portrait of Evan Brown

Evan Brown

Head of Multi-Asset Strategy Investment Solutions

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Ryan Primmer

Head of Investment Solutions

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Luke Kawa

Director Investment Solutions

Highlights

  • In our view, global activity is poised to re-accelerate in Q4 from Q3, and remain well above trend in 2022.
  • Supply chain issues that are contributing to slowing growth and higher inflation will get better, not worse, as vaccinations improve public health outcomes.
  • Regions such as Europe and Japan continue to have superior earnings trends and are also relative beneficiaries of rising bond yields as global central banks pare back stimulus.
  • However, risks to the procyclical trade, chiefly from more persistently elevated inflation as well as China’s real estate sector, have risen in prominence.

With the final quarter of 2021 underway, it’s important to refocus on the primary determinant of economic activity and financial market performance over the course of the past two years: the pandemic.

Many factors contributed to the downshift in growth during 2021. There has been a natural deceleration as unprecedented stimulus ebbs. The initial phase of pent-up demand has come and gone. And ongoing public health concerns have exacerbated supply shortages while preventing a durable, comprehensive economic reopening.

We believe that this final headwind should shift in a persistently positive direction, with material implications for growth and asset market performance. More progress on vaccinations is getting us closer to a broad normalization of activity. This is the future that forward-looking markets should be pricing in, in our view. Our outlook for strong growth is inconsistent with the prevailing narrative that stagflation is on the horizon.

The Delta variant has impeded production and shipping activity, particularly for Asian economies, while also weighing on the service-sector recovery in the developed world. Reduced opportunities for services consumption, in turn, translates to above-trend demand for durable goods, further exacerbating supply constraints. Now, case counts are declining and global vaccinations are moving higher. This allows for the reverse to occur: more production, more labor supply, and more services consumption rather than goods – all of which should prevent supply conditions from worsening.

In our view, these improving public health outcomes mean that the global economy is poised to enjoy a second round of pent-up demand being realized. We expect a re-acceleration of activity in Q4 from Q3, with relative performance across financial markets increasingly reflecting the likelihood that 2022 will be another year of above-trend economic activity.

Exhibit 1: Pandemic-induced shift in spending patterns beginning to normalize

Exhibit 1: Pandemic-induced shift in spending patterns beginning to normalize. Charts US durable goods spending and US services spending figures from January 2020 through August 2021.

Exhibit 1: Pandemic-induced shift in spending patterns beginning to normalize. Charts US durable goods spending and US services spending figures from January 2020 through August 2021.

Procyclical positions still preferred

Our positive outlook for global activity informs our preference for procyclical relative value positions –regions like Europe and Japan and sectors like financials and energy. The fundamentals are intact and improving. On a geographic basis, aggregate earnings revisions are stronger in Europe and Japan compared to the US, as is the breadth in profit upgrades downgrades. Valuations, on a relative basis, are also quite compelling to us.

Cyclical assets have performed well since early September even as central banks have grown more hawkish and the outlook for Chinese activity has become more uncertain. When assets, in this case the likes of financials and US equal weight, fail to react as might be expected to what appears to be bad news, this is often a signal that too much negativity had been priced in.
 

Exhibit 2: Three-month earnings revisions favor Japan, Europe over US

Exhibit 2: Three-month earnings revisions favor Japan, Europe over US. Charts earnings revisions for the S&P 500 Index, Topix and Stoxx Europe 600 from November 2020 through October 8 2021.

Exhibit 2: Three-month earnings revisions favor Japan, Europe over US. Charts earnings revisions for the S&P 500 Index, Topix and Stoxx Europe 600 from November 2020 through October 8 2021. 

Two of the top three risks for global equities – higher real rates and tax increases in the US – are particular headwinds for US equities. The other risk – continued disappointments on global growth amid uncomfortably high inflation – is why we hedge our favored expressions of non-US developed market equities with a positive view on the US dollar, particularly cyclical Asian currencies.

Some procyclical relative value positions lagged from March to September despite outperforming on earnings. In our view, this is largely attributable to the retracement lower in global bond yields. Therefore the renewed march higher in rates should allow for a catch-up in which more of this superior growth in earnings is reflected by better relative performance.

The Federal Reserve will continue to command outsized attention among global central banks, and for good reason.
 

Exhibit 3: Global cyclical outlook better than before the pandemic

Exhibit 3: Global cyclical outlook better than before the pandemic. Charts the net change in yields since the end of 2019 for 5y5y yields for the UK, Canada, Europe, New Zealand, US, Australia and Korea for the period from January 2020 through October 8, 2021.

Exhibit 3: Global cyclical outlook better than before the pandemic. Charts the net change in yields since the end of 2019 for 5y5y yields for the UK, Canada, Europe, New Zealand, US, Australia and Korea for the period from January 2020 through October 8, 2021. 

Exhibit 4: EPS revision breadth also favors Europe, Japan

Exhibit 4: EPS revision breadth also favors Europe, Japan. Charts the relative EPS revision of the S&P 500 Index, Topix and Stoxx Europe 600 from November 2020 through October 8 2021.

 

Exhibit 4: EPS revision breadth also favors Europe, Japan. Charts the relative EPS revision of the S&P 500 Index, Topix and Stoxx Europe 600 from November 2020 through October 8 2021. 

But what is shaping up to be different about this cycle is that US monetary policymakers are not expected to be going alone in withdrawing stimulus, in stark contrast to the 2017-2018 period.

A couple of developed market central banks, like Norway and New Zealand, are already raising rates. And importantly, the expected five-year yield in five years’ time for many advanced economies is above where it was prior to the onset of the pandemic. We believe that this is an indication that markets are beginning to tentatively acknowledge the cyclical strength in this expansion will be larger in magnitude and longer-lasting.

Growing risks to the outlook
While we have conviction in our procyclical view, we do acknowledge that the risks surrounding it have risen. The biggest threat is that the current state of affairs persists, contrary to our expectations. A sustained combination of inflation surprising to the upside, growth underwhelming, and stressed supply chains preventing end-demand from being realized would be broadly negative for financial assets – both stocks and bonds. In our view, the Q3 earnings season may mark a peak in the impact of these supply chain concerns on operating performance and guidance.

However, the onset of winter and accompanying heightened risk of COVID-19 spread in the Western world could push back the timing of a comprehensive economic reopening and enhance price pressures. Central banks’ patience with inflation could wear thin, with a pivot to more aggressive policy tightening. And even a gradual withdrawal of central bank accommodation would challenge equity valuations, particularly for expensive, growth-oriented segments of the market, and may cap the upside in stocks to the still-strong rate of earnings growth. An appreciation for the wide-ranging ramifications of an extension of this slowing activity, rising inflation backdrop is a key reason why we are running what we believe are judicious levels of risk at the portfolio level and maintain a long US dollar bias.
 

Exhibit 5: Growth surprises should improve as inflation surprises roll over

Exhibit 5: Growth surprises should improve as inflation surprises roll over. Charts the Global Economic Surprise Index and the Global Inflation Surprise Index from December 2020 through 12 October 2021.

Exhibit 5: Growth surprises should improve as inflation surprises roll over. Charts the Global Economic Surprise Index and the Global Inflation Surprise Index from December 2020 through 12 October 2021.

China’s regulatory campaign and prioritization of the quality and nature of economic growth, rather than the quantity, is a known but difficult to quantify source of downside risk. Markets are conditioned to expect meaningful Chinese policy offsets when the domestic outlook worsened. Investors may be overconfident and wrong-footed in case China’s policymakers are willing to endure greater short-term economic pain in the pursuit of long-term goals. A protracted Chinese slowdown, whether linked to a prolonged regulatory crackdown or a severe retrenchment in real estate, would be negative for both domestic risk exposures and have adverse spillovers for global procyclical positions. One mitigating factor to this risk is that China has not been as big of a driver of cyclical upside or commodity demand recently compared to the pre-pandemic early economic expansion, due to a stronger fiscal-led rebound in developed economies.

Conclusion
Threats to the outlook – both from monetary tightening and negative side effects from the organization of Chinese economic policy – are introducing downside risks to growth while capping the upside available. But, more importantly, public health outcomes are offering more cause for conviction in the well-being of this nascent expansion. That progress is key to unlocking a healthier nominal growth environment in which both labor and goods shortages dissipate.

Shifting from a high inflation/slowing growth backdrop to a moderating inflation/robust growth regime should support the outperformance of procyclical positions. We believe that inflation is still likely to remain elevated enough to keep central banks telegraphing the withdrawal of policy accommodation, especially as labor markets continue to heal. This should keep real rates grinding higher while market-based measures of inflation compensation stay relatively lofty, as well. Rising yields, in turn, should prove a boon to cyclical regions like Europe and Japan and sectors like financial and energy. Higher rates may serve as important corroborating evidence as to the likely vigor and duration of the economic expansion – not as a sign of looming stagflation – which should allow the better earnings growth in these areas of the stock market to be more fully reflected in price performance.
 

Asset class attractiveness (ACA)

The chart below shows the views of our Asset Allocation team on overall asset class attractiveness, as well as the relative attractiveness within equities, fixed income and currencies, as of 1 October 2021.

Asset Class

Asset Class

Overall signal

Overall signal

UBS Asset Management’s viewpoint

UBS Asset Management’s viewpoint

Asset Class

Global Equities

Overall signal

Light green

UBS Asset Management’s viewpoint

  • Our outlook for stocks over the next 12 months remains positive. The economic recovery is likely to continue this year on the back of robust global growth, still accommodative financial conditions, and progress on the broad administration of effective COVID-19 vaccines.
  • Improving earnings expectations are likely to underpin continued gains in global equities despite elevated valuations. The equity risk premium is near the floor of the previous cycle, which may cap upside as policy risks start to become more two-sided and growth momentum peaks.
  • We see more upside in relative value opportunities that offer attractively priced exposure to re-accelerating activity in developed markets compared to beta exposures.

Asset Class

US Equities

Overall signal

Neutral

UBS Asset Management’s viewpoint

  • US equities continue to command premium valuations. The sectoral composition drives this dynamic, with a higher weighting towards acyclical defensive technology than other markets. This characteristic may not prove a boon in the event that investors aim to boost cyclical exposure. Accordingly, we prefer US equal weight to market cap indexes.
  • Continued strong earnings, robust balance sheets, and accommodative policy from the Federal Reserve should continue to support US equities, but fiscal/tax policy risks are becoming more two-sided.

Asset Class

Ex-US Developed market Equities

Overall signal

Light green

UBS Asset Management’s viewpoint

  • Non-US developed market equities are attractively valued and have significant exposure to the global economic recovery.
  • Earnings growth in Europe and Japan is poised to outstrip that of US, and this superior performance is not well reflected by the relative performance of these regions in 2021.
  • Both earnings and valuations have more room to run in ex-US developed market equities, and improving vaccine administration should also bolster investor sentiment.
  • The upcoming Japanese election may serve as a catalyst for investors to increase exposure to the region, which is underweight across global portfolios relative to history.

Asset Class

Emerging Markets (EM) Equities(ex. China)

Overall signal

Neutral

UBS Asset Management’s viewpoint

  • A stabilization of growth in China amid measured policy support is a positive for the asset class, particularly for countries with the tightest economic and financial linkages. Resilience in industrial metals continues to point to a strong foundation for real activity.
  • However, EM equities continue to face near-term challenges that include a negative turn in forward earnings growth relative to DM, renewed strength in the US dollar, and slower administration of vaccines

Asset Class

China Equities

Overall signal

Neutral

UBS Asset Management’s viewpoint

  • Policy actions designed to limit the power of major internet companies may linger as a headwind for this pocket of the market.
  • The peak in credit tightening has passed, in our view. The upcoming turn in Chinese fiscal support and credit impulse during the fourth quarter should provide support for global cyclical assets.
  • Concern over China’s real estate market and uncertainty on the timing and magnitude in policy support, however, constitute important downside risks to activity and procyclical positions.
  • We prefer international equities where the recoveries are less mature and earnings revisions are more supportive.
  • The new US administration will be more predictable in its relations with China, while continuing the process of economic decoupling in areas of strategic importance.

Asset Class

Global Duration

Overall signal

Light red

UBS Asset Management’s viewpoint

  • Long-term bond yields have risen well off their year-to-date lows as major central banks begin to signal the withdrawal of policy support.
  • Inflation risks remain tilted to the upside and global economic activity is poised to remain robust well into 2022.
  • We expect increases in real rates in particular, as well as measures of inflation compensation, to contribute to this renewed rise in yields.
  • Global yields have increased even as macroeconomic risks increased, a sign that there was previously too much pessimism priced in.
  • Sovereign fixed income continues to play an important diversifying role in portfolio construction, and remains particularly effective in hedging downside in procyclical relative value equity positions.

Asset Class

US Bonds

Overall signal

Light red

UBS Asset Management’s viewpoint

  • US Treasuries remain the world’s preeminent safe haven and top source of risk-free yield. The Fed’s responsiveness to inflation risks has limited the appeal of curve steepeners, but the curtailment of policy accommodation is conducive to higher yields across the curve.
  • We expect weakness in US bonds to continue as domestic activity picks up from Q3 to Q4, inflation decelerates but remains well above the central bank’s target, and global activity remains firm.
  • The Federal Reserve is poised to reveal its plan to taper its asset purchasing program at the November meeting, with an eye on ending bond buying by mid-year 2022. The persistence of inflationary pressures into 2022 will determine whether this schedule is accelerated or delayed.

Asset Class

Ex-US Developed-market Bonds

Overall signal

Light red

UBS Asset Management’s viewpoint

  • We continue to see developed-market sovereign yields outside the U.S. as unattractive. The Bank of Japan's domination of the Japanese government debt market and success in yield curve control diminishes the use of the asset class outside of relative value positions. The strong outlook for European growth in 2022 may help continue to compress and looming discussions about reducing the European Central Bank’s QE program potential for European fiscal integration and solid commitment to supporting economies during the pandemic are factors that may compress periphery spreads, but perhaps at the expense of rising core borrowing costs, as well.

Asset Class

US Investment Grade (IG) Corporate Debt

Overall signal

Light red

UBS Asset Management’s viewpoint

  • Spreads have fully retraced thanks to policy support and an improving economic outlook, while all-in borrowing costs are well below pre-pandemic levels. US IG is one of the few sources of quality, positive yield available and therefore a likely recipient of ample global savings. However, the duration risk embedded in high-grade debt as the economy recovers as well as the potential for spread widening should threats to the expansion arise serve as material two-sided risks that weigh on total return expectations for this asset class.

Asset Class

US High Yield Bonds

Overall signal

Light green

UBS Asset Management’s viewpoint

  • We expect carry, rather than spread compression, to drive total returns in HY going forward. The coupons available will continue to attract buyers in a low-yield environment.
  • The asset class is more attractively valued and has less sensitivity to rising interest rates than IG bonds. However, strong relative performance in September as global equities declined makes US high yield less attractive on a tactical basis.

Asset Class

Emerging Markets Debt - US dollar / Local currency

Overall signal

Neutral / Light green

UBS Asset Management’s viewpoint

  • We have a positive view on emerging market dollar-denominated bonds due to the balance of carry opportunity and duration risk.
  • Asian credit is enticingly valued and poised to perform well in environments in which growth expectations improve or plateau, so long as highly adverse economic outcomes fail to materialize.
  • The more rangebound environment for the US dollar removes one previous tailwind for the outlook for total returns in EM local bonds.

Asset Class

Chinese Sovereign

Overall signal

Dark green

UBS Asset Management’s viewpoint

  • Chinese government bonds have the highest nominal yields among the 10 largest fixed income markets globally as well as defensive properties that are not shared by most of the emerging-market universe. We believe that cooling domestic economic growth and inclusions to global bond market indices should put downward pressure on yields during the next 3-12 months.

Asset Class

Currency

Overall signal

 

UBS Asset Management’s viewpoint

  • The Federal Reserve’s telegraphed tapering, along with the meaningful number of Fed officials who signal rate hikes may be warranted as early as next year, puts a higher floor under the dollar and meaningfully reduces the prospect of a retest of its late-May lows in the near term.
  • EMFX like RUB and BRL, which are supported by continued monetary tightening, are well-positioned to outperform even in a rangebound to upwards USD environment, while cyclical Asian currencies and select G10 commodity exporters are poised to struggle.

Source: UBS Asset Management. As of 1 October 2021. Views, provided on the basis of a 3-12 month investment horizon, are not necessarily reflective of actual portfolio positioning and are subject to change.

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UBS Asset Management Investment Solutions manages USD 167.9 billion (as of 30 June 2021). Our 100+ Investment Solutions professionals leverage the depth and breadth of UBS's global investment resources across regions and asset classes to develop solutions that are designed to meet client investment challenges. Investment Solutions' macro-economic and asset allocation views are developed with input from portfolio managers globally and across asset classes.

For more information, contact your UBS Asset Management representative or your financial advisor.
 

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