CIO Top Ideas CIO WM Research January 17 Investment ideas expected to benefit from rising inflation CIO Top Ideas are highconviction investment ideas that are expected to deliver better returns than cash. Source: istock Mark Andersen, strategist Jackie Bauer, strategist Matthew Carter, strategist Christopher Swann, strategist We believe inflation will rise globally and there are ways investors can benefit from this. Since the financial crisis, central banks have pursued innovative ways of stimulating the global economy via monetary policy to push headline inflation toward their targets. Falling oil prices and slack in the labor market largely caused the low inflation numbers. Now, oil prices have doubled over the last year to around USD 5/bbl, and commodity prices have risen. More important is the recent rise in labor costs. Tighter labor markets, particularly in the US and Germany, mean rising wages and producer prices and subsequently inflation pressure. Roughly 7% of a country s consumer price index (CPI) is linked to domestic labor costs. In general, equities tend to outperform bonds in an inflationary environment. Bonds tend to perform poorly in periods of rising inflation as central banks adjust interest rates higher and yield levels rise. Equities often benefit from company sales growth increasing with inflation, despite the negative impact from rising interest rates. Investors should be selective, however. Below we present a list of investment ideas which we believe will perform well in the coming months, as inflation continues to rise. CIO Top Ideas Target return Time horizon Equity US energy 1 15% 1 months US banks 1 15% 1 months Eurozone energy 1% 1 months Swiss dividends 8% 1 months US REITs 1 11% 1 months Commodities & Precious Metals Platinum, palladium & gold 5% 1 months Alternative Investments Hedge funds % p.a. 5 7 years For further information please refer to our other report, Chief economist s comment What does inflation mean for you? This report has been prepared by UBS AG, UBS Switzerland AG and UBS Financial Services Inc. Please see important disclaimer at the end of the document.
Idea: US energy 1 months, +1 15% in USD Why CIO likes this idea: Oil prices have been trending higher since November 1, when OPEC delivered a deal to curb production. Though the level of implementation remains uncertain, we see upside risks to our base case oil price outlook. Our expectation is that WTI oil prices will rise over coming months, lending a positive outlook for S&P 5 energy stocks. Furthermore, current 1-month trailing earnings are severely depressed, and 17 earnings should rebound sharply. In both absolute terms and relative to the S&P 5 Index, US energy sector valuations remain below their long-run average. CIO recommends that energy investors focus on financially strong, efficient operators with top-quality assets. CIO prefers exploration and production, and oil services companies, whose earnings are most sensitive to changes in oil prices. Our return expectation of 1 15% for the S&P 5 Energy sector is based on our expectations for an approximate 5 1% valuation re-rating on price to book value, stable to moderately higher (~ 5%) sector book value in 17 and a.% sector dividend yield. For more information please see our equity sector reports. Brent crude oil prices in USD/bbl Opec s production agreement has supported oil prices recently 1 1 1 8 1 15 1 17 Brent in USD Source: Bloomberg, UBS, as of January 17 Analyst: Jeremy Zirin, Nicole Decker Idea: US banks 1 months, +1 15% in USD Why CIO likes this idea: US banks (money center, capital markets and regional banks) benefit from rising inflation and accelerating growth in the US. Banks are a clear winner from reflation as stronger economic activity supports: a) increased commercial and consumer investment spending along with loan demand (increasing client engagement, trading and capital markets activities), b) higher interest rates have the potential to boost bank net interest margins, and c) improved asset quality (stabilizing/improving loan loss rates). With a little help from easing regulatory pressures, CIO expects banks excess capital to be redeployed into growth areas including loans, investments and mergers and acquisitions. The 1 15% expected return over 1 months reflects expected EPS growth of high single digits-to-low double digits plus average dividend yield of 3% while maintaining the current P/E multiple of roughly 1 times for the sector. For more information please see our equity sector reports. S&P 5 total return vs US 1yr bond yield 3..5. 1.5 1..5. Jan-15 Apr-15 Jul-15 Oct-15 Jan-1 Apr-1 Jul-1 US 1 year (lhs) S&P 5 banks index (rhs) Source: Bloomberg, UBS, as of January 17 Oct-1 35 3 5 15 1 5 Analyst: Bradley Ball
Idea: Eurozone energy 1 months, +1% in EUR Why CIO likes this idea: The expected rise in Eurozone inflation is largely driven by higher oil prices, which should provide a major boost to the sector s net earnings from current, depressed levels. In addition, the industry should benefit from its high operating leverage, which should translate in a strong recovery in free cash flows as investment stabilizes. The sector s above-average dividend yield of close to 5% looks attractive in an environment where dividends are likely to make up a significant part of total equity returns, given the limited potential for P/E expansion due to rising inflation. Our total return target is made up of a 5% capital gain driven by an expected 8% rise in oil prices and a 5% dividend yield. US 1yr bond yield vs MSCI EMU Energy price index In % Index 5 3 18 1 1 1 1 1 8 1 1 1 1 Analyst: Bert Jansen 1yr US Treasury yield (%, lhs) Source: Datastream, UBS, as of January 17 MSCI Energy Price index (rhs) Idea: Swiss dividends 1 months, + 8% in CHF Why CIO likes this idea: By global standards, Swiss inflation will remain relatively low over coming years. Still, CIO expects the Swiss consumer price index to begin rising after two years of declining prices, swinging from.% in 1 to +.% this year and.9% in 18. In this environment, CIO prefers companies with the ability to raise dividends as earnings increase. Rather than simply buying the highest-yielding stocks, investors should select high-quality dividends that exhibit high dividend sustainability coupled with decent growth. Such companies can support attractive dividend payouts due to relatively low net indebtedness and robust profitability. We expect up to % absolute performance for the Swiss equity market, driven by corporate profit growth while valuation multiples should stay unchanged and a dividend yield of 3 %. Analyst: Stefan Meyer, Tobias Hochstrasser, Alessandro Bee Factor growth is back again Year on year growth in net earnings per share (EPS) and dividend per share (DPS) for the Swiss Performance Index, in % 15 1 9 3 3 EPS 1 DPS 15 Source: FactSet, UBS, as of December 1 1e 17e 18e 3
Idea: US Real Estate Investment Trusts (REITs) 1 months, +1 11% in USD Why CIO likes this idea: Historically, commercial real estate (CRE) has provided a good inflation hedge when rising prices have resulted from improving economic conditions. An accelerating US economy should lead to greater demand for CRE and provide landlords with more pricing power, something that could help offset the risk of rising interest rates. On average over the past six years, REITs have traded at an 11% premium to the S&P 5 based on forward valuation estimates. Currently, REITs are trading in line with the S&P 5 Index. CIO does not expect REITs to recover all their historical premium, due to the risk of rising rates and faster S&P projected EPS growth. However, CIO believes some premium to the S&P is warranted by the solid operating fundamentals, strong yields, and rising dividends offered by REITs. Our total return assumptions are based on a current dividend yield of.8% and consensus FFO and AFFO growth rates of 5% 7%. For more information please see our equity sector reports. REITs historically offered a premium to S&P 5 S&P 5 forward P/E multiples, REIT FFO forward multiples In % 18 1 1 1 1 15 13 11 9 7 5 9 1 11 1 13 1 15 1E 17E S&P 5 (Le ) REITs (Le ) REIT Premium (Right) Source: UBS, as of January 17 Analyst: Jonathan Woloshin
Idea: Platinum, palladium and gold 1months, +5% in USD Why CIO likes this idea: CIO forecasts that inflation will rise faster than policy rates in the US, driving real interest rates further into negative territory. This environment favors yield-free real assets like precious metals. We favor industriallyoriented precious metals, like palladium and platinum. Stalling supply and accelerating industrial activity in the coming quarters should result in 17 being the sixth consecutive deficit year for both white metals. With regard to gold, CIO believes the metal offers insurance in the event of policy mistakes, higher-than-anticipated inflation or growth disappointments. Adding the yellow metal to a basket also mitigates the larger price swings of palladium during adverse economic times. Our target upside is based on our target price forecasts for the metals. For more information please see our 17 commodity outlook report. Analyst: Giovanni Staunovo, Wayne Gordon, Dominic Schnider US real interest rates are likely to go deeper into negative territory In % 7 8 9 1 11 1 13 1 15 1 17E Source: Bloomberg, UBS, as of January 17 Idea: A diversified hedge fund portfolio 5 7 years, + % annual returns in USD Why CIO likes this idea: The US Federal Reserve increased interest rates by 5 basis points in December 1, in part due to signs that inflation has started rising noticeably. CIO expects two additional 5bps hikes over the course of this year. Based on historical data, hedge funds are fairly resilient to both rising inflation and interest rates. In fact, most managers enjoy an increasing range of opportunities during periods of higher US borrowing costs. Also, opportunities for hedge funds tend to rise in an environment of rising inflation. If inflation does rise gradually, especially from a low base, then equities tend to benefit. And hedge funds have a positive, albeit small, beta to equities and should gain from such a move. Meanwhile, if inflation accelerates well ahead of market expectations, equity market volatility could rise, and extend the range of opportunities available to hedge funds further. We are targeting a return of % which is based on a blend of returns across various hedge fund strategies, which include exposure to private markets, equities, foreign exchange and fixed income investments. Investors are reminded that hedge funds are not a tactical trade. CIO recommends a well-diversified hedge fund portfolio as part of a broader multi-asset strategy. Hedge funds have historically outperformed in a rising rates environment Annualized total return, in % 1 1 1 8 Equity Fund Event- Hedge Weighted Driven Composite Relative Value S&P 5 1 month Macro Cash TR Barclays US High Yield JPM Global Agg. Bond Source: Bloomberg, HFR, UBS, Period: /199 /1995; /1999 5/; / / Barclays US Inv. Grade Analyst: Alec Zimmermann, Karim Cherif, James Purcell, Max Kunkel. 5
Non-Traditional Assets Non-traditional asset classes are alternative investments that include hedge funds, private equity, real estate, and managed futures (collectively, alternative investments). Interests of alternative investment funds are sold only to qualified investors, and only by means of offering documents that include information about the risks, performance and expenses of alternative investment funds, and which clients are urged to read carefully before subscribing and retain. An investment in an alternative investment fund is speculative and involves significant risks. Specifically, these investments (1) are not mutual funds and are not subject to the same regulatory requirements as mutual funds; () may have performance that is volatile, and investors may lose all or a substantial amount of their investment; (3) may engage in leverage and other speculative investment practices that may increase the risk of investment loss; () are long-term, illiquid investments, there is generally no secondary market for the interests of a fund, and none is expected to develop; (5) interests of alternative investment funds typically will be illiquid and subject to restrictions on transfer; () may not be required to provide periodic pricing or valuation information to investors; (7) generally involve complex tax strategies and there may be delays in distributing tax information to investors; (8) are subject to high fees, including management fees and other fees and expenses, all of which will reduce profits. Interests in alternative investment funds are not deposits or obligations of, or guaranteed or endorsed by, any bank or other insured depository institution, and are not federally insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other governmental agency. Prospective investors should understand these risks and have the financial ability and willingness to accept them for an extended period of time before making an investment in an alternative investment fund and should consider an alternative investment fund as a supplement to an overall investment program. In addition to the risks that apply to alternative investments generally, the following are additional risks related to an investment in these strategies: Hedge Fund Risk: There are risks specifically associated with investing in hedge funds, which may include risks associated with investing in short sales, options, small-cap stocks, junk bonds, derivatives, distressed securities, non-u.s. securities and illiquid investments. Managed Futures: There are risks specifically associated with investing in managed futures programs. For example, not all managers focus on all strategies at all times, and managed futures strategies may have material directional elements. Real Estate: There are risks specifically associated with investing in real estate products and real estate investment trusts. They involve risks associated with debt, adverse changes in general economic or local market conditions, changes in governmental, tax, real estate and zoning laws or regulations, risks associated with capital calls and, for some real estate products, the risks associated with the ability to qualify for favorable treatment under the federal tax laws. Private Equity: There are risks specifically associated with investing in private equity. Capital calls can be made on short notice, and the failure to meet capital calls can result in significant adverse consequences including, but not limited to, a total loss of investment. Foreign Exchange/Currency Risk: Investors in securities of issuers located outside of the United States should be aware that even for securities denominated in U.S. dollars, changes in the exchange rate between the U.S. dollar and the issuer s home currency can have unexpected effects on the market value and liquidity of those securities. Those securities may also be affected by other risks (such as political, economic or regulatory changes) that may not be readily known to a U.S. investor.
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