Wells Fargo Securities, Dec 11, 2013. 2014 Economic Outlook, "Finding Balance"

8/13/2019 Wells Fargo Securities, Dec 11, 2013. 2014 Economic Outlook, "Finding Balance"

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Economics Group

Economic OutlookFinding Balance

December ,

Sustained subpar growth, low inflation, and Fed easing underlie our outlook for 2014. A

mixture of positive results for short-run growth have emerged, but also evident are the

lingering long-run problems that cannot be solved by another bout of stimulus. Setting a

more balanced course for fiscal and monetary policy will be key to reducing uncertainty

and hopefully set the stage for improving, sustainable growth in the years ahead.

This report is available on

wellsfargo.com/economicsand on Bloomberg at WFRE


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2014 Economic Outlook WELLS FARGO SECURITIES, LLCDecember 11, 2013 ECONOMICS GROUP

2

Executive Summary

An Economic Balancing Act

Sustained subpar growth, low inflation, Fed easing: repetitive, yes, but these three themes havebeen a useful guideline to the economic outlook for the past three years and underlie our view for2014. Sustained, below-trend economic growth reflects caution on both the part of consumers and

business decision makers over the past few years. For 2014, growth should improve to2.4 percent, with much of the improvement in the private sector. We expect a modest gain inconsumer spending along with stronger investment in business equipment, structures andhousing. In contrast, government spending will remain a drag. The labor market is expected toimprove slightly. We look for monthly gains of 180,000190,000 jobs on average in 2014, along

with a modest decline in the unemployment rate below 7 percent. Meanwhile, inflation is set toremain low and not a source of concern to investors or the Federal Reserve. Our outlook is for a1.6 percent rise in the Feds benchmark inflation indicator in 2014, the PCE deflator, compared toan increase of 1.1 percent in 2013. The expected rate of inflation for 2014 remains below the2 percent Fed benchmark and, therefore, comfortably below any flash point for action from theFederal Reserve.

Although growth remains modest and inflation low, interest rates are very low on many safeinstruments such as short-term Treasury bills and notes. Therefore, investors have sought higher

yields in corporate bonds and emerging market instruments. The benchmark 10-year Treasuryyield likely will rise in 2014 as the Fed takes the first steps toward a more traditional policyenvironment. With the Fed leaving short-term rates alone, we expect a steeper yield curve withthe yield on the 10-year Treasury security breaking the 3 percent barrier. Finally, pretax profitslikely will continue to record modest growth of 5 percent6 percent. These profit gains willsupport improvement in employment and business investment in the domestic economy.

Monetary Policy, Credit Markets and the Interest Rate Outlook

We expect the Fed to gradually reduce its asset purchases as early as March 2014. However, anypolicy change is likely to be small. After tapering talk began in May 2013, the jump in interestrates and weakness in interest rate-sensitive sectors of the economy were lessons that will lead theFed to be cautious before signaling a move next time. We do not expect any increase in the fedfunds rate until the second half of 2015 at the earliest.

The Global OutlookThe global economy will likely grow 3.5 percent in 2014 compared to 3.0 percent in 2013. Mostmajor economies should post stronger growth rates in 2014 than in 2013. China likely will growmore slowly in 2014, but should still record one of the strongest growth rates in the world. Foremerging economies, the implications of less accommodative U.S. monetary policy on economicgrowth, currencies and capital flows have been significant as evidenced by the large and sustaineddecline in currency values for G-20 countries, such as India and Indonesia. Risk assessments ongrowth have risen for emerging markets with subsequent shifts in capital flows globally.

The U.S. Housing Market

The national housing market continues to transition away from a market driven primarily byspeculators and investors to one being driven by the underlying positive fundamentals for bothsingle- and multifamily housing. Employment and credit availability are improving, albeitmodestly, and the pace of the housing recovery varies considerably by region. After several years

of dramatic price swings, home prices are set to moderate as supply adjusts to the economysslower long-term growth trend.

Demographics

Similar to other Western industrial countries, the United States will experience a significantdemographic shift due to the aging of baby boomers. Changing demographics have implicationsfor the pace and financial feasibility of federal entitlement spending including Social Security andMedicare. The upcoming echo-boom generation is showing signs of diverging tendencies fromgenerations before it due to the tight labor market and the preponderance of student loan debt

which will likely weigh on the nations economy in the long term.


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U.S. Outlook

A Rebalancing of Private and Public Spending

In 2014, economic fundamentals will continue to rebalance toward a slightly stronger pace ofeconomic growth. We expect the economy to expand 2.4 percent in 2014, following 1.7 percent

growth in 2013 (Figure 1). More important, the composition of growth will become morebalanced, with a broader base of drivers, which is a divergence from the recent post-recessiontrend. So, what is the key difference in the year ahead? Business investment, along with thecontinued housing market recovery, should help to support stronger headline growth. The onlymajor drag to growth in the outlook comes from government consumption, which is expected tosubtract from GDP growth for the fourth year in a row. Even as growth moves closer to the long-run average, overall GDP will remain below potential, although the somewhat faster pace of GDPgrowth should begin to close the gap between potential and actual GDP. 1

Figure 1 Figure 2

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

Consumer spending will again remain in the 2 percent range in 2014, following a 1.9 percentincrease in 2013 (Figure 2). The story since the end of the recession has been one of demographic

and regional inequality in job and income growth. As such, job growth and consumer spendinghave been primarily concentrated among those with a college education and computer skills,

which are also typically higher-income earners. For the most part, middle-income householdshave seen only modest job and income growth in the wake of the recession.

In the year ahead, we expect employment growth to continue to hover around180,000-190,000 jobs per month, on par with the prior two years, as structural issues continue toplague the labor market (Figure 3). The difference next year is that real disposable income shouldrise 2.6 percent on a year-over-year basis compared to the slight 0.8 percent rise in 2013. Modestinflation pressures combined with the absence of major tax policy changes in 2014 should help tosupport more robust real disposable income growth.

More than five years after the end of the recession, the small business sector continues to struggleas evidenced by the absence of small business optimism; however, the small business sectorshould begin to provide support to job and income growth in 2014.2One key source of funding forsmall businesses that has been missing has been home equity. With the dramatic negative equitysituation in the wake of the housing market crash, new funding has been difficult to procure. Thehome price appreciation experienced over the past year and the continued housing recoveryexpected in 2014 should support a more robust pace of improvement in the small business sector.Other key factors holding back small businesses, however, will likely remain in place, includingincreased healthcare costs and uncertainty around tax policy and regulations.

1Congressional Budget Office. (2013). The Budget and Economic Outlook: Fiscal Years 2013 to 2023.2For further reading, see Vitner, M. (Nov. 21, 2013). Wells Fargo Small Business Confidence Stalls in Q4,which is available upon request.

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2000 2002 2004 2006 2008 2010 2012 2014

U.S. Real GDPBars = CAGR Line = Yr/Yr Percent Change

GDP - CAGR: Q3 @ 3.6%

GDP - Yr/Yr Percent Change: Q3 @ 1.8%

Forecast

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2000 2002 2004 2006 2008 2010 2012 2014

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

PCE - CAGR: Q3 @ 1.4%

PCE - Yr/Yr Percent Change: Q3 @ 1.8%

Forecast

We expect theeconomy to

expand at a2.4 percent pacein 2014.


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Figure 3 Figure 4

Source: U.S. Dept. of Commerce, U.S. Dept. of Labor and Wells Fargo Securities, LLC

In addition to continued job growth in 2014, another factor supporting consumer spending will bethe modest pace of inflation. While inflation will pick up slightly from the low rates of 2013, we

continue to expect inflation to remain tame. Consumer prices will likely rise 1.7 percent for theyear (Figure 4). Producer prices will begin to accelerate toward the end of 2014 as strongerdomestic and global demand increase cost pressures. The personal consumption deflator, theFederal Open Market Committees (FOMC) preferred inflation measure, will slowly increase asthe year progresses, reaching 2.0 percent by the fourth quarter of 2014. With the PCE deflatorhovering below the Feds target range of 2.0 percent for most of the year, it is unlikely thatinflation pressures alone would force the FOMC to reduce the pace of its asset purchases.

The FOMC is not likely to change the pace of asset purchases (known as tapering) until theMarch meeting at the earliest, but long-term rates will likely creep higher ahead of any expectedtapering announcement. Our expectation is that the 10-year Treasury will rise to around3.2 percent by the end of 2014 from its current 2.85 percent. In turn, the conventional mortgagerate will also slowly edge higher from around 4.70 percent in the first quarter of 2014 to 4.90 bythe end of the year. Short-term rates will continue to muddle along at low levels as the first fed

funds rate hike is not expected until the second half of 2015 at the earliest.We expect the housing market recovery to continue in the coming year as residential investmentplays a greater role in supporting headline GDP growth. Home prices will continue to appreciate

but not at the pace observed over the past year. The gradual improvement in the fundamentalsunderlying the housing market should help drive new construction activity higher for the year

We expect housing starts to climb to a 1.1 million-unit pace, in turn, leading to a faster pace oresidential investment. While still coming off a low base, residential investment should contribute0.4 percentage points to headline GDP growth for the year.

Business investment will accelerate from 2013s modest 2.5 percent gain to around 4.4 percent in2014. The faster pace of business investment will be driven by more robust gains innonresidential structures and a modest increase in equipment and software spending. Structureoutlays will continue to see an increase in power and commercial construction, which includeslodging and retail. Growing demand for industrial space should also support further

nonresidential construction activity as the reduced need for retail space is replaced with onlineretail distribution centers and warehouses. Greater investment in equipment, helped byimproving credit and higher profits, will also contribute to a stronger pace of business investmentspending for the year.

Net exports will also play a more dominant role in supporting economic growth in 2014. Weexpect net exports to contribute 0.3 percentage points to overall GDP growth next year. Exportsare expected to grow 6.6 percent, as somewhat stronger global economic growth, along withcontinued support from the domestic shale gas boom, supports the increased pace of export

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2000 2002 2004 2006 2008 2010 2012 2014

Nonfarm EmploymentThousands of Employees, Average Monthly Change

Nonfarm Employment: Q3 @ 167.3K

Forecast

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2000 2002 2004 2006 2008 2010 2012 2014

Consumer Price IndexBars = CAGR Line = Yr/Yr Percent Change

CPI - CAGR: Q3 @ 2.6%

CPI - Yr/Yr Percent Change: Q3 @ 1.6%

Forecast

We expect thehousing market

recovery tocontinue in the

coming year.


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activity. The pace of import growth will also pick up compared to 2013 in lockstep with strongerreal final demand growth in the United States.

The one sector of the economy that will continue to subtract from GDP growth in 2014 isgovernment, specifically federal government spending. We expect overall government spending todecline 0.5 percent for the year (Figure 5). Implicit in our economic outlook for 2014 is a

continuing resolution or series of continuing resolutions that will maintain more or less 2013sspending levels for federal fiscal year 2014 and will include the automatic budget cuts known assequestration. The result will be a continued drag from federal spending throughout 2014, but thedrag will not be as dramatic as observed in 2013. At the state and local level, governments willcontinue to deal with modest revenue growth, but stronger tax collections should help to supportsomewhat higher state and local spending in the coming year. Thus, the higher spending at thestate and local level will help to offset some of the expected drag from federal spending cuts.

Figure 5 Figure 6


Next year will again be characterized by an elevated level of domestic fiscal policy and globaleconomic uncertainty. On the domestic front, ongoing wrangling in Washington on the federal

fiscal year 2014 budget and the need to raise the nations borrowing limit in the months aheadwill increase the risk of disruptions to business investment and consumer spending.3 On theglobal economic front, ongoing issues within the Eurozone and modest growth in emergingmarket economies could pose a risk to domestic manufacturing and export activity. Of these twokey risk factors, the uncertainty around future federal fiscal policy poses the greatest risk toeconomic growth in the year ahead.

Even with the drag from reduced government spending and ongoing political uncertainty, coreaggregate demand, as measured by real private sales, will continue to build momentumthroughout the year. The year ahead should be marked by continued modest consumer spending

but somewhat stronger business investment. These factors will combine to drive growth in realprivate final sales of 2.6 percent in the fourth quarter of 2013 to 3.3 percent by the fourth quarterof 2014 (Figure 6). With core economic activity continuing to build momentum in 2014, theprospect of GDP returning to its historical 3.0 percent rate of growth will become increasinglylikely in the years ahead.

3The suspension of the federal debt ceiling expires on February 7th; however, the Congressional BudgetOffice estimates that the Treasurys extraordinary measures will keep the nation under the borrowinglimit until at least March. See Congressional Budget Office. (Nov. 20, 2013).Federal Debt and theStatutory Limit, November 2013.

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2000 2002 2004 2006 2008 2010 2012 2014

Real Government PurchasesBars = CAGR Line = Yr/Yr Percent Change

Government Purchases-CAGR: Q3 @ 0.4%

Government Purchases-Yr/Yr: Q3 @ -2.7%

Forecast

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2000 2002 2004 2006 2008 2010 2012 2014

Real Private Final Sales to Domestic PurchasersBars = CAGR Line = Yr/Yr Percent Change

Real Priv Fin Sales to Dom. Purch. - CAGR: Q3 @ 2.1%

Real Priv Fin Sales to Dom. Purch. - Yr/Yr Pct Chg: Q3 @ 2.4%

Forecast

Governmentspending willcontinue tosubtract fromGDP growth in

2014.

The year aheadshould be markby continuedmodest consumspending butsomewhatstronger busineinvestment.


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Monetary Policy, Credit Markets and the Interest Rate Outlook

Balancing Growth, Inflation and Unconventional Policy Measures

Three economic fundamentals support our baseline view that any reduction in the FederaReserves large-scale asset purchase program may start as soon as March 2014. First, overalleconomic growth looks unlikely to have strengthened in a significant manner in the fourth

quarter, and it remains below the Feds desired rate of growth for the economy. Conditions areexpected to improve over the course of 2014, however, and fall more in line with the Feds long-run expectations of 2.2 percent2.5 percent growth (Figure 7). This moderate pace of growth has

been the experience of the past four years and, while disappointing, is sustainable.

Second, the unemployment rate has declined from 7.9 percent in January to 7.0 percent inNovember (Figure 8). With the drop in labor force participation helping to lower theunemployment rate, the recent rate of unemployment continues to support the case for monetaryeasing. Yet, job gains have firmed since the start of the Feds most recent round of asset purchasesand have picked up over the past four months. We believe the Fed will wish to see a few additionamonths of sound job improvement before scaling back purchases in light of continued difficulty inlowering the unemployment rate.

Figure 7 Figure 8

Source: U.S. Dept. of Commerce, U.S. Dept. of Labor, FRB and Wells Fargo Securities, LLC

Third, inflation continues to run well below the Feds target; the benchmark inflation rate, thepersonal consumption deflator (PCE deflator), has risen at a 2.0 percent annualized pace over thepast three months and 1.1 percent over the past year (Figure 9). In recent months, oil prices havedeclined, which should support continued modest inflation, even as final demand firms. We lookfor inflation to pick up over 2014, but to remain within the Feds comfort zone at 1.6 percent.

That said, we do not view moderate growth and continued low inflation as reasons enough for theFed to continue to pursue the current pace of quantitative easing. The periods of 19961999 and20032006 should illustrate that extended periods of easy money and suppressed interest ratesare not good for long-term economic growth and financial stability, as evidenced by theexperiences of the 20002001 and 20072009 recessions.

With economic fundamentals approaching a sustainable path, discussions have turned to

monetary policy taking the first step toward normalization through a reduction in the pace ofasset purchases. At this point in the economic and policy cycle, we must remember thatquantitative easing is not standard monetary policy with clearly predictable results. Directpurchases of financial assets, in this case U.S. Treasury and mortgage-backed securities, havealtered asset prices, with returns on the open market lower and reminiscent of the distorted pricesin the period before the Treasury-Fed accord in 1951. Investors will recall that until that accord,Fed purchases of U.S. Treasury assets assisted in lowering the interest expense of federal finance,

but once those purchases ended, investors in debtboth Treasury and municipalexperiencedsignificant capital losses. Moreover, quantitative easing, and now its potential end, sets the tone

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00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Real GDP Growth ForecastFed Central Tendency Forecast vs. Wells Fargo Forecast

Central Tendency Forecast Range

Historical GDP Growth

Wells Fargo Economics Forecast

Q4-over-Q4Percent Change

7.4%

6.8%6.4%

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Unemployment ForecastFed Central Tendency Forecast vs. Wells Fargo Forecast


Historical Unemployment Rate

Wells Fargo Economics Forecast

Q4 Average, FOMC September Forecast

Any reduction inthe Federal

Reserves large-scale assetpurchase

program maystart as soon as

March 2014.


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for asset pricing throughout the global capital markets, as witnessed by the sharp selloff inemerging market currencies and assets during May 2013September 2013. With Fed officialsmere mentioning of tapering setting off tighter financial conditions, the pursuit of tapering willrequire more than just a mechanical turn of the policy dial, but also Volcker-like conviction tofollow-through on the difficult policy decision to take away the punch bowl.

Tapering at the intermediate and long end of the Treasury curve is of course distinct from anactual increase in short-term interest rates through a hike in the federal funds rate. The latestprojections from the FOMC support the view that the first increase in the federal funds rate willlikely occur in the middle of 2015 and will be slow to rise after the initial increase (Figure 10). Wenote, however, the growing possibility that the first increase in the fed funds rate may be delayeduntil 2016, given modest inflation and tougher reductions in the unemployment rate should laborforce participation stabilize.

Figure 9 Figure 10

Source: U.S. Dept. of Commerce, Federal Reserve System and Wells Fargo Securities, LLC

Recently, there has been some discussion that the FOMC may lower the 6.5 percentunemployment rate threshold for action. Our view is that moving the goal posts will reduce the

credibility of Fed policy and create more confusion in credit markets. Instead, decision makerswould be better served if policy had followed its legislative guideline of seeking maximumemployment and avoided a specific numbersuch as the 6.5 percent unemployment rate that issensitive to changes in the labor market itself, such as the participation rate.

Finally, monetary policy operates in the context of regulatory and fiscal policies that can becounterproductive to the FOMCs objectives. Regulatory policy can have a restrictive effect oncredit, while monetary policy is attempting to increase lending. As for fiscal policy, there isneither an agreement on tax and spending priorities nor any serious attempts to reformentitlement spending over the long term. Balance needs to be achieved between monetary,regulatory and fiscal policy for effective decision making by businesses and households. For now,that balance is lacking.

Interest Rates and Credit Markets in the Post-Tapering Environment

Over the past year, the yield curve has shifted upward as markets anticipate the Fed reducingaccommodation and moving closer to a more neutral policy environment (Figure 11). After theFeds decision in September not to reduce asset purchases, intermediate- and long-term interestrates remain higher than before the tapering discussion, including interest rates on mortgage-

backed securities. While the economic impact of the rise in interest rates has been modest, thisexperience will likely prompt the Fed to be more cautious in its rhetoric and its eventual taperingapproach. Corporate bond yields are now above 20042006 levels but down from the peak of the

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PCE Deflator ForecastFed Central Tendency Forecast vs. Wells Fargo Forecast


Historical PCE Deflator

Wells Fargo Economics Forecast Fed Forecast asof September

Q4-over-Q4Percent Change

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

2014 2015 2016 Longer Run

September 2013

There is agrowing

possibility thatthe first increasin the fed fundsrate may bedelayed until

2016.

Balance needs tbe achievedbetweenmonetary,regulatory and

fiscal policy foreffective decisiomaking.


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20082009 period.4Since May, corporate Aaa and Baa debt yields have risen 93 basis points and85 basis points, respectively, suggesting markets have at least partially priced in a Fed move totaper quantitative easing (Figure 12).

In the year ahead, we expect long-term rates to exhibit an upward bias as Fed tapering movesforward. However, the extent of any increase in long-term rates should be modest, givencontinued low inflation and a reduced federal budget deficit. At the short end of the yield curvethe Feds policy of administered rates will keep the funds rate at zero to 25 basis points.Unfortunately, this means that the yields on short-term Treasury bills, and two- and three- yearnotes will be less than the rate of inflation and thereby yield negative real returns, even beforetaxes. Our expectation is for the 10-year yield and benchmark mortgage rates to end 2014 at3.2 percent and 4.9 percent, respectively.

Figure 11 Figure 12

Source: Bloomberg LP, Federal Reserve System and Wells Fargo Securities, LLC

As for credit markets, while easy monetary policy may provide some support to the aggregateeconomy, the current Fed policy is clearly altering asset prices at the sector level. The Fedspurchases of mortgage-backed securities are providing a boost to homeowners, but are a negativeto renters and future homeowners who will now pay higher home prices. Suppressed Treasury

yields have pushed investors into riskier assets, such as equities, high-yield corporate debt andemerging market assets, where returns may not be balanced relative to risks. The allocation ofcredit may, therefore, reflect a distortion of resource allocation and asset pricing. The large selloffin emerging markets in anticipation of the September tapering is a good example of the globalimplications of Fed policy and its possible credit misallocation. As asset purchases continueagainst a firming economic backdrop, the debate over whether the benefits outweigh the costs willintensify pressure to wind down QE.

For investors and business decision makers, the reality is that the current level of Treasuryinterest rates, which serves as a basis for asset pricing, along with pricing of mortgage-backedsecurities, is being distorted. Despite the modest adjustment after September, not all Fed-relateddistortions have been removed and yields on the Treasury curve are still suppressed. Whenmarkets attempt to return to normal, something has to givethe dollar, inflation, real savingscapital flight, interest rates or growth. This will be the price of a suppressed interest rate policy

today as it was in the late 1990s and the first decade of this century.

4For discussion of the incentives and strong private credit financing that have resulted from the lowinterest rate environment, see Silvia, J.E. and Miller, M. (Nov. 1, 2013)Results, Not Rhetoric:Rebuilding the Financial Face of Manufacturing, which is available upon request.

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Yield CurveU.S. Treasuries, Active Issues

December 6, 2013

November 8, 2013

December 6, 2012

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0.2%

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Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13

10-Year vs. 2-YearYield

10-Year Yield: Dec-9 @ 2.85% (Left Axis)

2-Year Yield: Dec-9 @ 0.30% (Right Axis)

9/13/2012: QE 3

5/22/2012:

JEC Testimony

9/18/2013:

FOMC Meeting

We expectlong-term rates

to exhibit anupward bias as

Fed taperingmoves forward.


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the government is attempting to rebalance the economy (less investment spending and moreconsumer spending) to reduce the chance that overinvestment causes the economy to eventuallycrash.

Could China experience a hard landing in the next two years? Possibly, but it is not our base-case view. Financial leverage in the household sector remains low, and the debt-to-GDP ratio of

the central government in Beijing is only 15 percent of GDP. However, leverage in the businesssector, where the debt-to-GDP ratio has mushroomed to 140 percent, is a bit worrisome. We arekeeping a close eye on financial developments in the Chinese business sector.5

Figure 15 Figure 16

Source: IHS Global Insight and Wells Fargo Securities, LLC

Guarded Optimism for Japanese Growth

The economic policies that have been implemented by the Japanese government since PrimeMinister Abe came to power in December 2012, which are commonly referred to as Abenomics,have contributed to stronger economic growth in Japan (Figure 16). 6Despite the slated increasein the consumption tax from 5 percent to 8 percent in April 2014, we project that the recovery willremain intact (after a one-quarter contraction in real GDP in Q2 2014).

We are guardedly optimistic about the Japanese economy over the next two years, but we wouldneed to see progress on the third arrow of Abenomics for us to become more bullish on growthprospects in the longer run. That is, we would need to see more structural reforms to the Japaneseeconomy. The government has proposed some reforms, but it has not executed most of them yetIn our view, structural reforms hold the key to the long-run success of Abenomics.

Developing Economies: Fundamentals Starting to Deteriorate

Due to extensive supply chains, developing Asian economies have benefitted enormously fromintra-regional trade that the economic rise of China has spawned over the past few decades.Economic growth in commodity-producing countries within Latin America has also been pulledalong by Chinas rise. Due to our forecast of slower rates of Chinese real GDP growth, it seemsreasonable that economic growth in developing Asia and Latin America likely will be slower as

well. We forecast that real GDP in developing economies will grow 4.8 percent in 2014 and5.0 percent in 2015 (Figure 17). Although these growth rates are stronger than the 4.7 percent rate

that we project for the current year, they represent a significant downshift from the 7 percent to8 percent rates that characterized the 20042007 period.

5For further reading, see our special report, Bryson, J. H. (Sept. 23, 2013)Does China Have a DebtProblem?, which is available upon request.6For further reading, see our special report, Quinlan, T. (Aug. 22, 2013)Is Abenomics Working?,whichis available upon request.

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Chinese Real GDP ForecastYear-over-Year Percent Change

Year-over-Year Percent Change: Q3 @ 7.8%

Forecast

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Japanese Real GDPBars = Compound Annual Rate Line = Yr/Yr % Change

Compound Annual Growth: Q3 @ 1.9%

Year-over-Year Percent Change: Q3 @ 2.6%

Forecast

We would need tosee progress on

the third arrowof Abenomics for

us to becomemore bullish on

growth prospectsin the longer run.


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Figure 17 Figure 18

Source: International Monetary Fund and Wells Fargo Securities, LLC

As these slower rates of economic growth imply, economic fundamentals in the developing worldare not quite as strong as they were before the global financial crisis. Furthermore, the current

account surpluses that many developing economies were incurring in the years preceding theglobal financial crisis have recently turned to deficits (Figure 18). Although we do not believe thata wave of financial crises in the developing world la 19971998 is imminent, the marginaldeterioration in economic fundamentals among developing economies bears watching in the

years ahead.7

Outlook for the Dollar

With Federal Reserve monetary policy about to turn less accommodative, we look for the U.S.dollar to appreciate modestly vis--visthe euro and the Japanese yen over our forecast horizon,

which is six quarters. Due to economic weakness and benign inflation, ECB monetary policy couldarguably become even more accommodative over the next few quarters. The Bank of Japan willalso continue to expand its balance sheet. With the Bank of England unlikely to ease policyfurther, we look for the greenback to move essentially sideways against the British pound, at least

over the next few quarters.The currencies of some developing economies, especially those with large current account deficits(e.g., Brazil, India, Indonesia and Turkey), could experience some volatility as the Fed begins totaper its security purchases. Although we do not believe the volatility will be as pronounced as it

was during May 2013August 2013some emerging currencies depreciated 10 percent to2o percent against the dollar when Fed officials began to publicly discuss the possibility oftaperingthese currencies could experience some near-term weakness. Further out, however,many of these currencies likely will rebound vis--vis the dollar as market participants solidifytheir expectations about the pace of Fed tightening. If, as we forecast, the global economicexpansion remains intact, investors should become less risk averse, which should be generallysupportive for capital flows to developing economies.

7For further reading see, Bryson, J. H. and Miller, M. (Oct. 28, 2013) Are Developing EconomiesHeading for a Crash?and Bryson, J. H. and Miller, M. (Oct. 30, 2013)Developing Economies and CrisisVulnerability. Both of these special reports are available upon request.

2%

3%

4%

5%

6%

7%

8%

9%

2%

3%

4%

5%

6%

7%

8%

9%

00 02 04 06 08 10 12 14

Developing Economies GDPConstant Prices, Percent Change

GDP Growth: 2012 @ 4.9%

Forecast

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

91 93 95 97 99 01 03 05 07 09 11 13

Developing Economies Current AccountPercent of GDP

All Developing Economies: 2013 @ 0.8%

Excluding MENA and China: 2013 @ -1.9%

(P)

Marginaldeterioration ineconomic

fundamentalsamongdevelopingeconomies bearwatching.


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12

The U.S. Housing Market

The Housing Recovery Is Set to Take Another Small Step Forward

The housing recovery lost its footing around the middle of 2013, as early talk about the Fedbeginning to scale back its monthly security purchases sent mortgage rates higher. While interestrates soon settled down and then partially reversed their run-up, demand has been slow to

recover and price appreciation has moderated. After topping out this summer, sales of existinghomes have been trending lower and recent trends in pending home sales suggest the slowdownhas further to go (Figure 19). New home sales have also stumbled following a huge downwardrevision to sales this past summer (Figure 20). Sales and buyer traffic are still well ahead of theirearlier lows but there is no question that sales have lost momentum. The pace of home priceappreciation, while still up solidly year-over-year, has also started to moderate.

Figure 19 Figure 20

Source: NAR, FHLMC, U.S. Dept. of Commerce, NAHB and Wells Fargo Securities, LLC

While a one percentage point hike from 2013s earlier lows represents a fairly large proportionaincrease in interest rates, mortgage rates are still near historic lows. The sharp reaction to thispast summers rise in mortgage rates raises some serious questions about how much the

fundamentals underlying the housing market have improved. Higher mortgage rates haveexposed at least two potential weak spots in the housing market. The first is that investor demandfor homes has cooled considerably. Second, housing affordability has decreased much moreabruptly than would have been expected this early into the recovery process (Figure 21).

Figure 21 Figure 22

Source: National Association of Realtors and Wells Fargo Securities, LLC

Reduced investor demand for single-family homes is hardly a surprise considering that the supplyof deeply discounted distressed properties has rapidly been depleted, and prices of existing homes

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

2%

3%

4%

5%

6%

7%

8%

9%

10%

94 96 98 00 02 04 06 08 10 12

Existing Home Sales vs. Mortgage RatesSeasonally Adjusted Annual Rate - In Millions

Mortgage Rate: Oct @ 4.19% (Left Axis)

Existing Home Sales: Oct @ 4.5 Million (Right Axis)

0

10

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40

50

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0

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450

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900

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1,500

90 92 94 96 98 00 02 04 06 08 10 12

New Home Sales vs. Wells Fargo NAHB IndexThousands of Units, Index

New Home Sales: Oct @ 444,000 (Left Axis)

Wells Fargo NAHB Index: Nov @ 54.0 (Right Axis)

80

100

120

140

160

180

200

220

80

100

120

140

160

180

200

220

92 94 96 98 00 02 04 06 08 10 12

Housing Affordability, NAR-Home SalesBase = 100

Housing Affordability Index: Sep @ 164.3

6-Month Moving Average: Sep @ 169.6

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

0%

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10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

2009 2010 2011 2012 2013

U.S. Distressed Home SalesPercent of Total Sales

Total Distressed: Oct @ 14.0%

Higher mortgagerates have

exposed at least

two potentialweak spots in thehousing market.


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13

have increased dramatically over the past two years (Figure 22). Besides the supply consideration,rising interest rates also make the yields earned from rental housing relatively less attractive,

which has slowed capital flows into residential real estate. The net result has been a steady declinein the all-cash share of home purchases, the preferred method by investors.

The slide in housing affordability has provided a bigger shock. Affordability had skyrocketed just

a few years ago, as home prices tumbled and mortgage rates fell to modern-era lows. The influx ofinvestors into the single-family market pushed prices up sharply, well ahead of the recovery inemployment and income. When interest rates began to spike in late spring, affordability took a hitand many potential buyers found themselves priced out of the market. The net result is that weare not as far along in the housing recovery as the rebound in prices would, by itself, suggest.

While 2013s reversal in home sales was a setback, the housing recovery was not thrown back tosquare one. Inventories of both new and existing homes remain exceptionally low and homeprices have returned to their historical norms relative to income and rents across most markets.The appraisal process has also normalized and lenders are in a much better position to providecapital to homebuilders, developers and home buyers.

Unfortunately the underlying demand fundamentals have improved less than we had hoped. Thelargest single drag on housing demand has been the sluggish pace of household formations, whichhave averaged just 638,000 over the past four years compared to a long-term norm of around

1.3 million. Population growth remains sufficient to support household growth, but persistentlyweak job and income growth, particularly among younger persons, is causing a large proportionof young people to delay moving out on their own or forming families.

Demographics still remain positive. Over the past 10 years, the nation added around 2.6 millionnew residents annually. While household size has increased since the Great Recession, it shouldgradually return to normal, leading to 1.1 million new households per year. After takingobsolescence into account and adding a cautious estimate of second homes, demand shouldreturn to around 1.55 million units per year. Returning to this level will take time and requirefurther improvement in employment and income growth. The housing market will also need toadjust to tighter credit standards and increased constraints on land development. We see demandreturning incrementally, with housing starts rising 15.8 percent to 1.1 million units in 2014.

Demographics will also help shape the recovery. Homeownership rises with age, with the largestincrease occurring with persons in their late 30s (Figure 23). Some of the largest populationgains, however, are among persons younger and older than this age cohort, which is drivingdemand for apartments and active adult housing (Figure 24). First-time homebuyers and trade-up buyers, however, are still largely missing in action. Many homeowners remain in negative ornear-negative equity position, making it more difficult to sell their existing home and trade up foranother home. Second-home demand will also likely be stunted, even though the number ofpersons age 45 to 54, which is the age of most first-time, second-home buyers, is solidly growing.

Figure 23 Figure 24


0%

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90%

0%

10%

20%

30%

40%

50%

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90%

Less than

25

25-29 30-34 35-44 45-54 55-64 65+

Homeownership Rate by Age GroupPercent

1990

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2010

0

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Population by Age GroupIn Millions

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2010

Unfortunatelythe underlying

demandfundamentalshave improvedless than we hahoped.


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14

Demographics

U.S. Population Booms: Secular Demographic Shift on the Horizon

Thus far, our commentary has been focused on the near-term outlook. However, similar to manyother industrial countries, the United States will experience a significant demographic shift in thecoming decades due to our aging population. The baby-boom generationborn between 1946 and

1964is expected to comprise about 20 percent of the U.S. population in the next two decades. Asa result, the nation will be faced with long-run implications for economic growth and fiscal policyIn fact, the aging of the population along with slower population growth will work to reduce theeconomys potential rate of growth, which could further strain the labor market. 8 Anotherchallenge will likely be excess inventory in the residential market, especially in markets with fewer

job prospects and slow population growth, as many baby boomers transition to more suitableliving arrangements.

At the same time, the children of baby boomers, commonly known as echo boomersbornbetween 1980 to the early 2000swill come of age and will also leave an imprint on the reaeconomy. These young adults are highly educated, technologically savvy and eager to enter the

workforce. However, many of these young adults are faced with a tight labor market andsignificant student loan debt, which may cause them to delay major life decisions.

Baby-Boom Generation: Planning for the Future Today

One of the most pressing issues for policymakers today is how to plan for the looming budgetarypressures in the years to come. The largest effect will be in spending on Social Security andMedicare. Spending on Social Security and Medicare, which are funded on a pay-as-you-go basisis expected to double from its long-run average to almost 14 percent of GDP by 2038.9With thisgeneration projected to live longer than their parents, many are also concerned that low savingcould also lead to slower growth in investment, productivity and wages.10

The demographic shift should continue to put downward pressure on the labor force participationrate. The CBO estimates that demographics alone will account for nearly all of the drop in theparticipation rate between 2007 and 2021.11When the first baby boomers reached the minimumage for receiving Social Security benefits in 2008, there were five working-age adults in theUnited States for each person aged 65 and older. Fast forward 20 years, when most baby boomers

will have retired, the ratio will have fallen from five to three. All else equal, the expected decline in

labor force participation could reduce per capita real GDP and per capita consumption belowwhat these variables would be in the absence of a decline in labor force participation.12

In a speech to the Washington Economics Club, Federal Reserve Chairmen Ben Bernanke notedthat, these [demographic] trends are large and unavoidable and the nation will have to facetough decisions that may include higher taxes, less non-entitlement spending, a reduction inoutlays for entitlement programs, a sharply higher budget deficit, or some combination. 13 Whileall of these options may be a bitter pill for the nation to swallow, the alternative of living withexorbitant national debt is far less favorable.

Excess housing inventory could be an additional obstacle as many baby boomers choose todownsize their home. While there is still a lot of pent-up demand in the housing market, as somehomeowners are still underwater on their mortgage and new home inventories remain at ahistorically low level, younger generations may not share the same preference in housing as baby

boomers including size, amenities and location. This standoff in taste could lead to another bout

of excess supply especially in suburban areas. An Atlantic Cities article, The Great Senior Sell-Off

8Bernanke, B. S. (Nov. 20, 2012). The Economic Recovery and Economic Policy. Speech presented at theNew York Economic Club, New York, NY.9Congressional Budget Office (September 2013). The 2013 Long-Term Budget Outlook.10Elmendorf, D. (Nov. 13, 2013).Presentation on Federal Health Care Spending. Presentation to theUniversity of Pennsylvania Wharton School.11Congressional Budget Office. (March 2011). CBOs Labor Force Projections Through 2021.12Sheiner, L., Sichel, D. and Slifman,L. (2007). A Primer on the Macroeconomic Implications ofPopulation Age. Federal Reserve Boards Finance and Economics Discussion Series.13Bernanke, B. S. (Oct. 4, 2006). The Coming Demographic Transition: Will We Treat FutureGenerations Fairly. Speech presented at the Washington, D.C., Economic Club, Washington, DC.

The United Stateswill experience a

significantdemographic shift

in the comingdecades due to ouraging population.

The demographicshift will continueto put downward

pressure on thelabor force

participation rate.


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15

Could Cause the Next Housing Crisis, examined this looming issue by suggesting that when babyboomers are ready to sell their home, growing markets like Atlanta and Houston will likely haveready and willing buyers (Figure 25).14 However, shrinking and stagnant markets could bechallenged due to slowing demand. While this issue bears watching, the biggest determinant willcontinue to be housing affordability and access to credit, especially for young adults (Figure 26).

Another trend to watch is baby boomers transitioning into senior housing. Even though senioradults may prefer senior housing, solid demand and lack of supply have ratcheted up rent growthin this sector and in many cases have made it unaffordable.

Figure 25 Figure 26

Source: U.S. Dept. of Labor, Federal Reserve System and Wells Fargo Securities, LLC

Echo-Boom Generation: Will Homeownership Be an Option?

Although baby boomers are getting all of the media attention, the generation known as echoboomers is also worthy of discussion. The sheer size of this demographic will also have a long-lasting effect on the real economy. One key sector to consider is the residential market. Over thepast four years, echo boomers have helped fuel a surge in apartment demand, especially inmarkets concentrated in technology, energy and research and development, such as SanFrancisco; Austin, Texas; Boston; Houston and New York. Rent growth in these markets

skyrocketed and in many cases outpaced income growth. Moreover, the large number of youngadults living at home with parents suggests that there is pent-up demand for apartment space asthe prime age for renters (20 to 29 years old) hits this demographic. 15With this younger cohorthaving a higher propensity to rent and the preference for more of a walkable urban surrounding,rental demand should remain robust in the years ahead.

A big question is how many of these young adults will shift to owning a home. Income growth inthis generation is following trends in the greater economy where higher-educated young adults

with readily marketable skills are seeing the most job gains and, therefore, the highest incomegrowth. On the other hand, young adults with skills and majors that are not quickly employableare facing a tough labor market. With many young adults choosing to go back to school andincurring large student loan debt, we suspect that the transition to an owner-occupied homecould take a bit longer than for previous generations.

14Badger, E. (March 5, 2013). The Great Senior Sell-Off Could Cause the Next Housing Crisis. TheAtlantic Cities Magazine.15Fry, R. (Aug. 1, 2013) A Rising Share of Young Adults Live in Their Parents Home. Pew ResearchCenter.

Houston

San Jose

Atlanta

Washington D.C.

Boston

United States

Raleigh

Seattle

San Francisco

Austin

-2%

-1%

0%

1%

2%

3%

4%

-2% -1% 0% 1% 2% 3% 4%

3-MonthAnnualized

PercentChange

Year-over-Year Percent Change

Employment Growth in Growing Markets

3-Month Moving Averages, October 2013

Number of Employees

Greater than 2.5 million

1-2.5 million

Less than 1.0 million

Recovering Expanding

Contracting Decelerating

-80%

-60%

-40%

-20%

0%

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-40%

-20%

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Apr 07 Apr 08 Apr 09 Apr 10 Apr 11 Apr 12 Apr 13

Residential Loan Standards and DemandPrime Mortgages, Net Percent of Banks Reporting Change

Tightening Standards: Q4 @ -8.7%

Reporting Stronger Demand: Q4 @ -7.2%

Over the pastfour years, echoboomers havehelped fuel asurge inapartmentdemand.


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17/18

Economics Group International Economic Forecast W

Source: U.S. Department of Commerce, IHS Global Insight and Wells Fargo Securities, LLC

Wells Fargo International Interest Rate Forecast

(End of Quarter Rates)

3-Month Libor

2013 2013

Q4 Q1 Q2 Q3 Q4 Q1 Q4 Q1 Q2

U.S. 0.25% 0.25% 0.25% 0.30% 0.30% 0.30% 2.85% 3.00% 3.10%

Japan 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.65% 0.70% 0.75%

Euroland1 0.20% 0.15% 0.15% 0.15% 0.20% 0.25% 1.80% 1.90% 2.10%

U.K. 0.50% 0.50% 0.50% 0.50% 0.55% 0.65% 2.85% 2.95% 3.10%

Canada2 1.28% 1.28% 1.28% 1.28% 1.35% 1.50% 2.60% 2.70% 2.80%

Forecast as of: December 11, 2013110-year German Government Bond Yield

23-Month Canada Bankers Acceptances

2014 2015 20

10-Yea

Wells Fargo International Economic Forecast

(Year-over-Year Percent Change)

GDP CPI

2013 2014 2015 2013 2014 20

Global (PPP weights) 3.0% 3.5% 3.8% 4.0% 4.0% 4.Global (Market Exchange Rates) 2.6% 2.9% 3.3% n/a n/a n

Advanced Economies1 1.2% 2.1% 2.6% 1.3% 1.5% 1.

United States 1.7% 2.4% 3.0% 1.5% 1.7% 2.

Eurozone -0.4% 1.3% 1.9% 1.3% 1.1% 1.4

United Kingdom 1.4% 2.4% 2.5% 2.6% 2.1% 2.

Japan 1.8% 1.9% 1.6% 0.3% 1.5% 1.

Korea 2.8% 3.7% 3.5% 1.1% 2.4% 3.

Canada 1.7% 2.1% 2.6% 0.9% 1.5% 2.

Developing Economies1 4.7% 4.8% 5.0% 6.7% 6.4% 6.

China 7.6% 7.3% 7.0% 2.7% 3.0% 3.

India 5.2% 5.5% 5.6% 10.1% 9.2% 8.

Mexico 1.1% 2.1% 3.3% 3.7% 3.5% 3.Brazil 2.3% 2.6% 2.9% 6.2% 5.0% 5.

Russia 1.3% 2.2% 3.2% 6.8% 5.7% 5.

Forecast as of: December 11, 20131Aggregated Using PPP Weights


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Wells Fargo Securities, LLC Economics Group

Diane Schumaker-Krieg Global Head of Research,

Economics & Strategy

--

-- [email protected]

John E. Silvia, Ph.D. Chief Economist -- [email protected]

Mark Vitner Senior Economist -- [email protected]

Jay H. Bryson, Ph.D. Global Economist -- [email protected]

Sam Bullard Senior Economist -- [email protected]

Nick Bennenbroek Currency Strategist -- [email protected]

Eugenio J. Alemn, Ph.D. Senior Economist -- [email protected]

Anika R. Khan Senior Economist -- [email protected]

Azhar Iqbal Econometrician -- [email protected]

Tim Quinlan Economist -- [email protected]

Michael A. Brown Economist -- [email protected]

Sarah Watt House Economist -- [email protected]

Michael T. Wolf Economist -- [email protected]

Sara Silverman Economic Analyst -- [email protected]

Zachary Griffiths Economic Analyst -- [email protected]

Mackenzie Miller Economic Analyst -- [email protected]

Blaire Zachary Economic Analyst -- [email protected]

Peg Gavin Executive Assistant -- [email protected]

Cyndi Burris Senior Admin. Assistant -- [email protected]

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Wells Fargo Securities, Dec 11, 2013. 2014 Economic Outlook, "Finding Balance"

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