Coming in a little late to the game, UBS' Investment Bank division today released its top 5 themes and 19 trades for 2018. Not surprising from the bank whose base case S&P forecast is 2,900 one year from now (with potential upside to 3,200), and who just told CNBC that "valuations are still somewhat cheap", the bank is optimistic, if not "rationally euphoric" and writes that it all boils down to one question: will the Kool-Aid party continue, or "will underlying macro shifts reveal fragilities in asset valuations" and more specifically, will the yield curve invert. To wit:
The key macro issue for investors in 2017 was the likelihood of "global reflation" and its form. At the time, we urged investors to invest in growth, but fade expectations of higher inflation. In 2018, the pivotal question is: Is there macro room for markets to grow, or will underlying macro shifts reveal fragilities in asset valuations?
And before UBS clients get nervouse by this rhetorical question, the bank adds that it thinks "yes there is room to grow", and "we remain broadly constructive risk assets."
Solid growth, relatively low core inflation, and easy financial conditions imply a continuation of the low vol regime that has supported risk assets (Figures 1 & 2). Although many are concerned about the rise in P/Es, we have shown that high P/Es amid lower growth are a rational reflection of the low risk-free rate regime, not a source for concern. Although we remain constructive equities, given some potential slowing in global growth momentum, we see 10% returns as more likely in 2018 than a repeat of 2017's nearly 20% return.
That said, it concedes that "the starting point for markets is more challenging than it was before, as the flattening of the US curve makes cross-asset hedges and portfolio construction more difficult."
During the past two years, long duration positions have paired well with bullish risk positions, and we have argued for this combination. Long duration remains the best hedge to an equity sell off, and we continue to favor the combination of long equities and curve flatteners in the US. Fed tightening against a backdrop of low inflation has helped keep inflation expectations low. Low inflation expectations have helped anchor back-end yields, supporting equities, and this has in turn fed back to more rate hikes. At current levels, however, the risk/reward is not as good as it was previously.
With that caution in mind, here are UBS' Top 5 Themes for the coming year.
Theme #1: Room to grow
- Despite the length of the recovery, global growth can continue to expand amid very few signs of excess in the real economy. We run macro screens to identify the best risk-reward trades. We find that the path for commodity currencies, US industrials, and Japanese rates is likely to steepen.
- FX: Long BRL and CLP versus short USD and JPY
- Rates: Position in 1yr forward 5s10s curve steepener in Japan
- Equities: Long US industrials (XLI) versus utilities (XLU)
Theme #2: Gradual policy normalization
- Easy financial conditions allow central banks to tighten, while low inflation allows optionality to reverse course, should financial conditions consolidate in an unwarranted fashion. Yields may rise above forwards in H2, but paying bonds does not offer good risk/reward. We position for US long-term yields staying in ranges as front-end rates rise, and we are long Russian 10-year bonds. Absent substantial pressure from US yields, local policy dynamics create opportunities in Brazil & Japan equities. FX feedback loops to inflation should keep SEK & NOK in ranges.
- FX: Short EUR/NOK and EUR/SEK volatility
- Rates: Short US rates vol via 6m strangles on 30y rates; Long 10yr Russian OFZs
- Equities: Long Brazilian (Bovespa) and Japanese (Nikkei) equites
Theme #3: European growth is broadening
- Markets remain sceptical around the riskier parts of European markets, but growth is broadening. In 2018, several areas of investor concern (debt sustainability, balance sheets) are likely to improve cyclically. We see opportunity in moving up the risk spectrum (Greek bonds, Italian banks), positioning for a steeper curve, and EUR strength (CEE vs USD and CHF).
- FX: Long CZK and PLN versus short CHF and USD
- Rates: Position in 3yr forward 5s30s EUR IRS steepeners; Long Greek govt bonds (22s)
- Equities: Long Italian banks (IT8300)
Theme #4: China rebalancing
- Chinese growth has significantly rebalanced toward consumption. This should continue to support China consumption-related assets and help keep macro and EM vol low.
- FX: Long NZD versus short TWD
- Rates: Long EMBI (EMB) versus short US high yield (HYG)
- Equities: Long Korean equities (Kospi) and European autos (SXAP)
Theme #5: Having our cake and eating it too
- Our recommendations are broadly pro-cyclical, yet we are more selective versus past Top Trades. We seek some balance to our recommendations with positions that offer asymmetric payoffs in a downturn, but which can trade flat or positive in our base case.
- FX: Long USD/CAD
- Rates: Position in UST 2s10s flatteners
- Equities: Long a FTSE put contingent on lower GBP/USD
Some more detail.
While theme #1 is self-explanatory as it is the basis for the bank's entire optimistic outlook for the coming year, here is why UBS is confident that policy normalization - arguably the biggest risk cited by many investors - should not prove to be too challenging.
A combination of solid growth, low but gently rising core inflation, and easy financial conditions should allow policymakers to continue normalizing at a gradual pace and without accident. This should help keep volatility low, and has important market implications. Much has been made among investors regarding policy normalization, with many arguing bond bubbles will burst, sending stocks lower.
Such an interpretation is a very low likelihood outcome, in our view. Indeed, thinking about the four possible combinations of directional outcomes for stocks and bonds, this remains the lowest probability of the four in our view. Although at its peak QE helped term premia compress by about 150bp on average in G4 bond markets, and this term premium compression, in turn, helped account for a significant proportion of valuation expansion across equity markets, we do not think of the unwind of QE as the reverse process of the QE build-up. The effects of QE are unlikely to reverse abruptly, and more important, the unwinding is occurring as the growth environment improves, which allows for offsetting valuation improvements.
In addition, slower trend growth and low inflation imply lower terminal rates at the end of the cycle. In our estimates, even assuming that inflation eventually converges back to 2%, terminal rates in the US are likely to hover around 2.25% and around 1.75% in the Euro-area (Figure 13 and Figure 14).
Finally, the increase in term premia from the Fed's balance sheet unwind will likely be modest. Markets are already anticipating balance sheet unwind of meaningful size, and our economists argue that the actual decline in UST holdings may be smaller than the market assumes.
For markets, this implies that volatility should remain low, and although we expect higher back-end yields—particularly in Europe, but also in the US—the rise should be gradual and leave yields at a still low level. We express this through short-vol trades in FX and rates, and long equity positions in markets that should perform well in a backdrop of solid global growth and gradually rising rates.
We'll just timestamp that assumption and revisit in one year. Sarcasm aside, UBS has an interesting discussion on how much higher the Fed will be able to hike before it is forced to stop.
Perhaps the most direct market implication of continuing gradual policy normalization is in the rates market. Despite many predictions of huge increases in volatility in rates following the start of policy normalization, this has been far from the case, as low inflation, low inflation volatility, and well-telegraphed balance sheet normalization have helped anchor fixed income volatility.
All three should continue in 2018. Our economists expect only a very modest rise in core inflation during 2018 (core PCE reaching only 1.75% by end-2018). Inflation expectations remain low and upside risks to inflation are limited as headline inflation volatility has been declining. Moreover, with terminal nominal rates now much lower (we estimate 2.25%), volatility should be anchored lower, as Fed policy normalization will be need to be more gradual than in the past, as we are not far from the final destination.
Finally, and as we have been arguing for a while, balance sheet unwind is well priced, and the combination of these factors should limit back-end interest rate term premium.
How about curve flattening, and subsequent inversion? Yes it will continue, but no, it won't invert.
We have been recommending 2s10s UST curve flatteners, both in combination with long positions in risk assets, as well as on their own, and we still like this trade. Continuing Fed hikes against a backdrop of relatively low inflation should keep flattening pressure on the curve.
In the Macro Outlook 2018, we outlined that the gradual US policy normalization should continue as the global economic outlook is much more balanced for the coming year. As was the case at the start of the 2017, front-end rates in US are low in the current backdrop, and with financial conditions easy. Moreover, we see that relative to the US labour market slack in 2004-2007 hiking cycle, both 2s10s, 5s30s nominal/real curves are fairly steep (Figure 47).
Even with three realized hikes this year and relatively easy financial conditions, the bond market is only pricing in about 2.3 hikes for 2018 and 2019, cumulatively. In comparison, both our economics team and the Fed have penciled in five total hikes during that period. With our narrative of continuing global growth, we think the market is underpriced in the front end.
Meanwhile, 5y5y nominal rates are now trading close to 2.75%, which is at the Fed's terminal nominal rate and is above our estimate of a 2.25% terminal rate. Given subdued inflationary impulse, we think continued policy normalization with job market gains is much more likely to result in a flatter yield curve. A potential concern for the trade is balance sheet unwind, but we think balance sheet unwind is well priced, and thus this yield curve should be driven more by shifts in Fed hike expectations and inflation expectations.
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Ok, we get the optimism, but surely there must be some risks? This is what UBS goalseeked to fill a few pages of 'risk factors':
We remain broadly constructive on the global macro and market outlook. Our first four themes reflect this, with the vast majority of our trades positively correlated with global equities and global risk. What are the risks to such a portfolio? Beyond political events such as Brexit, we see three main risks:
- A growth slowdown. Many of our trades, particularly in themes #1 and #3 are positively correlated to a better growth backdrop, and a sharp slowdown in global growth would significantly challenge them, as well as potentially our trades depending on low volatility, though depending on the depth of the slowdown, the EM rates receiver trades could perform well.
- A rise in inflation not accompanied by strong growth. The degree to which policy makers can control the pace of policy adjustments is key. An unexpected spike in inflation that drives expectations and bond yields higher could be particularly damaging, as it could unlock corrections in asset premia, without a positive growth offset.
- Fed overtightening. This is a risk that we have written about previously, and view as important to watch. Despite many worrying about higher inflation, inflation rates continue to realize below-market expectations globally, and core inflation remains below target.
So far, this has been supportive of risk markets, as Fed tightening against a backdrop of low inflation has helped keep inflation expectations low, which has helped anchor back-end yields, supporting equity valuations. If, however, the combination of Fed hikes and lower-than-expected core inflation readings were to persist, it risks dis-anchoring inflation expectations lower, similar to what happened in late 2015/early 2016 (Figure 43).
Our metric that shows the impact of inflation surprises on inflation expectations is helpful in identifying the degree to which this risk is concerning. The measure (Figure 44) has been intensifying recently, and while it is not worrying or close to 2016 levels, it is important to watch. Cognizant of the above, and that equities and risk assets have had a strong run, we look for trades that have asymmetric payoffs in a global risk-off backdrop, but won't perform poorly (or can profit) in our base case of a benign global backdrop.
As a result, UBS's proposed "risk" trades are the following:
- FX: Long USD/CAD
- Rates: Position in UST 2s10s flatteners [see above]
- Equities: Long a FTSE put contingent on lower GBP/USD
While the details can be found in the full report, here is a summary of the top themes and the associated 19 trades: