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As human beings, the start of a new year is a good time to assess where we stand and what our goals are for the future. Many of us make resolutions to help us get there. For investors, it’s a time to take a fresh look at economic, policy and market dynamics, and in turn asset allocations, and decide the best way to move forward.
In my monthly letters, I typically focus on our six-month, tactical asset class view. Over the past three years, these tactical recommendations have fortunately been more right than wrong. However, since I do not have a crystal ball (despite inten-sive efforts by my colleagues and I to develop one), I rarely recommend that investors take major tactical swings away from their so-called strategic asset allo-cation (SAA).
The SAA, as a reminder, is an investor’s long-term asset class allocation, with a five-to-seven-year time horizon, which should match an investor’s ability and willingness to take on risk with their return requirements. Within the framework we use, more than 80% of the variation in the long-run value of a portfolio is attributable to the SAA. And, in the recent CIO Year Ahead, which I hope you have already received, we announced a variety of key changes to our recom-mended SAAs.
Given the importance of these allocations to overall portfolio returns, I want to use this letter to share my thoughts on five key market issues that drive the logic of our view on the SAA.
New year, new basics
CIO
Monthly Letter
CIO WM Global Investment Office | 23 January 2014
Alexander S. Friedman Global Chief Investment Officer Wealth Management
Our new strategic asset allocations include more credit, enabling
investors to maintain fixed income exposure without suffering
negative returns.
Hedge funds will appear increasingly attractive in 2014.
We believe the Fed can successfully withdraw from quantitative
easing this year without harming the US economy.
On a tactical basis we remain overweight US and Eurozone
equi-ties, along with US high yield credit, and add new CIO Preferred
Themes on Eurozone financials and Eurozone restructuring.
Of course, investors cannot ignore shorter-term market dynamics, so I also address a number of issues in discussing our current tactical asset allocations for 2014, later on in this letter.
Five key strategic considerations as we begin 2014
1. Fixed income allocations in an environment of rising interest rates Fixed income is a natural go-to asset class for many, given its historical reliability as a preserver of capital and source of return. But today, with the multi-decade bull market in bonds apparently at an end, determining what to do with a tradi-tionally reliable fixed income allocation is becoming more difficult. Returns in the government bond space were negative in 2013, and are likely to be very low (at best) in the years ahead. As a result, they are no longer functioning as a preserver of capital, nor an attractive source of return. Even alternatives among high-grade bonds, such as agency debt or supranational debt, no longer offer a material yield pickup.
Still, holding bonds within a diversified asset allocation has merit. Bonds should continue to provide some diversification in the event that equities decline and they offer a source of regular income. But investors clearly need insulation against rising interest rates.
To attempt to address this problem, our new SAAs have larger allocations to bonds with higher yields, such as emerging market bonds, US high yield credit, and short duration global investment grade corporate bonds. The higher yields available in a diversified basket of these bonds should offset rising interest rates, enabling investors to maintain an exposure to fixed income without suffering negative returns.
2. Allocating to alternative investments
Outside of credit, another potential area to consider for investors looking for investments with a reasonable return outlook and relatively low volatility is hedge funds.
Often discredited for being illiquid, opaque, and expensive, hedge funds can serve as an effective portfolio diversifier for investors with limited cash flow requirements. And with markets normalizing, correlations falling, and valuation dispersion still relatively low, we see a particularly good opportunity for managers employing equity long-short strategies.
>
Credit should enable
investors to maintain
fixed income exposure
without suffering
nega-tive returns
>
Hedge funds are an
important part of a
diversified asset
allocation
Fig. 1: Hedge funds have offered an attractive risk-return profile
Source: Bloomberg, UBS, as of 22 January 2014 Asset class total returns (rebased)
60 80 100 120 180 140 160 200 Fe b-1 1 Fe b-1 2 Fe b-1 0 Fe b-0 9 Fe b-0 8 Fe b-0 7 Fe b-0 6 Fe b-0 5 Fe b-0 4 Fe b-1 3 Global equities Investment grade bonds
HFRI fund weighted composite USD cash
> As we enter a lower return environment, hedge funds delivering returns of 4-6% will appear increasingly attractive
In recent years, hedge fund returns may have looked unappealing relative to equities or high yield corporate credit (see Fig. 1). But as we enter an environ-ment of lower returns in all financial assets, funds delivering consistent returns of around 4-6% (our expectation for these strategies), with volatility similar to that seen in corporate bonds, will appear increasingly attractive. Furthermore, the ability to extract an illiquidity premium from the likes of private equity will be important in a low return environment.
As a result, we recommend a 12-15% allocation to alternative investments in our new strategic asset allocations. Hedge funds represent an important part of that allocation, which can also include private equity and real estate.
3. The role of cash
Many investors focus on safety and capital preservation, and see cash as the ‘obvious’ solution. Yet within an SAA context, we continue to recommend a rela-tively limited allocation to cash.
Over the long haul, investors are only provided with excess returns by taking risk. This is why equities tend to outperform over the long run. And it’s why cash will typically underperform all financial assets that offer risk premia. A dollar invested in cash at the Fed funds rate 30 years ago would today be worth around USD 3.50. The same dollar invested in equities, with dividends reinvested, would be worth more than USD 22. As a result, we see only limited value for cash in a long-term SAA, particularly given the negative real interest rates on offer in most major currencies.
Furthermore, over a five-to-seven-year time frame, uncertainty around inflation is high. Central banks across the developed world face a major challenge in staying ahead of the game in normalizing their ultra-loose monetary policies.
4. Are commodities worth the risk?
Before investing in any new asset class, investors must consider whether they are taking unnecessary risk. As an asset class with volatility similar to equities, but with expected returns little better than government bonds, we believe that com-modities represent just this type of unnecessary risk.
Commodities are typically driven by supply and demand factors; they are vol-atile but offer no assurance of a positive return. Indeed, after some significant swings, the Dow Jones UBS Commodity Total Return index is up by just 4% in the past decade (see Fig. 2). Investors should expect little more going
Fig. 2: Commodities have offered next to no return in the past decade
Source: Bloomberg, UBS, as of 22 January 2014 DJ UBS Commodity Index
200 250 300 350 400 450 500 Fe b-1 0 Nov-10 Aug-1 1 May-12 Feb-1 3 May-09 Aug-0 8 Fe b-0 7 Nov-07 May-06 Aug-0 5 Nov-04 Fe b-0 4 Nov-13
> Unlike financial assets, com-modities offer neither an income stream nor a risk premium
>
Cash will, in the
long-run, underperform all
financial assets that
offer risk premia
>
Commodities are volatile
but offer no assurance
of positive returns
forward. Unlike financial assets, commodities offer neither an income stream nor a risk premium.
The current supply-demand outlook for commodities is also unfavorable. Within energy, non-OPEC supply of crude oil will likely rise at its fastest pace since 1978, and we expect Brent crude oil to trade at USD100/bbl this year, with potentially larger downside if the US surprises markets by lifting its export ban on crude oil. In base metals, stronger economic growth has failed to lead to higher prices, as the market remains oversupplied. And the outlook for gold is also negative, with a combination of low inflation, improving economic growth, and the withdrawal of the US Federal Reserve’s stimulus weighing on prices.
5. Whether to hedge foreign exchange risk
In some ways currencies are similar to commodities. Driven by supply and demand factors, they are often volatile, but do not offer a systematic risk premium to com-pensate for this. As a result, investors taking unhedged exposure to foreign curren-cies may be unwittingly taking on extra risk. Investors in Switzerland are well aware of this: despite trading at all-time highs in US dollar terms, the S&P 500 is still more than 35% shy of its 2000 peak in Swiss franc terms.
As a result, our currency positions within our recommend SAAs are hedged, with the exception of those in emerging markets, where hedging costs can be prohibitive.
Three key tactical questions as we begin 2014
It is critical to have the right SAA, but an active tactical asset allocation will also be important in navigating a year likely to prove more challenging than the last. Three key questions will be critical for investors over the tactical horizon.
1. Can the Fed successfully withdraw from quantitative easing?
Since I wrote my last CIO Monthly Letter, the Fed has begun to taper its quantita-tive easing (QE) program, with the pace of monthly asset purchases now down to USD 75bn per month from USD 85bn previously.
So far, it seems to be a success. By changing the emphasis of its communication toward loose interest rate guidance, the Fed has kept bond yields contained and equity markets calm. Maintaining this market calm will be critical in managing a successful withdrawal.
Fig. 3: The Federal Reserve is set to end quantitative easing this year
Source: Bloomberg, UBS, as of 22 January 2014 Federal Reserve Balance Sheet (USD, bn)
0 1000 500 1500 2500 2000 3500 3000 4000 4500 2012 2011 2009 2010 2008 2007 2006 2005 2013
> Maintaining market calm as the Fed reduces its stimulus will be critical in managing a successful withdrawal
>
Investors taking
unhedged FX exposure
may be unwittingly
tak-ing on extra risk
>
So far, the Fed has kept
bond yields contained
and equity markets calm
The 13% rise in house prices last year helped provide impetus for US growth, through the knock-on effects on construction, employment, and consumer con-fidence. While it would be rational to expect a somewhat slower pace of house price gains this year, the biggest risk of a major slowdown is a sharp upward move in mortgage rates.
Should this occur, the market impact could be large given the consensus expecta-tions for US growth. The lowest US GDP growth forecast by any major bank is 2.3%, in itself above 2013’s 1.9%.
However, while it is always prudent to be vigilant, it is also important not to over-react to short-term data such as last month’s disappointing non-farm payroll numbers. The US economy is like a super tanker: it takes a long time for it to change direction and when the captain is committed to a new course, as the Fed appears to be, it is not easily altered by a little unexpected chop.
Ultimately, the fundamentals of the US economy should remain solid enough to withstand a steady reduction in QE. We forecast GDP growth of around 3.0% this year, thanks to an easing of fiscal austerity, accelerating household spending, and a pickup in capital expenditures. As a result, we remain comfortable with overweight positions in US equities and US high yield credit.
Of course, for the taper of QE to be considered a global success, the Fed would also need to avoid sparking capital flight from the emerging markets. Just last week, the World Bank warned that an unplanned withdrawal of stimulus could cut capital flows to emerging markets by up to 80%. We do not foresee such a major event, although we are cautious on the equities and currencies of those countries potentially most exposed, namely Turkey, India, and South Africa. In these regions, a sharp withdrawal of Fed stimulus could lead to capital outflows, rising interest rates, slower growth, and an increase in corporate defaults. 2. Can China avoid a credit event?
China is in the midst of a critical transition. To maintain its long-term growth potential, it is undertaking reforms to allow the market, rather than the state, to determine the price of a range of things, including the price of money.
In China, liberalizing interest rates simply means that they will rise. For years, China has held its official interest rates well below what could be considered an “equilibrium” level, and we expect to see China’s money market rates move structurally higher by almost 200 basis points over the next two years.
Fig. 4: Stress in China’s interbank markets has been a source of concern
Source: Bloomberg, UBS, as of 22 January 2014 China interbank 7-day repo rate (%)
3 4 6 5 8 7 9 10 2-Jan-1 4 19-Dec-13 26-Dec-13 21-Nov-13 28-Nov-13 5-Dec-13 12-Dec-13
14-Nov-13 7-Nov-13 31-Oct-13 24-Oct-13 9-Jan-1 4 16-Jan-1 4 23-Jan-1 4
> The authorities have reacted to the concerns over rising rates by injecting extra liquidity into the market, which has helped reduce short-term stress
>
The US economy should
remain solid enough to
withstand a steady
reduction in QE
This should not have a major impact on companies getting traditional bank loans, but it will mean higher debt costs for borrowers dependent on the shadow bank-ing sector, and will raise the prospect of corporate defaults. The transition pro-cess has combined with seasonal factors to provoke turbulence in interbank markets.
At the time of writing, rates are at 5.4% (see Fig. 4), vs. a “normal” level of 4.00-4.25%, partly due to concerns that China’s largest bank, ICBC, is considering imposing losses on depositors in a USD 500m trust product after the onward loans to a coal company soured.
Ultimately, we believe China has the resources to bail out depositors and recapi-talize its banks if necessary. And the authorities have reacted recently to the con-cerns over rising rates by injecting extra liquidity into the market, which has helped reduce short-term stress. We are overweight Chinese equities due to attractive valuations, our belief that the authorities have the ability to contain market stress, and due to the positive reforms announced at the Third Plenary session which should boost the country’s long-term growth profile.
Nonetheless, China remains a concern due to its size. Transitioning an economy as large and complex as China’s will be difficult, and any missteps, such as an uncon-trolled default on an investment product, could pose a major risk to the outlook. 3. Can the Eurozone banking sector pass the Asset Quality Review? The banking sector has started the year strongly, with Eurozone banks equities climbing almost 8% (see Fig. 5). A decline in peripheral bond yields is primarily responsible for the upbeat start, as both Portugal and Ireland have successfully issued new debt in private markets.
This has created a virtuous circle. As the value of government bonds on bank bal-ance sheets has increased, bank solvency has improved, which in turn has raised the credit quality of the government. It is, in effect, the reverse of the downward spiral that occurred between banks and governments in 2011.
But a critical test will come later in the year when the European Central Bank (ECB) assumes direct supervision of the Eurozone banking sector. In taking on its new responsibility, the ECB will conduct an Asset Quality Review (AQR) to ensure that banks are recognizing non-performing loans on a consistent basis and are adequately capitalized to protect against adverse shocks.
Fig. 5: A sharp rally in the Eurozone banking sector
Source: Bloomberg, UBS, as of 22 January 2014 Eurostoxx banks index
120 125 135 130 145 150 140 155 160 7-Jan-1 4
26-Nov-13 10-Dec-13 24-Dec-13
12-Nov-13
29-Oct-13
15-Oct-13
1-Oct-13 21-Jan-1
4
> A decline in peripheral bond yields is primarily responsible for the upbeat performance, as both Portugal and Ireland have successfully issued new debt in private markets
>
We believe China has
the resources to bail out
its banks if necessary
>
The Eurozone banking
sector is currently
expe-riencing a virtuous circle
After the AQR concludes, likely sometime in November 2014, a number of banks will be required to raise capital. Small and unlisted banks will be a particular sub-ject of attention since, unlike their larger brethren, they have not yet undergone external stress tests.
As yet, there is no clear mechanism for how troubled banks might raise capital. Therefore, investing in Eurozone financial equities and, by extension, Eurozone equities in general requires the faith that either a) capital shortfalls will be rela-tively limited, or b) a clear mechanism for recapitalization will be developed. To translate our view on the Eurozone into portfolio positions, we are overweight Eurozone equities within our tactical asset allocation, and hold a CIO Preferred Theme on Eurozone financials. By our estimates, the AQR should reveal only lim-ited capital shortfalls, representing a fraction of the sector’s annual profits. Of course, staying selective to avoid those banks with potentially onerous capital requirements is key. As such, the uncertainty could limit sector performance in the lead-up to November, although we ultimately believe that the stress test should boost both investor confidence and stock performance. Elsewhere in Eurozone equities, we have added a new CIO Preferred Theme that seeks to iden-tify companies that can potentially benefit from corporate restructuring as Europe exits recession.
To summarise our tactical recommendations, we remain overweight risky assets and in particular US and Eurozone equities, along with US high yield credit. We are more cautious on government bonds, and defensive equity markets such as the UK and Switzerland which could lag as economic expansion continues. Thank you for reading this letter and I hope this year proves to be a good one for us all.
Sincerely,
Alexander S. Friedman Global Chief Investment Officer Wealth Management
>
The AQR should reveal
only limited capital
shortfalls
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