How can investors cope with today's volatile and directionless markets?

Monthly Investment Letter

?Year to date, global equities have finished 17 trading days with a move of greater than 1% up or down, compared with just three in all of 2017. Yet, having traded within a 10% range, they are roughly flat on the year at the time of writing (Fig. 1). Behind this volatile and directionless trading pattern are at least three areas of heightened uncertainty: geopolitics, trade, and interest rates.

At question is the direction markets take from here. Over our six-month investment horizon we think the most likely answer is that equities outperform government bonds, and advance. But the present uncertainty shouldn’t be ignored, so we also need to prepare portfolios for the possibility that we are wrong.

In this letter I go through: a) why we think equities can move higher, b) how markets might behave if we are wrong, and how we are preparing portfolios for this possibility, and c) how we are thinking about the challenge of making money in the interim, while more volatile markets seek direction.

In short, our base case is that investor focus will shift back to economic growth as some of the current uncertainties ease. In our base case we do not expect current tensions between NATO and Russia to escalate further than issues in the past, such as Crimea, and expect the trade dispute between the US and China to be negotiated without escalating to a trade war. And our view is that central banks are not likely to raise interest rates rapidly while inflation remains moderate. Given this base case, and with economic fundamentals still good, we overweight global and emerging market equities relative to government bonds.

Our base case is that investor focus will shift back to economic growth as some of the current uncertainties ease.

We prepare for the possibility we are wrong by holding counter-cyclical positions, including an overweight in US 10-year Treasuries. In our FX strategy, we overweight the Japanese yen vs the New Zealand dollar. And for investors who can hold options, we also recommend considering a small allocation to a put protection strategy linked to the S&P 500. We diversify these positions because how we might be wrong is almost as important as whether we are wrong at all.

With markets still lacking direction, we also take on a variety of relative value positions. These include an overweight to EM USD sovereign bonds versus US government bonds, and in our FX strategy, a series of currency positions: long EURUSD, JPYNZD, and CADUSD. Such positions require active monitoring, and this month we take profit on our overweight GBPCHF position, and close our emerging market currency basket trade. We also recently closed our overweight on the Eurozone versus the UK within European equities.

In these more volatile markets, it is also important not to forget basic principles, like rebalancing regularly toward target asset allocations.

Why we think equities will outperform government bonds and advance over the coming six months

Since late January, markets have been forced to digest fears of tighter monetary policy, a trade war, and a geopolitical shock. All of these risks contributed to the return of volatility. But we do not expect these to intensify.

First, we do not think it likely that airstrikes on Syria will have a material negative impact on global markets. Tensions between NATO and Russia have been high before, such as during the Crimea conflict, before ultimately calming down. While comparisons are difficult, we should note that global markets rallied by 11% in the six months following the last set of US airstrikes on Syria in April 2017, and 7% following Russia’s annexation of Crimea in March 2014.

Economic fundamentals remain good.

Second, while a trade war between the US and China is possible, it is not yet probable. China is the third-largest export market for the US, and the US is China’s largest export market; so both sides are incentivized to find compromises. And we shouldn’t neglect the possibility that the world ends up with lower tariffs as a result of the current spat. We note that China this month announced it would open its markets for more foreign investment, presumably in an attempt to stop the US broadening its tariffs.

Third, while inflation remains where it is, we think the Fed will operate at a manageable “speed limit” of four 25 basis point interest rate rises per year. Fed officials have been at pains to reassure markets that even slightly above-target inflation would not likely provoke faster tightening, and recent data is consistent with underlying inflation remaining contained. The three-month moving average of year-on-year core consumer price inflation was 1.9% to March, up only slightly from 1.8% previously.

Meanwhile, economic fundamentals remain good. We expect to see earnings per share growth of 20% in the US first-quarter earnings season (Fig. 2). The JPMorgan Global Composite Purchasing Managers’ Index, though down from a recent peak of 54.8 in late February, is still at 53.3, comfortably above the 50 level that separates expansion from contraction.

Taken together, we think good corporate earnings and economic growth more than offset the risks, and remain overweight global equities relative to US government bonds.

What might happen if we are wrong, and how to prepare

Our base case is, of course, not a certainty. As such, we need to consider the probability and potential consequences of adverse scenarios, and prepare.

Geopolitical shock

We see a 20–30% probability that fears over potential disruptions to global energy supplies could lead to a sharp rise in oil prices, above USD 80/bbl. Recent tensions between NATO and Russia come at a time when the US is potentially set to renew sanctions on Iran, and when Venezuela is in a state of turmoil. During previous episodes of large oil supply shocks, global equities fell by about 15% on average, although some sectors, such as energy, would likely fare better. We would expect government bonds to rally in this scenario as the market priced in slower growth, and we would expect the US dollar to appreciate given its safe haven status and the relatively limited dependence of the US on oil imports.

Trade war

We also see a 20–30% probability of a trade war between the US and China. The unpredictability of the Trump administration and persistence of the US trade deficit could lead to a broadening and deepening of tariffs. As in an oil price shock, global equities would probably fall, with trade-sensitive markets like the Eurozone and Japan faring worst. Government bonds might outperform as markets price in the negative impact on long-term global growth. But in this case we would expect the US dollar to depreciate, as the market repriced US growth and the path for US interest rates. Conversely, the Japanese yen could benefit from safe-haven demand. Precious metals could be expected to perform relatively well too, given US dollar weakness and a higher short-term inflation outlook.

Rapid interest rate rises

We believe there is a 10–20% chance that the fed funds rate could rise above 3% in the coming six to 12 months, leading to fears of slower growth. This could arise if inflation, or wage growth, starts to accelerate. In equities, bond-proxy sectors like consumer staples would likely underperform rate-sensitive ones like banks.

Bonds would not provide much insulation, since higher interest rates would likely drive higher bond yields (and lower prices). And precious metals would likely fall as real interest rates (the opportunity cost of owning precious metals) rise. Alternatives might be one of the few hiding places, as managers would be in a position to trade relative winners and losers from the shock.

The challenge with preparing portfolios for these scenarios is that the impacts across asset classes are different in each case. Individual equity market and sector impacts are variable across the scenarios, as are the performance of bond and currency markets.

Furthermore, it is worth noting that the scenarios are not mutually exclusive, so we shouldn’t simply add the probabilities. As such, we need to prepare in ways which don’t cost us too heavily if our more optimistic base case proves correct.

We find diversifying with select options and counter-cyclical positions can be a cost effective way to add some protection against downside scenarios:

1. Long Japanese yen versus New Zealand dollar

The yen tends to gain in periods of risk aversion as Japanese investors repatriate foreign assets in times of uncertainty. We think this FX strategy position could also perform well in our base case. The yen is undervalued and Japan should benefit from a strong global economy boosting trade. Also economic conditions in New Zealand are currently weakening.

2. US equity put

For investors who can hold options, we recommend considering a small allocation to a put protection strategy linked to the S&P 500. This is intended to provide protection for our tactical asset allocation in the event of negative market shocks.

3. Long US 10-year Treasuries vs. cash

US Treasuries would likely help cushion portfolios in the event of fears of slower growth (Fig. 3). Over the past decade, 10-year Treasury prices have exhibited a negative correlation to stocks about 80% of the time, based on a 13-week correlation. And even in our base case, we believe the carry of 2.8% per annum should be sufficient to deliver a positive return, if the Fed continues to increase interest rates only gradually.

How to make money in a directionless but volatile market

We are positioning our portfolios to benefit in the event that markets rise, but also to have some insulation against negative surprises. We also need to think about how to deliver performance while uncertainties persist in the months ahead. Two key parts of this strategy are rebalancing, and implementing relative value trades.

In a market that is trading sideways in a series of peaks and troughs, investors that consistently rebalance back toward target equity weightings will improve performance by selling when equities have risen in value and buying when they have fallen. Using data from 10 market cycles since 1950, we calculate that a systematic rebalancing strategy (rebalancing after a 5% deviation from target allocation) would have added approximately 0.8% alpha on an annual basis to a 60/40 equity/fixed income portfolio.

We also use the volatile environment to implement a series of relative value positions:

We overweight the euro and Canadian dollar versus the US dollar in our FX strategy

We expect the US dollar to remain under pressure as fiscal stimulus leads consumers to buy more imported goods, widening the US current account deficit. The gap between the US and Eurozone current account positions is now 7 percentage points, near the widest it has been in more than a decade (Fig. 4). Meanwhile, although fears over NAFTA have weighed on the Canadian dollar, we expect these tensions to ease, and the currency remains undervalued at a time when the Canadian economy is performing well.

We overweight EM hard-currency bonds versus government bonds and EM equities.

The growth environment for EM remains good: we expect EM growth to surpass that in developed nations by around 1.3 percentage points this year. We overweight EM equities, as well as EM hard-currency bonds, which offer an attractive 5.8% yield. That said, we would highlight that diversification is particularly important in EM. For example, US sanctions recently caused Russian stocks to fall over 12% in a single day, but diversified investors fared much better. The overall MSCI EM index closed 0.1% higher despite the Russian slide.

Relative value trades require active monitoring and management, so this month we make changes to some of our previously implemented positions:

In our FX strategy, we close our EM currency basket trade and add two new overweight positions in high-yielding EM currencies.

First, we are closing our overweight position in a basket of four EM currencies (the Brazilian real, Indian rupee, Russian ruble, and Turkish lira) versus a selection of developed market currencies. In a more volatile environment, currency swings can eliminate the extra carry offered by EM currencies. Political concerns in Russia and Turkey, in particular, have made the risk-reward profile of our basket trade less compelling.

However, we still believe there is value to be found in EM currencies. In particular, we add an overweight in the Indian rupee (INR) versus the Taiwan dollar (TWD), and an overweight in the Brazilian real (BRL) versus the US dollar (USD). The INR offers a roughly 7% carry over the TWD and we are forecasting an acceleration in India’s economic growth. Additionally, India’s economy is driven largely by domestic demand while Taiwan is more exposed to trade, so the position also offers some value as a hedge against a global trade conflict. Meanwhile, the BRL is being supported by an improving economic situation in Brazil while the interest rate carry remains attractive compared to EM peers.

In our FX strategy, we close our long British pound position versus the Swiss franc.

The pound has appreciated by more than 3% versus the CHF over the past month, thanks to reviving market confidence in a positive outcome to Brexit talks, and a likely Bank of England rate increase in May. With UK economic data starting to weaken we believe the time is right to take profit.

We also recently closed our overweight on the Eurozone versus the UK within European equities.

We initiated this trade in May 2017 based on our expectations for superior earnings growth in the Eurozone. Year-to-date, Eurozone equities have outperformed their UK counterparts by more than 4 percentage points, and we no longer see the catalysts for further outperformance. We now believe the period of peak acceleration for the Eurozone has passed, with recent economic releases falling short of expectations.

Please visit ubs.com/cio-disclaimer