next year PCE inflation to rise to 2.0 percent, with the core PCE deflator still below the FOMC’s target at 1.8 percent.

Fool Me Once, Shame on You. Fool Me Twice, Shame on Me. Given the persistence of inflation’s shortfall this far into the expansion, it is not surprising that many investors are cautious to assume that reflation is finally upon us. With inflation slowing as the unemployment rate has fallen half a percentage point below full employment, it has been tempting to declare an end, or at least a significant weakening, to the traditional relationship between resource

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PCE Deflator & "Core" PCE DeflatorLine = Yr/Yr Percent Change

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Med. Inflation Expectations 5 to 10-Years AheadU. of Mich. Consumer Sentiment, Breakeven Rate of Inflation, 3-MMA

Median Inflation Expect. For 5-10 Yrs: Sep @ 2.5

Fed 5-Year Five Years Forward: Sep @ 1.8%

The recent slowdown in inflation has renewed concerns about whether the FOMC can meet its inflation mandate in the coming years.

We view low inflation expectations as a major headwind to core inflation returning to 2 percent.

Wells Fargo Securities Economics Group Inflation

11

slack and inflation. This assumption, however, serves as a source of upside risk to the inflation outlook. If the response of prices to slack is nonlinear as some research suggests, the 0.3 percentage point decline in the unemployment rate that we expect in the coming year could have a more pronounced effect on labor costs and consumer prices.1 Since it is unclear as to why the relationship between the labor market and inflation has weakened, the link could strengthen again with little warning.

Political risks to inflation seem smaller than at this time last year. That said, even the modest fiscal stimulus provided by the tax changes being floated could generate additional upward pressure on inflation since the output gap has closed. A breakdown in trade relations also cannot be fully dismissed, as evidenced by the contentious NAFTA renegotiation. Unexpected strength in inflation could in turn lead the FOMC to raise interest rates more quickly than currently outlined.

Figure 13

Figure 14

Source: U.S. Department of Labor and Wells Fargo Securities

Could the Long-awaited Cyclical Pickup in Inflation Remain Absent Again in 2018? We see two main downside risks to our forecast. First, “full employment” remains a difficult state to pin down. The unemployment rate is at a 16-year low, but an older and more educated workforce intimates a lower natural level since these groups experience lower unemployment rates. In addition, the share of workers not in the labor force but who want a job points to some additional labor supply still not captured by the unemployment rate (Figure 13). Therefore even the modest upward pressure on inflation we expect from the labor market could be a tale for another year.

Second, higher labor costs do not necessarily translate into higher selling prices. Rising input costs can be absorbed by reducing margins. Competitive pressures stemming from new technology are one potential source weighing on margins. The tradeoff between lower margins and higher prices as input costs rise only needs to be made, however, if worker productivity is not improving. Labor productivity has been dismal over the course of the expansion, but has been rising more recently (Figure 14). Further gains in productivity as capital spending improves or new technology comes into the fold could hold down inflation even as labor costs rise. Therefore the Fed’s September projected path of three increases in the federal funds rate next year could prove unnecessarily aggressive if technology-driven productivity gains hold down inflation and potential growth is higher than currently perceived.

New FOMC, New Reaction Function? Roll with the Changes

The FOMC’s reaction to inflation developments in the coming year is an additional area of uncertainty. Janet Yellen’s steadfast belief in the Phillips Curve was central to the FOMC’s decision to move forward with rate increases and the balance sheet unwind this year despite the slowdown in core inflation. What is unclear is whether the FOMC under Jerome Powell, and what could be a meaningful number of new members, will be as committed to additional fed funds rate rises if inflation again falls short of projections. The run of below-target inflation is leading to increasing calls among FOMC members to let inflation overshoot, for a time, in an effort to show the Fed’s commitment to 2 percent inflation over the long run. Yet can such an overshoot be contained once started?

1 Nalewaik, Jeremy. (2016). “Non-linear Phillips Curves with Inflation Regime Switching.” Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C. 2016-078

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Unemployment vs. Want Job, Not in Labor ForcePct. of Labor Force vs. Pct. of Civilian Population, 12-MMA

Unemployment Rate: Nov @ 4.4% (Left Axis)

Unemployment Prev. Cycle Low: Jan @ 4.5% (Left Axis)

Want Job, Not in Labor Force Rate: Nov @ 2.2% (Right Axis)

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Unexpected strength in inflation could in turn lead the FOMC to raise interest rates more quickly than currently outlined.

Price pressures resulting from a tighter labor market and higher labor costs may remain absent again in 2018.

Wells Fargo Securities Economics Group Fiscal Policy

12

When One Door Closes, Another Door Opens: Fiscal Policy to the Rescue? The past eight years of expansion have witnessed significant monetary policy stimulus in the form of a historically low fed funds rate and significant balance sheet expansion by the Federal Reserve. More recently, however, the Fed has embarked upon a slow but steady series of fed funds rate hikes and balance sheet reductions. With monetary policy stimulus diminishing, will fiscal policy take the baton from the Fed in 2018?

From a short-run economic growth perspective, fiscal policy stimulus could take hold in two forms: higher spending or lower taxes. The spending side of the equation has been quietly exerting a drag on economic growth recently. With the federal government and some state & local governments facing budget deficits and rising entitlement spending, why has the government line of GDP not been more additive to growth (Figure 15)?

Figure 15

Figure 16

Source: U.S. Department of Commerce, Congressional Budget Office and Wells Fargo Securities

A key reason is that transfer payments for entitlements, a major component of government budgets, do not contribute to GDP directly through the government line as do real spending on goods and services. When a federal, state or local government builds a school, expands a road, buys equipment or engages in some other direct form of consumption/investment, it counts toward the government line of GDP. However, transfer payments, such as pensions, do not contribute to GDP directly via the government component but rather contribute indirectly when the recipients employ the money to consume goods and services.

At the federal level, despite the rhetoric surrounding higher defense/infrastructure spending and steep budget cuts to some other programs, the spending picture thus far has been largely unchanged. Real government expenditures in the GDP accounts are flat year over year. Federal spending on entitlements and interest payments continues to eat up all the incremental revenue growth. In FY 2017, spending on Medicare, Medicaid, Social Security and interest payments accounted for 55 cents of every dollar spent by the federal government, a trend that is unlikely to abate anytime soon. The Congressional Budget Office expects spending on the major healthcare programs, Social Security and interest payments to outstrip revenue growth over the next decade, squeezing the resources available for discretionary spending on defense, infrastructure or other similar forms of spending (Figure 16).2 In the short-run, we expect some higher defense spending in FY 2018, but any additional spending beyond that is likely to be limited as tax reform consumes most of the attention and fiscal resources. We look for the federal component of the government GDP line to grow 1.0 percent in real terms in 2018 and 1.1 percent in 2019.

Fiscal challenges extend down to the state & local level as well, where real consumption/investment has been negative, down 0.1 percent year over year. Years of structural headwinds such as moderate economic growth, low interest rates and rising pension and healthcare costs have weighed on state & local budgets, limiting spending growth in other areas, such as infrastructure. For instance, since 2000, Medicaid spending has risen as a share of state revenue by 4.5 percentage points, according to

2 Congressional Budget Office. (Jun. 2017). “An Update to the Budget and Economic Outlook: 2017 to 2027.” https://www.cbo.gov/publication/52801.

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Real Government Purchases Bars = CAGR Line = Yr/Yr Percent Change

Government Purchases-CAGR: Q3 @ 0.4%

Government Purchases-Yr/Yr: Q3 @ -0.1%

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With monetary policy stimulus diminishing, will fiscal policy take the baton from the Fed in 2018?

Real government expenditures in the GDP accounts are flat year over year.

Wells Fargo Securities Economics Group Fiscal Policy

13

research from the Pew Charitable Trusts. Similarly, unfunded pension and retiree healthcare costs represented more than 11 percent of state personal income as of 2013.3 The fiscal challenges have been particularly acute in some states, such as Illinois, Pennsylvania and Connecticut, where budget impasses have played out throughout the past year. State budgets in oil-producing states have also been somewhat strapped in recent years as policymakers in those states grapple with energy prices that have remained well below levels observed earlier in the expansion. In the short-run, we may see a modest rebound from the recent weakness, but the structural headwinds mentioned above are unlikely to meaningfully abate anytime soon. We expect the inflation-adjusted state & local component of the government GDP line to expand just 0.8 percent in 2018 and 0.5 percent in 2019.

Federal Tax Reform to the Rescue? You Can’t Always Get What You Want Tax reform received the bulk of the attention on the fiscal policy front in 2017. As we turn toward the outlook, we believe it is important to take a step back and understand the bigger picture problem facing policymakers. In order to employ the privileged reconciliation process to pass legislation with just 51 votes in the Senate, Republicans must subject themselves to a series of Senate rules that essentially require them to pick just two of the following three options: enact sizable gross tax cuts, maintain popular tax breaks and achieve permanence for the changes. It is possible, for instance, to pass sweeping tax cuts while maintaining popular tax breaks such as the mortgage interest deduction and the deduction for state & local taxes, but Senate rules would almost certainly make it so that these tax cuts must have an expiration date, be phased in, or some combination of the two. Alternatively, policymakers could choose the permanent/maintain big tax breaks combination, but this would mean the gross tax cuts that have been proposed would have to be scaled back.

Figure 17

Source: Congressional Budget Office, Joint Committee on Taxation and Wells Fargo Securities

For all of 2017, we have maintained that Republicans will have to scale back the large, permanent tax cuts they have proposed. As the tax debate has heated up, the policy assumptions underlying our economic forecast have remained unchanged: a targeted tax reduction for middle-income families through a doubling of the standard deduction/increase in the child tax credit coupled with a reduction in the corporate income tax rate to 25 percent, partially financed by a deemed repatriation of corporate profits held abroad. If enacted, we assume a tax program along these lines would boost real GDP growth in 2018 by about 0.2 percentage points, while also stoking slightly faster inflation at the margin. After-tax corporate profit growth should improve, although from quarter to quarter it is likely to be more volatile than usual as corporations wade through the tax overhaul implications.

With the House and Senate still ironing out the differences between their bills, the devil continues to be in the details. Broadly speaking, however, there may be more upside risk to the forecast in 2019 than 2018. As we have repeatedly noted, a combination of phase-ins and phase-outs will likely be in the final plan due to Senate budget rules. The Senate plan, for instance, delays the corporate rate reduction to 2019. On net, the Senate plan cuts taxes by just 0.2 percent of GDP in 2018 but roughly one percent in 2019 (Figure 18). In addition, some of the changes to the individual side, such as the doubling of the

3 The Pew Charitable Trusts. (Oct. 2017). “Fiscal 50: State Trends and Analysis.” http://www.pewtrusts.org/en/multimedia/data-visualizations/2014/fiscal-50#ind0

1986 Tax Reform Act 2001/2003 Bush Tax Cuts Outlook for Today

Revenue Neutral Not Revenue Neutral Likely Not Revenue Neutral

Permanent TemporaryStriving for Permanent, but

Budget Obstacles Are Large

Individual Tax Cut of $120 Billion

Over 5 Years

Individual Tax Cut of Roughly

$1.5 trillion over 10 Years

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Over 5 YearsNo Major Corporate Changes

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Controlled House)Single-Party Control Single-Party Control

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Impact on Future Surpluses/Deficits

Less of a Factor

Before the Tax Change, Projected

Budget Balance Over 10 Years:

Surplus of $5.6 Trillion

Before the Tax Change, Projected

Budget Balance Over 10 Years:

Deficit of $10.1 trillion

Tax Legislation: A Comparison

Individual and Corporate Tax

Cuts of Roughly $1.5 trillion

Whether or not certain tax changes are temporary or permanent will be a contentious issue in the reconciliation process.

If enacted, we assume the tax program would boost real GDP growth in 2018 by about 0.2 percentage points.

Wells Fargo Securities Economics Group Fiscal Policy

14

standard deduction and the increase in the child tax credit, are unlikely to be felt until 2019, when individuals file their 2018 taxes. For the outlook, policymakers will need to bring their alibis.

Figure 18

Figure 19

Source: Joint Committee on Taxation, U.S. Department of Labor and Wells Fargo Securities

However, there are a few countervailing forces that would likely work against the stimulative effect of the tax cuts. First, if the economic expansion continues as we expect, a combination of multiple fed funds hikes and balance sheet reductions are likely to make monetary policy less accommodative than it is today. In addition, the pool of available workers is already historically low, making the potential effect on hiring marginal at best (Figure 19). Thus, wage growth will have to carry the load to provide stimulus for the consumer. Even then, with actual GDP continuing to trend above potential output, a burst of spending may be just as likely to spur faster inflation, limiting the acceleration in real GDP.

What are the major downside risks posed by the government sector to the U.S. economy as a whole? As we have highlighted, both the federal and state & local governments face structural finance challenges despite continued cyclical improvement. Were an economic downturn to occur, there would be a more limited scope for fiscal policy to intervene and provide a boost to short-run growth. The debt-to-GDP ratio for the federal government, for example, is more than double today than what it was on the eve of the Great Recession, with the outlook for faster debt growth ahead even before tax reform (Figure 20).

If tax reform efforts were to fall through, the direct effect on our economic growth forecast would be relatively small. However, failure to deliver on a highly anticipated change could damage sentiment. With consumer confidence, business confidence and equity market valuations at or near cycle highs in the United States, it is possible that the optimism recorded in 2017 could rapidly begin to fade if the tax reform efforts fail/underwhelm (Figure 21). Expansions may not die of old age, but falling consumer and business sentiment would be an unwelcome strain on the economy’s aging immune system.

Figure 20

Figure 21

Source: Congressional Budget Office, The Conference Board and Wells Fargo Securities

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Pool of Available WorkersUnemployed + Not In Labor Force but Want a Job, % of Population

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U.S. Debt Held By The PublicCBO Baseline Projections Begin in 2017, Percent of GDP

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Confidence Yr/Yr % Chg: Nov @ 18.4%

Confidence: Nov @ 129.5

12-Month Moving Average: Nov @ 119.7

Federal and state & local governments face structural finance challenges.

Failure to deliver on a highly anticipated tax change could damage sentiment.

Monetary Policy & Interest Rates

Wells Fargo Securities Economics Group

15

Monetary Policy and Interest Rates: Search for Normalization Seeking normalization for the federal funds rate and the Fed’s balance sheet has been an elusive task. As illustrated in Figure 22, the FOMC’s target fund rate path, as well as the terminal rate, has been consistently lowered since the normalization process began. A pattern of over-forecasting the fed funds rate by the FOMC has become apparent. Likewise, and somewhat unsurprisingly, this trend of over-shooting is also associated with predicting the future value of the 10-year Treasury, as its value is influenced by the federal funds rate, growth and inflation expectations (Figure 23).

Figure 22

Figure 23

Source: Bloomberg LP, Federal Reserve Board and Wells Fargo Securities

The actual pace of economic growth and inflation have been below expectations in recent years. Average real GDP growth (YoY) remains relatively lackluster compared to past economic expansions, averaging only 1.7 percent between Q2-2009 and Q3-2017. This represents the smallest average gain in an economic cycle in the post-World War II era. Again, given the current late cycle readings, along with rising labor costs and interest rates, as well as slowing profit growth, it would be hard to imagine economic growth accelerating to 3 percent in the near future.

Meanwhile lower-than-expected inflation during this economic cycle has certainly loomed large in the minds of the FOMC members. Persistently below 2 percent inflation is not consistent with the goals of the Federal Reserve’s dual mandate, one of which aims for price stability at 2 percent. The PCE deflator, the Fed’s preferred measure of price pressures in the economy, averaged 1.82 percent for 2010-14, and has averaged just 0.98 percent since early 2015. Despite its positive sign, inflation remains well below the Fed’s 2 percent target. However, the outlook has changed.

Normalization: You Can Check Out Anytime You Like “Once the process of balance sheet normalization has begun, it should continue as planned as long as there is no material deterioration in the economic outlook,” Jerome Powell, The Economic Club of New York (June 1, 2017). As shown in Figure 24, the reduction in the balance sheet begins to make a difference in the second half of 2018, when there begins to be a meaningful reduction in the Fed’s balance sheet. However, at this point, the Treasury deficit financing needs will also start to rise.

The balance sheet run-off started in October of this year, with modest caps of $10 billion per month ($6 billion for Treasuries and $4 billion for agency/MBS), reinvesting principal payments that exceed those caps. Every three months, and assuming economic conditions still warrant the terms, the Fed will raise those caps by equal amounts four more times, until the final cap amount stands at $50 billion per month ($30 billion for Treasuries and $20 billion for agency/MBS). Nearly one half of the Fed’s $2.5 trillion in Treasury holdings come due between now and 2020, making now an opportune time for the Fed to begin to reduce the size of its balance sheet.

‘But You Can Never Leave.’ It is becoming increasingly likely that as the economic cycle ages, during a period when the Fed is slowly reducing its balance sheet, the size of the balance sheet will remain larger than the Fed’s long-run goal. In addition, given the possibility of a recession before the balance sheet returns to normal,

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Appropriate Pace of Policy FirmingTarget Federal Funds Rate at Year-End

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U.S. 10-Year TreasuryYield

U.S. 10-Year Yield: Nov @ 2.41%

A pattern of over-forecasting the fed funds rate by the FOMC has become apparent.

Lower-than-expected inflation during this cycle has loomed large in the minds of the FOMC members.

Monetary Policy & Interest Rates

Wells Fargo Securities Economics Group

16

the federal funds rate will likely remain low. In this type of environment, the balance sheet will likely resume its role as a policy tool.

Losing Weight While Eating Cheesecake? “Two percent…is a symmetric objective.” The problem here is that the PCE deflator has run consistently below 2 percent during the current economic cycle and has averaged below 2 percent since NAFTA was implemented in 1994 (Figure 25). Our outlook calls for inflation to accelerate in 2018. We are expecting three federal funds rate hikes on the assumption that the FOMC will raise the funds rate base on its model that low unemployment rates will lead to higher inflation in the future.

Figure 24

Figure 25

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

There Must Be Some Kind of Way Out of Here; Yes via Higher Interest Rates What is the path of market interest rates if the current dot plot and balance sheet policies are followed? Something has to give. We project the PCE deflator will be at 2.0 percent by the end of 2018, and at that time the Fed will have continued to raise the fed funds rate and begun to shrink the balance sheet in earnest, according to the current schedule. In addition, we anticipate rising federal deficits ahead to put additional upward pressure on interest rates.

Looking forward, we expect the FOMC to proceed along its policy tightening path, albeit at a more cautious and restrained pace than implied by the dot plot. A clear disconnect in predicting the federal funds rate exists between the market consensus, as measured by fed funds futures, and the Fed’s dot plot, which represents the FOMC members’ beliefs of where the fed funds rate should be at the end of a given year. While the market consensus has historically been a better gauge of the actual rate in the future, both forecasts tend to overshoot the actual fed funds figure. As of now, we expect the Fed to raise rates three more times in 2018.

Higher inflation, a tighter Fed policy and the change in the market balance of rising Treasury supply and diminished Fed purchases will prompt a rise in the benchmark rate. We expect the benchmark 10-year Treasury rate to inch up to 3.00 percent by the end of 2018 on the back of continued monetary policy tightening by the Fed, as well as continued domestic growth.

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PCE Deflator vs. Core PCE DeflatorYear-over-Year Percent Change

PCE Deflator: Oct @ 1.6%

"Core" PCE Deflator: Oct @ 1.4%

FOMC's 2.0% Inflation Target

We are expecting three federal funds rate hikes in 2018.

A clear disconnect in predicting the fed funds rate exists between the market consensus and the Fed’s dot plot.

Wells Fargo Securities Economics Group Global Outlook & Dollar

17

The Global Economic Expansion: Nine Years and Counting? Global economic activity accelerated in 2017 after global industrial production (IP) essentially stagnated in 2016 as industrial sectors in many economies adjusted to the collapse in commodity prices. But now global IP is currently up nearly 4 percent on a year-ago basis (Figure 26). Expansionary macroeconomic policies that were put in place last year in many major foreign economies have helped to stimulate global economic activity. Growth in global trade has also strengthened this year in line with the acceleration in global IP.

Looking forward, we expect that the global economic expansion will continue through 2019 (Figure 27). We estimate that global GDP has grown at its long-run average of 3.5 percent this year, and we forecast that this pace of growth will remain more or less intact in 2018 and 2019. However, a return to the “boom” years of 2003-2007, when global GDP grew in excess of 5 percent on an annual average basis, does not seem likely anytime soon. Global economic growth was propelled higher a decade ago when many large and populous developing economies (e.g., China, India, Brazil and Russia) opened their economies up to global markets.

Figure 26

Figure 27

Source: IHS Global Insight, International Monetary Fund and Wells Fargo Securities

However, that one-off event has largely run its course, and those economies are now fairly integrated into the global economy. Furthermore, population growth is slowing, if not contracting, in the world’s largest economies (i.e., the United States, China, Western Europe and Japan). Everything else equal, slower population growth translates into slower economic growth.

As noted above, macroeconomic policy turned even more expansionary as growth slowed in many economies last year. Fiscal policy was eased in some countries (e.g., China), and many central banks ramped up their policy accommodation. However, now that economic growth is picking up again, many foreign central banks are starting to dial back their accommodative policy stances. For example, the Bank of Canada (BoC), which cut its main policy rate by 50 bps in 2015 when the Canadian economy slid into a mild recession, took back that easing with two 25 bps rate hikes since July. Looking forward, we expect that the BoC will follow the Fed with two more 25 bps rate hikes in 2018 and another two in 2019.

The Bank of England (BoE) cut its main policy rate by 25 bps last year after the Brexit referendum clouded the economic outlook for the United Kingdom. Although U.K. GDP growth has slowed somewhat this year, the economy continues to expand. Consequentially, the BoE took back its previous rate cut on November 2. If, as we forecast, the British economy does not succumb to the uncertainties of the Brexit negotiations, then we anticipate that the BoE will hike rates by another 25 bps next year and by a total of 50 bps in 2019. The quantitative easing (QE) program at the European Central Bank (ECB) continues, but the ECB has dialed back its monthly purchase rate. We look for the ECB to stop buying bonds altogether in late 2018, and forecast that it will begin a slow process of rate hikes in early 2019. We expect that the Bank of Japan (BoJ) will keep its main policy rates unchanged through at least the end of 2019.

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World Export & IP VolumeYear-over-Year Percent Change

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World Industrial Production: Sep @ 4.0%

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Growth in global trade has strengthened this year in line with the acceleration in global IP.

Many foreign central banks are starting to dial back their accommodative policy stances.

Wells Fargo Securities Economics Group Global Outlook & Dollar

18

What Could Possibly Go Wrong? Got a World of Trouble on My Mind In general, we have a fairly constructive view of the global economy over the next two years as our base-case scenario. So what could go wrong? For starters, the debt-to-GDP ratio in the Chinese economy has shot up over the past decade, with leverage in the non-financial corporate sector rising markedly (Figure 28). In our view, the debt issues in China are largely manageable, and we look for Chinese economic growth to downshift slowly over the next two years. However, the Chinese economy is opaque, and the debt issues in that country could conceivably be far worse than what our analysis suggests. A debt implosion in China probably would not have large financial effects on the rest of the world, at least not directly. Foreign exposure to the $30 trillion of outstanding Chinese debt totals only $1.6 trillion. However, China is the second-largest economy in the world and a sharp economic slowdown in the Chinese economy that is caused by an inability to service excessive leverage would clearly have economic repercussions on China’s major trading partners. We will be keeping a close eye on leverage in the Chinese economy in coming years to see if more pessimism is warranted.

Speaking of debt, the debt-to-GDP ratio of the Japanese government has mushroomed from about 70 percent in the late 1980s to nearly 250 percent today. Although some analysts have worried for years about a debt-induced financial meltdown in Japan, the yield on the benchmark 10-year Japanese government bond is essentially zero percent at present, due in large part to purchases of government bonds by the Bank of Japan. Although the Japanese economy will probably continue to “muddle through,” a sharp increase in borrowing costs in the world’s third-largest individual economy could weigh on global growth prospects.

Figure 28

Figure 29

Source: CEIC, IHS Global Insight and Wells Fargo Securities

A sharper-than-expected rebound in global inflation poses another potential downside risk to the global economic outlook. At present, inflation generally remains benign on a global basis (Figure 29). If, as we expect, inflation creeps up only slowly, then central banks are likely to tighten policy at a restrained pace. However, if inflation was to shoot up sharply, then central banks could tighten at a much faster pace, posing a threat to the global economic expansion.

Then there are a whole host of geopolitical risks to ponder, which are truly difficult to forecast. Clearly, a nuclear exchange with North Korea, should one occur, would not be positive for the global economic outlook. However, there are less cataclysmic geopolitical risks that, if they were to come to pass, could weigh on global economic growth. A “hard” Brexit, in which the United Kingdom abruptly leaves the European Union before a new economic and financial relationship can be negotiated, would probably cause a recession in the former. But it probably would not lead to a global recession. Of more concern, would be a potential unraveling of the Eurozone. Italy must hold a general election by May 2018, and a populist and anti-EU party is polling well at present. A victory by this party could raise market concerns about a potential Italian exit from the Eurozone that could cause financial market volatility and economic weakness to return to the euro area.

Finally, there is the risk of global trade tensions. The United States, Mexico and Canada are currently negotiating revisions to the NAFTA agreement. There are extensive trade ties among the three North

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06 07 08 09 10 11 12 13 14 15 16

China Debt Outstanding by SectorPercent of GDP

Household

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Central Government

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1%

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8%

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2000 2002 2004 2006 2008 2010 2012 2014 2016

World Consumer Price InflationYear-over-Year Percent Change

World Consumer Prices: Sep @ 3.0%

Debt issues in China present a downside risk to our global economic outlook.

Inflation generally remains benign on a global basis.

Wells Fargo Securities Economics Group Global Outlook & Dollar

19

American economies, and an abrupt end of the agreement would impart adjustment costs on many businesses in the three countries. In addition, the Trump Administration came into office talking a hard line about American trade relations with China. So far, the administration’s actions have not matched its rhetoric, but an increase in trade tensions between the two largest economies in the world could lead to financial market volatility and slower global economic growth.

Will the Dollar Continue to Depreciate? The Fed’s “Major Currency” index, which measures the trade-weighted value of the dollar vis-à-vis the other major currencies of the world, rose more than 40 percent between 2011 and the 2016 (Figure 30). However, the index has declined more than 5 percent on balance in 2017, and we look for further dollar depreciation against many foreign currencies in coming quarters.

Figure 30

Figure 31

Source: IHS Global Insight, Bloomberg LP and Wells Fargo Securities

The U.S. dollar was boosted over the past few years by monetary policy “divergence.” That is, market participants looked for the Federal Reserve to dial back its policy accommodation, and these expectations were subsequently realized. Not only did the Fed “taper” its QE program, but it also began to raise the funds rate starting in late 2015. Conversely, most foreign central banks were ramping up their policy accommodation during this period. Not only did many foreign central banks increase their QE programs, but they cut policy rates as well, in some cases moving into negative territory. Consequently, interest rates moved in favor of the U.S. dollar (Figure 31).

We are now entering a period of monetary policy “convergence.” As described above, foreign central banks are starting to remove policy accommodation. Although the Fed will likely continue to hike rates, history has shown that the dollar tends to do best at the beginning of the Fed’s tightening cycle. Once the tightening cycle becomes more mature, the greenback tends to get “less bang for the buck” in terms of additional rate hikes. If, as we expect, most foreign central banks begin a process of hiking rates or, in some cases, tighten further, then the U.S. dollar likely will continue to follow a downward trend against many foreign currencies. The extent of foreign currency strength should depend on the degree of monetary policy adjustment by foreign central banks.

Not only do we forecast dollar weakness against most major currencies (e.g., the euro, Japanese yen and Canadian dollar) but we also look for the greenback to depreciate versus the currencies of most developing economies. In our view, Chinese authorities will want to keep the Chinese renminbi more or less stable on a broad trade-weighted basis. If the dollar depreciates against most major currencies, then it will need to weaken vis-à-vis the renminbi to keep the trade-weighted value of the Chinese currency stable. One currency against which the greenback could appreciate, at least over the next few months, is the Mexican peso. Political uncertainty ahead of the Mexican presidential election on July 1 and the NAFTA negotiations could weigh on the value of the peso.

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2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Trade Weighted DollarMajor Curency Index, 1973 = 100

Trade Weighted Dollar: Q3 @ 88.1

Forecast

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10 11 12 13 14 15 16 17

Expected Short-Term Interest RatesImplied Interest Rate, Fourth Interest Rate Futures Contract

Major Countries: Dec-11 @ 0.53% (Left Axis)

United States: Dec-11 @ 2.00% (Right Axis)

We look for further dollar depreciation against many foreign currencies in coming quarters.

We are now entering a period of monetary policy convergence.

Wells Fargo Securities Economics Group Recession Outlook

20

Recession Prediction for the Short and Long Run: Rain on the Scarecrow? Predicting recessions is one of the most important elements of decision-making in the public and private sector. As such, a different set of policy tools is needed during a recession than that employed for an economic expansion. Signals are an important characteristic in economic behavior. The analyst does not need to wait for the actual recession if, instead, a signal is present that provides information that a future event is coming. The timely and accurate recession prediction helps decision makers to prepare against the impending recession and set policies accordingly. We discuss two different approaches to forecast recession with one method focusing on the short run (for the next six months) and a second approach that can foresee a recession during the next couple of years. We are looking for clues at the scene of the crime.

Bright Sunshine in the Near Future: Low Chance of a Recession during the Next Six Months Over the near term, one practical method to predict the probability of a recession is to build a probit model. A probit model, in the present case, estimates, using a handful of predictors, the probability of a recession for a certain period in the future. Our probit model predicts the probability of a U.S. recession during the next six months and utilizes the Leading Economic Indicators Index, the S&P 500 index and the Chicago-PMI employment index as predictors. Our model has served us well, as it started predicting (in real-time) a significantly higher probability of recession in 2007 (58 percent probability in Q3 2007). In addition, we never joined the “double-dip” camp back in 2010-2012, largely due to the fact that our probit model never indicated a recession during that time period was likely. Using the most recent data (through October 2017), our model predicts a low chance of a U.S. recession during the next six months (1.17 percent probability, Figure 32). Therefore, there are no recession clouds in our outlook for the next six months—just bright sunshine.

Recession’s Long-Run View: Clouds May Block the Sunshine Decision makers ponder both the short-run and long-run economic outlook, with a particular focus on the next couple of years. Therefore, to provide a recession prediction for the next couple of years, we have developed an alternative framework to our short-term model.

Is This Time Different? An inverted yield curve has preceded the past seven recessions but missed the 1957-1958 and 1960-1961 recessions. That is, the yield curve remained positive and did not hit the inversion point during the 1954-1965 period. Furthermore, the misses associated with the 1957-1958 and 1960-1961 recessions (false negative) raises questions about the yield curve’s effectiveness in predicting the next recession. This begs the question, is there an alternative method for recession prediction that is more effective?

Figure 32

Source: Federal Reserve Board, IHS Global Insight and Wells Fargo Securities

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Recession Probability Based on Probit Model Model with LEI

Two-Quarter Ahead Recession Probability: Q4 @ 0.20%

Threshold: Two-Consecutive Quarters > 50%

Timely and accurate recession prediction helps decision makers to prepare against the impending recession.

An inverted yield curve has preceded the past seven recessions, but is there a better signal? We think so.

Wells Fargo Securities Economics Group Recession Outlook

21

Our proposed framework identifies a threshold between the fed funds rate and the 10-year Treasury yield: we call it the FFR/10-year threshold, as a leading indicator of recession. The threshold is described as, in a rising fed funds rate environment, the time when the fed funds rate touches/crosses the lowest level of the 10-year Treasury yield in that cycle (Figure 33).

When this occurs, the risk of a recession in the near future is significant since this framework has successfully predicted all recessions since 1955 with an average lead time of 17 months. Furthermore, our framework predicted several recessions before the yield curve inversion point and, therefore, serves as a more effective long-range tool in predicting recessions and provides a more advanced warning. That is, with our framework, we do not need to wait for the yield curve to invert to predict a recession.

The crossover of the fed funds rate from below to above the prior cyclical low of the 10-year Treasury rate provides two clues to the markets. First, crossing the threshold signals the intentions of the central bank to continue to raise rates and thereby eventually tighten credit and possibly invert the yield curve. Second, the increase in the fed funds rate puts a number of existing fixed-income holdings under the threat that their total return value could turn negative if the central bank continues to pursue a tighter policy.

Why is our analysis important for decision-makers? In the current monetary cycle, the lowest 10-year Treasury yield was 1.37 percent (hit on July 5, 2016) and the current fed funds rate is 1.50 percent. The rate hike by the FOMC (December 2017) pushed the federal funds rate above the lowest level of the 10-year Treasury (1.37 percent) and thus breaching the threshold (Figure 34). Historically, when the threshold is met, there is a 69.2 percent chance (average probability) of a recession within the next 17 months (average lead time). Therefore, in the December rate-hike scenario, the chances of a recession in 2018 through mid-2019 are elevated (69.2 percent).

Figure 33

Figure 34

Source: Federal Reserve Board, IHS Global Insight and Wells Fargo Securities

It is important to note that, at present, our official call is for continuously moderate growth in 2018-2019 (around 2.5 percent GDP growth rate) and this recession-forecast framework posits a downside risk to our forecast as the time horizon of the forecast lengthens. Therefore, we are not making an official call for a recession over the two-year forecast horizon. Instead, decision-makers may want to watch 2018 through mid-2019 for the potential of a higher recession probability. However, mindful of the analysis, we will begin by watching incoming data closely to determine whether conditions that could lead to a recession/slowdown starting late 2018 are developing. We would encourage decision-makers to do so as well.

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1954 1964 1974 1984 1994 2004 2014

10-Year Minus Federal Funds Policy Rate

10 Year - FFR: Nov @ 1.20%

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Dec-15 Apr-16 Aug-16 Dec-16 Apr-17 Aug-17 Dec-17

10-Year and Federal Funds Rate

10-Year: Dec @ 2.39%

FFR: Dec @ 1.50%

With our framework, we do not need to wait for the yield curve to invert to predict a recession.

We are not making an official call for a recession over the two-year forecast horizon.

22

Wells Fargo U.S. Economic Forecast

Q4 2010 q420172017

2015 2016 2017 2018 2019

1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Qq42017 #### #### ## ## #### #### #### ####

Real Gross Domestic Product (a) 0.6 2.2 2.8 1.8 1.2 3.1 3.3 q42017 2.4 2.6 2.6 2.6 2.6 2.4 2.5 2.5 2.6 2.9 #### #### 1.5 ## ## 2.3 #### #### 2.7 #### #### 2.5

Personal Consumption 1.8 3.8 2.8 2.9 1.9 3.3 2.3 q42017 3.0 2.5 2.6 2.6 2.6 2.3 2.5 2.4 2.4 3.6 #### #### 2.7 ## ## 2.7 #### #### 2.6 #### #### 2.5

Business Fixed Investment -4.0 3.3 3.4 0.2 7.2 6.7 4.7 q42017 5.4 4.8 4.1 4.0 3.7 3.7 3.6 3.6 3.7 2.3 #### #### -0.6 ## ## 4.6 #### #### 4.7 #### #### 3.7

Equipment -13.1 -0.6 -2.1 1.8 4.4 8.8 10.4 q42017 7.6 5.4 4.3 4.2 3.7 3.7 3.3 3.5 3.7 3.5 #### #### -3.4 ## ## 4.5 #### #### 6.1 #### #### 3.7

Intellectual Property Products 6.3 11.1 4.2 -0.4 5.7 3.7 5.8 q42017 4.2 5.2 4.8 4.7 4.5 4.6 4.6 4.6 4.6 3.8 #### #### 6.3 ## ## 4.2 #### #### 4.8 #### #### 4.6

Structures 2.3 0.5 14.3 -2.2 14.8 7.0 -6.8 q42017 1.0 3.0 2.4 2.4 2.2 2.5 2.4 2.4 2.4 -1.8 #### #### -4.1 ## ## 5.3 #### #### 1.4 #### #### 2.4

Residential Construction 13.4 -4.7 -4.5 7.1 11.1 -7.3 -5.1 q42017 4.5 5.0 8.0 7.5 7.0 5.5 5.0 5.0 4.5 10.2 #### #### 5.5 ## ## 1.2 #### #### 3.8 #### #### 6.0

Government Purchases 1.8 -0.9 0.5 0.2 -0.6 -0.2 0.4 q42017 2.5 0.2 0.8 0.8 0.8 0.7 0.7 0.7 0.7 1.4 #### #### 0.8 ## ## 0.0 #### #### 0.9 #### #### 0.7q42017 #### #### ## ## #### #### #### ####

q42017 #### #### ## ## #### #### #### ####

Net Exports -584.2 -572.4 -557.3 -631.1 -622.2 -613.6 -594.4 q42017 -617.8 -625.3 -631.7 -635.1 -636.4 -635.0 -633.5 -628.6 -620.1 -545.3 #### #### -586.2 ## ## -612.0 #### #### -632.1 #### #### -629.3

Pct. Point Contribution to GDP -0.3 0.3 0.4 -1.6 0.2 0.2 0.4 q42017 -0.5 -0.2 -0.1 -0.1 0.0 0.0 0.0 0.1 0.2 -0.7 #### #### -0.2 ## ## -0.2 #### #### -0.1 #### #### 0.0

Inventory Change 40.6 12.2 17.6 63.1 1.2 5.5 39.0 q42017 40.0 50.0 50.0 48.0 45.0 44.0 43.0 40.0 40.0 100.5 #### #### 33.4 ## ## 21.4 #### #### 48.3 #### #### 41.8

Pct. Point Contribution to GDP -0.6 -0.7 0.2 1.1 -1.5 0.1 0.8 q42017 0.0 0.2 0.0 0.0 -0.1 0.0 0.0 -0.1 0.0 0.2 #### #### -0.4 ## ## -0.1 #### #### 0.2 #### #### 0.0q42017 #### #### ## ## #### #### #### ####

q42017 #### #### ## ## #### #### #### ####

Nominal GDP (a) 0.8 4.7 4.2 3.8 3.3 4.1 5.5 q42017 5.0 5.0 4.9 4.7 4.3 4.9 4.9 4.7 3.9 4.0 #### #### 2.8 ## ## 4.1 #### #### 4.9 #### #### 4.7

Real Final Sales 1.2 2.9 2.6 0.7 2.7 3.0 2.5 q42017 2.8 2.4 2.6 2.7 2.7 2.5 2.6 2.6 2.7 2.6 #### #### 1.9 ## ## 2.4 #### #### 2.6 #### #### 2.6

Retail Sales (b) 2.9 2.7 2.6 3.8 5.1 3.9 4.0 q42017 4.4 4.7 5.8 6.3 5.9 5.7 5.4 5.0 4.7 2.6 #### #### 3.0 ## ## 4.3 #### #### 5.7 #### #### 5.2q42017 #### #### ## ## #### #### #### ####

q42017 #### #### ## ## #### #### #### ####

Inflation Indicators (b) q42017 #### #### ## ## #### #### #### ####

PCE Deflator 1.0 1.0 1.2 1.6 2.0 1.6 1.5 q42017 1.6 1.7 2.1 2.3 2.0 2.1 2.1 2.1 2.0 0.3 #### #### 1.2 ## ## 1.7 #### #### 2.0 #### #### 2.1

"Core" PCE Deflator 1.6 1.7 1.8 1.9 1.8 1.5 1.4 q42017 1.5 1.5 1.8 1.9 1.8 1.9 1.8 1.9 1.9 1.3 #### #### 1.8 ## ## 1.5 #### #### 1.7 #### #### 1.9

Consumer Price Index 1.1 1.1 1.1 1.8 2.6 1.9 2.0 q42017 2.0 1.8 2.4 2.5 2.0 2.0 2.1 2.2 2.3 0.1 #### #### 1.3 ## ## 2.1 #### #### 2.2 #### #### 2.1

"Core" Consumer Price Index 2.2 2.2 2.2 2.2 2.2 1.8 1.7 q42017 1.7 1.7 2.1 2.1 2.1 2.1 2.0 2.1 2.1 1.8 #### #### 2.2 ## ## 1.8 #### #### 2.0 #### #### 2.1

Producer Price Index (Final Demand) 0.0 0.1 0.2 1.4 2.0 2.2 2.3 q42017 2.6 2.3 2.3 2.5 2.1 2.3 2.3 2.4 2.4 -0.9 #### #### 0.4 ## ## 2.3 #### #### 2.3 #### #### 2.3

Employment Cost Index 1.9 2.3 2.3 2.2 2.4 2.4 2.5 q42017 2.6 2.4 2.5 2.5 2.6 2.6 2.6 2.7 2.7 2.1 #### #### 2.2 ## ## 2.5 #### #### 2.5 #### #### 2.7q42017 #### #### ## ## #### #### #### ####

q42017 #### #### ## ## #### #### #### ####

Real Disposable Income (a) 0.2 1.9 0.7 -1.8 2.9 2.7 0.5 q42017 2.1 2.5 2.7 2.7 2.6 2.5 3.5 2.5 2.5 4.2 #### #### 1.4 ## ## 1.3 #### #### 2.3 #### #### 2.7

Nominal Personal Income (b) 2.9 2.5 2.6 1.6 3.1 2.7 2.6 q42017 3.7 3.6 4.1 4.5 4.7 4.7 4.8 4.6 4.4 5.0 #### #### 2.4 ## ## 3.0 #### #### 4.2 #### #### 4.6

Industrial Production (a) -1.3 -0.7 0.8 0.7 1.5 5.6 -0.3 q42017 5.2 2.4 2.2 2.3 2.1 2.5 2.3 2.3 2.3 -0.7 #### #### -1.2 ## ## 1.9 #### #### 2.7 #### #### 2.3

Capacity Utilization 75.8 75.7 75.8 75.8 75.8 76.6 76.3 q42017 76.9 77.0 77.2 77.4 77.5 77.7 77.8 78.0 78.0 76.8 #### #### 75.7 ## ## 76.4 #### #### 77.3 #### #### 77.9

Corporate Profits Before Taxes (b) -6.2 -8.2 -1.6 8.7 3.3 6.3 5.4 q42017 3.8 3.4 3.3 3.1 3.1 3.0 2.9 2.8 2.8 -1.1 #### #### -2.1 ## ## 4.7 #### #### 3.2 #### #### 2.9

Corporate Profits After Taxes -4.2 -8.0 -2.2 14.1 3.7 7.8 7.7 q42017 3.2 3.1 4.4 4.4 4.2 4.0 3.5 3.3 3.1 -1.5 #### #### -0.5 ## ## 5.5 #### #### 4.0 #### #### 3.5q42017 #### #### ## ## #### #### #### ####

q42017 #### #### ## ## #### #### #### ####

Federal Budget Balance (c) -245 60 -186 -210 -317 4 -143 q42017 -319 -266 25 -190 -365 -300 -35 -200 -375 -439 #### #### -586 ## ## -666 #### #### -750 #### #### -900

Current Account Balance (d) -119.2 -108.2 -110.3 -114.0 -113.5 -123.1 -114.0 q42017 -125.0 -125.0 -125.0 -130.0 -130.0 -130.0 -135.0 -135.0 -135.0 -434.6 #### #### -451.7 ## ## -475.7 #### #### -510.0 #### #### -535.0

Trade Weighted Dollar Index (e) 89.8 90.6 90.0 95.8 94.0 90.5 88.1 q42017 89.3 88.5 87.5 86.3 84.8 83.3 82.0 81.0 80.0 91.1 #### #### 91.6 ## ## 90.5 #### #### 86.8 #### #### 81.6q42017 #### #### ## ## #### #### #### ####

q42017 #### #### ## ## #### #### #### ####

Nonfarm Payroll Change (f) 196 164 239 148 166 187 128 q42017 212 170 165 160 155 150 150 145 145 226 #### #### 187 ## ## 173 #### #### 163 #### #### 148

Unemployment Rate 4.9 4.9 4.9 4.7 4.7 4.4 4.3 q42017 4.1 4.1 4.0 3.9 3.8 3.8 3.7 3.8 3.7 5.3 #### #### 4.9 ## ## 4.4 #### #### 4.0 #### #### 3.8

Housing Starts (g) 1.15 1.16 1.15 1.25 1.24 1.17 1.16 q42017 1.27 1.27 1.28 1.28 1.29 1.35 1.37 1.37 1.38 1.11 #### #### 1.17 ## ## 1.20 #### #### 1.28 #### #### 1.37

Light Vehicle Sales (h) 17.3 17.2 17.5 17.8 17.1 16.8 17.1 q42017 17.9 16.8 16.8 16.7 16.7 16.6 16.6 16.5 16.5 17.4 #### #### 17.5 ## ## 17.2 #### #### 16.8 #### #### 16.5

Crude Oil - Brent - Front Contract (i) 35.2 47.0 47.0 51.0 54.6 50.8 52.2 q42017 60.5 55.0 56.0 52.5 55.5 56.5 56.5 56.5 56.5 54.0 #### #### 45.1 ## ## 54.5 #### #### 54.8 #### #### 56.5q42017 #### #### ## ## #### #### #### ####

q42017 #### #### ## ## #### #### #### ####

Quarter-End Interest Rates (j) q42017 #### #### ## ## #### #### #### ####

Federal Funds Target Rate 0.50 0.50 0.50 0.75 1.00 1.25 1.25 q42017 1.50 1.75 2.00 2.25 2.25 2.50 2.50 2.75 2.75 0.27 #### #### 0.52 ## ## 1.25 #### #### 2.06 #### #### 2.63

3 Month LIBOR 0.63 0.65 0.85 1.00 1.15 1.30 1.33 q42017 1.65 1.90 2.15 2.40 2.40 2.65 2.65 2.90 2.90 0.32 #### #### 0.74 ## ## 1.36 #### #### 2.21 #### #### 2.78

Prime Rate 3.50 3.50 3.50 3.75 4.00 4.25 4.25 q42017 4.50 4.75 5.00 5.25 5.25 5.50 5.50 5.75 5.75 3.27 #### #### 3.52 ## ## 4.25 #### #### 5.06 #### #### 5.63

Conventional Mortgage Rate 3.69 3.57 3.46 4.20 4.20 3.90 3.81 q42017 3.89 4.06 4.20 4.30 4.35 4.45 4.50 4.62 4.67 3.85 #### #### 3.65 ## ## 3.95 #### #### 4.23 #### #### 4.56

3 Month Bill 0.21 0.26 0.29 0.51 0.76 1.03 1.06 q42017 1.35 1.60 1.85 2.10 2.15 2.35 2.40 2.60 2.65 0.05 #### #### 0.32 ## ## 1.05 #### #### 1.93 #### #### 2.50

6 Month Bill 0.39 0.36 0.45 0.62 0.91 1.14 1.20 q42017 1.48 1.70 1.95 2.20 2.25 2.45 2.50 2.70 2.75 0.17 #### #### 0.46 ## ## 1.18 #### #### 2.03 #### #### 2.60

1 Year Bill 0.59 0.45 0.59 0.85 1.03 1.24 1.31 q42017 1.65 1.80 2.05 2.25 2.30 2.50 2.55 2.75 2.80 0.32 #### #### 0.61 ## ## 1.31 #### #### 2.10 #### #### 2.65

2 Year Note 0.73 0.58 0.77 1.20 1.27 1.38 1.47 q42017 1.80 2.00 2.25 2.45 2.60 2.70 2.80 2.93 3.00 0.69 #### #### 0.83 ## ## 1.48 #### #### 2.33 #### #### 2.86

5 Year Note 1.21 1.01 1.14 1.93 1.93 1.89 1.92 q42017 2.20 2.39 2.58 2.75 2.85 2.90 2.97 3.10 3.17 1.53 #### #### 1.33 ## ## 1.99 #### #### 2.64 #### #### 3.04

10 Year Note 1.78 1.49 1.60 2.45 2.40 2.31 2.33 q42017 2.49 2.66 2.80 2.90 2.95 3.05 3.10 3.22 3.27 2.14 #### #### 1.84 ## ## 2.38 #### #### 2.83 #### #### 3.16

30 Year Bond 2.61 2.30 2.32 3.06 3.02 2.84 2.86 q42017 2.89 3.05 3.25 3.37 3.50 3.53 3.56 3.66 3.70 2.84 #### #### 2.59 ## ## 2.90 #### #### 3.29 #### #### 3.61q42017 #### #### ## ## #### #### #### ####

Forecast as of: December 14, 2017

Notes: (a) Compound Annual Growth Rate Quarter-over-Quarter (f) Average Monthly Change

(b) Year-over-Year Percentage Change (g) Millions of Units - Annual Data - Not Seasonally Adjusted

(c) Quarterly Sum - Billions USD; Annual Data Represents Fiscal Yr. (h) Quarterly Data - Average Monthly SAAR; Annual Data - Actual Total Vehicles Sold

(d) Quarterly Sum - Billions USD (i) Quarterly Average of Daily Close

(e) Federal Reserve Major Currency Index, 1973=100 - Quarter End (j) Annual Numbers Represent Averages

Forecast

2016 2017 2018

Actual

2019

ForecastActual

23

Wells Fargo International Economic Forecast

(Year-over-Year Percent Change)

GDP CPI

2017 2018 2019 2017 2018 2019

Global (PPP Weights) 3.5% 3.4% 3.4% 3.1% 3.5% 3.5%

Global (Market Exchange Rates) 3.3% 3.3% 3.2% 3.1% 3.5% 3.5%

Advanced Economies1 2.4% 2.4% 2.2% 1.8% 1.9% 2.0%

United States 2.3% 2.7% 2.5% 2.1% 2.2% 2.1%

Eurozone 2.4% 2.1% 1.9% 1.5% 1.6% 1.8%

United Kingdom 1.5% 1.4% 1.8% 2.7% 2.3% 2.0%

Japan 1.5% 1.1% 1.0% 0.4% 0.9% 1.1%

Korea 3.3% 3.0% 2.6% 2.0% 1.8% 2.1%

Canada 2.9% 2.0% 1.7% 1.6% 2.0% 2.0%

Developing Economies1 4.7% 4.5% 4.5% 4.4% 5.0% 5.1%

China 6.6% 6.4% 6.0% 1.6% 2.2% 2.2%

India2 7.1% 6.7% 7.1% 3.3% 5.0% 4.7%

Mexico 2.0% 1.9% 2.9% 5.9% 5.0% 5.1%

Brazil 1.0% 2.6% 3.0% 3.5% 3.8% 4.4%

Russia 1.8% 2.1% 2.2% 3.7% 3.4% 4.5%

Forecast as of: December 14, 20171Aggregated Using PPP Weights ²Forecast Refers to Fiscal Year

(End of Quarter Rates)

2019

Q4 Q1 Q2 Q3 Q4 Q1 Q4 Q1 Q2 Q3 Q4 Q1

U.S. 1.65% 1.90% 2.15% 2.40% 2.40% 2.65% 2.49% 2.66% 2.80% 2.90% 2.95% 3.05%

Japan -0.02% -0.01% -0.01% 0.00% 0.01% 0.01% 0.03% 0.05% 0.07% 0.09% 0.12% 0.14%

Euroland1 -0.37% -0.35% -0.25% -0.10% 0.05% 0.15% 0.35% 0.50% 0.65% 0.80% 1.00% 1.15%

U.K. 0.52% 0.52% 0.55% 0.65% 0.85% 0.90% 1.30% 1.40% 1.60% 1.75% 1.85% 1.95%

Canada2 1.40% 1.65% 1.75% 1.90% 2.00% 2.15% 1.90% 2.05% 2.25% 2.35% 2.45% 2.50%

Forecast as of: December 14, 20171 10-year German Government Bond Yield 2 3-Month Canada Bankers' Acceptances

Wells Fargo International Interest Rate Forecast

10-Year Bond

20182018

3-Month LIBOR

2017 20172019

24

Wells Fargo Securities Economics Group

Diane Schumaker-Krieg Global Head of Research, Economics & Strategy

(704) 410-1801 (212) 214-5070

diane.schumaker@wellsfargo.com

John E. Silvia, Ph.D. Chief Economist (704) 410-3275 john.silvia@wellsfargo.com

Mark Vitner Senior Economist (704) 410-3277 mark.vitner@wellsfargo.com

Jay H. Bryson, Ph.D. Global Economist (704) 410-3274 jay.bryson@wellsfargo.com

Sam Bullard Senior Economist (704) 410-3280 sam.bullard@wellsfargo.com

Nick Bennenbroek Currency Strategist (212) 214-5636 nicholas.bennenbroek@wellsfargo.com

Eugenio J. Aleman, Ph.D. Senior Economist (704) 410-3273 eugenio.j.aleman@wellsfargo.com

Azhar Iqbal Econometrician (704) 410-3270 azhar.iqbal@wellsfargo.com

Tim Quinlan Economist (704) 410-3283 tim.quinlan@wellsfargo.com

Eric Viloria, CFA Currency Strategist (212) 214-5637 eric.viloria@wellsfargo.com

Sarah House Economist (704) 410-3282 sarah.house@wellsfargo.com

Michael A. Brown Economist (704) 410-3278 michael.a.brown@wellsfargo.com

Jamie Feik Economist (704) 410-3291 jamie.feik@wellsfargo.com

Erik Nelson Currency Strategist (212) 214-5652 erik.f.nelson@wellsfargo.com

Michael Pugliese Economic Analyst (704) 410-3156 michael.d.pugliese@wellsfargo.com

Harry Pershing Economic Analyst (704) 410-3034 harry.pershing@wellsfargo.com

Hank Carmichael Economic Analyst (704) 410-3049 john.h.carmichael@wellsfargo.com

Ariana Vaisey Economic Analyst (704) 410-1309 ariana.b.vaisey@wellsfargo.com

Abigail Kinnaman Economic Analyst (704) 410-1570 abigail.kinnaman@wellsfargo.com

Shannon Seery Economic Analyst (704) 410-1681 shannon.seery@wellsfargo.com

Donna LaFleur Executive Assistant (704) 410-3279 donna.lafleur@wellsfargo.com

Dawne Howes Administrative Assistant (704) 410-3272 dawne.howes@wellsfargo.com

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