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UBS House ViewMonthly Letter12 December 2019 Chief Investment Office GWMInvestment ResearchStay investedFind growth trendsPrivate marketsAsset allocationAfter a strong decade forequities we expect returnsto be lower in the 2020s,but still think stocks willoutperform other publicassets.The 2010s were about BigTech. In the 2020s we’rebacking stocks focused onsustainable investing, digitaltransformation, genetictherapies, and alleviatingwater scarcity.With returns from publicassets likely to be lower inthe coming decade, investorsshould consider boosting theirreturns by taking advantageof illiquidity premiums inprivate markets.We are making no changesto our tactical asset allocationthis month, retaining a neutraloverall tactical stance onequities pending more clarityon US trade policy.Looking backward,looking forwardThe end of a year, the end of a decade – a time to reflect and to plan for the future.Mark HaefeleChief Investment OfficerGlobal Wealth ManagementFollow me on LinkedInlinkedin.com/in/markhaefeleFollow me on Twittertwitter.com/UBS CIODepending how you’ve been invested over the past 10 years, you might be feelingsome satisfaction with your portfolio performance. The 2010s have deliveredextraordinary returns across financial assets. Global bonds have returned 49%,Asian stocks 74%, European stocks 102%, and the US market 245% since theend of 2009. For developed market equities this has been the best decade sincethe 1980s. Correctly picking the growth stocks from the US market would havegenerated even greater returns. The Nasdaq has returned 325%, with Apple,Microsoft, Alphabet, and Amazon creating USD 3.5 trillion in value.How will investors boost their portfolio performance in the next decade, whileminimizing the chance of regret? In this letter I look at three key strategies:First, remain invested in equities. Although returns are likely to be lower in the2020s than the 2010s, we believe stocks are still likely to outperform other publically listed asset classes. It might seem hard for investors holding cash to buy in nowafter such a sustained rally, but investing is about looking forward, not back. Systematic put selling or capital protection strategies are both approaches that canhelp investors manage their fears around near-term equity volatility.Second, allocate toward longer-term growth trends within equities. Large-cap technology stocks probably won’t repeat their performance of the last decade, butother parts of the market do have the potential to deliver above-average growth.We look to stocks focused on sustainable investing, digital transformation, genetictherapies, and alleviating water scarcity.Finally, look for alternative risk premiums. With the available returns from publicmarkets likely to be relatively muted, investors should think carefully about whetherthey could boost their returns by taking advantage of illiquidity premiums in privatemarkets. If you are not likely to need to access a portion of your funds in themedium term, you could shift assets you would otherwise allocate to liquid publicThis report has been prepared by UBS AG. Please see important disclaimers and disclosures at the end of thedocument.
Looking backward, looking forwardequities into private markets, and earn additional potential return. Over the courseof a decade an estimated 1–3 percentage point illiquidity premium per year translates into an additional 10%–35% gain.Nearer term, we are making no changes to our tactical asset allocation this month,retaining a neutral overall tactical stance on equities. Recent news headlines havesuggested that the US and China are edging towards postponing the scheduled15 December US tariff increase while they continue to negotiate. This is our expectation, and our neutral positioning reflects this outcome. Clearly there is two-wayrisk to this scenario, with a rollback of tariffs likely to prompt a rally in equities andan imposition of the December levies likely to be followed by a sell-off. We continueto seek relative value tactical trades within equities, favoring the US and Japanesemarkets relative to the Eurozone.We prefer to take more risk by finding alternative sources of yield, notably inemerging market sovereign bonds, and by overweighting the Indian rupee andIndonesian rupiah relative to the Australian and Taiwan dollars.We acknowledge there aresome short-term reasons notto be overweight equities.Staying investedFor portfolios fully invested in equities, it has been a great year for returns, but weacknowledge there are some short-term reasons not to be overweight equities.Even Larry Kudlow, US President Donald Trump’s economic advisor and an eternaloptimist, has recently admitted that the president may not hesitate to add moretariffs on 15 December. The threatened reinstatement of US tariffs on steel andaluminium exports from Brazil and Argentina, as well as on a range of Frenchexports, also shows that trade risks are not confined to China.Meanwhile, earnings expectations could be set for disappointment: next year weexpect growth of just 4% compared with consensus forecasts for 10%, andthe scope for fiscal stimulus to change the growth outlook outside of Asia lookslimited, although the Fed does appear to be more willing to let the US labor market“run hot.”Against this backdrop, we are tactically neutral overall on stocks and prefer relative value trades within equities, favoring consumer-facing sectors over those reliant on business investment spending.Figure 1Equities are the best performer over the long runTotal returns on the S&P 500, 3-month Treasury bills, 10-year Treasury bonds (log 719471957196719771987199720072017BondsSource: Aswath Damodaran, Stern Business School New York University, UBS, as of December 2019December 2019 – UBS House View Monthly Letter2
Looking backward, looking forwardIn public markets, thereremains no strategicalternative to equities.But strategically, in public markets, there remains no alternative to equities. Even ifglobal GDP growth were to stay at the decade-low annual rate we forecast for2020, the world economy would still expand 80% in nominal terms by 2029 at thecurrent global inflation rate of 3%, offering meaningful scope for long-termgrowth in corporate earnings. Absolute valuations for global equities, based on a12-month forward price-to-earnings are 16.1x, close to their long-term averagesince 1987 of 15.7x. And the contrast to bonds is stark. Equity dividend yields areclose to a record high relative to bond and cash yields in Europe. And in the US theequity risk premium is 5.7%. We expect developed market equities to return4%–6% a year in local currency terms over the coming seven years, and 9% a yearfor emerging markets.The challenge for many investors is how to balance this longer-term logic withnear-term fears. Structured strategies can provide one way of doing this.Buying and writing putsA put option gives an investor the right, but not the obligation, to sell anasset at a specified price (the strike price) on or before a specified date (thematurity). At maturity, put options can be settled physically, by transferringownership of the asset, or in cash, by exchanging the difference betweenthe current price and strike price.Selling a put is known as writing. Investors who write puts receive a premium, but give their counterparty the right to sell them the asset at thestrike price. If the market goes up, the puts will expire worthless and theinvestor will realize the premium as a profit. If the market goes down, however, the investor may be forced to buy the asset above its current marketvalue, although this cost would be partially offset by the premium.Reverse convertible securitiesA reverse convertible uses a similar concept to “put writing” but is structured into a note. It is effectively a combination of holding a debt instrument and writing a put option. When you buy a reverse convertible notelinked to a stock you receive a coupon payment, but give the issuer the rightto sell the underlying stock to you at a set price.A barrier reverse convertible is a variant in which the put can only be exercised if the market falls to a predetermined barrier – for example, 80% ofthe asset’s initial price.Capital protected notesA capital protected note offers the buyer high or complete protection oftheir initial investment, in return for limited participation in the market’supside. The buyer is also exposed to the creditworthiness of the issuer.Investors with cash who areafraid to deploy capital withstocks close to an all-timehigh can consider defensiveentry strategies.Investors who are holding cash, but are afraid to deploy capital with stocks closeto an all-time high (see breakout below), can think about defensive equity entrystrategies as one option to earn income while waiting to buy into stocks in adisciplined way. One example is physically settled put writing (known as reverseconvertibles when structured into a note). Over the long term we would expectsuch strategies to underperform stocks, but by allowing investors to combat theirbehavioral biases and get themselves invested in growth assets, such strategieshave the potential to improve the long-term return profiles of portfolios.December 2019 – UBS House View Monthly Letter3
Looking backward, looking forwardEqually, investors already invested in stocks and keen to realize gains could consider hedging some equity exposure (either by buying a put option or by substituting a portion of their equity allocation for a capital protected note) to lock insome gains. Hedging doesn’t come for free of course, but when cash rates areclose to zero, investors have a higher chance of realizing long-term gains ifhedges help them stay more fully invested through periods of volatility.See more in our reports, Structured solutions for an uncertain world and CIOHedging guidebook.Equity performance after all-time highsInvestors are often fearful of putting money to work when the equity market is at an all-time high. But, perhaps counterintuitively, history tells us thatinvestors should in fact be more willing to invest at an all-time high thanduring other periods. In the six months after any given record high, marketshave returned an average of 4.7%, versus 4.2% at other times (based onS&P 500 data since 1950). The incidence of a decline of 5% or greater inthe following six months has been just 11% after a record high, versus 18%at any other time.Within equities investors shouldfocus on the next decade’s likelyhigh-growth sectors.Seeking high growth sectorsIf the 1990s were about the internet (Nasdaq 812%), the 2000s about commodities (oil 333%, gold 206%), and 2010s about Big Tech (S&P Tech index 378%), what will be the dominant trend of the 2020s?We favor four areas with potential: Sustainable investing. Consumers, governments, and regulators are all goingto be big drivers of a shift toward sustainable investments and products overthe next decade, and we think that investors who get ahead of that trend willbe rewarded. Take recent comments in Europe as an example. European CentralBank President Christine Lagarde has said she wants climate change to becomea “mission critical” priority for the European Central Bank (ECB). And Italy’sPrime Minister Giuseppe Conte recently suggested that the government should“strip out green projects funded with green bonds [from its] deficit calculation.” If this trend leads to a green-focused fiscal and monetary stimulus package in Europe, the sustainable investing market is likely to be well supported. Genetic therapies. Fans of Netflix’s documentary series Unnatural Selectionwill know that genetic therapies represent a paradigm shift in medicine, withthe potential to revolutionize healthcare delivery and disrupt the biopharmaindustry. Research scientists from MIT and Harvard recently announced theyhave developed a gene-editing technique that could help correct nearly 90%of genetic diseases, and we are now seeing a whole new generation of geneand cell therapies gaining regulatory approval to treat certain rare diseases andcancers. Large-cap pharma is sitting up and taking note, and we thereforeexpect to see heightened deal activity in the next decade. Just this month,Japan’s Astellas Pharma announced the acquisition of Audentes Therapeuticsat a106% premium to its closing price, and we estimate that large-cap pharmaand biotech companies have now spent USD 41 billion acquiring gene and celltherapy companies since 2017. Of course, we recommend investing in thistrend through a well-diversified portfolio of companies to manage the risksassociated with clinical failure.December 2019 – UBS House View Monthly Letter4
Looking backward, looking forwardFigure 2Early indications of gene and cell therapy market potential exceedUSD 20bnConsensus forecasts for late-stage gene and cell therapy products, USD 24Gene therapyCell therapySource: Bernstein Research, UBS, as of March 2019Enabling technologies like 5Gand AI will define a new eraof digital transformation inthe coming decade. Digital transformation. The combination of 5G, artificial intelligence (AI),big data, and cloud computing will define a new era of digital transformationand innovation in the decade ahead. South Korea, the US, and the UK havealready begun rolling out 5G networks this year, and last month China’s threestate-owned mobile operators launched 5G services in 50 cities. Global 5Gwireless network infrastructure revenue will reach USD 4.2bn in 2020, an 89%increase from 2019, according to research group Gartner. These rollouts willsupport further growth in the Internet of Things (IoT). By the end of this yearthe enterprise and automotive IoT market will have reached 4.8bn endpoints,a 21.5% increase over 2018, with a similar growth rate predicted for next year,according to Gartner data.To benefit from digital transformation, we advise diversified investing focusedon six key themes: digital data, enabling technologies, E-commerce, fintech,healthtech, and security and safety. Water. The world faces a mismatch between water demand and supply, whichwill be exacerbated in the decade ahead by the effects of demographics andclimate change. China and India represent 35% of the world’s population, yethave access to less than 10% of its freshwater resources. Owing to the urgencyand scale of water-related issues, and the need for capital spending in emerging markets, we expect continuous revenue and profit growth for the entirewater value chain. We’re already seeing this trend playing out. In November,China’s premier Li Keqiang said that China needs to increase investment inwater infrastructure to combat water shortages created by pollution and risingpopulations in its arid northern regions. Meanwhile, in Europe this month, theEuropean Commission agreed on new minimum requirements for the safereuse of treated urban wastewater in agricultural irrigation, a practice which isestablished in only a few member states, and will require further investment toimplement.The additional premiums onoffer in private markets are morevaluable in a lower return world.Boosting returns with a better understanding of liquidity needs.As well as staying invested and seeking higher return parts of the market, in thenext decade investors will also need to look at other sources of risk premiums,such as those available in private markets. Academic studies estimate that privatemarkets offer an illiquidity premium of 1–3 percentage points. If this holds trueDecember 2019 – UBS House View Monthly Letter5
Looking backward, looking forwardover the next decade in a world of lower returns for financial assets in general,this would represent a greater proportion of overall returns than in the past. Inprivate markets we anticipate returns of 8%–10%, due to the effect of illiquiditypremiums, access to niche opportunities, and manager emphasis on driving operational value.Figure 3Private market returns are attractiveVintage year IRR comparison between global PE and public equities, in 0CA global buyout growth equity pooled IRRMSCI ACWI public market equivalent (PME)Note: Given most funds take a few years for performance to settle, performance of recent vintage years may be less meaningfulSource: Cambridge Associates, UBS, as of 1Q19With the case for private markets more compelling, what sort of allocation shouldinvestors make to this asset class? Much depends on an investor’s personal abilityto tolerate medium-term illiquidity. One approach that can help clarify this is ourLiquidity. Longevity. Legacy. framework. In this framework, the Liquidity strategyis designed to cover near-term spending needs, the Longevity strategy to meetyour needs for the rest of your lifetime, and the Legacy strategy for assets inexcess of those needed for spending.Investors can consider allocating a substantial portion of their Legacy strategy toprivate markets, and, depending on the time horizon of their Longevity strategy,could also consider allocating a portion of this strategy toward private markets toimprove returns and enable their portfolio to keep pace with inflation.We generally recommend a phased approach to buying into private marketsto ensure investors build exposure across the business cycle. At the current stagein the cycle we favor a more defensive approach, looking for strategies less dependent on the macro environment. We like managers with proven operational valuecreation capabilities and investments that reflect durable organic growth rates. Inprivate debt markets, we prefer more conservative managers who can deploy capital in less explored areas to maintain attractive risk-rewards for investors.We continue to seek relativevalue trades within equities.We favor US and Japaneseequities over Eurozone stocks.Asset allocationWe are making no changes to our tactical asset allocation this month, retaining aneutral overall tactical stance on equities. We continue to seek relative value tactical trades within equities, favoring the US and Japanese markets relative tothe Eurozone. The Fed’s willingness to keep rates low in spite of a strong US laborLiquidity. Longevity. Legacy. disclaimer:Timeframes may vary. Strategies are subject to individual client goals, objectives, and suitability. This approachis not a promise or guarantee that wealth, or any financial results, can or will be achieved.December 2019 – UBS House View Monthly Letter6
Looking backward, looking forwardmarket and the lack of a real alternative to equities for long-term investors couldcontinue to push markets higher in the months ahead. Yet uncertainty about thestatus of trade negotiations, lack of a meaningful pickup in manufacturing data,scope for disappointment to corporate earnings expectations, and a wide-openrace for the Democratic nomination could each inspire volatility.We prefer to take more risk finding alternative sources of yield, notably in emerging market sovereign bonds, and by overweighting the Indian rupee and Indonesian rupiah relative to the Australian and Taiwan dollars.Figure 4Go domestic versus globalDomestic versus foreign exposure for listed companies in select regions, in %100806040200USEuropeJapanEmerging MarketsChinaSwitzerlandDomesticForeignSource: Morgan Stanley, as of 30 May 2019This month we are highlighting three main investment ideas:We overweight US dollardenominated emerging marketsovereign bonds versus highgrade bonds. We overweight US dollar-denominated emerging market sovereignbonds versus high grade bonds. Against a backdrop of easy monetary policy,low global yields, and sluggish global growth (but no recession), US dollar- denominated emerging market sovereign bonds offer an attractive carry ofmore than 3% versus US Treasuries. We expect the
growth in corporate earnings. Absolute valuations for global equities, based on a 12-month forward price-to-earnings are 16.1x, close to their long-term average since 1987 of 15.7x. And the contrast to bonds is stark. Equity dividend yields are close to a record high relative to bond and cash yields in Europe. And in the US the
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