Outlook 2008: After the bubble, diversification only looks better, says UBS

2007 will surely be known as the year the US housing bubble burst. As US house prices fell and mortgage delinquencies surged, shock waves spread across global financial markets. Equities still managed to deliver decent performance in these much more volatile conditions, but choppy waters are likely to be with us for some time. However analysts at UBS think that global equities have the potential to outperform bond markets again in 2008.

 

End of credit innocence

As 2007 draws to a close, UBS analysts note the end of an era of credulous credit, when “subprime” was a category of loans, not a pejorative. After the US housing market bubble burst, not only did the US mortgage business contract, but growth worries also spread quickly to other credit and financial market segments. As a result, volatility surged in financial markets, fueled by a series of disclosures from key participants on their exposure to the US sub-prime mortgage mess. Worries about a US recession, particularly in the fourth quarter, only added further stress.

The Fed continued its policy of monetary easing, to date cutting its target interest rate by 1 percentage point to 4.25% since September. The bond market has been fairly quick in anticipating the increased risk to growth due to tighter monetary and credit conditions in the wake of the mortgage debacle. In recent months the yield on two-year US government bonds has dropped by 100 basis points to roughly 3%.

The Fed’s accommodative stance has been supportive for equity markets, helping to sustain positive equity returns for the year, even though the financial industry has suffered large write-downs and uncertainty on the total amount of losses related to subprime loans has remained high. Overall, this confirms the view we voiced a year ago that equities in general have not become overvalued and should therefore be able to withstand a tougher investment environment, albeit with considerable ups and downs (volatility). Other risky asset classes without the merit of good valuations, such as listed real estate and corporate bonds, had more difficulties.

 

2008 a test for decoupling

Investors should be prepared for some choppy waters in the sea of international

financial markets as we enter 2008. The meltdown in subprime mortgages in the US and the liquidity and credit crises this has unleashed will continue to fan financial market volatility at the start of 2008. However, though we expect a protracted phase of below-trend growth in the US, we also believe that a US recession is avoidable.

Importantly, economic activity throughout much of the rest of the world is in better shape. While growth rates globally may have peaked, we believe they should still serve to buffer the weakness emanating from the US.

UBS analysts think the antidote for market jitters – in both equity and credit markets – is more transparency on the effects of the US subprime debacle. Greater transparency and signs that the worst of the growth slowdown in the US is over should lead to an improved investment environment during 2008. Previewing the asset classes under such a scenario, we still find good value in global equities. This contrasts sharply with the blatant overvaluations seen in the late 1990s. Although equities may struggle in early 2008, UBS thinks that the environment will improve once growth worries recede.

Thus, during 2008 as a whole UBS analysts believe equities are likely to outperform cash by a margin sufficient to compensate for their risk.

 

An asset class overview

UBS analysts now find the developed equity markets in the US and Europe generally more attractive than emerging markets equities. After their recent strong outperformance, emerging markets are less attractively valued compared to other markets, in our view, but emerging market equities are so diverse that selective investors can still find good value. In the US and Europe we prefer larger capitalization stocks over smaller companies in terms of investment style. After years of outperformance by the small-cap segment, we think the time has come for an extended period of large-cap outperformance.

UBS analysts remain cautious on real estate, despite recent sharp setbacks in selected markets with a view that the listed real estate markets in the US and Europe offer less attractive prospects than equity markets.

Low bond yields might provide some shortterm relief, but demanding valuation levels, tightening lending conditions and slower income growth are likely to dominate next year. Regionally, we prefer the Asian real estate market, where we see stronger fundamental underpinning.

For commodities, UBS analysts think supply and demand should remain supportive of prices. However, we expect short-term corrections in some key commodity markets in the wake of slowing economic growth on the belief that the risk-return trade-off has significantly improved for corporate bonds compared to a year ago. After a sell-off, the interest rate spreads over government bonds are now at sufficiently high levels to allow for decent returns in 2008 and thus have a bias towards corporate bonds relative to government bonds. UBS expects governments to perform poorly, since yields are likely to resume their recent upward trend as soon as uncertainty on the investment environment recedes and the allure of a safe haven diminishes. We thus prefer bonds with shorter maturities where prices are less vulnerable to rising yields.

On the currency front, UBS analysts expect the carry trade to run out of steam. Carry trades –borrowing in low-yielding currencies to invest in high-yielding ones – have detached currencies from their fundamental fair values. These trades have now become increasingly risky lately. UBS analysts recommend caution in engaging in them in 2008 and see potential for further appreciation of the Japanese yen and Swiss franc. They also see rising risks of sharper movements among quasi-managed currency blocs. Here, UBS analysts expect increasing pressure on central banks to loosen their managed links to the US dollar.

Asian currencies are expected to appreciate, which should provide room for the extreme euro strength to recede.

 

Diversification is key

Last but not least, one key piece of investment advice UBS would offer for these challenging times is to exploit the benefits of diversification. The future is by definition uncertain, and by pooling different types of assets it is possible to reduce overall portfolio risk.