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07.07.2016 CIO Market Watch – Deeper underground
With Christopher Wright, Cross-Asset Strategist, UBS Wealth Management

Deeper dive

Deeper underground

In 1998, the British band Jamiroquai released the number one song “Deeper Underground.”

Eighteen years on, “Deeper Underground” is a number one description for how global high grade bond yields have reacted to the UK referendum result. By the end of June, EUR 10.6trn of developed market government debt traded at zero or negative yields. Just in the last week, 10-year yields on UK, US, and German government bonds touched record lows – 0.73%, 1.32%, and –0.2% respectively at the time of writing. Even more extreme, high demand drove the whole Swiss government bond curve into negative-yielding territory, with the discount rate on 50-year Swiss debt slipping to –0.03%.

We expect central banks to respond to post-Brexit economic and political uncertainty with more policy easing. The Bank of England will likely cut its base rate to zero before year end to try to avert recession. Further financial market declines could lead the European Central Bank to increase monthly asset purchases from EUR 80bn/month or extend quantitative easing beyond next March. And the US Federal Reserve must assess how a stronger US dollar affects conditions at home and abroad before raising rates.

Our developed market interest rate forecasts have been marked down across the board to reflect “lower for longer” central bank policy. High grade yields could move even deeper underground. So if buying negative-yielding bonds and holding them to maturity guarantees losses, does high grade debt still have a place in portfolios?

It does by continuing to play an important role as a diversifier, typically mitigating portfolio losses when stocks decline and smoothing portfolio volatility.

Since 1996, 5–7 year Treasury bonds have risen an average 0.7% in months when US stocks have posted losses. But we are underweight high grade debt on a tactical basis, as continued global growth should cause interest rates to gradually rebound from these historic lows.

Ultra-low bond yields increase the attractiveness of other global asset classes. US investment grade debt offers similar diversifying effects to US Treasuries – but pays around 130 basis points (bps) more yield. We maintain a modest overweight in the asset class.

Similarly, our tactical overweight in euro high yield credit looks even more attractive as sovereign yields decline. Easy corporate financing conditions should curb expected defaults to just 2% over the next 12 months. And spreads of around 480bps look appealing for income investors.

Dividend growth stocks in Europe and Asia Pacific also retain their allure. The spread between German Bunds and the 12-month forward dividend yield of the MSCI EMU index, now around 4%, is close to all-time highs. Our analysts’ selected stocks, focused on high-quality names with dividend-growth potential, are expected to outperform both high grade debt and the broader Eurozone equity market.

Mark Haefele

Global Chief Investment Officer
Wealth Management

Matthew Carter

Global Investment Office

Bottom line

Economic uncertainty in the wake of the UK referendum has pushed high grade yields toward all-time lows. While easier central bank policies may cause them to fall even further, high grade debt still

has a diversifying role to play in portfolios. But we see better tactical opportunities elsewhere, especially in euro high yield credit and US investment grade debt.