With monetary policy in aggregate still accommodative, we do not see the recent moderation as heralding … an imminent global recession
Erin talks about drivers of global growth, inflation and the key risks to growth
- Overall, the residual rate of growth remains strong and above-trend.
- We do not see US economic strength wavering significantly in the short-term.
- Recent tax reform and rising capital expenditure also gives us confidence in the sustainability of this cycle.
Views on inflation
- Consumer prices are likely to tick higher
- Monetary policy outside of the US is likely to stay looser for longer.
- Federal Reserve to stay on its gradual path of normalization
3 key risks
- Higher-than-expected US inflation,
- Geopolitics and
- China hard landing
Of these, geopolitics in general and rising protectionism in particular are perhaps the most immediate threat.
Erin explains why she is positive on global equities
- Rising nominal bond yields as a de facto negative for equities
- Strong support from earnings growth, M&A activity and from share buy backs.
- Equities globally attractively against both government and corporate bonds.
Strong demand for EM hard currency debt
- In fixed income, our view on global duration remains negative.
- Current default rates in high yield are still very low by historical standards. We do not expect any material pick-up in US corporate debt defaults in the near-term, but do not view the risk/reward as attractive.
- We see continued strong demand for EM hard currency debt's attractive real yield.
Head of Asset Allocation
One of the most notable features of the global fixed income market in 2018 has been the sharp increase in USD Libor rates.
Investors need to think outside of traditional bond exposures to protect from the potential for rising rates globally and to exploit short-term opportunities as and when they arise.
Floating rate bonds, short-duration credit and securitized investments are attractive in this environment.
Sharp increase in USD Libor rates – a notable feature in global fixed income markets in 2018
- 60 basis point increase in USD Libor since the start of the year to levels last seen in the financial crisis in 2008 (See Exhibit 1)
- The increase, however, has not been accompanied by equivalent increases in EUR Libor or GBP Libor.
- This suggests very strongly that the increase reflects specific technical factors in the US market rather than investor concerns about overall bank creditworthiness.
Why is libor increasing?
US tax reform has precipitated a repatriation of US dollars held overseas by US corporations. This overseas cash had become a significant source of funding for global markets. The owners of this cash are not simply leaving this money on deposit once repatriated. By employing some of this cash for M&A and capital expenditure, demand for commercial paper and other money market instruments from corporates is falling. All this comes at a time when the widening US budget deficit is being funded by increased US Treasury Bill issuance. Unsurprisingly given the volume of issuance, the US Treasury is having to compensate investors with higher yields. In turn, this puts upward pressure on money market rates by ‘crowding out’ commercial paper markets.
Despite the increase in front-end rates, volatility in global fixed income markets has remained relatively subdued. As the US Federal Reserve continues on its path of monetary policy normalization at a time when the issuance schedule for US treasuries is significant, we suspect volatility is likely to increase.
What works in the current environment?
Floating rate bonds, short-duration credit and securitized investments are attractive in this environment
Floating rate bonds have two components—one component is based on a floating reference rate, such as Libor, and a second component being a spread, which is based on the bond issuer’s credit quality.
The coupon is adjusted periodically, so any increase in interest rates is soon reflected in the yields of the bonds.
Therefore cash flow will increase in a rising rate environment. Because coupon rates mirror the market interest rate, floating rate bonds have very low price sensitivity to changes in interest rates.
For investors concerned about a sustained increase in interest rates, short dated credit looks attractive.
Short dated credit exposure looks particularly interesting on a risk-adjusted basis. We believe carry (coupon earned) provides a solid income stream with limited downside risk given fundamentals in corporate credit continue to look healthy.
And while leverage has increased in some segments, a focus on shorter maturity issues increases the ability to project the financial health of issuers.
Securitized assets such as mortgage-backed securities (MBS), asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) possess many positive attributes including enhanced yield and the secured nature of the bonds.
In the current environment perhaps one of the more important and underappreciated attributes is the diversification these assets can provide.
Securitized bonds exhibit low historical correlations to both investment grade and high yield corporate credit.
Head of Fixed Income
The recent bout of volatility in emerging market equities was driven more by sentiment than fundamentals.
We don’t view the cycle as broken … large opportunities exist in ... consumer, internet / e-commerce, and financials.
While there are some vulnerable spots in EM, we are mindful of these risk and have very limited exposure to these areas.
The upcycle is not broken in emerging markets
Although investors may have been worried, we believe the recent bout of volatility in emerging market equities was driven more by sentiment than fundamentals. While risks overall increased (including stronger USD/US rates, trade concerns and geopolitics), fundamentals have remained strong with continued earnings and economic growth across EM.
Absent a strong growth shock, we assume these risks will not derail the multi-year upcycle currently underway for emerging markets equities (see Exhibit 1). After being cut for several years, capital expenditure is on the rise again. This development should drive demand across emerging markets and support further improvement in corporate margins and earnings, although at a more moderate pace going forward.
Trade issues: An escalation of the trade conflict between US and China into a full blown trade war is not our base case. However, there are uncertainties as to how the situation might evolve. We believe US President Donald Trump wants a fairer trade playground and we believe China will be ready to offer some concessions (e.g. China recently ended the requirement for foreign car brands to set up a joint venture with a local company when building manufacturing facilities in China).
Stronger USD: a stronger USD may continue to overhang the performance of EM assets in the near term. However, we see reduced crisis risks for EM given the asset class is healthier than in the previous episodes of weakness (e.g., during the Taper Tantrum in 2013). This is thanks to stronger fundamentals both at the macro level via more balanced current accounts, more competitive exchange rates, less FX debt with localized exceptions and replenished FX reserves—and at the micro level via lower corporate indebtedness.
China: rebalancing continues to offer investment opportunities
Looking across emerging markets, the Chinese economy continues to face many structural challenges, but we believe they will result in lower medium-term economic growth, accompanied by some volatility, rather than pose crisis risks. China has remained resilient at the macro level.
The rebalancing of the economic structure toward services should continue to provide investment opportunities, especially within sectors such as e-commerce, e-payments, social media, education and insurance. For the next few years, we expect China to focus on the quality of growth and to continue its reforms agenda including corporate deleveraging and environmental improvements.
India remains an attractive long-term story
In India, corporate earnings are beginning to improve but only gradually. While we currently see attractive bottom-up opportunities, we are also monitoring the macro risks, such as the widening trade and current account deficit.
In the nearer term, the government’s focus on infrastructure spending continues to boost domestic sentiment. There should also be further fiscal support in the run up to 2019 national elections, especially for the rural economy. The consumer remains somewhat robust and household sentiment has improved from last year.
We see India as an attractive long-term story and believe that the Modi government will continue to focus on removing bottlenecks and pushing through calibrated reforms to revive investments for sustained growth in the medium term.
Outside Asia—contagion risks and political uncertainties overshadowing economic improvement
We see limited contagion risks from Argentina and Turkey woes, which we believed are already reflected in currencies that have weakened against the USD, and inexpensive valuations. The situation is also quite different for many countries, primarily commodity producers, as commodity prices are currently strong despite the stronger USD, which should offer some buffer and offset the potential economic impact of tighter financial conditions.
Overall, while we don’t view the upcycle as broken, risk perception has risen and we expect heightened stock price volatility going forward. We thus encourage investors to look through the noise and focus on long-term fundamentals and the continued economic recovery. Our analysis shows large opportunities exist in various sectors, including consumer, internet/e-commerce, and financials. While there are some small vulnerable spots in EM, we are mindful of these risks and have very limited exposures to these areas.
Head of Emerging Markets and Asia Pacific equities
More and more investors are expressing an interest in ESG investing beyond equities.
Given bonds form a key constituent of institutional portfolios, it is hardly surprising that investors are looking to integrate ESG principles … particularly as regulatory and fiduciary pressures increase
ESG integration into fixed income is now easier
- ESG data and ratings are now available for almost all investment grade credit, and for many high yield issuers.
- Investors can now allocate more private capital to sustainable fixed income instruments
- The ease is due to several important innovations in fixed income -
- green bonds,
- social bonds,
- and unique collaborations, such as that between the World Bank and UBS
These provide sustainable investment alternatives to high grade fixed income.
Look beyond ESG ratings
- The ‘integration' of sustainability is more than the application of sustainability data or ratings to the investment process.
- These ratings do not cover the impact of material sustainability issues on the actual financial assessment.
- For these sustainable ratings to be meaningful, credit analysts and portfolio managers need to apply those ratings to their own financial credit assessment.
UBS Asset Management’s approach reflects our core belief: ESG integration is strongest when the credit analysts sit at the heart of it. They are best placed to use their in-depth knowledge of issuers, and experience in fundamental analysis, to provide the context in which to consider sustainability issues.
It is that same skill set which they use to analyze ESG factors. Most crucially, the analysts make forward-looking judgments – something which applies as much to ESG issues as to financial ones. By having analysts own their understanding of sustainability issues, we expect ESG integration to deepen further still.
Collaboration is vital. Our sustainability investment research team provides close support to the credit analysts, advising on materiality and timing of relevant ESG issues. Through this ongoing dialogue, we can address questions about the materiality of a topic:
- how well an issuer manages its risks;
- will the ESG issues impact the credit assessment;
- to what extent does the ESG analysis change the credit opinion?
These are some of the key questions the sustainability analysts work with the credit analysts to determine.
UBS Asset Management’s white paper – “The next frontier” gives a detailed analysis of how ESG can be integrated into fixed income investing. We also present 2 case studies on how our analysts considered ESG factors in analyzing investment grade and high yield issuers.
The search for more cost-effective alpha has seen strong institutional flows into equity factor investment mandates over the past year.
Isolating individual factor styles is important in volatile markets
Factor premia—or styles—that are widely believed to add value in the long term. The most commonly accepted are value, momentum, quality, low risk and size (small minus large). That said, style performance and correlation can vary over time and through investment cycles.
For example, growth and momentum factors dominated global equity markets in 2017, while value and low risk investing underperformed. This continued into the beginning of 2018 and even well into February, as inflation scares triggered a short market correction. Only in March, when geopolitical risks started to dominate investors’ agenda, styles started to behave differently. This serves as a powerful reminder that a static bet on one style can lead to suboptimal results.
We believe this is particularly relevant now as risks of a regime shift in markets have increased. The rate of acceleration in global growth has moderated in recent months, and global demand growth rates are less synchronized. If geopolitical risks prevail, central banks’ loose monetary policies gradually unwind, and the economic cycle matures, it is reasonable to assume that equity markets’ will remain volatile.
3 ways to isolating the specific components
- active timing of factor premia,
- blending factor premia efficiently, or
- isolating the specific value-adding components of the factor premia and combination of these
Isolation individual factor premia is critical to the efficient use of the risk budget, to reducing systematic risks, to lowering drawdowns and to generating the more consistent alpha contributions that all investors seek.
Senior Equity Specialist, Systematic and Index Investments team.
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