US economy. The beginning of the end of QE3. And so it begins...

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1 CIO WM Research 18 December 2013 US economy The beginning of the end of QE3 On Wednesday, the FOMC decided to taper its QE3 bond purchases, against our expectation and to the surprise of many economists. It also reinforced its forward interest rate guidance indicating that it would wait an extended period before considering raising rates. We continue to look for medium to long-term government bond yields to trend moderately higher and the yield curve to steepen over the course of next three months. The outlook for equities remains positive. The underlying fundamental drivers of the early taper - strengthening US economic data and declining fiscal policy risks are unambiguously positive for corporate earnings growth, which we already expected to be the primary contributor to US equity market returns in For emerging market assets, tapering may create some shortterm headwinds. However, solid growth prospects in the US should ultimately benefit emerging markets, albeit with differentiation among countries. The Fed s focus on normalizing monetary conditions may give the dollar some upside relative to developed and emerging market currencies. Thomas Berner, CFA, economist, UBS FS thomas.berner@ubs.com, Jeremy Zirin, CFA, strategist, UBS FS jeremy.zirin@ubs.com, Jorge O. Mariscal, Regional CIO Emerging Markets, UBS FS jorge.mariscal@ubs.com, Daniela Steinbrink Mattei, strategist, UBS AG And so it begins... In a move that caught many market observers by surprise, The Fed announced that it would scale back its purchases of treasury and mortgage backed securities by an initial USD 10bn beginning in January. The bond purchase reduction will be evenly split between Treasuries and agency MBS, lowering the pace of Treasury purchases to USD 40bn and of agency MBS purchases to USD 35bn. The Fed, however, also reinforced its forward interest rate guidance to strengthen the signal that tapering does not mean tightening and that it would wait an extended period before considering raising rates. It did so by stating that it anticipates, based on its assessment of broader labor market conditions and inflation indicators, that it will be appropriate to keep the Fed Funds target at % well past the time that the unemployment rate falls below 6.5% - especially if inflation continues to miss the Fed's 2% target. This report has been prepared by UBS Financial Services Inc. (UBS FS) and UBS AG. Please see important disclaimers and disclosures that begin on page 6.

2 The Fed justified its tapering move by citing the cumulative improvement in economic and labor market conditions since inception of the current asset purchase program. Adding to that picture, the Fed did not feel compelled to lower its real GDP growth projections for the first time during the current recovery. In fact, the Fed lowered its unemployment rate projections somewhat and raised its inflation projections slightly. In 2014, it expects real GDP growth of % on a 4Q-on-4Q basis, an unemployment rate at % in 4Q14 and personal consumption expenditures (PCE) price inflation of % on a 4Qon-4Q basis. The Fed emphasized that the taper did not signal premeditated sequential further reductions in the pace of bond purchases, but rather that the economic data and the outlook would dictate that pace. It guided, however, that given its outlook it would likely reduce the pace of its purchases in further measured steps. Given our expectation for a persistent acceleration in real GDP growth to 3% and for inflation to gradually move towards the Fed's 2% target in 2014, we look for the Fed to reduce its bond purchases by on average USD 10bn per meeting and end its bond purchases by 4Q14. Fig. 1: Bond markets unsettled by Fed taper discussion in May Option-adjusted spreads on US investment grade and high yield corporates, in basis points Dec-12 Feb-13 Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 IG OAS (left) HY OAS (right) Source: BoAML, UBS CIO We expect an about equal reduction in the pace of purchases of Treasuries and agency MBS, leading to total Treasury purchases of USD 795bn and total agency MBS purchases of USD 823bn under the program. Thomas Berner, Economist US Bonds - moderate headwinds ahead Bonds are apt to come under some selling pressure following the Fed s decision to pare back its monthly purchases of Treasury and mortgage-backed securities. However, don t look for a repeat of the taper tantrum back in May when the 10-year treasury yield spiked by more than 100 basis points and spreads on US investment grade and high yield corporate bonds widened by 30bps and 110bps, respectively. (see Fig. 1). Unlike the sharp and broad-based selloff earlier this year, market participants had already largely priced in a policy shift. What s more, by further qualifying its forward guidance, the Fed has effectively neutralized concerns over a premature tightening of policy - in contrast to the taper confusion experienced during summer/ autumn That said, we still look for medium to long term government bond yields to trend higher and the coupon curve to steepen over the course of next three months. We therefore continue to emphasize neutral-to-short duration positions within the treasury market, with a focus on the 2-5 year sector. Non-callable agency debt will likely perform in line with treasuries - but with a modest spread widening bias amid higher yields and increased swaptions volatility. The outlook for callable agency debt is more mixed however. While par and premium paper is likely to underperform as rates rise and the curve steepens, discount paper has less extension risk and should therefore hold up better amid fed tapering. Mortgage-backed securities may underperform the Treasury market, as higher yields prompt a slowdown in mortgage prepayments and an increase in extension risk (i.e., negative convexity ). In addition, the decision by the Fed to pare back pur- UBS CIO WM Research 18 December

3 chases of Treasury and mortgage backed securities (MBS) in equal amounts also creates something of a demand void for MBS, further contributing to the risk of underperformance. We recommend sticking with short-duration, well seasoned higher coupon paper that appears less vulnerable to both the re-pricing risk from a Fed taper and the event risk from incoming FHFA chairman Mel Watt. Initially at least, holders of corporate bonds are apt to be negatively impacted by both rising bond yields and wider credit spreads. However, we would look for risk premiums to begin narrowing once again amid still solid credit conditions and relatively solid seasonal factors. We therefore continue to recommend both high yield and investment grade corporate paper as an alternative to treasury debt. Fed tapering could well prompt further outflows from municipal bond funds, thereby putting additional upward pressure on taxexempt yields. However, with the M/T yield ratio already at elevated levels and new supply likely to remain tight in the months ahead, we look for this underperformance in the municipal market to be transitory. Although tax-exempt yields are also likely to track treasury yields higher, they will likely do so at a more moderate pace. Mike Ryan, Regional CIO WM US James Rhodes, Daniela Steinbrink Mattei, Barry McAlinden, Kathleen McNamara, Strategists Developed market equities no taper tantrum The somewhat sooner-than-expected beginning of the Fed s tapering of asset purchases does not change our positive intermediate-term (i.e. six-month) view on the US equity markets. In fact, the underlying fundamental drivers of the early taper - strengthening US economic data and declining fiscal policy risks are unambiguously positive for corporate earnings growth, which we already expected to be the primary contributor to US equity market returns in Furthermore, we would not expect US valuations to sustainably suffer. On the contrary, the process of interest rate and monetary policy normalization has historically been consistent with expanding, rather than contracting, US equity valuations (Fig 2). US equity markets surged after the FOMC decision. Stronger forward interest rate guidance more clearly separated its tapering decision from the timing of the first actual increase in the fed funds rate. This can help explain why equities have initially reacted positively to tapering, in contrast to earlier this year when the S&P 500 fell nearly 6% in late May (through late June) after the Fed only first discussed the potential for tapering by year-end. With economic growth momentum now on even firmer footing and with the bond market now more clearly prepared for tapering (US 10-year T-bond yields are approximately 100 basis points higher Fig. 2: Rising rates from low levels typically a positive for valuations S&P 500 P/E on trailing operating EPS and 10-year t- bond yield P/E - last 12 months EPS 30x 25x 20x 15x 10x 5x 0x 0% 2% 4% 6% 8% 10% 12% 10-yr Treasury bond yield Source: Bloomberg, FactSet and UBS CIO as of 16 December 2013 We maintain also our overweight on Eurozone equities. The easing bias by the European Central Bank will limit the impact of any Fed tightening on the European economy. The gradual Eurozone economic recovery should translate into rising earnings and enable the more cyclical Eurozone equity market to outperform defensive markets like the UK and Switzerland on a six month horizon. Jeremy Zirin, Markus Irngartinger, Strategists UBS CIO WM Research 18 December

4 Emerging markets - time for differentiation Emerging market equities might suffer short-term from the reduced liquidity provisioning by the Fed. However, solid growth prospects in the US should eventually also benefit emerging market equities. The May 22 Fed taper announcement caught EM countries by surprise. The re-pricing in EM equities was striking, especially in those countries with large external financing needs, including Turkey, South Africa, Indonesia, India and Brazil. Since then, EM equities have regained most of the lost ground as countries have become better prepared to face a less benign global liquidity environment. Exchange rates were allowed to adjust, current account deficits narrowed, the large EM foreign exchange reserves did not deteriorate and many of the most vulnerable countries have hiked local rates to increase their attractiveness to international capital. The overall effect tapering will have on capital flows and EM equities performance is mixed. On the one hand, a less favorable environment of global liquidity could reduce capital flows into EM, including the volatile equity portfolio flows. On the other hand, the normalization of US rates is occurring against the backdrop of better US economic prospects which would lift growth in EM, boost investor confidence, prop up commodity prices and support capital flows, helping EM equities. Furthermore, while the Fed is withdrawing liquidity, Europe and Japan are expected to maintain loose monetary policy. Lastly, while this taper decision comes somewhat earlier than expected, we believe it is at least partly priced in 10- year US Treasury yields, considering its greater than 107 bps yearto-date increase. Today's Fed decision might temporarily support emerging market FX and fixed income markets as it removes one layer of uncertainty. However, we expect renewed upside pressure on global interest rates over the next six months in our base case scenario. The Fed s forward guidance suggests that the federal funds rate will remain at current levels for a prolonged period of time. In some emerging countries, policy makers might use this additional window of opportunity to initiate structural reforms or continue with their reform agendas. This could reduce their countries' dependencies on external financing and help to partially protect local markets against the renewed upward trend in global interest rates we expect in the months ahead. We maintain our neutral position on EM equities. However, EMs are becoming increasingly more differentiated, and their reaction to tapering will vary accordingly. In our tactical asset allocation, we are underweight countries with large external financing needs, such as Turkey, South Africa, Indonesia and India, which are more vulnerable to rising global yields and bouts of risk aversion. On the overweight side we are emphasizing reforms and financial resilience and therefore favor Mexico, China, Korea and Russia. On the FX side, we maintain our preference for currencies like MXN, PLN, SGD, and CNY while we remain relatively cautious on ZAR, TRY, BRL, INR, and IDR. Looking at fixed income markets, we maintain our moderate preference for EM corporate bonds denominated in USD relative to EM sovereign bonds in USD, while keeping a cautious stance toward emerging market sovereign bonds in local currencies. Jorge Mariscal, Regional CIO Emerging Markets Alejo Czerwonko, Strategist UBS CIO WM Research 18 December

5 Foreign exchange - some support for the greenback In principle, a timely taper is positive for the US dollar. Timely in this case refers to a self-sustaining economic recovery, so fear of a rise in unemployment is small. Timely also means that the Fed eases off new asset purchases in time to contain inflation. If investors perceive the Fed has found such a middle ground, confidence in the US dollar should be enhanced. In the short term, the taper is good for the dollar so long as it is associated with a steeper US Treasury curve and rising expectations for rate hikes. It is therefore no surprise that the dollar rose slightly after the FOMC announcement. Given that most global central banks are not tightening, this likely increases the dollar s relative yield. However, the positive effect has been offset by the Fed suggesting it will keep fed funds rate near zero even after unemployment has dropped below 6.5%, thereby strengthening forward guidance. The critical aspect about suggesting rates will remain low for longer is that it prevents yields from rising. The best for the dollar would be a quick rise in yields, giving investors confidence in US bonds. With the Fed s forward guidance, yields are not likely to rise significantly, which may leave investors uncomfortable. Overall, the combination of earlier taper but with stronger forward guidance does not present a big change for the dollar. Treasury yields are unlikely to rise quickly, but the Fed s focus on normalizing monetary conditions may give the dollar some upside relative the developed and emerging market currencies. We continue to look for EURUSD to drift lower in the established range of 1.30 to Thomas Flury, Strategist Katherine Klingensmith, Strategist UBS CIO WM Research 18 December

6 Appendix Investors should be aware that Emerging Market assets are subject to, amongst others, potential risks linked to currency volatility, abrupt changes in the cost of capital and the economic growth outlook, as well as regulatory and socio-political risk, interest rate risk and higher credit risk. Assets can sometimes be very illiquid and liquidity conditions can abruptly worsen. WMR generally recommends only those securities it believes have been registered under Federal U.S. registration rules (Section 12 of the Securities Exchange Act of 1934) and individual State registration rules (commonly known as "Blue Sky" laws). Prospective investors should be aware that to the extent permitted under US law, WMR may from time to time recommend bonds that are not registered under US or State securities laws. These bonds may be issued in jurisdictions where the level of required disclosures to be made by issuers is not as frequent or complete as that required by US laws. For more background on emerging markets generally, see the WMR Education Notes, "Emerging Market Bonds: Understanding Emerging Market Bonds," 12 August 2009 and "Emerging Markets Bonds: Understanding Sovereign Risk," 17 December Investors interested in holding bonds for a longer period are advised to select the bonds of those sovereigns with the highest credit ratings (in the investment grade band). Such an approach should decrease the risk that an investor could end up holding bonds on which the sovereign has defaulted. Sub-investment grade bonds are recommended only for clients with a higher risk tolerance and who seek to hold higher yielding bonds for shorter periods only. Please note that these bonds may not necessarily be registered with the US Securities and Exchange Commission nor blue-skyed in the US. 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