"Drive for show, putt for dough." What can an old golf saying teach investors?

Monthly Investment Letter

The old golf adage goes that you “drive for show, and putt for dough,” suggesting that accuracy is more important than distance in golfing success. Columbia University Professor Mark Broadie had a different take. He crunched the numbers and found that distance in fact explains the majority of success.

We think that going the distance is the most important skill in investing too.

The composition of your strategic asset allocation should explain around 80% of your long-term returns. But while most investors would probably agree with this, it can be hard to take the long view when what lies ahead is so unclear.

In this letter, I update on our latest positioning, before looking at what we will be monitoring in the months ahead to help us gain more visibility on the longer-term prospects for asset markets.

2018 started strong.

Corporate earnings growth is robust, and has been further boosted by US tax cuts: we project 8 –12% profit growth for global equities this year. Global growth looks set to accelerate to 3.9% from 3.8% last year. And, relative to a month ago, tail risks have diminished: North Korea appears to be adopting a more conciliatory diplomatic stance with the South, and tensions between Saudi Arabia and Iran have eased.

Against this supportive backdrop, we maintain our overweight to global equities, while adding a new overweight to emerging market equities relative to US government bonds.

• Emerging market stocks are relative value plays, and should provide investors with exposure to a strong global economy.
• Finally, we see the current environment as one in which investors can afford to engage in more active intra-market trades. Therefore, in our FX strategy we double the size of our existing currency positions – overweight CADUSD, overweight SEKNOK, and overweight in our basket of select emerging market currencies.

As we look to the months ahead, we will be closely watching for the global reaction to the US tax cuts, how bond markets respond to the withdrawal of quantitative easing, and the debate on the longer-term mandate of the Federal Reserve. Signs that the US tax cut could spark a global trend would support corporate profit margins over the medium term, while the interplay between central bank policy, bond markets, and equities will play an important role in setting longer-term return expectations for asset markets.

Our latest positioning

Despite good recent performance, we think that this period of economic and earnings growth is one in which investors should continue to take equity risk, and look to relative value trades. Specifically:

• We maintain the size of our overweight position in global equities relative to government bonds. The faster-than-expected passage of US tax cuts, reduced geopolitical tail risks, and continued strong economic data leave global markets in arguably a stronger position than at the end of last year.
• We add a new overweight in emerging market equities. Although we will continue to monitor the risk of increased US protectionism, emerging markets (EM) seem well placed to benefit from global economic momentum – we project low double-digit earnings growth for 2018, and the recent rise in commodity prices should support profits in the upcoming earnings season. Emerging markets today are also more than just a commodity play – almost 30% of the MSCI EM Index is made up of technology stocks. And the region is more favorably valued than other global markets: the MSCI EM is trading on 14.5x P/E vs. 19.4x for developed markets, and 21.7x in the US. We implement our EM equity overweight relative to US government bonds.

• In our FX strategy, we double the size of our existing currency positions – overweight in the Canadian dollar vs. the US dollar, overweight in the Swedish krona vs. the Norwegian krone, and overweight the Russian ruble, the Brazilian real, the Indian rupee, and the Turkish lira vs. the Australian dollar, the Hungarian forint, the Norwegian krone, and the Taiwanese dollar.
• Within Europe, we maintain our overweight position in Eurozone equities relative to UK stocks. Domestic Eurozone demand is robust and leading indicators point to continued solid domestic activity. Moreover, companies are well positioned to benefit from robust global demand given their cyclical sector composition and high operational leverage. Earnings in the UK, meanwhile, are likely to lag behind, in part due to the recent strength in sterling.
• We also maintain our overweight in a diversified set of EM local currency bonds relative to government bonds. EM local currency bonds offer an attractive carry of 3.6% against US government bonds. In a strong economic environment, we think EM currencies have further room to appreciate against the US dollar. Amid lower inflation, we also believe that local currency yields are unlikely to rise.

What we are watching in the months ahead

America first, rest of world follows?

Cuts in US corporation tax have inevitably boosted expectations for US economic and profit growth in 2018. We have revised up our estimate for 2018 S&P 500 earnings growth from 8% to 16%, and for US economic growth from 2.2% to 2.4%. But it remains to be seen if the second order effects will prove positive or negative.

This might be seen as the start of a more protectionist global trade environment. The EU, for example, has been investigating whether the US cuts contravene global rules on “fair” taxation, and may consider protectionist measures to counteract. We also can’t rule out the possibility that President Trump announces additional tariffs or other protectionist measures in the months ahead.

But a more positive story could also emerge.

We’ve already seen some glimpses of positive second order effects in the US: Walmart CEO Doug McMillon has stated that the recent increase in the company’s minimum wage was linked to the US tax reforms “[giving] us the opportuntity….to accelerate plans for the US.” If replicated at other large US employers, this could help support consumption. And overseas, China has announced it will exempt foreign companies from withholding taxes in certain industries retroactively – almost certainly a reaction to US measures. And a debate on lower corporate taxes has entered the German coalition negotiations.

Should the path from here be one of protectionism, benefits are likely to prove oneoff and US-centric in nature, with concerns rising for trade-reliant markets and sectors. But if this instead marks the beginning of a renewed leg down in tax rates (see Fig. 2), it could boost the equilibrium profit margins we can reasonably expect companies to make through a cycle, supporting equities over the long term.

Bond markets

The fourth quarter of 2018 will be the first time since the financial crisis when central banks are withdrawing, rather than adding, liquidity to global markets. Having spent a decade trying to stimulate growth, central bankers will be keen to ensure that the process of backing away from easing is about as eventful as “watching paint dry.” Keeping bond yields stable will be a key measure of their success.

So far this year, US 10-year government bond yields have risen by as much as 15bps.

A combination of concerns about US quantitative tightening and reports that China is considering stopping its purchases of Treasuries have likely contributed to the bond sell-off and higher yields. But higher inflation expectations are also playing a role. In the last six months, 10-year inflation breakevens have risen by 30bps (see Fig. 3).

Whatever their cause, significantly higher bond yields (e.g. the US 10-year above 3%) could lead to concerns about corporate and household debt refinancing, as well as make equity valuations appear relatively less attractive: the US 10-year yield is already at its greatest premium to the S&P 500 dividend yield in close to four years.

But for now, we remain doubtful that we are approaching a major turning point in bond markets.

The Fed’s balance sheet reduction still looks to be very gradual in nature, and the Fed will in fact be increasing its rate of purchases of longer-term debt to offset the maturing of short-term bonds in its portfolio. China is unlikely to make a huge policy shift on Treasuries: the country holds USD 1,189 billion and it wouldn’t be in China’s interest to risk crashing the market. And with US shale oil production set to ramp up in response to higher prices – the US Energy Information Administration this month upped its 2018 US oil production forecast to 1.5 million barrels per day – we think the next leg for prices is likely to be down. This should help moderate inflation expectations.

Should we start to see robust global growth translating into higher expectations for core inflation, or if markets begin to lose faith in central banks’ economic management, we would revise our expectations. But at this stage, we do not expect a significant increase in yields.

The Fed’s end game

Regardless of how successful the Fed, and others prove in their withdrawal of easy money, the “normalization” of policy is unlikely to see monetary policy go back to what was considered “normal” before the financial crisis.

The Fed estimates that, to fulfill its current mandate, interest rates are unlikely to go much higher than 3% in the current cycle (see Fig. 4).

This poses a potential challenge: with rates likely to stay low, and balance sheets already large, central banks have much less scope than usual to boost the economy in any future slowdown.

The Fed is therefore reported to be looking at potential changes to its mandate, which could have important long-term implications for markets.

Two options presented by former chair Ben Bernanke this month were to:

1. raise the inflation target, which, if it led to higher inflation expectations, could allow the Fed to run nominal interest rates above 3%,
2. to adopt “price level targeting,” which would force the Fed to keep rates close to zero and “run the economy hot” for an extended period following any future recession to make up for periods of low inflation.

We’re not expecting any fireworks soon.

New Fed chair Jay Powell is only just getting his feet under the desk, and the Fed is only part way through executing on a long-planned policy under its current mandate. But we will continue to follow this debate as one that could have an important impact on portfolios over the longer term. Either policy would likely mean higher average nominal growth, which would be supportive for corporate revenue growth. But both would also likely prove negative for bond markets, with the market needing to price for higher average inflation.

Conclusion

This remains an environment where we believe it will pay to take equity market risk and implement intra-market trades.

While the daily news flow – from false-alarm missile attacks on Hawaii, to threats of US protectionism, to European political negotiations – makes navigating the short term difficult, we are not neglecting the driving for the putting. In the months ahead, we will be watching for the second order effects of major tax changes in the US, and the consequences of unwinding easy monetary policy – each of which could shape the long-term outlook for equity and bond markets.

please visit ubs.com/cio-disclaimer