UBS CIO Monthly Letter

Transcription

1 ab Chief Investment Officer Wealth Management June 13 Ice-skating through the markets Alexander S. Friedman Global CIO UBS WM When I was young, I liked to ice skate on a pond near our house. I learned early that this was a binary proposition: either it would be effortless fun or a disaster if the ice was not sufficiently thick. It is with this frame of mind that I write this letter. The past two years represent a period of broad and strong market performance. Investors in credit, in particular, have enjoyed a very smooth skate. Annualized volatility in this asset class this year has been less than 2%, lower than for Treasuries even, and spreads have fallen to multi-year lows. But is the ice below our feet solid? Since the financial crisis, a key pillar buttressing the market has been unprecedented central bank support. A secondary pillar has been how well this support has fostered economic growth in various regions. While we believe central bank support will continue (even as markets reach new nominal highs), we base our investment view more on this secondary pillar, i.e. our confidence in the stability and strength of regional economic growth. At a regional level, the US continues to provide us with more confidence than other markets; the US economic recovery remains on track, though with sub-trend growth. It is being fueled by improving housing and labor markets, accommodative monetary policy, and increasingly healthy credit conditions. The Japanese economy appears to be responding well to the new government s innovative policy mix, although the ultimate results are unclear. Meanwhile, data from Europe has struggled to meet low expectations. At the other end of the spectrum, China s economic activity has not matched much higher consensus expectations, as its policymakers gradually rebalance their growth model to make it more sustainable. Other emerging markets have experienced a moderate slowdown, but their policymakers have cut rates and, in some isolated cases, have resorted to fiscal stimulus. Our conclusion is that the ice is solid over our tactical timeframe of the next six months, but given that economic activity is heavily influenced by the actions of central banks, we are adjusting our portfolio. First, this is a logical time to lock in some of our profits in US high yield credit and reduce our exposure to the segment. The fundamental picture for US high yield remains good, however, so we are maintaining a small overweight position in it. Should spreads fall below our 4bps target, we would likely review this position again. Second, to reinforce our positive view of the US economy, we are adding to our long-held overweight position in US equities, funded in part from high yield and from an underweight position we have adopted in Australian equities. Finally, we are sticking to our long position in the US dollar against the euro, but removing our short position in the Swiss franc as we believe its recent sharp sell-off against the euro is overdone. 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 The US: best pond for skating In the US, the recent price movements of risk assets do not appear to have diverged markedly from the improved economic fundamentals. As a result, we recommend an overweight position in US equities, in particular mid-cap stocks exposed to the domestic economy, as well as the aforementioned overweight in US high yield credit. A consumer-led recovery The recovering housing market is the key factor fueling economic growth. Recent data shows home prices in March rose at the fastest single month pace on record (1.3%), a jump that pulled up to 4, households out of negative equity. Prices are now increasing at the highest year-on-year rate since 6 (see Fig. 1). These higher values are materially improving construction spending and, through the wealth effect, spurring US consumer demand the recent Conference Board consumer confidence indicator showed the highest level of confidence in more than five years (see Fig. 2). This is particularly important at this juncture in the economic recovery. Consumption growth was respectable in the first quarter, with real personal goods spending rising 3.3% despite the 2% payroll tax increase at the start of the year. But this consumption has partly been funded by a decline in personal savings rates, which have fallen by around 1% from 12 s average level. Provided consumer confidence stays strong, savings rates can remain relatively low and the consumer-led recovery will continue. Turning to business investment, we have already begun to see a broad improvement. Durable goods orders this month surpassed expectations, and the labor market is in its best overall condition since the start of the financial crisis. And this recovery should be further supported by credit conditions continuing to ease. Corporate bond yields have set record lows, with the average yield-to-worst on high yield debt now just 5.6% and the first quarter s Senior Loan Officer s survey recording the strongest rate of credit easing since the recovery began. Worries over a near-term Fed exit overdone Ironically, the biggest concern facing US risk assets is that economic growth might be too good. As markets look to the medium term and focus on the US Federal Reserve s critical decision of what to do with its USD 3.4trn balance sheet, we could face a counterintuitive situation where better economic growth leads to an emboldened Fed selling its assets, resulting in pressure on equity and bond markets. Every Federal Reserve utterance will now receive increased scrutiny for signs that the central bank will cut back on quantitative easing (QE), and we have already seen how such exegesis affects markets on an intra-day basis. But the real potential unintended consequences of such a policy are unknown, since no central bank has tried to unwind a USD 3.4trn balance sheet before. In the near term, however, we believe that worries over a Fed exit are overdone. First, it is worth noting that over the past six months US consumer prices have actually fallen, and inflation is likely to remain well below the Fed s 2% target this year. As a student of the Great Depression, Fed chairman Bernanke will likely err on the side of loose policy, particularly if such disinflation is persistent. Second, we should remember that the Fed is still expanding its balance sheet by USD 85bn per month, or nearly USD 2m every minute. While financial markets love to look at second derivatives, even a reduced pace of expansion would still represent exceptionally loose policy. Third, the Fed has made it clear that it would reduce the rate of purchases until it is convinced that the labor market improvements are sustainable. Since we won t know the full impact of government spending cuts until the fourth quarter, the Fed is unlikely to be able Fig 1: US house prices rising S&P/Case-Shiller city home price index (% yoy) Fig. 2: Consumer confidence boosted by wealth effect Conference Board consumer confidence indicator Source: Bloomberg, UBS, as of 29 May 13 Source: Bloomberg, UBS, as of 29 May 13 UBS Chief Investment Office June 13 2

3 to make its decision for another three or four months. And, finally, Bernanke s term as chairman expires in February. Given the importance of directional signaling in central bank policymaking, he may maintain the status quo and allow his successor to determine the future path of policy rather than begin down a path that may be reversed just months later. In short, we believe that US economic growth is robust and the Fed is likely to want more certainty on the pace of economic recovery before reducing its asset purchases. Europe: cracks below the surface In Europe, there does appear to be a divergence between relatively benign markets and still weak economic fundamentals. Supportive actions by the European Central Bank (ECB) last year led to a sharp recovery in equity markets, a renewed calm in peripheral bond markets, and strength in the euro. However, economic growth remains anemic, and the lack of volatility in markets and the ECB s do whatever it takes policy mean that the pressure for vital structural reforms is diminishing. Given the painful economic outlook and a dearth of realistic or helpful policy solutions, we hold an underweight position in the euro and are neutral on the region s equities. Our preferred means of equity exposure in the region is through a new theme Playing away from home, focused on companies listed in the Eurozone but with significant business exposure outside of the region. Economic growth anemic Real economic growth in Europe is anemic. First-quarter GDP revealed an economy in contraction for the sixth consecutive quarter, and without fundamental reforms it is difficult to see this malaise changing in any meaningful way. The core problem is a lack of fiscal integration. Funding costs for small companies in Spain are now more than 2% higher than in Germany (see Fig. 3), a spread that has shown no signs of abating despite the apparent market calm. With such a wide gap, it is not surprising that loan growth and, consequentially, investment are so weak. So what can Europe do? After failed efforts at austerity pushed some of the weaker countries close to depression, the great hope is that in the wake of the German elections in the fall, German Chancellor Angela Merkel will partner with French President François Hollande to champion a path toward real fiscal integration and banking union. However, this may be an over-optimistic assumption. Recent opinion polls indicate that Hollande has an approval rating of just 25%, the weakest for a president just one year after election in half a century, and French consumer confidence is approaching alarming lows. Hollande s political position may be too tenuous to champion any major initiatives, and Germany, given its own sensitivity to perceptions of imperialism, is highly unlikely to "go it alone" and push for reforms that require nations to give up some existing sovereignty. Central bank actions unlikely to help meaningfully Political inertia will likely force the ECB to bear the burden of driving growth. The ECB has cut the refinancing rate to.5%, but positive effects will be limited due to the fundamental lack of credit demand in the region (see Fig. 4). In particular, demand for loans from small and medium-sized enterprises is feeble the ECB Bank Lending Survey reported that a net 26% of banks saw a decline in loan demand in the first quarter, more than the 23% in the fourth quarter of last year. Ultimately, unless business confidence improves, it is difficult to see how ECB measures alone can meaningfully improve conditions. Fig. 3: Expensive SME funding in periphery MFI lending rates on SME lending (<EUR 1m loans) Fig. 4: Fundamentally weak loan demand in Eurozone ECB change in demand for loans to enterprises Germany Spain Jul-6 Apr-7 Jan-8 Oct-8 Jul-9 Apr-1 Jan-11 Oct-11 Jul-12 Apr-13 Source: ECB, UBS, as of 29 May 13 Source: Bloomberg, UBS, as of 29 May 13 UBS Chief Investment Office June 13 3

4 Japan: speed skating for now Japanese equities have rallied by more than 5% over the last six months. This has led to concerns over a divergence between asset price performance and fundamental economic performance. However, we believe there are ongoing catalysts for this rally (see Fig. 5) that warrant holding a small overweight position in Japanese equities, chief among them the country s exporters. Japan provides the clearest case of a supportive central bank and an aligned fiscally stimulative policy serving as the primary driving forces of a market. And as market sentiment swings between the vastly different potential final scenarios, we should expect to see continued volatility. In the successful scenario, the "Abenomics" combination of fiscal and monetary stimulus conspires to raise both inflation and growth expectations. For over a decade, Japanese companies have maintained high savings rates, and companies listed on the Nikkei 225 hold one of the highest ratios of cash-to-market cap of any major market. This is entirely rational in a country suffering deflation, low real growth, and overcapacity. Increasing inflation and growth expectations would encourage both personal consumption and business investment, and spur a virtuous circle in which we could expect more than 2% GDP growth and 2% inflation. Such performance would not be stellar, but it would represent a real transformation for Japan after average growth in the past decade of just.6%. On the downside lies what could be called the "Abegeddon" scenario: stagflation. In Japan, such an outcome could have even graver consequences than it would elsewhere. In this scenario, the Bank of Japan s (BoJ) monetary stimulus is successful in boosting inflation expectations, but it is not accompanied by higher growth and higher tax revenues. Investors grow increasingly concerned about Japanese debt sustainability, and an inflation-driven rotation out of Japanese government bonds (JGB) turns into a stampede. We estimate that, in a stagflation scenario, the Japanese debt-to-gdp ratio would rise above 3%, from 226% today (see Fig. 6), and the 1-year yield could approach 5%. This would damage the financial system significantly, and regional bank capital would be severely impaired. The BoJ could try to control the bond yield with ever-increasing purchases which, even if successful, would only lead to concerns of monetary financing and cause USDJPY to weaken beyond 13, from 12 today. It may be years before we can fully judge any long-term success of Abenomics, but over our tactical investment horizon we believe the combined actions of the government and BOJ can continue to drive earnings growth for Japanese companies. Prime Minister Shinzo Abe s fiscal stimulus package should result in a boost to 13 GDP of around 1%. And with inflation likely to remain close to zero, we do not expect a stampede out of the bond market: any short-term sell-off would likely be met by temporary BoJ stabilization measures. We therefore are keeping a small overweight position in Japanese equities over our tactical six-month horizon as we monitor the potential changes in long-term dynamics closely. Emerging markets: struggling to regain momentum Despite stronger economic growth rates, emerging market equities have underperformed developed markets by over % in the past two years. This suggests that, over the longer term, today s valuations should represent an attractive entry point. However, valuation alone does not represent a catalyst for outperformance over our tactical timeframe, and we recommend a neutral allocation to emerging market equities. China s economy is slowing. The sharp increase in credit growth this year has not yet translated into investment in Fig. 5: Japan s rally Nikkei 225 equity index Fig. 6: Japan debt scenarios Government debt-to-gdp projections FY 5 FY 6 FY 7 FY 8 FY 9 FY 1 FY 11 FY 12 FY 13 FY 14 FY 15 FY 16 FY 17 FY 18 FY 19 FY May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 Feb-13 May-13 Main case Positive case Negative case Extremely negative case Source: Bloomberg, UBS, as of 29 May 13 Source: UBS, as of 29 May 13 UBS Chief Investment Office June 13 4

5 the real economy (see Fig. 7), with only the real estate sector showing accelerating investment growth. This is a far from ideal source of growth, given that real estate prices have ballooned as an unintended consequence of China s financially repressive policies. The Chinese government has sought to contain prices, and we expect to see further targeted property tightening measures in tier 1 cities in the months ahead. With the government now more focused on structural reform than cyclical stimulus, and with the flash HSBC purchasing managers index (PMI) falling into contractionary territory, China s growth is unlikely to accelerate in the months ahead. Yet in a global context, the Chinese economy still looks like a speed skater, with GDP growth of 7.7% and consumption growth of 8.1% expected for 13. We believe it is best to seek exposure to this increasing consumption, China s future engine of growth, through our themes on Asian consumption and Western Winners from Emerging Market growth rather than through direct investment in the Chinese equity market. The slowdown in other emerging markets (EM) in recent months has also produced lower-than-expected inflation readings, which gives policymakers room to cut rates. Hungary, Poland, Turkey, India, South Korea, Colombia and Mexico have dropped rates a combined total of 18 times this year. With the average EM policy rate at 4.3% and average headline inflation of 3.2%, there is some additional room to cut. Debt-to-GDP is less than 4%, so EM policymakers retain fiscal latitude. Our positioning We continue to place our firmest bets on the US market by adding to our overweight position in US equities. This is funded by reducing our US high-yield position and by adopting an underweight position in Australian equities, which could suffer from any further slowdown in China. We expect the US economy to help deliver solid revenue growth for US companies, while the improving housing market should prop up domestic demand and the outlook for financials. In terms of valuation, despite a 16% run this year, we believe there is approximately 6% upside in the coming six months, and just under % upside to fair value on a cyclically adjusted earnings yield basis, given current trends in inflation and real interest rates. As discussed earlier, we have scaled back our overweight position in US high yield to lock in this year s 6% gain. The fundamental outlook remains supportive of this asset class, with default rates likely not to climb much above 1.5%, interest coverage ratios still good, and liquidity abundant. However, with spreads now around 45bps, and the high yield risk premium falling below its long-term average for the first time since the 8 financial crisis (see Fig. 8), the upside is now more limited, and we have chosen to take advantage of the still-positive environment to reduce our overweight position by half. Should spreads fall below our 4bps target, all else being equal, we would likely review this position again. We are also overweight the US dollar. Traditional correlations in currency markets have broken down this year, providing greater opportunities to generate alpha. The huge appreciation in the US dollar, one of our preferred currencies, relative to the Australian dollar, one of our least preferred, in a risk-on market has been a great example of this dynamic. The Australian dollar has been the worst-performing major currency in the past month. We introduced an overweight US dollar relative to Swiss franc in my last monthly letter. With the Swiss franc having weakened not only relative to the US dollar but to the euro (EURCHF is now trading close to 1.25), we are taking profits on this trade. We maintain our short position in the euro relative to the US dollar. Potential for even further US dollar appreciation in the near term also means we are removing emerging market Fig. 7: China credit growth not yet translating into economic growth China total social financing growth, %, and China manufacturing PMI May-1 Sep-1 Mar-11 Source: Bloomberg, UBS, as of 29 May 13 Sep-11 China new total financing (3mma, % yoy, LHS) China Manufacturing PMI (RHS) Mar-12 Sep-12 Mar Fig. 8: High yield risk premium now below average High yield risk premium, % HY risk premium Long-term median Source: UBS, Moody s, as of 29 May UBS Chief Investment Office June 13 5

6 currencies as a CIO preferred theme, although we continue to see potential in the asset class over the longer term. Elsewhere in currencies we are closing our overweight position in the British pound relative to the euro and removing GBP best of the majors from our CIO preferred themes. We see the pound as undervalued and expect positive returns over the next six months, but we believe we could see an uptick in volatility in the coming months as Mark Carney takes over as governor of the Bank of England. The long GBPEUR position served as a diversifier to other pro-risk positions in our portfolios, but we see larger potential in the long USDEUR position. We are sticking to our neutral stance on duration. Bond yields have risen sharply this month, but while the debate over central bank policy remains focused on balance sheet size rather than interest rates, we believe the scope for a more significant rise in long-term rates is limited. Within commodities, we are maintaining a neutral allocation. Gold suffered once again in the past month and we advise investors to look toward more industrially exposed metals, such as platinum, that stand to benefit from economic growth and have tighter supply environments. Thank you for taking the time to read this letter and we wish good skating to all. Sincerely, Alexander S. Friedman Global Chief Investment Officer Wealth Management 3 May 13 UBS Chief Investment Office June 13 6

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