UBS Wealth Management Research Study: “UBS research focus”

UBS Wealth Management Research Study: “UBS research focus”

The financial crisis and its aftermath

In its latest UBS research focus report, UBS Wealth Management Research concludes that the global economy will grow at a slower pace than it has over the past few decades and that inflation expectations will likely increase. Given this more austere outlook, corporate earnings growth will likely revert to a more sustainable trend – but a much lower one than prevailed before the crisis, especially within the financial industry. However, the report also stresses that fundamentals continue to support strong growth in emerging markets once the worst of the financial crisis has passed. With government reflationary measures in full swing, the authors conclude that higher-risk assets appear cheap, assets traditionally perceived as safe, such as nominal government bonds, are expensive, and the US dollar will remain under pressure.

The latest UBS research focus, “The financial crisis and its aftermath,” details the causes of the current crisis, looks at likely outcomes and explains the potential investment implications. The authors find that government policy will play an increasingly important role in shaping the economy and financial markets in the years to come. The report also looks at the longer-term structural implications for the economy, the financial sector, and the return outlook for various asset classes.

Lower trend growth, risk of higher inflation
UBS Wealth Management Research expects longer-term economic growth to slow as a result of broad-based deleveraging and increased regulation in the aftermath of the financial crisis. This reinforces a long-term trend already set in motion from the ongoing aging of the population. Consequently, governments face ever-increasing deficits and subdued growth with few effective options at their disposal. Debt-to-GDP ratios will likely rise unless there are cuts in discretionary and entitlement spending or taxes are increased. And in countries most exposed to the financial crisis, policymakers may prefer higher inflation as an antidote to ever-increasing debt.

The authors also forecast higher inflation expectations to emerge as a result of the policies being pursued to reflate the economy. The main problem for policymakers once the financial crisis has passed will be to ensure that the massive liquidity injections from governments and central banks do not lead to a surge in inflation. But given the persistent reemergence of deflation concerns, policymakers might opt to delay tightening monetary conditions too long. In addition, inflation would advance the deleveraging process because it profoundly affects wealth redistribution by reducing the real value of outstanding debt.

Nominal government bonds expensive
Given the cyclically depressed level of bond yields, UBS Wealth Management Research finds that nominal government bonds offer little value at present. The only supportive scenario for nominal government bonds is one of intensifying deflation risk, which, while it cannot be flatly excluded, is an unlikely outcome. On a standalone basis, the authors conclude that a more compelling risk-return tradeoff exists in other sectors of the bond market, such as money market instruments, inflation-linked bonds and corporate bonds.

Earnings growth to return to a more sustainable path
The crisis has had a profound effect on the drivers of asset returns. According to the authors, a sharp earnings recovery appears unlikely, and trend earnings are likely to be structurally weaker. Given the diversity of sectors and companies in overall equity market indexes, the risk to the sustainable earnings trend is much less pronounced than for individual sectors. Overall, UBS Wealth Management Research concludes that a trend growth rate of real earnings of about 2.5% for the US is a reasonable assumption. Although this is significantly lower than the earnings growth rate during the two decades preceding the financial crisis, it is broadly in line with the postwar experience.

Lower trend earnings in the financial sector
The financial crisis faces more regulation and tighter supervision. However, too tight a grip on the industry might undercut efforts to unclog the financial system and encourage lending. The authors expect that after the crisis passes, the financial sector in developed economies will be more heavily regulated and will face more limited growth opportunities than in the past. After outpacing other industries since the 1980s, UBS Wealth Management Research expects lower trend earnings growth in the financial sector as regulation curtails activities that offer higher margins and growth, whether because of market realities, loss of risk appetite or because of regulatory constraints.

Equities appear cheap
Stocks have tended to deliver the strongest returns after periods of extreme economic stress and financial market upheaval, which, not surprisingly, were times when stocks were at their least expensive levels. Despite the weak outlook for growth in trend earnings, equities offer significant long-term scope for gain in the authors’ base case scenario where the economic environment stabilizes.

US dollar at risk
UBS Wealth Management Research believes the US dollar remains at risk of further depreciation despite its neutral valuation. The financial crisis had its epicenter in the US, and the fiscal and monetary policy reactions there have been much more aggressive, and much bigger, than in the Eurozone, for example. As soon as the US economic situation starts to stabilize, this liquidity overhang will pose a major risk to the USD. Moreover, the supranational architecture of the European Central Bank could help to ensure stronger inflation-fighting credentials compared to national central banks that would face pressure from rapidly rising government deficits and debt. This would further support the euro relative to the US dollar if inflation expectations were to begin to diverge between the two regions, an increasingly likely outcome according to the report’s authors.

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