Mark Haefele Global Chief Investment Officer Wealth Management
28/07/2015
I’m sure many of you know the old expression “If America sneezes, the world catches a cold.” But what if China coughs? Or Greece splutters? How do we assess whether a local malady will become the next global contagion event?
I wrote last month that neither events in Greece nor China would likely be enough in the near term to derail the global recovery. Some wrote to tell me I was being too optimistic. Having begun my financial career often betting on companies going bankrupt, I am not sanguine by nature. Instead, my confidence was based on applying a framework for understanding the risks of financial contagion. I want to devote this letter to explaining how we assess such risks. Finance and economics are – at best – social sciences, so they don’t follow the same natural laws that epidemiologists use to model contagious disease.
Yet in today’s complex financial Tracking contagion world, investors must also develop models to understand the potential impact of contagion on their portfolios.
Our contagion framework is helping us get through the Greek crisis and China’s stock volatility. While we can’t know exactly what lies ahead, we are also using it to prepare for the anticipated interest rate hike from the Federal Reserve. In summary, I believe that the threat from Greece, China and the Fed are passed, passing and passable respectively for investors with a globally diversified portfolio.
The spillover effects we do foresee from the Fed’s move are one reason we are underweight in EM equities over our six-month tactical horizon, while we remain overweight Eurozone equities and initiate a new overweight in Japanese equities. We
retain an overweight sterling position against the Australian dollar, as the UK moves towards monetary tightening.
This report has been prepared by UBS AG. Please see important disclaimers and disclosures at the end of the document. 2 UBS House View Monthly Letter — August 2015 Tracking contagion Contagion framework
Financial contagion can spread through multiple channels, so our framework needs to assess multiple dimensions. We look at four key factors.
1) First order effects: When an economy slows, its major trading partners will suffer as well. This import transmission mechanism has been illustrated recently in Australia, which relies on China for about a third of its exports and so has felt the chilling effect of weaker demand growth from its biggest customer. Similarly, direct external creditors to a country or region that is experiencing sluggish growth or high unemployment are likely to suffer from higher bad debts.
2) Second order effects: Damage to sentiment and financial market volatility can spread contagion far from their original source. I frequently brainstorm with my colleagues to chase down any conceivable links a region has to other parts of the global financial system. These connections can be difficult to assess, but UBS’s geographic reach helps us to collect the quantitative and qualitative “big data” that aids decision making.
2) Second order effects: Damage to sentiment and financial market volatility can spread contagion far from their original source. I frequently brainstorm with my colleagues to chase down any conceivable links a region has to other parts of the global financial system. These connections can be difficult to assess, but UBS’s geographic reach helps us to collect the quantitative and qualitative “big data” that aids decision making.
3) The economic or financial immune system: Nations are less likely to feel the ill effects of contagion from another country or region if they enjoy accelerating growth, sustainable debt levels, and a diversified base of funding. We saw which nations lacked this strong immune response during the so-called “taper tantrum” of 2013, when fears about an end to US quantitative easing led investors to pull capital from vulnerable emerging markets like Turkey and Indonesia.
4) Policy support: Finally, we consider policymakers’ capacity and willingness to intervene effectively. Part of the reason that the 2008 subprime crisis proved to be so toxic was the lack of a swift policy response, especially compared to the stimulus that helped China mitigate the crisis. Encouragingly, since then we have seen a transformation across the world in the willingness and ability for policymakers to intervene proactively to cut off potential contagion at its source.
So, how have we applied this framework to the recent problems in Greece and China and how does it apply to the looming threat posed by Fed rate hikes?
Greece
Thankfully, the recent deal between Greece and its creditors has reduced a threat to the financial system. But even when Grexit started to seem likely, using our model convinced us that the risk of lasting contagion was relatively modest.Direct economic and financial links between Greece and the rest of the world are low. The country accounts for less than 2% of Eurozone GDP, making it a minimal source of export demand. In addition, large European banks have long since cut back their exposure to Greek debt – eliminating the danger that a Greek default would cause a contraction in bank lending in France, Germany or Italy. Now around 73% of Greek debt is held by official creditors .
Skipping to our third test, we also judged that the rest of the Eurozone was in better financial and economic health than in many years, reducing the chance that problems in Greece could tip the continent back towards recession. We first consider the direct economic and credit links between countries and regions.
Harm can also spread through damage to market sentiment. Nations with strong financial and economic immune systems are better placed to fight off infection.
We also consider the willingness and ability of economic policy makers to lend support.
The direct economic and financial fallout from a Grexit would be modest.. and the Eurozone economy seems robust enough to cope with the Greek threat.
UBS House View Monthly Letter — August 2015 3
Tracking contagion
The danger to the Eurozone economy from Greece has faded.
The greatest threat rather, came from second-order effects. Rising risk aversion among investors could have pushed up the cost of borrowing in the Eurozone and undermined equity markets. A Grexit could also encourage speculative attacks on other peripheral nations, exposing the common currency as a breakable exchange rate systemOffsetting these risks, however, is European Central Bank support. ECB President Mario Draghi said he would do “whatever it takes” when the Eurozone
was last under assault from rising peripheral bond yields in 2012. We remain confident that the ECB would attempt to act decisively to mitigate the adverse market effects if Greece did end up leaving the zone. As a result we felt comfortable with an overweight position in Eurozone equities and now take the opportunity to add further to our overweight in Eurozone high yield credit.
So, what now? The recent crisis underlined that the task of European integration remains incomplete. The zone lacks harmonized rules on pensions or taxation and there is still no pan-Eurozone deposit guarantee scheme. Without these there will
always be some risk of euro contagion lurking in the background. It’s not for me to pronounce how the European people and leaders should address these structural problems. However, the reality is that the European Central Bank’s quantitative easing is helping to paper over these issues. For markets this means near-term liquidity and cheap money – a trend we expect to continue
China
The recent “popping” in the Chinese domestic equity market has been heard around the world. But will it spill over into a global concern? After Greece, this is the question clients most frequently ask.
Let’s apply the framework:
First, there are relatively few direct links between domestic Chinese equities and foreign markets. Domestic Chinese equities represent just 1% of global investor portfolios, and China’s closed capital account also limits the international fallout from turbulence in the nation’s stock markets.We have seen some second order effects. The Chinese government introduced measures to discourage investors from selling domestic stock – leading them to use the more freely-traded Hong Kong market as a sort of ATM.
If necessary, the ECB is ready to intervene.
China’s domestic equities are relatively isolated from international markets.
The spillover has been largely limited to the freely traded Hong Kong market. European banks have become less vulnerable to a Greek default
Tracking contagion
We can’t rule out further turbulence and we are neutral on MSCI China. Still, pockets of value have emerged. Many financial firms are trading at attractive valuations especially given the prospects of further rate cuts from the People’s Bank of China. This should limit further declines.In terms of overall financial and economic health, China has been getting some bad press. Of course, recent data has been weak and debt levels have been rising. That said, China has defenses against contagion. It holds USD 3.6 trillion in foreign exchange reserves, about a third of the world’s total, and Chinese citizens hold bank deposits of USD 21 trillion – equivalent to the combined annual output of the US and Germany. With a gross household savings rate just shy of 50%, that savings pile continues to grow.
The turbulence in the equity market shouldn’t threaten China’s economic health. Only around 14% of urban households currently participate in the stock market. For that reason we do not expect equity losses to translate into a big hit to consumption. Only a fifth of household financial wealth is tied up in the equity market.
Finally, the Chinese government has repeatedly shown its readiness to try and prevent isolated issues from causing wider problems. The long-term impact of such a heavily manipulated market and economy remains to be seen, but in the near term it should limit the risk of major shocks.
US Fed
Looking ahead, how are we using the framework to assess the contagion risks from the expected Fed rate rises?
First, we believe the direct effects on borrowers and hence domestic demand will be manageable. Many corporate and private borrowers have locked in lending rates. Over the last five years adjustable rate mortgages have accounted for less than 10% of the applications, down from around 30% before the 2008 financial crisis. On the corporate side, only 16% of high yield bonds will need to be refinanced before the end of 2018.
Second order effects from rising rates do affect our investment outlook. Our base case remains for US dollar strength, which could lead to higher volatility China has financial and economic defenses to limit the effects of a stock market collapse.
Gradual Fed rate rises are unlikely to hurt many borrowers.
We do not expect US equities to swoon.
Chinese households hold only a modest share of their wealth in stocks.
Tracking contagion
in the US equity market. At a sector level, higher rates are likely to encourage investors to shift away from higher-yielding sectors toward value stocks. We are thus underweighting utilities and overweighting financials. Still, we do not think higher rates will cause US equities overall to swoon. America’s economic immune system is still getting stronger. The 5.3% jobless rate is near to the 5–5.2% level that most Fed officials consider consistent with full employment. Debt levels are also improving. Household liabilities are down to 102% of disposable income, from a 2007 peak of 130%. On the policy front, the Fed continues to assert its willingness to stimulate growth if unexpected vulnerabilities emerge. Fed Chair Janet Yellen has
indicated that tightening will be “gradual” and that “monetary policy will need to be highly supportive of economic activity for quite some time.”
Of course, we also need to consider the international effects of Fed tightening, given the pivotal role of the US economy and the dollar. Since we don’t expect Fed policy to curb US growth, the rate cycle shouldn’t harm top trading partners. We are positive about economies such as Taiwan that rely on strong US growth. There will, however, be second order effects as more attractive rates cause capital to flow back to the US. This is a concern for nations that have done too little to reduce their overdependence on foreign dollar financing since the 2013 taper tantrum. The likes of Indonesia, Turkey and Thailand, with large current account deficits, may suffer. That said, emerging markets such as India have shrunk their reliance on foreign capital and are hence less vulnerable.
The bottom line is that we believe the risks from Greece, China, and Fed rate hikes are, once again, passed, passing and passable respectively. That supports our risk-on investment stance.
Tactical investment view
Over our six-month investment horizon, Eurozone equities still offer the best opportunity. A combination of a weak euro and cheap oil are driving strong earnings growth, which we expect to be 12–15% for 2015. Meanwhile the benefits of ultraeasy
monetary policy are boosting the outlook for economic growth. Finally, the improving prospects of a solution to the Greece crisis removes a long-running drag.
The US economy is strong enough to withstand higher rates.but the Fed stands ready to adjust policy if problems arise.
Higher US rates support our underweight position in emerging market equities. The overweight in Eurozone equities remains our largest position.
The balance sheets of US consumers have improved, making them less exposed to rate rises.
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We increase our overweight position in Eurozone high yield bonds. We believe the recent widening in Euro HY spreads by roughly 60bps from their March level provides an attractive entry opportunity. The current yield-to-maturity of 4.7% is at the
upper end of the range since 2013 and provides appealing carry over higher-rated bonds. Meanwhile, leverage has remained low in recent years as balance sheet repair was the main focus for companies amid the recent crisis years. Default rates
are expected to increase only modestly from 0.5% to 2% in 12 months. Elsewhere we see promising relative value opportunities. We are introducing an overweight Japan equity position versus UK equities. Not only do leading indicators point to an improving outlook for Japan, but we have now seen strong profit growth for long enough to be confident in such qualitative measures.
Earnings have now surprised on the upside for nine consecutive quarters, and Japan is on track for EPS growth of 18% this fiscal year compared to 2015. We believe that monetary policy will remain supportive. By contrast, Bank of England Governor Mark Carney has indicated that rate rises are “moving closer.” A stronger sterling will weigh on UK earnings.
Earnings have now surprised on the upside for nine consecutive quarters, and Japan is on track for EPS growth of 18% this fiscal year compared to 2015. We believe that monetary policy will remain supportive. By contrast, Bank of England Governor Mark Carney has indicated that rate rises are “moving closer.” A stronger sterling will weigh on UK earnings.
The policy outlook also increases our confidence in our overweight sterling position relative to the Australian dollar. The drag to growth from weaker commodity prices has encouraged the Reserve Bank of Australia to push rates to a record low. We expect further easing.
UBS Investor Forum Insights
At July’s Investor Forum – the monthly gathering where CIO invites fund managers to debate the key topics affecting financial markets, and to challenge the UBS House View – the rollercoaster ride in Chinese equity
markets dominated discussions. The debate focused on whether the volatility in Chinese equity markets could harm the nation’s economy or even effect growth globally.
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Participants agreed that the Chinese equity market is not a leading indicator for Chinese or global economic growth.
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Some participants were concerned about the level of government intervention during the recent plunge, although others added that Western governments have been intervening on a massive scale for the last four years with some success
הנתונים, המידע, הדעות והתחזיות המתפרסמות באתר זה מסופקים כשרות לגולשים. אין לראות בהם המלצה או תחליף לשיקול דעתו העצמאי של הקורא, או הצעה או שיווק השקעות או ייעוץ השקעות ב: קרנות נאמנות, תעודות סל, קופות גמל, קרנות פנסיה, קרנות השתלמות או כל נייר ערך אחר או נדל"ן– בין באופן כללי ובין בהתחשב בנתונים ובצרכים המיוחדים של כל קורא – לרכישה ו/או ביצוע השקעות ו/או פעולות או עסקאות כלשהן. במידע עלולות ליפול טעויות ועשויים לחול בו שינויי שוק ושינויים אחרים. כמו כן עלולות להתגלות סטיות בין התחזיות המובאות בסקירה זו לתוצאות בפועל. לכותב עשוי להיות עניין אישי במאמר זה, לרבות החזקה ו/או ביצוע עסקה עבור עצמו ו/או עבור אחרים בניירות ערך ו/או במוצרים פיננסיים אחרים הנזכרים במסמך זה. הכותב עשוי להימצא בניגוד עניינים. פאנדר אינה מתחייבת להודיע לקוראים בדרך כלשהי על שינויים כאמור, מראש או בדיעבד. פאנדר לא תהיה אחראית בכל צורה שהיא לנזק או הפסד שיגרמו משימוש במאמר/ראיון זה, אם יגרמו, ואינה מתחייבת כי שימוש במידע זה עשוי ליצור רווחים בידי המשתמש.
