Investment strategyinsightsBull Market Monitor: Getting later in the cycle

Chief Investment Office Americas, Wealth Management | 24 January 2019 11:47 pm GMTBrian Rose, Senior Economist Americas, brian.rose@ubs.com; Jason Draho, Head Asset Allocation Americas, jason.draho@ubs.com

• Over the past few months, fears of a recession in thenext year have risen considerably. We think that risk is stillrelatively contained, but that the US economy has enteredthe late stage of the business cycle, as reflected in our BullMarket Monitor update.

• Various measures of US and global economic activity haveslowed sharply in the past two months. Growth deceleratingfrom its peak toward long-term potential and Fed monetarypolicy being roughly neutral are the two characteristicstypical of a late-cycle economy.

• The good news is that the economy can be late-cycle for along time. There are encouraging signs in that regard: labormarket strength is helping consumer spending, businessactivity is still above average, inflation looks contained, andthe Fed is likely on pause until growth data have clearlystabilized.

• Gauging the business cycle is critical for our investment viewsbecause equities have performed well in the first half of thelate-cycle stage. In December the markets were pricing insignificant recession risk, but that has been dialed back inJanuary. We think the recent growth slowdown will abate,with a better global outlook in six months.

Financial markets have been on a wild ride since early December.On 24 December the S&P 500 closed only 22 basis points awayfrom being down 20%, the unofficial bear market threshold.Since then the index has rallied 12%. Thus, Bull Market Monitor(BMM) is still an applicable name for our business cycle gauge. Yeteconomic conditions today are clearly different than they were twomonths ago. Fears of a recession have grown—a big factor in theDecember sell-off—but have they gone up too much relative toshifting economic conditions? This BMM update evaluates the cycleindicators to answer this question.

In short, we think the US economy has transitioned into the latestage of the business cycle, from mid-to-late stage before (see Fig.1). Estimates of global growth have slowed sharply in the past twomonths, as PMI manufacturing surveys have plunged and trade andexport data fell. Financial conditions tightened aggressively, thoughhave eased in recent weeks. Thus, it’s understandable that recessionprobability estimates for the next year have gone up.

Business cycle compass (see page 2 for fullchart)

Source: UBS. See page 2 for details.

Fig. 1: Bull Market Monitor: Entering late cycle

Source: UBS, as of 24 January 2019

This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures at the end of the document.

Fig. 2: Summary of asset class returns by business cycle stage

Note: Approximate total returns on asset classes by business cycle stage, annualized, based on historical observations over the past 30years and CIO expert assessment. Source: Bloomberg, Congressional Budget Office, OECD, UBS, as of December 2018

Fig. 3: Framework for defining stages of the business cycle using economic activity and interest rates

Source: UBS, as of December 2019

Investment strategy insights

Chief Investment Office Americas, Wealth Management 24 January 2019 2

Our formal categorization of the economy as late cycle is based ona business cycle framework introduced in two recent reports (hereand here). The economy is “late cycle” if: 1) growth has slowed fromits cycle peak and is trending back toward the long-term potentialrate; and 2) monetary policy has now reached a roughly neutralstance for the economy. These are the typical characteristics of theUS economy in the late stage of the expansion. Figs. 2 and 3 showthe current cycle stage status and the attributes corresponding toeach stage.

The good news is that the economy can be late-cycle for a longtime. There are encouraging signs in that regard: strongly growingemployment, rising wages, and lower oil prices are all helping con-sumer spending. Business activity is still above average, and “hard”production data has held up much better than “soft” survey data.Meanwhile, inflation looks contained and the Fed is likely on pauseuntil growth data and market conditions have clearly stabilized. Sowhile the change in growth and financial conditions has been neg-ative, the actual levels are still above potential and generally accom-modative, respectively.

This is reflected in changes to the BMM indicators. Growth slowingtoward trend, but not below, actually reduces overheating risk. TheFed has hiked rates to about neutral, but has also become moredovish. Similarly, credit spreads have widened, but credit growth forthe overall economy is still healthy. Of course, the outlook couldchange quickly if the government shutdown persists and trade dis-putes linger. The specific details of each BMM indicator are dis-cussed below.

Gauging the business cycle and how it could evolve is critical for ourinvestment views. In December the markets were pricing in signif-icant recession risk, but that has been dialed back in January. Wethink the recent growth slowdown will abate, with a better globaloutlook in six months. This matters because the cycle compass inFig. 2 shows that equities have performed well in the first half ofthe late-cycle stage.

Overheating IndicatorsGrowthThe second and third quarters of 2018 were one of the strongestperiods of growth since the financial crisis, with GDP expanding4.2% and 3.4%, respectively. Growth has slowed since then, withmost indicators down from their highest levels. Previous Fed ratehikes, tariffs and uncertainty over the ongoing trade disputes,slowing growth overseas, and the partial government shutdownare all having a negative impact. However, our economic outlookremains reasonably optimistic.

Growth continues to be supported by strong consumer spending.Faster wage growth and falling energy prices have been a pow-erful combination, allowing households to splurge on their holidayseason spending. In contrast, after years of recovery in housingstarts and rapidly rising home prices, higher mortgage rates havedented the housing market. The manufacturing sector is anothersoft spot, bearing the brunt of the trade disputes.

Investment strategy insights

Chief Investment Office Americas, Wealth Management 24 January 2019 3

It's important to note that even in the weaker segments of theeconomy, there aren't signs of an outright contraction and we seerecession risks as low in the near term. We estimate that GDPexpanded 2.9% in 2018 and forecast growth to slow to 2.5% thisyear, but that would still mean the economy is expanding faster thanits potential. The government shutdown will not have a materialimpact on 2019 growth if it ends soon.

Labor marketThe latest data shows some easing in labor market tightness,though it still remains hot. For example, job openings have slippedfrom their record highs and the unemployment rate ticked upin December. However, nonfarm payrolls increased by 312,000 inDecember and many businesses report that they are having diffi-culty finding workers. Certain categories of skilled workers becamescarce years ago, but now labor shortages have become wide-spread. Combined with increases in the minimum wage imple-mented by state and local governments, wages have startedgrowing at a faster pace, and this is not limited to the upper echelonof the labor force (see Fig. 4).

One factor helping to prevent the labor market from completelyoverheating is that some people who left the labor force after thefinancial crisis have come back. Seniors have also been encouragedto stay in the market even after turning 65. Further, more womenare working than in the past. As a result, the labor force partici-pation rate, which most economists had expected to trend loweras baby boomers retired, has instead moved sideways for the lastsix years (see Fig. 5).

InflationThe Fed’s preferred inflation measure, core PCE (more precisely, theyear-over-year increase in the core personal consumption expen-ditures deflator), began 2018 at 1.6%. It breached the Fed's 2%target in July and at the time appeared likely to continue rising.With economic conditions already strong, we expected the big taxcuts and government budget increases passed by Congress to pushinflation higher. Instead, a soft patch in the data brought inflationback slightly below the target. The most recent reading in Novemberwas 1.9% (see Fig. 6).

Strong economic conditions, especially tight labor markets, tendto stoke inflationary pressure. Higher tariffs on imported goodshave also had some impact. But there are some factors helping tokeep inflation down. Technological progress has meant that at leastin quality-adjusted terms, the prices of some goods and serviceshave been falling sharply in recent years. To give one example, tele-vision prices were down 18% year-over-year in November. In thenear term, lower oil prices and the cooling housing market shouldhelp constrain inflationary pressures. In our view, the various forcesshould more or less balance, keeping core inflation near the Fed's2% target.

Fig. 4: Tight labor market promoting wagegrowthAverage hourly earnings, year-over-year change in%, and unemployment rate in %

3.04.05.06.07.08.09.010.011.0

0.00.51.01.52.02.53.03.54.0

2007 2009 2011 2013 2015 2017Average hourly earnings (left scale)Unemployment rate (right scale)

Source: Bloomberg, UBS as of 23 January 2019

Fig. 5: Higher participation helps prevent over-heatingLabor force participation rate, in %

62

63

64

65

66

67

68

1999 2002 2005 2008 2011 2014 2017Labor force participation rate

Source: Bloomberg, UBS as of 23 January 2019

Fig. 6: Inflation near Fed's 2% targetPCE and core PCE price index, year-over-year changein %

(2)

(1)

0

1

2

3

4

5

2008 2010 2012 2014 2016 2018PCE price index y/y Core PCE price index y/y

Note: PCE = Personal Consumption Expenditures

Source: Bloomberg, UBS as of 23 January 2019

Investment strategy insights

Chief Investment Office Americas, Wealth Management 24 January 2019 4

Financial Conditions IndicatorsMonetary policyThe Fed raised interest rates by 25bps on 19 December, bringingtheir target range to 2.25–2.5%. The actual rate in the federal fundsrate market is 2.4%, which translates into a real, inflation-adjustedrate of 0.5% after subtracting out the most recent core PCE inflationreading of 1.9%. The Fed considers this to be the bottom of theneutral range, where neutral means that monetary policy is neitherpromoting nor restraining economic growth.

Since the December hike, the Fed’s messaging has turned moredovish, with even the most hawkish FOMC members saying that theFed can be “patient” when considering further hikes. Their com-ments suggest that the Fed will refrain from raising rates furtherin the near term. Our base case still calls for the Fed to hike onemore time by the end of the year, which would bring rates towardthe middle of the neutral range. But even this modest move wouldrequire that both economic data and financial market conditionsimprove in the months ahead. As long as inflation remains near theFed's target, we believe it is unlikely that the Fed would hike beyondneutral.

Even this conservative outlook is more than what the market ispricing (see Fig. 7). For now the market is pricing rate hikes in 2019and a cut in 2020. The result is market expectations below the Fed's"dot plot" path for rate hikes.

Yield curveHistorically, a flat or inverted yield curve has been a precursorof recessions. Because of this, most models of recession proba-bility incorporate the shape of the yield curve as a factor. Thus,when the difference between 10- and 2-year Treasury bond yields—one measure of the yield curve—fell to 11bps in December,market-implied recession probabilities were peaking. Since then,the “2s10s” curve has traded mostly in the 15–20bps range (seeFig. 8).

We’re not as concerned about a relatively flat yield curve, for tworeasons. First, structural forces will tend to keep the curve flatterthan it has been in the past. In particular, the yield curve is flatbecause the market expects inflation to remain low and the Fed torefrain from further rate hikes. It is not a signal that the economyis about to fall in recession.

Second, the flat curve is an important signal for the Fed. In ourview, the Fed will be very reluctant to hike rates if it results in aninverted yield curve. In the years after the global financial crisis, theFed revised down its estimate of the neutral fed funds rate, butconsiderable uncertainty remains and there’s no way to know forsure if the lower estimates are correct. The fact that the yield curveis flat at the current fed funds rate suggests that the Fed really isclose to neutral rate.

Fig. 7: Market pricing in no further hikesFed funds futures and dots from FOMC Summary ofEconomic Projections, in %

0.0

1.0

2.0

3.0

4.0

Fed funds futures December FOMC dots

end-2019 end-2020 end-2021

Source: Federal Reserve, Bloomberg, UBS as of 24January 2019

Fig. 8: The yield has stopped flatteningEconomic recessions represented in grey

-4%

-2%

0%

2%

4%

6%

1980 1985 1990 1995 2000 2005 2010 201510yr - 2yr Treasury yields 10yr - 3mo Treasury yields

Source: Bloomberg, UBS, as of 24 January 2019

Investment strategy insights

Chief Investment Office Americas, Wealth Management 24 January 2019 5

Credit conditionsOverall credit conditions remain reasonably good both for busi-nesses and consumers. Corporate bond spreads have narrowed sofar this year after widening sharply at the end of 2018 (see Fig. 9). Inour view, the current level of spreads will not be a major hindranceto business investment. Banks on net continue to ease their lendingstandards on business loans, and the growth rate of loans has beenpicking up in recent quarters. For consumers, it is more difficult toget a mortgage than in the pre-crisis period, but mortgages aregenerally available to people with decent credit scores. In addition,standards on auto loans are also still fairly loose after some gradualtightening over the last couple of years. Overall, credit conditionshave tightened modestly during the past few months, but they’renot restrictive for growth.

Fig. 9: High-yield spreads have widened andtightened, and are still far from cycle highs

2%

3%

4%

5%

6%

7%

8%

9%

Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19

Source: Bloomberg, UBS, as of 23 January 2019

Investment strategy insights

Chief Investment Office Americas, Wealth Management 24 January 2019 6

Appendix

Emerging Market InvestmentsInvestors should be aware that Emerging Market assets are subject to, amongst others, potential risks linked to currency volatility, abrupt changes in the cost of capitaland the economic growth outlook, as well as regulatory and socio-political risk, interest rate risk and higher credit risk. Assets can sometimes be very illiquid and liquidityconditions can abruptly worsen. CIO GWM generally recommends only those securities it believes have been registered under Federal U.S. registration rules (Section12 of the Securities Exchange Act of 1934) and individual State registration rules (commonly known as "Blue Sky" laws). Prospective investors should be aware that tothe extent permitted under US law, CIO GWM may from time to time recommend bonds that are not registered under US or State securities laws. These bonds maybe issued in jurisdictions where the level of required disclosures to be made by issuers is not as frequent or complete as that required by US laws.For more background on emerging markets generally, see the CIO GWM Education Notes, Emerging Market Bonds: Understanding Emerging Market Bonds, 12 August2009 and Emerging Markets Bonds: Understanding Sovereign Risk, 17 December 2009.Investors interested in holding bonds for a longer period are advised to select the bonds of those sovereigns with the highest credit ratings (in the investment gradeband). Such an approach should decrease the risk that an investor could end up holding bonds on which the sovereign has defaulted. Sub-investment grade bonds arerecommended only for clients with a higher risk tolerance and who seek to hold higher yielding bonds for shorter periods only.

UBS Chief Investment Office's ("CIO") investment views are prepared and published by the Global Wealth Management business of UBSSwitzerland AG (regulated by FINMA in Switzerland) or its affiliates ("UBS").

The investment views have been prepared in accordance with legal requirements designed to promote the independence of investmentresearch.

Generic investment research – Risk information:

This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment orother specific product. The analysis contained herein does not constitute a personal recommendation or take into account the particularinvestment objectives, investment strategies, financial situation and needs of any specific recipient. It is based on numerous assumptions.Different assumptions could result in materially different results. Certain services and products are subject to legal restrictions and cannotbe offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressedin this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express orimplied, is made as to its accuracy or completeness (other than disclosures relating to UBS). All information and opinions as well as anyforecasts, estimates and market prices indicated are current as of the date of this report, and are subject to change without notice. Opinionsexpressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using differentassumptions and/or criteria. In no circumstances may this document or any of the information (including any forecast, value, index orother calculated amount ("Values")) be used for any of the following purposes (i) valuation or accounting purposes; (ii) to determine theamounts due or payable, the price or the value of any financial instrument or financial contract; or (iii) to measure the performance ofany financial instrument including, without limitation, for the purpose of tracking the return or performance of any Value or of definingthe asset allocation of portfolio or of computing performance fees. By receiving this document and the information you will be deemedto represent and warrant to UBS that you will not use this document or otherwise rely on any of the information for any of the abovepurposes. UBS and any of its directors or employees may be entitled at any time to hold long or short positions in investment instrumentsreferred to herein, carry out transactions involving relevant investment instruments in the capacity of principal or agent, or provide anyother services or have officers, who serve as directors, either to/for the issuer, the investment instrument itself or to/for any companycommercially or financially affiliated to such issuers. At any time, investment decisions (including whether to buy, sell or hold securities)made by UBS and its employees may differ from or be contrary to the opinions expressed in UBS research publications. Some investmentsmay not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk towhich you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained inone or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is not suitable for everyinvestor as there is a substantial risk of loss, and losses in excess of an initial investment may occur. Past performance of an investment isno guarantee for its future performance. Additional information will be made available upon request. Some investments may be subjectto sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changesin foreign exchange rates may have an adverse effect on the price, value or income of an investment. The analyst(s) responsible for thepreparation of this report may interact with trading desk personnel, sales personnel and other constituencies for the purpose of gathering,synthesizing and interpreting market information. Tax treatment depends on the individual circumstances and may be subject to changein the future. UBS does not provide legal or tax advice and makes no representations as to the tax treatment of assets or the investmentreturns thereon both in general or with reference to specific client's circumstances and needs. We are of necessity unable to take intoaccount the particular investment objectives, financial situation and needs of our individual clients and we would recommend that youtake financial and/or tax advice as to the implications (including tax) of investing in any of the products mentioned herein.

This material may not be reproduced or copies circulated without prior authority of UBS. Unless otherwise agreed in writing UBS expresslyprohibits the distribution and transfer of this material to third parties for any reason. UBS accepts no liability whatsoever for any claimsor lawsuits from any third parties arising from the use or distribution of this material. This report is for distribution only under suchcircumstances as may be permitted by applicable law. For information on the ways in which CIO manages conflicts and maintainsindependence of its investment views and publication offering, and research and rating methodologies, please visit www.ubs.com/research.

Additional information on the relevant authors of this publication and other CIO publication(s) referenced in this report; and copies of anypast reports on this topic; are available upon request from your client advisor.

Important Information about Sustainable Investing Strategies: Incorporating environmental, social and governance (ESG) factorsor Sustainable Investing considerations may inhibit the portfolio manager’s ability to participate in certain investment opportunities thatotherwise would be consistent with its investment objective and other principal investment strategies. The returns on a portfolio consistingprimarily of ESG or sustainable investments may be lower than a portfolio where such factors are not considered by the portfolio manager.Because sustainability criteria can exclude some investments, investors may not be able to take advantage of the same opportunities ormarket trends as investors that do not use such criteria. Companies may not necessarily meet high performance standards on all aspectsof ESG or sustainable investing issues; there is also no guarantee that any company will meet expectations in connection with corporateresponsibility, sustainability, and/or impact performance.

Distributed to US persons by UBS Financial Services Inc. or UBS Securities LLC, subsidiaries of UBS AG. UBS Switzerland AG, UBS Europe SE,UBS Bank, S.A., UBS Brasil Administradora de Valores Mobiliarios Ltda, UBS Asesores Mexico, S.A. de C.V., UBS Securities Japan Co., Ltd,UBS Wealth Management Israel Ltd and UBS Menkul Degerler AS are affiliates of UBS AG. UBS Financial Services Incorporated of PuertoRico is a subsidiary of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report preparedby a non-US affiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this reportshould be effected through a US-registered broker dealer affiliated with UBS, and not through a non-US affiliate. The contents of thisreport have not been and will not be approved by any securities or investment authority in the United States or elsewhere. UBS FinancialServices Inc. is not acting as a municipal advisor to any municipal entity or obligated person within the meaning of Section 15B of theSecurities Exchange Act (the "Municipal Advisor Rule") and the opinions or views contained herein are not intended to be, and do notconstitute, advice within the meaning of the Municipal Advisor Rule.

External Asset Managers / External Financial Consultants: In case this research or publication is provided to an External Asset Manageror an External Financial Consultant, UBS expressly prohibits that it is redistributed by the External Asset Manager or the External FinancialConsultant and is made available to their clients and/or third parties.Version 01/2019. CIO82652744© UBS 2019. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

Investment strategy insights

Chief Investment Office Americas, Wealth Management 24 January 2019 7