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A UBS report says “low volatility” sectors would be hit hardest hit in any correction because these market areas have the most stretched valuations.Getty Images/iStockphoto

UBS's global quantitative strategy team led by Paul Winter is the first I've seen to outright declare the end of the global credit cycle. It's an outlier view so far, but because the negative implications for popular dividend-paying equity market sectors is so potentially severe, it's a thesis we should take seriously.

In a Monday report entitled When is the Stock Market Likely to Correct?, Mr. Winter first outlines how the investment cycle leads to asset bubbles and severe corrections: "Bubbles tend to form during periods of excess liquidity … valuations become stretched … [but] eventually the competitive landscape increases and costs pressures build, placing pressure on margins and squeezing earnings," Mr. Winter writes. "At this stage, credit becomes more challenging to raise … credit spreads increase and place further pressure on company earnings. The net result is the end of the earnings cycle."

Mr. Winter believes we are now at the stage where credit is being withdrawn globally while equity valuations – particularly in the "safe," dividend-paying sectors – are being exposed as too high. The strategist points to the U.S. Federal Reserve's senior loan officer opinion survey, which shows more American banks raising lending rates and restricting access to credit, as proof the low-growth economic backdrop is causing lenders to become more cautious.

UBS recognizes that global equity valuations should be higher in light of ultra-low bond yields but believes things have gone too far. The rise of macroeconomic risk – notably China's frantic attempts to print enough money to keep the economy growing – means valuations should be much lower. Mr. Winter calculates that either global corporate profits must improve from the current minus 1.5 per cent year-over-year to 3.5 per cent or "alternatively, equities would need to correct [lower] by about 20 per cent."

The report outlines that high-debt, credit-sensitive "low volatility" sectors such as consumer staples, banks, utilities and real estate, would be hit hardest hit in any correction because these market areas have the most stretched valuations.

Indeed, according to UBS, relative price-to-book value for low-volatility sectors is reaching highs last seen during the financial crisis. If an overall 20-per-cent global market correction materializes, these sectors will fall more than 20 per cent.

Canadian investors should keep in mind that this is the outlook of only one team, within one company, and there are plenty of major research firms with far more optimistic views. In addition, the perspective is global and there are aspects that may not apply to domestic markets or portfolios.

Domestic investors should view the UBS team's outlook as a bear market checklist or a road map to somewhere they don't want to go. There's no need to drastically restructure portfolios in the near term, but if domestic bank lending stalls, corporate earnings and profit margins decline, the bubble-bursting pattern outlined by UBS implies that the odds of a significant market correction will rise.