Investment Strategy

Diversified Banks: Sentiment weakness, core strength

The Financials sector has performed well since we upgraded it to favorable on July 19, 2024. Since then, the S&P 500 Financials Sector Index has delivered a 26.6% total return (16.9% annualized), trailing the S&P 500 Index by just 1.5%.¹ Yet the strength beneath the surface has been uneven, with only four of the sector’s 12 sub‑industries — Diversified Banks, Regional Banks, Consumer Finance, and Investment Banking & Brokerage — outperforming the broader index. Much of this leadership reflects key themes from 2025: a rebound in capital‑markets activities, including stronger equity and debt underwriting and robust trading activity; a steepening yield curve that improved the earnings outlook for most lenders; a broadly resilient credit environment; and rising confidence that the regulatory backdrop could ease rather than tighten. However, perceived regulatory and policy tailwinds in 2025 have shifted to headwinds in 2026, leading to notable underperformance to begin the year.

Chart 1. Sub-sectors heavily exposed to lending and capital markets have outperformedSources: FactSet and Wells Fargo Investment Institute. Data from July 19, 2024, through January 27, 2026. Past performance is no guarantee of future results.

The recent weakness in the Financials sector, and the Diversified Banks sub-industry, is tied to news of a potential one‑year 10% cap on credit‑card interest rates and revived political support for the Credit Card Competition Act. To our way of thinking, the pullback appears more like a shift in sentiment than a shift in fundamentals. Neither initiative has a clear or likely path to implementation at this stage. While neither proposal appears likely to advance, the introduction of new policy ideas adds an unwelcome layer of uncertainty to our favorable view of Diversified Banks. The issue is less about the probability of passage of the aforementioned policies and more about the potential for additional consumer‑finance measures to be floated, which complicates visibility and increases risks, weighing on sentiment. As a result, valuations may be slower to re‑rate even as the underlying fundamental backdrop continues to strengthen. We heard from large-cap bank management teams over the past few weeks during their quarterly earnings calls; they expressed the following regarding fundamentals for 2026:

• Net interest income (NII): Firms expect low‑ to mid‑single‑digit NII growth as loan volumes and card activity remain healthy. Growth should be supported by continued fixed‑rate asset repricing and steady commercial and consumer loan demand.
• Equity and fixed‑income underwriting: Underwriting pipelines entering 2026 are the strongest in years, reflecting healthier advisory activity and a more open equity calendar. Management teams expect deal flow to improve further as corporate financing needs rise and capital markets sustain momentum.
• Trading: After record 2025 performance, trading is expected to normalize at healthy levels, supported by steady client flows and a more stable rate environment. Firms anticipate continued demand across macro and equities products, aided by rising institutional activity.
• Wealth management: Wealth management remains a stable earnings engine, with strong margins and record client engagement across firms. Growth in 2026 is expected to benefit from improving market valuations and a rotation from cash into advisory and investing solutions as short-term rates continue to fall.
• Credit: Credit normalization is continuing, with higher but manageable loss rates expected across consumer cards and select commercial portfolios. Despite pockets of stress in commercial real estate, overall consumer health and repayment trends remain broadly stable.
• Expenses: Expense growth is projected to continue as firms invest in technology, AI, and modernization initiatives. Most management teams still expect operating leverage, supported by efficiency improvements and automation.

The sell‑off in Diversified Banks linked to recent policy headlines creates a potential buying opportunity, in our view. These firms draw earnings from a wide range of businesses: lending, trading, underwriting, advisory, payments, and wealth management. That diversification, coupled with strong capital positions and underwriting standards, should help absorb card‑related policy uncertainty. Additionally, the cyclical and structural tailwinds supporting the sector, including a steeper yield curve, strong capital markets, resilient credit, and disciplined cost management, remain intact. Taken together, the underlying investment case for the Diversified Banks sub-sector entering 2026 appears to be stronger than the noise surrounding it. Recent proposals look more like headline risks than foundational cracks, offering long‑term investors an appealing entry point into a sub-sector positioned to benefit from both cyclical momentum and fundamental strength.

¹ Performance through January 27, 2026.

New York City: Headwinds and guardrails

We remain largely credit‑neutral on New York City. In our view, recent political developments represent incremental headwinds but are constrained by institutional guardrails. Budgetary outcomes require agreement among the mayor, city council, and New York State, historically limiting abrupt fiscal shifts.

That said, for several years we have believed New York City is vulnerable to rating agency downgrades, reflecting structural credit challenges that are not fully captured by current AA‑level ratings. Key headwinds include the wind‑down of federal stimulus, a narrow balance sheet, ongoing intergovernmental funding risk, and high revenue volatility driven by concentration among top earners and exposure to capital markets. Federal aid declines from roughly 8% of operating receipts in fiscal year 2025 to approximately 6% in fiscal year 2026, increasing pressure on locally generated revenues. Commercial office values have stabilized better than feared but remain a longer‑term risk, particularly for lower‑quality assets.

Policy proposals under the new administration introduce potential medium‑term budget pressure, most notably the phased expansion of free childcare. While the state has committed to funding the first two years, longer‑term cost sharing remains unclear and could become a modest credit headwind if shifted to the city. Proposed tax increases face meaningful state‑level approval hurdles, reinforcing governance guardrails.

Despite these pressures, we expect New York City to maintain its investment‑grade rating, supported by its economic scale, market liquidity, and strong market demand for double‑ and triple‑tax‑exempt bonds. We continue to favor diversification and remain constructive on essential‑service revenue credits, including water and sewer.

For more detailed analysis, see our January 15 report, Municipal Sector Insights, “New York City: Guardrails versus headwinds.”

Table 1. Guardrails to abrupt New York City policy changes

Tax type or program change	NY City Control	NY State Control
Property tax	Can set rates within state framework; administer assessments	Sets overall structure and limits
Other taxes (e.g. personal income tax, sales tax, corporate tax)	Cannot change rates or brackets	Must approve any changes
New taxes	Cannot create without state approval	Must authorize
Local fees and fines	City control (parking, permits, service charges)	N/A
Free busing	MTA Board decision (City appoints 4 of the 23 MTA Board members)	State law; state appoints majority of MTA Board
Free childcare		State has agreed to fund first two years

Source: Moody’s Investors Service “Strong fiscal governance structure will be tested by new mayor's mandate to address high cost of living” November 5, 2025.

Technology meets geology in the oil patch

As U.S. shale oil production growth is maturing, the industry continues to evolve and is becoming more efficient. Drilling rigs and fracking fleets are becoming more sophisticated, aided by technological advancements, including the use of AI to aid exploration activities and optimize production operations.

Improved production efficiency is evident in U.S. rig count trends as shown in Chart 2, as U.S. oil production reached new highs in 2025 while the rig count has continued to decline. A few of the production strategies employed at large by the industry include drilling longer laterals (the distance a well is drilled underground); simultaneous fracking techniques; optimizing well pad design and spacing; utilizing high-performance equipment; and using more advanced materials and chemicals in the process.

It is important to remember that shale drilling is still a relatively new concept in the history of U.S. oil production, which leads us to believe that there is potentially a long runway for further evolution of the industry. While we acknowledge that the depth and quality of oil and gas reserves are a legitimate long-term concern for shale producers, we believe that there is the potential for further advancements to offset some of the geological challenges and improve the production economics of lower quality inventory. On recent earnings calls, a couple of large oil services firms reported upside to quarterly results driven by demand for high-tech solutions as operators remain focused on achieving further gains in efficiency.

Chart 2. U.S. shale oil drilling has become more efficientSources: EIA, Baker Hughes, and Wells Fargo Investment Institute. Data as of January 24, 2026.

Direct Lending stress has been contained despite headlines

Recent headlines suggest mounting systemic risk in Private Credit — Direct Lending. While isolated pockets of stress are emerging, primarily among lower-quality borrowers, there is little evidence of widespread credit deterioration to date.

Although Direct Lending sub-strategies were not directly impaired by the rise in interest rates in recent years, the predominantly floating-rate nature of these loans has increased borrowers’ interest expense as rates reset higher. Most borrowers — typically small- to mid-sized businesses — have been able to navigate this higher rate environment with limited disruption (see Chart 3). Pressure has been more pronounced among over-leveraged businesses with limited pricing power, many of which have been relying on an economic rebound or lower interest rates to ease financial strain.

So far, we believe the data suggests that credit conditions remain manageable. Nonaccrual loans, generally defined as those more than 90 days past due, remain within historical ranges. As illustrated in the chart from data provider Cliffwater (see Chart 3 ), nonaccrual levels measured at cost and fair value are well below the peaks observed in 2010 and 2020. In addition, the implied recovery rate — calculated as the fair value of nonaccrual loans relative to cost — has remained near 50% in recent quarters, suggesting meaningful recovery potential even in default scenarios.

We remain vigilant in monitoring the asset class for signs of rising stress. That said, a modest increase in defaults from today’s levels would likely be offset by the yields generated from these loans. Overall, Private Debt — Direct Lending has historically provided an attractive source of income and a smoother return profile than comparable public-market exposures.² We believe it can offer long-term, qualified investors meaningful diversification benefits, though risks could increase if economic conditions weaken or inflationary pressures delay further relief in debt-service costs.

Chart 3. Direct Lending nonaccruals (defaults) and recovery rates modest compared to historical rangesSources: CDLI and Wells Fargo Investment Institute. Data through September 30, 2025.

Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not appropriate for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.

² Cliffwater Direct Lending Index (CDLI) performance versus comparable public-market indexes including the Bloomberg U.S. Corporate High Yield Bond Index and the Morningstar LSTA U.S. Leveraged Loan Index.

Cash Alternatives and Fixed Income

Equities

Real Assets

Alternative Investments**

Source: Wells Fargo Investment Institute, February 2, 2026. Please see Wells Fargo Investment Institute's Asset Allocation Strategy Report for more detailed, investable ideas in each asset group.

*Tactical horizon is 6-18 months

**Alternative investments are not appropriate for all investors. They are speculative and involve a high degree of risk that is appropriate only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. Please see end of report for important definitions and disclosures.

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Sector investing can be more volatile than investments that are broadly diversified over numerous sectors of the economy and will increase a portfolio’s vulnerability to any single economic, political, or regulatory development affecting the sector. This can result in greater price volatility. The Energy sector may be adversely affected by changes in worldwide energy prices, exploration, production spending, government regulation, and changes in exchange rates, depletion of natural resources, and risks that arise from extreme weather conditions. Investing in the Financial services companies will subject an investment to adverse economic or regulatory occurrences affecting the sector.

Floating rate loans are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, borrower industry concentration, and limited liquidity.

Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is appropriate only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.

Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.

An index is unmanaged and not available for direct investment.

Bloomberg USD High Yield Corporate Bond Index is a rules-based, market-value weighted index engineered to measure publicly issued non-investment grade USD fixed-rate, taxable, corporate bonds. To be included in the index a security must have a minimum par amount of 250mm.

Cliffwater Direct Lending Index: The CDLI seeks to measure the unlevered, gross of fees performance of U.S. middle-market corporate loans, as represented by the underlying assets of Business Development Companies (BDCs), including both exchange-traded and unlisted BDCs, subject to certain eligibility requirements. The CDLI is an asset-weighted index that is calculated on a quarterly basis using financial statements and other information contained in the U.S. Securities and Exchange Commission (SEC) filings of all eligible BDCs. Cliffwater believes that the CDLI is representative of the direct lending asset class. The index was launched on September 30, 2015, and was reconstructed using publicly available data dating back to 2004. The index encompasses approximately 17,000 loans and $425 billion in assets as of December 31, 2024.

Non-accruals at cost value: Represents the outstanding principal balance of the loans that have stopped interest recognition, typically those loans 90 or more days delinquent, divided by the original cost value of the loan (par).

Non-accruals at fair value: Represents the outstanding principal balance of the loans that have stopped interest recognition, typically those loans 90 or more days delinquent, divided by the fair (or appraised) value of the loan (par).

Implied recovery rate: Calculated as the fair value of non-accrual loans relative to cost and attempts to estimate the recoverable value potential in default scenarios.

Non-accrual status: For public BDCs and aligns with Generally Accepted Accounting Principles and FDIC regulatory guidance. Non-accrual status means a loan no longer earns interest due to doubt about collecting principal or interest. A loan generally enters non-accrual when it is 90 days past due, the borrower’s condition has deteriorated enough to question full repayment, or it is placed on a cash-basis due to repayment concerns.

Morningstar LSTA U.S. Leveraged Loan Index is designed to deliver comprehensive, precise coverage of the US leveraged loan market.

S&P 500 Investment Banking & Brokerage Sub-Index is a subset of the S&P Composite 1500® Index (which includes the S&P 500, MidCap 400, and SmallCap 600) that tracks firms classified under the GICS® (Global Industry Classification Standard) investment banking and brokerage sub-industry. It measures the performance of U.S. companies providing financial services such as advisory, underwriting, and securities brokerage.

S&P 1500 Index is a market capitalization-weighted index that is based on the S&P 500, S&P MidCap 400 and the S&P SmallCap 600 Indices and represents approximately 90% of the entire U.S. equity market. 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. S&P MidCap 400 Index is a capitalization-weighted index measuring the performance of the mid-range sector of the U.S. stock market, and represents approximately 7% of the total market value of U.S. equities. S&P SmallCap 600 Index consists of 600 domestic stocks chosen for market size, liquidity (bid-asked spread, ownership, share turnover and number of no trade days) and industry group representation. It is a market value-weighted index (stock price times the number of shares outstanding), with each stock’s weight in the index proportionate to its market value.

S&P 500 Diversified Banks Index focuses on the performance of banks classified as “Diversified Banks” within the broader S&P 500 Index.

S&P 500 Financials Index comprises those companies included in the S&P 500 that are classified as members of the GICS® financials sector.

Bond rating firms, such as Moody’s, Standard & Poor's and Fitch, use different designations consisting of upper- and lower-case letters 'A' and 'B' to identify a bond's credit quality rating. 'AAA' and 'AA' (high credit quality) and 'A' and 'BBB' (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ('BB', 'B', 'CCC', etc.) are considered low credit quality, and are commonly referred to as "junk bonds". Not-Rated securities are securities that have not received a credit rating from one or more of the major credit rating agencies. These securities can present significant liquidity disadvantages to investors.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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