Weekly investment views across key regions

The reaction by investors was largely expected. Equity investors switched from secular tech winners to cyclicals, value and commodities (ex-gold), and bond investors from investment grade to high yield. With the 10-year UST yield set to rise further, this rotation is likely to continue in the months ahead. But as we expect the pace of yield increase to be modest from here, and as it broadly reflects stronger inflation expectations, we think the equity rally has further to run.

A new economic cycle has begun, which portends robust activity in 2021. We do expect consumer inflation rates to move higher and eclipse pre-COVID levels (Asia CPI at 2.5%–3%, China CPI around 2%, and producer price inflation to climb back to mid-single-digit growth after contracting last year). But as this reflation is being driven by the bounce-back in activity, we view it positively for investors given the following conditions.

First, policy remains relaxed, and we do not envision monetary tightening this year. If central banks —as we expect—do not hike policy interest rates this year, then short-term interest rates will likely drop in real terms. This supports the bias to stay risk on and to increase borrowing. Local long-dated yields are a different story, as they reflect a tightening in liquidity conditions. But without higher policy rates, we expect only a further 25–50bps rise in Asia’s long-term bond yields.

Second, higher producer prices—driven by recovering demand and restrained supply in industries like commodities and manufacturing—signal stronger corporate pricing and profit margins. Investment in production is growing to meet demand. Given high shipment/inventory ratios, we expect producer prices to rise 3%–5% this year. Likewise, service industries—which had to cut capacity last year—should enjoy strong demand as pent-up savings are spent on recreation. Price inflation for services could therefore rise above pre-COVID levels for a while.

The last key reason is the backdrop of vigorous economic growth in 1H21. China should achieve a high growth rate of over 18% y/y in 1Q; growth should then slow but remain above trend thereafter. The rest of the world is expected to see a similar pattern in 2Q, with growth peaking at over 20% y/y in Asia (ex-China). This signifies a return of consumption and strong international trade of goods and services in 1H.

The impact on markets as inflation dynamics shift depends as much on the context as the overall direction—e.g., the starting point, the speed of adjustment, and the causes of rising inflation and yields.

The recent pace and magnitude of the rise in 10-year US yields (as well as real rates) was clearly sufficient to unsettle markets, but we don’t believe further increases will be as disruptive. However, the forces that brought us here are likely continue to fuel the rotation to value and cyclicals for now. For example, generous government and central bank support should persist longer than in past cycles, and pent-up demand will likely increase further after 2Q. A step up in corporate earnings expectations and the subsequent further steepening of yield curves should be expected until 2H. Also, positioning is still light in value segments and heavy in growth.

We therefore recommend rebalancing portfolios to more value-oriented and cyclical markets that should benefit from reopening (India and Singapore), and to sectors that should benefit from reflation (financials, industrials, and energy). For example, the energy sector is still trading 25% below its pre-pandemic level relative to the benchmark, yet crude futures out three to four years are trading around pre-COVID levels.

Furthermore, the crunch in growth valuations could offer appealing entry points for long-term positioning, in our view. The sell-off hasn’t changed our earnings forecasts or structural narratives, so we remain bullish on emerging secular themes like 5G, the digital economy, and greentech.

Authors

Philip Wyatt, Economist, UBS AG Hong Kong Branch
Sundeep Gantori, CFA, CAIA, Equity Strategist, UBS AG Singapore Branch

Indeed, not one, not two, but three of them delivered rate hikes beyond what markets were expecting. While the "dot plot" that maps Fed policymakers’ views on interest rates indicated no US liftoff until at least 2023, policy rates were set higher in Russia and Brazil, supporting our positive view on the Russian ruble, and somewhat capping the downside on the Brazilian real. Türkiye also delivered a hike last week. But in a dramatic turn of events, the central bank president was replaced shortly after, severely denting investor confidence in the country's willingness and ability to address its structural challenges.

The Russian central bank (CBR) decided to act against rising inflation and elevated inflation expectations by hiking its policy rate by 25bps to 4.5% on Thursday. With risks more on the pro-inflationary side, in the CBR’s view, further hikes are possible. The central bank thus again showcased its prudent approach to monetary policy, one of the pillars for the ruble. The currency has remained unfazed by higher longer-term US rates and oil price gyrations, even though it came under pressure earlier in the week as geopolitical news flow again turned more negative.

While severe adverse measures against Russia by European nations and the US would undermine our positive RUB view, we think the positive global growth outlook and high oil prices should ultimately outweigh international political concerns over time, enabling the ruble to retrace more of the losses it has sustained since the start of the pandemic.

The Brazilian central bank (BCB) delivered a 75-basis-point hike that lifted the policy rate to 2.75% on Wednesday, and also communicated that it might repeat the act when it meets again in May, assuming the inflation and risk outlook is not significantly altered. This should help anchor inflation expectations around 3.5% for next year, notwithstanding the transitory upward pressure on inflation this year. The Brazilian real appreciated, but Wednesday’s BCB move is still likely not enough for a sustained strength in the currency.

In our view, the BCB would have to maintain its hawkish stance in the face of the ongoing pandemic in Brazil and the politics around former President Lula da Silva’s acquittal, both of which will affect election, fiscal, and reform dynamics. An easing of worries around the fiscal outlook and meaningful progress around managing the pandemic are essential preconditions for lasting BRL strength, in our view.

The Turkish central bank surprised on Thursday with a 200bps policy rate hike, to 19%, against the consensus expectation of 100bps; with that move, the central bank had hoped to reaffirm its inflation-fighting credentials. However, an even larger surprise came the next day, when a presidential decree installed a new central bank president. The uncertainty around the future course of monetary policy and the perceived erosion of institutional strength in Türkiye look set to weigh heavily on the lira in coming days. (For more, refer to our report "Another change at the central bank, Turkish lira suffers," published 22 March.)

By and large, despite the political noise in Türkiye which makes up a small share of the emerging market asset class universe, we expect emerging market currencies to regain in value against the US dollar as the global economy picks up steam, the pandemic ebbs away, and markets become less anxious about further shifts in the US Treasury curve. US dollar returns on emerging market equities should therefore be well-supported by future currency moves—one of the reasons we regard them as a most preferred asset class.

Author

Alejo Czerwonko, Chief Investment Officer Emerging Markets Americas, UBS Financial Services Inc. (UBS FS)
Tilmann Kolb, Analyst, UBS Switzerland AG

Since no changes to monetary policy were expected, we were far more interested in reading between the lines of the accompanying announcements and press conferences, hoping to get a sense of when we are likely to see any shifts in the BoE’s stance, and, more importantly, how central bankers are feeling about the recent rise in global bond yields.

Some intriguing nuances are emerging. At one end of the spectrum, we have the European Central Bank, which is not at all comfortable with what is happening in bond markets right now—so much so that it has agreed to accelerate its pace of bond buying to avoid a tightening in financial conditions. At the other end is Norway’s central bank, which signalled that it could be ready to hike rates as soon as later this year.

The BoE and the Federal Reserve land somewhere in between on this continuum. Both are not in any rush to hike interest rates, nor are they ready to “taper” the current pace of bond purchases. And both seem content to live with the recent rise in bond yields and associated tightening of financial conditions (which in the case of the UK includes the strengthening of sterling), accepting that these developments reflect the improving outlook for the economy.

For its part, the BoE has settled into something of a holding pattern, waiting to see what happens with the economy before making its next move. The Bank has set the bar quite high for any future rate rises, saying that “…the Committee did not intend to tighten monetary policy at least until there was clear evidence that significant progress was being made in eliminating spare capacity and achieving the 2% inflation target sustainably”. Not quite as definitive as the Fed, which doesn’t seem to foresee any rate hikes before 2023, but certainly a signal that low interest rates are going to be with us for some time yet.

While interest rates aren’t going to move, central bank thinking may further evolve in the months ahead. The BoE’s meeting in May will be key, as this is when it will update its outlook for growth and inflation. Both will be higher than in February, at least in the short term. But I doubt this will be enough to motivate a dramatic change in language from the Bank, which has unquestionably turned more hawkish of late (it wasn’t too long ago that folks were floating the possibility of negative interest rates). That said, the absence of any bad news could widen the gap between the BoE and some of its more dovish peers.

For the UK markets, this could mean a few things. If the BoE continues to think that financial conditions are not tight, as it said last week, gilt yields could drift higher. All else equal, this should also open the door for sterling to continue to drift higher. The global low interest rate environment, which should persist, will be welcome support for UK stocks, enabling share prices to benefit from recovering earnings. And against this backdrop, the broader economic recovery should mean that value stocks—thus far an unloved part of the market—can shine.

Author

Dean Turner, Economist, UBS AG, UBS AG London Branch

Economic outlook perking up

First, it's important to understand why interest rates are rising. It seems pretty clear that rates are rising because expectations for both real economic growth and inflation are improving from depressed levels, thanks to the accelerating pace of the vaccine rollout and additional fiscal stimulus.

While rapid increases in interest rates can cause short-term bouts of equity market volatility, the historical record is pretty clear. When rates rise from low levels, stocks perform well because it is confirmation that economic conditions are "normalizing." That's exactly what happened in 2013 and 2016, when the rate increases were even larger.

Bull market remains intact

But the recent increase in rates has caused some hand-wringing about equity valuations. Investors have been willing to pay somewhat lofty price-to-earnings (P/E) multiples for stocks because interest rates are so low. Will rising rates be a headwind for valuations?

At a market level, we are not yet too concerned. One way to gauge the relative valuation of stocks versus bonds is to look at the S&P 500 earnings yield (earnings divided by price) versus the 10-year Treasury yield. This spread has compressed to near post-financial crisis lows, but it is still more than 1 percentage point higher than the average since 1985. Our modeling of the yield spread also suggests that it should compress further as inflation expectations rise.

Also bear in mind that material valuation contractions are usually driven by fears of an economic growth slowdown. With close to USD 2 trillion of excess consumer savings and another USD 1.9 trillion of stimulus that is just now being deployed, interest rates would likely have to rise further before investors start to downgrade their economic growth expectations.

Rotation

But higher rates do have implications for the relative performance of segments within the equity market. Valuations for secular growth companies got the biggest boost from the decline in interest rates last year. Because these companies should produce a nicely growing stream of cash flows well into the future, investors have treated these companies as long "duration" assets, similar to long-dated bonds. When rates fall, long duration assets benefit the most. Conversely, now that interest rates are rising, growth stocks are coming under pressure.

So far, the valuation contraction for growth stocks is tracking pretty much in line with the increase in interest rates. In other words, the outlook for growth stocks will likely continue to hinge on interest rates. If rates rise to pre-pandemic levels, the headwinds will likely continue.

Also bear in mind that earnings for value stocks are more tied to economic activity. The snapback in the economy this year will lead to a much sharper improvement in value stock earnings relative to growth stocks. With so much stimulus in the pipeline, it's possible that the robust economic momentum continues into 2022, suggesting that the tailwinds for value stocks may be more than just a flash in the pan.

Overall, the increase in interest rates appears to be confirmation of the coming economic recovery. And in our view, rates have not yet increased enough to derail the equity bull market. But the rotation out of growth stocks and into value could have legs, especially if rates rise further. While we have a neutral stance on growth versus value, we continue to prefer more cyclical segments of the equity market such as consumer discretionary, energy, financials, and industrials, most of which tend to benefit from higher interest rates.

Author

David Lefkowitz, CFA, Head of Equities Americas, UBS Financial Services Inc. (UBS FS)