Investment Strategy Insights

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1 CIO WM Research 7 October 213 Investment Strategy Insights Putting Worry to Work: 213 Edition The US government has been shut down due to Congress inability to reach a funding agreement, and the US Treasury is set to hit its current debt limit in a matter of days. While global financial markets have thus far taken the negative political news in stride, recent experience tells us that uncertainty about the US debt ceiling can create volatility. We are not expecting a repeat of 211 s market activity, but investors who are worried about a worst-case scenario playing out can take concrete steps to protect portfolios. Debt ceiling déjà vu In an unwelcome repeat of recent history, US political risk has recaptured the financial headlines (Fig. 1). The US federal government shut down on 1 October due to a lack of funding from Congress. It is now possible, even likely, that the government will not reopen until we reach the second major political hurdle of the season: the need for Congress to raise the US Treasury s debt ceiling to allow continued payment on its obligations. Brian Nick, Senior Investment Strategist brian.nick@ubs.com Michael Crook, Co-Head of Investment Strategy michael.crook@ubs.com Fig. 1: Political risk once again disproportionately represented in media headlines 1.4% % of News Stories with References 1.2% 1.%.8%.6%.4% Debt Ceiling Mention Government Shutdown Mention We ve been here before. In 211, Congress and the President negotiated an agreement to raise the debt ceiling and cut discretionary spending, but not before displaying enough political dysfunction to lead Standard and Poor s to remove the US government s AAA credit rating. This decision sent shockwaves through financial markets already brittle from a US recession scare and an existential euro crisis. While these factors are thankfully not present today, the experience of a rapid 18% fall in US equity prices in mid-211 is still quite fresh in most investors memories..2%.% Davis at as of 3 September 213 While we fully recognize the severity of the crisis that could result from a technical default of US Treasury obligations, we do not expect this scenario to play out. Instead, we believe politicians will once again strike a last-minute deal barely acceptable to all sides, leaving financial assets shaken but not permanently damaged. The balance of this piece seeks to provide guidance to investors looking for ideas to protect and grow their portfolios as we anticipate the outcome of this fledgling crisis. This report has been prepared by UBS Financial Services Inc. ("UBS FS"). Please see important disclaimer and disclosures at the end of the document.

2 Coping Constructively with the Wall of Worry Investors often react instinctively to a string of negative headlines by seeking to dramatically reduce risk in their portfolios. We advise against taking any drastic action at this time. The likelihood of a default on US Treasury securities remains extremely low, and we do not expect even another few weeks government shutdown to seriously derail economic growth. An unlikely technical Treasury default aside, we believe that any spike in near-term political uncertainty will likely contribute to a short-lived uptick in volatility. In the past, policy-related volatility has reversed quickly once a deal is struck (Fig. 2). Our advice to investors is as follows: First: Don't Overreact Were the US government unable to honor its obligations on account of the debt ceiling, the likely effect on virtually all financial markets would be severe. Credit default swaps on US Treasury debt have actually spiked as speculators believed that things will look even worse before any resolution is reached (Fig. 3). As we ve said, however, the likelihood of even a technical default is incredibly low (as is the probability that CDS tied to US Treasuries would even pay out in the event of a default). Dramatically reducing risk in the face of an extremely unlikely event does not strike us as sensible. As we mentioned earlier, the bulk of the nearly 2% equity market correction in 211 came in anticipation of and immediately after Standard & Poors downgrade of US government debt. The debt ceiling had already been raised before the worst of the market reaction occurred. Because we do not anticipate any involvement from the ratings agencies this time around, a selloff that rivals 211 seems unlikely. Second: Consider the Likely Outcomes Investors should carefully evaluate how the various political outcomes could impact financial assets and consider what each scenario could mean for their long-term investment goals. We believe the two most likely outcomes are, in order: 1. A last-minute political deal is reached after some modest market volatility; US growth remains low but positive. 2. The negotiations continued past the official debt ceiling deadline, causing a more severe market reaction; the prolonged shutdown more seriously threatens US economic growth as consumer and business confidence falls. Fig. 2: High policy uncertainty has been correlated with short-term spikes in volatility Policy Uncertainty (lhs) VIX Index (rhs) Davis at as of 3 September 213. Fig. 3: Market s US Treasury default probability has increased for what it s worth US 5-year CDS spread Sep-9 May-1 Jan-11 Sep-11 May-12 Jan-13 Sep-13 Source: Bloomberg, as of 4 October Because we view Scenario 1 as more likely, we continue to hold our largest tactical overweight to US equities, particularly to midand small-cap stocks and large-cap stocks with strong cyclical properties. Our equity strategists see the S&P 5 rising to 177 within six months, over a 5% increase from the current level. CIO WM Research 7 October 213 2

3 Scenario 2 would likely result in a significant and possibly prolonged pullback in equities. By contrast, assets like US Government bonds, which have understandably fallen out of fashion this year, should perform well in this scenario based on recent evidence (Fig. 4). Third: Take Action As long as uncertainty remains as to whether either Scenario 1 or 2 will materialize, we recommend that investors take stock of their current holdings and ensure they can reasonably expect their portfolios to perform relatively well in either outcome. Here are three steps to achieving this: 1. Own some high-quality, long-duration bonds 2. Consider buying protection on existing equity positions 3. Opportunistically deploy cash in undervalued assets Fig. 4: Long-duration, high-quality bonds performed well during the last debt ceiling crises 13 Standardized on 7/1/ Long-duration Treasuries Global Equities 7/1/11 7/2/11 8/8/11 8/27/11 9/15/11 1/4/11 1/23/11 Source: Barclays, Bloomberg, July October 211. Portfolios likely entered Q4 out of strategic balance given the high dispersion in asset class returns this year. For most investors, a routine rebalancing may entail buying assets like US Government and Municipal bonds, which should perform relatively well in a worst-case political scenario. Back in 211, many market observers predicted US interest rates would spike as the risks of a default and downgrade increased. Instead, just the opposite happened. Long-term US interest rates plummeted during July and August 211 and the highest-quality, longest-duration bonds beat all other asset classes even as their ratings were cut. We recognize that the ongoing "search for yield" over the past several years has left many fixed income portfolios oriented towards lower-quality securities. High yield credit has enjoyed excellent risk-adjusted returns since 29, but holding it exclusively at the expense of safer, lower-yielding assets leaves portfolios vulnerable to exactly the kind of sell-off we experienced in 211 and could see again this year (Fig. 5). Investors who are especially concerned about extreme downside risk to equities should consider adding hedging strategies to their portfolio. Because volatility in most markets remains relatively low even amid the government shutdown, downside protection strategies like put options do not look exorbitantly expensive. Investors can further cut back on costs by employing strategies like collars, which pay for downside protection by capping potential gains. A high-quality bond portfolio and selected hedging strategies have been effective tools for shielding portfolios from severe losses in the past. But as we ve seen in past instances of policy uncertainty, politically-driven pullbacks in risk assets can be shortlived and prone to rapid reversal. We thus recommend using any extreme market moves during the coming few weeks as opportunities to deploy any large cash holdings into investable assets. Fig. 5: Credit spreads have widened during policy crises 35 Daily "Headline Policy Risk" % Policy Uncertainty (lhs) High Yield OAS (rhs) Jan-9 Oct-9 Jul-1 Apr-11 Jan-12 Oct-12 Jul-13 Davis at as of 7 October CIO WM Research 7 October 213 3

4 We know many investors still hold significantly larger cash allocations than they did before the financial crisis in 28. In many cases, investors have waited to invest their cash opportunistically following a severe pullback only to see equity markets rise nearly 5% without ever correcting more than 1% since 211 (Fig. 6). Should such a pullback unexpectedly occur in the next few weeks, we recommend using it as an opportunity to bring portfolios back to strategic norms. A Note on Money Market Funds Recognizing that much of the money our clients currently hold in cash is actually domiciled in cash-like vehicles such as money market funds, we wanted to briefly comment on the risk to those funds in the event the US Treasury misses or delays payment on its debt. Money market funds typically hold very liquid and shortdated instruments with the primary goal of preserving capital while earning a nominal return on their assets. The current fear in some quarters is that money market funds may come under pressure in the event of a technical Treasury default and a resulting outflow of funds through redemption requests. Should even one money market fund break the buck, as we saw happen in 28, wider systemic problems could result. We are not currently concerned about the risk to money market funds for several reasons. First, as we have said repeatedly, the risk of a delay in Treasury payments on its bills is quite low. Second, it appears many funds have already taken steps to reduce this very near-term risk by selling its ultra-short bills (Fig. 7). Third, we deem it unlikely that even a short delay in some Treasury payments would result in a serious fall in the price of short-term Treasury securities. If anything, a breaking of the buck on the part of one ore more money market funds would probably be associated with an investing environment in which money market funds are still among the safest assets to hold. Put differently, credit and equity markets would experience more severe corrections than money market funds would in the event these funds dropped even a few cents per share in value. Fig. 6: S&P 5 rally since 211 has come without any major pullbacks 1,8 S&P 5 Index 1,7 1,6 1,5 1,4 1,3 1,2 1,1 1, -9.9% -7.7% Jul-11 Nov-11 Mar-12 Jul-12 Nov-12 Mar-13 Jul-13 Source: Bloomberg, as of 7 October % -4.6% Fig. 7: Ultra-low T-bill yields rising sharply as debt ceiling limit approaches.2%.16%.12%.8%.4%.% -.4% 1-month T-bill Yield Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Source: Bloomberg, as of 7 October % Conclusion We believe significantly de-risking portfolios in anticipation of a severe market event related to current political gridlock will likely prove unnecessary counterproductive. Any unexpected market volatility would likely provide investors with an opportunity to constructively rebalance their portfolios while appropriately positioning for downside risk. CIO WM Research 7 October 213 4

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