UBS: Volatility remains high

Despite increased cautiousness among investors towards the end of the month, global equity markets in aggregate posted positive returns. This was largely supported by improved economic data in the US and eurozone. Sentiment was also buoyed by the Fed’s view that the US economy was ultimately strong enough to weather higher interest rates later in the year, as well as the agreement Greece reached with its creditors, which eased eurozone-related investor concerns.

• Japanese data showed a continued recovery in industrial production, while the market was also helped by the weakening of the yen.

• Emerging market equities suffered negative returns largely in part due to the strength of the US dollar.• Oil prices continued their recovery in May, reaching new highs for 2016. They have now gained over 80% from their February low, with the continued rally supported by a sharper-than-expected fall in inventories largely due to the wildfires in Canada.

• Within fixed income, US government bonds underperformed due to a re-pricing of interest rate expectations. In contrast, UK and German bonds fared well, while peripheral European bonds were especially strong given relief over the Greek deal. Within the corporate sector, credit spreads were generally lower with US high yield bonds faring quite strongly thanks to their strong, recent ties to the fortune of oil.

Outlook:

• While political risks have moderated following the debt negotiation agreements reached in Greece, it is likely to remain one of the biggest drivers of volatility as we approach the UK referendum in June and US presidential elections later this year. Fears about a slowing Chinese economy have faded on account of improving economic data. However, we believe that long-term challenges still remain a concern and need to be monitored closely.

• Given risky assets remain relatively challenged in the short term, we have positioned our portfolios to be neutral in risk assets overall. We have reduced exposure to equities since the beginning of the year on a tactical basis, perceiving better opportunities to play cyclically through other asset classes, like investment grade corporate bonds, where we see scope for attractive risk-adjusted returns. Within equities, we continue to maintain our preference for European and Japanese equity markets over the US because of valuation support and more favorable monetary policy.

• In fixed income, we tactically favor inflation-linked bonds in the US over their nominal counterparts, believing US inflation risks are underpriced. Within the high yield universe, we prefer European exposure where spreads over European government bonds are attractive and quality remains high.

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