vk.com/id446425943

Box 1: What do asset, product and labour markets tell us about the stage of the economic cycle?

Assessing the current stage of the global economic cycle is not clear-cut; different measures point in different directions. We try to identify it from different parts of the economy and asset markets, and synthesise these into one indicator. We look at five areas for clues: a) corporate debt market, b) the banking system, c) the equity market, d) the money and bond markets, and e) economic information in the Phillips curve. For each sub index in these categories we look the latest reading as a percentile of its 20 year history (Figure 19 and Figure 20).

We take a particularly close look at credit markets, analysing the levels and changes in corporate leverage and spreads, the proportion of lower-rated (B and CCC) corporate issuers within the HY segment, and the gap between companies' refinancing costs and their historic coupon. In aggregate, these indicators are at the 60th percentile of their distribution for the US, and 52nd for Europe. To assess the health of the banking system, we look at banking assets to GDP, and the change in NPLs. This part of the economy signals little concern, particularly in the US, probably because the shock from the last crisis and the regulation since has forced the banking system into better shape. This is important because it prevents a new shock (say in the housing or auto markets) from being amplified into the economy through clogged financing.

Figure 19: What are different assets say about the stage of the cycle: Sub indicators

Figure 20: What different assets say about the stage of the cycle: Main indicators

	US	EU
Corporate credit
Corp debt (% of GDP)	96%	76%
Change in corp debt (% of GDP)	48%	4%
B and CCC (% of HY index)	27%	42%
HY Index yield minus coupon	49%	45%
HY spreads levels	94%	79%
Change in HY spreads	49%	68%
Bank credit
Change in NPLs (% of bank assets)	38%	31%
Bank assets (% of GDP)	49%	73%
Philips curve
Unemployment rate	100%	88%
Change in unemployment rate	45%	8%
Inflation gap	88%	47%
Equity market
Profit margin	100%	80%
Change in profit margin	28%	49%
Bond markets
Policy rate priced over 5y	86%	40%
Aggregate	66%	51%

Source: Haver, UBS. * Values in the table are a percentile of current level since 1999 for US and early 2000 for EU. Colors refers to different quartiles with Red representing Top quartile and Green representing bottom quartile

100%						US						EU			78%			86%
	44%		52%	60%				64%	65%					51%			48%			40%
						52%						66%
80%
60%
40%
20%
0%
		Bank credit			Corporate credit			Equity market					Aggregate			Philips curve			Bond markets

Source: CEIC, Bloomberg, UBS

In equity markets, we look at the levels and changes in corporate profit margins over time, which suggests that the cycle is a little longer in the tooth than credit markets imply: the aggregate equity cycle index sits at the 64–65th percentile in both the US and Europe.

Figure 21: What do assets say about the stage of the cycle in the US?

1.2	Corporate credit	Bank credit	Philips curve	Equity market	Bond markets	Average
1.0
0.8
0.6
0.4
0.2
0.0
Mar-99	Jun-02	Sep-05	Dec-08	Mar-12	Jun-15	Sep-18

Source: Bloomberg, UBS

Global Macro Strategy 19 November 2018

13

vk.com/id446425943

Box 1: What do asset, product and labour markets tell us about the stage of the economic cycle? (continued)

The big difference between the US and Europe is in the indicators that have tended to provide the most leading information about the cycle: bond markets, and economic indicators that compromise the Phillips curve.

Figure 22: What do assets say about the stage of the cycle in the EU?

1.2
	Corporate credit	Bank credit	Philips curve	Equity market	Bond markets	Average
1.0
0.8
0.6
0.4
0.2
0.0
Mar-99	Jun-02	Sep-05	Dec-08	Mar-12	Jun-15	Sep-18

Source: Bloomberg, UBS

The aggregate Stage of Cycle Indices for US and Europe corroborate the commonly accepted view that the US (Figure 21) is later cycle than Europe (Figure 22); but this framework puts a number on this. It says US is middle of the third quartile of its cycle, while Europe, where cycles have been less sinusoidal, is closer to the median. Being quantifiable, this framework also allows us to track the stage of the cycle in real time.

In building the aggregate Stage of the Cycle Indices of US and Europe, we have simply taken an average of the 5 indices that represent various financial, product and labour markets. These, in turn are built upon simple averages of percentiles of the sub-indices. However, there are some indices that move quicker– the bond market and the Phillip's curve stand out in this regard. On the basis of a proxy policy distance from neutral, the levels and changes in unemployment and the inflation gap to target, these two sub-indices point to the US cycle being more advanced (well into the fourth quartile) and the European cycle being less advanced (below the median) than the aggregate reading suggests. Having reached 100th percentile of its reading about 2 years before the aggregate index turned from late cycle into recession, the US bond market indicator is once again close to the highest point of its history.

But this needn’t imply a recession is imminent. Apart from the fact that history itself would suggest there are several quarters before any major turn, we would also point out that in the present cycle the expansion in our US aggregate has been more gradual than usual. This is due to indices like bank credit are at much earlier stages than the Phillips curve or the bond market indices. This more gradual maturing in the cycle has given economic agents and policymakers time to adjust expectations and policy settings, very likely contributing to the longevity of the cycle.

On the whole, we conclude, as laid out in our 2019 Global Macro Strategy Outlook, that we are still in the expansion stage of the cycle. The banking system is not a big cause of concern in this cycle. We will focus instead on a turn in corporate credit and profit margins as warnings that confirm the message of bond market and Phillips curve indicators.

Bhanu Baweja and Stephen Caprio

Global Macro Strategy 19 November 2018

14

vk.com/id446425943

Figure 23: 12m fwd P/E relative to MSCI World (percentiles Figure 24: EM equity valuation vs cost of capital since 2002)

100%																96%
90%															72%
80%													65%	69%
70%												60%
60%								43%	47%	51%	51%
50%					34%	35%	40%
40%			23%	26%
30%		20%
20%	9%
10%
0%
	TR	RU	KR	PL	CN EM TW CL				ZA MX PH			ID	BZ MY		IN	TH

Source: IBES, MSCI, Datastream, UBS

13.5				3.5
13.0
12.5				4.0
12.0
				4.5
11.5
11.0				5.0
10.5				Corr =-0.62
10.0				5.5
14	15	16	17	18

MSCI EM: 12m fwd P/E

10y UST+10y CDS (RHS, inverted, MSCI-weighted)

Source: IBES, MSCI, Datastream, UBS

A read on sectors offers additional perspective. It is largely EM Value sectors, such as materials, energy, financials and utilities that are cheap relative to DM (Figure 25). Growth-overweight sectors – consumer discretionary, consumer staples, health care and tech – still screen as expensive. It does not help that these expensive Growth sectors are precisely the ones facing the bigger earnings downgrades (Figure 27). In this context, we still recommend being long EM Value relative to EM Growth as a near-term trade (Figure 26). Once valuations have adjusted, we expect Growth stocks to offer better exposure to EM’s more dynamic segments, and constitute a better medium-term investment. We will likely need to see some capitulation in current positioning before the market can rally (See Box 2 for how far we are in this process).

Amid earnings downgrades for expensive Growth sectors, we retain a preference for Value tactically; longer term, we prefer Growth style in EM

If we cannot hope for a major re-rating of multiples, the upside will have to be earned. Our earnings model, the backbone of which is the EM cycle index, points to earnings growth of 5–7% next year, compared with a 2019 (IBES) consensus at 10.6%. If our EM cycle index does not bottom, and these downgrades do not end, MSCI EM is unlikely to rebound strongly.

We expect 5–7% earnings growth next year; our EM cycle index will help o identify when the earnings downgrades are likely to end

Figure 25: 12m fwd EM sector P/E relative to MSCI World (DM; percentiles) vs proportion of Value in EM sector

Figure 26: MSCI EM and World (DM): Value/Growth relative indices

100%	12m fwd P/E							1.3
	relative to DM
90%		(percentile	HTC					1.2
80%		since 2002)	CST		TEL
70%			CDS					1.1
60%															12th
50%								1.0							percentile
40%					ENE	UTL
								0.9
30%						FIN
		ITS	EM	INDMAT
20%								0.8
10%				REL										3rd percentile
0%								0.7
	0%	20%	40%	60%	80%		100%	97	00	03	06	09	12	15	18
			Proportion of Value stocks in sector						MSCI EM Value/Growth				MSCI DM Value/Growth
Source: IBES, MSCI, Datastream, UBS								Source: MSCI, Datastream, UBS

Global Macro Strategy 19 November 2018

15

vk.com/id446425943

Figure 27: 12m fwd P/E relative to MSCI World (percentile since 2002) vs 6m revisions in 12m fwd EPS

	25	6m change in 12m
		forward EPS
	20	ENE

15Cheap and being upgraded

10
5			MAT
			EM
0	REL
		IND		FIN				TEL
-5			ITS		UTL		CST		HTC
-10							CDS	Expensive and
								being
-15								downgraded
0%	10%	20%	30%	40%	50%	60%	70%	80%	90%	100%

12m fPE relative to DM (percentile since 2002)

Source: IBES, MSCI, Datastream, UBS

We think it is likely that EM’s troubles are more front-loaded into early 2019, as EM growth is still shifting weaker and the Fed remains comfortable with a modest tightening in financial conditions. As a base case, we expect downward revisions to earnings to stabilise around late Q1 to early Q2 2019, which is when we expect to see EM (and China) growth to hit its sequential bottom. It is around this time that we would expect to see a decent turnaround in EM performance, helped by an undervalued EUR as the ECB is re-priced.

The downgrade cycle could end, along with sequential growth bottoming, and a weakening in the USD, around Q2 2019

Chinese equities better placed than many in EM

We have argued that in this cycle investors should not expect a high degree of accommodation from China; both the willingness and the ability to deliver this is lower than in the previous cycles. That does not mean that there will be no stimulus, however. The probability of Chinese authorities announcing further spending hikes and tax cuts at the mid-December Economic Work Conference is high, and these should begin to work their way into company earnings over the coming two quarters and into investor sentiment sooner.

As laid out in the section on China’s choices, we believe any stimulus is likely to be more focused on infrastructure than on housing. This probably implies that the incremental benefit to China’s own earnings is higher than it is for those of China satellites. Coupled with the fact that China’s valuations are now close to the bottom quartile of their historical distributions in both absolute and relative terms, we think Chinese equities present compelling optionality going into 2019. This is particularly so for China A-shares, where our analysis also shows much lower sensitivity to USD/CNY volatility than MSCI China.

Currencies: Better total returns

Higher CNY volatility would be a headwind for EM currencies next year too, as would weak trade growth (Figure 34), but, once again, as 2019 ages, should receive a boost as the undervalued EUR finds its correct value. In 2017, global trade was the strongest in the post-crisis era, but EM failed to outperform the EUR. We expect the same EUR outperformance of EM next year amid 0–5% trade growth. Much as this would imply that, and while the EM currency aggregate loses ground in trade-weighted terms, it should remain broadly stable against the USD (for more on to overcome this weak link in EM, see Box 3).

An aggregate EM currency index is likely to slip in trade-weighted terms, but remain stable against the USD

Global Macro Strategy 19 November 2018

16