Global Investment Strategy Global Fixed Income Strategy: Quarterly Guidance August 22, 2019 Quarterly guidance on global fixed income investments Brian Rehling, CFA Co-Head of Global » Yields remain relatively low on a historical basis. Fixed Income Strategy » We believe that investors should consider positioning George Rusnak, CFA duration (a bond’s price sensitivity to interest-rate changes) Co-Head of Global to match that of their individually selected benchmarks. Fixed Income Strategy » We favor raising average credit quality in fixed-income Peter Wilson portfolios. Global Fixed Income Strategist » We believe that investors should maintain fixed-income exposure at targeted allocations and remain broadly and Luis Alvarado globally diversified. Investment Strategy Analyst Quarterly Fixed Income Guidance: Third Quarter 2019 In this report, we share our current tactical (6-18 month) guidance for fixed-income classes and sectors. We no longer recommend strategic allocations to Developed Market (ex-U.S.) Fixed Income. We also do not favor holding tactical positions in Developed Market (ex-U.S.) Fixed Income at this time. Global Fixed Income Indices: Total Returns as of June 30, 2019 Global Fixed Income Indices: Total Returns as of June 30, 2019 WFII Guidance WFII Guidance Most Unfavorable Most Favorable YTD 1 Year Most Unfavorable Most Favorable YTD 1 Year U.S. Taxable Investment 6.1% 7.9% Government Securities 5.2% 7.2% Grade Fixed Income U.S. Short Term Taxable Fixed 2.7% 4.3% Treasury Securities 5.2% 7.2% Income U.S. Intermediate Term 5.2% 7.5% Agencies 4.2% 6.1% Taxable Fixed Income U.S. Long Term Taxable Fixed Inflation-Linked Fixed 13.5% 13.9% 6.2% 4.8% Income Income High Yield Taxable Fixed 9.9% 7.5% Investment-Grade Credit 9.4% 10.3% Income Developed Market Ex-U.S. Investment-Grade 5.6% 4.4% 9.9% 10.7% Fixed Income (Unhedged) Corporate Emerging Market Fixed 10.6% 11.3% Preferred Stock 10.9% 4.9% Income (U.S. Dollar) Municipal 5.1% 6.7% Securitized 4.2% 6.2% Residential Mortgage- 4.2% 6.2% WFII Guidance Legend: Backed Securities (MBS) Commercial Mortgage- NA NA Most Favorable Favorable Neutral Backed Securities Unfavorable Most Unfavorable Asset-Backed Securities NA NA Sources: Wells Fargo Investment Institute (WFII), Bloomberg, June 30, 2019. WFII Guidance updated on August 19, 2019. Past performance is no guarantee of future results. See end of report for important risk information, index definitions, and Wells Fargo Investment Institute guidance definitions. Inflation-Linked Fixed Income equates to Treasury Inflation-Protected Securities. Asset classes in blue are tactical recommendations, and specific tactical allocation models can be found in the most recent Asset Allocation Strategy Report. Asset classes in gold represent sector guidance and do not have specific allocations within tactical asset allocation models. YTD = year to date. Investment and Insurance Products: NOT FDIC Insured NO Bank Guarantee MAY Lose Value © 2019 Wells Fargo Investment Institute. All rights reserved. Page 1 of 13 Global Investment Strategy—|—Quarterly Fixed Income Guidance—|—Third Quarter 2019 Tactical Guidance U.S. Taxable Investment-Grade Fixed Income Neutral Our economic growth expectations remain modest, and we have seen a significant dovish Federal Reserve (Fed) pivot year to date. As we currently forecast additional federal funds rate cuts by year-end and do not expect meaningfully higher interest rates, we favor a neutral stance in U.S. Taxable Investment Grade Fixed Income. While we believe that investors’ taxable total-return expectations should be tempered, high-quality fixed income remains an important portfolio diversifier and can provide a portfolio shock absorber during times of market stress. A neutral tactical guidance position can help to better position portfolios should the economic slowdown unexpectedly deepen. Additionally, if rates increase to a level that is near (or above) the midpoint of our year-end 2019 target ranges, we would have the opportunity to add additional exposure to investment-grade (IG) fixed income. U.S. Short Term Taxable Fixed Income Favorable Short-term interest rates (as measured by 2-year Treasury yields) fell during the second quarter as the market continued to price in future Fed interest-rate cuts. Recent Fed guidance has led to a dovish market view of future Fed action. Investing in short-term, fixed-income securities typically offers a lower volatility profile than for longer duration fixed-income instruments, helping to mitigate the potential risk of any unexpected interest-rate increases. We maintain our favorable view of U.S. Short Term Taxable Fixed Income as an attractive alternative to excess holdings of cash alternatives in portfolios. U.S. Intermediate Term Taxable Fixed Income Neutral Modest growth and inflation expectations, along with a dovish Fed, suggest that a neutral view of U.S. Intermediate Term Taxable Fixed Income is appropriate. With the prospect of meaningfully higher long-term rates now unlikely, we look for low- to mid-single-digit 2019 returns for investors in intermediate fixed income. U.S. Long Term Taxable Fixed Income Neutral Modest growth and inflation expectations, along with a dovish Fed, suggest that a neutral view of U.S. Long Term Taxable Fixed Income is appropriate. With the prospect of meaningfully higher long-term rates now unlikely, we look for mid- to upper-single-digit returns for investors in long-term fixed income. Longer-dated, high quality fixed income can be an important portfolio diversifier that has tended to perform well during periods of market stress. Duration Neutral We believe that duration positioning is important for fixed-income investors. Bonds with shorter duration are less sensitive to changes in interest rates (assuming a parallel shift in the yield curve). We hold a neutral duration stance in both taxable and tax-exempt bond sectors. Portfolio Positioning Structure We expect modest global inflation and an uneven global recovery to keep interest rates relatively low overall. In June, interest rates fell across the yield curve, with maturities of one year and less declining the most. This has resulted in portions of the yield curve becoming more inverted (for issues from three months to three years). However, there are other segments of the yield curve that have been steepening (i.e., the yield difference between 10-year and 30-year Treasury securities has increased).We generally expect the Treasury yield curve to remain relatively flat for the foreseeable future, but yield-curve movement may prove to be somewhat volatile as the market grapples with the expected pace of Fed interest-rate cuts and the growth and inflation outlook. Our current analysis suggests that U.S. taxable interest rates could remain at low levels for at least the next six months as uncertainty continues to cloud the market. We believe that investors should consider utilizing multiple positions along the yield curve in the current environment. As noted, we favor a neutral duration position. © 2019 Wells Fargo Investment Institute. All rights reserved. Page 2 of 13 Global Investment Strategy—|—Quarterly Fixed Income Guidance—|—Third Quarter 2019 Credit Quality As we reach the latter stages of the economic cycle, we believe that investors should exercise care in security selection. Lower-rated credits within the IG universe underperformed higher-rated credits by a wide margin late in 2018, but they have had strong year-to-date returns in 2019. Given the price appreciation driven by the recently strong performance of lower-rated taxable bonds, and our position late in the economic cycle, we continue to favor a higher-quality bias, with an emphasis on diligent credit analysis for fixed-income portfolios today. Government Securities Unfavorable The Fed has ended its balance-sheet normalization. This should provide some stability to U.S. government securities. We recommend that investors hold government security allocations for diversification, liquidity, and situations in which investors choose to de-risk portfolios. Government securities may offer a hedge in the event of unexpected geopolitical developments or an economic slowdown and are generally the beneficiary of risk-off market events. Treasury Securities Neutral Despite the substantial yield decline in recent weeks, yields on U.S. Treasury securities still appear relatively attractive versus those in developed sovereign bond markets abroad (but less so when hedging costs are taken into account). Overall, Treasury securities appear fairly valued relative to their risk profile and continue to offer an attractive liquidity profile. Agencies Unfavorable The yield spread offered by agency securities over Treasury yields has tightened (declined) recently. Given the higher liquidity of Treasury issues and the fact that agency securities currently offer only a modest yield pickup versus Treasury securities, we do not see compelling value in agency securities today. Inflation-Linked Fixed Income Neutral Inflation expectations, as measured by the breakeven rate for 10-year Treasury Inflation-Protected Securities (TIPS), have declined steadily since the end of April. We currently view TIPS as fairly valued; however, with breakeven rates that are in line with (or even below) the Consumer Price Index (CPI), TIPS can offer an attractive hedge against unexpected inflation over the medium-to-long term. Investment-Grade Credit Favorable (was neutral) High quality IG credit can allow fixed-income portfolios to generate excess yield through spread premium (also known as “carry”) that is meant to compensate investors for perceived issuer credit risk. We believe that, at times, high-grade corporate debt offers investors better carry and liquidity per unit of risk than can be found in many other credit offerings in the fixed-income markets, such as high-yield debt. We reiterate our bias toward higher quality in the current market. Investment-Grade Corporate Favorable (was neutral) IG corporate securities offer reasonably attractive carry potential in a market segment that offers better liquidity than several other sectors (in our view).