Global Macro Strategy 27 November 2018 2ContentsSummary of Calls ..... 4US: Better value emerging, attentive to pressure points . 5US model estimates: spreads near fair value after recent credit carnage ....... 7Box 1: What do asset, product and labour markets tell us about the stage ofthe economic cycle9IG Outlook: will foreign or domestic demand step up ...... 13LL Outlook: can robust CLO demand be disrupted ........... 20HY Outlook: can low supply backstop valuations . 24EU: How healthy is the EU credit cycle ... 28Will the recent credit selloff accelerate in 2019 .... 30Can the EU credit cycle diverge from the US credit cycle .. 32How will tighter monetary policy impact EU IG and HY .... 33Will the lack of monetary tightening lead to rising pressure on EU banks . 38What are upside and downside risks to our forecasts ....... 41EM: Help from more realistic risk premia . 45EM spread widened on weak-than-expected growth ......... 47Box 2: Is it time to buy after the rough ride in Argentina .. 48CNY volatility will mean greater pressure on EM corporates ........... 51Box 3: Will onshore defaults continue in China .... 52We would like to thank Bunny Badal, Chaitanya Ravuri, Nadeem Shaikh, andPavan Komanduru, our research support service professionals, for their assistancein preparing this research report.Bhanu BawejaStrategistbhanu.baweja@ubs+44-20-7568 6833Matthew Mish, CFAStrategistmatthew.mish@ubs+1-203-719 1242Stephen Caprio, CFAStrategiststephen.caprio@ubs+44-20-7567 5788Anna HoAnalystanna.ho@ubs+852-3712 2965Alexey OstapchukStrategistalexey.ostapchuk@ubs+44-20-7567 0239 Global Macro Strategy 27 November 2018 3Global Corporate CreditUBS Research THESIS MAPPIVOTALQUESTIONSQ: What are the key calls across regionsAs we move further along in an extended expansion we see global growth slowing, but valuations have largely re- priced to reflect this reality. The big step adjustment is likely behind us. Lower-duration losses should make for abetter year across most markets, with total returns projected in the 0% to 6% range. With little yield cover,European IG credit will likely be the worst-performing market on a total-return basis, while US, particularly HY,should be better placed to generate near-coupon returns. EM should fall in between, with corporatesunderperforming sovereigns amidst a gradual weakening in the CNY. Asia HY has widened to particularly attractivelevels.Q: Does late cycle mean significant credit stressNot when the expansion has been so gradual. Structural risks persist for credit, specifically in the form of highcorporate leverage (US/EU), elevated profit margins (US/EU), rising financing costs (US), near-record shares of low- quality debt (US), and a weak banking sector (EU). But it also points to few imminent cycle threats. Overall leverageand interest coverage trends are stable, NPLs are falling, and bank + non-bank lending standards are easing. Thefollowing assets will tell us if we are wrong, and the cycle is headed lower quicker: 1) US leveraged loans, 2)floating rate issuers, 3) non-bank consumer lenders, 4) EU banks, 5) JGBs and 6) Chinese financials.US: What are the key micro vulnerabilities to monitorCorporate and consumer heterogeneity mask rising micro credit vulnerabilities. Ground zero for our concerns is USleveraged/private debt, which has seen unprecedented easing in underwriting standards via earnings addbacks,debt cushions and covenants, coupled with less than stable correlation and asset-quality assumptions. In USconsumer credit, we are watchful of lower-tier debt-fuelled consumption, and the significant fallen-angel riskassociated with this. For 2019, modest deterioration in growth and lending conditions should put US IG and HYspreads at 125bp and 435bp. We expect total returns of roughly 5.6% in HY and 3.0% in IG. Leveraged loansshould return about 4.3%, the bulk of which is likely to be front loaded.EU: How healthy is the European credit cycleWhile EU growth worries are multiplying, recession risks are still quite low. Leverage is stable, interest costs are low,lending standards are easing, and delinquencies continue to drop. We believe fatigue over idiosyncratic risk (Brexit,Italy, trade protectionism), secondary market illiquidity, and investor de-risking into year-end have exacerbated thecurrent selloff. Hence, the groundwork is being laid for a short-term rally. But the more structural negatives ofglobal monetary tightening will remain a headwind throughout 2019. The end of ECB corporate bond purchases isnot priced into EU IG and BB-rated HY credit, while the scope for European credit to decouple from an aging UScredit cycle is limited. We expect 2019 fair-value IG and HY spreads to be 140bps & 440bps, with returns of 0.2%& 3.8% respectively. At a micro level, we are positioned defensively in EU IG given the end of ECB CSPP, while wetake more risk in HY, given over-discounting of a cycle downturn in the near-term. EM: Weak macro, attractive yieldWeaker growth should still make for credit widening in EM, particularly in corporates as China growth and externalbalances come under scrutiny. However, the risks of a major widening are now much lower as the weakest linksalready saw significant pressure this year. Longer term, China’s credit markets bear watching, but contagion isunlikely until we see the Chinese housing market, the collateral of its credit boom, come under severe pressure.This is unlikely in 2019. We expect sovereign spreads to widen by 15bp, and corporates by 35bp in 2019, makingfor total returns of 4.25% and 3.75%, respectively.Figure 1: YTD return and forecastFigure 2: Current spread and target Source:Bloomberg Barclays Index Services, UBS, Our 10Y Bund and 10y USTreasury year-end forecast is 0.9% and 3.4%, respectively.Source:Bloomberg Barclays Index Services, UBS, Our *Bloomberg Barclays US IG, US HY, EUR IG ,EUR HY and EM Corporate indices, EM GD for EM Sovereign. 5.6% 4.3% 4.3%3.8% 3.8% 3.0%0.2%-9% -7% -5% -3% -1% 1% 3% 5% 7% US HYUS LLEM Sovereign EUR HYEM CorpUS IGEUR IG 2019 Total Return Forecast 2018 YTD Return 440 435410 400140 1250 100 200 300 400 500 EUR HYUS HYEM Sovereign EM CorpEUR IGUS IG 2019 Spread Target* Current Spread*Global Macro Strategy 27 November 2018 4Summary of Calls PreferencesKey ThemesTheme 1 2019 Markets Outlook: Something wicked this way comesTheme 2 Global Economic Outlook 2019-2020Theme 3 EM Outlook 2019: Are cheap valuations enoughTheme 4 US Equity Strategy Outlook 2019: De-rating and deceleration: how to invest for 2019Theme 5 European Equity Strategy: Outlook 2019: End of CycleThe statistical framework for the model is a dynamic linear model (DLM). UBS Evidence Labtested many model types, but found this was the most appropriate for modelling HY issuance.The key difference with a standard linear regression model is that the DLM can time-vary theparameters using recursive algorithms. Data used went back to 2005 and included: 1) Change inYTW; 2) HY YTW – HY coupon; 3) HY flows / Index par amount of prior month; and 4)Seasonality. Most Preferred Sectors/Countries Least PreferredSectors/CountriesRating PreferenceCurve Preference US IGEnergy, Utilities, Large BanksAutos, Beverage,Media, and Consumer FinanceMid-to-higher rated BBB1-5yr (total return), 5-10yr (excess return) US HYEnergy, UtilitiesAutos, Retail, TelecomB----- EUR IGUtilities, HealthcareSub Banks, Basic Industrials, TelecomA3-7y EUR HY Consumer Non-Cyclical,Consumer Cyclical ex-Autos,Tech Basic Industrials, CapitalGoods, TelecomNeutral (BB vs Bs)----- EM SovereignIndonesia, Russia, front -end ArgentinaSouth AfricaBBB, B10-30y EM Corp Chinese HY renewableenergy, 3y BB/B Chinese HYproperties, Indonesia coal,high-coupon step-up callablecorporate perps Indian IG & HY, ChineseHY Industrials, ChineseBanks' senior BBB rated Chinese centralSOE, BB/B rated Chineseproperties 5-7y BBB Chinese centralSOE, short-dated ChineseHY properties 。。。。。。