• 2018 has been a negative year so far for many asset classes in dollar terms. Emerging markets (EM) have taken their share of the pain. However, they have broadly outperformed in the fourth quarter, as equity and credit-market falls have been driven from the U.S., and valuations have supported EM assets.
• There may still be surprises in store after a year full of geopolitical and policy risk. Yet if our expectations are correct, and near-term risks subside, 2019 may provide a better environment for EM performance.

• We raised our guidance on EM fixed income from neutral to favorable earlier this year, and since mid-2018, we have upgraded our EM equity guidance from neutral to most favorable. Cheap valuations should provide a useful cushion against ongoing, near-term volatility. Our outlook for economies and the relative policy settings between the U.S. and the rest of the world also suggests more fundamental reasons for EMs to outperform next year.

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Year to date (as of November 30, 2018), 2018 has been a tough year across almost the whole range of asset classes. And yet, it is worth pointing out that the drivers of this broad market decline have not been constant over the course of 2018. Different markets have had their share of pain at different points: U.S. Treasury securities in the first quarter, EM assets over the summer, U.S. equities more recently, and (of course), oil.

Most non-U.S. asset classes are lower in dollar terms, in part, because of the broad-based dollar rally this year. The dollar’s strength has been driven by a number of factors: quarterly Federal Reserve (Fed) rate increases; U.S. fiscal and trade policies (resulting in rising expectations of U.S. growth compared to those of global trading partners); and the sheer range of geopolitical risks and policy uncertainty that has boosted dollar demand from risk-averse accounts.

This narrative of overarching dollar strength needs qualifications (see the chart below). On the basis of the Dollar Index (DXY), developed market (DM) currencies have fallen some 5% versus the dollar in 2018. Yet, almost all of these losses came during the three-month period between April and June; and while DXY has been edging higher lately, the second half of the year may be viewed more as a trading range rather than a sustained dollar rally.

More importantly, the three months since early September have seen a clear decoupling between DM and EM currencies. As the dollar has been edging higher against the euro, yen, and pound, EM currencies appear to have formed a base and are recovering. While it is early days yet, we believe that currencies may be early predictors of turning points in fixed income and equity asset class sentiment—perhaps because of their liquidity and ease of trading for early-moving investors and traders. We think that this decoupling from dollar strength and recovery in EM currencies may be a good sign for performance in the coming year.

Chart 1. Emerging-developed FX decoupling may mean the worst is overSources: Bloomberg, JP Morgan, December 3, 2018. DMFX is represented by the Dollar Index (DXY). EMFX is represented by the JP Morgan Emerging Markets Currency Index (EMCI). Both Indices are rebased to Jan 1 2018 = 100. For illustrative purposes only. JP Morgan Emerging Market (local currency, unhedged) Index tracks debt issued in local currencies by emerging market governments. Index returns do not represent fund performance. U.S. Dollar Index (USDX/DXY) measures the value of the U.S. dollar relative to majority of its most significant trading partners. This index is similar to other trade-weighted indexes, which also use the exchange rates from the same major currencies. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

There are a number of reasons why EM sentiment is looking better in the fourth quarter. The first, and most obvious, reason is that several EM markets plunged dramatically earlier in the year, and the asset class is due for a bounce. To put it another way, valuations have become so attractive that they provide a good cushion against ongoing market volatility as well as still-present geopolitical and policy risks.

To end November, the DXY has risen 5.5%, but the dollar on this basis (around 97.00) is still broadly mid-range between the 103.80 highs and the 88.25 lows of the past four years. On the other hand, the JP Morgan EMCI hit a low of 60.30 back in early September—13.4% lower on the year and 45% lower since the post-financial-crisis high in early 2011. On a trade-weighted and inflation-adjusted basis, most EM currencies now appear on the cheap side of our fair-value tracking models.

Similarly, emerging equities and fixed income appear attractively valued versus alternatives after the big hits seen earlier in the year.¹ On the fixed income front, we upgraded our view on EM sovereign debt (U.S. dollar-denominated) as yields moved above 7%—the highest levels seen since the global financial crisis—and as spreads widened beyond 400 basis points (100 basis points equals 1%) over Treasuries and to extreme levels of near 200 basis points against comparably-rated U.S. high-yield corporate debt.

There are also reasons to believe that EM currencies are pre-empting a better environment for EM assets more generally in 2019. While many risks remain, our macro-economic forecasts suggest that, while the U.S. likely will grow more slowly next year, growth in emerging economies will be sustained. Further stimulus from fiscal easing should be constrained in the U.S.; however, China is already embarking on stimulus measures to ease the economic slowdown and more may be seen in 2019. We expect the Fed to end its current cycle of interest rate rises sometime in 2019. If this scenario comes about then the dollar’s strength against DM currencies also may be set to peak in 2019. Given the cheap valuations and the anticipation of some of the 2018 headwinds reversing, we believe that the fourth-quarter stabilization of many EM exchange rates may be presaging better performance for EM assets in the coming year.

On November 29, we upgraded our view on emerging market (EM) equities from favorable to most favorable.² Financial results for many of the companies in the MSCI Emerging Market Index seem to be on track, and we expect earnings to rise in double digits over the next 12 months. We have also increased our earnings per share (EPS) forecast from today’s actual of $94 to $116 (estimate for December 2019). EM equities valuation is favorably discounted relative to U.S. large cap equities. For example, the MSCI Emerging Market Index forward price-to-earnings (P/E) is trading at a 33% discount to the S&P 500 Index.³

We expect a higher commodity price to positively impact EM companies throughout 2019. In addition, EM governments, including China, India, and South Korea, are providing fiscal and monetary stimulus to fuel growth. External pressures should also ease as we expect the U.S. dollar to weaken somewhat in 2019 and are looking for a mid-teens total return over the next 12 months from EM equities.

According to Bloomberg, investors added money to exchange-traded funds that buy EM stocks and bonds during the last week of November, leading to the largest weekly flow since late January at $2.63 billion and the seventh straight week of inflows. We believe there will be improved market sentiment for buying EM equities as companies in the MSCI Emerging Market Index have recently hit (for the first time since 2011) the EPS, cash flow per share, and dividend per share targets of the average analyst consensus forecasts, which were made 12 months ago.

• Valuations, growth, and economic indicators support our most favorable view of EM equities.
• Signs that sentiment, such as investors flows, have improved are showing in the final quarter of 2018.

There are special risk considerations associated with investment in emerging markets. These countries may have unstable, volatile governments and subject to political unrest which can have serious consequences for their economies and for investors. Currencies issued by emerging market governments may be particularly volatile and will be subject to heightened risks. Please see the end of this report for other risks associated with investing globally.

The yield curve is flattening⁴, and trade and Brexit concerns are on investors’ minds; but when the Fed meets on December 19, we expect the policy statement to focus on the positives, including good growth at target inflation and a low unemployment rate. So when the Fed announces their rate decision next week, we expect that the federal funds rate will be increased by 25 basis points. While a rate hike is all but assured, what fixed income investors are most interested in is how the Federal Open Market Committee (FOMC) views monetary policy going forward.

What to watch

1. The policy statement: We do not expect significant changes to the statement, but investors will be looking to see if the Fed acknowledges that (once again) future rate hikes will become “data dependent.”
2. The “dot plots”: On a quarterly basis, the Fed releases its projection of economic expectations, including the closely watched “dot plot.” The September release indicated that 9 of the 16 members submitting projections expected three or more rate hikes in 2019 with a median rate projection of 3.1%. We do expect that some of the “dots”⁵ will be shifted lower in the December release. The extent of that shift lower will better tell investors if the Fed has significantly altered expectations for rate hikes next year.
3. The press conference: Going forward, Fed Chairman Jerome Powell will hold a press conference after each FOMC meeting. As we approach the end of the rate hike cycle, Fed communication and transparency will become more challenging as the Fed tries to tailor rate policy relative to changes in the incoming data. The press conference gives Powell an opportunity to fine tune the policy message. We recently saw how important this can be when he stated that the federal funds rate was “just below” neutral.

• We expect a rate hike at the December meeting and gradual rate hikes to continue next year. Our current outlook is for three additional rate hikes over the next 12 months.
• We retain a favorable view of short-term fixed income and expect the yield curve to continue flattening. We remain unfavorable on duration, a measure of interest rate sensitivity, and believe that investors should position duration below that of their individually selected benchmarks.

“We can complain because rose bushes have thorns, or we can rejoice because thorn bushes have roses.”
--Abraham Lincoln

What a wild ride it has been for investors recently. These past two months saw the S&P 500 Index drop 10% to its low; oil drop over 30% to its low; and volatility spike considerably across many markets. This type of market turbulence can be alarming but oftentimes can offer opportunities across, and within, asset groups. Today, we will look at opportunities that the recent volatility has exposed within the real assets space.

The chart below illustrates the performance of major asset classes since the market meltdown began. Real assets are in maroon. Notice how real assets occupy both the best and worst performing slots. Lower interest rates, investor fear, the desire for low beta (market sensitivity), tangible assets, and historically consistent cash flows benefited REITs, which outperformed. Global growth concerns and a stronger dollar hurt commodities, while collapsing oil prices also hurt commodities and master limited partnerships (MLPs)—both of which underperformed. Over the next 12 months, we see these short-term developments giving way to longer-term trends of higher interest rates, resilient global growth, a weaker dollar, and higher oil prices.

We believe these performance dislocations and deviating trends provide a good opportunity for real asset investors to align with our guidance: unfavorable view of REITs and favorable views towards commodities and MLPs. In other words, now may be a great time for investors to trim REIT gains, add to commodities, and consider MLPs.

• Recent volatility has offered opportunities for real assets investors to align with our tactical guidance.
• We view REITs as unfavorable and commodities and MLPs as favorable.

Cumulative performance of major asset classes since October’s market volatilitySources: Bloomberg, Wells Fargo Investment Institute. Daily data: October 3, 2018 – December 4, 2018. Index return information is provided for illustrative purposes only. Index returns do not represent investment performance or the results of actual trading nor are they forecasts of expected gains or losses a portfolio might experience or constitute a recommendation to invest in any particular asset class. Index returns reflect general market results, assume the reinvestment of dividends and other distributions, and do not reflect deduction for fees, expenses or taxes applicable to an actual investment. There can be no assurance any asset class will perform in a similar manner in the future. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. Please see the end of this report for the names and definitions of the indices representing each asset class and for the risks associated with them.

Private real estate funds cover sectors where underlying asset values are highly correlated to gross domestic product (GDP) as well as those more correlated to demographic factors. Given the solid appreciation of core properties (generally newer properties with high occupancy rates) in recent years, we are more constructive toward U.S. value-add strategies, particularly multifamily rentals, over the next several years. Value-add and opportunistic strategies acquire generally older properties with lower occupancy rates and improve them. Multifamily rentals benefit from historically low homeownership, declining rental vacancies, and modest new supply. They exhibit defensive characteristics when homeownership becomes less affordable due to higher interest rates or economic slowdowns.

U.S. homeownership rates are on the low end of historical levels as millennials and others increasingly rent. In the third quarter of 2018, homeownership rates (the percentage of residences occupied by owners) were 64.4% nationwide, down from a 69.2% peak in 2004 and below the 25-year mean of 66.2%. Due to limited affordability and growing populations, regional home ownership levels hover even lower: 61.5% in the northeastern U.S. and 60.2% in the western U.S. We believe that opportunities in the value-add, multifamily sector generally have greater upside for net operating income improvement and are more likely to be sold for attractive cap rates.

• Multifamily real estate strategy is expected to continue benefiting from long-term demographic trends.
• Value-add and opportunistic multifamily strategies are well-positioned to capitalize on rising interest rates and any economic slowdowns over the next three to five years.

There are risks particular to investments in real estate securities, including, without limitation, changes in property values or revenues due to oversupply, changes in tax laws and interest rates, environmental issues and declining rents. The value-add strategy seeks to add value by making enhancements to properties. These properties may have operational issues and usually require additional leverage to acquire. There is no guarantee value appreciation will be achieved and the operating company may be forced to sell properties at a lower price than anticipated.

Declining homeownership rates across the U.S.Source: U.S. Census Bureau, downloaded on November 27 and 28, 2018.

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

¹ A summary of EM equity market valuations can be found in the WFII publication, “Why We Upgraded Emerging Market Equities,” published on September 13, 2018.
² WFII Institute Alert, “Changing Our Equity, Real Asset, and Alternatives View,” November 29, 2018.
³ MSCI Emerging Markets Index P/E 10.5 relative to S&P 500 Index P/E 15.6x, as of December 4, 2018.
⁴ When the yield curve flattens, the yield spread between long- and short-term interest rates narrows.
⁵ Each dot represents a member's view on where the fed funds rate should be at the end of the various calendar years as well as the “long run.”

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 and frontier 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, prepayment, extension 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. These bonds are subject to interest rate and credit/default risk. Treasury Inflation-Protected Securities (TIPS) are subject to interest rate risk, especially when real interest rates rise. This may cause the underlying value of the bond to fluctuate more than other fixed income securities. Although free from credit risks, U.S. government securities are subject to interest rate risk. Preferred securities are generally subordinated to bonds or other debt instruments in an issuer's capital structure, subjecting them to a greater risk of non-payment than more senior securities.

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.

Investments in Master Limited Partnerships (MLP) involve certain risks which differ from an investment in the securities of a corporation. MLPs may be sensitive to price changes in oil, natural gas, etc., regulatory risk, and rising interest rates. A change in the current tax law regarding MLPs could result in the MLP being treated as a corporation for federal income tax purposes which would reduce the amount of cash flows distributed by the MLP.

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 suitable 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.

Chart: Page 6

Alerian MLP Index is a composite of the 50 most prominent energy Master Limited Partnerships (MLPs) that provides investors with an unbiased, comprehensive benchmark for this emerging asset class. The index, which is calculated using a float-adjusted, capitalization-weighted methodology, is disseminated real-time on a price-return basis and on a total-return basis.

Commodities (BCOM). Bloomberg Commodity Index is a broadly diversified index comprised of 22 exchange-traded futures on physical commodities and represents 20 commodities weighted to account for economic significance and market liquidity.

Developed Market Ex-U.S. Equities (U.S. dollar)/(Local). MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of 21 developed markets, excluding the U.S. and Canada.

Developed Market Ex-U.S. Fixed Income (Hedged). J.P. Morgan Non-U.S. Global Government Bond Index (Hedged) is an unmanaged market index representative of the total return performance, on a hedged basis, of major non-U.S. bond markets. It is calculated in U.S. dollars.

Emerging Market Equities (U.S. dollar)/(Local). MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of 23 emerging markets.

Emerging Market Fixed Income/Emerging Market Debt (U.S. dollar). J.P. Morgan Emerging Markets Bond Index (EMBI Global) currently covers more than 60 emerging market countries. Included in the EMBI Global are U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.

Frontier Market Equities (U.S. dollar)/(Local). MSCI Frontier Markets Index is a free float-adjusted market capitalization index that is designed to measure equity-market performance of 24 frontier (least developed) markets.

Inflation-Linked Fixed Income/Treasury Inflation-Protected Securities (TIPS). Bloomberg Barclays U.S. TIPS Index consists of Inflation-Protection securities issued by the U.S. Treasury.

International REITs. FTSE EPRA/NAREIT Developed ex-U.S. Index is designed to track the performance of listed real estate companies in developed countries worldwide other than the United States.

Mortgage-Backed Securities (MBS) or Securitized Assets. Bloomberg Barclays U.S. Mortgage Backed Securities (MBS) Index includes agency mortgage backed pass-through securities (both fixed-rate and hybrid Adjustable Rate Mortgages) guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).

Municipal Bonds. Bloomberg Barclays U.S. Municipal Index represents municipal bonds with a minimum credit rating of at least Baa, an outstanding par value of at least $3 million and a remaining maturity of at least one year. The index excludes taxable municipal bonds, bonds with floating rates, derivatives and certificates of participation.

Preferred Stock. ICE Bank of American Merrill Lynch Fixed Rate Preferred TR U.S. Dollar Index measures the performance of fixed rate U.S- dollar-denominated preferred securities issued in the U.S. market.

Public Real Estate. FTSE EPRA/NAREIT Developed Index is designed to track the performance of listed real-estate companies and REITs in developed countries worldwide.

U.S. Agency. Bloomberg Barclays U.S. Agency Index measures the performance of the agency sector of the U.S. government bond market and is comprised of investment-grade, native-currency U.S- dollar-denominated debentures issued by government and government-related agencies, including FNMA. The index includes both callable and non-callable agency securities that are publicly issued by U.S. government agencies, quasi-federal corporations, and corporate and foreign debt guaranteed by the U.S. government.

S&P global infrastructure index is designed to track 75 companies from around the world chosen to represent the listed infrastructure industry while maintaining liquidity and tradability. To create diversified exposure, the index includes 3 distinct infrastructure clusters: energy, transportation, and utilities.

U.S. Aggregate Bond: Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment grade, U.S. dollar denominated, fixed-rate taxable bond market.

U.S. Government Securities. Bloomberg Barclays U.S. Government Bond Index is comprised of the U.S. Treasury and U.S. Agency Indices. The index includes U.S. dollar-denominated, fixed-rate, nominal U.S. Treasury securities and U.S. agency debentures (securities issued by U.S.-government-owned or government-sponsored entities, and debt explicitly guaranteed by the U.S. government). The U.S. Government Index is a component of the U.S. Government/Credit and U.S. Aggregate Indices.

U.S. High Yield: Bloomberg Barclays U.S. Corporate High-Yield Index covers the universe of fixed-rate, non-investment-grade debt.

U.S. Investment Grade Corporate Fixed Income. Bloomberg Barclays U.S. Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers.

U.S. Investment-grade Credit (Credit). Bloomberg Barclays U.S. Credit Index measures the investment grade, U.S.-dollar-denominated, fixed-rate, taxable corporate and government-related bond markets. It is comprised of the U.S. Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supra-nationals and local authorities.

U.S. Large Cap Equities. S&P 500 Index is a capitalization-weighted index calculated on a total return basis with dividends reinvested. The index includes 500 widely held U.S. market industrial, utility, transportation and financial companies.

U.S. Mid Cap Equities. Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe.

U.S. REITs. FTSE NAREIT U.S. All Equity REITs Index is designed to track the performance of REITs representing equity interests in (as opposed to mortgages on) properties. It represents all tax-qualified REITs with more than 50% of total assets in qualifying real estate assets, other than mortgages secured by real property that also meet minimum size and liquidity criteria.

U.S. Small Cap Equities. Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.

U.S. Intermediate Term Taxable Fixed Income. Bloomberg Barclays US Aggregate 5-7 Year Bond Index is composed of the Bloomberg Barclays US Government/Credit Index and the Bloomberg Barclays US Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 5-7 years.

U.S. Long Term Taxable Fixed Income. Bloomberg Barclays US Aggregate 10+ Year Bond Index is composed of the Bloomberg Barclays US Government/Credit Index and the Bloomberg Barclays US Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 10 years or more.

U.S. Short Term Taxable Fixed Income. Bloomberg Barclays US Aggregate 1-3 Year Bond Index is the one to three year component of the Barclays US Aggregate Index, which represents fixed-income securities that are SEC-registered, taxable, dollar-denominated, and investment-grade.

U.S. Treasury. Bloomberg Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury with a remaining maturity of one year or more.

An index is unmanaged and not available for direct investment.