Q3 outlook

Exploring ideas for growth, income, protection, and addressing key questions at the forefront of investors’ minds.

18 Jun 2021

At a glance

"Our outlook for 3Q" is the continuation of the series where UBS Chief Investment Office provides quarterly updates on the investment outlook.

In this edition, we address five questions at the forefront of investors’ minds at the mid-point of 2021: Where can I still find short-term portfolio growth? How can I protect against downside risks? How do I boost my portfolio income? How should I prepare for higher inflation? What are the most attractive structural opportunities?

Five key topics to help you prepare your portfolios

Short-term portfolio growth

Where can I still find short-term portfolio growth?

Global equity markets are now 24% above pre-pandemic levels, leading some investors to wonder if upside may be limited from here. However, we think equity indexes can move higher, driven by a combination of robust earnings growth, still-attractive valuations relative to bonds, and accommodative central banks.

The rally is underpinned by very strong earnings growth, which has continued to beat expectations over the first half of this year. We now expect S&P 500 earnings to be 30% above pre-pandemic levels in 2022. Eurozone earnings should be 18% higher, and Asia ex-Japan earnings 50% higher. At a global level, the current equity risk premium for the MSCI All Countries World Index is around 400bps, comfortably above its long-term average of 274bps. The 2022 P/E ratio is 18.8x. But while we continue to anticipate gains at a global index level, we don’t expect those gains to be evenly distributed. We see greater potential in regional markets that underperformed in the first half of 2021, particularly China and Japan. We also think there is more upside to come in stocks that are more heavily exposed to economic reopening.

Japan, Asia, and EM stocks are yet to fully reflect strong earnings growth

Returns since January 2020, in %, 2022/2019 CIO EPS growth forecasts, in %

Source: UBS, as of 17 March 2021

Protecting against downside risks

How can I protect against downside risks?

As equity markets have rallied to record highs, some investors are beginning to focus more on potential downside risks, including coronavirus mutations, inflation, and geopolitics. They’re considering whether it’s time to lock in profit, or to wait before committing more capital.

Overall, we do not think the downside risks we face today are higher than average. In our base case, we do not expect them to topple the rally, and long-term investors should generally not try to time the market, in our view. Waiting for risks to subside can be an indefinite and costly process, and investing at all-time highs has historically not proven to be riskier than investing during other periods.

At the same time, investors should regularly review if equity market gains mean they are now taking excessive portfolio risk. If so, they should consider ways to reduce some of that risk, while keeping long-term plans on track. This can be done by locking in gains on stocks that have outperformed and now have limited upside, or by seeking greater downside protection via hedge funds, options, and structures. Diversifying into select defensive stocks is another option to consider.

Current high bond-equity correlation boosts hedge fund appeal

Trailing 3-month US equity bond correlation using daily returns

Source: Bloomberg, UBS, as of June 2021

Boost portfolio income

How do I boost my portfolio income?

Despite high levels of growth and inflation, interest rates are likely to remain low in the months and years ahead. Our view, mirroring the Fed’s own projections, is that US rates are likely to remain in the 0–0.25% range until 2023. Rates in the Eurozone and Switzerland are negative, and increases there could take longer still.

For investors who rely on their portfolios to provide income, this environment is especially challenging. Even if smaller economies like Norway, Canada, and New Zealand raise rates sooner, in most major currencies yields not only are insufficient to compensate for inflation, but also are not expected to rise
in the immediate future. With inflation elevated, real returns are under particular pressure.

This means investors will need to find ways to boost portfolio yield. In various recent publications, we‘ve discussed the need to diversify away from cash and investment grade bonds into higher-yielding assets. But as market leadership shifts away from growth stocks, we think the “hunt for yield” will also become more worthwhile for equity-heavy investors too.

Specifically, we see less potential scope for meaningful gains among mega-cap growth stocks, whereas we expect a recovery in dividend payments in other parts of the market in the second half of the year. This backdrop provides investors with the opportunity to diversify into select dividend stocks, senior loans, or engage in “alternative yield” strategies.

Investment ideas:

Hunt for yield

Rates set to stay for longer

Cash rate expectations by central bank, in %

Source: Bloomberg, UBS, as of June 2021

Preparing for higher inflation

How should I prepare for higher inflation?

Inflation has not been a major problem for investors since the 1980s. After averaging 7.1% in the US in the 1970s, and 5.6% in the 1980s, inflation rates since 1990 have averaged just 3.0% in the US, 2.3% in Switzerland, and 1.3% in the Eurozone (since 1997).

Yet, as the post-pandemic recovery takes hold, prices of various goods and services are rising. In the US, the consumer price index rose by 4.2% year-over-year in April and 5% in May, and the Citi US inflation surprise index is at its highest level since its inception in 1998. The Bloomberg Commodity index went up more than 50% over the last year, and the UN FAO food price index is up 40% in one month.

In our base case, we don’t think persistent inflation above 3% is likely. Many of the structural factors that have helped keep inflation low during the last decade remain in place, including the ongoing shift to services, the influence of technology, aging populations, and inequality. In addition, low, stable inflation remains a primary central bank objective, and policymakers have the necessary tools to keep it in check.

That said, the Federal Reserve’s new average inflation targeting framework, unprecedented fiscal stimulus, and policymakers’ more tolerant attitude toward high debt-to-GDP levels could drive a regime change. In particular, the current spike in inflation could prove sustainable if labor market imbalances lead to higher wages, excess savings are spent, or if companies seek to exercise their pricing power.

Higher inflation is relevant for investors for two reasons. First, higher inflation and inflation volatility could drive higher interest rates, leading to volatility in stocks and bonds. Second, if sustained, higher long-term rates of inflation would erode purchasing power more quickly, making investors reassess whether current financial plans were still viable. Investors need to make sure they are prepared for both eventualities by building inflation protection into portfolios. Without portfolio adjustments, just a 1pp increase in long-term inflation would mean a 21% reduction in sustainable real spending power (assuming the difference between the impact of 2% and 3% inflation on a 60/40 portfolio over 16 years).

Inflation concerns have intensified

US CPI and core PCE, year-on-year, in %

Source: Bloomberg, UBS, as of June 2021

Structural opportunities

What are the most attractive structural opportunities?

The pandemic accelerated a variety of secular trends, including e-commerce, digital payments, and remote working, driving strong performance across the technology sector. But as economies reopen, investors will need to be more selective about long-term growth exposure.

Mega-cap tech has already benefited from significant upward revisions in analysts’ earnings estimates, with 2021 expectations raised by between 7% and 24% over the past three and six months. With product refresh cycles generally unfavorable in 2Q and the second half now offering limited scope for earning beats, we don’t see many catalysts for mega-caps to move markedly higher from here.

But we think there are still other opportunities for investors seeking structural growth. In particular, we highlight some of the overlooked parts of the growth space, including smaller and mid-cap technology companies in high growth industries, and digital subscription business models.

We have also identified several ways for investors to go sustainable across electric vehicles, greentech, and in stocks that are solution providers for the Future of Earth. Separately, we note that private markets can also often offer better access to early-stage, innovative companies operating in these thematic areas.

Growth stocks have started to wobble

Nasdaq index, since January 2020, in %

Source: Bloomberg, UBS, as of June 2021

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