EFTA01089665.pdf

Chief Investment Officer UBS Wealth Management May 2013 UBS CIO Monthly Letter The rubber ducks Gold's recent decline can help us grasp the is particularly pertinent in a world where interplay between major market perfor- central banks are perceived as driving the mance and central bank stimulus efforts. prices of many asset markets, particularly the fixed income market. Alexander S. Friedman In the last few weeks, gold garnered a great Global CIO UBS WM deal of attention as its price fell approxi- I have now written four paragraphs of my mately 10% (see Fig. 1). This led many inves- monthly letter without employing a meta- tors to reconsider their notions of a "safe phor, but I can resist no longer. haven," and to reassess what fair value might be. Buyers of gold have long known We can picture markets today as a bunch of that its price is divorced from the fundamen- rubber ducks floating in bathtubs. The water tal factors that move pure commodities, and flowing from the tap represents central bank is driven instead by more ethereal dynamics liquidity, the ducks signify market perfor- like private investor demand. Valuing gold mance, and the plug stands for the funda- as a simple commodity would imply a fun- mental strength of the economy. damental price of USD 1,150/oz. At that price, 10% of gold mines would be loss Concerns over the fundamental strength of making, and the metal would trade 19% the economy have grown in regions around below current levels and 40% below 2011's the world. This concern is evident in the all-time peak. recent weakness in commodity prices and in the declines in some economic growth It would be wrong to conclude, however, trends, like the purchasing managers indi- that investing in assets purely based on fun- ces, across the US, the Eurozone and China. damental value will always work. There may Therefore, in each region, we must carefully be good reason for asset prices to diverge assess: (i) the velocity of the flowing water; from pure fundamental value. In the case of (ii) how long the tap will remain turned on; gold, investor demand to diversify away and (iii) whether the plug is secure. Broadly, from paper money has helped gold rise by as long as we're comfortable with two of more than 300% in the past decade, and these three factors, it can make sense to bet long-term holders are still sitting on tidy on the duck rising. profits. John Maynard Keynes's quip that "markets can remain irrational a lot longer In the American bath, the tap remains on. than you and I can remain solvent," is an There is some debate about how long the enduring lesson. US Federal Reserve (the Fed) will keep it on, but over our tactical time frame of the next The volatility in gold reminds us that inves- six months we are confident the water will tors must employ a critical eye when prices keep flowing. Moreover, we believe the plug are divorced from pure fundamental value. is secure given the recovery in the housing In such cases, it is important to assess market and good corporate earnings whether the "other" factors that are prop- growth. As such we feel comfortable with ping up prices are going to persist. This our overweight positions in US equities and applies whether we are looking at gold, US high yield credit. government bonds or bitcoins. And it This report has been prepared by UBS AG. Please see important dulaimers and chsclosins at the end of the docionent. Past performance is no indcaticn of future performance. The market paces worded are closing prices on the respective principal stork exchange. This applies to all performance charts and tables in this puttication. EFTA01089665  UBS CIO Monthly Letter In the Japanese bathtub, the plug has been out of place securities (MBS). This kind of market noise regarding the for years, but with the Bank of Japan (Bo.° now turning Fed is worrisome, as some investors believe the market is the tap fully open, the bath water is rising fast, and we divorced from fundamental value, with even the Fed are adding an overweight position in Japanese equities. minutes stating that "a lengthy period of low long-term We will fund this overweight position in Japan by reduc- rates could encourage excessive risk-taking." ing emerging markets to neutral. So we need to assess whether US asset prices are indeed In our Chinese bath, the government has become wor- divorced from fundamental value and, if so, what impact ried the duck is floating too near the top, so it has turned a withdrawal of Fed stimulus could have. off the tap, and other emerging markets could suffer weaker earnings if commodity prices remain at current Our conclusion is that the strength of US risk assets year- levels. to-date reflects an improved fundamental economic pic- ture. However, the USD 60bn "sequester" series of auto- Finally, in the Eurozone tub, the European Central Bank matic spending cuts has begun to have an impact on the (ECB) has put in place a secure temporary plug, but the wider economy. The direct negative hit of around 0.4% tap is producing little more than a trickle and we know of GDP is manageable, but indirect effects could be that longer term, the temporary plug must be replaced higher. For example, consumer and corporate confidence with a better one, a long-term structural solution (a big is hardly likely to be boosted by the recent air travel dis- unknown at this point), so we are maintaining an under- ruption. As a result, we expect real consumption growth weight position in the euro. to slow in the second quarter to 2.4% annualized, from 2.9% in the first quarter. However, the underlying pri- There are many subtleties in each regional bath, and in vate sector remains healthy, and recent soft data has the remainder of this letter I will discuss in more detail been largely attributable to lower government spending the underlying economic picture and the impact and and inventory destocking (see Fig. 2). Over the balance future evolution of central bank stimulus measures. of the year consumption should accelerate as a result of the improving labor market, lower gasoline prices, and The mighty US duck stronger capital formation as businesses finally begin to In last month's letter, I described how the US economy invest their unprecedented cash balances. Finally, higher and its consumers represent the most important driver house prices have the potential to boost GDP growth for the global outlook. Since then there has been rela- through a combination of the wealth effect and con- tively weak data, with non-farm payrolls rising by just struction spending; March saw the fastest pace of new 88,000 in March (after climbing by 268,000 in February), home construction since June 2008. retail sales declining 0.4% in the month (from +1.0%), and the ISM Manufacturing index dropping to 51.3 from In the near term, there are a number of reasons we do 54.2. This has led many to question the stability of the not expect the Fed to scale down its stimulus. First, the US economic recovery, at the same time as investors have Fed should remain accommodative while the full impact become worried that the Fed might "turn the tap off," of the sequester spending cuts lies ahead. Second, the by ending quantitative easing (QE), or even by starting to US labor market has improved, but the 7.6% unemploy- sell its USD 3trn pile of Treasuries and mortgage-backed ment rate remains well above the 6.5% threshold the Fig. 1: Gold price falls sharply Fig. 2: US underlying demand stable Gold prize IUS0. oz) US GOP Icraq, annualised. %) 2000 4.5 1900 4 1800 3.5 1700 3 1600 2.5 1500 2 1400 1.5 1300 1 1200 0.5 1100 1000 0 Om 0211 0311 0411 0112 0212 0312 0412 a 4' .1 A — US GDP 4• Sc A — Final sales Source: Bloomberg, UBS, as 0124 Apra 2013 Source: Bloomberg, U8S. as of 24 A20 2013 UBS Chief Investment Office May 2013 2 EFTA01089666  UBS CIO Monthly Letter Fed set as its target before it will consider tightening pol- Japan calls in the fire truck hoses icy. Third, the Fed is well aware that, while funding costs If some believe the US market may be divorced from fun- have improved, overall credit availability remains tight. damentals, then the more than 50% rise in the Nikkei Recent results from the US banks show decelerating loan 225 equity index (calculated in yen) since November begs growth and declining net interest margins. And, finally, for discussion. The rally has taken on new impetus since continued weakness in the Eurozone economies and flux the BOJ announced it would double its monetary base in the European political situation support a continued within the next two years. Using my rubber duck anal- loose monetary stance by the Fed. ogy, this is the equivalent of the BoJ turning the tap on full and then calling in the fire trucks to use their hoses Therefore, we expect only a steady tapering off of eco- as well. It is no surprise the water is rising. nomic stimulus, and foresee the Fed reducing monthly asset purchases by USD 10bn per month starting around To put this in context, the Fed is making annual net pur- October, leaving the rate of asset purchases at USD 65bn chases of 7% of GDP. Japan will be purchasing assets at by year-end. This is unlikely to have a major negative close to twice this rate, or about 13% of GDP. Addition- impact on risk assets. ally, the BoJ is not focusing purely on fixed income assets like government bonds and mortgage-backed securities, Ironically, if the Fed were to consider withdrawing its but is instead also buying equities through exchange- stimulus more aggressively, the "safest" assets could traded funds, as well as real estate investment trusts. prove the most dangerous. Merely signaling a sale of the Fed's Treasury holdings would risk bond market partici- But will it help Japan achieve its 2% inflation target? It pants pricing almost USD 2trn of new supply, and could will be difficult, and indeed many economists would sug- lead to disorderly bond markets. Chairman Ben Ber- gest that 2% consumer price inflation (CPI) in Japan is nanke is well aware of this and Fed members have impossible. The country's output gap sits at roughly 3%, recently sought to highlight the interest rate mechanism and, after a generation of deflation, resetting inflation as the primary "exit" tool. This would nonetheless be expectations is extremely difficult. The most recent labor detrimental to (if not catastrophic for) the Treasury mar- market data showing a 0.7% fall in wages for the first ket, but, provided it came in response to better-than- few months of this year is evidence of this. expected growth, it is unlikely to affect riskier assets meaningfully. However, there is an argument that 2% inflation may be achievable. First, the yen's 25% fall in the past six months In sum, we don't believe the Fed will turn off the bath should translate into a 0.5% boost to inflation, and tap and stop its support for our American rubber duck should "Abenomics," the economic policy promoted by until it is confident of a more self-sustaining recovery. In Japanese Prime Minister Shinzo Abe, begin to have an the meantime, US assets will continue to benefit from effect, the yen could fall a further 10%. Second, there the rather enviable situation of strong central bank sup- are signs that there may not be as much spare capacity port coinciding with an improvement in economic in the labor market as deflating wages might suggest — activity. the Tankan survey actually indicates the labor surplus is Fig. 3: The Bank of Japan impacting earnings estimates Fig. 4: Emerging markets seeing divergent performance Japan equtties earnings growth (yay, Index Insbased. ytc0 60 125 120 so 115 40 110 105 30 100 20 95 90 10 85 0 ao '7 '7 ? ? ? 1 is 47. A — EPS grmh FY 2013 - Brazil Russia Phippines — EPS grmh FY 2014 — China Indonesia Source: Thomson Reuters. UBS• as of 24 .4pnl 2013 Source: eaoorriaerg. UBS• as of 24 April 2013 UBS Chief Investment Office May 2013 3 EFTA01089667  UBS OO Monthly Letter turning into a labor shortage. Third, inflation expecta- optimal strategy. In this same vein, it should be noted tions are starting to rise, and the five-year inflation rate that just because emerging markets as a whole are Lnplied by the inflation-protected bond market is 1.5% "cheap" doesn't mean their underperformance will cor- up from 0.5% just a year ago. rect in the near term. Returning to my bathtub analogy, it is unclear if One of the most striking features about emerging mar- Abenomics will be successful in "securing the plug" and kets this year, aside from their underperformance as a transforming the Japanese economy after more than a whole, has been the stark divergence between the mar- decade of malaise. But the Bar tap is clearly having an ket performance of individual countries. It has been less impact. The weakness in the yen has helped earnings a case of emerging markets, and more a case of diverg- growth estimates for the Nikkei for the financial year to ing markets. After a strong start to the year, Chinese March 2014 rise to over 50% in the past six months equities have fallen sharply in recent months due to alone (see Fig. 3) from around 20%. If the yen remains signs of policy tightening, particularly with respect to at current levels we could even see earnings upgraded increased government regulation of wealth manage- by a further 10%. The Nikkei has run ahead of these ment products and the property sector. Furthermore, earnings upgrades, but on a 14.9x one-year forward there are signs that economic growth is slowing — GDP price-to-earnings ratio, it is not obviously overvalued data disappointed expectations, rising by only 7.7% in relative to its 10-year average of 16.3x. the first quarter (consensus 7.9%), and this week's HSBC purchasing managers' index fell to 50.5 in April Finally, the Bar is nothing if not determined to give Japan from 51.6 in March. The associated weakness in com- a fighting chance with its massive dose of new liquidity. modity prices has weighed on Brazil and Russia too. We therefore are initiating an overweight position in Jap- Meanwhile, Korea's competitiveness has been chal- anese equities, and within this market we believe the lenged by the Japanese yen's 20% depreciation against best way of taking advantage of the Japanese reflation the Korean won in the past six months. Partially as a theme is through positions in Japanese exporters. result, Korean equities have lagged Japanese equities by close to 25% (in constant currency terms) year-to- Emerging markets = diverging markets? date. Conversely, the more domestically oriented mar- If the return of Japanese equities has been one of the kets, such as the Philippines and Indonesia, have per- great surprises of the past six months, the stark under- formed very strongly (see Fig. 4). performance of emerging market equities is certainly one too. It seems almost counterintuitive that the region With such divergence, emerging markets as a group of the world with the fastest economic growth also suf- are testing investors. Near-term uncertainties over fers from the lowest equity valuations. But after a 12% global growth, the future of Chinese policy, and the underperformance year-to-date, emerging market equi- outlook for commodities all combine to make it hard ties are now trading on a 2013 price-to-earnings ratio of to foresee a near-term catalyst to help emerging mar- just 10.1x. kets realize their significant longer-term valuation potential. Given this, it makes sense to focus on In the earlier discussion on gold, I said that investing in selected countries. Specifically, on a tactical basis, we assets based purely on fundamental value is not an recommend that investors seek exposure to the Fig. 5: Weak German manufacturing data Fig. 6: Positioning speaks in favor of the CAD vs AUD Purchasing Managers' lodes sAi postai% n 100 contacts 1503 1003 CO 0 —S00 it S s s en en en en a .6 te g — CAD cc & LL — AUD Source: Blcomterg UBS, as o124 Apnl 2013 Source: Bloomberg CFI( U8S, as of 24 Apr' 2013 UBS Chief Investment Office May 2013 4 EFTA01089668  UBS 00 Monthly Letter domestic recovery stories in Brazil and India, the out- loans to commercial banks appeared to send the gold of-favor Russian and Korean equity markets, and also market into a tailspin, with prices dropping as much as to broader emerging market growth through Western 15% over three trading sessions. corporations, via Western Winners from Emerging Market growth. To be clear, Draghi's comments were misinterpreted. It was always the case that if the Cypriot central bank sold On a strategic basis, however, an adequate allocation to its gold it would have to cover its own losses before emerging markets overall remains important. Valuations transferring any money to the Cypriot government. are attractive, and emerging markets will continue to Draghi was merely clarifying this, not ordering the asset offer the world's highest GDP growth rates, with the sale. As such, we believe the move is overdone. However, lowest sovereign leverage. And, outside of equities, we with over one-third of global gold demand attributable continue to hold an overweight position in corporate to investment demand, gold relies greatly on the trust emerging market credit, and emerging market curren- among investors that it can truly act as a hedge against cies remain a 00 preferred theme. expansionary central bank policies. The recent gold price move may have dented that trust, and so we are main- Calm on the surface in the Eurozone taining a neutral position, forecasting gold to trade in a It is ordinarily a positive sign if I can get through the bulk range of USD 1,150-1,550 per ounce over the next three of my monthly letter without lots of discussion of the months. Eurozone. The "good news" is the Eurozone appears to be diminishing in importance in terms of driving global Asset allocation and themes markets, with the near-term fear of a break-up falling Within equities, we are replacing our tactical overweight away. Spanish and Italian bond yields have begun to move position in emerging markets with one in Japan, for the more independently of wider risk sentiment, and the reasons described earlier. We also are maintaining our inverse correlation between their yields and global equity overweight position in the US relative to Canada, since markets is near the weakest level it has been in a year. the Canadian housing market recovery is likely to lag that of the US, and since the sharp downward move in Sadly, this calm on the surface does not reflect an the gold price is likely to hinder Canada's large gold min- improvement in the Eurozone's underlying prospects. ing sector. This week's sentiment indices show the ongoing weak- ness in the economy: the German Manufacturing PMI Elsewhere, within fixed income we remain overweight fell to 47.9 from 49.0 (see Fig. 5), and the German Ifo global investment grade credit as well as US high yield business climate index dropped to 104.4 from 106.7. bonds, which continue to offer an attractive premium of Structural solutions remain elusive, and ahead of the 466bps over US Treasuries. We expect low corporate German elections in September, progress is likely to be default rates, and a strong appetite for yield from inves- non-existent. Italy has finally found a new prime minister, tors to offer support for the sector. but he faces challenges in enacting reforms. Elsewhere, credit rating agency Moody's retains a negative outlook We are making a number of additions to our currency on Spain, threatening it with a downgrade to junk sta- positioning. First, we are adding an overweight position tus, potentially exacerbating an already difficult funding in the US dollar. Economic growth is stronger than in situation for the country's corporations. Cyprus retains other regions, and discussions over a potential reduction its capital controls, which if maintained for a long period in QE could support the currency, particularly relative to of time, endanger the integrity of the euro. And there is the euro where an ECB refinancing rate cut is likely. With speculation that Slovenia could be the "next domino to economic growth expected to stay weak in the Euro- fall;" a potential loss of access to the bond market could zone, we will increase our underweight in the region, force the country into an ESM bailout. but instead of adding to our euro short, we will intro- duce a long USDCHF position. The EURCHF 1.20 floor These dim economic prospects lead us to believe the ECB remains solid, and as such the franc could weaken fur- will cut its refinancing rate from 0.75% to 0.5% at its ther from current levels. upcoming meeting on May 2. If this materializes, it would support our underweight position in the euro. Second, we are taking an overweight position in the Canadian dollar. Canadian consumer confidence, busi- Troubling commodities ness sentiment, and investment spending are picking up, The problems in the Eurozone may not be influencing while the recent rise in inflation should calm any dovish- global equities as strongly as they have previously, but ness at the Bank of Canada. Meanwhile, positioning they have had a huge influence on the price of gold in data suggests the market is very short the Canadian dol- recent weeks. ECB President Mario Draghi's comments lar (see Fig. 6), meaning positive surprises could have an that the profits of any gold sales by the Central Bank of outsized impact. We suggest setting this against the Cyprus must be used to cover any losses made on its Australian dollar. It is overvalued, its positioning is long UBS Chief Investment Office May 2013 5 EFTA01089669  UBS CO Monthly Letter and Australia's most recent economic data suggests a England policy should continue to recede following potential slowdown in employment growth. March's Budget Statement. These two currency positions also will help diversify our Thank you for your consideration in making it all the overall portfolio. While a return to a "risk-off" environ- way through this letter. As always, any comments are ment is not our base case, such currency positions should appreciated. perform particularly well if global growth deteriorates, balancing some of the potential weakness that could be seen in our overweight positions in equities and credit. Finally, we continue to favor the British pound over the euro. This week's announcement of an extension to the Alexander S. Friedman Funding for Lending scheme could see some Monetary Global Chief Investment Officer Policy Committee members back away from calls for Wealth Management more QE, and concerns over a change in Bank of 25 April 2013 UBS Chief Investment Office May 2013 6 EFTA01089670 UBS CIO WM Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisions of 1185 AG (UBS) or an affiliate thereof. In certain countries U8S AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment a other specific product. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be efigble fa sale to all investors. 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