This action might not be possible to undo. Are you sure you want to continue?
com, UBS AG
Wealth Management Research
11 June 2010
Updating our investment strategies for deflation
s Although not our base case scenario, we examine the potential impact
Selected related publications
of a prolonged period of deflation on various asset classes. We also suggest investment strategies suitable for those who expect such an extended period of falling prices.
s For equity investors, we think shares of companies with proven pricing
knife-edge: Corporate bonds facing inflation, 10 February 2010 meet a surge in inflation, 15 September 2009
s Deflation-inflation knife-edge: Strategies to
power, solid balance sheets and good regional diversification may be attractive.
s Extending the average portfolio duration and a careful selection of
Table of contents
bonds can also help preserve purchasing power. The fine print relating to embedded deflation floors should also be well understood by investors in inflation-linked bonds.
s While cash seems to be king and liabilities are less welcome, investors
are well advised to understand the FX landscape since deflation promises to trigger some bouts of high volatility on this market.
s Other asset classes, such as hedge funds or commodities, are also
examined in this note and we highlight how important selectivity becomes in a persistent deflationary environment. On the cusp Economic opinion is divided, and this makes life difficult for some investors. In the aftermath of the financial crisis, do we face an era of inflation or deflation? Investors need to know how best to position themselves in either case. In this paper, we now take a close look at the investment implications of a deflationary scenario after having shed some light on the consequences of inflation in an earlier publication. Although we think it is less likely to unfold than an inflationary environment (Fig. 1), we cannot dismiss the emergence of deflation altogether. For investors who think deflation is inevitable in the coming years, we outline some strategies for preserving wealth in what would prove to be a challenging environment.
Economics Liabilities Fixed Income Investments Currencies Equities Hedge Funds and Private Equity Real Estate Commodities
2 3 4 6 8 9 10 11
Fig. 1: WMR inflation expectations In percentage points
Source: UBS WMR, Reuters Ecowin, as of 07. June 2010
This report has been prepared by UBS AG.
Please see important disclaimers and disclosures that begin on page 13.
Past performance is no indication of future performance. The market prices provided are closing prices on the respective principle stock exchange. This applies to all performance charts and tables in this publication.
a drop in spending so severe that producers across all sectors must cut prices on a sustained basis in order to find buyers for their products. we think that monetary policy may remain loose for longer than currently anticipated in order to counterbalance the burden of tighter fiscal policy. We contend that. In this form." as it is called – as soon as government support is reversed. Before looking at the implications of deflation for different asset classes. which we will consider in detail in the following sections Dirk Faltin. in the longer-term. Today. deflation is bad for borrowers. Consider a loan of USD 1000: If prices drop 3% per year for 10 years. for example. Following the great recession of 2009. But there is also "bad" deflation. prices falling for a few months would not constitute much of a problem. Likewise. Their thrift is rewarded well beyond any nominal interest gains they may receive. This prompts consumers and businesses to postpone purchases. However. UBS AG th Deflation-inflation knife-edge . In fact deflation has two faces: There is "good" deflation that results from more efficient and thus cheaper means of production (think: flat screen TVs). It is a fact that a looming sovereign debt crisis has already prompted many governments. to announce tough fiscal austerity programs. prices of some goods and services will fall. it is good for savers. reflecting changes in demand and supply. Thus. accompanying strong economic growth. inflationary pressure may be the bigger problem. which is associated with a deep. The cause of pernicious deflation is said to be a collapse of aggregate demand. at any given time. In short. On the other hand. dark economic recession. overall economic conditions are such that declining prices reinforce expectations that prices will fall even further in future.340. the nominal repayment sum at the end of that period would be worth more than USD 1. Economist.UBS Wealth Management Research 11 June 2010 Deflation-inflation knife-edge Economics — Defining deflation Inflation is commonly understood as a persistent rise in the general level of prices. demand has been successfully propped up by the massive fiscal and monetary stimulus programs implemented by governments worldwide. deflation risks cannot be dismissed out of hand and investors are well advised to contemplate its consequences. Painful as this may be for the sectors and industries that have to cut prices in response to weakening demand. there are concerns that the world's economy may slip back into recession – the W-shaped "double dip. this is not what we mean by deflation. we highlight one specific and profound economic consequence: Deflation actually increases the real value of debt. only aggravating the drop in total demand that has caused prices to weaken in the first place. The emphasis here is on the words "sustained" and "general. 3% inflation would have lowered the value of the loan to only USD 737. especially in Europe. This single effect of deflation has consequences for virtually all asset classes. On the other hand. deflation discourages borrowing and encourages saving.2 . This type of deflation prevailed for much of the 19 century. while deflation is a sustained drop in prices as measured by the consumer price index." Clearly. In contrast.
either by selling assets that are likely to fall in value anyway in a deflationary environment or through retained income. outstanding mortgage debt is higher than the value of the home. 2: Energy-driven swing in headline inflation Core inflation more stable (% y/y rates) We have outlined the consequences of inflation on an investor’s asset and liability management in a previous paper. UBS WMR. Implications for investors are straightforward: If deflation is anticipated with high conviction. i. Deflation is good for savers (or holders of cash) and bad for debtors. If deflation is protracted. but typically also wages. as we have seen. Usually. But in the case of a prolonged period of deflation.3 . UBS AG Source: ThomsonReuters EcoWin. a rational approach would be to start paying down debt. in a deflationary environment it is not only consumer goods and services prices which fall. as of 06. Thus. not only will consumer prices fall. driving short-term loan rates below those for longer-term loans. as noted above. this dynamic is reversed.UBS Wealth Management Research 11 June 2010 Deflation-inflation knife-edge Managing assets deflationary times and liabilities in Fig. Deflation in the form of falling consumer prices will increase the real value of debt. We concluded that higher inflation is generally positive for debt holders. it should be financed with short-dated loans since central banks usually cut interest rates all the way down to zero in a prolonged period of deflation. June 2010 Deflation-inflation knife-edge . all the more if they have been able to finance their debt with long-term fixed-rate loans when inflation (and therefore interest rates) was still low. the "real" (inflation-adjusted) burden of a private household's debt increases as its ability to pay for interest fees and amortization shrinks with its falling wage income. Economist. The various forms of deflation will affect the balance sheet of a private household or a company in different ways. If debt cannot be completely paid down. Falling real estate prices diminish the home equity position of a private household and one can even end up in a situation where home equity is negative. but also asset prices such as equities or real estate. Daniel Kalt.e.
the latter can impact the former as inflation expectations tend to be adaptive. Companies with considerable amounts of (fixed) debt on their balance sheets are likely to have difficulties paying it down quickly if business volumes and cash flows fade. the market thinks consumer price inflation in Germany will remain below the ECB inflation ceiling of 2% over the next five years. Chart 4 shows that the market shifted from a deflation towards an inflation scenario in 2009. calculated as the difference between yields on 5-year nominal and 5-year real inflation-linked bonds Source: UBS WMR. in our opinion. Reuters EcoWin as of 08 June 2010 Deflation-inflation knife-edge . we would avoid the high-yield bond segment. nominal government bonds should be preferred over inflationlinked bonds. regionaly well diversified issuers of corporate credit who enjoy pricing power – the ability to maintain their prices at higher levels – and who have good cost control should perform better given their more stable cash flows. government-guaranteed agencies. and the prices of their bonds may well suffer more than they could benefit from falling government bond yields. Similarly. Credit quality becomes an important factor in times when risk aversion is likely to revive. bond yields in the US In percentage points 16 14 12 10 8 10 6 4 2 0 (2) (4) 1977 198 1985 1989 US CPI (lhs) 1993 1997 2001 10-year treasury yields (rhs) 2005 2009 6 4 2 0 8 18 16 14 12 Source: UBS WMR.) should do well. with consumer prices falling significantly? Experience suggests that if consumer price inflation were to be lower than breakeven inflation over a given period. Thus. some local governments. Nominal government bonds preferred The market's inflation expectations can be broadly inferred from the difference between yields on nominal government bonds and those on real or inflation-linked bonds (ILBs) of a similar maturity. And since deflation is not likely to be a global phenomenon. As a consequence. deflation. nominal government bonds would be one of the main beneficiaries of a prolonged period of falling prices. if an investor expects deflation. yields tend to decline and prices for nominal government bonds tend to rise. Therefore. that is. However. etc. many bond issuers with lower credit ratings see their credit metrics detriorate in a period of prolonged deflation. Considering corporate credit We think it useful to differentiate within nominal bonds.4 . We woud prefer higher-rated credits of these segments to cyclical sectors and capital goods since delayed investment activity is likely to hurt such companies. since early this year markets have revised their inflation expectations sharply downward and now project inflation to remain below its long-term average over coming years in major countries. Instead. For example.UBS Wealth Management Research 11 June 2010 Deflation-inflation knife-edge Fixed income investments and deflation The underlying trend of consumer price inflation is critical for any bond investment. Market prices and yield trends for government bonds are closely linked to changes in inflation expectations. but also to actual inflation (Figure 3). However. nominal government bonds would be more attractive than inflation-linked government bonds. 3: Deflation vs. Fig. 4: Market’s inflation expectations In %. Therefore. credit issuers that benefit from guarantees (supranationals. What if there were in fact a lengthy period of unexpected deflation. Reuters EcoWin as of 07 June 2010 Fig. Hence. we would move up the rating scale as credit default rates might not drop to levels seen in previous credit cycles. Industries with inelastic demand include health care. food and to some degree utilities. It is important to note that expected and not actual inflation is the driver here. the developments of yields is not only correlated to inflation expectations. If consumer price inflation is expected to decline. driving credit risk premiums higher.
due to inflation.5 3 2. even if consumer prices have declined over the period. prices fall by more than the cumulative inflation to date. It will only kick in if. the real yield is higher than the real coupon on the bond as set at the time of issue. Investors should therfore be prepared to hold bonds to maturity in some segments. central banks try to counter falling inflation by lowering interest rates. with other variable (nominal) rate bonds – such as floating rate notes – investors worried about deflation should prefer products with an embedded interest rate floor.5 -1 1986 1989 1992 1995 1998 2001 2004 2007 2010 US 10 year . but rather the bond's nominal value at issue. This floor determines that the redepmtion amount at maturity cannot be lower than the nominal value at the time of issue. investors expecting an extended period of falling prices can generate a positive return by investing in nominal government bonds and thus hope to increase purchasing power. Dirk Effenberger. Investors with a strong deflationary view should therefore focus on recently issued bonds with a deflation floor. The floor acts as nominal capital protection (not issuer protection!) at maturity. the principal is adjusted for increases in the reference price index. tobacco (HICPx) Euro-area Consum-er Price Index. This means that during the term of the bond. Similarly. In addition. Finally.US 2 year Inverse floating rate notes and curve positioning Generally.5 1 0. 5: Steepness of the US interest rate curve Difference between 2. With respect to inflation-linked bonds. thus stimulating consumption via cheaper credit. Reuters EcoWin as of 07 June 2010 Deflation-inflation knife-edge . Accordingly.5 . If a bond were issued years ago and. ILBs pay a fixed real coupon plus compensate for rising consumer prices by adjusting the bond’s nominal value for inflation. Müller. an economic environment associated with deflation leads to lower interest rates.5 2 1. In sum. To limit deflationary pressures and ensure gradual price increases over the medium to long term. Secondly. long-term interest rates first fall in anticipation of lower inflation as investors accept lower compensation. which helps an investor maintain overall purchasing power. Inflation-linked bonds can still shine during deflation Under certain circumstances. The "deflation floor" of some ILBs can work in their favor. Normally. can be sold only at a loss on the invested capital. not all issuers have bonds with deflation floors (see Table). UBS AG ILBs in different regions ILBs offer a real coupon that is constant over the life of the bond. for example.” Market US TIIPS Reference Index All Items consumer Price Index for all Urban Consumers (CPI-U) Deflation Floor* Yes Coupon Semi-annual UK Treasury Gilt I/L Retail Price Index (RPI) French OATie Euro-area Consumer Price Index.and 10-year rates 3. coupon payments compensate for inflation. we note.5 0 -0. then the deflation floor may not be effective. tobacco (HICPx) No Yes Semi-annual Annual Germany I/L Yes Annual Inflation-linked bonds (ILBs) and products like inflation swaps and inflation-linked structured notes are the most direct types of investment to protect against an increase in consumer prices. In an ordinary interest-rate cycle. its nominal value may drop below its level at issue and. In an environment of lower growth with incentives for corporations to pay down debt rather than refinance debt. Source: UBS WMR. Part 8 – Inflation-linked bonds. For more details. Analyst. For one thing. In contrast to nominal bonds. lower interest rates have positive consequences for fixed-income investments: already issued ordinary bonds with fixed coupons rise in value. new issuance could decline and net activity could be flat to negative. since only lower interest rates are available in the market compared a pre-existing bond's fixed coupon. Mind the gaps in the deflation floor ILB's are not without pitfalls. investors should prefer recently issued ILBs with an embedded deflation floor. protection against deflation comes at the price of a lower real yield to maturity. its inflationadjusted nominal value is now well above that nominal value at issue. UBS AG Philippe G.UBS Wealth Management Research 11 June 2010 Deflation-inflation knife-edge The potentialy lower liquidty of corporate bonds is also an important aspect to consider in a prolonged deflationary period. Source: UBS WMR Fig. see our Education Note: “Understanding Bonds. In any case. the protection depends on the timing of the issue. during this period. Analyst. If consumer prices were to fall over the entire term of a newly issued ILB. inflation-linked bonds (ILBs) can perform well in a deflationary environment. during the residual term to maturity. Thus. this deflation protection only kicks in at maturity. excl. excl. at maturity the investor would not receive the inflation-adjusted value.
not least because its mechanisms often defy our intuition. which for most of us has been formed during periods of normal and or even high inflation. inverse floating rate notes profit from lower Libor. even result in an inverse interest rate curve. 5).6 . The Federal Reserve Bank. investors observe an initially flattening of the yield curve.72% in the UK on 7 June. UBS AG Currencies — Deflation promises chaos Analyzing deflation's economic impact is complicated. investors should expect the current very steep curve to change shape. Given the recent debt turmoil in Europe. A typical cycle suggests that a country entering deflation will first face an appreciation of its currency.UBS Wealth Management Research 11 June 2010 Deflation-inflation knife-edge An inverse floating rate note (FRN) is even better protected against falling yields and deflation. In a portfolio context.and short-dated bonds is still considerable. as its coupon is adjusted to the new interest rate environment at each coupon date and rises if the Libor rates decrease. It is crucial to distinguish between theory and practice when investing. in deflation. In anticipation of future deflation or substantially lower inflation. In a second stage of the deflation cycle. This means that the interest rate curve is historically steep in the US. This is equivalent to a narrowing of the interest rate spread of long. with limited potential to decrease further. which improves the country's net trade position. over time. they may consider extending the average duration of their bond allocation. In Switzerland Libor slipped to 0. we think investors expecting a deflationary environment over the next years should favor investments in long-term rather than short-term bonds in order to lock in the higher yields (see Fig. the Bank of England and the Swiss National bank have slashed their central bank rates to 0. where short-dated bonds would pay higher coupons than longer-dated bonds. Libor has increased by 10 basis points since the end of 2009. Even though Libor increased slightly. UK and Switzerland. Daniela Steinbrink-Mattei.1%. Accordingly. Typically. Usually.and short-term yields. This flattening could. Also. the UK. consumer demand falls. three-month Libor traded at 0. when market participants expect inflation to fall. Even though yields across the whole interest rate curve are currently at historically low levels. they remain at a historically depressed level. deflation also means that the real interest rate is much more attractive than what is available abroad. with its very steep yield curve. the difference between long. In the current interest rate environment. This is especially the case for the US. and the EU and also very steep in Switzerland.25%. because the banking system of a country in deflation needs money. Economist. Deflation typically triggers repatriation. Today's historically low central bank rates do not offer much potential for lower rates. primary driven by movements at the long end of the curve. Deflation-inflation knife-edge . Generally. This typically leads to a depreciation of the currency. the government tries to jump-start domestic demand and expands government spending. Thus inverse floaters make little sense in the current low interest rate environment. For currency markets the most important effect of deflation economics is that investors and companies have high incentives to save and low incentives to spend or invest.4% in the US and at 0.
deflation promises chaos on currency markets. The strong appreciation of the USD this year signals that future appreciation potential is limited. This supports lowyielding currencies (at present. Finally. the investor receives a positive real interest rate. The most likely candidate for a deflationary cycle is Japan. The currency cycle of deflation The effects of deflation on currencies are dynamic. In the first phase.7 . We identify two disruptive processes at work in this cycle. Economist. s Persistent deflation keeps real interest rates high and the currencies of countries with the strongest deflation experience the sharpest appreciation. the currencies of the deflation countries tend to depreciate sharply as growth prospects decline and the need for government intervention increases. These measures are likely to weaken import demand but improve competitiveness and therefore strengthen the euro again. We note three discreet stages that form the deflation cycle of currencies: s The onset of deflation leads to a rapid reduction of credit positions (deleveraging) and the unwinding of carry trades. the US is also not fully protected against a deflationary cycle. hurting the Yen further. One kicks in at the outbreak of deflation and the other is at work in the transition from the second to the third stage. as well as during the latest financial crisis. In times when prices fall and money stays stable. UBS AG Deflation-inflation knife-edge . even when the nominal interest on cash holdings is zero. In short. not static. We are now awaiting the second stage. because they can be tremendous. suggests that the effect of rising real interest rates is most strongly felt at the outset of the crisis and is later replaced by other influences. due to the fiscal austerity measures. leading to a depreciation of the currency that is often accelerated by reflation policies as governments spend unusually high amounts of money to revive their stricken economies. Its currency appreciated as inflation rates entered negative territory. low-yielders and the currencies of countries with strong deflation tend to appreciate due to repatriation of capital and deleveraging. an even more expansive monetary/fiscal policy. In the second phase. indeed.UBS Wealth Management Research 11 June 2010 Deflation-inflation knife-edge The economic inefficiency of reducing the growth prospects of a country – and here is just one example of a counterintuitive aspect of deflation economics – is that the interest rate on simple cash holdings cannot become negative. which can be traced back to the reduced growth outlook for the given country. Our experience with deflation in Japan in the mid-1990s. We also note that while deflation is never supportive for a currency in the long term. The next candidate for a deflation cycle is Europe. Thomas Flury. the Japanese yen or US dollar) and pressures high-yielders (currently those of emerging markets and commodity producers). the possibility of short-term spikes should not be ignored. A vicious cycle. Both processes are highly disruptive and the shift in currency valuation at these stages can be very large. which is almost half the way through it. s Eventually the countries where deflation is strongest will see their economic strength reduced. however.
Intuitively. The auto sector meets both of these criteria. Another sector that also depends on the overall business cycle are capital goods companies like machinery producers and aerospace. Both arguments would also apply for the tobacco industry and regulated utility companies. weak nominal returns are somewhat counterbalanced.UBS Wealth Management Research 11 June 2010 Deflation-inflation knife-edge Equities — Diversification is key The historical examples of equity returns during prolonged periods of deflation are very rare. if real purchasing power of money increases. with no possibility for investors to diversity internationally. Given the significant profit contribution of their financial services arms. Both factors are almost unique to this industry and are clear advantages. However. On the other hand. as installed products are used longer. a few segments of the corporate sector are able to operate even under these circumstances and to show slightly positive earnings growth. we discussed the case of equity in closed economy and capital market. which still might generate sufficient returns. if the overall economy suffers from deflation. However.8 MSCI JAPAN FINANCIALS INDUSTRIAL MATERIALS TELECOM UTILITIES CONS STAPLES HEALTH CARE . 6: Pricing power sectors fare better in deflation 10-year performance of MSCI Japan sector indices during 350 300 250 200 150 100 50 0 00 0 02 03 04 Utilities 05 06 MSCI Japan 07 08 Energy 09 1 Health Care Source: Datastream. with a few exceptions. 7: Only Energy and Utility companies delivered positive returns Annualized JP sector performance over the last 10 years 10% 5% 0% -5% -10% -15% -20% ENERGY RETAILING IT CONS DISCR annualized sector performance Source: Datastream. Past deflationary periods have seen earnings fall as a result of lower sales or because purchases are delayed by consumers. equities generated weak returns and haven’t been a good hedge against deflation. in our view. risk premiums tend to rise in a deflationary environment. They also enjoy better access to capital markets than weaker companies. Other consumer discretionary companies would be heavily impacted as well. auto makers would likely suffer in a deflationary environment. bond yields tend to fall. However. The consequences of deflation for equity market returns are intimidating. for example. and the annualized nominal return of all equity sectors in figure 7. So far. However. Therefore. Integrated oil companies generally meet these criteria. While lower interest rates reduce borrowing costs. and that are also exposed to discretionary consumption would suffer in a deflationary environment. An additional drag for the car industry is its important leasing and financing activities. companies with relatively high debt levels and fixed maturities. albeit to a weaker extent. higher customer credit defaults in a deflation scenario would add pressure to auto makers' balance sheets. making the net effect of deflation on discount rates for earnings less clear. repair-and-maintenance businesses should suffer less. In addition. it is very difficult to operate profitably when new orders are delayed and order books shrink. mitigating the impact of the order shrinkage on profitability. as of 07 June 2010 Fig. listed companies of such industry groups are unlikely to deliver superior earnings growth and should be avoided by investors who expect deflation. The most prominent example is probably Japan during the last decade. as of 07 June 2010 Deflation-inflation knife-edge . as purchases are truly discretionary and can be easily delayed by a couple of years. Both low-end and luxury goods would be hurt. With long lead times for production in both segments. The Health Care sector offers the advantage that their product demand can't be delayed and that the price sensitivity of their clients is very low in general. The historical performance of the better performing sectors during the deflationary decade in Japan is shown in figure 6. A closer look at the key drivers of stock returns can help to identify some less vulnerable companies. From a theoretical point of view. companies that have strong balance sheets and good credit ratings suffer less from the rising risk premiums effect. especially under the discussed scenario of deflation it would be a crucial alternative for investors to diversify their equity portfolio into regions Fig.
Analyst. especially if their domestic market suffers from deflation. Companies with a relative stable product demand are better positioned to maintain their margins and should be preferred by investors in a deflationary economic environment. which should lead the recovery. However. Strategist. a deflationary environment would probably be challenging for most companies. Hence we see no reasons from deviating too strongly from the above mentioned strategies (e. It is Interesting to note that private companies are preponderantly in the US and are obviously more dependent on their domestic economy. some bonds segments). Global Macro managers should be therefore able to extract value from fixed income and FX. talented long-short managers can increase their long exposure to dividend paying stocks providing good adjusted-for-deflation rates of return. equities is likely to be the greatest due to liquidity concerns. generally. geographical biases. We stress the long term positive outlook for emerging markets. In particular. Cesare Valeggia. Consequently. for instance. if such phase proves short lived. and are therefore somewhat less affected by turmoil elsewhere. Health Care. UBS AG Deflation-inflation knife-edge . In a prolonged deflationary environment. the insurance sector. Private Equity: If the deflationary phase is prolonged. and large growth divergences. international diversification plays a far more important roll under this scenario. investors may want to consider exposure to global macro and equity long/ short strategies. Analyst. Corporate profits would be under pressure and equity market returns would be weak as well. This is particularly true under a scenario where underlying growth drivers and the pace of growth vary significantly among countries. Energy companies.9 . As we all know. with a deflationary environment confined only to certain economies. liquidity in some markets could suffer (i. in particular in Asia and the related investment opportunities for private investors. which have higher inflation and growth rates. hedging strategies in general should continue to produce good returns when compared to traditional buy and hold strategies. is unwarranted in our view. In addition. Moreover. investors should take advantage of this investment opportunity. UBS AG Oliver Dettmann. Long/short equity strategies should benefit from fundamental analysis as well as trading skills in an environment that allows positive attribution on both the long and the short side (trading).UBS Wealth Management Research 11 June 2010 Deflation-inflation knife-edge and countries. UBS AG Hedge Funds and Private Equity Hedge Funds: If the economy turns deflationary and uncertainty stays high. global macro).e. in Europe. based on timing. Philippe G.g. Investors are also likely to pay down for their investments as we expect the valuation discount vs. The region is likely to experience higher growth rates than developed markets. Hence. we advocate staying clear from this group. in most cases the higher discount (25%-30% premium over equity). Müller. and private equity valuations. which will be accompanied by positive inflation rates as well. and tobacco firms exhibit these characteristics. As economies recover over time. so should primary offering. acquisition. we see it as good entry point. Although a deflationary environment is not good for equities. such a divergence was seen between the US and Japan over the last two decades. In this context we also suggest investors to choose products that offer a certain minimum level of liquidity. To sum up.
0 0. Furthermore. as of 07 June 2010 Deflation-inflation knife-edge . The highly leveraged real estate investors may be forced by their lenders to increase the equity stake in their investment or to sell the properties. monthly) 3.0 0. The income return – which is the quotient of NOI and capital value – grew rapidly (see chart).0 2.5 0. We conclude that an expected slight and brief deflationary period could be positive for capital values as far as investors do not price a recession in. while the overall market related risk premium wouldn't increase at all. Second. multi-year deflation is expected or instead a slight and brief one.10 .0 02 03 04 05 06 Inflation Expectations 07 08 09 Total Return (rhs) 10 5 4 3 2 1 0 -1 -2 -3 -4 -5 -6 Source: IPD. is believed to have triggered deflation and recession fears. Second.0 1.0 2. Equity-financed as well as highly leveraged real estate investors are both affected by deflation expectations by experiencing a deterioration in their asset holdings: future cash flows are estimated to decrease. we consider the development of the capital values based on monthly capital growth. The answer also depends on whether a severe. which revealed huge debt deleveraging needs. then one would expect the discount rate to decrease faster and deeper than the expected future net operating income (NOI).5 0.5 3.0 1.5 3. real estate investors may be forced to sell their properties.5 2.4 0. which in turn could additionally burden the future capital values. while the discount rate doesn't fall enough due to increased uncertainty. monthly) 3. thus unable to protect against deflation or even causing it.0 -0. The reason is that the future NOI would consequently be expected to stay stable as the perennial lease contracts are believed to be enforceable. UBS WMR. the recent real estate crisis. Thus real estate was unable to protect against expected deflation. as of 07 June 2010 Fig.5 3.5 1. 10: Total Return and deflation Total returns (UK) negatively affected by US deflation expectations (%. which are externally appraised on a monthly basis. The growth rates indicate the change in the month under review compared to the same month a year earlier. First. as of 07 June 2010 Fig.putting together capital growth and income return . UBS WMR.7 0. The premium first reflects the fears that the lease contracts won't be enforceable and tenants will default or force the investors to revise lease terms downward. 8: Capital growth and deflation Deflation expectations in the US and capital growth in the UK strong correlated(%. This case is quite unrealistic in our view as negative inflation expectations normally reflect recession fears.0 1. because the Fig.5 2.0 02 03 04 05 06 Inflation Expectations 07 08 09 10 Income Return (rhs) 0.8 0. Bloomberg.5 0.5 -1.6 0. driven by growing risk premiums and a sharp decrease in expected capital values. 9: Income return and deflation Inflation expectations (US) and incorme return (UK) inversely linked (%.2 0. In the case of an expected slight and brief deflationary period.5 0.5 -1. Deflation expectations materialized quickly in the fourth quarter of 2008 and were highly correlated with fast decreasing capital values (see chart). The fact that negative inflation expectations and recession fears are related is best illustrated by the recent developments in UK real estate values. monthly) 3.0 02 03 04 05 06 Inflation Expectations 07 08 09 10 Capital Growth (rhs) 4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 Source: IPD.0 -0.5 1.was left quite negatively affected.3 0. driven by decreasing or negative inflation expectations.1 0 Source: IPD.5 1. Bloomberg.UBS Wealth Management Research 11 June 2010 Deflation-inflation knife-edge Real estate By assessing whether return oriented real estate investment is a good hedge against deflation one should formulate expectations about the appropriate future cash flows and the required discount rates (see appendix for details on how they are defined) to come to the estimated real estate capital value.0 0.5 -1.5 2.0 -0. UBS WMR. as a proxy we derive the overall inflation expectations by subtracting the 5 year real yield of the US inflation linked bond from the yield of the closest nominal US treasury maturity. The total return on property (see chart) . Bloomberg. income return and total return figures derived from 75 UK based real estate portfolios including 4'300 commercial and investment properties.0 2. discount rates tend to decrease quite quickly. Should the short deflationary period not be expected to drive the economy into a recession. This in turn would result in growing capital values.
Analyst. In addition.11 . with the exception of copper. crude oil prices should still head towards USD 90 to USD 100 per barrel. given the uncertainty that would likely prevail. On average. Good investments for deflation are accordingly based primarily on safety. Deflation risks are a topic for the developed world but not for emerging markets. office. Thus. Commodities are real assets and. prices are at the lower end.UBS Wealth Management Research 11 June 2010 Deflation-inflation knife-edge credit quality will be put into question. more than 55% of commodity demand relates to emerging markets. Emerging markets still have room to increase leverage and reap the benefits of their catch-up potential. it is expected that equity financed real estate investors with long term and well enforceable lease contracts will perform better under a deflationary environment than highly leveraged investors with uncertain tenant creditworthiness. With the present market situation. Given the oligopolistic supply structure of crude oil and the strong emerging market demand. there is less need for prices to appreciate in nominal terms. have been trading below marginal production costs. In reality the impact depends on the degree of deflation. Dominic Schnider. in a later stage gold would come under pressure and drop below USD 1000/oz as the market would price gold again as an industrial commodity and not as a currency to protect against inflation. Economic textbooks suggest that the impact of deflation on commodities would be negative.ambiguous impact There is no simple answer to how deflation might impact commodities. Incremental here demand also relates to emerging markets. which definitively left cash to be the sole asset not to decline during deflationary periods. Were the deflation in the develop world mild. emerging market growth would be sufficient to see commodity prices still trending higher in USD. Economically sensitive commodities like base metals and energy would suffer the most. UBS AG Commodities . That said. Agricultural commodities would only be affected in a limited way. Moreover. but perhaps with a delay of a year or two. However. retail or the industrial segment – seems to clearly offer any advantage over another. while our preference would be the residential real estate market. Base metal prices. Therefore. Furthermore in a severe deflationary environment. a strong appreciation in nominal terms would be difficult. the overall impact on commodities is ambiguous. we think commodity prices are more than halfway through the process of discounting a very negative economic outlook. which we forecast to grow at a robust pace. However. there is limited downside potential from present levels in the case of increased deflationary tendencies. deflationary environments are generally accompanied by subdued economic activity. in an environment of no genuine inflationary pressure. properties may be marketed below their actual value. Thomas Veraguth. Hence. Analyst. We conclude that it is unwise to consider real estate investments as a hedge against deflation. borrowers may be unable to repay their debts since the real cost of debt repayment may rise sharply. It is the developed world that needs to deleverage. UBS AG Deflation-inflation knife-edge . on average. EUR or JPY terms. Gold would hold up well initially. thus reinforcing a deflation spiral due to forced sales. In the case of crude oil. where investment will satisfy long-term demand. no single segment of real estate investment – the residential.
the future net operative income (NOI) . 11 year m a) 10 US war of independence 5 Napoleonic wars: deficit m onetised Fiscal m onetisation during Volcker WWI clam ps Fiscal m onetisation during down on inflation WWII US civil war 0 1st industrial revolution: productivity. Capitalization rates on the other hand are made up of at least three elements: the real interest rate (1). as of 25 Sept 09 1875 UK 1900 1925 1950 1975 2000 Real Estate Appendix The present capital value for return oriented residential and commercial real estate depend both on expected future cash flows .12 . gold finds Depression (5) (10) 1750 1775 1800 1825 1850 US Source: Reuters EcoWin.UBS Wealth Management Research 11 June 2010 Deflation-inflation knife-edge Appendix Fig. Deflation-inflation knife-edge . the expectations over future inflation (2) and a risk premium (2). Capital values are therefore positively driven by improving expectations towards future NOI but also by falling capitalization rates. oil shocks 2nd industrial revolution: productivity rebound. which rewards investors for risk taking. UBS WMR. Therefore real estate capital values are fundamentally determined by inflation expectations not actual inflation. The appropriate net operating income (NOI) is generally driven by expected economic or income growth (1). the expected duration of the lease contracts (3) and possible vacancies (4). 11: Fiscal debt monetization and inflation Consumer Price Index in percentage points 15 Consum er price inflation (% yoy. the expected tenant default's rates (2).led deflation Fiscal m onetisation during Vietnam War.in the numerator and on the required capitalization rate on the denominator.
Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. units. is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). Australia: Distributed by UBS Wealth Management Australia Ltd (Holder of Australian Financial Services Licence No. Deflation-inflation knife-edge . Bahamas: This publication is distributed to private clients of UBS (Bahamas) Ltd and is not intended for distribution to persons designated as a Bahamian citizen or resident under the Bahamas Exchange Control Regulations. boulevard Haussmann F-75008 Paris. and will not be. UBS Deutschland AG is authorized and regulated by the "Bundesanstalt für Finanzdienstleistungsaufsicht". Singapore: Please contact UBS AG Singapore branch. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. is regulated and authorized by the Jersey Financial Services Commission for the conduct of banking. a subsidiary of UBS AG. the Dubai Financial Market.. Dubai: Research is issued by UBS AG Dubai Branch within the DIFC.. UBS will not be liable for any claims or lawsuits from any third parties arising from the use or distribution of this document. by UBS Bank. regulated by French banking and financial authorities as the "Banque de France" and the "Autorité des Marchés Financiers".A. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS.p. into other areas. R. Luxembourg: This publication is not intended to constitute a public offer under Luxembourg law. Germany: The issuer under German Law is UBS Deutschland AG. Austria: This publication is not intended to constitute a public offer or a comparable solicitation under Austrian law and will only be used under circumstances which will not be equivalent to a public offering of securities in Austria. Securities mentioned in this material have not been. the analysis or report. funds and investment business. UK: Approved by UBS AG. to which this publication has not been submitted for approval. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. Canada: In Canada. Jersey Branch. The analysis contained herein is based on numerous assumptions.. In certain countries UBS AG is referred to as UBS SA. the Emirates Securities and Commodities Authority. a regulated bank under the supervision of the "Commission de Surveillance du Secteur Financier" (CSSF). 2 Chifley Square. All rights reserved. an Italian bank duly authorized by Bank of Italy to the provision of financial services and supervised by "Consob" and Bank of Italy. All transactions by a US person in the securities mentioned in this report should be effected through a US-registered broker dealer affiliated with UBS. or deal as principal or agent. registered under the Indonesian Capital Market Law and Regulations. Italy: This publication is distributed to the clients of UBS (Italia) S. Business Divisions of UBS AG (UBS) or an affiliate thereof. or a solicitation of an offer. a bank registered with the Bank of Spain. 60306 Frankfurt am Main. All information and opinions as well as any prices indicated are current as of the date of this report. Chifley Tower. UBS Financial Services Inc. This publication is distributed to private clients of UBS London in the UK. an exempt financial adviser under the Singapore Financial Advisers Act (Cap. or in connection with. S. and not through a non-US affiliate. financial situation and needs of our individual clients and we would recommend that you take financial and/or tax advice as to the implications (including tax) of investing in any of the products mentioned herein. New South Wales. Changes in FX rates may have an adverse effect on the price. This report is for distribution only under such circumstances as may be permitted by applicable law. authorized and regulated in the UK by the Financial Services Authority. UAE: This research report is not intended to constitute an offer. accepts responsibility for the content of a report prepared by a non-US affiliate when it distributes reports to US persons. is intended for professional clients only and is not for onward distribution within the United Arab Emirates. to buy or sell any investment or other specific product. UBS expressly prohibits the distribution and transfer of this document to third parties for any reason.A.A. 231127). This document may not be reproduced or copies circulated without prior authority of UBS or a subsidiary of UBS.. and are subject to change without notice. they will not be covered by the UK regulatory regime or the Financial Services Compensation Scheme. The document may only be used by the direct recipient of this information and may under no circumstances be passed on to any other investor.. a licensed bank under the Hong Kong Banking Ordinance and a registered institution under the Securities and Futures Ordinance.A. S. Milano. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith. Sydney. but no representation or warranty.The key symbol and UBS are among the registered and unregistered trademarks of UBS. USA: Distributed to US persons by UBS Financial Services Inc. Futures and options trading is considered risky. A member of the London Stock Exchange. via del vecchio politecnico 3.Version as per January 2010. Where products or services are provided from outside the UK. Jersey: UBS AG.S. UBS Securities LLC is a subsidiary of UBS AG and an affiliate of UBS Financial Services Inc. At any time UBS AG and other companies in the UBS group (or employees thereof) may have a long or short position. 19) regulated by the Monetary Authority of Singapore. Spain: This publication is distributed to clients of UBS Bank. Past performance of an investment is no guarantee for its future performance.C. express or implied. value or income of an investment. UBS (France) S. Bockenheimer Landstrasse 2-4..944. This publication is for your information only and is not intended as an offer. NSW 2000. The contents of this report have not been and will not be approved by any authority in the United Arab Emirates including the UAE Central Bank or Dubai Financial Authorities. We are of necessity unable to take into account the particular investment objectives.A. France: This publication is distributed by UBS (France) S. Hong Kong: This publication is distributed to clients of UBS AG Hong Kong Branch by UBS AG Hong Kong Branch. the Abu Dhabi Securities market or any other UAE exchange. divisions or affiliates of UBS. in respect of any matters arising from. to its clients and prospects. Different assumptions could result in materially different results. 69. in relevant securities or provide advisory or other services to the issuer of relevant securities or to a company connected with an issuer. but might be made available for information purposes to clients of UBS (Luxembourg) S.UBS Wealth Management Research 11 June 2010 Deflation-inflation knife-edge Appendix Global Disclaimer Wealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas.726. is a provider of investment services duly authorized according to the terms of the "Code Monétaire et Financier". © UBS 2010. Paris B 421 255 670.13 . 110) and a wholesale bank licensed under the Singapore Banking Act (Cap.A. Indonesia: This research or publication is not intended and not prepared for purposes of public offering of securities under the Indonesian Capital Market Law and its implementing regulations. this publication is distributed to clients of UBS Wealth Management Canada by UBS Investment Management Canada Inc. French "société anonyme" with share capital of € 125. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. sale or delivery of shares or other securities under the laws of the United Arab Emirates (UAE).
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue reading from where you left off, or restart the preview.