UBS-monthly review_watermark

Published

Jun 20 2019

GBP undervalued against AUD

GBPAUD spot, Purchasing Power Parity (PPP)

3.50

3.00

2.50

2.00

1.50

1.00

1982 1987 1992 1997 2002 2007 2012 2017 GBPAUD PPP GBPAUD

Source: Macrobond, UBS, as of 17 June 2019

US vs. EMU: relative macro is a key driver

The euro area's relative resilience is unlikely to last if trade tensions escalate further and global growth slows

20%

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Euro area vs US equities return, 6m chg, lhs

Euro area PMI vs US ISM, mfg, 6m chg, 3-month lead, rhs

Source: Bloomberg, UBS, as of 17 June 2019

Global Tactical Asset Allocation

•Asset allocation

In our base case, global growth should stabilize in the second half of the year. Equity valuations look fair rather than expensive and with an attractive equity risk premium, stocks remain attractively valued relative to bonds. However, the rhetoric around US-China trade has deteriorated since early May and the near-term prospects for a trade deal look increasingly uncertain. In a scenario of prolonged uncertainty with lower consumer confidence and slowing investments, we see risk of the global economy growing below trend. However, we don't foresee an end to the business cycle. In our base case, we expect a ceasefire between the US and China on trade following the G20 meeting later this month. Negotiations should continue, leading eventually to an agreement on trade, but is likely to take more time than previously anticipated. We keep our overweight in global equities, while partially protecting the downside risk with a put option.

•Equities

While we still expect global economic growth to stabilize in the second half of the year, and the oil price to make gains over the next six months, risks around China-US trade negotiations remain elevated. Assuming the risk scenarios we are monitoring do not materialize, we believe equities can advance moderately. We have an overweight in Japanese and US equities vs Eurozone equities. While both the Eurozone and Japan are heavily geared to the global cycle, the former has priced in a macro recovery while the latter has not. Eurozone stocks look expensive compared to the Japanese market. In addition we prefer US versus Eurozone stocks as the former should deliver superior profits growth in 2019 and 2020. We are closing our overweight in Canadian equities against Swiss ones, as Canadian economic growth is softening, while dovish central banks and the decline in European rates has increased the appeal of defensive Swiss stocks as bond proxies.

•Bonds

We overweight EUR IG against higher-rated bonds, as we expect the former to be supported by stabilizing Eurozone growth and accommodative ECB policy. We consider the carry attractive against healthy corporate fundamentals and our base case of no recession over the coming 12 months. We hold a tactical short on the 2-year US Treasury note. While the Fed seems increasingly likely to cut rates as economic data globally disappoints, we think that market pricing of around four rate cuts is too pessimistic. We close our underweight in 10-year Japanese government bonds versus JPY cash. A catalyst for an adjustment higher in the yield curve control target for the 10-year yield is lacking over the near-term, given modest inflation pressures.

•Foreign exchange

We don't like...

•UK equities (1–4 year horizon)

•Eurozone equities

•Developed market high grade bonds

•2-year US Treasuries vs. USD cash

•"Well-worn" bonds

•Mind the gap - Corporate "fallen angel" candidates

•...Swiss franc

•...Swiss franc

•...Canadian dollar

•...Australian dollar

•...Australian dollar ( )

•DM FX (AUD, NZD, TWD)

•...base currency

Model portfolios (EUR & USD)*

Source: UBS, as of 20 June 2019; * Additionally, the portfolios include an underweight 2-year US Treasuries bonds (via overlay) and a put option on the S&P 500 index.

Note: Portfolio weightings are for a EUR model portfolio and a USD model portfolio, with a balanced risk profile (including TAA). We expect the EUR balanced portfolio (excluding TAA) to have an average total return of 2.8% p.a. and a volatility of 7.9% p.a. over the next seven years. We expect the USD balanced portfolio (excluding TAA) to have an average total return of 5.1% p.a. and a volatility of 7.9% p.a. over the next seven years.

Tactical asset allocation deviations from benchmark

Liquidity

Equities total*

Global

US

Eurozone

UK

Switzerland

Canada

Japan**

Emerging markets (EM)

Australia

Bonds total

High grade bonds

Corporate bonds (IG)

High yield bonds

EM sovereign bonds (USD)

EM corporate bonds (USD)

EM local currency bonds

US TIPS

Duration overlay (USD)

Duration overlay (JPY)

Hedge Funds

Source: UBS, as of 20 June 2019

Please note that the bar charts show total portfolio preferences, which can be interpreted as the recommended deviation from the relevant portfolio benchmark for any given asset class and sub-asset class. *We are holding a put option on the S&P 500 to partly protect the tactical asset allocation.

**Currency exposure of Japanese equities is not hedged.

Currency allocation

Source: UBS, as of 20 June 2019

*** EM FX basket contains South African rand, Indian rupee, Indonesian rupiah. DM FX basket contains Australian dollar, New Zealand dollar, Taiwanese dollar (all equally weighted).

Expected market performance for select asset classes

US equities 0% to +5% based on our 16.5x forward eps estimates

Chinese equities -5% to 10% amid higher volatility due to tariffs and sanctions against tech companies weighing on earnings, alongside coordinated policy support

EURUSD between 1.15 and 1.20 as the Fed eases and European economy stabilizes

US equities down -10 to -15% as forward earnings decline 5% and valuation falls

Chinese equities down 15% as sentiment tanks further with worse-than-expected economic consequences

USD appreciates to around EURUSD 1.10 and USDCNY 7.1- 7.3, as US tariffs support the USD

US IG -2% to -3% as spreads widen to 280bps, 5y US Treasury drops back to 2016 low and additional loss from 5-10% rating dongrades into HY

US HY -8% to -10% with spreads widening to 800bps. Default rates increase to 5% within 6 months

US equities -10% to -15% as earnings growth disappoints by 5% and valuation compresses by 5% to 10%

US equities +5 to 10% upside as forward estimates rise towards USD 180 and the forward P/E expands to 17x

Chinese equities +10% to 15% due to a recovery on valuation as growth beats consensus expectations

USD depreciates to EURUSD 1.20- 1.25 and USDCNY 6.4- 6.7

Chinese equities +10 to 15% due to a recovery on valuation as growth beats consensus expectations

EMBIGD bonds return 1% to 2% as spreads tighten to around 310bps due to improving EM growth prospects

CNY up to USDCNY 6.4- 6.7 as strong Chinese growth supports the domestic equity market, preventing outflows and supporting inflows of capital

Key points

•Markets are currently pricing in rate cuts from the US Federal Reserve (Fed) in the near future. We now expect a preemptive 50 basis point cut, probably in July.

•The European Central Bank (ECB) has ended its aggressive phase of bond-buying. Following the recent escalation on the trade front, the Governing Council has adopted an easing bias.

•The Swiss National Bank will likely raise interest rates only after the ECB. The Bank of England's policy remains contingent on the nature of the UK-EU separation although without that uncertainty rates would probably rise.

•In recent months, inflation has moved further below the US Federal Reserve's 2% target. Combined with some downward surprises in the economic data, such as tepid job growth in May, this has lead the market to price in rate cuts in the near future. The results of the 19 June FOMC meeting have lowered the bar for a rate cut significantly. Therefore, the Fed is likely to cut rates in July unless there is a big move in markets before the meeting. We have changed our base case to call for a 50 basis point cut.

•Given the increasing uncertainties on the back of the trade war, the ECB is ready to ease policy in the event of a significant further escalation. We think that the hurdle for a new sovereign QE program is higher than for further rate cuts.

•In many countries, inflation remains below the central bank's target despite very loose monetary policy and low unemployment rates.

•The tone has shifted as political risks have created economic disruption. Central banks appear keen not to amplify those risks by adding to the uncertainty. Most central banks should remain on hold in the near term. Rate cuts are more likely than hikes in our view (the UK is perhaps an exception).

Positive scenario (Probability: 30%*)

•Political policy errors threaten economic growth either through more aggressive trade disruption or weaker US or European growth. Central banks respond to the changing economic outlook with appropriate easing.

Negative scenario (Probability: 10%*)

• Tighter labor markets move from squeezing profit margins to causing firms to raise prices more significantly. Trade taxes are passed on more comprehensively than has been the case so far.

*Scenario probabilities are based on qualitative assessment.

•Over the past nine months the market volatility arising from taxing trade (which can be thought of as being primarily a tax on equities) has been notable. Trade tensions have nonetheless increased. The fact that ordinary consumers have been largely

unaware of the taxes to date may have led to political complacency about the consequences. Any escalation would make those negative consequences more visible, and gives an incentive to resolve the situation over time.

•Brexit: Our base case is for further delay, opening up a wider range of possibilities including a general election. Changing the prime minister will not change the parliamentary arithmetic around the different options; going back to voters at some point seems the only way to break the deadlock.

•In the US, investor attention is being drawn to the debt ceiling and the budget, which need to be addressed by the end of September.

•The change of leadership in European Union institutions is relatively smooth.

Positive scenario (Probability: 20%*)

•A trade deal is agreed on the fringes of the G20 at Osaka in late June. NAFTA uncertainties are contained. The UK parliament moves more quickly towards a negotiated exit from the EU.

Negative scenario (Probability: 30%*)

•Trade tensions escalate into a full scale Sino-US trade war. Trade taxes are applied between the US and Europe, and NAFTA is called into question.Nationalist tendencies continue to increase. Greater polarization of politics makes compromise on policy increasingly

difficult.

*Scenario probabilities are based on qualitative assessment.

Source: Wikipedia, as of 17 June 2019

OECD leading indicators

China ahead of the US and the Eurozone

Source: Haver Analytics, as of 17 June 2019

OECD leading indicator refers to the NSA amplitude adjusted total indicator

Key points

•Corporate profit growth has decelerated

•But growth should pick up later this year

•We expect S&P 500 EPS growth of 3% in 2019 and 7% in 2020.

•US earnings growth has decelerated as the one-time boost from a lower tax rate fades and economic growth slows in the US and overseas. Still, a material decline in profits looks unlikely in our view. Leading indicators such as access to capital, business sentiment, and new claims for unemployment insurance remain supportive. Our 2019 S&P 500 EPS estimate is USD 168 (3% growth).

•Earnings growth should modestly re-accelerate later this year and beyond as the economic expansion continues, comparisons in the energy sector get easier, and tech markets stabilize, especially for semiconductors. We forecast 2020 S&P EPS of USD 179 (7% growth).

•S&P 500 earnings grew 3% in the first quarter. We expect growth to be "flattish" again in the second quarter. Encouragingly, analysts are no longer reducing forward earnings growth expectations, due to generally supportive management commentary about the outlook.

•Despite the improving profit picture, investor attention has shifted to renewed trade tensions between the US and China. We continue to believe that a further escalation in the trade dispute is unlikely because it would be disruptive for both economies. However, an easing of tensions may also be difficult to achieve. If the US imposes tariffs on the remaining USD 325 billion of Chinese imports, CIO economists and strategists believe GDP growth could drop by about 0.75–1% and S&P 500 profits could get hit by 3% or more (bottom chart). The pain would likely be larger for the Chinese economy.

•We expect profit margins to fall by a modest 0.4% in 2019. Still, we don't expect margins to decline on a sustained basis. The weakness this year is a result of slow revenue growth and idiosyncratic factors in various sectors such as investment spending in communications services and currency headwinds in consumer staples and tech. Most of the pressure is not due to rising wages. Labor-intensive consumer discretionary companies are the most exposed to higher wage costs but, outside of this sector, the average company should be able to offset higher wages through greater productivity and targeted price increases. Also, bear in mind that higher wages typically translate into faster consumer spending.

•Boost from fiscal stimulus lasts longer than expected. Deregulation further boosts financial sector earnings. Investment spending picks up.

Negative scenario (Probability: 20%*)

•Trade and geopolitical tensions flare up, depressing business and consumer sentiment. Wage pressures, without improving consumer and business demand, crimp profit margins and earnings growth rates. Declines in long-term interest rates pressure financial sector earnings.

*Scenario probabilities are based on qualitative assessment.

Earnings growth has decelerated but should rebound

S&P 500 EPS growth; tan denotes impact of lower tax rate. 2Q19E–4Q19E are consensus estimates.

30%

25%

20%

15%

10%

5%

0% -5% -10%

Source: FactSet, UBS, as of 13 June 2019

Trade frictions escalate

Estimated reduction in S&P 500 profits; potential tariffs in tan

8%

1.5%

Source: UBS, as of 13 June 2019