Europe at a Turning Point Can the Old World Adapt to New Challenges?

Paul Christopher, CFA Head Global Market Strategist Sean Lynch, CFA Co-Head of Global Equity Strategy

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Recovery Progresses but Problems Persist For a week in September 2016, in Munich and Stockholm, we met with German and Swedish companies, government officials, and analysts. In brief, what we found is that the economic recovery is progressing, but that Europe’s difficult decisions about the future are becoming more pressing. Comments echoed German Chancellor Angela Merkel’s post-Brexit observation that the European Union (EU) had reached a decisive turning point following the UK’s June vote to leave the EU. In our view, along with the Brexit-vote impact, a series of intertwined issues are becoming more urgent for Europe. Eurozone1

Germany

Sweden

U.S.

$34,150

$40,959

$50,050

$56,124

2.0%

1.5%

4.2%

2.6%

0.2%

0.4%

1.1%

1.1%

10.1%

6.1%

6.6%

4.9%

0.3%

0.0%

0.9%

0.7%

19.6%

21.0%

19.6%

15.3%

0.0%

-0.1%

0.2%

1.6%

Large-cap stocks

-8.1%

-2.2%

-0.5%

5.1%

Price/earnings ratio

23.6

23.8

22.9

20.4

Gross Domestic Product Per capita Growth rate Inflation

3

Unemployment

2

Population 10-year change 4 Over age 65 Fixed Income

5

10-year yield Equities

6

Dividend yield

Currency

YTD gain/loss7

4.0%

2.9%

4.1%

2.1%

Euro

Krona

3.4%

1.6%

Yields represent past performance. Past performance is no guarantee of future results. Yields may be lower or higher than that quoted above. Yields will fluctuate as market conditions change. Sources: International Monetary Fund (IMF), Bureau of Labor Statistics, U.S. Census, Eurostat, World Bank, CIA World Factbook, Bloomberg, and Wells Fargo Investment Institute. Inflation and unemployment data are as of August 31, 2016. 1 The Eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. 2 Gross Domestic Product (GDP) refers to total national output. Per capita for 2015 in U.S. dollars. Growth rate for fourth-quarter 2015 year-over-year average. 3 Inflation is measured by 12-month changes in consumer price/indices. 4 10-year annualized population change for all ages. Population data as of Dec. 31, 2015. 5 Eurozone represented by German 10-year Bund; U.S. represented by 10-year U.S. Treasury note. Both are as of Sept. 30, 2016. 6 Eurozone represented by MSCI Europe Index; U.S. represented by S&P 500 Index; price returns shown are year-to-date through Sept. 30, 2016. Please see page 9 for index definitions. 7 Gain/loss shows currency’s 2016 year-to-date change in value vs. the U.S. dollar.

2 Europe at a Turning Point | Can the Old World Adapt to New Challenges?

Gradual Economic Recovery Still Struggling With Debt As in the U.S., consumer spending has led the European economic recovery since 2014 while business spending has lagged. The cost of high corporate debt levels reduces earnings, and executives resist borrowing if they have to further encumber assets or manage higher borrowing costs. Corporate-debt levels might decline if nonviable firms were closed or merged with successful firms. In such cases, the surviving firm could have higher market share and, with healthier finances, could restructure its debt and make room on its balance sheets to assume new liabilities to exploit improving customer demand. The benefits could extend to shareholders and the labor markets. Healthy firms that expand can lower their average costs of production, which should benefit shareholders and create new jobs. Firms that can add new equipment should enjoy more efficient production methods that also boost earnings and should lift wages.

Improving Banking-System Health Is a Key Need Improving the corporate debt picture probably means that banks write off their nonperforming loans. While there is demand for new loans, nonperforming loans siphon off earnings by requiring additional loan-loss provisions. The European Banking Authority reported that, in March 2016, EU nonperforming loans represented 5.7 percent of total loans, more than twice the 2 percent share in the UK, which did not experience the 2011-2012 crisis that afflicted the Eurozone.1 We believe that the most effective policies for reducing nonperforming loans await a political consensus that remains elusive. Court procedures are long, and more timely out-of-court procedures should help the banks and maintain the value of the borrower’s collateral. We also believe that Europe broadly needs stronger distressed-assets markets. Finally, a deposit guarantee system that is backed by the resources of the EU could encourage depositors to leave their money at the banks, even during crises. Nonperforming loans have forced monetary policy makers to adopt unconventional tools to boost lending. Central-bank securities purchases and low-cost lending to banks provide abundant cash, but a drawback of these programs is that low-cost housing has accelerated housing-price inflation in the healthy financial systems. For example, Stockholm and Munich had some of the highest home-price inflation in the world over the past 12 months. A second monetary-policy tool, negative interest rates, attempts to lower borrowing costs but also may force savers to pay banks to hold deposits. As customers withdraw deposits, the deposit base becomes less reliable as a source of funds for bank lending. One large Swedish bank told us they have so far avoided the growing pressure to charge customers to hold deposits. 1

 uropean Banking Authority, EBA Report on the Dynamics and Drivers of Non-Performing Exposures in the E EU Banking Sector, July 2016, Figure 1, page 12.

3 Europe at a Turning Point | Can the Old World Adapt to New Challenges?

First-Time Asylum Seekers Entering the European Union 200,000 2015 2016

Number of persons per month

160,000

120,000

80,000

40,000

0 Jan.

Feb.

Mar.

April.

May

June

July

Aug.

Sept.

Oct.

Nov.

Sources: Eurostat and Wells Fargo Investment Institute, October 10, 2016

The Refugee Crisis Adds Social and Economic Challenges and Opportunities Though the inflow of refugees has eased somewhat this year (see chart above), this is one of the most significant migrations into Europe since World War II. The impact on the national economies in 2016 and 2017 should be concentrated in the humanitarian expenditures to settle the asylum seekers. The short-term resettlement cost ranges widely but has been estimated at between 0.05 percent (for Ireland) and 1.0 percent (Sweden) of economic output. This cost also is rising quickly. Although finding the money is difficult, the extra spending should help support the economic recovery in 2016 and, we expect, into 2017. The new arrivals help to offset Europe’s declining population, but only if they steadily find homes and jobs. From our conversations with officials and analysts in Sweden and Germany, the integration rate into the economy so far is below 10 percent of the asylum seekers this year. This rate seems too slow to offset the national government budget deficit strain or improve national wage growth and productivity. Without a faster integration pace, unemployment levels could rise while wages stagnate.

4 Europe at a Turning Point | Can the Old World Adapt to New Challenges?

Dec.

Keep Risks in Perspective Europe faces significant economic and political hurdles during the next several years, but we would not dismiss the economic recovery peremptorily. The present economic expansion appears to have momentum, and households and businesses are repairing their balance sheets. Labor-market reforms are progressing and, with low interest rates, support consumer spending. Monetary policy has encouraged some loan demand. Fortunately, steady oil prices are easing deflationary risks and the need for even deeper negative interest rates, to the probable benefit of Europe’s banks. The main risk we foresee is the frustration over low wages, slow growth, and the surge in asylum seekers, which has generated new political parties and given new life to others that for decades were regarded as extreme. Arguably, the June Brexit vote is the most notable example of the impact of this frustration. However, we do not expect other countries to jump quickly for similar exit referendums, at least until they can see what separation terms the UK can negotiate with the EU. We could become more concerned about Europe as an investment destination if reforms are delayed long enough to allow anti-euro and anti-business parties to gain strength in upcoming elections: in Italy (December 4, 2016) and France and Germany (both in fall 2017).

Financial-Market Outlook Bonds. We remain underweight developed-market debt outside of the U.S. as many yields are below U.S. Treasury yields and many major European bond yields remain negative. Investment-grade corporate debt yields are slightly higher, but their spreads over yields on German bunds (government bonds) have tightened rapidly since the UK Brexit referendum and remain significantly lower than average spreads over the past year. Since valuations on corporate bonds are no longer cheap, we are watching closely as spreads grind toward the post-2008 low range of 0.90 percent to 1.00 percent. These levels, if achieved, might warrant more caution. An overriding negative factor for all bonds denominated in European currencies is the prospective currency depreciation resulting from the aggressive monetary stimulus discussed above. It is notable that European Central Bank (ECB) policy changes put heavy pressure on Sweden to match policies or face falling export competitiveness as the krona appreciates amid policy divergence. Both currencies have traded in a relatively narrow band since early 2015, but we foresee that further U.S. Federal Reserve rate hikes will produce modest additional euro and krona depreciation. In turn, the prospect for further euro and euro-linked currency weakness also supports our underweight position in developed-market bonds, excluding those in the U.S. Nor do we recommend hedging currency exposure to this broad asset class, which includes developed Pacific Rim markets. We expect that dollar strength against the European currencies may be offset by dollar weakness against the yen. 5

Europe at a Turning Point | Can the Old World Adapt to New Challenges?

Equities. Despite the problems of recent years, we believe that several factors give a more balanced picture of upside and downside risks: An incipient earnings recovery in Germany and Sweden: Corporate earnings in European equity markets have been declining for the past three years, but German and Swedish earnings have moved above 2010 levels. Expectations are for a slight improvement next year, despite the headwind for earnings growth from the banking sector. The problems of nonperforming loans, negative interest rates, and tighter capital requirements should limit loan growth and profitability, at German and Italian banks especially. We heard from a number of German multinational companies that have raised estimates multiple times this year. These companies are in the automotive, industrial manufacturing, and apparel industries. Some of the upward revision can be attributed to management setting a low bar for earnings coming into this year, but a slight German earnings improvement seems to have occurred, especially in the auto and machinery sectors. We also believe that German personalconsumption growth may come more into focus in the coming months and broaden the gains in earnings. For its part, Sweden did not suffer the Eurozone financial crisis of 2012 and enjoys strong construction and export industry growth—thanks to the cheapened krona. European equity valuations remain attractive, in both relative and absolute terms: The region’s stocks continue to look attractive relative to their fixed-income counterparts, many of whose sovereign yields are negative. At 3.64 percent (see chart on page 7), the dividend yield on the MSCI Europe Index is compelling, not only vs. sovereign bonds but also compared to equities in other parts of the world. In an absolute sense, the current forward price/earnings (P/E) multiple on European equities is at 16.2 times earnings and looks attractive compared to history (see chart on page 8). In fact, some of our analyses show that European P/E ratios have not been this reasonable in a decade, particularly relative to those in the U.S. With not much risk to valuation compression, even if share prices may remain in a fairly stable range with slow earnings, total returns are enhanced by the aboveaverage dividend yields in the region. Constructive themes are emerging: Valuation cycles are usually measured in years, not months or quarters; this is one of the worries about being too early to pull the trigger on Europe. However, meeting with companies and other investors gave us insights into major themes for this region. The first centered around autonomous driving and its impact on German auto manufacturers. We heard one auto executive describe it as waiting for the ketchup to come out of the bottle: It’s coming, but you just don’t know how much or how fast. The second theme is the digital factory that we hear the large industrial conglomerates discuss. They are looking for efficiencies but also new avenues for growth, and software and technology are the industrial tools of this decade. We would expect major changes in these areas by the year 2020. 6 Europe at a Turning Point | Can the Old World Adapt to New Challenges?

Yield Comparison of Selected Investments 5% 4%

Percent per year

3%

2% 1%

0% -1% German Bund Yield

U.S. 10-Year Treasury Yield

S&P 500 Index

MSCI Germany Index

MSCI Sweden Index

MSCI Europe Index

MSCI France Index

MSCI Italy Index

Sources: Wells Fargo Investment Institute, Oct. 10, 2016 An index is unmanaged and unavailable for direct investment. Please see page 9 for index definitions.

Investors may want to see fundamentals improve before committing more capital to European equity markets, but a “wait and see” approach may miss significant gains if earnings improve only slightly. Europe could become an opportunity, or at least be an interesting value play, if negative sentiment dismisses the improving fundamentals. However, we would wait until the banking sector stabilizes. This is a large sector in Europe and will need to show some growth if the economy is to gain steam.

Investment Conclusions Europe faces a number of challenges, some of which are intertwined. Nevertheless, we recommend a balanced view. Despite the political challenges, Europe’s cyclical economic recovery appears steady, is supported by monetary policy, and should enjoy normalizing inflation now that oil prices are steadying.

7 Europe at a Turning Point | Can the Old World Adapt to New Challenges?

European Equity Price/Earnings and Earnings per Share 17

8

16 7

15

P/E Ratio

13 12

6

5

Earnings per Share

Estimated Earnings per Share for 2017

14

11 10

4 Forward P/E Ratio Earnings per Share

9 8 2010

3 2011

2012

2013

2014

2015

2016

2017

Sources: Bloomberg (including the 2017 earnings forecast) and Wells Fargo Investment Institute, October 3, 2016. Valuation and earnings data are that of the MSCI Europe Index. An index is unmanaged and unavailable for direct investment. Please see page 9 for index definitions.

Our Investment Takeaways • In the fixed income markets, negative yields make sovereign bonds unfavorable. Corporate bonds take some additional support from the ECB’s bond-buying program. However, on balance, the prospect for further currency depreciation creates an unfavorable outlook for European bonds. • For equities, we expect slight 2017 European earnings improvement. Meanwhile, persistent negative sentiment seems to ignore the improving fundamentals and the basic support of aggressive monetary stimulus. • We remain neutral on the broad European equity market. Widespread improvement probably awaits a steadying in the banking sector, a large sector that will need to show some growth if the economy is to gain steam. • We recommend that investors remain selective and look for promising themes between now and 2020. Autonomous driving should favor auto manufacturers, especially in Germany. The second theme is the positive trends toward digital factories among large industrials.

8 Europe at a Turning Point | Can the Old World Adapt to New Challenges?

Risk Information All investing involves risks including the possible loss of principal. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities. Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets. Investing in fixed income securities is subject to interest rate, issuer, credit, inflation and liquidity risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond's price. In addition to the risks associated with investing in international and emerging markets, sovereign debt involves the risk that the issuing entity may not be able or willing to repay principal and/or interest when due in accordance with the terms of the debt agreement.

Index Definitions An index is unmanaged and not available for direct investment. MSCI Germany: The MSCI Germany Index is designed to measure the performance of the large and mid-cap segments of the German market. With 57constituents, the index covers about 85% of the equity universe in Germany. MSCI Sweden: The MSCI Sweden Index is designed to measure the performance of the large and mid-cap segments of the Swedish market. With 30 constituents, the index covers about 85% of the equity universe in Sweden. MSCI Europe: The MSCI Europe Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the developed markets in Europe. MSCI France: The MSCI France Index is designed to measure the performance of the large and mid-cap segments of the French market. With 74 constituents, the index covers about 85% of the equity universe in France. MSCI Italy: The MSCI Italy Index is designed to measure the performance of the large and mid-cap segments of the Italian market. With 24 constituents, the index covers about 85% of the equity universe in Italy. 10-year German Bunds: Yield on government bonds issued by the Federal Republic of Germany located in central Europe. U.S. 10-year yield: Yield on 10-year government bonds issued by the United States Department of the Treasury. S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. stock market. The Index is unmanaged and not available for direct investment.

9 Europe at a Turning Point | Can the Old World Adapt to New Challenges?

About the Authors Paul Christopher, CFA Head Global Market Strategist, Wells Fargo Investment Institute Mr. Christopher focuses on the global economic outlook and currency trends, and guides the investment strategy process. He is frequently quoted in the national media, including The Wall Street Journal, The New York Times, Forbes, Time, Investor’s Business Daily, USA Today, Bloomberg News, ABC News, NBC News, and CNBC. Prior to joining Wells Fargo, he developed economic strategies to trade in global financial and commodity futures markets for Eclipse Capital Management. In previous positions, Mr. Christopher supplied international economic perspectives for Wells Fargo predecessor A.G. Edwards, and advised institutional clients of Istanbul-based Global Securities on the oil-based economies of the Caucasus and Central Asia. He has consulted with the governments of Hong Kong, Egypt, Russia, Kazakhstan, and the Kyrgyz Republic on monetary policy issues. He is based in St. Louis, Missouri.

Sean Lynch, CFA Co-Head of Global Equity Strategy, Wells Fargo Investment Institute In his current role, Mr. Lynch is responsible for developing global equity strategy and oversees proprietary equity strategies as well as the equity trading desk. He has represented Wells Fargo to the media on numerous occasions, providing insights and perspectives on the global markets. He has also written extensively about global issues and the implications on client portfolios, appearing in Bloomberg, The Wall Street Journal, USA Today, Money, and on CNBC. Mr. Lynch has been with Wells Fargo for 17 years. Prior to his current role, he served as a global investment strategist for Wells Fargo Private Bank. He has traveled extensively internationally – from Asia to South America to Europe – to gather firsthand knowledge and information, and has shared his observations and perspectives with clients and team members. He has been in the investment management and trust industry for 24 years. Mr. Lynch is located in Omaha, Nebraska.

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