Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
2014
CONTENTS
CIO Year Ahead 2014 This report has been prepared by UBS AG and UBS Financial Services Inc. (UBS FS). This report was published on 11 December 2013. Editor in Chief Mark Andersen Project Management Paul Leeming Nikki Ackerman Brian Alden Corrine Fedier Rda Mouhid Sita L. Chavali Editors Thomas Gundy Andrew DeBoo CLS Communication Design Linda Sutter Layout CIO Digital & Print Publishing, UBS AG
Observe
08 Editorial
2014: Time to re-orient
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Economic outlook
A world shaped by deleveraging and convergence Global growth shiing up a gear in 2014
Orient
Decide
24 Investment principles
Look before you leap Succeeding with timeless investment principles
34 Asset allocation
Positioning portfolios for 2014 and beyond
49 Investment themes
Water: thirst for investments Energy independence: forward march Dividend investing: dont overpay for yield
35 Bonds
Limited value
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52 Currencies
A major rebound
54 Commodities
Little in return
42 Municipal bonds
Managing credit risk
56 Hedge funds
Attractive risk-adjusted returns expected
43 Preferred securities
Look back to look forward
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Private markets
Complement traditional portfolios
44 Investment theme
Tiptoeing out the yield curve
45 Equities
Stay stocked up on stocks
This report has been prepared by UBS AG and UBS Financial Services Inc. (UBS FS). Please see the important disclaimer at the end of the document.
EDITORIAL
ince 2008, the main secular trends driving the markets have been deleveraging and declining core government bond yields. As we end 2013 and move into 2014, these trends are changing in important ways. US Federal Reserve Chairman Ben Bernankes speech last May to the US Congress, suggesting that the central bank was considering recalibrating its pace of asset purchases, sparked a retreat in government bond prices and ended their three-decade long secular bull market. The era of falling government bond yields and perpetual stimulus appears to be ending. This adjustment caused a sharp sell-o in many emerging markets, particularly those with dual scal and current account decits. Combined with Chinas difculties in containing credit growth while maintaining its economic expansion, this situation laid bare the need for structural reforms in many of the larger emerging markets. Implementing such reforms will mean these economies will likely grow at a slower pace than investors have become used to over much of the past decade. In the developed markets, we have moved further down the long road of deleveraging that began in 2008. In the US, the private sector deleveraging process appears close to complete, with house prices having risen markedly. Public sector debt remains high, but as long as the US dollar remains the worlds reserve currency, the US faces little external pressure to reform its scal prole. In the Eurozone, bank deleveraging still has a way to go, but government austerity is easing and is no longer acting as a major drag on economic growth and political condence. And in Japan, the government enacted its most aggressive attempt yet to end its roughly two-decade-long economic malaise, combining aggressive monetary and scal stimulus with structural reforms. So, as what may come to be viewed as a game changing year winds down and we look to the future, it makes sense for investors to take stock of some of the structural shis underway and reorient their portfolio holdings. It is therefore important to remember that even in the unusual world we have lived in since 2008, the basic principles of investment management have not changed. First, at the core is the idea that investors should not take unnecessary risks. This means that investors should diversify across, and within, asset classes. A concentrated portfolio of individual stocks contains much greater idiosyncratic risk while oering no greater expected return than a widely diversied basket.
Second, it can be easy for investors to underestimate risks close to home, due to familiarity. Home bias, however, can lead to excess risk for no commensurate return. Investors should avoid home bias by diversifying globally. And third, when diversifying, investors should consider hedging their currency exposure. Currencies tend to add little more than noise to investment performance. Hedging enables an investor to reduce risk without sacricing returns. Beyond these core tenets, there is also now a need for investors to consider making shis in their portfolio construction to account for the structural changes we mentioned earlier. First, diversication across asset classes remains critical, so investors should still generally hold bonds as well as equities in their portfolios. But the beginning of the end of quantitative easing will bring about rising bond yields, undoubtedly aecting the returns available in bonds. The best solution to this problem could prove to be credit, which oers not only some of the diversication benet of government bonds but also a higher return. As a result, we believe credit should play a more integral role in investors allocations than may have been assumed in recent years. Second, the end of the era of falling bond yields will not come without its risks. We witnessed in May and June how worries about a withdrawal of central bank stimulus can temporarily lead to all asset classes falling in tandem. Investors will need to increasingly consider alternative investments as sources of less correlated returns. Finally, aer annualized returns of more than 15% from global equities and around 20% from high yield credit over the past ve years, investors will have to revise down their return expectations. Economic and earnings growth have simply not kept pace. We expect annual equity returns to be more in the range of 7%8% over the coming ve to seven years. Therefore, nding extra return will require not only increased allocations to alternatives, but also the agility to adjust to changes in short-term market conditions. Entering 2014, our highest tactical conviction is to be overweight risk assets, including equities and US high yield credit. That said, a number of dangers do potentially lurk in the year ahead. We face the threats of continued US government dysfunction, a Chinese credit crunch, a reappearance of the Eurozone crisis, and the possibility of ination in Japan without economic growth, producing pressure on its government bonds. Cutting across these risks is the biggest risk of all policy error. We still rely on policymakers to make the right choices at the right times. Overall, however, the environment for risk-seeking investors appears positive. We expect 2014 will produce 3% growth in the crucial US economy, close to the highest growth rate in the developed world. Meanwhile, the Eurozone should nally experience modest expansion. And we anticipate that the overall global economy will grow by 3.4% over the next 12 months, the fastest pace of growth since 2010. All the best for the year ahead.
Observe:
Before you start your journey, you need to observe the environment that shapes the investment landscape.
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ECONOMIC OUTLOOK
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mong the largest developed countries, the US economy is best positioned and boasts the strongest growth outlook (see Fig. 1). We foresee the US expanding on average by 2%3% per year, as opposed to the Eurozones 1%2% over the next ve to seven years. China should continue to lead the emerging world and outpace most developed nations growthwise, but its expansion has decelerated from the 10% it posted since remaking its economy in the early 1980s to a level of 7%8%. In the process of converging toward the developed world, emerging markets (EM) are seeing their growth rates naturally decline, though due to their larger economies, they have more impact on the rest of the world than ever before. As for ination, we expect prices to rise only moderately despite the ultra-expansionary monetary policies major central banks are still pursuing. Slower GDP growth means that it will take years to close the existing output gap in the developed nations the dierence between a countrys actual GDP (or output) and its potential GDP and to reduce unemployment rates to pre-nancial crisis levels. Consequently, companies will nd it difcult to raise prices for their goods and services, and workers will have little bargaining power to secure higher wages. We see ination in developed markets reaching 1.5%2.5%, and running 2%3% higher in emerging economies as prices there gradually converge toward those of the G7 nations.
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Russia 2.5 %
Japan 1.5 %
The size of the bubbles represents the countries current share of global GDP.
Source: UBS, as of 26 November 2013
In general, demographic developments continue to support stronger economic growth in emerging than in developed nations. The UN estimates that population growth in the former will surpass that in the latter by a full percentage point in each of the next 10 years. Greater population growth oers advantages not only in terms of total labor input but also in maintaining the ratio of working to retired people. This so-called support ratio has been eroding steadily in developed economies. It has dropped in the US from 7.8 in 1950 to 5.1 today, and is expected to fall below four by the end of the decade. The situation is even bleaker in Western Europe, where the ratio will plunge to three, and Japan, where each retiree, once able to rely on 12 workers in 1950, will have to make do with just 2.1 in 2020. In contrast, emerging countries higher birth rates will keep that ratio between six and 10 for the foreseeable future.
process of repairing their balance sheets. Such a balance sheet recession can last much longer than a normal business cycle and has been weighing on many developed economies in recent years. Japan, Switzerland and several Nordic countries experienced an extended period of stagnation in the 1990s aer their housing bubbles burst. The US, UK and many peripheral Eurozone nations are or have been in the midst of a
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ECONOMIC OUTLOOK
similar situation. The US and UK appear relatively far along in their deleveraging eorts and in cleaning up the balance sheets of their nancial sectors. While credit activity has been rising for more than a year in the US, it was still falling as of the end of 2013 in the Eurozone (compared with the previous year), and is expected to remain tepid. This illustrates a decoupling in the deleveraging process between the two regions and is a critical reason why we see the US maintaining its stronger position in the years ahead. Emerging markets are undergoing the phenomenon of convergence, which means that, everything else being equal, investment activity will be more pronounced where capital remains scarce because higher returns on capital can be expected. This leads to a greater growth rate of capital and, more generally, stronger economic expansion in emerging than in developed nations (see Fig. 2). However, convergence does not aect all emerging markets equally. A country can experience it to a greater or lesser degree depending on its institutional framework (whether the rule of law and clearly dened property rights prevail within it) and educational system (how good it is).
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Fig. 2: Emerging economies outpacing their developed peers Development of GDP per capita in USD (index 1980 = 1; incl. IMF forecasts)
35 30 25 20 15 10 5 0 1980 1985 1990 1995 2000 2005 2010 2015 2020 Korea Brazil China India US Estimates
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Fund estimates that the US economy in 2013 is still running roughly 5% below its potential output. Closing this output gap will take the better part of this decade. Unemployment rates remain markedly higher than they were pre-crisis and are only slowly retreating. In some peripheral European countries, they exceed 20%. Cost-push ination can gain little traction where wage costs stay at or decline due to high unemployment. The ination prospects for the emerging markets as a whole are easier to describe. Indeed, as mentioned above, many emerging economies have begun decisively converging with their developed counterparts. As they do, their real exchange rates tend to appreciate, i.e. either their currency itself appreciates or, more commonly, ination powers the rise. Therefore, even when governed by a conservative central bank, emerging markets will tend to experience higher ination than their developed counterparts do. The GDP-percapita convergence of emerging markets means, ultimately, that their price levels draw closer and closer to those of the developed economies as their non-tradable goods, i.e. services, rise in price as a consequence of their increasing wealth and the greater purchasing power of their inhabitants.
Demographics
Over a long time frame, population growth plays a prominent role in inuencing growth. From UN projections we can infer that the US, in the next 20 years, will add another 57 million people to its current population of 312 million and has better economic growth prospects than the Eurozone, whose 331 million inhabitants will be joined by just another eight million in that same time period. The US benets in this regard from its open immigration policy and birth rate of almost 2.1 per woman: even absent immigration, the US population can sustain itself, in contrast to the EU (with its 1.6 birth rate), Japan (1.4) and even China (1.6). In addition, the US excels at attracting young skilled immigrants. From 2000 to 2010, its net immigration amounted to 5.1% of its total population, well ahead of such competitors as the UK (3.1%), Germany (1.6%) and Japan (0.3%).
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ECONOMIC OUTLOOK
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US:
Among the developed countries of the world, the US is likely furthest along in the process of deleveraging. We expect private sector balance sheets to stop shrinking in 2014, which would support increased consumer and business spending and thus economic growth. US scal policy, however, can still trigger major surprises, especially since decisions about the debt ceiling and the budget have simply been delayed. Even assuming they have no severe economic consequences, they pose signicant event risk for markets in the short term. But if we look past such temporary uncertainty, the picture will actually brighten in 2014. The scal drag will likely abate further, from an estimated 1% of GDP in 2013 to around 0.3% in 2014. While an additional USD 45bn in sequester spending cuts (about 0.3% of GDP) are legally due in 2014, we sense little to no appetite in Congress for raising personal taxes further, and dont expect a dramatic shi in scal policy aer the next round of budget negotiations in early 2014. All eyes will thus be on the private sector in 2014, as we expect US household spending to accelerate and spur on a more robust, self-sustaining recovery. Factors inuencing consumption have turned positive and should serve to boost it. The almost two-year-old rebound in house prices has underpinned the rise in household wealth. Households are more willing to take on new debt, while banks have turned sympathetic to lending more freely. Real labor income growth remains mediocre, but we expect easier credit conditions to raise overall economic activity and, with it, growth in payrolls and real wages. Households also face fewer hindrances to spending. The savings rate has already increased to a more sustainable level of around 4.5%, higher personal taxes have been absorbed, interest rates have retreated somewhat again, and ination has stayed low. We expect real consumption to climb from its average rate of close to 2% since the recovery began to close to 3% as 2014 progresses. The pickup in household spending should persuade businesses to invest at a faster pace, especially since the other key drivers of capital expenditure (capex) are all conducive
CIO YEAR AHEAD 2014
to increasing it. The cost of capital remains low. The average age of the capital stock outstanding is at a 50-year high. The capex share of GDP is still below its long-term average, and aggregate stock prices have risen to all-time highs. If we combine the spending of the private and government sectors, we see real GDP growth expanding from just above 2% in 2013 to slightly above 3% in 2014 (on a 4Q-to-4Q basis).
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ECONOMIC OUTLOOK
OBSERVE
Europe:
The economic recovery in the Eurozone is expected to gain ground in 2014, though its doubtful that growth will reach even half the rate we expect for the US (see Fig. 3). The Eurozone private sector is still digging itself out of debt, and the deleveraging, along with the forthcoming bank stress tests and new capital requirements that could still crimp banks ability to lend, is likely to limit the continents economic expansion. Still, even modest growth beats the contraction of last year. Aer peaking in 2012, austerity remains on the retreat and the scal drag is decreasing. We anticipate scal
Fig. 3: Growth shiing up a gear Real GDP growth and forecasts for 2014 in % (adjusted for ination)
9 8 7 6 5 4 3 2 1 0 1 2 3 4 5 Estimates
tightening of only half a percentage point on average for 2014 down from almost a full point in 2013 which should nally permit the economy to breathe a bit easier. Consumer condence, beneting from greater economic and political stability and a stabilizing unemployment rate, is expected to settle in at more normal levels. The better nancial conditions and increased external demand should enable rms to invest more than in recent years. A rise in exports, however, should also be accompanied by recovering imports as pentup demand materializes, which would cap the large gains in net trade observed in recent years. Consumer price ination is expected to fall well short of the European Central Bank (ECB) target of just under 2%. Faced with low ination and mediocre growth, the ECB, in our view, will retain its easing bias to boost the recovery and provide enough liquidity when banks ll their capital shortfalls stemming from the stress tests. Meanwhile, some downside risks persist: economic disappointments could bring a country, such as Cyprus, close to default and reignite exit fears. However, we believe the ECB and its mechanisms will continue to serve as a credible backstop against any return to crisis. While political developments could disrupt the recovery, we expect the current relative calm to persist. For instance, early elections are likely to be held in Italy in the rst half of the year, but chances are good that the outcome will be a stable majority as opposed to the current hung parliament. Elsewhere on the continent, the Swiss economy is expected to experience robust growth. While exports stagnate, the domestic economy booms on the back of strong private consumption, easy monetary policy and greater immigration. As long as the euro-Swiss franc exchange rate oor of 1.20 stays in place, and we see no near-term end to it, Switzerland in eect continues to follow the ECBs accommodative monetary policy, which will go on fueling consumption and driving housing prices higher. We expect the Swiss economy to grow by 2% in 2014. The UK is expected to outpace even Switzerland at 2.3% real GDP growth, as its housing support measures, easier access to credit and declining household savings rate kickstart its economy. We anticipate the Bank of England will maintain its loose monetary stance through 2014, despite a decline in the unemployment rate.
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1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
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Emerging markets:
Aer tracing a atter trajectory for three straight years, economic growth in the emerging markets (EM) should rise moderately again in 2014, reaching 5% from around 4.5% in both 2013 and 2012. A 5% real GDP growth rate on almost USD 30trn would enlarge the EM share of the global economy to nearly 40%. The larger emerging countries Brazil, Russia, India, China are facing the need for structural changes as they converge toward the more developed economies. This process will require some of them, like China, to adapt to lower annual rates of growth than what they have become accustomed to. The highest risk for those emerging economies that rely on foreign capital inflows to finance growth stems from higher global interest rates. The fragile ve (India, Indonesia, Brazil, Turkey, South Africa) are particularly vulnerable, though some of them, such as Indonesia, have made structural improvements recently. Additionally, an earlierthan-expected tightening of the US Federal Reserves monetary policy could cause renewed capital outows and weigh on currencies such as the Indian rupee. Overall, however, as exports pick up we expect net capital ows into EM to trend higher into 2014 from the outows seen last year. Any weakening in US and/or European growth would curtail exports in China and curb growth across EM, but our outlook for higher growth in the developed world bodes well for EM.
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nterest rates still sit at or close to zero in most developed countries, while monetary stimulus policies enacted at the onset of the nancial crisis persist in the form of various kinds of quantitative easing. Getting to normalized rates and self-sustaining economies is the daunting task central bankers face.
Normalizing monetary policy conditions looms as a delicate balancing act that central bankers face in the years ahead.
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since the nancial crisis commenced, central bank money creation alone appears to be insufcient to provoke the ination beast. Both ination and ination expectations look very stable. Therefore we do not expect the major developed market central banks to raise interest rates during 2014. We expect the Fed to apply the brakes to its bond-buying program (QE3), with its balance sheet peaking sometime in late 2014. In 2015, we expect the Fed to start raising interest rates. However, the pace of the hikes will be slower than in the past, when the Fed raised rates by roughly two percentage points per year on average. We currently assume an increase of about 1% annually. Toward the end of 2017 we anticipate that the Fed funds and the US dollar short-term
money markets rates will approach 2.5%3.0% (see Fig. 4). Aer 2017 we expect the Fed funds rate to climb to its terminal value of about 3%4%. We think real interest rates in other markets will also start to normalize. This process, along with our views on ination, determines our forecasts for the nominal central bank rates in these countries. We foresee a level between 2% and 2.5% for the Eurozone, 1.25% and 1.75% for Switzerland and 2.5% and 3% for the UK in 2017, with each thereaer rising somewhat higher.
Fig. 4: Rates will only increase gradually US central bank policy rate and 10-year Treasury yield (with forecasts), in %
6.0 5.0 4.0 3.0 2.0 1.0 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Estimates
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Orient:
To choose the right path, you need to orient yourself toward your nancial goal and consider the challenges you might face on the way.
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INVESTMENT PRINCIPLES
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he journey toward any goal becomes easier with preparation. Where are you starting from? How much risk will you take along your path? Do you believe in your plan enough to stick with it when the going is difcult?
Orient yourself:
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INVESTMENT PRINCIPLES
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ts great to watch the price of a stock you own double in a year. But over the long term, the lions share of your portfolio performance is determined by the allocation among dierent asset classes. Frankly, much of what passes for successful investing in nancial newspapers stems from lucky timing and is oen shortlived. In our view, investors benet far more from focusing on their long-term strategy. While we are passionate about the individual stocks and bonds we select, these timeless principles determine how we invest:
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in 2013 as well. Developed market equities have returned 20% or more, depending on the region and sector. Emerging market equities, on the other hand, are actually down about 2%. Assuming this holds through December, it will be the rst calendar year since 1998 in which emerging market equities have declined while developed market equities appreciated. Despite slightly negative returns in many xed income assets, all of the major asset classes we track appear on course for a normal year, dened as being within one standard deviation of our long-term return estimates2 (see Fig. 7). Better-than-expected performance has been concentrated in developed market assets, and US assets specically. Yet, given the volatile nature of equity markets, returns in the order of 20% in US equities like weve seen this year are not unusual even if they are not expected to occur with regularity.
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2008-09 nancial crisis, have been relatively low this year. Additionally, none of the major policy risk events, including the government shutdown, resulted in spiking correlations among risk assets. However, some unique correlations between asset classes manifested themselves this year, particularly within xed income. We typically expect US government bonds and US Investment grade (IG) credit to be moderately correlated with each other. They both exhibit interest rate risk, but the credit risk component of investment grade credit generally provides some disconnect between the two bond sectors. This year, however, the correlation has been 0.96 meaning that they have been nearly perfectly correlated. In contrast to the high correlation between IG and government bonds, the correlation between high yield corporates and government bonds has been virtually zero. Of course, we normally expect lower-grade credit to be more correlated to equities than to other types of xed income. This year has not been an exception in that regard, with correlations between high yield and equities coming in at 0.5 or greater. Investors who are tempted to shi the bulk of their portfolio toward high yield bonds and developed market equities on the basis of their strong 2013 performance should nonetheless refrain from excessively concentrating
their wealth in these two asset classes. Their high correlation means that in the case of an economic downturn or market shock, such a portfolio would oer very little diversication to control volatility and protect assets.
Portfolio performance
Roughly speaking, portfolio returns have been in line with long-term return estimates in 2013. Globally diversied moderate portfolios, not including fees or manager outperformance (something increasingly common this year), will have returned about 7%8% this year. In ination-adjusted terms thats a real return of 5.5%6%. Our long-term estimate is between 5.5% and 6% nominally (3%3.5% real), so were above target thus far. Fig. 6 provides return numbers into November for our moderate agship portfolio, a nave 60/40 US equity/US xed income portfolio, and a global market cap portfolio.3 The reason why the nave US-centric portfolio has outperformed the other two is that US assets have outperformed their international counterparts this year. Throughout 2013, we have capitalized on this development by tilting our portfolios toward high yield and US equities which has benetted performance on the margin. That being said, even with these tilts, our portfolios contain international exposure and its clear that
Fig. 6: 2013 year-to-date returns have favored US assets Portfolio performance year to date
16 14
US Equities
12 10 8
6 4 2 0 60/40 S&P/ Barclays Agg UBS Moderate Portfolio Global Market Cap Portfolio
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portfolios concentrated in US risk assets, including equities and high yield, have performed better. However, we believe that the more globally diversied portfolios should provide better outcomes over multi-year periods.
ORIENT
retain these exposures in their portfolios. However, were that view to change, our strategic asset allocation recommendations would also change in kind. Additionally, structural risk and correlation changes should be accounted for in strategic asset allocation decisions. For instance, we hold relatively large positions in high yield xed income across our portfolios. The 0.96 correlation between IG and government bonds this year is important in that regard because if we believed that such a high correlation would persist structurally (i.e. zero diversication benet), it would justify modifying the makeup of the bond allocation. However, at this time we feel very comfortable in maintaining our overall asset allocation recommendations. We believe 2014 has a good chance of being a year that is actually more normal than the last two. Although we continue to prefer US equities and high yield bonds on a tactical basis, we acknowledge that were unlikely to see the same outperformance in those positions in 2014 as 2013 has oered so far. While more-normal will likely mean more-modest returns, at least for US equities, we do expect to see continued dierentiation between sectors and regional equity markets. Within xed income, the only real dierentiation in 2013 has been between high yield and everything else. Its reasonable that in 2014 investors should expect greater dispersion and better performance in that market as well. Unlike cash, a well-constructed bond portfolio has a good chance of providing positive real returns in 2014.
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Fig. 7: Returns have been within normal range Performance relative to 1-year estimates
40 30 20 10 0 10 20 US Government FI US Munici- US Investment pal FI Grade FI US High Yield FI Intl Developed EM Fixed Mkt FI Income US Equity International Emerging Developed Markets Markets Equity Equity Commodities
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Decide:
Along the journey, you need to make sound investment decisions. Insight into each asset class is vital.
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ASSET ALLOCATION
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OBSERVE
e expect stronger economic growth and accommodative central banks to continuously favor equities and credit during the year ahead. We recommend reecting this in your portfolio by being tactically overweight equities and credit at the expense of government bonds and liquidity.
We advise investors to shi from traditional government bonds into corporate credit. We recommend corporate bonds of medium and shorter duration as well as high yield credit. The easy financial conditions and improved growth outlook are expected to result in rising interest rates and lower returns for government bonds that barely exceed the ination rate in the years ahead. A move into corporate credit would help oset the eects of these trends by oering a better return outlook. If the economy has improved enough for central banks to start hiking rates, it has probably improved enough for the yield spreads on corporate bonds to tighten and boost the bonds value. These dynamics also hold true for emerging market (EM) sovereign and corporate bonds, which oer better return prospects than developed market bonds. As a result, we recommend a small strategic position in EM bonds for most portfolios.
GOVERNMENT BONDS
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Limited value
Government bonds, and other bonds with strong credit ratings, will oer only limited returns in the years ahead. Nonetheless, they continue to provide safety and diversication, and still have a role to play as part of a diversied portfolio.
Thomas Berner, Strategist Achim Peijan, Strategist Daniela Steinbrink Mattei, Strategist
ajor developed economies have an interest in keeping government bond yields low to support their decit reduction eorts and economic recoveries. We think that most developed market sovereigns cannot aord a large climb in interest rates because it would cause their budgets to teeter further out of balance and endanger debt sustainability. As a result, we expect central bank rates to remain low (see page 20, The hard way forward from easy money).
CIO YEAR AHEAD 2014
How quickly bond yields normalize will dier from region to region depending on the speed at which each is recovering. As these dierences in the pace of recovery become more evident, we anticipate the market distinguishing between regions and reecting local fundamentals in its pricing of future rates. Since we see the US furthest along in its economic recovery, we expect US rates and bond yields to lead the European markets, with Japanese bond yields lagging on the way to normalization.
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Fig. 8: The end of the bond bull market Total return indexes of medium-term (57 yrs) government bonds (2009 = 100; incl. forecasts)
135 130 125 120 115 110 105 100 95 90 2009 EUR 2010 2011 USD 2012 2013 CHF 2014 2015 Estimates
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Count on credit
We believe credit should play a more important role in asset allocation than in the past. Developed market corporate and emerging market bonds will outperform government bonds in the years ahead, in our view.
Barry McAlinden, Strategist Donald McLauchlan, Strategist Philipp Schttler, Strategist Bernhard Obenhuber, Strategist
ne can easily form the impression from nancial newspapers that sequences of sensational events determine the movements of asset classes. But we believe that a meaningful analysis of credit investments has to focus on underlying economic trends and the broader credit cycle. To us, what really matters for credit returns over the medium and long term is how the business cycle is progressing. We view the returns as primarily governed by the prevailing yield level and default losses both of which change meaningfully through the credit cycle.
In addition, the US Federal Reserve is playing an important role. By keeping interest rates low it has in essence encouraged investors to seek out higher-yielding assets. Bond issuers, in particular those with a high yield rating, benet from open primary markets. As long as ample funding is available, default rates are unlikely to climb. We expect the default rate on US high yield bonds to stay below 2% through 2014 and foresee total returns of 4%6% for the year. Investment grade corporate bonds (with an average maturity of ve years) will feel the drag from rising benchmark rates, but their expected total return of 1%2% in 2014 compares favorably with that of government bonds of close to zero. In terms of the credit cycle, the US corporate sector entered the re-leveraging stage in 2013 (see Fig. 10). Aggregate credit metrics for non-nancial issuers have peaked and are in the soening phase. Over the past year the average debt level on the balance sheets of US non-nancials rose by almost 10% while earnings climbed by roughly 7%. Furthermore, more aggressive issuance practices, such as loans with limited covenants (covenant lite), and shareholderfriendly activities, such as debt-nanced dividend payouts, have revived since early 2013. But they have done so from a very low level and remain far below the excesses seen in 2006 and 2007.
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Fig. 10: A stylized credit cycle Additional yield of US high yield over government bonds (spread) in percentage points and stylized credit cycle phases
20 18 16 14 12 10 8 6 4 2 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 Overheating 2008 2009 2010 2011 2012 2013 (IV) (I) (II) (III) (IV) (I) (II) (III)
Downturn
Re-leveraging
This gure illustrates the credit cycle in a stylized manner, using US high yield bonds as an example.
Source: BoAML, UBS, as of 26 November 2013
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tightening standards 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 US Eurozone Emerging markets
better than Portugals. However, the bulk of rating convergence occurred before 2007. Since then, EM ratings have only marginally improved, and we expect them to stabilize at the current level. EM structural improvements over the last 15 years that led to the rating convergence include: more exible exchange rates; prudent scal and monetary policies; and a better institutional and regulatory framework. The greater economic and political stability in EM led to more sophisticated domestic capital markets, which, along with fewer capital account restrictions, enabled EM corporates to issue bonds more regularly on the global market. In 2000, the EM corporate bond market totaled around USD 72bn. It is now 15 times as large and amounts to more than USD 1trn. The US corporate bond market, by comparison, is at roughly USD 5trn. EM corporate bonds, in short, have become a sizable market for global bond investors.
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restrictive with their loans, which should weigh on credit and, by extension, economic growth. Domestic demand will not fuel it. While the major EM economies are expected to revive, the credit conditions of the weakest EM sovereigns, such as Ukraine, Argentina and Venezuela, continue to deteriorate. This means, as it relates to the EM corporate bond segment, that the credit cycle is somewhat more challenging. Tighter bank lending standards (see Fig. 9), ongoing re-leveraging of corporate balance sheets and weak EM corporate earnings portend a rising number of corporate defaults in 2014, in contrast to the developed markets. Despite the mixed fundamental outlook, and credit spreads close to fair, we still expect EM bonds to outperform developed market government bonds. But they will be more vulnerable when the Fed begins scaling back quantitative easing due to their dependence on capital from foreign investors, especially if domestic growth is shaky. For 2014, US and Eurozone corporate bonds thus have a more favorable outlook, in our view.
DECIDE
The credit rating scale goes from AAA (highest rating, i.e. lowest default risk) to D (defaulted)
Source: BoAML, UBS, as of 1 November 2013
41
e continue to recommend deemphasizing agency debt within the taxable xed income (TFI) component of the UBS CIO recommended portfolio. We expect a relatively healthy economic recovery in 2014 will motivate the Fed to taper back QE in 1Q2014, the result of which should be a rising rate environment. Specically, we expect this environment to manifest itself as a so-called bearish steepening, where longer maturity rates rise more than shorter maturity rates. Likewise, we expect interest rate volatility to evolve in the same manner, i.e., an overall rise led by longer-term tenors vis--vis shorter-term tenors. This environment generally augurs poorly for the expected total return for the asset class on both an absolute and relative basis. While we dont expect anything approaching what a reasonable person would call substantive regulatory reform of the government-sponsored enterprises (GSEs) next year, we do expect more related headlines. For example, 1) Fannie and Freddie continue to make signicant payments to Treasury as part of the Senior Preferred Stock Purchase Agreement, and 2) the midterm electioneering season kicks into full gear. The combination of higher rates and elevated headline risk historically has been associated with wider spreads and increased spread volatility, neither of which would bode well for the so-called carry trade (i.e., the strategy of buying and holding xed income securities to clip the coupon and roll down the yield curve). Thus, we expect some unwinding of the spread compression that weve seen in high quality, liquid alternatives to Treasury notes (e.g., agency callable and noncallable notes, mortgage-backed securities) as the combination of programmatic central bank buying and the reach for yield trade presumably recedes. We continue to believe that mortgage-backed securities (MBS) will perform broadly in line with the rest of the taxable xed income segment. In other words, we prefer mortgages to agency debt. This is because the additional spread oers relative total return outperformance potential over a oneyear horizon, assuming our interest rate forecasts are realized. Note that this analysis is purely based on changes in interest rates, i.e., it does not impute any spread widening in
CIO YEAR AHEAD 2014
either agency debt or MBS. One major concern we have for MBS spreads going forward is that if and when the Fed tapers back its support for the product, its not apparent to us which buyers would replace that demand at current spread valuations, i.e., spreads may widen. Within the mortgage universe, we still like the up in coupon trade (i.e., a preference for higher coupon passthroughs versus lower coupons). This is for two key reasons: 1) higher coupons oer relatively better protection against duration extension than lower coupons; and 2) the Feds QE-related buying has been disproportionately concentrated in lower coupon securities, so their valuations should be expected to weaken disproportionately if and when that support eventually slackens.
Fig. 12: Compressed spread pickups available in agencies and mortgages Agency debt and MBS spreads
100 90 80 70 60 50 40 30 20 10 0 10
31-Dec 31-Jan 28-Feb 31-Mar 30-Apr 31-May 30-Jun 31-Jul 31-Aug 30-Sep 31-Oct
Mortgage
Source: Bloomberg, Yield Book, UBS Note: Spreads to 10yr Treasury for 10yr agency bullet, 10yr non-call 3mo agency callable and 30yr current coupon mortgage pass-through
42
MUNICIPAL BONDS
OBSERVE
ORIENT
DECIDE
ndividual investors constitute the single most important source of capital for state and local governments. Alone, they hold approximately half of all tax-exempt bonds outstanding. When combined with open-end mutual funds, through which many individuals purchase munis, the retail investor holds roughly three-quarters of the markets nominal value. Individuals favor muni bonds for their tax advantages and oen pursue a buy-and-hold strategy but nancial disclosure practices are inconsistent and pale in comparison with the corporate bond market. The regulatory regime is disjointed and spread across the 50 states and territories, all of which tends to weaken price transparency and contributes to periodic bouts of volatility. The municipal market responds by lurching between extended periods of tranquility and abrupt interludes of instability. The most recent bout of price volatility began in May 2013 on the heels of Chairman Bernankes inference that the Fed would begin tapering its large-scale asset purchases. The prospect of higher rates was enough to convince many investors to focus on duration risk in their portfolios and redeem mutual fund shares at a record pace, a trend reinforced as net asset values declined. Previous periods of market instability have been short-lived aairs. Indeed, market sentiment improved in late September as more state governments reported better nancial results. However, while the fourth quarter of 2013 oered a brief respite, the year ahead is shaping up to be a volatile one for four reasons.
managed to upend traditional notions regarding the safety of GO debt. We expect that litigation surrounding the Motor City bankruptcy will extend beyond 2014, and initial bankruptcy court decisions will add to investor uneasiness.
PREFERRED SECURITIES
43
referred investors can take a page out of 2013 to help them navigate the year ahead as the uncomfortable prospect of Fed tapering will surely be a focal point toward the beginning of the year. So, just as we ushered in 2013 with a cautious view on securities with long duration, we again expect interest rates to be the primary driver of market valuations next year. Demand from individual investors is likely to remain tempered by the expectation of rising rates, although the outlook for robust new issuance of xed-to-oat structures is sure to spark investor interest. With credit spreads currently range-bound at levels approximately 110bps wider than the historical average of 190bps, we expect material spread widening to be a less likely scenario in the year ahead. The worst of the Eurozone debt crisis is seemingly behind us. Furthermore, systemically important US nancial institutions have been bolstering their capital and liquidity ratios at an encouraging pace. The concentration of bank issuers in the preferred market makes the reduced systemic concerns particularly relevant. We are generally comfortable with the improved issuer fundamentals and continue to look for preferred credit spreads to cushion some of the interest rate movements as the 10-year Treasury heads toward the 3.3% mark forecasted by CIO in the next 12 months. In 2014, we foresee possible risks stemming from a few areas that are mostly demand-based in nature. First, average coupon rates have been dropping steadily since the beginning of 2012, to 6.6% on average, as issuers took advantage of strong demand and lower interest rates to renance debt at historically low xed rates. The now deeply discounted prices of where these preferreds currently trade and the forecast for a continued rise in rates should keep investors cautious. Second, outows from the preferred securities asset class have been signicant since the second half of 2013. Unless these outows subside, they could further weigh on performance in 2014. Third, supply tends to follow demand and the second half of 2013 saw a diminishing supply of new issues, which is typically a sign of a jittery market.
On balance, we look to the year ahead with cautious optimism. With the largest US banks estimated to raise additional regulatory capital to the tune of USD 50bn60bn in the next two years, investors should expect new issues to oer higher coupons to conform to a higher rate environment and spur investor demand. Inevitably, we believe most preferreds with xed low coupons that trade to their perpetual/long maturity dates will be subjected to further price pressure. This phenomenon is already unfolding with recent new issuance being repriced with higher yield levels, in the 7% range. These new securities may serve to be the new benchmark toward which preferred yields will eventually converge, with some adjustments in spread premium according to the individual securitys credit quality.
Fig. 19: Preferreds not created equal Cumulative total return, index 31 (August 2013 = 100)
105 104 103 102 101 100 99 98
31-Aug-13 15-Sep-13 30-Sep-13 15-Oct-13 30-Oct-13 14-Nov-13
Capital securities Euro Tier 2
Source: BofAML, UBS, as of 15 November 2013
44
INVESTMENT THEME
BONDS
OBSERVE
ORIENT
DECIDE
nlike during prior cyclical economic recoveries in the US, rates on the short end of the curve are unlikely to rise sustainably in the near term. With cash rates likely to remain anchored until 2015, we recommend that investors redeploy excess cash into short-term credit instruments.
Fig. 13: The Fed funds rate inuences short-term yields Yield, in %
8 7 6 5 4 3 2 1 0 1 92 94 96 98 00 02 04 06 08 10 12 14
EQUITIES
45
he robust rebound in global equities that characterized 2013 should continue in the coming year due to increased global economic growth and corporate earnings. In our view, the asset class still oers the requisite upside to justify a solid longer-term portfolio allocation, though we caution investors who may be spoiled by the gains of recent years to temper their expectations. Despite the rather tepid increase in overall corporate earnings in 2013, global equities went right on rising, paced by the developed market indices and buoyed by the removal of several political roadblocks. US policymakers failure to resolve the US budget and debt ceiling issues resulted in the Federal Reserve delaying its decision to scale back its quantitative easing (QE) program, which kept its ultra-loose monetary bias in place and eliminated a key market concern. Worries that governments in Europe, mainly that of Italy, might fail proved unfounded, bolstering market sentiment. Developed markets also beneted from additional evidence that the US nancial system had largely healed from its crisistime wounds, and that deleveraging in Europe was proceeding apace. The unfortunate consequence of the climbing equity prices in the face of unimpressive earnings is that price-toearnings (P/E) ratios have risen and earnings yields fallen (see Fig. 14). The earnings yield is a measure of a companys ability
to deliver returns to investors, whether by issuing dividends, buying its shares back or investing in growth. The current cyclically adjusted reading of greater than 5% still compares favorably with the low real yield of less than 1% on 10-year US Treasuries, even if it is below last years mark. Thus, the near-term return potential occasioned by a re-rating of equities the falling equity risk premium driving the earnings yield further down is also more limited. This applies to all regions that have shown strong stock market performance.
46
DECIDE
ORIENT
OBSERVE
reforms as liberalizing its interest rates and opening up its state-dominated service sector while curtailing the risks associated with its ve-year credit boom.
EQUITIES
47
a single banking supervisor should help rebuild investor condence and li equities. We expect the ECB to maintain easy liquidity conditions, which will limit the impact of any Fed tightening on the European economy. The gradual Eurozone economic recovery should translate into rising earnings and enable Eurozone equities to outperform markets like the UK and Switzerland, with their greater share of defensive sectors such as healthcare and consumer staples. Monitoring the progress of the recovery is crucial as ongoing economic malaise in weak countries could bring back euro exit fears. Japan will face a test of Abenomics, the scal policies named aer Prime Minister Shinzo Abe, as April approaches and indirect taxes rise from 5% to 8%. We expect a sharp but temporary economic contraction, with part of the tax hike blow being counteracted by supplementary scal measures. Aer the boost the Bank of Japan (BoJ) measures gave equities last year by drastically weakening the yen and contributing to a broad earnings rebound, further gains will hinge on additional, difcult-to-time policy moves, including the BoJ buying equities. On the governments willingness to enact true reform by ring the so-called third arrow of Abenomics from its quiver, we are skeptical.
Fig. 14: US earnings yield suggests upside for equities Cyclically adjusted earnings yield; in %
12 10 8 6 4 2 0 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 Cyclically adjusted earnings yield
Source: Thomson Reuters, UBS, as of 26 November 2013
48
OBSERVE
ORIENT
DECIDE
ectors of the US equity market that are most sensitive to changes in economic growth, i.e., cyclical sectors, outperformed defensive sectors in 2013 and we expect further outperformance in 2014. The strong relative performance of cyclicals over defensives may seem surprising considering the fact that US real GDP growth decelerated from 2.8% in 2012 to just 1.7% (UBS forecasts) in 2013. So, why did cyclicals outperform in an environment of slowing US GDP growth? We identify three main drivers: 1. Valuation. At the beginning of 2013, cyclical sectors traded at an 11% discount relative to defensives compared to their long-term 8% average premium valuation. 2. Rising interest rates. Defensive sectors carry higher dividend yields. Rising interest rates are not only a signal that economic growth is improving (boosting earnings prospects for cyclical sectors), but also reduce the relative attractiveness of the defensive, high dividend yielding sectors. 3. GDP is not the only measurement of economic growth. Other indicators, such as purchasing managers surveys, housing starts, auto sales, and the unemployment rate, all experienced meaningful improvement during the year. Additionally, GDP growth was largely constrained by reduced government spending. Private sector GDP remained resilient in 2013. From this perspective, 2014 should be another solid year for cyclicals as the drag from higher taxes and lower government spending fades, and as the US expansion broadens and shows increasing signs of becoming self-sustaining. Our economists expect US real GDP growth to accelerate to 3% in 2014. Furthermore, as economic growth prospects improve, interest rates are likely to head higher. Our xed income team forecasts 10-year Treasury yields to rise to 3% in six months and to 3.3% in 12 months a further headwind for the higher-yielding defensive sectors. And while cyclical sector valuations are no longer at extremely low levels (as was the case one year ago), cyclicals remain inexpensive compared to defensive sectors. So in a nutshell, cyclical sectors remain undervalued relative to defensives and should deliver stronger earnings growth over the next 12 months. Mix in the prospect of rising
interest rates and we expect 2014 to be another year of cyclical sector outperformance. But which of the cyclical sectors Consumer Discretionary, Technology, Industrials, and Materials appear best positioned? During the past year, Consumer Discretionary has delivered the strongest performance of the ten S&P 500 sectors. This sector typically performs best during the early stages of an economic expansion as low interest rates spur recoveries in two of the sectors most important end-markets housing and autos. As the economic expansion broadens to also include stronger manufacturing activity and an increase in business spending on capital equipment, we believe investors should focus on the beneciaries of an upturn in capital spending. In our view, the Industrials and Technology sectors the sellers of capital equipment as well as Financials, are poised to be the market leaders of 2014.
Fig. 15: Rising rates, driven by stronger growth, is a positive for cyclicals Performance of cyclicals vs. defensives and 10-year Treasury yield
106 104 102 100 98 2.2 96 94 92 90 88 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 2.0 1.8 1.6 1.4 3.0 2.8 2.6 2.4
INVESTMENT THEME
49
EQUITIES
and presents opportunities for companies specializing in improving water quality. We also expect shale gas/oil development, which is booming in the US, to raise water-treatment expenditures. Between 7.5 million and 19 million liters of water per well, depending on the shale play, are used in the fracking process and need to be treated.
he worlds population exceeds 7 billion, and the UN estimates that this number will rise to 9.3 billion by 2050. This growth will increase demand for food, energy and consumer products, all of which require substantial amounts of water to produce. Over the next 12 months, we expect companies tied to water infrastructure, treatment, etc. to outperform the global equity market.
Fig. 16: S&P Global Water vs. MSCI World Jan 2003 - Sep 2013
250 200 150 100 50 0 50 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13
50
INVESTMENT THEME
EQUITIES
OBSERVE
ORIENT
transportation fuel base. In addition, by 2016, we project the US to be a natural gas exporter. This should help support natural gas prices, which have hovered at cash breakeven levels. However, the US will retain its relative energy cost advantage versus the rest of the world due to its ability to meet its natural gas needs with domestic resources.
DECIDE
he potential for North American energy independence by the end of the decade, made possible by new shale drilling and extraction techniques, has become widely recognized and accepted. Supported by a structurally high price of crude oil, US oil production is rising at a rapid pace. Abundant and cheap natural gas is creating a competitive advantage for the US by bolstering energy-intensive industrial operations. As the world looks on, we expect growth in US oil and gas supplies to continue to impress in 2014, providing additional economic benets for the US, and opportunities for investors.
Ongoing technical advances may help fuel high US production growth in 2014
In each of the past two years, US oil production has risen by 1 million barrels per day, to 8 million barrels per day. This has exceeded expectations, and we believe a high rate of growth may continue in 2014. Operators in the major shale plays are testing higher density drilling, enhanced well design, and other technical and efciency improvements; and early results show potential for meaningful productivity gains. These gains will become more evident as use of these processes becomes more widespread, in our view. Meanwhile, persistently high oil prices, as well as policy initiatives have led US consumers to use fuel more efciently. Domestic consumption of rened products such as gasoline is below historical peak levels, and we expect US oil consumption to continue to decline.
Fig. 17: US crude oil production Accelerated growth over the past two years
8,000 7,400 6,800 6,200 5,600 5,000 4,400 3,800
Dec
2008 2009
Thousand B/D
Mar
2010 2011
Jun
2012 2013
Sep
Dec
INVESTMENT THEME
51
EQUITIES
elative to high dividend yielding stocks, high dividend growth stocks trade at very attractive valuations. We expect high and consistent dividend growers to outperform the highest dividend yielding stocks over the next 12 months (and beyond). Stocks with strong income-generating properties, i.e., dividend paying stocks, are more attractive to investors when interest rates are low. So it should come as no surprise that dividend-based investment styles have gained enormously in popularity. But investors should note that not all dividend-paying companies have the same investment characteristics. While 84% of S&P 500 companies pay shareholders some form of recurring dividend payment, the level of the dividend relative to the companys share price (dividend yield) and earnings (dividend payout ratio) strongly varies across industries and companies, as does the growth rate of the dividends per share paid by companies. Stocks with the highest current dividend yield are trading at high relative valuations compared with history. At a sector level, this becomes quite clear when looking at the current relative sector P/E (price-to-earnings ratio) of some of the highest yielding sectors of the market. Utilities, for instance, has a dividend yield of 3.9% and is currently trading at a 2% P/E premium to the S&P 500 compared to its long-run average of a 14% discount. Alternatively, S&P 500 stocks with more moderate current dividend yields but high dividend growth rates appear much more attractively valued compared to the aforementioned expensive high dividend yielding stocks. In fact, the top decile of dividend growers S&P 500 stocks that have delivered the strongest dividend growth rates over the past 10 years currently trade at a par valuation with the S&P 500. Historically, high dividend growth stocks have traded at a premium to the market. So for investors looking for cheaper yield, high dividend growth stocks are trading at very attractive valuations relative to the highest dividend yielding stocks.
Fig. 18: Dividend growth still cheap relative to high dividend yield Relative P/Es
1.6 1.5 1.4 1.3 1.2 1.1 1.0 0.9 0.8 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 Relative P/E of high dividend growth versus high dividend yield Average
Source: FactSet, UBS, as of 4 December 2013
52
CURRENCIES
OBSERVE
A major rebound
The worlds major currencies have weakened in recent years due to loose monetary policy. But with less accommodative conditions on the horizon, currencies like the US dollar and the British pound could benet.
Katie Klingensmith, Strategist Thomas Flury, Strategist
DECIDE
ORIENT
e expect 2014 to be the year when major currencies recover some of the losses they experienced due to the ultra-accommodative monetary policies in place in recent years. We expect the majors especially the US dollar, euro and British pound to outpace the weaker emerging market currencies and even those of some of the commodity producers. Foreign exchange (FX) markets will likely become anxious about potential monetary policy tightening, which in our view will boost major currencies. For strategic investors, we recommend hedging broad international FX exposure.
CURRENCIES
53
and the damage from the European debt crisis persists, such that the European Central Bank (ECB) has little leeway to hike rates over the next two years. Such a hike, which would signal the end of the European debt crisis, is in our view the minimum requirement for the SNB to abandon the oor. We therefore see EURCHF continuing to trade in a 1.201.25 range over the next year.
54
COMMODITIES
OBSERVE
Little in return
Commodities have a distinct appeal for certain investors. However, we expect negative returns in 2014 with demand still muted and supply ample.
Dominic Schnider, Analyst Giovanni Staunovo, Strategist
DECIDE
ORIENT
s real and tangible assets, commodities provide attractive opportunities to benet from specic economic trends. Gold, for example, denitely has its merits as long-term insurance against extreme risks such as hyperination. But aer the mid-to-high single-digit percentage decline in broadly diversied commodity indices over the last year, investors should not expect the asset class to catch up with other risky assets like equities in the year ahead. But that does not mean we dismiss commodities as an asset class. We recommend instead taking tactical exposure whenever short-term opportunities arise. Global economic growth should improve throughout 2014, but only mildly in emerging markets, which have become the biggest consumers of many commodities. China will need to balance its economy by curbing investment growth. And the entire Asian region is poised to expand more slowly as it converges toward the developed world, aer having re-leveraged in recent years, so incremental commodity demand should be so in the market. Keep in mind that China alone consumes more than 40% of global copper production and 50% of global coal. Therefore, most commodity markets will experience excess supply, and any temporary market tightness is likely to be short-lived. The years economic growth should occur primarily in the rst several months, and potential price advances are then expected to reverse and in some cases trigger even lower prices by the end of the year. Thus, investors are well advised to use higher prices in the rst half to exit positions.
expect an average price around USD 100/bbl in 2014, but temporary dips below that mark are likely. Gold is another candidate for lower prices. Outows from gold ETFs as a result of a lack of ination in the developed world and the US Federal Reserve likely starting to taper in the rst half of 2014 could pressure the yellow metal. Although its price fell substantially in 2013, an additional 300500 tons (i.e. 7%11% of yearly demand) of outows from ETFs and futures/option positions in 2014 are forecast to hit the market. They are unlikely to be absorbed even at lower current prices due to prohibitively high import duties in India and fewer central bank purchases. Only a fall in the price of
Fig. 20: Oil supply likely to outpace demand growth also in the coming years Annual global oil supply and demand growth (incl. demand forecast) in million barrels per day
3.5 3.0 2.5 2.0 1.5 1.0 0.5 0 0.5 1.0 1.5 2001 2003 2005 2007 2009 2011 Global oil demand growth Global oil supply growth
Source: EIA, IEA, UBS, as of 26 November 2013
Estimates
2013
2015
COMMODITIES
55
gold to marginal production costs of USD 1,050/oz1,150/oz (cash cost basis) would balance supply and demand, in our view. Negative spillovers from a lower gold price should be visible in silver, which faces a meaningful fabrication surplus. We advise investors seeking exposure to precious metals to hold the industrially oriented platinum and palladium: both metals are expected to be undersupplied.
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HEDGE FUNDS
DECIDE
ORIENT
OBSERVE
edge funds invest opportunistically across asset classes, using techniques like short-selling and leverage and instruments such as derivatives to pursue compelling returns while limiting downside risk. Managers seek to capitalize on certain market inefciencies not available to classic long-only fund managers. Although hedge funds do not have the same liquidity as traditional assets, they should nonetheless be important strategic components of well-balanced portfolios for investors willing to accept this trade-o, in our view. Our recommended allocations to hedge funds presume diversied exposure across dierent hedge fund strategies; we would advise disproportionate weightings only to target individual preferences. Over the long term, we expect hedge funds to enhance portfolio characteristics due to their lower volatility, their focus on downside protection, and their potential for achieving incremental outperformance due to manager skill. In the year ahead we expect the market environment to remain positive for equity long/short strategies, with low intra-stock correlations and high equity return dispersion supporting the ability of stockpickers to deliver attractive riskadjusted returns. This should create opportunities to generate alpha, the excess return of an investment over its benchmark on a risk-adjusted basis. Rising levels of corporate actions such as mergers & acquisitions should create opportunities for certain event-driven strategies. Macro/trading strategies typically serve a diversifying role in portfolios, producing returns less correlated to other hedge fund strategies and traditional assets. Although discretionary macro managers may be able to reverse lackluster recent performance, with crossasset opportunities unfolding in Japan, Europe and emerging markets, we view systematic strategies less favorably due to the continuing lack of persistent trends. Finally, we
are becoming more cautious on relative-value strategies that depend on high leverage and low-rate volatility. We emphasize the importance of diversifying among hedge fund managers who reect diverse investment styles. Bottom-up manager selection remains critical, particularly in equity long/short, as performance dispersion remains high. Also, we view emerging and midsize managers as better positioned than larger managers to be opportunistic and responsive to macro and market developments.
A positive outlook
Over the next ve years, we expect investments in diversied hedge funds to deliver annual returns of 4%6%, depending on the liquidity of the instruments, with volatility of about 5%7%. This compares favorably to expectations for traditional asset classes. Investors who can tolerate moderate illiquidity should therefore replace some bond and equity exposure with hedge funds.
PRIVATE MARKETS
57
he umbrella term private markets encompasses all illiquid strategies that target long-term equity and debt investments in assets not listed on classic stock and bond markets. Although people have historically associated illiquid investments with private equity for the most part, the range of such strategies has expanded to include private debt and real asset strategies. Private market investments oer numerous compelling advantages over traditional investments. Examples include investing in unlisted rms, in companies undergoing turnarounds and in direct corporate lending. Private market managers can also exploit temporary asset mispricing that results either when public markets or private owners value assets differently from their intrinsic or potential value or from shortterm uncertainties. Finally, managers can eect operational and strategic change in the underlying assets and companies to enhance value and generate returns. Allocations to private markets require a long-term perspective, as managers need time to make strategic and operational changes, reposition underlying investments, and exit the investments. Private market strategies are particularly well positioned to capitalize on the following opportunities, in our view: European bank deleveraging. Banks in Europe will continue to deleverage. Private market strategies can take advantage of this situation by lending privately as banks reduce their loan activity and by selectively purchasing assets divested by banks. Contrarian plays. Long-term-oriented private market funds can benet from short-term negative sentiment. For instance, they can purchase peripheral European assets being sold, as
well as investments in emerging markets that target longterm structural shis in sectors less well served by public markets. Energy value chain opportunities. New gas resources, shis toward certain types of renewable energy, and aging infrastructure are creating long-term opportunities that enable investors to tailor energy exposure to their return and risk objectives while potentially mitigating underlying commodity price volatility.
60
DISCLAIMER
Disclaimer
Chief Investment Ofce (CIO) Wealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisions of UBS AG (UBS) or an afliate 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 oer, or a solicitation of an oer, to buy or sell any investment or other specic product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, nancial situation and needs of any specic recipient. It is based on numerous assumptions. Dierent assumptions could result in materially dierent results. We recommend that you obtain nancial and/or tax advice as to the implications (including tax) of investing in the manner described or in any of the products mentioned herein. Certain services and products are subject to legal restrictions and cannot be oered 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 afliates). All information and opinions as well as any prices indicated are current only as of the date of this report, and are subject to change without notice. Opinions expressed herein may dier or be contrary to those expressed by other business areas or divisions of UBS as a result of using dierent assumptions and/or criteria. At any time, investment decisions (including whether to buy or hold securities) made by UBS AG, its subsidiaries and employees thereof, may dier from or be contrary to the opinions expressed in UBS research publications. 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 difcult to quantify. UBS relies on information barriers to control the ow of information contained in one or more areas within UBS, into other areas, units, divisions or afliates 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 eect on the price, value or income of an investment. This report is for distribution only under such circumstances as may be permitted by applicable law. Distributed to US persons by UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and an afliate of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US afliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be eected through a US-registered broker dealer afliated with UBS, and not through a nonUS afliate. The contents of this report have not been and will not be approved by any securities or investment authority in the United States or elsewhere. UBS specically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect. Version as per September 2013. UBS 2013. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.
Footnotes
Asset allocation in 2013, a retrospective, pg. 28
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Crook, Michael and Brian Nick. Portfolio Positioning: Not a time for complacency. CIO WMR Year Ahead 2013. UBS WMAs Capital Markets Model: Explained, January 2013. Doeswijk, Ronald et al., Strategic Asset Allocation: The Global Multi-asset Market Portfolio 1959-2011 SSRN Working Paper. WMRA Decade Ahead, 2011. WMRA Decade Ahead, 2012. Mariscal, Jorge. The case for emerging markets, revisited. August 28, 2013.
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