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We continue our 2010 outlook series with the latest from UBS.  The European bank has an outlook that is dissimilar from two of the European teams we highlighted over the last few weeks (CS here and MS here).  They do, however, have many similarities with the majority of banks we have covered which are bullish about 2010.  The UBS outlook can best be described as a transitional recovery.  Despite recovery, they believe the risks are numerous and will likely result in a more risk averse investment community.  Investors will move out of the risk trade:

Over the last two years, markets have been driven primarily by the ‘risk trade.’ We see this trend moderating and anticipate a more balanced performance at both the sector and stock level as investor focus returns to fundamentals and valuation. We believe this should make 2010 a more investable market from a fundamental perspective, and we recommend investors seek out ‘quality’ in their stock selections.

This transition will result in a search for yield as investors move into higher quality dividend paying names (see our 8 high quality global dividend payers here) and out of the high beta names that performed so well in 2009.

UBS is not concerned about the value of the markets despite concerns that the markets have gotten overheated.  They believe the earnings rebound in 2010 will justify the current levels:

We continue to see equity markets as fairly valued, noting that the rise in multiples reflects investor expectations for earnings recovery. However, we also see structural challenges limiting further multiple expansion. This balance suggests that gains in equity markets will need to be driven primarily by earnings growth.  Despite modest GDP growth, both top-down and bottom-up estimates forecast a year of robust earnings growth in 2010. This growth, along with higher margins and strong balance sheet conditions, provides a solid backdrop for equity markets.

Like JP Morgan, they favor emerging markets over developed markets:

Our base case forecasts call for a continued, gradual recovery in demand from
developed markets, with emerging economies faring better.

This doesn’t mean the markets are without risks, however.  The broader macro trends of an end to the government stimulus, high unemployment and continued deleveraging will hang over the markets:

But just as the investment landscape looks better than it did 12 months ago, new challenges await. To that end, we expect 2010 to be a year of transition where cyclical and structural forces meet and the strength of the recovery is tested. For one, markets will be forced to consider the impact of government ‘exit strategies,’ where the Fed and other central banks begin a process of stimulus removal and interest rate normalization. Other concerns center on high unemployment, further de-leveraging and balance sheet repair, increased
regulation, and funding of large fiscal deficits.

How to play it?  UBS favors tech, consumer staples, and energy.  They are underweight consumer discretionary, telecomm and industrials.  They are neutral on financials and materials.  Globally, they prefer emerging markets, neutral on US and Europe and underweight Japan.