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UBS CIO Monthly Extended
July 2012
Published
29 June 2012
Please see important disclaimer and disclosures at the end of the document.
The content of this publication reflects the view of UBS Wealth Management & Swiss Bank’s Chief Investment Office (CIO). The relative asset
class preferences in this publication refer to an investment horizon of 6 months following the publication date – if not indicated differently –
and will be updated on a monthly basis. The preferred investment themes have a time frame of either 3-12 months or >12 months since
inception, as indicated. The information does not constitute UBS financial research and therefore may not reflect or be fully aligned with the
views of UBS Research expressed in other publications. The statutory regulations regarding the independence of financial research are not
applicable to this publication. Investments may be subject to jurisdictional and regulatory restrictions and may therefore not be available –
please discuss the availability and appropriateness of specific investments with your client adviser.
Table of Contents
Section 1 Base slides 3
Section 2 Asset class views 12
2.A Equities 13
2.B Fixed income 23
2.C Foreign exchange 30
2.D NTAC: Commodities, Listed real estate, Hedge funds and
Private equity 34
1
Section 1
Base slides
Summary
"With the global
economy
continuing to
muddle through,
we believe that
US corporate
bonds offer the
best risk return."
• Economy
The successful formation of a Greek government after the June 17 elections has reduced
the risk of an imminent Greek exit from the Eurozone. However, the Euro debt crisis
persists, and further reform and consolidation efforts in Spain and Italy are needed. In the
US, economic data weakened recently, but it remains in line with our forecast of moderate
growth of around 2% in 2012. The Fed extended "Operation Twist" until the end of the
year and is ready to do more if the economic situation deteriorates materially. Meanwhile,
Chinese activity data is showing signs of stabilization and inflation remains low. We expect
the Chinese economy to gradually pick up in the second half of 2012.
• Equities
Despite our relatively positive outlook for US and Chinese economic growth, ongoing
Eurozone issues keep us neutral on global equities. We think US companies are better
positioned than their European peers, and thus keep our longer-standing preference for
US equities. US earnings are relatively robust and the recovery of the domestic economy
continues to support revenues. Furthermore, we keep a moderate overweight in emerging
market (EM) equities as valuations are attractive and we expect growth to accelerate in
the second half of the year. In the near term EM currency weakness remains a risk factor.
• Fixed Income
High grade government bond yields remain extremely low due to ultra-expansive
monetary policy and ongoing investor concerns over global growth. While we expect
yields to only rise very gradually in the near term, we continue to see better investment
opportunities in other fixed income segments. US high yield remains our favorite asset
class, given attractive valuations and a favorable default outlook. We also keep our
overweight recommendations on investment grade and EM bonds.
• Commodities
We avoid broad commodity exposure as we see further price weakness ahead. While the
worst of the oil sell-off is likely behind us, we see no reason for higher prices in the near
term and expect roll costs to weigh on positions.
• Foreign Exchange
In light of the ongoing Eurozone troubles, we continue to prefer the US dollar over the
euro. We also prefer the Canadian dollar, given its relatively good growth dynamics, a
possible rate hike, and relatively high short rates.
3
Please see important disclaimer and disclosures at the end of the document.
Cross-asset preferences
Most preferred
Least preferred
Portfolio weights
Equities
• US
• Western winners from EM
growth
• High quality dividend yields
• Event-driven and relative value
hedge funds
• Natural gas growth gainers
• Europe
Commodities
3%
Real Estate
5%
Hedge Funds /
Private Equity
10%
Equities USA
10%
Liquidity
10%
High Grade
Bonds
6%
Inv Grade
Corporates
Bonds
9%
High Yield
Bonds
6%
Fixed income
Foreign
exchange
• US high yield
• Global investment grade credit
• Event-driven and relative value
hedge funds
• EM corporate bonds
• USD
• GBP
• CAD
• Developed market
government bonds
• CHF
• EUR
Equities
Europe
20%
EmMa Equities
6%
Equities Other
9%
Emerging
Markets Bonds
6%
Note: Portfolio weights are for an advisory
client with a "EUR moderate" profile. For
portfolio weights related to other risk profiles
please contact your client advisor.
Commodities
• Agriculture
• Energy
� Recent upgrades �
Recent downgrades
4
Please see important disclaimer and disclosures at the end of the document.
Reference portfolio
Tactical asset allocation deviations from benchmark*
Currency allocation
underweight
neutral
overweight
underweight
neutral
overweight
Cash
USD
Equities total
EUR
Equities
US
Eurozone
UK
Japan
GBP
JPY
CHF
Switzerland
SEK
EM
NOK
Other
CAD
Bonds
Bonds total
Government bonds
Corporate bonds (IG)
High yield bonds
NZD
AUD
new
old
EM bonds (USD)
Commodities total
Commodities
Precious metals
Energy
Base metals
Agricultural
* Please note that the bar charts show total portfolio preferences and thus can
be interpreted as the recommended deviation from the relevant portfolio
benchmark for any given asset class and sub asset class.
Listed Real Estate
Source: UBS CIO
new
old
Also note that the implementation in advisory or discretionary products might
slightly deviate from the "unconstrained" asset allocation shown above,
depending on benchmarks, currency positions and for other implementation
considerations
5
Please see important disclaimer and disclosures at the end of the document.
Preferred themes
• High quality dividend yields (sourced from existing European
and UK equities)
High quality companies with geographically diversified business models
that pay sustainable dividends offer an attractive income stream in a
low yield world. Historically, dividends have made a substantial
contribution to total returns, and we expect this to remain the case in
the current environment.
• Western winners from emerging market growth (sourced from
existing equity holdings)
Emerging economies continue to grow faster than developed
economies. With little need to deleverage and repair balance sheets,
Asian economies are also well positioned to continue to outpace their
Western peers in the years ahead. We have identified companies from a
variety of sectors in Europe, the US and Japan which have significant
exposure to the rapidly growing emerging regions. We believe a
diversified portfolio of these companies will reward investors seeking
to profit from the robust demand growth in emerging economies.
• Natural gas growth gainers
Natural gas is a relatively clean source of energy, and we think it will
benefit from continued substitution for other energy sources over the
long term. We have examined the dynamics of the global market and
the various components of the gas value chain, and identified the areas
we see as the most significant beneficiaries currently. These include
producers in Europe and Asia, suppliers of infrastructure, services and
related machinery, and Master Limited Partnerships (MLPs) in the US,
that offer both attractive yields and growth.
• Government bond alternatives (sourced from government bonds
–CIO UW)
Developed world government bonds offer a comparatively small cushion
against future interest rate hikes and many face increasing credit risk. We
expect select bonds of supranational or national agencies, sub-national
governments, multinational corporates, and covered bonds to
outperform government bonds. We recommend switching out of
government bonds into these alternatives.
• US high yield corporate bonds (sourced from government bonds –
CIO UW)
Positive economic growth, robust corporate earnings and healthy
balance sheets provide support to US high yield corporate bonds. Current
yield spreads of roughly 660 basis points still price in a much more dire
economic outcome than we expect. Historically, US high yield bonds have
delivered similar returns to US equities with lower volatility. We continue
to believe that US high yield corporate bonds represent a more favorable
risk/return potential than equities and expect total returns of
approximately 7% over the next 6 months.
• The place to be in Hedge Funds
Recent economic data has shown signs of improvement, but growth in
most developed markets remains muted. In this environment, less
directional hedge fund strategies, such as relative value and event driven,
should offer above average returns.
• EM corporates: a growing asset class (sourced from global
government bonds – CIO UW)
Given our relatively constructive current view on risk, we regard EM
corporate debt as more attractive than EM sovereign debt due to its
higher overall yield. Over a 6-month horizon, we expect EM corporate
bonds to outperform US Treasuries and deliver total returns of close to
8% p.a.
6
Please see important disclaimer and disclosures at the end of the document.
Global economic outlook
–
Summary
Key questions
• Can emerging markets (EM) continue to offset developed market (DM) weakness to buoy global
growth?
• What are the risks of near-term faltering of the US economic recovery?
• When is the European economy likely to return to sustainable economic expansion?
CIO View (Probability: 60%*)
• Global economic activity remains moderate; the growth impulse stems largely (some 80%) from the EM
region. As expected, China started to ease monetary policy. The country is better placed than other EM
and particularly DM countries to counter growth weakness with further monetary and fiscal stimuli. Thus,
we expect EM growth to stabilize soon and pick up in 2H 2012.
• US economic indicators have on balance been disappointing recently, especially data related to business
fixed investment and employment growth. Thus, we lowered our 2Q 2012 real GDP growth forecast to an
annualized rate of 1.5% from 2%. We still expect growth slightly above 2% in 2H 2012. We think that the
risk that the Fed will take measures in addition to the extension of "Operation Twist" is still significant.
• Large parts of Western Europe are in recession or stagnation. We expect the economies of the Eurozone
and the UK to show mild improvement in 2H 2012. Still, economic activity is likely to remain very sluggish
despite support from lower oil prices and less rigorous fiscal austerity. The Bank of England may support
the UK economy by increasing its amount of bond purchases soon. The probability that the ECB will take
further action to support the economy has risen significantly.
� Positive scenario (Probability: 15%*)
• The Eurozone crisis abates. Financial market conditions recover, mitigating the drag from fiscal austerity.
• Growth in Western Europe is marginally positive (Eurozone stagnates) in 2012 and the US economy
grows moderately above trend.
� Negative scenario (Probability: 25%*)
• There are three key downside risks to the global economy: 1. a significant escalation of the Eurozone
debt crisis; 2. a sharp fiscal contraction in the US, and 3. a sharp deceleration of the Chinese economy. Each
one of these risks could precipitate a significant downturn of the global economy.
Key dates
2 July USA: ISM manufacturing PMI for June
5 July Eurozone: ECB press conference
24 July Eurozone: purchasing managers indices (PMI), July estimates
22–25 July China: HSBC flash manufacturing purchasing managers index (Jul)
Global growth expected at just under
3% in 2012
Source: UBS CIO, as of 28 June 2012
Global economic momentum is
deteriorating (UBS GDP tracker)
14
%
12
10
8
6
4
2
0
-2Jan
-4 05
-6
Jan
06
Jan
07
Real GDP growth in % Inflation in %
Jan
08
Jan
09
Global DM EM*
2011 2012F 2013F 2011 2012F 2013F
Americas US 1.7 2.1 2.6 3.1 2.1 1.7
Canada 2.4 2.1 2.4 2.9 2.1 2.3
Brazil 2.7 2.0 4.8 6.5 5.2 6.5
Asia/Pacific Japan -0.7 2.5 2.0 -0.3 0.2 0.5
Australia 2.1 3.7 3.5 3.4 1.6 2.5
China 9.2 8.2 8.5 5.4 3.0 4.0
India 6.5 6.0 7.0 7.8 6.9 7.0
Europe Eurozone 1.5 -0.4 0.4 2.7 2.3 2.0
Germany 3.1 1.0 1.1 2.5 1.7 1.5
France 1.7 0.3 0.4 2.1 2.5 2.2
Italy 0.5 -1.8 0.2 2.9 3.4 3.9
Spain 0.7 -1.6 -1.3 3.1 1.9 1.9
UK 0.7 0.2 1.3 4.5 2.8 1.9
Switzerland 2.1 1.3 1.7 0.2 -0.4 1.4
Russia 4.3 3.8 3.7 8.5 4.9 6.9
World 3.2 2.8 3.3 3.9 3.0 3.0
In developing the CIO economic forecasts, CIO economists
worked in collaboration with economists employed by UBS
Investment Research. Forecasts and estimates are current
only as of the date of this publication and may change
without notice.
Jan
10
Jan
11
Jan
12
May
6.3%
3.1%
1.0%
Jan
13
Source: Bloomberg, UBS CIO, as of 22 June 2012
* DM= developed markets, EM = emerging markets
Note: Past performance is not an indication of future returns.
**Scenario probabilities are based on qualitative assessment.
7
For further information please contact CIO economist Dirk Faltin, dirk.faltin@ubs.com
Please see important disclaimer and disclosures at the end of the document.
Key financial market driver 1 –
Eurozone crisis
Key questions
• What is the way forward for Eurozone banks?
• What is the most likely course of events in Spain, Italy and Portugal?
• In what direction will the economy and the ECB go?
CIO View (Probability: 65%*)
Austerity and weak growth
• Support for the banking sector is a major political agenda item, and the request for external support for
Spanish banks can be seen as the starting point for greater European support and oversight for banks, to
be discussed at the upcoming European Council.
• Greece's debt remains unsustainable, but the risk of a euro exit over the next six months has diminished
after the 17 June elections, which have produced a viable government coalition. The Troika may only
accept moderate adjustments to the second Greek package. Portugal is likely to receive an increased
bailout package and is unlikely to default in 2012. Progress on reforms and consolidation in Spain and Italy
is most crucial for the near-term development of the crisis. Risk premiums would rise strongly on any
failure to meet deficit targets; we expect bond risk premiums to remain elevated for Spain and Italy over
the next six months.
• Following stagnation in 1Q 2012, economic surveys are commensurate with a quarterly GDP contraction
of around 0.3% at present. Business survey evidence points to a general wait and see mode. The risk to the
outlook for a stabilization of economic growth in the second half of 2012 is skewed to the downside. The
ECB remains on hold, but the bar to support the economy and markets has been lowered substantially. We
see a significant probability of policy action in early July, including the possibility of a rate reduction.
Despite all the talk about political measures to support growth and increased tolerance for budget
slippages, there is practically no leeway for fiscal stimuli. The near-term growth impact of any fiscal
measure will at best be marginal, in our view.
� Positive scenario (Probability: 15%*)
Return to macro stability
• Bond yields are contained, as peripheral countries' budgets stay on track and economic activity recovers
faster than expected. Greece fully complies with the austerity plans and receives further support. Market
confidence is restored, and economic growth stagnates in 2012.
� Negative scenario (Probability: 20%*) Major shock
• Major shocks could include Spain being pushed into a full IMF/EU program, possibly by a rating cut to
junk, enhancing pressure also on Italy; serious political disagreement in core countries (for instance after
Dutch elections, etc.); a possible Portuguese default; a Greek euro exit; or a major external growth shock.
Key dates
5 July ECB press conference
9–10 July Eurogroup/ECOFIN-Meeting
24 July Eurozone purchasing manager indices (PMI), July estimates
Bottoming in Eurozone leading
indicators (PMI) in June?
65
60
55
50
45
40
35
30
Source: Bloomberg, UBS CIO, as of 21 June 2012 (estimates)
Yield of Spanish and Italian 10-year
bonds over German Bunds (in bps)
600
500
400
300
200
100
06 07 08 09 10 11 12
Manufacturing Services Composite
0
01/2011 04/2011 07/2011 10/2011 01/2012 04/2012
Italy Spain
Source: UBS CIO, Bloomberg, as of 18 June 2012
Note: Past performance is not an indication of future returns.
* Scenario probabilities are based on qualitative assessment.
For further information please contact CIO analyst Thomas Wacker, thomas.wacker@ubs.com and
CIO economist Ricardo Garcia, ricardo-za.garcia@ubs.com
Please see important disclaimer and disclosures at the end of the document.
8
Key financial market driver 2 –
US policy
Key questions
• Will the economic outlook deteriorate? Will QE3 become necessary?
• How will the election outcome change fiscal policy deliberations?
• Can politicians find an agreement to avoid sharp fiscal contraction in early 2013 ("fiscal cliff")?
CIO View (Probability: 65%*)
No QE3, political gridlock and some fiscal tightening
• The economy stays on a moderate growth path, coupled with stable core PCE inflation close to the Fed’s
target of 2%. UBS forecasts real GDP growth of 1.5% in 2Q 2012 (consensus: 2.1%) and 2.3% in 3Q 2012
(consensus: 2.4%), with some downside risk due to rising uncertainty. The Fed has decided to extend so
called "Operation Twist" until the end of the year. More near-term monetary easing is still possible, but it
is currently not our central scenario.
• In the elections, Republicans will likely lose seats in the House overall, but retain a majority; we also
expect them to win a narrow majority in the Senate. Obama will likely retain the White House. Such an
electoral outcome would confirm the existing gridlock between Republicans and Democrats.
• Against the backdrop of ongoing political gridlock, we expect only moderate fiscal tightening of about
0.9% of GDP in 2013. The government will likely let unemployment benefits and the payroll tax cut expire,
but postpone income tax hikes and sequestration spending.
� Positive scenario (Probability: 10%*) No QE3, Democratic sweep and more fiscal tightening
• Propelled by ultra-expansive monetary policy and improved confidence, cyclical forces surmount the
structural hindrances and thus growth accelerates. More rapid growth leads to higher inflation, and the
Fed responds by tightening monetary policy sooner.
• The improved economic outlook raises the odds for an Obama re-election and makes it harder for
Republicans to win a majority in the Senate. US fiscal consolidation efforts are facilitated by faster rising
tax collections. A Democratic stronghold leads to some tax hikes and limited spending cuts. Fiscal policy
tightens by about 1.2% of GDP in 2013.
� Negative scenario (Probability: 25%*) QE3, political dysfunction and huge fiscal tightening
• Structural hindrances dominate and weigh on the cyclical recovery, thus growth weakens or turns
negative. The Fed embarks on QE3, most likely in the form of agency MBS and Treasury purchases.
• Weaker economic conditions raise the odds for a larger Republican majority in Congress, but Obama
remains President. The debt limit is reached earlier and the Treasury runs out of money before year-end.
The political gridlock becomes dysfunctional, thus fiscal policy tightens by USD 600 billion (3.7% of UBS
estimate of 2013 GDP) in 2013 (“fiscal cliff”). The US credit rating is downgraded.
Key dates
2 July ISM manufacturing PMI for June
6 July Nonfarm payrolls and unemployment rate for June
6 Nov US Presidential and Congressional elections
US moderate growth to continue
US real GDP and its components, quarter-over-quarter
annualized in %
8%
q/q annualized
6%
4%
2%
0%
-2%
-4%
-6%
-8%
-10%
-12%
Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1 2012
Consumption
Capital expenditures
Inventories
Government
Source: Thomson Datastream, UBS CIO, as of 20 June 2012
US fiscal cliff at year-end 2012
Commercial real estate investment
Residential investment
Net Exports
Real GDP (q/q annualized)
Fiscal effects of change in provisions under current law, USD
billion annualized
UBS CIO
forecasts
1Q13 2Q13 3Q13 4Q13 CY2013