In its mid-year Panorama report, published on Wednesday, UBS Asset Management said that some fundamental relationships in the markets could change.
‘One such potential regime change over the next five years is the stock-bond correlation. Over the last 22 years, stock returns have been negatively correlated with Treasury bond returns in most developed markets.
‘We believe that there is an increased likelihood that this negative correlation will break down sometime in the next five years,’ the report said.
‘The historic data indicate that the stock-bond relationship is regime dependent. The critical threshold is sustained 2.5% inflation; below this, we expect the relationship to be negative; above this, there has been a positive stock-bond correlation. For now, inflation has been negated by the pandemic, with the US price index dropping 1.3% for the three months ending in May.’
Another potential fundamental change was noted within the report by Jonathan Gregory, the head of UK fixed income, who said that the balance of power may swing from capital towards labour, reversing a 20-year-long trend.
The report said that its estimate of expected inflation dropped sharply in the last 10 months, and the bank has pegged cumulative inflation to be around 1.4% annualised for the next five years.
In the medium term, the report said that the resetting of valuations provides a more favourable backdrop for riskier assets.
‘For most risk assets, this valuation improvement was quite large, but it was somewhat offset by declines in expected growth and inflation,’ it said. US large-cap equity is a significant outlier due to the bounce back in valuations.
Kevin Russell, CIO of O’Connor, said in the report that the firm expects a high level of dispersion in credit performance and faster than normal convergence on relative value trades within credit markets over the next 18 months.
UBS AM’s current allocation is heavily influenced by which regions recover fastest from the coronavirus.
It said: ‘Our base case, given that uncertainty, is for a gradual, uneven economic recovery. Capital spending is likely to stay in the doldrums in this highly uncertain backdrop, and the scope for households reducing saving rates is limited.’
Alternatively, it said there could also be a bull scenario with swift progress on vaccines or treatments for Covid-19 facilitating very fast economic recovery, or a bear scenario with a material second wave of infections, government fiscal support proving underwhelming and geopolitical risks resurging.
UBS said that in any of these situations, a delicate balance should be struck, which includes identifying opportunities for fast recovery if there is significant medical progress. Demand for risk assets is expected to remain below pre-Covid-19 levels in 2020 and beyond.
The report said: ‘Within US assets, we prefer investment grade and inflation-linked bonds, which benefit from central bank accommodation.
‘We prefer equities in markets including Japan and Germany, which are trading at much more attractive valuations.’
UBS also highlighted China and South Korea as potentially outperforming their cohort due to strong contact tracing infrastructure and stabilising the virus early.
Within emerging markets, the picture is mixed.
‘Dollar-denominated emerging market debt, particularly Asian countries, represents another area in which relative returns are skewed to the upside should risk appetite remain resilient,’ the report said.
‘We are underweight cyclical North Asian currencies against the safe-haven Japanese yen, to hedge against an escalation of tensions or downside surprise in global growth.
‘The rest of the emerging markets cohort is likely to be weighed down by lacklustre global growth and trade.’