InvestmentInsights | 2019

Expand views on debt

Adapt to changing discount rates

Adjust portfolio duration

Expand, adapt, and adjust: Managing risk in an aging recovery

1

The past 10 years featured generally declining interest rates, rising investor confidence, and a restoration of balance sheet health for most households and businesses. Yet the tailwinds of the past decade look to be turning into headwinds. Interest rates have been rising, making long-duration assets underperform shorter-duration assets. Discount rates have been rising, making assets with riskier cash flows underperform higher-quality assets. Debt levels have reached points where they are raising concerns. In this aging recovery, we believe there are concrete steps investors can consider to manage risks:

1 Expand views on debt Open questions about rising rates, the pace of economic growth, and corporate and government debt levels will likely require nuance to identify the right investment opportunities.

2 Adapt to changing discount rates Shifting risk premia (or the amount that investors expect in compensation for taking on various risks) and widening credit spreads should cause credit quality and fundamental security selection to play a critical role in helping drive returns.

3 Adjust portfolio duration Duration, security price movement as a result of interest rate movements, is more than just a fixed-income concern. Knowing when to adjust duration across asset classes is often one benefit of active management.

Table of contents

Portfolio positioning 2

Expand views on debt 4

Adapt to changing discount rates 8

Adjust portfolio duration 11

Conclusion 13

About the authors 13

2

Portfolio positioning

U.S. equitiesNotable overweights: In an overall environment of scarce growth, our U.S. growth equity teams continue to favor companies with secular tailwinds. These opportunities have been and continue to be found within disruptive information technology and communication services companies. They remain disciplined on valuations for this growth, differentiating their strategy from momentum strategies. Our U.S. core and value equity teams are finding more opportunities within the industrials and materials sectors in companies that may be experiencing transitory cost pressures amid continued global growth.

Notable underweights: U.S. growth equity teams are underweight consumer staples, where earnings and revenue growth have been challenging. Our U.S. core and value equity teams are underweight real estate investment trusts (REITs) and utilities. Such stocks tend to be pressured in a rising rate environment, given higher financing costs and competition from higher-yielding U.S. Treasury securities.

Non-U.S. equitiesNotable overweights: Although fundamentals are a bit less favorable due to slowing global growth, higher oil prices, and ongoing trade wars, our international managers that also manage global portfolios are finding more opportunities outside of the U.S. Internationally, our managers are also finding opportunities to overweight information technology. They are also adding self-help restructuring opportunities within Europe. Our managers believe that emerging market valuations look attractive in the intermediate to long term, particularly within Asia.

Notable underweights: As sovereign interest rates and yield curves rise, our international equity teams are also underweight REITs and utilities.

Taxable domestic fixed incomeNotable overweights: Corporate debt has grown, but not evenly across all sectors. Banks and financials have been exhibiting lower leverage levels than prior to the financial crisis, due largely to regulatory changes. Many teams are overweight credit, but with valuations in many credit sectors stretched and spreads near the lower end of the range, those teams are finding it prudent to build dry powder and favor an up-in-quality bias in portfolios. Fundamentals in the high-yield market continue to be supportive and default rates remain low, lending teams an opportunity to find positions here, though valuations remain rich. Our U.S.-focused teams are generally moving closer to a more neutral interest rate duration positioning with the view that the majority of market participants have priced in the remaining Federal Reserve (Fed) rate hikes.

Notable underweights: U.S. nonfinancials and industrials remain underweights given their higher levels of leverage late in the cycle. Underwriting and credit quality of the leveraged loan market have deteriorated, potentially leaving investors less protected when the credit cycle turns.

Taxable non-U.S. fixed incomeNotable overweights: The speed and magnitude with which developed nations have issued debt, as measured by debt to gross domestic product (GDP), is concerning and has left smaller developed/developing and emerging markets with less relative debt. As central banks look to normalize their policies around the world, the focus on fundamentals should help differentiate credits. European investment-grade spreads are seeing more dispersion and we expect this to continue as the cycle matures, offering relative-value opportunities. We also believe moving up in quality and maintaining liquidity will be important as the influence from exchange-traded funds, asset managers, and the broader shadow banking system has grown.

Notable underweights: Teams are underweight developed nations whose debt levels have increased rapidly or which remain elevated to historical levels. Currency valuations and hedging costs are leading teams to look for value in local currencies around the world and underweighting U.S.-dollar-denominated debt.

3

Portfolio positioning

Tax-exempt fixed incomeNotable overweights: After having positioned portfolio durations short relative to their benchmarks for much of the past two years, the team has been moving closer to neutral levels of interest rate duration. Given that we are in the later stages of the cycle, the team has been opportunistically improving credit quality and taking advantage of the steeper municipal yield curve by purchasing higher credit-quality bonds in key rates along the curve. Highly rated securities within Texas and select securities within Illinois remain notable overweights. The strategies have maintained an overweight to lower-quality credits, but the exposures have been reduced.

Notable underweights: Changes to federal tax laws enacted in late 2017 have created relative-value differences across municipalities leading to underweight positions in California debt and prerefunded bonds.

QuantitativeNotable overweights: Analytic and Golden are the two Wells Fargo Asset Management quantitative teams. Analytic takes a pure quantitative disciplined approach to maintain exposures across quality, value, momentum, small size, and low-volatility factors. Golden takes a similar disciplined “quantamental” approach but also seeks to identify those companies with strong and improving company fundamentals, strong balance sheets, experienced management, and attractive valuations. Currently, this has led to an overweight positioning in health care.

Notable underweights: Golden’s underweight to consumer staples is driven by revenue and earnings growth challenges, along with fuller valuations.

Multi-assetNotable overweights:• A multi-asset perspective on investing is about focusing on

risk premias and risk allocation, letting the capital allocation follow the risk allocations. Traditional asset allocation puts capital allocation first. For example, allocating toward economic growth can be done via high-yield bonds or equities, albeit with different risk/return properties. Within the multi-asset strategies focused on growing wealth, the team is leaning cyclically, although less so than it did last year.

• Within the strategies focused on generating income, the team continues to favor more economically growth-linked sources of income, like global dividend-paying stocks, high-yield bonds, contingent convertible bonds (or CoCos), and emerging market debt.

• For those strategies that are geared toward protecting wealth, the team continues to favor long-short strategies to capture alternative risk premias, as well as the use of systematic futures and options strategies to provide dynamic risk hedging.

Notable underweights:• For a few years, the multi-asset strategies focused on growth

have favored the momentum factor in the U.S., but they reduced exposure to that factor over the course of 2018, shifting attention to the value opportunities outside the U.S. Our multi-asset strategies have been underweight duration risk across portfolios because the team anticipated a rise in interest rates. Now that the Fed is closer to neutral than it has been in a decade, the strategies are still underweight duration but not nearly to the extent they were even a year ago.

4

Expand views on debt

Alison ShimadaSenior Portfolio Manager

“ Despite China’s slower economic growth, we do not expect nonperforming loans to materially increase for the following reasons—the continuation of the country’s deleveraging campaign, stable earnings growth in an economy growing at ~6%, an interest coverage ratio (earnings before interest and tax/interest expense) in the 3.5–8.0 times range, the implicit guarantee of state-owned enterprise debt, and a more accommodative interest rate policy. Our outlook has been confirmed by the banks as they report results and guide toward stable credit costs for 2019. Additionally, I believe the continuing shift away from infrastructure investment, which is capital intensive, toward technology sectors with higher return potential, as well as reforms to enhance capital efficiency, are long-term solutions to China’s high debt problem.”

Debt is rising—but not everywhere Whether it’s the Bank for International Settlements or the International Monetary Fund, organizations are issuing warnings about rising debt levels. A nuance that is often omitted is the distribution and concentration of that debt. Many governments have increased their debt levels to the point that they equal their GDP, and some nongovernment sectors have also increased their leverage. However, across and within geographies and sectors, not everyone has levered up to concerning levels. Nuance will likely make all the difference if and when rates rise further or economic growth slows faster than many expect.

Portfolio positioningMulti-asset solutions Nuance is important. Government debt has grown, but corporate balance sheets look pretty healthy. Through the lens of debt growth and valuations, the multi-asset managers think there are places investors can ride out any market storms that may hit.

Equity Our equity managers think about debt from a few angles. As an example, have the companies incurred too much debt such that if growth slows they will have a hard time servicing the debt? There may be cases of that in any country or any sector, but a focus on quality (Alison Shimada) or balance sheet flexibility (Bryant VanCronkhite) should help navigate around those potholes.

Fixed incomeOur fixed-income managers have a lot of perspectives on this from a sector and country level. Again, a focus on quality and bottom-up credit analysis is their tactic for threading the needle of high debt loads and rising debt-servicing cost.

Global government debt has generally grown faster over the past decade than corporate debtThe data below shows the change in corporate leverage versus the change in government debt burdens. The bubble size represents forward price/earnings multiples from Bloomberg estimates.

5

Chan

ge in

MSC

I Ind

ex d

ebt-

to-a

sset

s (p

erce

ntag

e po

ints

)

Change in government debt-to-GDP from 2008 to 2018 (percentage points)0-10-20-30 10 20 30 40 50 60 70 80

5

0

15

10

-5

-10

-15

-20

-25

-30

United States

Brazil

Japan

Greece

Spain

Portugal

Britain

France

Italy

Australia

Canada

Mexico SouthAfrica

India

Hong Kong

Russia

SouthKorea

Germany

Turkey

-30-30

-25

-20

-15

-10

-5

0

5

10

15

-20 -10 0 10

Change in government debt-to-GDP from 2008 to 2018 (percentage points)

Chan

ge in

MSC

I Ind

ex d

ebt-

to-a

sset

s fro

m 2

008

to 2

018

(per

cent

age

poin

ts)

20 30 40 50 60 70 80

Expand views on debt

Source: Bloomberg. Price/earnings (P/E) is the price of a share of a stock divided by earnings per share, using Bloomberg estimates for next twelve months’ earnings per share.

6

Expand views on debt

$ bi

llion

s

02009 2010 2011 2012 2013 2014 2015 2016 2017 2018

200

800

400

1,200

600

1,000

02009 2010 2011 2012 2013 2014 2015 2016 2017 2018

50

100

250

150

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200

400

450

300

U.S. high yield U.S. institutional loans

Janet Rilling, CFASenior Portfolio Manager

“ While broad generalizations about rising debt levels are not to be ignored, they don’t necessarily apply to all parts of the credit market. Within the investment-grade bond universe, there are several sectors that are defying the rising debt narrative. Banking is a good example of a sector that is exhibiting lower leverage levels than prior to the financial crisis, largely as a result of regulatory changes.”

Moreover, it might surprise some to learn that leverage metrics for the U.S. high-yield corporate bond market have been declining, while interest coverage metrics, an indicator of how much cash flow a company has to service its interest expense, are at cycle-high levels.”

Niklas Nordenfelt, CFASenior Portfolio Manager

“ Typically, at this point in the cycle, one would expect to see a significant growth of the high-yield bond market as companies engage in aggressive borrowing and/or merger and acquisition activity. However, the high-yield bond market, in contrast to the investment-grade corporate bond market, has actually declined in size.”

A rising tide of leveraged loansWhile many governments have increased their debt-to-GDP ratios since 2008, the corporate sector is looking much healthier, with many companies having reduced their debt-to-asset levels. There is also a wide variety of valuations across the globe, creating potential opportunities for investors. A global search for quality should uncover opportunities for investors who may be nervous about rising debt levels and the possibility of peaking economic activity.

Although aggressive borrowing is occurring, the majority of deals are being financed by a combination of the syndicated loan and private debt worlds. Issuers are finding more generous terms in those markets. The positive is that high-yield issuers, fundamentally, are well positioned at this point in the cycle relative to history. There are fewer issues rated CCC (the lowest-rated tier) and a higher percentage of BBs than average. The negative is the deterioration in the quality of the loan market.

Corporate loans are increasingly issued at the expense of bonds

New issue volumes ($ billions)

Par amount outstanding ($ billions)

Source: ICE BofA Merrill Lynch Global Research, data as of September 30, 2018

U.S. high yield bondU.S. institutional loans European Union high yield

Emerging Markets high yield

$ bi

llion

s

7

The seemingly insatiable demand for floating-rate debt and the creation of collateralized loan obligations has resulted in a significant increase in both lower-rated loans and loan-only structures. It seems that investors are trading interest rate risk for credit spread risk. As investors, this is important to understand. In an eventual downturn, we expect lower recovery rates for loans than most investors have modeled based on historical measures. We prefer higher-quality loans (generally BB rated), which have experienced less erosion in structure.

Lower-quality loans now account for a greater proportion of the market

Loan market ratings mix

Jan. 2012 Jan. 2013 Jan. 2014 Jan. 2015 Jan. 2016 Jan. 2017 Jan. 2018

55

50

45

40

35

30

25

20

15

10

5

0

BB-/BB+BB+/BB B/B- Below B-

Jan 2013:BB-/B+ = 44.6%B/B- = 20.3%

Aug 2018:BB-/B+ = 28.0%B/B- = 38.1%

Par based, excluding nonrated and defaulted loans

Perc

ent (

%)

Sources: LCD and Wells Fargo Securities

Bryant VanCronkhite, CFA, CPASenior Portfolio Manager

“ A lot of investors have lived for 10 years in a world where cash earnings have grown and interest costs have fallen. That cocktail typically allows for very high leverage ratios. However, the true variability of cash flows is far greater for many industries than we’ve experienced over the past 10 years. What looks today like a safe leverage ratio could quickly turn into a debt tail that wags the equity dog.”

Alex TemplePortfolio Manager

“ Nuance will be meaningful. Considerations include the mix of a country’s local and hard currency debt, the term structure of debt, and diversification of funding sources. In this latter stage of the credit cycle, liquidity might trump leverage and fundamentals as the greatest concern in a period of heightened volatility, which one might expect at the end of the cycle. While general leverage in the system might be lower than pre–global financial crisis, there has been a risk transfer from banks to asset managers and exchange-traded funds and the wider shadow banking system. This could have implications for liquidity.”

Expand views on debt

8

Adapt to changing discount rates

Alison ShimadaSenior Portfolio Manager

“ We often hear from investors that rates are going up and that is bad for emerging markets, especially higher-yielding names. However, the numbers are not supportive of that assertion as the correlation between changes in the U.S. 10-year Treasury and emerging market equity performance over three-year periods has been quite low—in the single digits. Emerging market equity markets rallied in 2017 as the Fed raised rates four times during the year. Emerging markets are down so far in 2018, but that can’t be attributed only to the three Fed rate hikes this year. Thus far, we have not seen and do not expect to see a disproportionate negative impact in the portfolio for the aforementioned reasons. With our dividend-focused strategy, there’s also the fact that 90% of companies in the MSCI Emerging Markets Index pay a dividend, allowing us to rotate out of names that may be disproportionately hurt by rising rates.”

Jeffrey Weaver, CFASenior Portfolio Manager

“ We remain concerned around the level of nonfinancial corporate leverage. Many merger and acquisition agreements leave little room for operational challenges and we find concerning the leverage levels being taken on by issuers. While leverage for BBB-rated issuers is marginally higher than precrisis levels, the aggregate leverage for A-rated issuers is significantly higher. In many instances, BBB-rated issuers are better able to manage their leverage levels within existing ratings, but a deteriorating macroeconomic backdrop could lead to a large number of downgrades out of A ratings.”

Risky cash flows should not be discounted by risk-free interest rates. Instead, investors should use discount rates that reflect shifting risk premia. If economic activity slows, credit spreads and risk premia can widen, even absent a recession. Rising discount rates lowers the present value of a security. For this reason, many of our fixed-income managers are moving up in credit quality and focusing on those issues where their bottom-up analysis lends stronger confidence in the issuer’s credit quality than what may be reflected in market prices or credit ratings. Our equity managers are looking for areas where their expectations differ from the consensus, based on confidence arising from their investment processes. This means focusing more on security selection than on sector allocation for possible outperformance.

Discount rates have recently risen off their lowsThe historical option-adjusted spread represents changing discount rates.

0

5

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adju

sted

spre

ad (%

)

15

20

12/3

1/20

07

Bloomberg Barclays U.S. Corporate High Yield Bond

Bloomberg Barclays Pan-European High Yield

Bloomberg Barclays Emerging Markets High Yield

12/3

1/20

08

12/3

1/20

09

12/3

1/20

10

12/3

1/12

01

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9/29

/201

8Source: Bloomberg

A decent amount of portfolio gains since 2008 have come from falling interest rates, tightening credit spreads, or rising valuations. All three of these factors may be in the early stages of making a turn. That’s where strong fundamentals in the form of cash flow growth and a company’s ability to pay dividends will likely become more important over the next few years.

9

The decomposition of equity returnsRecently, P/E multiple expansion has heavily influenced S&P 500 Index returns. Whereas …

Dividend yield + Earnings

growth + Valuation/PEchanges

= Annualized return

Cumulative return

S&P 500 2.3% 7.7% 5.6% 15.6% 130%

MSCI EAFE 2.9% 1.6% 2.1% 6.6% 44%

MSCI EM 2.5% -0.9% 0.7% 2.3% 14%

1/1/2013 to 9/30/2018

... Longer term, dividends and earnings growth, not valuation, are the drivers.

Dividend yield + Earnings

growth + Valuation/PE changes = Annualized

returnCumulative

return

S&P 500 2.2% 6.5% 0.1% 8.8% 220%

MSCI EAFE 2.9% 2.6% -0.7% 4.8% 90%

MSCI EM 2.6% 4.1% 0.8% 7.5% 169%

1/1/2005 to 9/30/2018

Sources: FactSet, Bloomberg, USD, S&P 500 Index, MSCI EM (Emerging Markets Net Return) Index, MSCI EAFE (Europe Australasia, Far East Net Return) Index, cumulative and annualized returns calculated monthly.Dividend yield for MSCI EM (Emerging Markets Net Return) Index, MSCI EAFE (Europe Australasia, Far East Net Return) Index is estimated using net dividends. Earnings growth and valuation to P/E changes components are U.S.-dollar estimated total return percentages, using next 12 months. Past performance is no guarantee of future results.

Janet Rilling, CFASenior Portfolio Manager

“ While it is always important to practice careful security selection, it is especially crucial to do your homework in the later stages of a credit cycle. Fundamental analysis can help uncover credit stories that buck the trend—such as companies generating a more geographically diversified revenue stream, resulting in less sensitivity to a U.S. downturn. Another attractive place to focus could be sectors that are less correlated with U.S. GDP growth, either because they are less cyclical or because they are benefiting from a larger secular trend. Companies that provide productivity improvements to their customers, such as in the technology industry, could be a third place to look. In any case, attention to financial flexibility and liquidity position should help an investor better assess a company’s ability to weather economic headwinds that could be on the horizon.”

Portfolio positioningMulti-asset solutionsMulti-asset’s bread and butter is examining risk premias. Discount rates—which include various risk premias—have been rising across asset classes, but the turn looks to be in the early stages. We’ve been overweight domestic equities and growth. With rising risk premias but differentials across countries, we think it’s prudent to adapt portfolios by reducing that home bias and growth bias.

EquityThe return decomposition chart above shows how much of total return tends to come from fundamentals versus valuation changes. In the U.S., the story in recent years has been one of valuations rising to drive returns. A focus on fundamental earnings growth should uncover opportunities. Outside the U.S., there hasn’t been the same surge in valuations, which should bode well for non-U.S. exposure.

Fixed income For fixed income, credit spreads have widened, but they’re still narrow. This credit cycle could end with more of a fizzle than a burst. Spreads might gradually rise as economic growth looks good, and there seems to be only pockets of craziness in the credit market.

Adapt to changing discount rates

10

Niklas Nordenfelt, CFASenior Portfolio Manager

“ Spreads on CCC-rated bonds have declined to 2018 tights in response to the strong U.S. economy and, mostly, low equity volatility. We anticipate that a rise in the equity risk premium will negatively affect this segment of high yield the most, in spite of a still-projected low default rate in the coming year.”

Alex TemplePortfolio Manager

“ Investors are increasingly focusing on corporate fundamentals as central banks normalize policy. We are already seeing increased dispersion in European investment-grade corporate bond spreads and only expect this to increase as the interest rate cycle matures. An expectation that assets are subject to revaluation risks—for example, the value of commercial property backing REITs or the secondhand car values for leasing companies—could have a negative impact on credit spreads as investors demand higher compensation for lower implied recovery rates. To this end, we are generally moving up in quality across our portfolios, with a significant focus from analysts on asset valuations.”

As shown in the graphics below, spreads have tightened significantly between CCC-rated and B-rated bonds. Lower-quality bonds benefited from multiple factors, including improving overall credit quality and investors’ search for yield. Moreover, although equity volatility spiked in October, stock market volatility has been muted for most of 2018, further supporting lower-rated debt. Despite the strong performance of the credit markets in general and lower-quality debt in particular, concerns about the levels of leverage at some companies is not going away.

In the high-yield bond market, lower-rated bonds had yields come in relative to mid-rated debt

CCC-B spread differential

0

500

1,000

1,500

Basi

s poi

nts (

bps:

100

bps

= 1

.00%

)

2,000

2,500

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

20162017

CCC-B spread Long-term average Average in periods

Past 12 months

300

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450

500

550

600

650

CCC-B spread Long-term average

Basi

s poi

nts

September

October

November

December

January

FebruaryMarch April May

June July

SeptemberAugust

Source: ICE BofA/ML Constrained Indices. Data as of September 30, 2018.

Adapt to changing discount rates

11

Adjust portfolio duration

Fixed-income investors are familiar with adjusting duration, or the interest rate sensitivity of portfolios. Most investors worry only about fixed-income duration, but even equities have duration—whether it’s due to how changes in interest rates affect valuations or how changes in interest rates affect the profitability of firms. Defensive sectors tend to be high-dividend-yielding ones, which makes them interest rate sensitive. Yet even growth stocks can have high duration exposure because their expected cash flows are often in the distant future. Shortening duration in equities typically means underweighting the classic interest-rate-sensitive defensive sectors and moderating allocations to go-go-growth stocks.

Everything else equal, growth stocks can have a high sensitivity to changes in interest ratesAlthough investors often discuss the effect of interest rate changes on fixed income, changes in the yield curve can also have an effect on stocks. This chart shows the historical relationship between a one percentage point increase in the slope of the yield curve (difference in yields between the 10-year and the 2-year Treasury) and the total return of various indices.

(7.26)

S&P 500 Index

(12)

(10)

(8)

(6)

(4)

(2)

0

Tota

l ret

urn

(%)

(11.58)

S&P 500 Pure Growth Index

(2.53)

S&P 500 Pure Value

Index

(2.66)

Russell 2000 Index

(1.22)

ICE BoAML U.S. High Yield

Constrained Index

(0.62)

Bloomberg Barclays U.S.

Corporate Bond Index

(0.96)

Global Financial

Data 10-Year Treasury Total Return Index

Sources: Global Financial Data and WFAM calculation from regression model for each index where the explanatory variables are the level of two-year yield, the slope of the yield curve, and the change in the slope over the next six months.

Portfolio positioningMulti-asset solutionsOur multi-asset portfolios have generally maintained a short duration in fixed income, balancing that with a longer duration in equities (growth overweight). With the recent rise in yields and increase in risk premias, the team has shifted both fixed-income and equity durations toward neutral.

EquityGrowth is a long-duration equity exposure, though there’s a lot more to equity returns than just interest rate sensitivity. A rapid rise in valuations—and occasional hiccup in prices—has been more a function of exposure to momentum than growth.

Fixed incomeFixed-income portfolio managers have a number of tools to manage duration while maintaining exposure to the higher-yielding parts of the market that they favor.

12

Tom OgnarSenior Portfolio Manager

“ Don’t confuse momentum investing with growth investing. As the embedded chart indicates, and which is reflected in our portfolio positioning, relative to history, the momentum factor or positive price behavior is expensive, while the growth factor defined as predictable earnings growth is not. Our style at its core has a growth focus that is executed with a disciplined eye on how much growth is being priced into a stock’s valuation. The key is to be disciplined on the buy and, as important, the sell decisions.”

Janet Rilling, CFASenior Portfolio Manager

“ Fixed-income managers have a range of tools to address duration. A blunt and effective instrument to help protect against interest rate increases is the outright reduction of portfolio duration. A manager can also favor less interest rate sensitive sectors such as high-yield bonds or those foreign bonds that are exposed to a different interest rate cycle. Floating-rate securities can be another way to avoid interest rate risk because their coupon resets periodically, allowing the investor to benefit from rising rates.”

Not all growth, but mostly momentumThe interest rate sensitivity of growth stocks is not uniform. There are many different flavors of growth stocks. Firms whose cash flows are expected in the distant future tend to be stocks with the highest durations. Our managers focus on finding companies with substantial, sustainable, and underappreciated abilities to generate cash flows, reducing their effective duration exposure. Most of the almost meteoric rise in growth stocks—in areas that may be most vulnerable—tend to be more momentum plays than genuine growth stories. Momentum—the tendency for rising asset prices to continue rising—often occurs among growth stocks, but not all growth stocks display the same degree of momentum.

Q1–Q5 forward P/E spread: Momentum has been a more significant factor than growth in explaining relative performance over the past few years

U.S. momentum

141210

86420

-2

March 2001

March 2003

March 2005

March 2007

March 2009

March 2011

March 2013

March 2015

March 2017

Nov. 2001

Nov. 2003

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Nov. 2009

Nov. 2011

Nov. 2013

Nov. 2015

Nov. 2017

July 2002

July 2004

July 2006

July 2008

July 2010

July 2012

July 2014

July 2016

Jul. 2018

Q1–

Q5

forw

ard

P/E

spre

ad

U.S. growth

141210

86420

-2

March 2001

March 2003

March 2005

March 2007

March 2009

March 2011

March 2013

March 2015

March 2017

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Nov. 2003

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July 2018

Q1–

Q5

forw

ard

P/E

spre

ad

Sources: FactSet and MSCI Barra, as of September 30, 2018

The Q1–Q5 forward P/E spread shows the difference between consensus projected P/E for one quarter ahead (Q1) and consensus projected P/E for five quarters ahead (Q5). The gray area represents the first standard deviation. Standard deviation is the square root of the average squared deviations from the mean. It is often used as a measure of volatility, variability, or risk. Standard deviation is based on historical performance and does not represent future results.

Adjust portfolio duration

13

Conclusion

For what seems like at least six years now, people have been saying the economic and market expansion is in the seventh or eighth inning. As viewers of the 2018 World Series can attest, some innings can be short and some can be long and some pivotal games can go into many extra innings, exhausting fans. Our portfolio managers think that instead of trying to call the end of the game, or even predict when it might happen, a more prudent approach is to manage the newly emerging risks as the game goes on. For this part of the market and economic cycle, we think investors across asset classes can manage the risks of debt, discount rates, and duration to better align their portfolios with their long-term investment goals.

• Debt loads are rising but still manageable and affordable for many issuers. Slowing but continued economic growth shouldn’t undermine the fundamentals of most issuers. That’s why an expanded view on debt may help investors navigate equity and fixed-income markets over the next year.

• Discount rates are what investors typically use to value future cash flows. When risks increase, these discount rates usually rise. Many of our portfolio managers are upgrading the quality of their portfolios in an attempt to dampen the effects of rising discount rates.

• Duration is the measure of an asset price’s sensitivity to changes in interest rates. All assets have at least some sensitivity to interest rates. Our fixed-income managers have a number of levers to pull to adjust duration to targeted levels while generating acceptable levels of coupon income. Equity managers can adjust the duration risks of their holdings by shifting toward those areas that are less sensitive to interest rates. For growth managers, this means looking for sustainable growth rather than mistaking momentum for growth. For value managers, this means shying away from those areas (such as REITs or utilities) that tend to serve merely as bond proxies for investors. Individual investors can help manage the duration risk in their portfolios through broad, global diversification, taking advantage of the different growth and interest rate cycles around the world.

About the authorsWells Fargo Asset Management’s investment professionals offer their views on the economy, equities markets, and fixed-income markets in the U.S. and abroad. Their combined view of the investment landscape gives investors a comprehensive perspective on recent market activity.

F. Jon BarankoChief Equity Officer

Lyle Fitterer, CFACo-Head of WFAM

Global Fixed Income, Managing Director,

Head of Municipal Fixed Income

Brian Jacobsen, Ph.D., CFA, CFP®

Senior Investment Strategist, Multi-Asset Solutions

The views expressed and any forward-looking statements are as of November 20, 2018, and are those of Chief Equity Officer F. Jon Baranko, Co-Head of Wells Fargo Asset Management Global Fixed Income and Managing Director, Head of Municipal Fixed Income Lyle Fitterer, Senior Investment Strategist, Multi-Asset Solutions Brian Jacobsen, and Wells Fargo Asset Management. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Asset Management and its affiliates disclaim any obligation to publicly update or revise any views expressed or forward-looking statements.

Mutual fund investing involves risks, including the possible loss of principal. Consult a fund’s prospectus for additional information on risks.Asset allocation and diversification do not ensure or guarantee better performance and cannot eliminate the risk of investment losses.

The Bloomberg Barclays Emerging Markets High Yield Index is a market capitalization weighted index that consists of the high yield bonds in the Bloomberg Barclays Emerging Markets USD Aggregate Bond Index, which includes fixed and floating-rate US dollar-denominated debt issued from sovereign, quasi-sovereign, and corporate emerging markets issuers. Country eligibility and classification is reviewed annually and based on the World Bank income group (low/middle income) or International Monetary Fund country classifications (non-advanced country). At the security level, there must be at least US $500 million par outstanding.

The Bloomberg Barclays Pan-European High Yield Index measures the market of non-investment-grade, fixed-rate corporate bonds denominated in the following currencies: euro, pounds sterling, Danish krone, Norwegian krone, Swedish krona, and Swiss franc. Inclusion is based on the currency of issue and not the domicile of the issuer. You cannot invest directly in an index.

The Bloomberg Barclays U.S. Corporate Bond Index is an unmanaged market-value-weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more. You cannot invest directly in an index.

The Bloomberg Barclays U.S. Corporate High Yield Bond Index is an unmanaged, U.S.-dollar-denominated, nonconvertible, non-investment-grade debt index. The index consists of domestic corporate bonds rated Ba and below with a minimum outstanding amount of $150 million. You cannot invest directly in an index.

The Global Financial Data’s 10-Year Treasury Total Return Index measures the 10-year Treasury note’s total rate of return, including changes in the prices of 10-year Treasuries, as well as interest income. You cannot invest directly in an index.

The ICE BofAML U.S. High Yield Constrained Index is a market-value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment-in-kind securities. Issues included in the index have maturities of one year or more and have a credit rating lower than BBB-/Baa3 but are not in default. The ICE BofAML U.S. High Yield Constrained Index limits any individual issuer to a maximum of 2% benchmark exposure. You cannot invest directly in an index. Copyright 2018. ICE Data Indices, LLC. All rights reserved.

The ICE BofAML U.S. High Yield Index is a market-capitalization-weighted index of domestic and Yankee high-yield bonds. The index tracks the performance of high-yield securities traded in the U.S. bond market. You cannot invest directly in an index. Copyright 2018. ICE Data Indices, LLC. All rights reserved.

The Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) (Net) is a free-float-adjusted market-capitalization-weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI (Net) consists of 46 country indices comprising 23 developed and 23 emerging market country indices. The developed market country indices included are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. The emerging markets country indices included are Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, the Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates. You cannot invest directly in an index.

The Morgan Stanley Capital International (MSCI) Emerging Markets (EM) Index (Net) is a free-float-adjusted market-capitalization-weighted index that is designed to measure large- and mid-cap equity market performance of emerging markets. The MSCI EM Index (Net) consists of the following 24 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, the Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates. You cannot invest directly in an index.

The Morgan Stanley Capital International (MSCI) Europe, Australasia, Far East (EAFE) Index is a free-float-adjusted market-capitalization-weighted index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 21 developed markets country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. You cannot invest directly in an index.

Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.

The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. You cannot invest directly in an index.

The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value-weighted index with each stock’s weight in the index proportionate to its market value. You cannot invest directly in an index.

The S&P 500 Pure Growth Index measures the performance of the pure growth stocks from the S&P 500 Index, which represent approximately 33% of the total market capitalization of the S&P 500 Index. You cannot invest directly in an index.

The S&P 500 Pure Value Index measures the performance of the pure value stocks from the S&P 500 Index, which represent approximately 33% of the total market capitalization of the S&P 500 Index. You cannot invest directly in an index.

Carefully consider a fund’s investment objectives, risks, charges, and expenses before investing. For a current prospectus and, if available, a summary prospectus, containing this and other information, visit wellsfargofunds.com. Read it carefully before investing.Wells Fargo Asset Management (WFAM) is the trade name for certain investment advisory/management firms owned by Wells Fargo & Company. These firms include but are not limited to Wells Capital Management Incorporated and Wells Fargo Funds Management, LLC. Certain products managed by WFAM entities are distributed by Wells Fargo Funds Distributor, LLC (a broker/dealer and Member FINRA).

This material is for general informational and educational purposes only and is NOT intended to provide investment advice or a recommendation of any kind—including a recommendation for any specific investment, strategy, or plan.

NOT FDIC INSURED • NO BANK GUARANTEE • MAY LOSE VALUE

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