Investment Insights UBS Asset Management For professional clients/institutional investors only October 2017

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1 Investment Insights UBS Asset Management For professional clients/institutional investors only October 217 On October , the Dow Jones Industrial Average fell 22.6% as concerns about valuation were exacerbated by new program trading techniques and systematic hedging strategies. Thirty years later, at least some of the characteristics of Black Monday are beginning to echo uncomfortably. With developed equity markets still posting very strong risk-adjusted returns, are investors complacent or not? The complacency conundrum Erin Browne, Dan Heron Very low levels of implied volatility have not prevented equity returns from rising historically; major drawdowns have all occurred from higher implied volatility starting points MSCI World s 436 trading days without a 5% drawdown over three months is fifth longest since 1969 but lags significantly behind 736 day record QE reversal likely to have only marginal impact on market volatility in 218 High degree of scepticism about valuations and constant challenge to market supports in contrast to peaks of previous market cycles Rising geopolitical risks, extended hedge fund positioning and a new Fed chair have the potential to disrupt markets in the short-term but we see scant evidence of widespread complacency Strong macroeconomic backdrop, valuation support against bonds suggests further upside to equity markets As Andrew Mellon, Secretary of the US Treasury famously reassured immediately preceding the 1929 Stock Market Crash: There is no cause to worry. The high tide of prosperity will continue. With the global equity bull market in its ninth year and risk-adjusted equity returns strong for an unusually long period in an historical context, are investors similarly complacent about the risks of another major drawdown to equity markets? Much of the commentary regarding investor complacency takes aim at the very low levels of the widely-watched VIX index and investors perception of the VIX as a strong contrarian indicator. However, our analysis reveals that very low levels of implied equity market volatility have not been a major barrier to subsequent global equity market progress historically. In fact, since bull markets are associated with low levels of volatility, it should be no surprise that average global equity returns have been meaningfully higher in low volatility regimes than in high volatility regimes. If you would like to learn more about the ways we can help you meet your investment challenges, please contact your UBS representative or visit But averages can hide a multitude of sins, what about the VIX prior to major drawdowns? Looking at VIX values by decile and subsequent twelve month equity returns shows that the biggest drawdowns have tended to occur when levels of implied volatility have already started to move higher. In fact, of the 43 annual drawdowns in the MSCI World in excess of 1% since 199 based on monthly data, not one has occurred when the starting value of the VIX was below 15.

2 The same analysis for the VIX s overlooked bond counterpart, the ML MOVE Index, gives broadly analogous results. All historical twelve month global equity drawdowns greater than 1% have occurred when the MOVE index is higher than current levels. However, it is worth noting that some of those drawdowns have occurred when the MOVE Index was only marginally higher than current levels. QE roll-off to spark higher volatility? We believe that there are both structural and cyclical forces at work in the current low volatility regime and that the cyclical drivers will abate only slowly over an extended period. In particular, loose monetary policy and forward communication from major central banks have helped to reduce economic volatility. The argument that risk assets are likely to We believe that there are both structural and cyclical forces at work in the current low volatility regime and that the cyclical drivers will abate only slowly over an extended period. become more vulnerable to short-term spikes in investor risk aversion as Quantitative Easing (QE) is reversed in the US has clear logic. After all, liquidity is being withdrawn. But the QE reversal process has been clearly communicated and will be very gradual. The US Federal Reserve s (Fed s) on-going liabilities also mean it will maintain a significantly larger balance sheet than existed prior to the financial crisis, with only around a third of the USD 3.6 trillion it has created since 28 being withdrawn. We therefore do not expect the reversal of QE to be the catalyst to a meaningfully higher volatility regime in 218. VIX by Decile: Average 12m MSCI World Returns and Max Drawdown 12m % Return VIX Levels before 12m MSCI World drawdowns >1% VIX VIX 12m Drawdown MSCI World Total Return (RHS) Current VIX as at 3 September 217 5% % Return Jan 2 Mar 2 Apr 2 May 2 Jun 2 Jul 2 Aug 2 Sep 2 Oct 2 Nov 2 Dec 2 Jan 21 Feb 21 Mar 21 May 21 Jun 21 Jul 21 Aug 21 Sep 21 Oct 21 Nov 21 Dec 21 Jan 22 Feb 22 Mar 22 Apr 22 May 22 Jul 27 Aug 27 Sep 27 Oct 27 Nov 27 Dec 27 Jan 28 Feb 28 Mar28 Apr 28 May 28 Jun 28 Jul 28 Aug 28 Sep 28 Jun 211 3% Average 12m Return Max 12m Drawdown Top: VIX Decile (1 Low, 1 High) Bottom: Average VIX Value per decile Source: UBS Asset Management, Datastream Source: UBS Asset Management, Datastream 2

3 Bond basics: Convexity risk and why it matters In the world of fixed income, duration expresses a bond s price sensitivity to changes in interest rates. However, using duration to estimate the price impact of large changes in yield can lead to inaccurate results. This is because the duration calculation incorrectly assumes that a bond s sensitivity to interest rates changes proportionately in a straight line when in reality the relationship is curved or convex. Convexity is therefore a measure of the rate of change of bond duration to interest rates. In the US, mortgage holders can generally repay their mortgage at any time without penalty. For buyers of MBS this clearly creates some complexities and risks around convexity. The sensitivities of any MBS portfolio can and do change over time, sometimes significantly, as mortgage prepayments accelerate or slow as interest rates change. All else equal, prepayments tend to increase as interest rates fall, thereby reducing duration of the remaining portfolio, and tend to fall as interest rates increase. To protect from these risks, certain types of MBS buyers hedge their convexity risk. The Federal Reserve did not hedge this risk when it bought MBS under its Quantitative Easing programme. Some market commentators believe that as the Fed steps away from the MBS market, the MBS buyers replacing the Fed will hedge resulting in higher interest volatility as MBS holders respond to the changing interest rate backdrop. However, if investors are broadly in agreement that the Treasury roll off is unlikely to roil markets in the short-term, there has been a lot of industry comment about the potential for higher volatility in rates markets as the Fed withdraws from its mortgage backed security (MBS) holdings. Much of that comment has focused on the fact that the Fed did not hedge its convexity risk and that MBS buyers replacing the Fed will hedge and will increase volatility accordingly. That premise appears to be based on the assumption that government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac, and hedge funds, will return in force to the MBS market they dominated prior to the financial crisis. However, both the GSEs and the overall MBS market have changed significantly since 28. In the search for yield, we believe that the most likely investor types to step in to replace the Fed demand will be banks, money managers and foreign investors. These investors, like the Fed, are not likely to be convexity hedgers. While they may well require higher yields, they are much more likely to respond to valuations in a rational economic fashion by buying more MBS when spreads widen and selling MBS when spreads tighten. This is more likely to keep MBS spreads range-bound than the Fed s mechanical buying regardless of spreads. Moreover, the Fed s MBS taper: USD 4 billion per month rising in USD 4 billion increments every three months until it reaches USD 2 billion pales relative to the current run rate of USD 5 billion to USD 6 billion of monthly corporate issuance. We believe the latter will have a larger impact on rates and volatility. ML Move 1m Bond Volatility Index by Decile: Average 12m MSCI World Returns and Max Drawdown 12m % Return 3% Average 12m Return Max 12m Drawdown Top: MOVE Decile (1 Low, 1 High) Bottom: Average MOVE Value per decile Source: UBS Asset Management, Datastream 3

4 Duration of rally Clearly linked to lower volatility, but worthy of mention in its own right, has been the length of time that has passed without any sort of major drawdown in global equity markets. Buy the dips, even small dips, has been the dominant mantra for investors. Despite the surprise outcomes of both the UK s Brexit vote and the US presidential elections, the MSCI World has not endured a three month fall of more than five per cent for over 4 trading days, or, to put it another way, since early March 216. While relatively rare in a long-term historical context, such a protracted period without a meaningful spell in the doldrums is hardly unprecedented. In fact, well over another year would have to pass without such a drawdown before surpassing the previous longest period. Geopolitical Risk But what about political risk? Doesn t a VIX below 12 seem incongruous against a backdrop which includes a Trump presidency, a belligerent North Korea, Brexit, Catalonian independence and Italian general elections? On the whole investors have either largely ignored geopolitical risks or they have taken any initial risk aversion in their stride as was the case with the surprise outcomes of the Brexit vote and the US elections. We believe this simply reflects the difficulty in accurately assessing political risk and investors strongly held belief since the financial crisis that, in the main, these events will not significantly impact economic growth or profitability while monetary policy remains so accommodative. MSCI World: Number of Trading Days without a 3 month drawdown > 5% Days Longest period without a 3 month drawdown >5% is 715 trading days Source: UBS Asset Management, Datastream 2, 1,8 1,6 1,4 1,2 1, mma LHS 12mma RHS 1989 Current run is 426 trading days as at October 19, 217 On the whole investors have either largely ignored geopolitical risks or they have taken any initial risk aversion in their stride as was the case with the surprise outcomes of the Brexit vote and the US elections. Geopolitical Risk Indicator Source: Caldera, Dario and Matteo Lacoviello, Measuring Geopolitical Risk working paper, Board of Governors of the Federal Reserve Board, August ,

5 According to industry data from UBS Financial Services, net positions (long) are now in the 99th percentile of values going back to late 212 as equity hedge funds ride the beta rally as hard as they dare. Net % of Fund Managers Surveyed that Believe Equities are Overvalued Current Percentile Ranking 99 Investor rhetoric It is not without reason that this bull market has been dubbed the most hated of all time. We are hardly alone in our on-going search for signs of complacency or dislocations that might preface a sharp broader market sell off. We see this as contrasting sharply to the blue sky consensual assumptions that have characterised the peak of many previous market cycles. Encouragingly, there also seems to be a healthy degree of scepticism around equity valuations. According to the Bank of America Merrill Lynch Fund Manager Survey in October, a net 43% of fund managers surveyed believe equity markets are overvalued, up 6% from the previous survey in August. This is the third highest rating since the survey began in 1999 and ranks in the 99th percentile of overall values. -6 ' '1 '2 '3 '4 '5 '6 '7 '8 '9 '1 '11 '12 '13 '14 Source: Bank of America Merrill Lynch Fund Manager Survey, October 217. '15 '16 '17 Nonetheless, the report goes on to reveal that the net percentage of surveyed fund managers overweight equities rose from 36% in August to 44% in October tempering our view a little about the absence of complacency. Long/Short Global Equity Hedge Fund Gross and Net Exposures Gross (lhs) Net (rhs) Source: UBS Financial Services Hedge Fund positioning If long only investors current positioning in equities does not look particularly extreme relative to recent history, the positioning of Global Equity Long/Short Hedge Funds certainly does. According to industry data from UBS Financial Services, net positions (long) are now in the 99th percentile of values going back to late 212 as equity hedge funds ride the beta rally as hard as they dare. Overall gross exposures are in the 89th percentile. With such an extended starting point it seems highly unlikely that global equity hedge funds will increase their net exposure to global equity markets. 5

6 Factor/Sector crowding The continued and significant outperformance of Growth sectors and specific risk premia factors across developed equity markets has been one of the defining features of this bull market. The sharp rise in flows into Smart Beta funds has played an important role in these developments, as has the broader lower for longer environment that has seen investors seek out more cost-efficient exposures. While some risk premia factors now look crowded and the outperformance of Growth vs Value in developed markets looks vulnerable to a pick-up in longer-dated bond yields, we do not see these characteristics as evidence of complacency. Parallels between the very strong performance of US technology heavyweights in this rally and the dot com bubble appear misplaced, not least given the profitability of the current US technology giants. In terms of market breadth the comparison is also inaccurate. The weighting of the five largest stocks in the S&P 5 is currently 12.2% (Source: Datastream as at October 23, 217). At the end of March 2 at the peak of tech bubble, the five largest stocks accounted for 18.3% some 5% higher. Broadly speaking we believe the environment will be an attractive one for high conviction, active managers and fully expect active managers to continue their recent outperformance. The sharp decline in individual stock realized and implied correlations supports this view. Interest rate expectations Our analysis shows that equity market implied volatility has a strong statistical relationship with interest rate implied volatility historically. Are equity investors complacent about the outlook for interest rates and therefore vulnerable to a shock from faster than expected tightening? Our base case is that that major central banks will act gradually in their bid to unwind ultra-loose monetary policy in developed economies over the course of 218. However, while not our base case, we see a sharp jump in wage growth and faster-than-expected rises in interest rates as among the biggest fundamental risks to the low volatility backdrop. Global ETF Growth Jan 25 to Sep 217 Google Trends: Smart Beta ETF searches on Google, Jan 213 to Oct 217 6, 6, 7 Assets (USD bn) 5, 4, 3, 2, 1, 5, 4, 3, 2, 1, Number of ETFs 12 Week Rolling Average ETF Assets No. of ETFs Source: UBS Asset Management, ETFgi.com as at September 3, 217 Source: UBS Asset Management, Google Trends Fed Fund Rate Probability Dec 218- (Current Rate 1.25) as at September 7 Fed Fund Rate Probability Dec 218- (Current Rate 1.25) as at October 23 45% 45% Source: UBS Asset Management, Bloomberg Source: UBS Asset Management, Bloomberg 6

7 Until very recently, we believe that there was complacency about the potential pace and scale of tightening in the US. However, after the sharp move higher in short-term interest rate expectations, we believe that those risks have now at least partly reduced. The probability of a global recession is low. Lead indicators are strong; core inflation is subdued within major economies (ex UK) and profits growth ahead of expectations. Combining both fundamental and political risks, the appointment of a new Federal Reserve chair is a meaningful short-term risk to all asset classes in our view given extended positioning. Of the known candidates, Stamford University Economist John Taylor whose rules based monetary policy model would see the Federal Funds rate significantly higher than current levels if followed to the letter is the one that would likely have the biggest impact on markets. However, even if Taylor is appointed, we believe that the volatility would be relatively short lived. Recent rhetoric from Taylor strongly suggests that his approach to policy would not be as rigid and mechanistic as many fear. Nonetheless, a new Fed chair may also herald a very different approach to the detailed market communication which has had such a meaningful impact on implied volatility levels for both rates and equity markets and for overall investor risk appetite since the financial crisis. Conclusions While there are signs of very low risk aversion not least the extended net position of Long/Short Global Equity Hedge funds we do not believe that the technical and non-fundamental factors analysed here in aggregate are evidence of symptomatic complacency. The probability of a global recession is low. Lead indicators are strong; core inflation is subdued within major economies (ex UK) and profits growth ahead of expectations. Equity valuations appear full on a PE basis, particularly in the US, relative to history. However, as we have argued before, low rates and low economic volatility are likely to continue to support high equity multiples. Meanwhile, equity valuations in aggregate remain compelling versus bonds. Importantly, having largely completed the process of deleveraging, bank balance sheets are in much better shape than they were prior to the last recession. Risks? Yes, plenty. But very high levels of complacency? Not on this analysis. In fact, strong macroeconomic fundamentals point to further equity upside. Further reading If you would like to learn more about the ways we can help you meet your investment challenges, please contact your UBS representative or visit For marketing and information purposes by UBS. For professional clients / qualified / institutional investors only. This document does not replace portfolio and fund-specific materials. Commentary is at a macro or strategy level and is not with reference to any registered or other mutual fund. 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