The outlook is better than the market is pricing

After stabilizing last week, the market sell-off resumed this week, with the S&P 500 down 3.3% the past two days and the MSCI All Country World Index 2.6% lower.

While tech led the market lower on Monday on concerns about slowing smartphone sales, Tuesday’s market activity reflected the ongoing fears of slowing growth and a general risk-off sentiment, as cyclical sectors were the worst performers and oil prices fell 6%. The sharp drop in oil prices has added to concerns about US high yield corporate bonds, where spreads have now widened to 425bps, up 114bps from their October low.

A tech slowdown, a deceleration in growth, oil, US housing market weakness, and credit stress are reasons for concern that we are monitoring, but we still don’t see them bringing an end to the US and global economic expansion.

The tech sector weakness has been driven by a combination of positioning, concerns over smartphone demand, and worries over semiconductors. The positioning unwind has left valuations more attractive, and in contrast to the softer smartphone market, enterprise IT spending remains healthy.

Disappointing earnings from major US retailers on Tuesday added to existing growth concerns. But revenue growth, a better indicator of the strength of the US economy, has shown continued strength, and spending during the upcoming holiday season is expected to be up at least 5%, one of the best seasons in recent years. The economy as a whole is on track to boast 4Q GDP growth between 2.5% and 3%. Outside the US, growth rates have been declining throughout the year, but the level is still above long-term trend rates.

The steep drop in oil on Tuesday occurred without much new fundamental news, suggesting the sell-off was part of the broad risk-off move. We believe that favorable supply-demand fundamentals should lift oil prices over the medium term.

On Monday, another weak data point on the US housing market – the monthly National Association of Home Builders survey – added to the concern that higher rates are slowing the economy. However, demand remains reasonably solid for moderately priced homes, while supply constraints are easing in many markets. In our base case of rates staying relatively stable over the next year, affordability pressures should abate somewhat, mitigating a further deceleration in the housing market.

Finally, for credit, most of the spread widening has occurred in the past few weeks, after being relatively immune to the equity correction in October. The sharp decline in oil prices is one factor, while investors have become less forgiving of weaker credit. Still, high yield spreads now provide reasonable compensation for the default risk – in the context of a still strong economy, our base case forecast is a 2.5% default rate over the next 12 months, low by historical standards.

The bottom line

We view the sell-off as overdone and a bull market correction, with valuations that have become more compelling. In our tactical asset allocation, we recently increased our overweight to global equities on the view that the markets are already pricing in growth and trade risks. Consequently, we think that the risk-reward for owning equities is asymmetric to the upside over the next six months. But we also hold countercyclical positions, including an overweight to 10-year Treasuries, to manage the market volatility as investors wait more clarity on trade, the Fed, and growth.

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