Waiting on the Fed
Fixed Income Investments in an Uncertain World
Tom McLoughlin
CIO Wealth Management Research
April 2015
An uncertain world …
Uneven
economic
growth
Divergent
monetary
policies
Inconsistent
fiscal policies
Competing
labor forces
Geopolitical
tensions
Increased
volatility
Source: UBS CIO WMR, as of April 2015
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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
Let's take a closer look at the last item a little more
closely …
Source: UBS CIO WMR, as of April 2015
2
Technology adoption is faster
Time to reach 50 million users
Telephone
75 years
Radio
38 years
TV
Internet
Facebook
Angry birds
13 years
4 years
3.5 years
35 days
Source: Citigroup Global Perspectives, UBS CIO WMR, as of April 2015
3
Triggering some creative destruction
In music …
Music sales on physical media
2004
2008
800M units
$12.3B in sales
400M units
$7.4B in sales
Source: Brynjolfsson and McAfee, The Second Machine Age, UBS CIO WMR, as of April 2015
4
Creative destruction
In books …
Barnes & Noble
NYC Flagship
store : 40,000
titles
Amazon.com
2,000,000 titles
Source: Brynjolfsson and McAfee, The Second Machine Age, UBS CIO WMR, as of April 2015
5
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
Source: Brynjolfsson and McAfee, The Second Machine Age, UBS CIO WMR, as of April 2015
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Economic Drivers in an Era of Accelerating Technological Change
Intellectual property
• Patents
• Copyrights
Efficiency
Business model
• Automation – auto assembly
• Self service – airline check-
• User generated content
− Yelp, Trip Advisor
• On-line delivery of services
− Amazon.com
in
• Mobility – RFID, airline bag
tags
Source: UBS CIO WMR, as of April 2015
7
Creating winners and losers
1990
2015
Big 3 Automakers
Big 3 Tech Companies
Employees:
Employees:
1.2 million
137,000
Market Cap:
Market Cap:
$36B
$1.3T
Source: Citigroup Global Perspectives, UBS CIO WMR, as of April 2015
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Are we measuring economic activity properly?
Question
How much would you pay (or more accurately, would have paid)
for services now available for free on the Internet?
Answer
In a McKinsey survey, the answer was: $50 per month or an
estimated $35 billion annually.
Source: Brynjolfsson and McAfee, The Second Machine Age, UBS CIO WMR, as of April 2015
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Squeezing the middle class and altering labor demand
In high demand
Engineers
Plumbers
Electricians
Dentists
Gardeners
Source: UBS CIO WMR, as of April 2015
In less demand
Bookkeepers
Bank tellers
Billing clerks
Telephone operators
Assembly line workers
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Factors driving rates in the United States
•
•
•
•
•
•
Subdued inflation
The flight to safety
A strengthening dollar
ECB engages in QE
Portfolio rebalancing
Harsh winter slows growth
• Unemployment rate falls
• Private sector job creation
Source: UBS CIO WMR, as of April 2015
11
A low inflation rate encourages patience by the Fed
Source: Bloomberg, UBS CIO WMR, as of 31 March 2015
12
And crude oil prices decline, a net positive for the US
Crude remains under pressure
WTI crude price
North American oil production
In 1,000 barrels per day
160
10,000
9,000
140
8,000
120
7,000
100
6,000
80
5,000
4,000
60
3,000
40
2,000
20
1,000
0
1990
1995
2000
2005
2010
2015
Source: Bloomberg, UBS CIO WMR, as of 8 April 2015
0
2000
2003
2006
2009
2012
2015
13
But alters the outlook for the Eurozone, Russia, and Middle
East
Russian equity market and the ruble
Historical levels
Great default looms, exit risk moderate but rising
Greek 10-year government bond yield
13
1600
3.5
1400
3.0
1200
2.5
1000
2.0
800
1.5
12
11
10
9
8
7
6
5
Jan-14
Apr-14
Jul-14
Oct-14
Jan-15
Apr-15
Source: Bloomberg, UBS CIO WMR, as of 8 April 2015
1.0
600
Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15
RTS index (lhs)
14
Meanwhile, while central bank assets have increased …
Total assets of global central banks
$ in billions
16,000
14,000
12,000
10,000
8,000
6,000
4,000
2,000
0
2005
PBoC
2007
ECB
Fed
2009
2011
2013
2015
BoJ
Source: Bloomberg, UBS CIO WMR, as of 8 April 2015
15
… global monetary policies are now diverging
Source: UBS Investment Research, UBS CIO WMR, as of 31 March 2015
16
The economic expansion in the US appears durable …
Payrolls have continued to trend higher despite the recent data
US non-farm payrolls
600
400
200
0
(200)
(400)
(600)
(800)
(1000)
2008
2009
Non farm payrolls
2010
2011
2012
2013
2014
2015
12 month moving average
Source: Bloomberg, UBS CIO WMR, as of 8 April 2015
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… and puts the Fed is on path towards normalization
Government bond yield curves
3.0
2.5
2.0
1.5
1.0
0.5
0.0
(0.5)
3M
6M
US
1Y
Germany
2Y
Japan
Source: Bloomberg, UBS CIO WMR, as of 8 April 2015
3Y
5Y
7Y
10Y
30Y
Italy
18
… leaving the front end of the curve more exposed …
3.0
Yield to maturity (%)
2.5
2.0
1.5
1.0
0.5
0.0
0
5
Spot
10
Fwd (3mo)
Source: UBS CIO WMR, as of 20 March 2015
15
Maturity (years)
Fwd (6mo)
20
Fwd (9mo)
25
30
Fwd (1yr)
19
… as investors expect the Treasury curve to flatten
1yr forward curve today vs. spot curve on 9/5/2013
Yield to maturity (%)
4
3.5
3
2.5
2
1.5
1
0.5
0
2yr
5yr
10yr
30yr
Maturity (years)
9/5/2013
3/25/2016
Source: UBS CIO WMR, as of 26 March 2015
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Total return by fixed income sector
Total Return
In %
S&P 500
Taxable FI Agg
Munis
Build America Bonds
Emerging Markets
Preferreds
High Yield
Investment Grade
Agencies
TIPs
Treasuries
-10%
-5%
0%
2015 YTD TR
5%
10%
15%
20%
2014 TR
Source: BofAML, Bloomberg, UBS CIO WMR, as of 6 April 2015
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Yields have continued to trend lower
10 year Treasury yields
Average yield per year, in %
12
10
8
6
4
2
0
1980
1985
1990
1995
Source: Bloomberg, UBS CIO WMR, as of 8 April 2015
2000
2005
2010
2015
22
Biggest challenge: where to find income?
Yield-to-worst
Yield, in percent
7
6
5
4
3
2
1
0
(1)
Source: BofAML, UBS CIO WMR, as of 6 April 2015
23
The zero rate policy fuels higher volatility …
Volatility levels and Average over the past 12 years
The number of times volatility has risen above the average has been greater post crisis
250
13.4
12.4
Post Crisis
Pre-Crisis
11.4
200
10.4
9.4
8.4
150
7.4
6.4
5.4
100
4.4
3.4
2.4
50
Mar-03
Mar-04
Mar-05
MOVE Index
Mar-06
Mar-07
Mar-08
Mar-09
MOVE Index AVG
Source: Bloomberg, UBS CIO WMR, as of 9 February 2015
Mar-10
Mar-11
10-Year Treas Vol
Mar-12
Mar-13
Mar-14
1.4
Mar-15
10-Year Vol Avg
24
… but the next tightening cycle should be more gradual
Inflation rate is more subdued than in past
7
1
6
0.9
5
0.8
4
0.7
3
0.6
2
0.5
1
0.4
0
0.3
-1
0.2
-2
0.1
-3
1990
0
1992
1994
1996
Tightening cycles
1998
2000
2002
CPI YOY
Source: Bloomberg, UBS CIO WMR, as of 7 April 2015
2004
2006
2008
2010
2012
2014
Avg. Fed tightening cycle inflation rate
25
… and a slower rise in rates should boost fixed income returns
Total return of various fixed income spread product during the actual dates of tightening
using 1,2, and 3 year projections with rising rates and fed funds
20
16
12
8
4
0
-4
1994 Hikes
1999 Hikes
US Treas
2004 Hikes
IG Corp
Source: UBS CIO WMR, as of 20 March 2015
Proj. 1yr
HY Invest
Proj.2yr
MBS
Proj. 3yr
Preferred
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Our Outlook: "Will, Won't, Might"
• Will happen
− Global growth continues, led mainly by developed economies
− The Fed tightens gradually while other central banks ease
− The US dollar strengthen just a little more – then 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
Source: UBS CIO WMR, as of 31 March 2015
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Preferred investment views
Most preferred
Equities
Fixed income
Foreign exchange
Least preferred
•
•
•
•
•
•
US small caps
Eurozone
The rising Millennials
E-Commerce
US capex
Cancer therapeutics
• Emerging Markets ()
• UK ()
•
•
•
•
•
US high yield
US investment grade
Mortgage IOs
US senior loans
Beyond benchmark fixed income
investing
• Government bonds ()
Portfolio weightings
Source: WMA Asset Allocation Committee (AAC) and UBS
CIO WMR, as of 23 April 2015
• USD
• EUR
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.
Alternative
investments
Cash
Source: UBS CIO WMR

Recent upgrades

Recent downgrades
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