CIO WM Global Investment Office 23 January 2014 New year, new basics Alexander S. Friedman Global Chief Investment Officer Wealth Management Our new strategic asset allocations include more credit, enabling investors to maintain fixed income exposure without suffering negative returns. Hedge funds will appear increasingly attractive in 2014. We believe the Fed can successfully withdraw from quantitative easing this year without harming the US economy. On a tactical basis we remain overweight US and Eurozone equities, along with US high yield credit, and add new CIO Preferred Themes on Eurozone financials and Eurozone restructuring. As human beings, the start of a new year is a good time to assess where we stand and what our goals are for the future. Many of us make resolutions to help us get there. For investors, it s a time to take a fresh look at economic, policy and market dynamics, and in turn asset allocations, and decide the best way to move forward. In my monthly letters, I typically focus on our six-month, tactical asset class view. Over the past three years, these tactical recommendations have fortunately been more right than wrong. However, since I do not have a crystal ball (despite intensive efforts by my colleagues and I to develop one), I rarely recommend that investors take major tactical swings away from their so-called strategic asset allocation (SAA). The SAA, as a reminder, is an investor s long-term asset class allocation, with a five-to-seven-year time horizon, which should match an investor s ability and willingness to take on risk with their return requirements. Within the framework we use, more than 80% of the variation in the long-run value of a portfolio is attributable to the SAA. And, in the recent CIO Year Ahead, which I hope you have already received, we announced a variety of key changes to our recommended SAAs. Given the importance of these allocations to overall portfolio returns, I want to use this letter to share my thoughts on five key market issues that drive the logic of our view on the SAA. ab This report has been prepared by UBS AG. Please see important disclaimers and disclosures at the end of the document. Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication.
Of course, investors cannot ignore shorter-term market dynamics, so I also address a number of issues in discussing our current tactical asset allocations for 2014, later on in this letter. Five key strategic considerations as we begin 2014 1. Fixed income allocations in an environment of rising interest rates Fixed income is a natural go-to asset class for many, given its historical reliability as a preserver of capital and source of return. But today, with the multi-decade bull market in bonds apparently at an end, determining what to do with a traditionally reliable fixed income allocation is becoming more difficult. Returns in the government bond space were negative in 2013, and are likely to be very low (at best) in the years ahead. As a result, they are no longer functioning as a preserver of capital, nor an attractive source of return. Even alternatives among high-grade bonds, such as agency debt or supranational debt, no longer offer a material yield pickup. > Credit should enable investors to maintain fixed income exposure without suffering negative returns > Hedge funds are an important part of a diversified asset allocation Still, holding bonds within a diversified asset allocation has merit. Bonds should continue to provide some diversification in the event that equities decline and they offer a source of regular income. But investors clearly need insulation against rising interest rates. To attempt to address this problem, our new SAAs have larger allocations to bonds with higher yields, such as emerging market bonds, US high yield credit, and short duration global investment grade corporate bonds. The higher yields available in a diversified basket of these bonds should offset rising interest rates, enabling investors to maintain an exposure to fixed income without suffering negative returns. 2. Allocating to alternative investments Outside of credit, another potential area to consider for investors looking for investments with a reasonable return outlook and relatively low volatility is hedge funds. Often discredited for being illiquid, opaque, and expensive, hedge funds can serve as an effective portfolio diversifier for investors with limited cash flow requirements. And with markets normalizing, correlations falling, and valuation dispersion still relatively low, we see a particularly good opportunity for managers employing equity long-short strategies. Fig. 1: Hedge funds have offered an attractive risk-return profile Asset class total returns (rebased) > As we enter a lower return environment, hedge funds delivering returns of 4-6% will appear increasingly attractive 200 180 160 140 120 100 80 60 Feb-04 Feb-05 Feb-06 Feb-07 Feb-08 Feb-09 Feb-10 Feb-11 Feb-12 Feb-13 Global equities Investment grade bonds HFRI fund weighted composite USD cash UBS Chief Investment Office February 2014 2
In recent years, hedge fund returns may have looked unappealing relative to equities or high yield corporate credit (see Fig. 1). But as we enter an environment of lower returns in all financial assets, funds delivering consistent returns of around 4-6% (our expectation for these strategies), with volatility similar to that seen in corporate bonds, will appear increasingly attractive. Furthermore, the ability to extract an illiquidity premium from the likes of private equity will be important in a low return environment. As a result, we recommend a 12-15% allocation to alternative investments in our new strategic asset allocations. Hedge funds represent an important part of that allocation, which can also include private equity and real estate. > Cash will, in the longrun, underperform all financial assets that offer risk premia 3. The role of cash Many investors focus on safety and capital preservation, and see cash as the obvious solution. Yet within an SAA context, we continue to recommend a relatively limited allocation to cash. Over the long haul, investors are only provided with excess returns by taking risk. This is why equities tend to outperform over the long run. And it s why cash will typically underperform all financial assets that offer risk premia. A dollar invested in cash at the Fed funds rate 30 years ago would today be worth around USD 3.50. The same dollar invested in equities, with dividends reinvested, would be worth more than USD 22. As a result, we see only limited value for cash in a longterm SAA, particularly given the negative real interest rates on offer in most major currencies. Furthermore, over a five-to-seven-year time frame, uncertainty around inflation is high. Central banks across the developed world face a major challenge in staying ahead of the game in normalizing their ultra-loose monetary policies. > Commodities are volatile but offer no assurance of positive returns 4. Are commodities worth the risk? Before investing in any new asset class, investors must consider whether they are taking unnecessary risk. As an asset class with volatility similar to equities, but with expected returns little better than government bonds, we believe that commodities represent just this type of unnecessary risk. Commodities are typically driven by supply and demand factors; they are volatile but offer no assurance of a positive return. Indeed, after some significant swings, the Dow Jones UBS Commodity Total Return index is up by just 4% in the past decade (see Fig. 2). Investors should expect little more going Fig. 2: Commodities have offered next to no return in the past decade DJ UBS Commodity Index 500 > Unlike financial assets, commodities offer neither an income stream nor a risk premium 450 400 350 300 250 200 Feb-04 Nov-04 Aug-05 May-06 Feb-07 Nov-07 Aug-08 May-09 Feb-10 Nov-10 Aug-11 May-12 Feb-13 Nov-13 UBS Chief Investment Office February 2014 3
forward. Unlike financial assets, commodities offer neither an income stream nor a risk premium. The current supply-demand outlook for commodities is also unfavorable. Within energy, non-opec supply of crude oil will likely rise at its fastest pace since 1978, and we expect Brent crude oil to trade at USD100/bbl this year, with potentially larger downside if the US surprises markets by lifting its export ban on crude oil. In base metals, stronger economic growth has failed to lead to higher prices, as the market remains oversupplied. And the outlook for gold is also negative, with a combination of low inflation, improving economic growth, and the withdrawal of the US Federal Reserve s stimulus weighing on prices. > Investors taking unhedged FX exposure may be unwittingly taking on extra risk 5. Whether to hedge foreign exchange risk In some ways currencies are similar to commodities. Driven by supply and demand factors, they are often volatile, but do not offer a systematic risk premium to compensate for this. As a result, investors taking unhedged exposure to foreign currencies may be unwittingly taking on extra risk. Investors in Switzerland are well aware of this: despite trading at all-time highs in US dollar terms, the S&P 500 is still more than 35% shy of its 2000 peak in Swiss franc terms. As a result, our currency positions within our recommend SAAs are hedged, with the exception of those in emerging markets, where hedging costs can be prohibitive. Three key tactical questions as we begin 2014 It is critical to have the right SAA, but an active tactical asset allocation will also be important in navigating a year likely to prove more challenging than the last. Three key questions will be critical for investors over the tactical horizon. > So far, the Fed has kept bond yields contained and equity markets calm 1. Can the Fed successfully withdraw from quantitative easing? Since I wrote my last CIO Monthly Letter, the Fed has begun to taper its quantitative easing (QE) program, with the pace of monthly asset purchases now down to USD 75bn per month from USD 85bn previously. So far, it seems to be a success. By changing the emphasis of its communication toward loose interest rate guidance, the Fed has kept bond yields contained and equity markets calm. Maintaining this market calm will be critical in managing a successful withdrawal. > Maintaining market calm as the Fed reduces its stimulus will be critical in managing a successful withdrawal Fig. 3: The Federal Reserve is set to end quantitative easing this year Federal Reserve Balance Sheet (USD, bn) 4500 4000 3500 3000 2500 2000 1500 1000 500 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 UBS Chief Investment Office February 2014 4
The 13% rise in house prices last year helped provide impetus for US growth, through the knock-on effects on construction, employment, and consumer confidence. While it would be rational to expect a somewhat slower pace of house price gains this year, the biggest risk of a major slowdown is a sharp upward move in mortgage rates. Should this occur, the market impact could be large given the consensus expectations for US growth. The lowest US GDP growth forecast by any major bank is 2.3%, in itself above 2013 s 1.9%. > The US economy should remain solid enough to withstand a steady reduction in QE However, while it is always prudent to be vigilant, it is also important not to overreact to short-term data such as last month s disappointing non-farm payroll numbers. The US economy is like a super tanker: it takes a long time for it to change direction and when the captain is committed to a new course, as the Fed appears to be, it is not easily altered by a little unexpected chop. Ultimately, the fundamentals of the US economy should remain solid enough to withstand a steady reduction in QE. We forecast GDP growth of around 3.0% this year, thanks to an easing of fiscal austerity, accelerating household spending, and a pickup in capital expenditures. As a result, we remain comfortable with overweight positions in US equities and US high yield credit. Of course, for the taper of QE to be considered a global success, the Fed would also need to avoid sparking capital flight from the emerging markets. Just last week, the World Bank warned that an unplanned withdrawal of stimulus could cut capital flows to emerging markets by up to 80%. We do not foresee such a major event, although we are cautious on the equities and currencies of those countries potentially most exposed, namely Turkey, India, and South Africa. In these regions, a sharp withdrawal of Fed stimulus could lead to capital outflows, rising interest rates, slower growth, and an increase in corporate defaults. 2. Can China avoid a credit event? China is in the midst of a critical transition. To maintain its long-term growth potential, it is undertaking reforms to allow the market, rather than the state, to determine the price of a range of things, including the price of money. In China, liberalizing interest rates simply means that they will rise. For years, China has held its official interest rates well below what could be considered an equilibrium level, and we expect to see China s money market rates move structurally higher by almost 200 basis points over the next two years. Fig. 4: Stress in China s interbank markets has been a source of concern China interbank 7-day repo rate (%) 10 > The authorities have reacted to the concerns over rising rates by injecting extra liquidity into the market, which has helped reduce short-term stress 9 8 7 6 5 4 3 24-Oct-13 31-Oct-13 7-Nov-13 14-Nov-13 21-Nov-13 28-Nov-13 5-Dec-13 12-Dec-13 19-Dec-13 26-Dec-13 2-Jan-14 9-Jan-14 16-Jan-14 23-Jan-14 UBS Chief Investment Office February 2014 5
This should not have a major impact on companies getting traditional bank loans, but it will mean higher debt costs for borrowers dependent on the shadow banking sector, and will raise the prospect of corporate defaults. The transition process has combined with seasonal factors to provoke turbulence in interbank markets. > We believe China has the resources to bail out its banks if necessary At the time of writing, rates are at 5.4% (see Fig. 4), vs. a normal level of 4.00-4.25%, partly due to concerns that China s largest bank, ICBC, is considering imposing losses on depositors in a USD 500m trust product after the onward loans to a coal company soured. Ultimately, we believe China has the resources to bail out depositors and recapitalize its banks if necessary. And the authorities have reacted recently to the concerns over rising rates by injecting extra liquidity into the market, which has helped reduce short-term stress. We are overweight Chinese equities due to attractive valuations, our belief that the authorities have the ability to contain market stress, and due to the positive reforms announced at the Third Plenary session which should boost the country s long-term growth profile. Nonetheless, China remains a concern due to its size. Transitioning an economy as large and complex as China s will be difficult, and any missteps, such as an uncontrolled default on an investment product, could pose a major risk to the outlook. > The Eurozone banking sector is currently experiencing a virtuous circle 3. Can the Eurozone banking sector pass the Asset Quality Review? The banking sector has started the year strongly, with Eurozone banks equities climbing almost 8% (see Fig. 5). A decline in peripheral bond yields is primarily responsible for the upbeat start, as both Portugal and Ireland have successfully issued new debt in private markets. This has created a virtuous circle. As the value of government bonds on bank balance sheets has increased, bank solvency has improved, which in turn has raised the credit quality of the government. It is, in effect, the reverse of the downward spiral that occurred between banks and governments in 2011. But a critical test will come later in the year when the European Central Bank (ECB) assumes direct supervision of the Eurozone banking sector. In taking on its new responsibility, the ECB will conduct an Asset Quality Review (AQR) to ensure that banks are recognizing non-performing loans on a consistent basis and are adequately capitalized to protect against adverse shocks. Fig. 5: A sharp rally in the Eurozone banking sector Eurostoxx banks index > A decline in peripheral bond yields is primarily responsible for the upbeat performance, as both Portugal and Ireland have successfully issued new debt in private markets 160 155 150 145 140 135 130 125 120 1-Oct-13 15-Oct-13 29-Oct-13 12-Nov-13 26-Nov-13 10-Dec-13 24-Dec-13 7-Jan-14 21-Jan-14 UBS Chief Investment Office February 2014 6
After the AQR concludes, likely sometime in November 2014, a number of banks will be required to raise capital. Small and unlisted banks will be a particular subject of attention since, unlike their larger brethren, they have not yet undergone external stress tests. > The AQR should reveal only limited capital shortfalls As yet, there is no clear mechanism for how troubled banks might raise capital. Therefore, investing in Eurozone financial equities and, by extension, Eurozone equities in general requires the faith that either a) capital shortfalls will be relatively limited, or b) a clear mechanism for recapitalization will be developed. To translate our view on the Eurozone into portfolio positions, we are overweight Eurozone equities within our tactical asset allocation, and hold a CIO Preferred Theme on Eurozone financials. By our estimates, the AQR should reveal only limited capital shortfalls, representing a fraction of the sector s annual profits. Of course, staying selective to avoid those banks with potentially onerous capital requirements is key. As such, the uncertainty could limit sector performance in the lead-up to November, although we ultimately believe that the stress test should boost both investor confidence and stock performance. Elsewhere in Eurozone equities, we have added a new CIO Preferred Theme that seeks to identify companies that can potentially benefit from corporate restructuring as Europe exits recession. To summarise our tactical recommendations, we remain overweight risky assets and in particular US and Eurozone equities, along with US high yield credit. We are more cautious on government bonds, and defensive equity markets such as the UK and Switzerland which could lag as economic expansion continues. Thank you for reading this letter and I hope this year proves to be a good one for us all. Sincerely, Alexander S. Friedman Global Chief Investment Officer Wealth Management UBS Chief Investment Office February 2014 7
UBS CIO WM Research is published by Wealth Management and Retail & Corporate and Wealth Management Americas, Business Divisions of UBS AG (UBS) or an affiliate thereof. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). All information and opinions as well as any prices indicated are current as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. At any time UBS AG and other companies in the UBS group (or employees thereof) may have a long or short position, or deal as principal or agent, in relevant securities or provide advisory or other services to the issuer of relevant securities or to a company connected with an issuer. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is considered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income of an investment. We are of necessity unable to take into account the particular investment objectives, financial situation and needs of our individual clients and we would recommend that you take financial and/or tax advice as to the implications (including tax) of investing in any of the products mentioned herein. This document may not be reproduced or copies circulated without prior authority of UBS or a subsidiary of UBS. UBS expressly prohibits the distribution and transfer of this document to third parties for any reason. UBS will not be liable for any claims or lawsuits from any third parties arising from the use or distribution of this document. This report is for distribution only under such circumstances as may be permitted by applicable law. In developing the Chief Investment Office economic forecasts, CIO economists worked in collaboration with economists employed by UBS Investment Research. Forecasts and estimates are current only as of the date of this publication and may change without notice. External Asset Managers / External Financial Consultants: In case this research or publication is provided to an External Asset Manager or an External Financial Consultant, UBS expressly prohibits that it is redistributed by the External Asset Manager or the External Financial Consultant and is made available to their clients and/ or third parties. Australia: 1) Clients of UBS Wealth Management Australia Ltd: This notice is distributed to clients of UBS Wealth Management Australia Ltd ABN 50 005 311 937 (Holder of Australian Financial Services Licence No. 231127), Chifley Tower, 2 Chifley Square, Sydney, New South Wales, NSW 2000, by UBS Wealth Management Australia Ltd.: This Document contains general information and/or general advice only and does not constitute personal financial product advice. As such the content of the Document was prepared without taking into account the objectives, financial situation or needs of any specific recipient. Prior to making any investment decision, a recipient should obtain personal financial product advice from an independent adviser and consider any relevant offer documents (including any product disclosure statement) where the acquisition of financial products is being considered. 2) Clients of UBS AG: This notice is issued by UBS AG ABN 47 088 129 613 (Holder of Australian Financial Services Licence No 231087): This Document is issued and distributed by UBS AG. This is the case despite anything to the contrary in the Document. The Document is intended for use only by Wholesale Clients as defined in section 761G ( Wholesale Clients ) of the Corporations Act 2001 (Cth) ( Corporations Act ). In no circumstances may the Document be made available by UBS AG to a Retail Client as defined in section 761G of the Corporations Act. UBS AG s research services are only available to Wholesale Clients. The Document is general information only and does not take into account any person s investment objectives, financial and taxation situation or particular needs. Austria: This publication is not intended to constitute a public offer or a comparable solicitation under Austrian law and will only be used under circumstances which will not be equivalent to a public offering of securities in Austria. The document may only be used by the direct recipient of this information and may under no circumstances be passed on to any other investor. Bahamas: This publication is distributed to private clients of UBS (Bahamas) Ltd and is not intended for distribution to persons designated as a Bahamian citizen or resident under the Bahamas Exchange Control Regulations. Bahrain: UBS AG is a Swiss bank not licensed, supervised or regulated in Bahrain by the Central Bank of Bahrain and does not undertake banking or investment business activities in Bahrain. Therefore, Clients have no protection under local banking and investment services laws and regulations. Belgium: This publication is not intended to constitute a public offering or a comparable solicitation under Belgian law, but might be made available for information purposes to clients of UBS Belgium, branch of UBS (Luxembourg) SA, registered with the National Bank of Belgian and authorized by the Financial Services and Markets Authority, to which this publication has not been submitted for approval. Brazil: Prepared by UBS Brasil Administradora de Valores Mobiliários Ltda, entity regulated by Comissão de Valores Mobiliários ( CVM ). Canada: In Canada, this publication is distributed to clients of UBS Wealth Management Canada by UBS Investment Management Canada Inc.. Dubai: Research is issued by UBS AG Dubai Branch within the DIFC, is intended for professional clients only and is not for onward distribution within the United Arab Emirates. France: This publication is distributed by UBS (France) S.A., French société anonyme with share capital of 125.726.944, 69, boulevard Haussmann F-75008 Paris, R.C.S. Paris B 421 255 670, to its clients and prospects. UBS (France) S.A. is a provider of investment services duly authorized according to the terms of the Code Monétaire et Financier, regulated by French banking and financial authorities as the Autorité de Contrôle Prudentiel et de Résolution. Germany: The issuer under German Law is UBS Deutschland AG, Bockenheimer Landstrasse 2-4, 60306 Frankfurt am Main. UBS Deutschland AG is authorized and regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht. Hong Kong: This publication is distributed to clients of UBS AG Hong Kong Branch by UBS AG Hong Kong Branch, a licensed bank under the Hong Kong Banking Ordinance and a registered institution under the Securities and Futures Ordinance. India: Distributed by UBS Securities India Private Ltd. 2/F, 2 North Avenue, Maker Maxity, Bandra Kurla Complex, Bandra (East), Mumbai (India) 400051. Phone: +912261556000. SEBI Registration Numbers: NSE (Capital Market Segment): INB230951431, NSE (F&O Segment) INF230951431, BSE (Capital Market Segment) INB010951437. Indonesia: This research or publication is not intended and not prepared for purposes of public offering of securities under the Indonesian Capital Market Law and its implementing regulations. Securities mentioned in this material have not been, and will not be, registered under the Indonesian Capital Market Law and Regulations. Italy: This publication is distributed to the clients of UBS (Italia) S.p.A., via del vecchio politecnico 3, Milano, an Italian bank duly authorized by Bank of Italy to the provision of financial services and supervised by Consob and Bank of Italy. UBS Italia has not participated in the production of the publication and of the research on investments and financial analysis herein contained. Jersey: UBS AG, Jersey Branch, is regulated and authorized by the Jersey Financial Services Commission for the conduct of banking, funds and investment business. Luxembourg: This publication is not intended to constitute a public offer under Luxembourg law, but might be made available for information purposes to clients of UBS (Luxembourg) S.A., a regulated bank under the supervision of the Commission de Surveillance du Secteur Financier (CSSF), to which this publication has not been submitted for approval. Mexico: This document has been distributed by UBS Asesores México, S.A. de C.V., a company which is not subject to supervision by the National Banking and Securities Commission of Mexico and is not part of UBS Grupo Financiero, S.A. de C.V. or of any other Mexican financial group and whose obligations are not guaranteed by any third party. UBS Asesores México, S.A. de C.V. does not guarantee any yield whatsoever. Singapore: Please contact UBS AG Singapore branch, an exempt financial adviser under the Singapore Financial Advisers Act (Cap. 110) and a wholesale bank licensed under the Singapore Banking Act (Cap. 19) regulated by the Monetary Authority of Singapore, in respect of any matters arising from, or in connection with, the analysis or report. Spain: This publication is distributed to clients of UBS Bank, S.A. by UBS Bank, S.A., a bank registered with the Bank of Spain. Taiwan: This document is distributed to qualified clients of UBS Securities Pte. Ltd., Taipei Branch. This document may have been edited or contributed to from time to time by affiliates of UBS Securities Pte. Ltd., Taipei Branch. UAE: This research report is not intended to constitute an offer, sale or delivery of shares or other securities under the laws of the United Arab Emirates (UAE). The contents of this report have not been and will not be approved by any authority in the United Arab Emirates including the UAE Central Bank or Dubai Financial Authorities, the Emirates Securities and Commodities Authority, the Dubai Financial Market, the Abu Dhabi Securities market or any other UAE exchange. UK: Approved by UBS AG, authorised and regulated by the Financial Market Supervisory Authority in Switzerland. In the United Kingdom, UBS AG is authorised by the Prudential Regulation Authority and subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. Details about the extent of our regulation by the Prudential Regulation Authority are available from us on request. A member of the London Stock Exchange. This publication is distributed to private clients of UBS London in the UK. Where products or services are provided from outside the UK, they will not be covered by the UK regulatory regime or the Financial Services Compensation Scheme. USA: This document is not intended for distribution into the US and / or to US persons. UBS Securities LLC is a subsidiary of UBS AG and an affiliate of UBS Financial Services Inc., UBS Financial Services Inc. is a subsidiary of UBS AG. Version 01/2014. UBS 2014. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. UBS Chief Investment Office February 2014 8