CIO Monthly Letter. Teaming up to perform

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1 Chief Investment Office WM 26 June 2014 Teaming up to perform Mark Haefele Global Chief Investment Officer Wealth Management Tactically, we are overweight US and Eurozone equities, and US high yield and investment grade credit. However, we reduce the size of our overweight position in US high yield, and cut emerging market USD-denominated sovereign bonds to underweight, after strong performance in both segments year-to-date. As we approach the year s halftime whistle, the year has not been without its shocks. But what has actually surprised us most is the relative lack of surprises. We caution that the market calm does not lure investors into taking more risk than they can bear. Focus on a long-term strategic asset allocation with a tolerable level of risk is key. It is my honor to succeed my good friend Alex Friedman as Global CIO. Alex and I have invested together in one form or another for the past 20 years. My investment team and I have been involved in the CIO Monthly Letter since the beginning. So while you and I may not have been formally introduced, we already know each other. No level of involvement in formulating our UBS CIO House View can compare to having the privilege and responsibility of signing my name below. As we navigate the changing investment world together, I am certain of at least one thing: A healthy and open dialogue with you, our valued clients and partners, is a critical part of our transparent global investment process. More than 15 years ago, I wrote my first letter to partners who had entrusted me with their capital. I believed then and I believe now that the partner letter is one of the most important elements of a solid investment process. While not all our calls will be correct, we hope to maintain your trust and become better investors by clearly explaining our investment positions and inviting your feedback. Living in Europe during the football World Cup provides me plenty of free kicks to shoot for analogies, but more on these later. A surprising first half? CIO cannot pretend that it has got everything right this year. We did not forecast the so-called polar vortex, which sent US winter temperatures plummeting and brought economic output in much of the country to a near-standstill. Output contracted by 2.9% (annualized) in the first quarter. Growth will return in the second quarter, but some of this year s growth is simply lost. American consumers might buy a car in April if it was too cold in February, but they are unlikely to go to two restaurants in the springtime to make up for a foregone winter meal. We now forecast 2014 growth of 2.5%, from 3.0% at the start of the year. China s growth has also disappointed. The property market has proved weaker than we anticipated. Prices are declining month over month in 35 of China s 70 largest cities; this is ab This report has been prepared by UBS AG. Please see important disclaimers and disclosures at the end of the document. Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication.

2 > > Growth in the US and China is likely to be lower than we intially expected. also the first month over month decline of the overall price index since May This is weighing on property investment and construction, and exports have failed to compensate. We now forecast 2014 GDP growth of 7.3%, down from 7.7% at the beginning of January. Eurozone growth, which we peg at 1.1% for the year, has broadly matched our expectations. But inflation has declined persistently, and the European Central Bank (ECB) was forced to cut its deposit rate into negative territory, a measure we were positioned for but hadn t expected the ECB to take. > > The rally in high grade bonds, and the intra-sector shift in equities surprised us. With respect to our investment recommendations, the rally in high grade bonds surprised us, and the intra-sector shift within equities in March and April was unhelpful for some of our thematic ideas. Equity long-short hedge fund managers, a segment we have been recommending within alternatives, were also not able to distinguish in the first half environment. Overall, however, as we approach the year s halftime whistle, what has actually surprised us most is the relative lack of surprises. > > What has actually surprised us most is the relative lack of surprises. Our global economic recovery thesis remains intact. Growth is on course to be 3.0%, with consensus forecasts in a very tight range. We have been right to overweight risky assets: global equities are up 6.4%, with 30-day realized market volatility now at its lowest level since 1996 (see Figure 1). Credit spreads have contracted, the euro has (finally!) begun to depreciate against the US dollar, and Brazil, our World Cup pick, topped its group. Keeping the game within reach Considering the recent past, when financial crises in the US and Eurozone threatened to upend the entire global economic order, one might be forgiven for savoring a world of few surprises. But in future an unsurprising world is likely to make many investors feel like returns are uninspiring, particularly in light of the strong performance of financial assets over recent years. From here we expect equity markets to deliver 7 8% p.a., high yield credit 4 5% p.a., and high grade bonds 0 3% p.a. (see Figure 2). > > A desire for higher returns should not lure investors into taking more risk than they can bear. In this environment, finding extra return is more crucial than ever. To help meet this need, CIO will strive to deliver clearly explained, strong-performing investment ideas. But a desire for higher returns than the market can offer should not lure investors into taking more risk than they can bear. Risks that appear bearable in an unsurprising world may become unbearable later. This is why, throughout the economic cycle, we still advise clients to hold well-diversified portfolios suitable for their risk tolerance. When we do see investors overreaching for returns, there are three common pitfalls we want to help you avoid: 1) leaving little margin for unexpected events; 2) not diversifying properly; and 3) taking on excess leverage. Investors must always allow for the unexpected. This year s World Cup is a front-of-mind example. Heading into the tournament, bookmakers priced an 85% chance that Spain, the reigning world and European champions and the No.1-ranked team globally, would qualify for the knockout round. We also expected them to qualify, but of course they didn t. Fig. 1: Realized 30-day volatility is at its lowest level since 1996 MSCI World 30-day volatility (%, annualized) 40 > > Equity markets are at their least volatile level since Source: Bloomberg, UBS, as of 25 June 2014 UBS CIO WM July

3 > > Investors must always allow for the unexpected. Bookmakers had priced an 85% chance that Spain would qualify from their group. At our recent Investor Forum (our monthly pre-match analysis meeting with top external fund managers) a participant likened this to current activity in financial markets. The options market is pricing in an 86% chance that Brent crude oil prices will not increase by more than 10% in the coming three months. This participant, like us, foresees prices remaining contained, but noted there is of course a possibility that the situation in Iraq could deteriorate and oil prices could rise. We therefore need to do our homework and assess the potential impact of the unexpected on our positions, a discipline all good investors should practice. With respect to this particular risk, we remain comfortable with our positioning, with oil trading at USD 114/bbl, but a 10 15% price increase would concern us due to the negative effect it would have on developed market economic growth. Second, in a world of low returns, it is understandable that investors are looking hard at every part of their portfolio to ensure that it will return as much as possible. For example, it may seem senseless in isolation to hold a fixed-rate bond fund in a rising yield environment, when a floating-rate fund is likely to deliver greater returns. Similarly, in isolation, holding high grade bonds at all may seem illogical when credit has a more favorable return outlook. > > Diversification is critical for improving the risk-return profile of portfolios overall. > > Building a portfolio is like picking a winning football team, including players in every position. > > Using leverage to boost returns involves increasing risk by an even greater factor. But a series of decisions that may make sense in isolation can lead to a far-from-ideal outcome. We prefer high yield credit to high grade bonds currently, but an investor who dedicates an entire portfolio to it is probably ill-advised. Similarly, we also believe that yields will rise, but swapping all fixed-rate bond exposure for floating rates is likely also not a good idea if the portfolio also contains growth-sensitive equities. Floating-rate credits and equities will likely be highly correlated, and portfolios therefore more volatile. Diversification is critical to mitigating idiosyncratic risks and improving the risk-return profile of portfolios overall. It s rather like picking a winning football team. At our April conference with leading fund managers in Davos, where World Cup fever had already started, one of our colleagues likened constructing a portfolio to selecting a football team. Every squad, no matter where it hails from, is made up of a goalkeeper, defenders, midfielders, and attackers. Every team develops a style suited to it while deploying players in those positions. Picking the best 11 players in the country isn t a winning strategy if those 11 do not include any defenders or a goalkeeper. For the record, I played as a center back in school, which was good preparation for portfolio management, but not the only role needed in a winning investment team. Finally, there is leverage. In a world of low returns and volatility, employing leverage can boost returns to levels we all may have grown accustomed to. Leveraging credit investments is particularly tempting thanks to the combination of relatively low borrowing costs and an ongoing hunt for yield. Investors must remember, however, that increasing returns using leverage involves increasing risk by an even greater factor, once we account for borrowing costs. For example, leveraging an investment by a factor of two in a credit instrument that yields 5% p.a. at a borrowing cost of 2% increases the return from 5% to 8% p.a., but doubles the amount of risk the investor assumes. > > We expect equity markets to deliver 7 8% p.a., high yield credit 4 5%p.a., and high grade bonds 0 3% p.a. over the next five years. Fig. 2: Expect lower returns from financial assets in the future 5-year historic returns, and 5-year UBS projections (%, annualized) Global Equities USD Cash EM Bonds US HY Bonds High grade Historical 5y Bonds Expected 5y Source: Bloomberg, UBS, as of 25 June 2014 US IG Bonds UBS CIO WM July

4 > > We advise focusing on developing and maintaining a long-term strategic asset allocation. > > Tactically, we are overweight US and Eurozone equities. Investors can avoid such pitfalls by maintaining a clear investing framework and making individual decisions in an overall portfolio context. We advise focusing first on developing and maintaining a long-term strategic asset allocation (SAA) that has a tolerable level of risk. We supplement the SAA with thematic and tactical asset allocation (TAA) ideas, which I detail below. If used in a risk-controlled way in the context of an overall portfolio, we believe they can boost returns relative to their risks. Our strategy for the second half of the match Entering the second half of 2014, we field a diversified set of tactical bets and are playing to win. We are overweight risk assets and, within our equity allocations, overweight US and Eurozone stocks. In the US, indicators suggest the economy is on track again after the 1Q slowdown. We think US economic growth should translate into mid-to-high single-digit earnings growth in percentage terms, in line with our expectation for equity performance. In the Eurozone, leading indicators are mixed, but have stayed in expansionary territory. The euro s strength has hurt earnings, but they will improve in year-over-year comparisons provided the euro does not reach new highs. Thus we see the potential for high singledigit percentage earnings growth thanks to a combination of economic expansion and margin improvement. > > In currencies, we play underweights in the euro and Swiss franc relative to the US dollar and British pound. > > We reduce the size of our US high yield credit overweight. Furthermore, the ECB continues to demonstrate its commitment to stimulating growth and inflation through its twin interest rate cuts and its apparent openness to pursuing an asset-backed security purchase program. This has bolstered our confidence in our underweight positions in the euro and the Swiss franc. We play these underweights relative to the US dollar and the British pound: after comments from Bank of England Governor Mark Carney, we now think a UK interest rate hike is likely near the end of the year. We remain underweight UK equities due to the negative effect the strong pound is having on the earnings of British companies. Elsewhere in currencies, we removed our underweight position in the Japanese yen relative to the US dollar early last week. Our move is not intended to signal that we expect Japanese yen strength. But since the Bank of Japan appears comfortable with current economic and inflation developments, and is potentially wary of more than 10% yearover-year energy inflation, the chance of the currency declining markedly in the months ahead has declined. In credit, we recommend a prudent overweight allocation to US high yield (HY), but moderately reduce the size of our overweight position this month. Spreads of 335bps still offer some scope for tightening (our six-month target is 300bps) and provide attractive carry, but potential gains from here are likely more limited. Fundamentals remain relatively strong: 27% of issuance is being used for mergers and acquisition and capital expenditure, compared with more than 50% back in 2007, and the use of creditor-unfriendly paid-in- > > Growth in the US is likely to match growth for EMBI-issuers for the first time in over ten years. Fig. 3: We project GDP growth for EMBI-issuers to be in line with that for the US Real GDP growth (%, yoy) E 2015E EMBI-weighted US Source: Bloomberg, JP Morgan, UBS, as of 25 June 2014 NB: EMBI-weighted GDP growthestimated using current weights, for 9 largest constituents UBS CIO WM July

5 kind toggle bonds remains very low, with less than 2% of the last three months of HY issuance sporting such a structure. We expect default rates to bump along below 2% annualized over the next six months. > > We recommend reducing emerging market hard-currency government bond holdings to underweight. We also recommend reducing emerging market hard-currency government bond (EMBI) holdings to underweight. So far this year, EMBI has delivered performance of more than 8%, partially due to the strong performance of US Treasuries, and partially due to spreads contracting to 280bps. But economic fundamentals in major EM borrowers Brazil, Russia, and Venezuela are deteriorating, and we project GDP growth for EMBI-issuers to be in line with that for the US (see Figure 3). We expect spreads to widen to 330bps over the coming six months. Thank you for reading this CIO Monthly Letter. All feedback is welcome. While there is a different manager signature below, our seasoned professionals remain the same. UBS fields a world-class team that will continue practicing the fundamentals every day in our quest to keep putting the ball in the net. Mark Haefele Global Chief Investment Officer Wealth Management UBS CIO WM July

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