Waiting on the Fed - Sheeo 145 McLoughlin.pdf · And crude oil prices decline, a net ... 1990 1992 1994 1996 1998 2000 2002 2004 2006 ... −Structural reforms in EM lead to better

CIO Wealth Management Research

Tom McLoughlin

Fixed Income Investments in an Uncertain World Waiting on the Fed

July 2015

1

An uncertain world …

Uneven

economic

growth

Divergent

monetary

policies

Competing

labor forces

Inconsistent

fiscal policies

Geopolitical

tensions

Increased

volatility

Source: UBS CIO WMR, as of June 2015 1

2

The big picture: the Fed is keenly aware of the fact that …

Global growth remains uneven

Monetary policies around the world are diverging

Geopolitical risks are on the rise in the Eurozone, Russia, and the Middle

East

Currency values are moving in different directions, and

Demand for labor is evolving as the economy is buffeted by technological

change

2

Let's take a closer look at the last item…

Source: UBS CIO WMR, as of June 2015

3

Technology adoption is faster

Source: Citigroup Global Perspectives, UBS CIO WMR, as of April 2015 3

Time to reach 50 million users

Telephone

TV

Internet

Facebook

Angry birds

Radio

75 years

38 years

3.5 years

13 years

4 years

35 days

4

Triggering some creative destruction

Source: Brynjolfsson and McAfee, The Second Machine Age, UBS CIO WMR, as of April 2015 4

2004 2008

Music sales on physical media

In music …

800M units

$12.3B in sales

400M units

$7.4B in sales

5

In books …

Creative destruction


Amazon.com

2,000,000 titles

Barnes & Noble

NYC Flagship

store : 40,000

titles

6

Creative destruction


In photography …

Through 2014, there were 3.5 trillion photographs taken since the first image

was captured in Paris in 1838

10% of that total were taken in the last 12 months

Eastman Kodak employed 145,300 employees and had a market share of

90% at its peak

The company invented the digital camera in 1975 but shelved the idea

Today 2.5 billion people have the capability of taking digital photographs and

Kodak is a shadow of its former self

7

Economic Drivers in an Era of Accelerating Technological Change


Intellectual property

• Patents

• Copyrights

Efficiency

• Automation – auto assembly

• Self service – airline check-

in

• Mobility – RFID, airline bag

tags

Business model

• User generated content

− Yelp, Trip Advisor

• Online delivery of services

− Amazon.com

8

Creating winners and losers

Source: Citigroup Global Perspectives, UBS CIO WMR, as of April 2015 8

1990 2015

Big 3 Automakers Big 3 Tech Companies

Employees: 1.2 million

Market Cap: $36B

Employees: 137,000

Market Cap: $1.3T

9

Squeezing the middle class and altering labor demand


In high demand

Engineers

Plumbers

Electricians

Dentists

Gardeners

In less demand

Bookkeepers

Bank tellers

Billing clerks

Telephone operators

Assembly line workers

10

Factors driving rates in the United States

• Unemployment rate falls

• Private sector job creation

• Subdued inflation

• The flight to safety

• A strengthening dollar

• ECB engages in QE

• Portfolio rebalancing

• Harsh winter slows growth


11

Source: Bloomberg, UBS CIO WMR, as of 26 June 2015

Note: PCE (YoY%) and PCR Core (YoY%) as of 31 May 2015

A low inflation rate encourages patience by the Fed

11

-1

0

1

2

3

4

5

6

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

PCE (YoY%) PCE Core (YoY %) Fed Inflation Target

12

North American oil production In million barrels per day

Crude remains under pressure

WTI crude price

And crude oil prices decline, a net positive for the US


Note: North American oil production data as of 31 May 2015

12

1

2

3

4

5

6

7

8

9

10

1995 2000 2005 2010 2015

Barrels per day

0

20

40

60

80

100

120

140

160

2000 2005 2010 2015

WTI Crude Price

13

Meanwhile, while central bank assets have increased …

Total assets of global central banks $ in billions


Note: Central Banks asset data as of 30 April 2015 13

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

2005 2007 2009 2011 2013 2015

PboC ECB Fed BoJ

14

… global monetary policies are now diverging

Source: UBS Investment Research, UBS CIO WMR, as of 31 March 2015 14

15

Payrolls have continued to trend higher despite the recent data US non-farm payrolls


Note: Non farm payrolls data as of 31 May 2015

The economic expansion in the US appears durable …

15

(1,000)

(800)

(600)

(400)

(200)

0

200

400

600

2008 2009 2010 2011 2012 2013 2014 2015

Non farm payrolls 12-month moving average

16

Government bond yield curves

… and puts the Fed is on path towards normalization

Source: Bloomberg, UBS CIO WMR, as of 24 June 2015 16

(0.5)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 30Y

US Germany Japan Italy

17

… leaving the front end of the curve more exposed …

Source: UBS CIO WMR, as of 24 June 2015 17

(0.5)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

0 5 10 15 20 25 30

Spot Fwd (3 mo) Fwd (6 mo) Fwd (9 mo) Fwd (1 yr)

Maturity (years)

Yie

ld t

o m

atu

rity

(%

)

18

1yr forward curve today vs. spot curve on 9/5/2013

… as investors expect the Treasury curve to flatten

Source: UBS CIO WMR, as of 25 June 2015 18

0

0.5

1

1.5

2

2.5

3

3.5

4

2 Yr 5 Yr 10 Yr 30 Yr

6/25/2016 9/5/2013

Maturity (years)

Yie

ld t

o M

atu

rity

(%

)

19

Total return by fixed income sector

Total Return In %

Source: BofAML, Bloomberg, UBS CIO WMR, as of 24 June 2015 19

-10% -5% 0% 5% 10% 15% 20%

Treasuries

TIPs

Agencies

Investment Grade

High Yield

Preferreds

Emerging Markets

Build America Bonds

Munis

Taxable FI Agg

S&P 500

2015 YTD TR 2014 TR

20

Yields have continued to trend lower


10 year Treasury yields Average yield per year, in %

0

2

4

6

8

10

12

1980 1985 1990 1995 2000 2005 2010 201510 yr treasury yield

21

Biggest challenge: where to find income?

Source: BofAML, UBS CIO WMR, as of 24 June 2015

Yield-to-worst Yield, in percent

0

1

2

3

4

5

6

7

22

The zero rate policy fuels higher volatility …

The number of times volatility has risen above the average has been greater post crisis


Note: MOVE Index and 10-year Treasury Volatility data is monthly as of 31 May 2015

22

Volatility levels and Average over the past 12 years

1.4

2.4

3.4

4.4

5.4

6.4

7.4

8.4

9.4

10.4

11.4

12.4

13.4

14.4

50

100

150

200

250

May-03 May-04 May-05 May-06 May-07 May-08 May-09 May-10 May-11 May-12 May-13 May-14 May-15

MOVE Index MOVE Index Avg 10-year Treas Vol 10-year Vol Avg

Post Crisis Pre-Crisis

23

… but the next tightening cycle should be more gradual


Note: CPI data as of 31 May 2015

Inflation rate is more subdued than in past

23

-3

-2

-1

0

1

2

3

4

5

6

7

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Tightening Cycles CPI YOY Avg. Fed tightening cycle inflation rate

24

Our Outlook: "Will, Won't, Might"

Source: UBS CIO WMR, as of 24 June 2015

• Will happen

− Global growth continues, led mainly by developed economies

− The Fed tightens gradually while other central banks ease

− The US dollar remains strong and trades in a narrow range

− European equities get a boost from a lower euro

• Won't happen

− Inflation becomes a global problem

− The Federal Reserve tightens monetary policy too soon, too much, too fast

− The S&P 500 delivers better than average returns without volatility

• Might happen

− Structural reforms in EM lead to better earnings outlook & investor sentiment

− Long-term interest rates don't budge even if Fed raises the short end

− European economic growth accelerates, providing support to the euro

24

25

Preferred investment views

Please see important disclaimer and disclosures at the end of the document.

Recent upgrades Recent downgrades

• GBP ()

• Government bonds • US high yield

• US investment grade

• US senior loans

• Beyond benchmarks

Most preferred Least preferred

• US small caps

• Eurozone

• The rising Millennials

• North American energy

independence

• US capex

• Cancer therapeutics

• Environmental opportunities ()

• Emerging Markets

• UK

Equities

Fixed income

Foreign exchange • AUD ()

Cash

Alternative

investments

Portfolio weights

Source: WMA Asset Allocation Committee (AAC) and UBS CIO WMR, as of 25 June 2015

Note: Portfolio weightings are for USD-based

moderate risk profile, taxable account For portfolio

weights related to other risk profiles please see

the flagship publication UBS House View.

25

Source: UBS CIO WMR

26

The pace of muni mutual fund outflows is far smaller than in 2013

Source: Investment Company Institute, UBS CIO WMR, as of 15 June 2015

Note: June MTD flows are as of 3 June 2015 26

0

1

2

3

4

5

6

-20000

-15000

-10000

-5000

0

5000

10000

Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15

Monthly Net New Cash Flow AAA GO 30yr Monthly Yields

Meredith Whitney

"60 minutes"

interview

Rate volatility

Historically low yields

27

New issue supply running ahead of last year's levels…

Source: Bond Buyer, UBS CIO WMR, as of June 19 2015 27

… primarily driven by refundings

0

10

20

30

40

50

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Total Issuance 2013 Total Issuance 2014 Total issuance 2015

28

AAA muni-to-Treasury yield ratios remain elevated

Source: MMD, UBS CIO WMR, as of 15 June 2015 28

80

85

90

95

100

105

110

115

Jun-14 Aug-14 Oct-14 Dec-14 Feb-15 Apr-15 Jun-15

AAA GO 10 yr - Treasury 10 yr AAA GO 30 yr - Treasury 30 yr

1-year avg for 10 yr 1-year avg for 30 yr

29

Credit quality spreads have narrowed in recent years

Source: MMD, UBS CIO WMR, as of June 22 2015 29

0

50

100

150

200

250

Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15

BAA GO 10 yr - AAA GO 10 yr A GO 10 yr - AAA GO 10 yr AA GO 10 yr - AAA GO 10 yr

30

S&P 10-year default rates of munis vs. corporates

Source: S&P, 2014 Annual U.S. Public Finance Default Study and Rating Transitions, 5 May 2015, and Annual U.S. Corporate

Default Study and Rating Transitions, 12 May 2015, UBS CIO WMR 30

0.00%

0.03%

0.09%

0.42%

0.14%

0.87%

1.11%

2.01%

4.84%

2.81%

AAA

AA

A

BBB

InvestmentGrade

Municipal US Corporate

31

Hot topics in muni credit – mostly Illinois and Puerto Rico

32

Important Information

32

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Strategic asset allocations represent the longer-term allocation of assets that is deemed suitable for a particular investor. The strategic asset allocation models discussed in

this publication, and the capital market assumptions used for the strategic asset allocations, were developed and approved by the WMA AAC.

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five different Investor Risk Profiles ranging from conservative to aggressive. In general, strategic asset allocations will differ among investors according to their individual

circumstances, risk tolerance, return objectives and time horizon. Therefore, the strategic asset allocations in this publication may not be suitable for all investors or investment

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please consult your UBS Financial Advisor to see how these weightings should be applied or modified according to your individual profile and investment goals.

The process by which the strategic asset allocations were derived is described in detail in the publication entitled “UBS WMA’s Capital Markets Model: Explained, Part II:

Methodology,” published on 22 January 2013. Your Financial Advisor can provide you with a copy.

Deviations from strategic allocation

The recommended tactical deviations from the strategic asset allocation are provided by the Global Investment Committee and the Investment Strategy Group within Wealth

Management Research Americas. They reflect the short- to medium-term assessment of market opportunities and risks in the respective asset classes and market segments.

Positive / zero / negative tactical deviations correspond to an overweight / neutral / underweight stance for each respective asset class and market segment relative to their

strategic allocation. The current allocation is the sum of the strategic asset allocation and the tactical deviation.

Note that the regional allocations on the International Equities page are provided on an unhedged basis (i.e., it is assumed that investors carry the underlying currency risk of

such investments). Thus, the deviations from the strategic asset allocation reflect the views of the underlying equity and bond markets in combination with the assessment of

the associated currencies. The two bar charts (“Equity regions” and “Bond regions”) represent the relative attractiveness of countries (including the currency outlook) within a

pure equity and pure fixed income portfolio, respectively. In contrast, the detailed asset allocation tables integrate the country preferences within each asset class with the

asset class preferences stated earlier in the report.

33

Disclaimer

33

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Waiting on the Fed - Sheeo 145 McLoughlin.pdf · And crude oil prices decline, a net ... 1990 1992 1994 1996 1998 2000 2002 2004 2006 ... −Structural reforms in EM lead to better

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