Overly complacent markets could lead to an unexpected increase in volatility
THE UBS GLOBAL ASSET MANAGEMENT Cyclical Market Forum, held quarterly to discuss three plausible economic scenarios and their potential implication for investments over the next 12 months, found its 2Q14 Forum dominated by discussions over continued strong market returns and low volatility levels across many asset classes, as well as concerns that potential negative shocks to the global economy have not been fully priced into the markets. Curt Custard, the chair of the Forum, said, “The marketplace seems more consensus-oriented than I’ve seen in a long time. A policy misstep from the central banks or a rise in geopolitical tension could rattle the currently benign environment.”
Three market scenarios are proposed at each Cyclical Market Forum and are debated by UBS Global Asset Management investment teams across a wide variety of asset classes, including equities, fixed income, multi-asset portfolios, hedge funds, currencies, commodities and real estate. As of March 31, 2014, UBS Global Asset Management had approximately USD 674 billion in assets under management globally.
UBS Cyclical Market Forum 2Q14 Economic Scenarios Under Consideration
Scenario 1 – “Carry on regardless”
In this consensus scenario, the global environment of subdued growth and low inflation continues. US growth continues to be mostly supported by consumer spending, while investment growth continues to disappoint. The European Central Bank’s (ECB) new measures are not a quick fix for the eurozone’s recovery, leading to modest GDP growth. Despite the occasional surge in geopolitical tension and some uncertainty within China’s shadow banking sector, emerging markets continue their gradual rebalancing, which is supported by a relatively accommodative global monetary policy stance.
Scenario 2 – “Carry on cruising”
In this bullish scenario, global recovery is led by strong growth in the developed markets. As business confidence remains strong and monetary policy stays accommodative, investment spending becomes the main driver of recovery within the developed markets. Upside surprises from both inflation and growth will significantly increase export demand from developed markets, which will benefit emerging economies. Despite a normalization of monetary policy in the US, capital outflows from emerging markets are still limited, as domestic growth, supported by stronger external demand from developed markets, remains robust.
Scenario 3 – “Carried out”
In this bearish scenario, the expectation of stronger growth in developed markets never materializes. In the US, rising inflation and falling unemployment—driven primarily by lower labor market participation rates—signals to the market and the US Federal Reserve (Fed) that potential growth is much lower than pre-crisis levels. In the eurozone, the ECB’s new measures prove insufficient to stimulate growth. China continues to deal with shadow banking problems, and other emerging markets are hit by lower external demand and reduced risk appetite.
A majority of the Cyclical Market Forum participants voted Scenario 1 as the most likely, the bullish Scenario 2 as the second-most likely and the bearish Scenario 3 as the least-likely outcome. In terms of asset class expectations, a clear majority of participants expected developed markets to outperform emerging markets in equities and currencies, while emerging markets debt was expected to outperform developed market bonds. The participants agreed that the outcomes for most asset classes will likely be significantly impacted by the actions of major central banks. In particular, attention was focused on the following aspects: 1) whether the ECB will increase its monetary easing policies or continue to rely on the Fed’s policies to support the global recovery, 2) whether the Bank of Japan (BoJ) will tighten its monetary policies, or continue with economic stimulus as it has done under “Abenomics” and 3) whether the Bank of England (BoE) will adopt tightening measures to slow the economy, or risk building up a bubble, particularly in the housing market. While the market has priced in some of these actions, a surprise may throw off the markets and could lead to unexpected volatility.
Key Takeaways from the Forum:
- Curt Custard, Head of Global Investment Solutions, Chair of the Cyclical Market Forum (Chicago)”A change in monetary policy that surprises markets would likely affect correlations. I’m not sure whether bonds and stocks would be negatively correlated with one another, which would impact multi-asset portfolios. Tensions in Ukraine and a sectarian war in the Middle East have been largely ignored, as volatility has been trading at pre-crisis levels, despite some significant geopolitical uncertainty.”
- Joshua McCallum, Senior Economist, Fixed Income (London)”The primary driver of risks to asset prices remains monetary policy. Growth and inflation are also factors, but only insofar as they themselves influence monetary policy. We do not yet seem out of the clutches of central banks, the factors that determine their reactions and the mistakes they may make.”
- Michele Gambera, Head of Quantitative Analysis, Global Investment Solutions (Chicago)”Exports are more than 30% of the eurozone’s GDP. Unless the upcoming measures from the ECB are able to weaken the euro, I think it will be difficult for European companies to unlock their potential. For example, measures such as asset-backed securities (ABS) purchases could support lending and weaken the exchange rate, thus helping European equities in two ways.”
Comments on Specific Asset Classes:
- Tom Digenan, Head of US Equities (Chicago)”In our view, monetary policy will act as both a support system and a limiter for US equity levels. If there is stronger-than-expected economic growth, the Fed will likely tighten monetary policy sooner, resulting in a less-supportive environment for equities despite a more favorable economic backdrop. At the same time, weaker economic growth may lead to more accommodative monetary policies, which would likely support equity markets, even in a lower-growth environment. Therefore, we see moderate equity growth under all of the scenarios. Given everything the Fed has communicated, a lower-for-longer scenario should not be surprising.”
- Uta Fehm, Portfolio Manager, Emerging Markets Debt (Frankfurt)”Over the past several months, emerging markets debt has delivered relatively strong performance without any visible fundamental improvement from emerging economies. We believe that the stronger performance was driven primarily by a search for yield, especially as liquidity has remained adequate for this asset class. However, emerging market countries are diverging from each other, and viewing them as a homogenous asset class is becoming less useful.”
- Jonathan Davies, Head of Currency, Global Investment Solutions (London)”There are two key themes driving currency investing right now. First, the search for carry has been a major driver to returns this year, since the carry trade has provided strong performance so far in 2014. Secondly, central bank divergence is likely to become increasingly important as the market focuses more on the prospect of G4 central banks quitting their ultra-easy monetary policies at different times.”
About UBS Global Asset Management
UBS Global Asset Management is a large-scale asset manager with well-diversified businesses across regions, capabilities and distribution channels. It offers investment capabilities and investment styles across all major traditional and alternative asset classes. These include equity, fixed income, currency, hedge fund, real estate, infrastructure and private equity investment capabilities that can also be combined into multi-asset strategies. The Fund Services unit provides professional services, including legal fund set-up, accounting and reporting for traditional investment funds and alternative funds.
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About the Cyclical Market Forum
Assessing the economic and market environment is a key part of UBS Global Asset Management’s investment strategy-setting process across all investment areas. Our Cyclical Market Forum, open to representatives of all investment teams, regularly debates important economic and market themes and their potential impact on our investment strategies. The Forum’s purpose is to examine the main economic and market drivers – typically through scenario analysis over a 12- to 18-month time horizon – and to foster debate between the teams managing different asset classes. The three economic scenarios discussed should not be considered forecasts.
The way in which the output from the Forum is used varies across UBS Global Asset Management’s investment teams and it is just one of a number of inputs into each team’s investment process. One of the key benefits of the Cyclical Market Forum is the opportunity to exchange research and viewpoints from the various investment specialists and to examine the intersection between top-down and bottom-up drivers. As such, it broadens the input into our strategy-setting process in a structured format.