UBS DEC Letter En

8/13/2019 UBS DEC Letter En

1/6

Chief Investment Ofcer

Wealth Management December 2013

CIO Monthly Letter

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.

Bubble thoughts

Kids love blowing bubbles. A breath, a pu,and a shiny sphere oats o, defying gravity.And when the bubble bursts, laughter usu-ally follows. Investors tend to like bubblestoo until they pop. Tears, not laughter, arethe likely reaction.

On November 25, 2008, the US Federal Reserveannounced that it would initiate a program topurchase the direct obligations of housing-related government-sponsored enterprises.

With this dreary sentence what has sincebecome known as quantitative easing, orQE, began.

In the ve years since, QE has become a rou-tine part of the global economic landscape.

Other developed countries have emulated itby launching similar programs, all of whichhave helped cut borrowing costs and sup-ported asset prices (see Fig. 1).

Indeed, in that ve-year time frame, globalequities have returned more than 15% onan annualized basis, Treasuries close to 5%,and US high yield credit more than 20%.Investors holding cash havent done quite sowell, but even cash has not been disastrous.Despite repeated scares that so much

money printing could lead to ination,prices have remained well contained.

In short, it has been a highly favorable periodfor investment returns. Yet it has, at thesame time, been a distinctly mediocre periodfor the global economy. This disconnect isnow leading some to question whether QEsreation of asset prices represents the crea-tion of a bubble.

There are some worrying signs. Authoritiesseem to be targeting positive asset price

returns, regardless of fundamentals. Bearish

sentiment is now at levels that have previ-ously indicated investor complacency. Andstock markets seem almost indierent towhether fundamental economic data isgood or bad.

Ultimately, all that long-term investorsshould truly care about is whether such sen-timent has pushed valuations beyond rea-sonable levels. And by most measures itdoes not appear as though we are in bubbleterritory.

Whether we look at simple ratios of prices toearnings in equity markets, or adjust for thebusiness cycle using cyclically adjusted earningsyields, we get a similar story. Share valuationstoday are fair to slightly high. This means there

may be scope for earnings growth to drive priceappreciation, but investors should not expect arepeat of the 15%+ annualized returns enjoyedover the past ve years. Annual returns of7%-8% are more likely. Equally, it is highlyunlikely that high yield credit will continue toproduce double-digit percentage returns.

Of course, relative to government bonds,both remain attractive. Equities cyclicallyadjusted earnings yield of 5.4% comparesfavorably with real government bond yields.

In our view, the extra yield, or spread, onhigh yield debt compared with sovereignequivalents still more than osets the risksat this stage in the business cycle.

Bottom line, we do not believe investorsneed to fear that we are in the midst of adangerous bubble in risk assets.

QuestionsEarly last week, I spoke on a panel at the UBSEuropean Conference alongside leading for-mer central bankers Adam Posen of the Bank

of England (BoE), Philipp Hildebrand of the

Alexander S. Friedman

Global CIO UBS WM

ab


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CIO Monthly Letter

UBS Chief Investment Ofce December 2013 2

Swiss National Bank (SNB), and Lorenzo Bini Smaghi of theEuropean Central Bank (ECB) on this very topic: has quan-titative easing inated a bubble?

It is a topic I have been asked about with increasing fre-quency in recent weeks, particularly since the Feds deci-sion to extend its quantitative easing program.

There are conditions in place to suggest that bubbles couldform. Some governments are targeting positive asset pricereturns. The Fed closely monitors the health of the creditmarket and so implicitly targets mortgage and creditspreads. And it even revealed the back-up in mortgagerates as a reason for maintaining its pace of QE inSeptember.

Japan's economics minister had a go at equity strategyearlier in the year, setting a two-month target return of17% on the Nikkei 225. Meanwhile, ECB President MarioDraghis do what it takes policy in the Eurozone implic-itly guarantees positive returns on short-dated peripheralgovernment bonds.

This powerful backing is clearly changing investor behavior.Markets have rallied in response to both of the past two USnon-farm payroll reports, despite one materially missingexpectations and the other beating them. Good news is stillgood news, but now bad news means an increased likeli-hood of more QE, which is taken as good news. The one-month average level of bearish sentiment, as measured bythe American Association of Individual Investors, is at levelslast seen in early 2011 and early 2012. On both occasionsthis represented complacency (see Fig. 2).

Meanwhile, while demand is clearly buoyant, equity sup-ply has also increased in recent months. Aer an increasein initial public oerings (IPOs), companies in the US, theEurozone, Japan, and the UK are, in aggregate, now sell-ing more stock than they are buying. This raises the ques-tion of whether investors optimistic outlook is shared bythe companies in which they are investing.

Lets remember that companies have historically demon-strated no greater knowledge about the future thaninvestors. In fact, it has oen been the case that marketpeaks are instead marked by mergers and acquisitions

and share buybacks rather than IPOs.

Ultimately, the key for long-term investors should be val-uation alone.

Government bonds very overvaluedFinancial theory usually stipulates that measures of valu-ation begin with the risk free rate on a long-term USTreasury bond. This risk-free rate is usually used as astarting point when calculating the expected return ondollar-denominated equities.

In her testimony to the Senate Banking Committee, JanetYellen used the equity risk premium that is, the valua-tion of equities relative to government bonds to explainwhy there is no bubble in stock prices.

But with base interest rates at record low levels, and withQE helping to push down long-term bond yields, one couldargue that government bonds themselves are highly over-valued. Prices have declined this year, but 10-year yieldsremain just 1 percentage point from their all-time lows(see Fig. 3).

Therefore, while the equity risk premium helps us understandthe relative attractiveness of equities, it doesnt necessarilyprove there is no bubble. It could merely show that equitiesare in a smaller bubble than government bonds are.

Equity valuations fair to slightly highExcluding those measures of equity valuation that involvethe risk-free rate, we are eectively le with comparingprice-to-earnings (P/E) or price-to-book multiples relativeto historical levels.

Regionally, the largest two global markets trade in linewith long-run averages. US stocks trade at 16.5x their

Fig. 1: QE has supported asset prices

Source: Bloomberg, as of 20 November 2013

Selected asset class returns since 25 November 2008 (annualized, %)

10

0

US HY bonds

20%

MSCI World

16%

US IG bonds

10%

US 710 yeargovernment bonds

4%

Commodities

1%

15

20

25

5

Fig. 2: Bearish sentiment at potentially complacent levels

Source: Bloomberg, UBS, as of 21 November 2013

AAII Bearish Sentiment Index (4-week average)

0

10

20

60

40

30

50

70

2012

2011

2010

2009

2008

2007

2006

2005

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2003

2002

2001

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CIO Monthly Letter


trailing earnings versus their 25-year average of 16.9x,and the Eurozone trades at 14.8x versus its 25-year aver-age of 14.7x. Emerging markets trade at 11.7x, or a23% discount.

But with global net prot margins higher than average,and with corporate prots as a percentage of GDP atrecord highs, one could argue that the earnings them-selves are in a bubble. However, this is likely not the case.The gures can be explained by two secular trends. Thedeclining cost of capital has enabled companies to mate-rially lower interest costs for the foreseeable future, andglobalization has opened up new earnings streams aswell as enabling diversication into lower taxjurisdictions.

Meanwhile, operating prot margins still have scope forexpansion, particularly in the Eurozone. And with com-modity prices at to declining, and unemployment stillelevated, it is hard to pinpoint the specic factors thatcould push margins lower (see Fig. 4).

Nonetheless, in investing it usually pays to be conserva-tive in our assumptions. Therefore, we can also considervaluation metrics that seek to adjust for our position inthe business cycle.

Earlier this month, Robert Shiller was awarded the NobelPrize for economics for his work on asset price valuation.His fabled measure, the Shiller P/E, attempts to adjust forthe business cycle by taking a simple average of the prior 10years of earnings. This metric gained notoriety aer Shillersbook, Irrational Exuberance, used the metric to show equitymarkets were overvalued. It was published in March 2000,the very month the dotcom bubble began to burst.

Today it stands at 24.8x. This is nowhere near the level of43.2x reached back in March 2000, but has nonethelessled to some alarm: current levels are just over 50%higher than the average since the data series began inthe late 19thcentury (see Fig. 5).

But the measure is not without question due to the highvolatility of earnings over the past decade. And giventhat business cycles are not always precisely 10 years inlength, articial averages can misrepresent where the

midpoint of the business cycle lies.

Furthermore, comparing valuations to an average encom-passing more than a century of data can leave us missingstructural changes in demographics, ination, liquidity,volatility, or other factors that could aect the fair valua-tion of equities. For example, the Shiller P/E has onlytraded below its long-run average for nine months in thepast 20 years. It is of course possible that the market hasbeen almost perpetually overvalued, but it seems unlikely.

Attempting to adjust for these issues, we prefer to use a

cyclically adjusted earnings yield and compare it over amore modern timeframe. We do this by using a 20-yearregression to estimate where earnings would be in themiddle of a business cycle.

The net result is a cyclically adjusted earnings yield of5.4%. This represents about a 10% discount to the20-year median of 4.9% or, put another way, a 20% pre-mium relative to a post-gold standard median of 6.4%(see Fig. 6).

The bottom line is that, aer a signicant rally over thepast ve years, equity valuations are probably now fair toslightly high. Investors should therefore not expect arepeat of the multiple expansion that led to the returnsof recent years. But valuation is not yet at levels wheremean reversion is likely to detract from returns. Scoperemains for price appreciation driven by earnings growth.

Cash awaiting infationWith equities trading at or above long-run average valua-tions and bonds far above them, cash is coming back intofavor among some investors. A curious feature of the recentBank of America Merrill Lynch (BofA) fund manager surveywas that cash balances are, at 4.6%, unusually high given

Fig. 3: Government bond yields close to record lows

Source: Bloomberg, UBS, as of 21 November 2013

10-year government bond yield (%)

0

2

4

8

6

10

2010

2007

2004

2001

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2013

US

Germany

Fig. 4: Operating profit margins in line with averages

Source: Thomson Reuters, UBS, as of 21 November 2013

Global profit margins (%)

Net profit margin

EBIT margin

0

2

4

6

8

10

12

14

1988

1990

1992

1994

1996

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2012


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CIO Monthly Letter


the recent strong performance of equity markets. And in atrend I rst commented on in my July CIO Monthly Letter,overnight cash rates continue to decline.

Cashs greatest enemy, ination, remains elusive (see Fig. 7).All across the developed world over the past month, inationhas come in lower than expected. Notably, in the Eurozonethe surprise 0.7% year-over-year reading forced the ECB intoa renancing rate cut. Even incorporating the impact of this,Draghi expects a prolonged period of low ination.

This might seem odd given the sheer amount of liquiditythat has been added to the global nancial system overthe past ve years: since Lehman Brothers collapsed thecombined balance sheets of the G7 central banks havetripled in size. But with commodity prices at to declin -

ing, economies operating below full output, and highunemployment rates suggesting little prospect of wageincreases, we remain at too early a stage in the economicexpansion for ination to represent a threat.

And, more structurally, despite the very aggressive rea-tionary bias of central banks, other macroeconomic poli-cies have been distinctly deationary. For example, in theEurozone, rather than attempting to boost domesticdemand in surplus countries to help spur exports in de-cit countries, the region has instead attempted to rebal-ance through austerity and by suppressing demand inthe periphery. Indeed, this month, the US Department ofthe Treasury blamed Germanys China-topping currentaccount surplus for causing a deationary bias for theeuro area, as well as for the world economy.

Whatever the causes, investors clearly do not considerination to be a problem. The aforementioned BofA sur-vey showed that only around 2% of fund managersregard ination as the biggest tail risk in the yearahead. In 2013, traditional ination hedges have beenamong the worst-performing assets; 10-year Treasuryination-protected securities are down 12%, agriculturalcommodities 14%, and gold 23%.

But we have to remember that governments still need ina-tion as a last resort. Governments have eectively just threeways of raising revenue: through taxation, borrowing, orprinting money. The recent upsurge in labor activism, poor

economic data, and Standard & Poors recent downgradeof Frances credit rating demonstrate the limits of whathigh taxation can achieve. And the Eurozone crisis of 2011,as well as the recent battle in the US Congress, illustrate theproblems excess borrowing can bring about.

So while ination remains muted for now, it would beunwise to believe that ination is dead. History hastaught us that it is the last resort governments can drawupon, when they deem it necessary, to produce nominalgrowth. And in a world of lower returns from nancialassets, even moderate ination could act as a signicant

drag on returns for medium-term investors.

ConclusionValuations of equities and high yield credit are not at levelslikely to cause mean reversion to detract from returns.Earnings growth and low default rates should supportpositive returns in both asset classes, which remain moreattractive than cash and far more compelling than govern-ment bonds, whose real returns are likely to be negative.

Nonetheless, investors should not expect a repeat of thenancial asset performance seen in the past ve years,especially as monetary policy normalizes in the yearsahead. And in a world of lower returns, higher rates ofination could further cut into them. Investors will needto seek alternative sources of return, including privatemarkets, and take a more tactical approach to assetallocation.Asset allocationWe are making key changes to our tactical asset alloca-tion this month.

First, we are adding a short position in the Japanese yen,relative to the US dollar, to replace a long position in

Fig. 5: Shiller PE suggests equity overvaluation

Source: Irrational Exuberance, UBS, as of 21 November 2013

Shiller PE (price relative to 10-year average earnings)

0

5

10

35

40

20

25

15

30

45

1991

1997

1983

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1896

1888

1881

2007

Fig. 6: Cyclically-adjusted earnings yield in line withrecent mean

Source: MSCI, Irrational Exuberance, UBS, as of 21 November 2013

Cyclically-adjusted earnings yield (estimated trend earnings relative to price)

0

3

6

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15

9

18

2007

2010

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2012

CAEY 20-year average

Post-gold standard average


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CIO Monthly Letter


Japanese equities. Koichi Hamada, special economicadvisor to Prime Minister Shinzo Abe, said it all last week,awarding an A+ grade to the rst arrow of Abenomics(monetary expansion), but a D grade to the third arrow

(structural reform).

We concur with Hamadas assessment and believe thatJapan could be forced to re its more successful rstarrow once again in the rst half of 2014, particularly ifthe planned consumption tax hike weighs on economicgrowth. Further monetary expansion will likely weakenthe yen relative to the US dollar. While this should trans-late into earnings upgrades for Japanese companies, anenvironment in which structural reform is not forthcom-ing or economic progress stalls may cause the price ofJapanese equities to lag the decline in the yen. This is not

to say we believe Japanese equities will underperform inabsolute terms or relative to global equities. Instead,given the likely developments in Japanese policy, we con-sider a short yen position to oer a better risk-rewardtradeo than a long position in equities.

Second, we are adding to our position in Eurozone equi-ties in light of the recent ECB interest rate cut, whichensures that the central bank will continue to supportnancial conditions. The Eurozone is also a key beneciaryof an increasingly supportive global growth environmentdue to its large cyclical exposure (see Fig. 8). With corpo-rate margins three percentage points below their 2011peak, there is signicant scope for earnings-ledoutperformance.

Within our regional preferences we are upgrading Chi-nese equities to overweight aer the proposed reformsfrom the Third Plenary Sessions exceeded the marketsexpectations. Given that China currently trades at morethan a 20% discount to Asia ex-Japan equities, we seescope for this valuation discount to at least normalizeback to the ve-year historical discount of 11% onimproved sentiment.

We are also maintaining our British pound overweightand our underweight in UK equities. Our divergent viewson these two UK assets have raised questions from cli-ents this month. To be clear, the UKs economic funda-

mentals are strong retail sales have risen signicantly inrecent months as increases in house price have gener-ated a wealth eect, and the service sector is, accord-ing to the PMI reading, the strongest its been since1997. This, in conjunction with the Bank of Englandsunemployment forecast revision, has helped the poundto outperform our underweight in the Swiss franc by 1%in November a move we believe has further to go.However, this does not translate into equity outper-formance; our quantitative modeling suggests thatdomestic economic conditions explain just 4% of UKmarket relative performance since 75% of earnings are

generated outside of the country. And the aforemen-tioned strength in the pound presents a headwind forequity earnings. We therefore remain underweight UKequities.

Thank you, as always, for reading this letter. If you haveany questions or dierent points of view and would liketo share them, please feel free to contact me directly. Allinput is appreciated.My email is [email protected].

Sincerely,

Alexander S. FriedmanGlobal Chief Investment OfcerWealth Management21 November 2013

Fig. 7: Inflation remains elusive


Eurozone CPI (%, yoy)

1

0

1

3

2

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5

Feb-

07

Aug-

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Feb-

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Fig. 8: Developed markets lead the global recovery


GDP weighted Manufacturing PMIs

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2007 2008 2009 2010 2011 2012 2013

BRIC

Big 4 (US, UK, Eurozone, Japan)


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