CIO has added several positions that would benefit if the benign backdrop continues. (UBS)

The base case of the UBS Chief Investment Office (CIO) is that inflation will rise at only a modest pace, allowing for a continuation of the steady-growth, low-rate backdrop we have experienced over the past few years. But with higher valuations curtailing future investment returns, and the possibility of volatility as markets worry about policy errors, CIO keeps a more balanced exposure to risky assets and uses hedges where appropriate.

In our tactical asset allocation, we have added several positions that would benefit if the benign backdrop continues. These include new preferences for emerging market and Japanese equities vs. US government bonds, while we've gone back to a neutral allocation in US equities.

Has the Fed already tightened too much?

Bond markets seem to be saying the Fed has raised short-term rates too much, yet equity markets are buoyant. We think that the flat yield curve has more to do with a changing view of longer-term inflation than expectations of an economic slowdown, but will look for confirmation of this view in the months ahead. Factors we will be looking at include:

Credit conditions. Following the Fed‘s recent dovish shift, financial conditions are now among the loosest since 1994, according to the Chicago Fed‘s index. We will watch to see if this is reflected in the 1Q Fed Senior Loan Officer Survey.

Growth. Recent growth data have been supportive, with the US ISM index comfortably in expansionary territory, and the Atlanta Fed GDPNow forecast for the first quarter increasing to 2.4%, from less than 0.5%, at the beginning of March.

The labor market. With a recovery in March, and unemployment below 4%, the labor market doesn‘t appear to be suffering from interest rates being too high. If anything, it appears more at risk of overheating.

Or is the Fed making a mistake by pausing?

While we expect incoming data to confirm that the Fed has not gone too far in hiking rates, we also need to be cognizant that keeping rates on hold increases medium-term risks.

With annual wage growth at 3.2% (and close to 5% for workers in the retail sector, we will watch for signs that higher labor costs are feeding into prices. We don’t expect this to happen in the coming months, but any evidence that the Fed is “falling behind the curve” on inflation would likely lead markets to price a resumption of rate hikes and have a negative impact on markets.

Tactical Asset Allocation

Risky assets have been supported by the Fed's pause, as well as encouraging signs that the global economy has stabilized and is poised to accelerate. While US data has generally fallen short of expectations, the level of growth remains decent, and strong US payrolls for March suggest that the US labor market remains healthy.

Based on this improving economic outlook, we added to our overweight to equities vs. fixed income, while shifting its allocations to markets that are best positioned to benefit from the global growth re-acceleration. In case conditions deteriorate again, we maintain our overweight to long-duration Treasuries.

Main contributor: Mark Haefele, Chief Investment Officer

For more, see Investment Strategy Guide: End or extend? May 2019.

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