Monthly Investment Letter: clarity from chaos?

Monthly Investment Letter

This post was first shared on ubs.com/cio. Visit the website to find out more about my investment views.

As the financial world looks back at the Lehman Brothers bankruptcy, it is hard to remember that, in the moment, the event wasn’t seen as a turning point. Few people recall that the global equity market traded up in the week after Lehman Brothers’ collapse (see Fig. 1). Most like to believe in a decisive event that gives clarity to chaos, but markets will never make it that easy. At the time, the market saw Lehman Brothers as one more piece of news that might influence the complex interaction of fiscal, monetary, and corporate policies. Even today, people still argue over how different responses to the Lehman Brothers event could have made the unfolding scenarios better or worse.

With the humility that comes from the study of history, we attempt to pursue an investment course through the inevitable uncertainty of current events.

In our 2018 Year Ahead we stated that “overall, solid growth and limited evidence of an impending slowdown keep us positive on global equity markets as we enter the New Year.“ Overall it has indeed been relatively smooth sailing: global equities, as represented by the MSCI AC World hedged index, have delivered total returns of 5.3% year-to-date, but only 3.2% on an unhedged basis due to the stronger US dollar. But investors with a regional bias may have fared very differently (see Fig. 2). Of the top 20 equity markets by market capitalization tracked by Bloomberg, total returns in local currency are negative in 11 of them, and are worse than –10% in two of them. 

As we look ahead, we still see the outlook as broadly positive for well-diversified investors. We remain in an environment of good global growth, low inflation, and low or negative real interest rates. Equity valuations are not particularly high: the global earnings yield is around 6%. And the prospects for USD fixed income investors have improved as interest rates have risen. Total returns are admittedly unlikely to match those of the past few years, but forward-looking portfolio returns still look attractive—especially versus cash, where yields have risen but remain near record lows.

Yet, as I noted in my May letter Volatility is back. Are You Prepared?, a maturing economic cycle means we need to prepare for more volatility than we have been accustomed to in recent years. While this did not, and does not, mean I’m predicting any event risk as consequential as the collapse of Lehman Brothers, we will need to pay close attention to a number of dynamics whose evolution will inevitably affect global market performance in the months ahead: higher US Federal Reserve rates, slower growth in China, ongoing trade tariff negotiations, and rising oil prices.

In this month’s letter, I look at these dynamics in greater detail, consider the ways they could derail markets, and identify five key measures that investors can take to make their portfolios more robust while remaining positioned for growth.

Tactical Asset Allocation

In our tactical asset allocation, we increase our overall exposure to risky assets. We remain watchful of various downside risks, as I discuss in this letter, but the limited reaction to recent tariff announcements shows that the market has begun to digest some of the trade concerns. We maintain our overweight position in global equities and increase our exposure to emerging market dollar denominated sovereign bonds, maintain our overweight to US 10-year Treasuries and our FX strategy overweight to the Japanese yen relative to the Taiwanese dollar. Within international developed equities, we now recommend a tactical overweight to Canadian stocks relative to Australian equities, reflecting relative valuation and earnings momentum between the two markets. 

Key risks to watch

Accelerated Fed rate hikes. If the story of global markets since the financial crisis has been one of extraordinary stimulus – central banks bought USD 14.5trn of assets (18% of global GDP) over the past decade – the months and years to come will largely be defined by the success or failure of unwinding this stimulus (see Fig. 3).

Steady Fed rate hikes – we expect four by the end of 2019 – are priced in by markets and are unlikely to cause a shock. But we would be more concerned if the Fed were forced to act more aggressively. If US companies need to increase pay significantly to attract workers or increase prices to ration demand, the Fed will be less predictable. Wage growth in excess of 3.5%, or core PCE inflation, the Fed’s preferred measure, above 2.5% is likely to have more significant market implications. 

The impact of rapid Fed rate hikes, if not matched by strong growth, would be at least threefold. First, risky credits would suffer as yield-seeking investors meet their needs through safer USD assets. Second, emerging markets would likely underperform as USD strength and higher interest rates tighten liquidity. Third, stocks would likely decline as higher cash rates increase the opportunity cost of investing in equities.

China’s economic slowdown

As I discussed in last month’s letter, Wasting Assets, China’s huge stimulus program during the financial crisis helped guide its economy through the disruptions experienced elsewhere in the world. But the resulting debt means China now needs to rebalance its economy to nurture sustainable long-term growth and contain risks.

China has a good track record of intervening against various external shocks and internal imbalances. In our base case we expect only a modest slowdown in growth from 6.5% in 2018 to 6.0% in 2019 (see Fig. 4). The recent shift to easier monetary, fiscal, and credit policy has helped stabilize activity data: growth in industrial production and retail sales improved slightly in August.

But growth in fixed asset investment is sluggish, edging 0.2% lower to 5.3% year-on-year last month, and exports clearly remain vulnerable to trade tariffs.

Given China’s critical role in the global economy, accounting for two-thirds of all global growth in the past five years and half of all industrial metals demand, a slowdown toward 5% annual GDP growth there could have severe negative consequences for equities (particularly in Asia), commodities, and Asian credit.

Escalating trade tensions

Our base case is that US-China trade tensions will get worse before they get better. The White House this week announced a 10% tariff on a further USD 200bn of Chinese imports, effective 24 September, with the rate rising to 25% on 1 January. China’s plans to retaliate with tariffs of 5–10% on USD 60bn of US goods are less severe than widely expected. But we note that the US administration has previously vowed to immediately move toward imposing tariffs covering nearly all of China’s exports to the US if the Chinese retaliate.

Tariffs on US-China trade are unlikely to be significant enough to cause a global market shock, in our view. While the US and China combined account for 22% of world exports, bilateral trade between the two countries accounts for just 3.2%. But we will be watching for signs that “third countries” become involved or are affected by the dispute. This could happen, if, for example, goods originally destined for the US are rerouted to Europe at reduced prices, provoking tariffs there, or if China turns to active manipulation of its currency.

We estimate that such a scenario could lead global GDP to slow by 0.5–1.0 percentage point relative to our base case, taking growth from a high since 2011 to a low since the financial crisis. Trade-dependent markets like Germany, Japan, and the emerging markets would likely suffer most, alongside cyclical sectors like industrials and commodities.

Oil supply shock

As we look back on the run-up to the financial crisis, we also shouldn’t forget that the global economy was already creaking under the weight of USD 150/bbl oil. Since then, the development of US shale fields, and improved energy efficiency have reduced the risk of future oil price shocks. The world economy needs 7% less oil to produce the same amount of GDP as it did in 2007 and OECD countries need 12% less. But we think preconditions for a supply shock are building. US sanctions on Iran take effect in November, US inventories are low, Venezuela is in crisis, and production in Saudi Arabia and other Gulf Cooperation Council countries is close to capacity.

In our base case we expect a tight market to lead Brent crude oil prices to rise to USD 85/bbl over the next six months. Further upside could come from a sharper-than-expected drop in Iranian exports, or Iranian retaliatory measures against the US sanctions. We estimate that oil prices of USD 120/bbl would contribute to a sharp slowdown in global growth. During previous large oil supply shocks, global equities fell by an average of 15%.

Local risks

There are, of course, many more localized risks beyond the four scenarios outlined above, such as political ones in the UK, Italy, and Brazil. They might not have global implications, but could be very meaningful for investors heavily concentrated in those individual markets.

Are you prepared?

Some investors might have cause to focus on individual risk scenarios and prepare for them specifically. But most need to consider risks in aggregate while balancing them against the continued economic strength driving world markets. Preparing for just one scenario, for example by reducing holdings of consumer staples and buying energy stocks to prepare for an oil supply shock, might leave a portfolio poorly positioned to weather another, like a China economic slowdown.

To reduce portfolio vulnerability while remaining positioned for growth, investors should consider five key questions:

1. Are you relying too much on market performance?

In our base case, the outlook for a portfolio of bonds and equities is positive, but faster-than-expected Fed rate hikes could lead credit and equities to fall in tandem. To mitigate this risk, investors today should seek alternative sources of return beyond the beta of equity and bond markets. Manager alpha, illiquidity premia, and volatility premia from call overwriting strategies are all potential means of diversifying sources of return, reducing exposure to Fed rate risk, and maintaining expected returns.

2. Is your yield worth the risk?

This era of low yields has tempted many investors to seek higher returns by taking greater credit or foreign exchange risks. As the cycle matures, investors need to evaluate whether such risks are now worthwhile. A China slowdown would affect Asian credit, and more aggressive Fed rates hikes would hurt high yield worldwide. To mitigate these risks, investors should diversify fixed income holdings and both improve credit quality and extend duration. We currently see tactical value in US 10-year Treasuries, and EM hard-currency bonds now offer income that rivals high-yield corporate bonds, but with a higher-quality credit profile.

3. Is your portfolio too familiar?

For investors, familiarity tends to breed comfort rather than contempt. Yet investing too many of your assets close to home usually adds unnecessary risk. Every region has idiosyncratic risks, so global diversification in different markets and monetary regimes can help.

4. Have you considered protecting your profits?

Investors sitting on equity profits but now feeling uncomfortable about pending risks could consider buying protection, rather than fleeing to cash and forgoing potential upside. Our systematic hedging approach looks for put options that are attractively priced relative to the level of protection they have historically provided during market drawdowns. This research currently highlights options on the Euro Stoxx 50, HSCEI, and Nikkei 225 indexes as potentially effective insurance for global equity investors.

5. Are you prepared to look beyond the current noise in markets?

In an environment of heightened risk, investors can be their own worst enemies. Behavioral finance studies show that panic selling is an important source of the long-term underperformance of private investors relative to market benchmarks. Assets with exposure to long-term drivers, like population growth, urbanization, and aging, or those exposed to secular sustainability trends, are likely to outperform long-term economic growth, and reduce investor temptation to panic sell on short-term news.

Tactical Asset Allocation

This month the overall effect of our changes increases our exposure to risky assets. Two months ago, we reduced our exposure because we thought the market was not sufficiently pricing in US trade policy risks. While we still believe the trade situation between the US and China is likely to get worse before it gets better, the market has had time to digest some of the impact. We will continue to watch for the threat of further spillover, but are also starting to see some value after the emerging market sell-off.

At present we see the key tactical opportunities as follows:

1. We hold a modest overweight position in global equities, and initiate an overweight in Canadian equities relative to Australian equities within international developed markets. With global earnings on track to expand by c.15% in 2018 and c.10% in 2019, and with real interest rates still negative or close to zero, we still believe the path of least resistance for global stocks is one that, while volatile, leads higher. Meanwhile, we expect Canadian equities to outperform Australian equities over the coming six months – the Canadian market is cheaper, has more positive earnings momentum, and will benefit more from rising oil prices.
2. We overweight US 10-year Treasuries. We believe 10-year Treasuries have largely priced the Fed rate hiking cycle and could provide portfolio protection in the event of a jolt to global growth.
3. We add to our overweight in emerging market (EM) dollar-denominated sovereign bonds. Despite the current uncertainty in EM, we think the 6.5% yield on emerging market USD sovereign bonds is attractive, and the index is welldiversified across issuers.
4. We prefer the Japanese yen relative to the Taiwanese dollar. The yen is one of the world’s most undervalued currencies and could see upside if the Bank of Japan reduces its stimulus. Furthermore, the position provides a partial portfolio hedge against a global market shock. Both countries are heavily exposed to global trade, but the yen would be expected to appreciate in a sell-off as Japanese investors tend to repatriate funds in times of global uncertainty.

?Please visit ubs.com/cio-disclaimer #shareUBS