Low-Volatility Stocks At Risk As Credit Cycle Ends, UBS Warns A Crash Is Coming

UBS’ Paul Winter believes we are witnessing the end of the credit cycle – earnings growth rates are flat, and the stock market impact has been increasing. Importantly, from a risk perspective, Winter warns that Systemic Risk is rising, and Economic Policy Uncertainty has hit all-time highs, warning that the key risk today lies in low-volatility stocks and the broad market’s equity risk premia – “either earnings need to pick up dramatically, or alternately, equities would need to correct by around 20% to bring the equation back into equilibrium.”

The age of excess liquidity and inexpensive debt is over, according to Winter, and that makes it harder for management to use credit to satiate investors’ demands for corporate profits

UBS notes that “77% of stock crashes are driven by earnings announcements,” and more companies are likely to disappoint the market in the future.

We are currently witnessing the end of the credit cycle. Credit spreads have been increasing, global earnings growth rates are in aggregate flat and market impact has been increasing.

Market impact is currently running at 80bps across developed markets, a level that tends to be commensurate with negative returns and an elevated risk of correction. The risk today, oddly is in so-called ‘low-risk’ assets. We show that low volatility assets are generally more highly geared than higher volatility stocks. As a consequence, they tend to have a high residual beta to credit. As lending standards tighten and credit spreads increase, it is likely that highly geared stocks underperform regardless of their volatility.

Conventional wisdom defines a bubble as any asset driven by ‘irrational exuberance’ that exhibits valuations that have drifted significantly from their long-term valuations. This opens the door for bonds, property and equities to all be defined as bubbles right now, and perhaps they are. So how should we frame our thinking in terms of ‘What’s priced in?” and ‘Where’s the mispricing?”.

In theory, bubbles perpetuate themselves due to the business risk of asset managers. This motivates institutional herding and ‘rational bubble-riding’. As a consequence, bubbles, once formed, can last a long time.