Fed Facilitating a Controlled Descent, or Prompting a Sugar Crash?

Location: Chicago

Date: 2013-07-01

The UBS Global Asset Management Cyclical Market Forum, held quarterly to discuss three plausible economic scenarios and their potential implications for investments over the next 12 months, found its 2Q13 Forum dominated by discussion of the ripple effects of the US Federal Reserve Bank’s move to taper or end its quantitative easing (QE) program. Three market scenarios are proposed at each Cyclical Market Forum and debated by UBS Global Asset Management (UBS) investment teams with combined assets under management of more than USD 632 billion worldwide.

“Right now, high-dividend stocks have an 80% correlation with 10-year Treasuries, a relationship that we’ve never seen before. With rising rates, high-dividend stocks could see a lot of volatility. In our view, the areas that people think are safe are probably the most dangerous things out there right now.”

While previous Forums had addressed concerns over the eurozone sovereign debt crisis situation and the US “fiscal cliff,” this quarter’s largest focus was monetary policy. The Forum participants debated the extent of the Fed’s power to maintain control over the pace of rising yields, suggesting that a gradual rise in the 10-year US Treasury yield could be supportive for certain asset types over the next 12 to 18 months, but that a rapid spike in yields could cause extensive volatility in equity and fixed income assets. Amidst this backdrop, participants were encouraged by more positive economic data in the US, although they were concerned with slowing growth in China and other emerging markets, and saw discouraging signs in Greece, Portugal and Spain.

UBS Cyclical Market Forum 2Q13 Economic Scenarios Under Consideration

Scenario 1, “More of the same”: An intermediate scenario, in which US government spending cuts and tax hikes continue to restrict consumption and investment, and a reduction in fiscal austerity in the eurozone only partially offsets the effects of tight lending conditions. In this scenario, US GDP growth remains steady but modest, although economic data gradually improve throughout 2013. Aggressive monetary policy in Japan continues to support growth and produces a limited increase in inflation. China continues its rebalancing process, and growth expectations remain on target.
Scenario 2, “More of more”: The most bullish scenario, in which investment and consumer spending in the US pick up as housing, employment and income figures improve. In this scenario, quantitative easing and global fundamental improvements lead to rapid growth and sustainable inflation in Japan. The eurozone returns to growth in mid-2013 as the periphery countries begin to recover. In China, an increase in both domestic and external demand keeps GDP growth at about 8.5%. Easing programs in China and the US are gradually scaled back without disrupting growth.
Scenario 3, “More of less”: The most bearish scenario, in which the eurozone remains in a recession until the end of 2014 due to tight lending conditions and deleveraging. Falling housing prices and stress in bank balances in Spain, the Netherlands and Slovenia keep sovereign markets volatile. US GDP growth stays close to 2% in response to sluggish business investment and reduced government and consumer spending. Weak external demand pushes Chinese growth down to just above 6%. Growth in Japan remains subdued, with trade flows lagging expectations.

Roughly half of the Cyclical Market Forum participants voted Scenario 1 as the most likely. Slightly more participants voted for the bearish Scenario 3 than the bullish Scenario 2 as the second-most likely scenario. Participants’ expectations of year-on-year global earnings growth were more pessimistic than last quarter, with a majority of participants seeing 0% to 5% earnings growth as most likely.

Key Takeaways from the Forum:

Curt Custard, Head of Global Investment Solutions, Chair of the Cyclical Market Forum (Chicago)

“Since 2009, financial markets have been racing around like a toddler with a bowl of candy. The recent volatility can be seen as the protest when the toddler is told the candy—which took the form of QE—will soon be taken away. That’s what we’re facing now. What’s really interesting from a portfolio construction perspective is that during this volatility, we’re seeing simultaneous selloffs in everything. Credit spreads are widening, rates are backing up and equities are selling off. That’s not normally what happens. However, this environment could create opportunities for investors willing and able to tactically move across regions and asset types.”

Joshua McCallum, Head of Fixed Income Economics (London)

“The recent volatility does not mean that we’re necessarily looking at a rout for fixed income, but it does indeed look like the long bond rally is over. In my view, the pace of the rise in yields is key. Yields could reach a point where the Fed will be forced to step in to control the descent—which could catch investors by surprise. Ultimately, the data will determine the Fed’s decisions, so we may be entering a new volatility regime with the market moving rapidly on surprises in economic data.”

Comments on Specific Asset Classes:

Scott Dolan, Co-Head of US Multi-Sector Fixed Income (Chicago)

“I think the Fed is leading us to a path of ultimate tapering. We just have no historical perspective to judge the impact of the end of QE on traditional fixed income assets. At a time when the risk-taking of the market-making community globally just isn’t there, the fear is that there’s no place to hide.”

Tom Digenan, Head of Core/Value US Equities (Chicago)

Jon Adams, Portfolio Manager, Currency, Global Investment Solutions (Chicago)

“From my perspective, one big move over the last few weeks has been the selloff in emerging market currencies versus the US dollar. We’re having a very hard time seeing how that trend turns around in the short term. We think the selloff has further to go, especially in the case of currencies like the Indian rupee and South African rand that rely on extensive foreign financing.”

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