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How is this cycle different? Fundamental drivers can persist

Outside of the obvious point that this bull market and economic expansion is over 9 years old, there are other important differences between this cycle and past ones. Many of the differences are the key points of debate amongst investors. We lay out some of the major differences and assess the balance of risks around each in order to better position across sectors, industries, styles and factors.

Protectionist pendulum is swinging

At the start of 2018, investors were focused on how the tax plan would impact the bottom and top line for companies. However, the focus through 2018 shifted to how far the Trump administration would go to advance their policy goals related to US trade as well as broader foreign policy as it relates to China. Throughout the year, we have written about the potential impacts from tariffs and protectionism.

As we look back, one of the impacts of the financial crisis has been increased resistance to continued globalization, whether it was Brexit, Italy, the election of Trump and a number of other instances. Globalization has underpinned the economic cycles of the last 35 years. With the headwinds now to the globalization pendulum and protectionist forces gathering steam, this cycle is likely to be different. We try to think through potential first, second and third order effects.

President Trump announced 10% tariffs on $200bn of Chinese imports would go into effect from Sep 24 to Dec 31, with a 25% rate thereafter (link). Additionally, if China retaliates, tariffs on an additional $267bn of imports would be pursued. The statement is a forward commitment to escalate and the 25% tariff rate+$267bn threat are essentially options, with China's response key to how much further risk needs to be priced in, or out. The Trump-Xi G20 meeting is a key fulcrum.

EPS hit of 1.6% with 2nd order effects key; additional $267bn a big overhang (~7% hit). Based on our US economists' estimated growth impacts from 10% and 25% tariffs on the $200bn of China imports (link), which is our baseline, the hit to our 2019 EPS estimate is ~1.6%, with the potential for second order effects (namely oil and the USD) to add an additional 1-2%. The prospect of tariffs on another $267bn in China goods could see hit to EPS growth of ~7% given the potential direct effect on consumer goods.

Escalation/de-escalation probabilities will shift, with risks priced in/out. The cone of uncertainty around trade risks has widened and the pace of escalation has risen. Thus, China's response will determine the path for equities: 1) Tariffs on US products should be non-proportional (link), which is "less bad", but could trigger a new investigation for the $267bn; 2) Non-tariff measures are a wildcard, with sales restrictions now a risk (link); 3) Talks are important for limiting miscommunication and thus escalation, so G20 Trump-Xi meeting is critical; 4) USDCNY is key given USD has driven relative US stock returns (link). US actions/rhetoric will also affect the "trade discount" with the additional $267bn a big overhang, but auto tariffs could arise at the same time raising the risk to equities.

Trade affects productivity and thus long-term growth; 0.6-0.8x P/E impact.

Trade enables productivity, with NBER estimates of ~20% of productivity growth due to trade in the last cycle (link). An escalation to a trade war would weigh on trade and reduce future growth expectations. Based on our model, the S&P 500

Resistance to globalization has been an increasing trend in politics and a factor for markets.

The Trump-Xi G20 meeting is a key fulcrum for equities.

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P/E is very sensitive to 3-5yr expected EPS growth with a beta of 2.45x. In a downside scenario, productivity that is 20% lower because of weakening trade would be a 25-35bp hit to growth, and a 0.6-0.8x hit to the P/E (link).

UBS Evidence Lab HTS-NAICS mapping; industry effects of US-China tariffs.

UBS Evidence Lab Data Science team aggregated US-China trade data at the HTS (Harmonized Tariff Schedule) code level from the US Census Bureau, and mapped it to NAICS codes. We use this mapping to estimate industry impacts and identify companies that could be impacted by tariffs. The tariffs on $200bn of Chinese imports affect some industries by much more as a % of output/sales, such as comm equip (6.9% of output), electric lighting (6.3%) and HH furniture (4.1%), which is 2-3x the levels of the prior round. The step up to 25% tariffs, and the potential for the added $267bn of goods to be subject to tariffs, would be even more disruptive. The greater 1st order impacts should mean that 2nd order impacts are even larger as well through the supply chain (link). While Retail companies are not impacted in the mapping analysis given producer NAICS codes, we believe they could be impacted significantly as importers of goods.

Given that trade can be so disruptive, we analyze scenarios for further escalation as well as de-escalation in the earnings and price target section.

Figure 45: UBS Evidence Lab mapping: impact of tariffs

** - excludes Apple		Tariff on China imports, % of output					Tariff on China exports			Geographic exposure %		Performance
	$50bn enacted $200bn @ 25%		Remaining @		Total (trade	$50bn enacted	$60bn @ 17%	Remaining @	Total (trade	China	US Revenue	YTD
	@ 25%		25%		war)	@ 25%	(wtd)	25%	war)	Revenue
Sector
Consumer Discretionary	-0.12%	-0.83%	-2.42%		-3.37%	-0.22%	-0.09%	-0.01%	-0.31%	4.2%	68.9%	8.9%
Consumer Staples	-0.01%	-0.19%	-0.02%		-0.22%	-0.03%	-0.05%	0.00%	-0.08%	4.4%	58.6%	-2.0%
Energy	-0.08%	-0.05%	-0.04%		-0.16%	-0.64%	-0.13%	-1.91%	-2.68%	3.9%	58.2%	-7.1%
Financials	-	-	-		-	-	-	-	-	1.7%	76.7%	-5.4%
Health Care	-0.12%	-0.04%	-0.38%		-0.54%	-0.04%	-0.15%	-0.17%	-0.36%	3.5%	65.3%	11.2%
Industrials	-0.49%	-1.17%	-1.95%		-3.62%	-0.27%	-0.24%	-0.20%	-0.71%	4.3%	63.3%	-6.2%
Information Technology	-0.52%	-1.64%	-2.30%		-4.46%	0.00%	-0.42%	-0.34%	-0.76%	14.5%	41.5%	9.9%
Materials	-0.09%	-0.34%	-0.15%		-0.58%	-0.19%	-0.30%	0.02%	-0.47%	3.8%	49.9%	-10.9%
Real Estate	0.00%	-0.06%	0.00%		-0.06%	0.00%	-0.48%	0.00%	-0.48%	0.6%	88.8%	0.2%
Communication Services	-	-	-		-	-	-	-	-	1.9%	65.9%	-1.5%
Utilities	0.00%	0.00%	0.00%		0.00%	-	-	-	-	0.0%	96.8%	4.4%
Industry group
Autos & Components	-0.11%	-0.47%	-0.05%		-0.63%	-0.43%	-0.04%	-	-0.47%	8.2%	59.0%	-21.5%
Cons Durables & Apparel	-0.23%	-2.07%	-8.37%		-10.66%	-0.02%	-0.22%	-	-0.23%	4.8%	61.1%	-8.7%
Consumer Services	0.00%	-0.04%	-0.11%		-0.16%	0.00%	-0.04%	-	-0.04%	7.3%	61.1%	1.0%
Media & Entertainment	-	-	-		-	-	-	-	-	2.4%	58.3%	-0.7%
Retailing	-	-	-		-	-	-	-	-	2.4%	75.0%	20.1%
Food, Beverage & Tobacco	0.00%	-0.06%	-0.02%		-0.08%	-0.01%	-0.02%	-	-0.03%	3.2%	56.6%	-6.8%
Food & Staples Retailing	-	-	-		-	-	-	-	-	5.5%	77.0%	10.2%
Household & Personal Prod	-0.02%	-0.56%	-0.03%		-0.61%	-0.07%	-0.15%	-	-0.22%	6.1%	42.2%	-3.2%
Energy	-0.08%	-0.05%	-0.04%		-0.16%	-0.64%	-0.13%	-1.91%	-2.68%	3.9%	58.2%	-7.1%
Banks	-	-	-		-	-	-	-	-	1.0%	83.5%	-6.6%
Diversified Financials	-	-	-		-	-	-	-	-	2.1%	71.4%	-3.8%
Insurance	-	-	-		-	-	-	-	-	2.4%	71.2%	-6.0%
Health Care Equip & Svcs	-0.25%	-0.10%	-0.79%		-1.13%	-0.01%	-0.33%	-	-0.34%	3.1%	75.5%	17.0%
Pharma, Biotech & Life Sciences	-	-	-		-	-	-	-	-	-	-	-
Capital Goods	-0.50%	-1.16%	-1.94%		-3.59%	-0.27%	-0.24%	-	-0.51%	5.3%	56.2%	-9.0%
Commercial & Prof Svcs	-0.14%	-3.24%	-3.79%		-7.17%	-0.01%	-0.17%	-	-0.18%	1.7%	78.0%	3.4%
Transportation	-	-	-		-	-	-	-	-	2.0%	82.0%	-0.1%
Semis & Semi Equipment	-1.15%	-2.65%	-0.08%		-3.87%	0.00%	-0.24%	-	-0.24%	33.6%	14.5%	-8.0%
Software & Services	-0.07%	-0.35%	-2.53%		-2.96%	0.00%	-0.10%	-	-0.10%	6.6%	53.9%	16.4%
Tech Hardware & Equipment **	-0.20%	-1.24%	-3.74%		-5.18%	0.00%	-0.60%	-	-0.60%	14.8%	38.9%	11.1%
Materials	-0.09%	-0.34%	-0.15%		-0.58%	-0.19%	-0.30%	0.02%	-0.47%	3.8%	49.9%	-10.9%
Real Estate	0.00%	-0.06%	0.00%		-0.06%	0.00%	-0.48%	0.00%	-0.48%	0.6%	88.8%	0.2%
Telecommunication Services	-	-	-		-	-	-	-	-	0.1%	96.6%	-4.8%
Utilities	0.00%	0.00%	0.00%		0.00%	-	-	-	-	0.0%	96.8%	4.4%
Total	-0.26%	-0.69%	-1.07%		-2.02%	-0.09%	-0.21%	-0.20%	-0.50%	5.2%	63.1%	1.8%

Source: BEA, US Census Bureau, FactSet, UBS Evidence Lab, UBS

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Leverage has shifted: watch small corporates

The 2008-09 recession was so severe in part because consumers and financials levered up so much, and given how important the consumer and financial system are to the economy. However, leverage has shifted post-crisis, with consumers and financial firms de-levering and the federal government and corporates levering up. Additionally, with so much Fed QE post-crisis, money supply (M2) as a % of GDP has jumped 20pp and total US debt to GDP has fallen. Thus, risks have shifted. In our view, the next recession then should be much less severe with consumer and financial balance sheets in much better shape. Changes in the credit impulse from the government and corporates are likely to be a signal of a potential slowdown.

Figure 46: Financials and households de-levered

125		Household debt / GDP
		Financial institutions debt / GDP
100
					Households and
75					nonprofits have de-
					levered by 19%
50								Since 2008, financial
25								institutions have de-
								levered by 30%+ rel.
								to GDP
0
50	56	62	68	74	80	86	92	98	04	10	16

Figure 47: Corporate and government levered up

125		Government debt / GDP
		Nonfinancial business sector Debt / GDP
100					Since 2008, gov debt
					has increased 40%+
75					rel. to GDP
50									Nonfinancial
25									business
									leverage is back
									to cycle peaks
0
50	56	62	68	74	80	86	92	98	04	10	16

Source: Federal Reserve Board, Haver, UBS

Source: Federal Reserve Board, Haver, UBS

Leverage is near historical highs for Russell 2000 ex financials. Aggregate net debt to EBITDA for the Russell 2000 is currently 3.2x, compared to 1.5x for the S&P 500. For the median firm, net debt to EBITDA stands at ~1.7x for both the Russell and S&P 500. This is a historical high for the Russell 2000.

Interest coverage is near historic lows for R2000 (ex fins) despite low rates.

Currently the interest coverage ratio for the Russell 2000 is 1.9, compared to 7.8 for the S&P 500. For the median firm, interest coverage is 2.8 for the Russell and 7.9 for the S&P 500. This is near the midpoint of historical interest coverage levels for the Russell in aggregate, and near historical lows for the median company.

We estimate a 1% rise in rates would result in a ~6% hit to Russell 2000 earnings (ex fins) and a ~40bps hit to S&P 500 earnings (ex financials). This does not take into account fixed debt maturities and refinancing at higher rates.

7% of S&P 500 ex Fin debt is floating rate, 93% is fixed. For the Russell 2000, just 49% is fixed.

Figure 48: Net debt to EBITDA, aggregate index

Figure 49: Interest coverage ratio, for median firm

4

3

2

1

0

Russell 2000 ex Fin (+ RE)	12
S&P 500 ex Fin (+ RE)	10

8

6

4

2

0 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18

Russell 2000 ex Fin (+ RE)

S&P 500 ex Fin (+ RE)

90 92 94 96 98 00 02 04 06 08 10 12 14 16 18

Source: S&P, Compustat, FactSet, UBS

Source: S&P, Compustat, FactSet, UBS

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Consumer savings rate > prior cycle highs

Personal consumption expenditures account for nearly 70% of US GDP. Thus the consumer is the key to the economic cycle. Almost all consumers saw their aftertax pay checks increase 2-4% in February on the tax cut, helping to lengthen the US cycle. The US consumer savings rate went from 6.2% in Dec '17 to 7.4% in Feb '18 as tax withholdings went down. With the savings rate currently at 6.2% as of September, there is debate about whether consumers spent the tax windfall and thus spending growth will slow. Higher wage growth should help to support consumption over the next year.

Importantly, the savings rate is still basically above the highs of the prior 2003-07 upcycle. The savings rate could continue to fall, as it did toward the end of prior cycles such as 1998-2000 and 2005-06. More specifically, prior recessions were preceded by a ~2pp decline in the savings rate, which in turn led to a pullback in consumption. The combination of solid wage growth and the tax boost has led to retail sales growth accelerating to the highest since 2012. We see the current backdrop for the consumer as still supportive for US equities.

Real wages are also rising at a steady clip. Every cycle essentially ends with a drop-off in consumption driven by a rise in inflation (energy, food, shelter) as interest costs rise and employment growth slows amid low unemployment. Since the middle of last year, real earnings for production and non-supervisory workers have been rising at about a 50bp pace. That stands in contrast to the 2011-12 slow down which was preceded by a decline in real wages as oil spiked and inflation picked up while wage growth lagged. Even in the prior cycle, real wage growth was consistently negative, and very negative at the end of 2007.

In this cycle, the Fed is hiking at a slower pace of <100bp per year vs. ~200bp in the past; so the increase in consumer interest expense has been less than half the headwind of prior cycles (~15bp as a % of income, vs. ~30bp). Furthermore, the headwind from rising oil (50bp+) is more than offset by the 2% after-tax income boost (see Inflation and equities: how to invest?).

Given the divergence in performance between Retail and the rest of Discretionary, we do see opportunities outside of Retail in Consumer Services, discussed in the strategy section.

Figure 50: US consumer savings rate

Figure 51: Real wages are rising at a steady clip

12%		Recession				US personal savings rate
											6%
11%
10%											4%
9%											2%
8%											0%
7%
6%											-2%
5%											-4%
4%									Savings rate		-6%
3%									above prior
									cycle highs
2%											-8%
96	98	00	02	04	06	08	10	12	14	16	18

Real average weekly earnings of production and non supervisory workers (% yoy)

65

69

73

77

81

85

89

93

97

01

05

09

13

17

Source: Haver, UBS

Source: BLS, Haver, UBS

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