According to a UBS report entitled, “Proceed with Caution,” the year to come should be tackled carefully in terms of investment opportunities. The report identifies potential opportunities and highlights pitfalls to be avoided by investors as the global economy slides further into recession. It also looks beyond the present crisis of confidence occurring the world over and forecasts investment returns for major asset classes and regions. The report indicated it was time to calculate risk, noting “attractive valuations of certain assets must be weighed against the risks stemming from a global recession. We remain defensive overall but recommend increased exposure to corporate bonds.”
The autonomy of a price collapse
Bernhard Kern, executive director of Investment Solutions at UBS AG, remarked that over the past 129 years the SP 500 has had 44 negatives overall. “Among assets that have taken the hardest blow during the credit crisis are featured oil, followed by Middle East equities,” he pointed out. Kern emphasized that previous oil prices between $80 and $100 per barrel were driven by demand, while prices above this level had been mostly fueled by speculation. He explained that the price of oil would probably vary between $30 and $50 in coming months, but it would again witness levels of $100 per barrel in the next few years.
“The collapse of the financials culminated with the bankruptcy of Lehman brothers, which heralded the end of the brokerage model,” Kern pointed out.
The director explained that after September 15 — the date of the Lehman bankruptcy — trust had been significantly eroded, with lending plummeting, while equities were the only functioning market that had remained. He attributed the rally on the dollar partly to the fact that investors had sold off their foreign assets in order to bring their money closer to home.
Kern expected the real estate market to stabilize with the supply of new homes coming down. Regarding global growth levels, he pointed out that GDP growth levels in the developed world were below zero percent, while they remained far from their full potential in the developing world. He estimated that the first two quarters of the year would be difficult for global economies, while the recovery would be a gradual one.
Kern envisioned three possible economic scenarios for the crisis. The first was a V shaped economic recovery with economies picking-up relatively quickly, to which he attributed a 15 percent chance. The second scenario, the most probable according to Kern, would be a U shaped recovery accompanied by a fairly deep recession, which had a 60 percent probability. The final and most pessimistic recovery scenario, with a 25 percent probability, was defined by a deep recession followed by a prolonged period of stagnation.
Kern expected the economic situation to be difficult in the next few months, with stock markets possibly bottoming out yet again before recovery would kick in mid-2009.
His views were backed by the UBS report — which underlined that improved valuation should be balanced against recession risks — and this has several implications for asset markets. The report noted that “besides their corrosive effect on fundamentals, they also lead to heightened risk aversion, driving investors to seek shelter in risk haven assets such as cash, gold and government bonds. This then causes the price of assets to fall. If so, some higher risk assets may reach a point where they deliver a long-term cash flow that commensurates with the increased level of risk they entail. Although we do not foresee a deflationary outcome, we think a defensive stance is still warranted, given the uncertainty about the depth and duration of the global recession.”
The report added that corporate bonds offered value despite higher defaults. “We recommend that investors start rebuilding equity cautiously with a focus on sectors where earnings contraction is likely to be less pronounced.” Such sectors were identified as healthcare, consumer staples and telecoms.
The report added that, “higher risk opportunity awaited further evidence. It is unclear whether an easing of monetary conditions as reflected in central banks’ interest rates will begin to have a positive impact in 2009. However, as money and credit markets start to normalize, financials and other cyclical exposed equity sectors could benefit from such a policy stance.”
Reflation as a risk factor of government bonds was a final point mentioned in the report. Although deep economic recessions are usually supportive for government bonds, the UBS report fully dismissed that reflationary policies would begin to take hold before the end of 2009, stating that “a cyclical recovery in the economy amid higher fiscal deficits would likely push government bond yields high and prices lower.”