a ubs institutional consulting group publication · winter 2016 contents market review fourth...

A UBS Institutional Consulting Group publication

06 Market Outlook

08 Washington Watch

05 Market Performance Report

01 Market Review

Institutional PerspectivesWinter 2016

Contents

Market ReviewFourth Quarter 2015

Four years and almost 800 points ago for the S&P 500 Index, we wrote about “return-free risk” – the notion that the market provided a volatile ride, but at the end of the day investors were paid very little for the trouble. In 2011 the worries were about the U.S. creditworthiness, the European Monetary Union’s future in the face of the Greek debt crisis, and the effects of Federal Reserve action. In 2015, the worries were about the sustainability of China’s economic growth, the market for commodities, and the expansion of the Bank of Japan’s and European Central Bank’s quantitative easing programs alongside the long-anticipated end of the Fed’s zero-rate policy. While the circumstances were different, the timing had some rhyme and rhythm to it. By March in both years, the S&P 500 had rallied and immediately retreated to its January open, followed by another climb into May to find what proved to be the high for the year. Volatility marked the transition into Summer when the market attempted to locate previous May highs before falling sharply in August. Short and steep rallies heralded the end of August followed by equally steep declines to retest lows as Summer turned to Fall. October of both years saw sizeable recoveries which then dissipated amidst volatility in November and December.

Looking at 2015 in its entirety, perhaps the biggest theme for the year was that opportunities to make and lose money were fairly concentrated. In the U.S., consumer, health care and technology related companies showed mid- to high-single digit returns consistent with starting expectations for the broader

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Institutional Perspectives

market, and anything related to energy, commodities and materials underperformed to effectively erase those gains for a diversified investor. Diversification did not provide an absolute or relative return advantage in 2015, but looking inside and across industries, sectors, asset classes and markets, diversification mitigated worst-case outcomes. Many individual companies dropped sharply, MLPs as an asset class declined nearly 33%, and lower rated high yield bonds (CAA), also reflecting trouble in the energy patch, fell 12% for 2015 with select individual issues becoming illiquid or their issuers insolvent. Facebook, Amazon, Netflix and Google (the “FANG” stocks), when taken as a basket were up 86% and were all that stood between the S&P 500 and a negative return for the year of -4.8%. The difference in performance between large U.S. growth and small U.S. value companies was even starker. But owning a diversified, market-weighted basket of large, mid and small cap companies gave an effective return close to zero (0.48% for the Russell 3000 Index). Just a small group of active equity managers with a predisposition toward speculative high growth actually succeeded in outperforming while those seeking solid fundamental business models emphasizing earnings and dividends, particularly those that were undervalued by the market, were again punished.

On an absolute return basis, diversified fixed income also returned very little, but the spread of potential outcomes for more concentrated investors was similarly wide and notable. Easy monetary policy, the coincident weakening of currencies relative to the U.S. Dollar, and the collapse of the commodities complex made non-U.S. fixed income investments, particularly those of emerging markets, poor bets in 2015. High yield bonds had one of their worst years on record and, unlike in 2011, the traditional safety trade of the U.S. long-term Treasury bond was also challenged as expectations around Fed rate action drove volatility and negative returns at the long end of the curve. The bright spots were found in investment grade corporate debt, short and intermediate government bonds, and mortgages, which posted modest but positive gains for the year. Most distinguished were municipal bonds which showed strength to lead the fixed income markets despite challenges from Puerto Rico and Illinois.

Sources: Bloomberg, FactSet, Barron’s

To receive the detailed UBS Quarterly Market Review, please contact your UBS Institutional Consultant.

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Domestic fixed income performance

Domestic Fixed Income

-0.6

-0.6

-0.5

-0.7

-0.9

1.5

-0.1

-0.6

1.2

-1.1

0.5

1.2

1.7

1.7

1.3

1.1

-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0

BC Aggregate

BC TIPS

BC Credit

BC Gov/Cred

BC Gov

BC Municipal

BC MBS

BC Agency

Q4 2015 Q3 2015

Source: Morningstar

%

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Broad markets performance

Broad Markets Performance

0.01

-1.38

-0.57

7.70

7.04

6.50

3.59

7.70

4.71

0.66

7.68

0.03

-5.54

0.55

0.21

1.38

0.92

-4.41

0.21

-0.81

-14.92

2.83

0.03

-5.54

0.55

0.21

1.38

0.92

-4.41

0.21

-0.81

-14.92

2.83

0.04

-4.27

1.44

12.66

15.13

15.01

11.65

12.66

5.01

-6.76

10.63

0.05

-1.30

3.25

11.30

12.57

12.44

9.19

11.30

3.60

-4.80

11.91

0.08

0.40

4.09

13.26

14.81

15.12

14.01

13.26

7.83

7.50

16.28

-20.0 -15.0 -10.0 -5.0 0.0 5.0 10.0 15.0 20.0

Citigroup 90-day

CG Wld Gov Bond xUS

BC Aggregate

DJ Industrial Average

S&P 500

Russell 1000

Russell 2000

NASDAQ

MSCI EAFE Net

MSCI EM Net

NAREIT (EQ)

Q4 2015 YTD 1 Year 3 Year 5 Year 7Year Source: Morningstar

%


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2015 quarterly returns Annualized returns ending 12/31/2015

Index YTD Q1 Q2 Q3 Q4 1 Yr 3 Yrs 5 Yrs 7 Yrs 10 Yrs

S&P 500 1.38 0.95 0.28 -6.44 7.04 1.38 15.13 12.57 14.81 7.31

DJIA 0.21 0.33 -0.29 -6.98 7.70 0.21 12.66 11.30 13.26 7.75

NASDAQ Comp 6.96 3.79 2.03 -7.09 8.71 6.96 19.81 14.91 19.29 9.68

Wilshire 5000 0.67 1.61 0.06 -6.91 6.36 0.67 14.72 12.09 15.00 7.40

Russell 3000 0.48 1.80 0.14 -7.25 6.27 0.48 14.74 12.18 15.04 7.35

Russell 3000G 5.09 4.05 0.27 -5.93 7.09 5.09 16.62 13.30 17.05 8.49

Russell 3000V -4.13 -0.51 0.00 -8.59 5.41 -4.13 12.76 10.98 12.94 6.11

Russell 1000 0.92 1.59 0.11 -6.83 6.50 0.92 15.01 12.44 15.12 7.40

Russell 1000G 5.67 3.84 0.12 -5.29 7.32 5.67 16.83 13.53 17.11 8.53

Russell 1000V -3.83 -0.72 0.11 -8.39 5.64 -3.83 13.08 11.27 13.04 6.16

Russell 2000 -4.41 4.32 0.42 -11.92 3.59 -4.41 11.65 9.19 14.01 6.80

Russell 2000G -1.38 6.63 1.98 -13.06 4.32 -1.38 14.28 10.67 16.33 7.95

Russell 2000V -7.47 1.98 -1.20 -10.73 2.88 -7.47 9.06 7.67 11.72 5.57

Russell Mid Cap -2.44 3.95 -1.54 -8.01 3.62 -2.44 14.18 11.44 17.16 8.00

Russell Mid CapG -0.20 5.38 -1.14 -7.99 4.12 -0.20 14.88 11.54 18.04 8.16

Russell Mid CapV -4.78 2.42 -1.97 -8.04 3.12 -4.78 13.40 11.25 16.16 7.61

EAFE -0.39 5.00 0.84 -10.19 4.75 -0.39 5.46 4.07 8.32 3.50

MSCI Emerging Mkts -14.60 2.28 0.82 -17.78 0.73 -14.60 -6.42 -4.47 7.85 3.95

BC Aggregate 0.55 1.61 -1.68 1.23 -0.57 0.55 1.44 3.25 4.09 4.51

BC Int Aggregate 1.21 1.32 -0.67 1.08 -0.51 1.21 1.41 2.74 3.74 4.26

BoA-ML C/G 1–3 yr 0.67 0.59 0.14 0.28 -0.35 0.67 0.72 1.04 1.69 2.75

BC Int G/C 1.05 1.45 -0.62 0.95 -0.71 1.05 1.09 2.57 3.42 4.04

BC GC 0.15 1.84 -2.10 1.20 -0.74 0.15 1.21 3.39 4.01 4.47

BC US Tips -1.44 1.42 -1.06 -1.15 -0.64 -1.44 -2.27 2.55 4.31 3.94

BC US Treasury 0.84 1.64 -1.58 1.76 -0.94 0.84 1.00 2.91 2.37 4.18

BC Gov 0.86 1.60 -1.50 1.71 -0.91 0.86 1.01 2.77 2.43 4.10

BC US Credit -0.77 2.16 -2.88 0.53 -0.52 -0.77 1.49 4.38 6.55 5.18

BC Global Aggregate xUS -6.02 -4.63 -0.83 0.64 -1.26 -6.02 -4.07 -0.83 1.13 3.10

BC Global Aggregate -3.15 -1.92 -1.18 0.85 -0.92 -3.15 -1.74 0.90 2.39 3.74

BC Muni 3.30 1.01 -0.89 1.65 1.50 3.30 3.16 5.35 5.96 4.72

BC Agency 1.01 1.17 -0.56 1.06 -0.64 1.01 1.05 2.02 2.28 3.72

BC Mortgages 1.51 1.06 -0.74 1.30 -0.10 1.51 2.01 2.96 3.71 4.64

BC ABS 1.25 0.90 0.17 0.74 -0.57 1.25 0.86 2.22 5.19 3.36

BoA-ML High Yield -4.55 2.53 -0.04 -4.88 -2.09 -4.55 1.64 4.84 12.50 6.74

BoA-ML Treasury 1-5 yr 0.98 0.92 0.02 0.70 -0.66 0.98 0.67 1.25 1.44 3.04

CG T-Bill (90 Day) 0.03 0.01 0.00 0.01 0.01 0.03 0.04 0.05 0.08 1.17

CG Wld Gov Bond -3.57 -2.51 -1.55 1.71 -1.23 -3.57 -2.70 -0.08 1.03 3.44

Market Performance Report December 31, 2015

FOR INSTITUTIONAL USE ONLY. This document is prepared by the UBS Manager Research Group at UBS Financial Services Inc. and is for informational purposes only and is not a recommendation to buy or sell any securities. The information contained herein has been obtained from third parties and has not been verified by UBS Financial Services Inc. Please note any index performance presented does not reflect any transaction costs or management fees. An actual investment in the securities included in the index would require an investor to incur fees, which would lower the performance results. Indexes are not available for direct investing. Past performance is no guarantee of future results.


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Market OutlookIt remains our view that the bull market that began in March 2009 remains intact. However, the steep sell-off in risk assets that started the new year has clearly shaken investor confidence and prompted many to question that view. Against this unsettled backdrop, the burden of proof has now shifted away from those who hold a negative market view to those who have a more constructive outlook for risk assets.

So what will it take for markets to begin to stabilize and validate this more constructive view? It is our view that we will likely need to see some combination of the following to arrest the decline in risk assets:• clearer evidence that the deceleration in US economic

momentum in the fourth quarter was indeed temporary;

• indications that commodity prices and the US dollar have begun to stabilize;

• confirmation that corporate profit growth has not peaked and that the collapse in energy sector earnings is not spilling over to remaining sectors;

• commitment on the part of global policymakers to remain pragmatic and responsive in their decision making.

Keep in mind, of course, that these developments are highly interdependent. So it’s important to consider the dynamics as not only fluid, but linked as well. For example, the level of growth will influence monetary policy which will, in turn, impact the strength of the dollar. Likewise, energy prices and the level of the dollar will affect corporate profitability, which heavily influences investor sentiment.

With that in mind, consider the following:

Improvement in the economic data – This most recent sell-off in risk assets shares at least one characteristic in com- mon with each of the prior pullbacks we have seen since the crisis: it has been prompted in large part by a global growth scare. It is therefore necessary that upcoming economic data releases provide validation that the global economic expansion remains intact and that the weakness in the fourth quarter represents just another episodic “soft patch.” Of particular interest will be evidence that consumers in the US remain fully engaged, signs that the normalization of credit conditions in the Eurozone has created a more durable expansion, and validation that growth in China is not collapsing under the weight of both heavy debt burdens and a series of poorly planned policy moves. It is our view that upcoming data releases will confirm that the economic expansion endures – uneven and substandard though it may be. There is a whole host of data that can be scrutinized to help gauge the current pace of economic activity – PMIs, payrolls, industrial production, and retail sales among them. Keep in mind, however, that markets typically react not only

to the economic data releases themselves, but also by how far they deviate from consensus expectations. So a helpful way for market participants to gain confirmation is through a rise in the economic surprise indicator. Given the most recent downgrade of growth expectations, the bar is now set pretty low. We will therefore look for an upswing in the economic surprise indicator as a signal that recessionary fears are overdone.

Stabilization in commodity prices and the dollar – The ongoing slide in oil prices and strengthening of the dollar are especially burdensome for commodity producing emerging market economies with heavy external debt burdens (i.e., dollar denominated debt). But the decline in crude is also adding to the deflationary headwinds for developed market countries as well. Although falling oil prices are positive for energy importers such as Japan and the Eurozone in the long term, for now at least the focus is clearly centered upon financial market stress. Given the heavy supply overhang, crude prices are unlikely to recover in the very near term. However, with most of these “supply shocks” – sustained North American production, breakdown of discipline within OPEC, reintroduction of Iranian supply – being already well known, further oil price declines from here should be more limited. Meanwhile, the combination of softer growth and increased market volatility reduces the prospects for aggressive Fed rate hikes. This, in turn, will help take some of the edge off the dollar’s appreciation. The combination of more stable energy prices and a steadier dollar should help ease the stress on emerging markets and soften deflationary forces in the developed world.

Continued corporate profit growth – The stronger dollar and lower oil prices have also taken a heavy toll on US corporate profitability. Overall earnings growth stalled in 2015, with the energy sector posting year-over-year declines of 60% and companies with significant currency exposure representing another 3% drag on profits. Keep in mind that with US stocks trading at valuations close to historical norms and the Fed in the early stages of policy normalization, further equity market gains from here will depend mostly upon the level of corporate profits. With the fourth-quarter earnings season now upon us, we should begin to get a bit more clarity on the all-important profit picture. As has been the case for each of the three previous quarters last year, analysts have been active in cutting their earnings forecasts in the weeks leading up to the reporting season. As such, earnings in aggregate should handily beat currently depressed forecasts. More important, earnings outside of the energy sector are likely to have risen between 4% and 6% during the quarter and 7% for the full year. This should help ease concerns over an earnings recession and help stabilize the market.

Pragmatic policy response – The combination of China’s move to devalue its currency in August and the


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decision by the Fed to raise rates in December served to unsettle markets accustomed to a more benign policy backdrop. Although China’s move toward greater currency flexibility was prompted more by efforts to have the yuan added to the basket of central bank reserve currencies than to engage in a competitive devaluation, the impact on emerging markets was immediate and harsh. Meanwhile, the Fed’s decision to raise rates despite a near complete absence of price pressures only added to the overall tightening of financial conditions. Following a second surprise devaluation in January that contributed to the New Year sell-off, China has gone to great lengths to defend the yuan. This suggests that Chinese officials will be more cautious and deliberate in allowing for further currency depreciation. Likewise, recent comments by senior Fed officials indicate that weakness in the economy and volatility in financial markets could materially influence the Fed’s decision-making. So in the absence of a reacceleration of growth and stabilization of risk assets, the odds of a Fed rate hike in March have diminished. Chances for the European Central Bank to boost the size of its quantitative easing in March also seem to be rising given comments made during Mario Draghi’s press conference. These more pragmatic approaches should ease concerns over a significant policy misstep.

Burden of proofIt remains our view that markets are currently oversold and that the risks of an economic recession, policy mistake, and earnings collapse are greatly overstated. However, sentiment remains poor and the burden of proof now lies with the bulls rather than the bears. This suggests that markets are apt to remain volatile, and any recovery in risk assets will be limited in the near term until we get further clarity on the macro, policy, commodity, currency, and profit front. We believe this will begin to materialize as the year progresses, but investors may need to be patient. In the meantime, we recommend that clients refrain from actively selling out of equity positions, maintain “normal” levels of risk in their portfolios, and, assuming a sufficiently long time horizon, consider putting large cash positions to work

EconomyChina has once again taken center stage in early 2016 as its government’s currency management raised uncertainty about the future path and degree of renminbi depreciation among global investors. While the risk of global contagion has risen, our base case remains for China avoiding an economic “hard landing.” More importantly, we expect continued growth in the US and Eurozone, balancing the general growth weakness of emerging markets (EM). The Federal Reserve kicked off the rate-hiking cycle on 16 December. This occurred against the backdrop of a robust labor market, as highlighted by strong new job creation in December. Still, this hiking cycle will progress only very gradually due to low inflation and the prevalent weakness in parts of the economy, namely manufacturing. Meanwhile, Eurozone growth continues

apace. Latest leading indicators showed a further mild improvement in the outlook. Still, at persistently low inflation levels, more ECB easing is becoming more likely.

EquitiesAgainst a backdrop of volatile markets susceptible to otherwise manageable negative shocks as well as the uncertainty over the Chinese government’s currency management intentions, we recommend a neutral position in global equities in our tactical asset allocation. However, we believe Eurozone companies are currently best positioned to benefit from continued global demand. Low refinancing costs and a supportive currency effect should additionally support rising profitability. Therefore, we prefer Eurozone over UK and EM equities in a regional con- text. UK equities have a large exposure to the energy and the materials sectors, where the latest rout in commodity prices weighs, while EM equities’ earnings and profit margins continue to deteriorate against a backdrop of weak domestic fundamentals.

Fixed incomeWe maintain an overweight in US investment grade (IG) bonds. Spreads have widened amid the market turmoil but we do not believe there is a high probability of a US recession or a wider crisis in higher-quality corporate credit beyond the energy sector. At an average yield to maturity of 3.6% they offer an appealing yield pickup over government bonds. From current low yield levels, US government bonds are unlikely to deliver attractive total returns over the next six months. We are underweight the asset class while acknowledging that it continues to play a crucial role as portfolio diversifier, stabilizing portfolio returns when risk assets sell off.

Foreign exchangeWe maintain our favorable view on the Norwegian krone compared to the euro. A stabilizing Norwegian economy should lead to monetary policy divergence and support a rising yield differential in favor of the krone. We are adding an underweight position in the Japanese yen against the US dollar. The yen strengthened amid the recent global risk-off sentiment, thereby making it even more difficult for the Bank of Japan to reach its inflation target. The BoJ is hence expected to at least maintain, if not expand, its very easy monetary policy stance. The Fed, on the other hand, has embarked on a path of gradual policy tightening. For EU- RUSD, we maintain our 6- and 12-month forecasts of 1.08 and 1.10, respectively.

For further information

This summary was condensed from UBS House View “Mind the gaps” (February 2016) a report from the UBS CIO Wealth Management Research Office. To obtain a full copy of this report or discuss how its research insights might bear on your portfolio, please contact your UBS Institutional Consultant.

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Financial Services Issues

Financial Riders Fail. As we expected, the final government funding bill was devoid of any major victories for the financial industry. Bipartisan negotiations on financial regulatory relief fell apart well before the finish line, while banks’ attempts to mitigate the Fed dividend cut they suffered in the highway bill also stalled. Meanwhile, efforts to include a provision to push back the Department of Labor’s fiduciary proposal had some momentum but ultimately fell short. One financial services item that did make its way into the bill will restrict the government’s ability to sell its stakes in Fannie Mae and Freddie Mac. Notably, its inclusion is detrimental to investors in the two companies but causes little discomfort to the Obama Administration, which has no intention of selling. With a large number of Democratic votes needed to pass the funding bill, the Democratic leadership and White House had leverage to successfully stand firm on financial services and other policy riders.

Fed Oversight. At a delicate time when the Federal Reserve is shifting its monetary policy stance, the Fed has had to fight efforts it believes would undermine its independence as a central bank. In November, the House passed legislation that, among other things, would subject the Fed to wider-ranging audits by a government watchdog, limit its flexibility in setting benchmark interest rates, and limit its ability to act as a lender of last resort in a crisis. Meanwhile, the Senate voted this week on whether to move ahead with its own “audit the Fed” bill, which was sponsored by Senator Rand Paul (R-KY), a presidential candidate. While that effort failed, the Fed

will continue to serve as a convenient target for populist ire on the campaign trail, meaning these measures are likely to only gain political currency over the next year.

Iran and Sanctions. As the U.S. and other major countries prepare to ease sanctions on Iran as part of the P5 + 1 nuclear deal, many in Congress will intensify their scrutiny of the nuclear deal and call for new sanctions. Up to $100 billion of sanctions will be relaxed on Iran any day now, freeing up money that cash-starved Iran can use in whatever way it chooses. A bipartisan chorus in Congress wants to impose new sanctions on Iran for its reported firing of ballistic missiles late last year in violation of UN security resolutions. Legislation will soon move forward in this regard, and it will pass. However, the President will veto it. Lifting of sanctions on Iran per the nuclear agreement and imposition of new sanctions for Iran’s more recent behavior will continue to be a flashpoint between the Obama Administration and Congress throughout this year. How those issues continue to be shaped will to a large degree depend on what happens in the broader Middle East conflicts, where most of the security interests of the two countries are not well aligned.

Big Tax Bill Passed. The “Protecting Americans from Tax Hikes Act of 2015” (PATH Act) passed the House and likely will be passed in the Senate along with the government funding bill. This $680 billion tax package addresses dozens of tax issues and is likely to be the only real tax legislation that becomes law between now and the election. The PATH Act has significant impacts on investors and businesses, some of which are listed below.

Under the dome: Fourth Quarter 2015 select highlights

The UBS U.S. Office of Public Policy, located in Washington, D.C., publishes a weekly brief report on major public policy and political developments from Washington. This quarterly summary identifies select issues from the weekly reports, with a focus on financial services, tax and regulatory measures that may affect UBS and our clients.

UBS U.S. Office of Public Policy

Washington Watch

U.S. Office of Public Policy Washington Watch

Under the dome: Third Quarter 2014 select highlights The UBS U.S. Office of Public Policy, located in Washington, D.C., publishes a weekly brief report on major public policy and political developments from Washington. This quarterly summary identifies select issues from the weekly reports, with a focus on financial services, tax, and regulatory measures that may affect UBS and our clients.

Financial Services Issues Tax Incentives for Retirement Savings. The Senate Finance Committee held a hearing in September focusing on retirement savings and the effectiveness of federal tax incentives and other initiatives to encourage retirement savings. Some retirement savers were quick to note Chairman Ron Wyden’s (D-OR) opening comments that “The IRA was never intended to be a tax shelter for millionaires,” referring to a recent claim in a federal report that 9,000 taxpayers have accumulated at least $5 million in individual retirement accounts. In fact, one news article led with the headline “Romney-sized IRAs Scrutinized as Government Studies Taxes.” This scrutiny does not mean that tax incentives to save in IRAs will be curtailed soon. The hearing was designed to identify ways to improve and simplify retirement vehicles for American workers, especially those working in small businesses. Ideas from the hearing could be fed into next year’s

• IRAs and Charitable Giving. The PATH Act makes several charitable tax provisions permanent. Most notably, the PATH Act allows for those 70½ or older to make contributions of up to $100,000 from an IRA directly to a charity. This contribution would qualify for a required minimum distribution. The fact that this provision was made permanent instead of subject to a one-year extension (as it has in the past) underscores lawmakers support for using tax incentives to encourage charitable giving.

• R&D Tax Credit. The bill makes the research and development tax credit permanent and brings long-term certainty to many businesses. This is especially important to companies who conduct R&D in the U.S., such as those in the defense and pharmaceutical sectors.

• Bonus Depreciation. Companies that utilize bonus depreciation were a big winner in this deal. The bill extends and gradually phases out bonus depreciation over five years. This extension is significant for

industries like telecommunications that engage in capital-intensive projects. If the economy shows significant improvements by 2019, bonus depreciation may disappear after this extension.

• Alternative Energy. The bill also contains several energy related tax incentives. However, of greater significance, the government funding bill includes a multi-year extension of the wind production tax credit (PTC) and the solar investment tax credit (ITC). Both the PTC and ITC are phased out during their multi-year extension. If Republicans control Congress and the White House when these tax incentives expire (after 2019 for PTC and after 2021 for ITC), this could be the final renewal for these provisions.

For further informationTo regularly receive the Washington Weekly report, please contact your UBS Institutional Consultant.


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