Brace for Flight to Quality Stocks as Volatility Jumps, UBS Says

(Bloomberg) -- It’s time for investors to raise the quality bar for stocks to invest in, according to UBS Group AG.

Strategies that favor quality factors -- including measures such as high gross margins, elevated cash flow-to-asset ratios and low accruals -- should outperform in the year ahead, said Paul Winter, head of quantitative research for Asia-Pacific at UBS in Sydney.

“Our argument is that high-quality firms will work well over the next 12 months,” he said in a telephone interview last week. “It’s going to be a struggle for lower-quality firms.’

Brace for Flight to Quality Stocks as Volatility Jumps, UBS Says

Global markets have stumbled this year as rising U.S. interest rates, a trade war between Washington and Beijing, and fears of an end to the global economic expansion have all dented investor confidence. The MSCI AC World Index has fallen 4 percent in 2018 and is down more than 6 percent so far in October, on track for its biggest monthly decline since August 2015.

Still, Winter doesn’t see an end to the outperformance of fast-growing companies which are better placed to withstand any renewed volatility, he said. UBS argues that better use of technology has allowed companies in the consumer, industrial, financial and health care sectors to generate returns from lower capital bases than before, marking a break with history.

“These companies are more profitable than any have been in the past,” he said. Value stocks may see a pullback, but one that’s likely to be short-lived, he added.

Nevertheless, the bank expects volatility to pick up from here. The Cboe Volatility Index has risen almost 80 percent this year and hit the highest level since February on Oct. 11.

Rising interest rates could spell a vicious cycle for some companies as their cost of capital increases and they are forced to refinance debt at higher rates, according to UBS.

Should profits decline late in the economic cycle, firms with already low margins may be reluctant to give detailed guidance on earnings to the market, Winter said. The result would be a jump in equity market volatility, he added.

“There’s greater uncertainty about what these companies will actually earn and that causes prices to move quite dramatically,” he said.

©2018 Bloomberg L.P.