While risk-on has been a successful strategy since September, UBS' Stephane Deo is growing more cautious. The positives of activity improvement, reduction of political risks, and positioning are now considerably less convincing, and Deo is worried about a potential 'pocket of air' in the market in the near future. They lay out five reasons to be concerned from sentiment and valuation to political concerns in the US and Europe along with fundamental macro deterioration.
Via UBS' Stephane Deo,
Reason #1: US debt ceiling
One of our main worries is complacency over the US debt ceiling debate. We think this could prove much more difficult and damaging than many think. Our conversations with investors lead us to think that the market has adopted a very sanguine approach; by sharp contrast, what we hear from UBS' Office of Public Policy in Washington seems to point to much more troublesome issues. There are a number of signposts to keep in mind, the following table summarises the key ones.
[7]
Can things get resolved before the March 27th deadline? It is difficult to make this the central case scenario. In March we face the prospect of difficult negotiations and lots of partisan noise from the Hill. Ultimately we believe that a temporary government shut-down at the end of March should be regarded as the central case scenario. We believe that the negotiations to replace the sequester will eventually lead to a package close to but below $1 trillion, while the initial plan is a cut of $1.2 trillion. This is likely to include some partial reversal of the 2013 sequestration. We do not believe substantial sources of new taxes will be included given dissent on substance and process within Democratic ranks and strong opposition to tax increases among Republicans (although increased revenue through closing small tax loopholes is possible).
In terms of timing, if the above scenario indeed unfolds, the climax of the crisis is likely to come in mid-to-end July when the debt ceiling can’t be postponed further. From a market point of view, this means that the noise from Washington is likely to mount in Q2, but if one thinks about a “July-2011” moment, this is more likely to come later, during the summer. A reduction of risk in the portfolio such as the one we propose below, hence plays to some extent on the market’s expectations as the most rancorous parts of the negotiation are still a few months away.
Instead of being solved as described above, Congress and the Administration might not reach an agreement. In the no-agreement scenario after a raucous debate and government shut-down the debt ceiling would again be extended for a short period of time. This would avoid a major crisis and gridlock, but it would mean uncertainty on the timing and results of the negotiation. It would also keep the market on their toes. How long could this scenario last? Partisan deadlock could be protracted; however we believe that the funding difficulties of the government would reach a climax in the middle of the summer when the administration would have exhausted “exceptional measures” to fund the expenses. At this point, as in 1995, questions about a potential default would become pressing and certainly an agreement would be forced. But this, again, can be postponed with a suspension of the debt ceiling. In truth, it is very difficult to identify a true deadline in the process.
During the process, there could be talk about the US defaulting on their debt. We think this is a very remote possibility and we would attach a negligible probability to a default. The sequestration is not a source of concern on that front. It would cut spending, hence have no impact on the government’s ability to service the debt; arguably it would even raise the ability of the government to service the debt as some expenses would disappear. The risk stems from the debt ceiling: when reached, the funding of the government would come exclusively from tax receipts. The government could only borrow at the rate that bonds mature. Because debt service is one of the top priorities it is difficult to imagine a situation in which tax receipts would not be sufficient to cover debt repayments. If such an unlikely situation were to occur it is even unclear if US default would be possible. Indeed article XIV-4 of the constitution says that “The validity of the public debt of the United States, authorized by law, [..], shall not be questioned.” Hence the means to service debt could be provided. In summary, talks about a US default can certainly become fashionable, rating agencies might also take the opportunity to downgrade the US again, but in truth we think that even a technical default is extremely unlikely.
[8]
The first channel is simply economic growth. The sequestration, if fully implemented is expected by UBS US Chief Economist Maury Harris to impact GDP by 0.4%. Arguably this would not be such a sizeable impact: the current US growth forecast for 2013 stands at 2.3% while the latest consensus is at 2.0%: the potential impact of the sequestration would thus be (give or take a decimal point) the gap between our forecast and the Street’s. This is however a bit simplistic. The time-lag of the impact means that most of the effect will be felt later, falling mostly in 2014. Because 2014 is an election year, we very much doubt that Congress would be willing to inflict too much damage on the economy and that Congress will be strongly motivated to remove part of the sequester. Finally, let’s not forget that the Fed is still doing QE at full speed. We expect the QE programme to be reduced during the second half of the year, but that forecast is based on the view that the economy is growing close to 3% in H2 this year. If the fiscal tightening proves damaging, Fed QE is likely to last longer, at least partly compensating the fiscal drag.
In short, we do not see the sequester as a material source of concern. It could hurt our forecast at the margin, but certainly would not substantially change our view.
The second channel would be via volatility. Historical precedents are quite telling. In the chart below we simply take the VIX as an illustration. The previous two peaks in volatility were registered on August 8th 2011 and on December 30th 2012. The first one is just after the downgrade of the US in the wake of the debt ceiling negotiation. The elevated level of VIX at the time was also partly to be blamed on Europe, as Italy was put under pressure during the summer of 2011. The second peak is the latest fiscal cliff negotiation at the end of last year.
[9]
The third and last channel would be via portfolio allocation. This is very much linked to the previous argument: a surge in volatility would trigger a risk-off move like it did in August 2011. We however note that the fiscal cliff negotiations at the end of last year did not prompt such a move.
Conclusion: as the deadline (or we should say the deadlines) approaches, we are becoming uncomfortable with our risk-on position. This has worked very well indeed recently, but there is an increasing rationale for neutralising our position and removing part of the risk from our portfolio. After the almost uninterrupted equity rally we have enjoyed since mid-June, valuations are not as compelling any more and a technical pull-back is a distinct possibility.
Reason #2: end of QE
The UBS economic team took the view a while ago that QE could be reduced during the second half of the year. This is based on the view that the economy will be growing at close to 3% during the second half of the year with the labour market continuing to create jobs on a steady base.
Last week’s FOMC minutes surprised the market showing that the Fed is divided between those who would like to reduce the current balance sheet expansion, and those who would like to continue QE at the current pace: “…many participants also expressed some concerns about potential costs andrisks arising from further asset purchases.”
We also note that even once-dovish Fed members like Bullard have been talking about the exit strategy. This means that the balance of power is gradually shifting and a continuation of reasonable growth with job creation above 150k a month should continue to tilt the FOMC towards considering a reduction of QE in H2 this year.
Apart from the obvious direct impact on FI products, we identified essentially two asset classes that are impacted by QE: EM equity and commodities. We do not believe that QE has had a large market impact this time around, for more on this topic please refer to our publications last summer.
Reason #3: some European risks
While we thought a number of political risks were receding or disappearing at the turn of the year, the Italian elections came as a wake up call: political risks are now back on the agenda in Europe. Essentially there are three main countries that could provide short-term risk.
[10]
- Italy: this week’s elections have created an upper house that will be very difficult to govern. The market reacted predictably on the news with Italian spreads widening, stock markets plunging, EUR sliding and volatility spiking. On a fundamental note we are not that worried: Italy has the largest primary surplus of OECD countries, a deficit low enough this year to stabilise the debt to GDP and no issue with the current account. In short this is not a repeat of Q2 last year when markets plunged on the back of the Greek elections, the Italian situation is considerably different on the economic front. However this leaves us with considerable uncertainty, a country unlikely to make further progress in terms of reforms, and many reasons to worry about yet another surge in political turmoil in Europe. In short we are more worried about sentiment than fundamentals, but that is more than enough to roil markets.
- Spain: UBS FI strategists think Spain needs to issue €135 billion this year vs. c€80 billion last year (note that this is based on a 6% deficit, the government is currently targeting €121bn, based on a 4.5% deficit). This seems very difficult to achieve without external help. So far Spain has been able to tap the market and is in advance of its funding programme, and surprisingly to us, this has been mainly on the back of foreign buying. We also note that a number of local authorities are very advanced in their funding programme. All this seems positive. We still believe however that the economic situation is challenging despite some noticeable improvements (see two charts below for example) and we think that Spain will be forced at some point to request external help, i.e. call for OMT. Calling the OMT is unlikely to be pre-emptive, it will come via a crisis with markets compelling Spain to ask for help. The spark could come from further downgrade, which would push Spain into junk, and force some investors to exit their positions as Spain falls out of benchmarks. However, as soon as the OMT is put in place markets should calm down. We do not think this will trigger a long-lasting crisis like the one we saw during the second half of 2011.
- Cyprus: Here again the fundamentals are not worrying, simply because the numbers involved are minuscule compared to Euro zone aggregates. Cyprus however could be yet another important source of risk. First because the negotiations with the Troika could once again be difficult and long-lasting, exposing the lack of leadership in Europe. Second, because the solution might include some bailing of debt bank holders or some restructuring of the public debt. Here again the real impact on the financial sector would be negligible, but this would open again the Pandora’s box of discussions about country default; the risk is if the market extrapolates the Cyprus example to other countries.
In short, there are plenty of reasons to believe that Europe will once again provide negative news flow in the near future and cause market volatility.
[11]
In short Europe will certainly provide further sources of volatility and market unrest, but we think the potential of Europe to generate global systemic risks has declined considerably.
Reason #4: economic activity is less convincing
There has been no significant change in the UBS economic team’s forecasts since the beginning of the year. We still expect the world economy to grow at 3.0% this year and 3.4% next, which is very close to trend. What has changed though is the news flow and the momentum. The chart below shows our global growth surprise index: it increased rapidly in October, continued to progress albeit more slowly in November and December, but has been very slow so far this year.
[12]
Part of our call was based on the idea that the economy was accelerating. Data are still consistent with this idea, although the reservoir for positive surprises seems to be exhausted to a large extent.
Reason #5: sentiment and valuation
Our equity strategists have flagged warning signals from their bull/bear and relative strength indicators.
There is little information to be gathered from equity valuations. The following chart shows that the world P/E is somewhat cheap, but this is just 0.34 standard deviations away from the long-term average. We would argue that there is no compelling valuation argument one way or another.
[13]
Similarly from a regional perspective there are no particularly compelling valuations. For example the US is trading on 15.3 times, which is just below its long-term P/E average of 16.7 (note that this is the average of the MSCI USA index since 1970, one might question if that is really “long-term”, another source of data gives us an average P/E of 17.3 since 1990). This is indeed about 1/4 standard deviation away from the long-term average, providing no compelling signal.
Relative to the US, Europe is also close to its long-term P/E average. Europe traditionally trades at a discount; we find that, on average over the past 10 years, the discount was 1.9 times, it is now 1.8. Hence regional valuations are not particularly helpful at the moment in terms of providing decisive view. In short, we believe market valuations do not provide a trading signal because they are too close to what we could consider as being “fair”. There is no clear evidence that markets are cheap, nor is there evidence that markets are expensive.