The Compendium - The 10 toughest questions we've fielded

Team UBS tackles the most difficult questions we have received from investors.

1. Can mutant viruses derail the recovery?
   Increased transmissibility of the virus has lifted herd immunity thresholds perhaps as high as 90% (Developed Markets & Emerging Markets vaccination levels will be 10-20 pp short of that by year end). However, despite limited improvement in aggregate case counts, mobility restrictions on average are coming down and the impact of those restrictions (and voluntary social distancing) is only one third of what it was at the start of the pandemic.
2. Has the US neutral rate (r*) moved up or down?
   We estimate that the neutral rate in the US has fallen from roughly 2.5% prior to this pandemic (=the Fed's long run dot) to just 1.7%, but most of this is 'trend'. The pandemic volatility diluted the economic relationships in the workhorse central bank models, which also exclude other important drivers (savings, demographics, inequality). Fed references to r* have declined in their communication, suggesting, we think, that they too have lost faith in the models. Inflation developments are likely much more determinative of their normalization path and uncertainty over where 'neutral' is should increase term premiums and produce steeper curves.
3. Can the fiscal cliff next year derail the recovery?
   If pandemic stimulus is left to expire the global fiscal adjustment next year is 5x larger than that post Global Financial Crisis. However, the 'cliff' is mainly a US story (70% of the global adjustment in 2022) assuming the infrastructure and reconciliation bill add no more than $2trn in spending, and with most countries yet to submit draft budgets for 2020, we think the cliff may well evaporate like it did last year. We outline five reasons why the growth drag from expiring Covid stimulus is likely much less severe next year than meets the eye.
4. What is the outlook for liquidity, and what does it mean for markets?
   Given that tapering is occurring in the face of rapidly declining fiscal deficits (and therefore issuance), the net increase in supply of paper to the market is less than headlines suggest. Nonetheless, as the second derivative of central bank balance sheet becomes negative, our price-based measure of liquidity begins to tighten too. When that happens, returns, particularly in Growth stocks, do take a brief hit, even if the level of liquidity remains loose. We may have just commenced on this short but difficult period for the market. Liquidity's contribution to returns in this recovery has been twice that of growth so far. We believe the liquidity engine is now exhausted; thankfully growth isn't yet.
5. What does Common Prosperity in China mean for markets?
   As the focus on income distribution sharpens, the footprint of the state will increase. This will very likely mean reduced earnings CAGR for many companies, but it doesn’t mean China is moving away from a market economy. Motivated by 'common prosperity', China is conducting two types of tightening presently: regulatory tightening, which impacts Growth stocks in China, and credit tightening, which impacts Value stocks globally. In the near term, we think regulatory tightening is the bigger worry, while credit tightening may ease. But in the longer term, we are more concerned about the latter.
6. How long will the earnings upcycle extend?
   As earnings momentum peaks, returns decelerate and cyclicals lose their ability to outperform. As earnings momentum approaches its cycle mean, returns slip negative and cyclicals underperform. The typical gap between these two market regimes has been 4-5 months. But this cycle is shaping up differently. Four months after its peak, earnings momentum for most sectors is still within 80-90%ile of their respective histories. High operating leverage will likely overwhelm higher costs from energy and wages. We look into which sectors can see an increased wavelength of earnings expansion across regions.
7. How much reflation room is left in this cycle?
   We are running out of labour market slack, notwithstanding residual pockets of distress in services. By our estimate Europe is now closer to pre-pandemic employment levels than the US. Our Cycle Clock tells us that the cycle is nearly three-quarters of the way to its top. That sounds old, but we think earnings are likely to surprise positively over the coming 3-6 months. In developed markets a 'reflation equities basket' outperformed the market only between Oct'20 and Feb'21. This should see a tactical catch-up before growth reality catches down to expectations by Q2 next year.
8. Has the dollar troughed if twin deficits and the cycle have peaked?
   There is a pattern of lags between twin deficits peaking and the dollar's performance. We remain bearish the dollar against G10 currencies. Amidst still strong global growth we believe US residents are likely to look for returns globally in the coming quarters, and larger proportions of these outflows are likely to be unhedged. Although the Fed is hawkish, it is only in the middle of the central bank's hawkishness spectrum, limiting the consequences for the dollar.
9. Is temporary inflation becoming permanent?
   The inflation run-up has been more notable in DM, particularly the US, Germany, and Canada, than in EM. Much of the increase reflects a rebound in depressed service sectors but the big surprise is in 'goods', where bottlenecks have intensified price pressures and there is, so far, little relief from expenditure switching. With inflation concentrated in the tails of the distribution across DM, little impact on long-run inflation expectations, and energy and food prices easing in coming months, we expect most of the current inflation to dissipate.
10. Are bottlenecks dissipating/impact on global growth/inflation?
    The pandemic created a 20pp export volume gap between Asia and the US/Eurozone— a shift that was more than 10x larger than the one over the preceding 5 years. We see modest signs of expenditure switching starting to take some pressure off the trade imbalance, and a 56% jump in semis capex (vs ’19) should start to alleviate chips shortages at auto producers from Q4. We estimate that the container & chips shortages have subtracted roughly 50bp from global growth this year, but that shipping costs added surprisingly little to inflation.

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