EFTA01089766.pdf

For marketing purposes only UBS CIO WM July 2012 UBS CIO Monthly Letter External version The muddle-through market A great ice-hockey player once said, "I skate Despite the market's significant volatility, to where the puck is going to be, not where our asset allocation remains broadly it has been." For investors, there's wisdom unchanged since my last O0 Letter. In the in this quote on two levels. First, when we following sections, I explain why, and shed Alexander S. Friedman react to how things look today, we are often some light on the direction we think the CIO UBS WM too late and find ourselves chasing opportu- puck is going. nity, rather than taking advantage of it. Sec- ond, it is impossible for even the best players Our view of the current environment to anticipate exactly where the puck is going It appears that Europe will continue to cre- every time, so the key is to get the general ate policy responses that are adequate to direction right. keep the Eurozone together, but not suffi- cient to stave off renewed periods of extreme Today's financial markets seem largely driven market stress. This has proven to be the case by a titanic battle in the developed world in previous phases of the crisis, and seems between the forces of slow growth and de- set to be true going forward. Greece recently leveraging, and the money printing actions elected a "bailout friendly" government and of central banks. A result of this battle is should enter constructive negotiations with extreme market volatility and periods that the Troika, but remains in an economic alternate between euphoria and panic. In depression with an unsustainable level of this environment, it is tempting to follow the debt. Meanwhile, Spain accepted that its news headlines from one end of the invest- banks require more capital, but the move ing spectrum to the other, from risk-on to merely served to highlight the stressed risk-off and back. Such an approach to nature of government finances and the investing will not work and when it inevita- problematic intertwining of the banks and bly leads to the wrong approach to asset the sovereign. Finally, this week's Eurozone allocation, there are negative consequences summit is most likely to follow the form of for wealth preservation. Investing is not a previous summits — long on words and short binary dynamic, whereby one either on tangible actions. Once again, a "muddle- embraces risk or shuns it. Rather, it requires through" in Europe is more likely than a dispassionate analysis of the facts, a prudent comprehensive solution, suggesting that we balancing of risk and opportunity, and the will continue to see periods of stress and patience to hold positions over a longer heightened volatility. period of time. Today's fearful dimate makes this hard, but it has never been more In the US, growth weakened and non-farm important. payrolls disappointed for the third Please see important disclaimer and disclosures at the end of the docionent. ihe content of this publication reflects the view of UBS Wealth Management 8 Swiss Bank's Chief Investment Office (CC). ihe information does not constitute UBS finaloal research and therefore may not reflect or be fie/aligned with the views of MS Research expressed in other publications. The statutory regdaticos regarding the independence of financial research are not amicable to this publcabon. Investments may be subject to jurisdictional and regulatory restnctions and may therefore not be available - please discuss the avalabity and appropriateness of speofic investments with your client adviser. EFTA01089766  UBS 00 Monthly Letter consecutive month. Still, we believe that economic A common response by investors to this turbulent envi- growth in the US is sustainable, if muted; the Federal ronment has been to hide in the safest possible assets. Reserve has shown it is willing to support growth through Denmark issued two-year government bonds with nega- its extension of Operation Twist, and the cyclical recovery tive yields (—0.08%) this month, joining Switzerland as a remains broad-based, with small business confidence country where investors are actually willing to pay to increasing (see Figure 1), loan growth improving, and the hold their money for two years. Investors are avoiding housing market stabilizing. Like Europe, the US will need the Eurozone, and three of the four best performing to find a political bargain later in the year, when the fiscal bond markets in Europe over the last three months are deficit issues come to the forefront. Finding a consensus non-euro-denominated: UK, Denmark, and Sweden (see will be difficult, given that the political system is still grid- Figure 2). locked, but with approval for the Republican-controlled Congress at record lows, the party has as much to lose as These negative real yields, and extremely low yields on the Democrats if the "fiscal cliff" is not avoided ahead of other "risk free" assets, essentially guarantee real the election. As a result, we expect the majority of the wealth destruction if held to maturity. At the other fiscal tightening to be deferred. A "muddle-through" in end of the risk spectrum, valuations, earnings, and the US seems the most likely outcome. accommodative central banks support equities, but high volatility and political risk makes the picture very Finally, we continue to believe that China is on course to unclear. manage its economy to a soft landing. We expect 2012 growth of approximately 8%, despite the disappointing As a result, we continue to believe the best course of recent purchasing managers index (PMI) data. Inflation action is a middle-ground strategy, focused on earning has fallen and will likely fall further, providing policymak- yield in corporate credit, particularly US high yield, global ers with scope to support the economy through appro- investment grade, and emerging market USD-denomi- priate steps. Encouragingly, new loan growth re-acceler- nated bonds. ated in May to CNY 793bn from the disappointing CNY 682bn in April, and the People's Bank of China cut inter- Right now markets face an important few days. The est rates by 25bps. Meanwhile, 1Q GDP disappointed in European Union summit is taking place as I write this India and Brazil, leading to questions over the sustaina- letter. Expectations for a constructive outcome are bility of growth in the BRICs. However, we expect 2Q to low, although this does provide room for a positive represent the end of the growth deterioration. It is worth surprise in the unlikely event of a comprehensive noting that for many EM countries, the slowdown has solution. On Monday, we will see critical data from been policy-induced and designed to counter domestic the US (Institute for Supply Management manufac- inflationary pressures which built up in early 2011. With turing indicator), and China (official PMI). Provided inflation now falling across many of the emerging mar- the ISM-manufacturing remains above 50, and non- kets, aided by the recent declines in the oil price, central farm payrolls next Friday remain above +60,000, we banks are now entering a reflationary phase, which will likely leave our moderately pro-risk stance should help support EM growth through the second half unchanged. We will issue a 00 Note if necessary of the year and into 2013. following these events. Figure 1: Strong US small business confidence Figure 2: Investors avoiding the Eurozone NHIB Small Business Optimism Index Change in 10year raids - %, last 3 months 110 2.0 149% 1.5 105 1.04% 1.0 100 0.5 -033% -OAS% -0Al% -032% -0.16%I 0.0 95 —0.5 -038% -031% -0.43% -036% -0.29% —1.0 93 1.5 BS 2.0 2 g 1' 2000 2001 2002 2003 2004 2005 2006 2037 2038 2009 2010 2011 2012 Source: Bloomberg. UBS Source: Bborrbes UBS Please see implant disclaimer and disclosures at the end of the document. UBS Chief Investment Office July 2012 2 EFTA01089767  UBS CIO Monthly Letter Remain neutral on equities despite market volatility Figure 3), with data this week showing that new home In this environment of low growth, high political risk, sales jumped 7.6% m/m in May, the fastest pace since and elevated market volatility, it might appear that an April 2010. underweight in equities is appropriate. However, we remain neutral for five reasons: Nonetheless, we are mindful of the risks to the US econ- omy, most notably from uncertainty surrounding the US First, sentiment is already depressed. Financial markets fiscal deficit. At the end of this year, Bush-era tax cuts are discounting weak global growth, so the hurdle for a expire at the same time as USD 600bn (3.7% of GDP) of market-neutral outcome to the European Union summit spending cuts are instituted. Unless a political agreement is not high. Second, while global growth is weak, it has is reached to defer some of these measures, the "fiscal not collapsed; in the US we expect about 2% growth, cliff" could tip the economy into recession; the Congres- and growth in China in 2012 is likely to be c.8%. Third, sional Budget Office estimates that the US economy central banks remain broadly supportive. In the past could shrink by 1.3% in the first half of 2013. However, month alone, the US Fed extended Operation Twist, the the Republican-controlled Congress has an abysmal Chinese authorities increased the bank loan quota and approval rating, and the party has as much to lose as the cut interest rates, the Bank of England boosted funding Democrats if the "fiscal cliff" is not avoided ahead of the conditions for banks, and the European Central Bank election. Hence, while we monitor this key risk, our base again eased its collateral rules. Fourth, profit margins are case is that the majority of the fiscal tightening will be likely to remain high, given interest rates should stay low delayed. We expect income tax hikes and sequestration and labor has weak bargaining power. Finally, our propri- spending to be deferred, while unemployment benefits etary business cycle and market momentum indicators and the payroll tax cut will expire, in aggregate leading signal that a "neutral" position is appropriate. to only moderate fiscal tightening of approximately 0.9% of GDP in 2013. Our biggest overweight positions remain in US assets We continue to hold the majority of our overweight posi- In sum, we believe US economic growth is sustainable at tions in the US market. Although economic growth has current, sub-par levels. come under question recently, particularly after relatively weak labor market data, we continue to believe the posi- This economic backdrop is well suited to investments in tive trends in the US are sustainable. The National Fed- credit, given that growth is high enough to prevent eration of Independent Business (NFIB) small business default rates rising substantially, yet too low for equities optimism index is close to a four-year high, and bank to meaningfully outperform. Of all the asset classes we lending growth remains positive. Furthermore, the Fed- cover, we believe US high yield credit offers the most eral Reserve remains supportive, recently extending attractive risk-reward profile, and we expect total returns "Operation Twist," its program of buying longer dated of about 8% over the next six months. It is our biggest Treasuries to lower long-term financing costs. We also overweight position. US companies are sitting on record- believe the Fed would step in with a broader quantitative high cash balances, while refinancing pressures have easing program if economic conditions deteriorate. been alleviated by generally low leverage, long-term Meanwhile, housing indicators are trending higher (see debt (see Figure 4), and robust primary bond markets. Figure 3: Housing sentiment at highest levels since 2007 Figure 4: Relatively few high yield and loan maturities ('000) NAHB market index in 2012 and 2013 2500 80 marmeriuSo br0 160 2000 60 140 1503 120 40 100 ICE 80 20 60 S00 40 0 0 20 0 A A A A a a A A A a A 2012 2013 2014 2015 2016 2017 2018 2079 — Basing starts(LHS) — NAHB market index (RHS) - Bonds — Building permits OHS) - Loans Source: Bicomterg, U8S Sauce: EA, UBS Please see important disclaimer and disclosures at the end of the document. UBS Chief Investment Office July 2012 3 EFTA01089768  UBS CIO Monthly Letter Global high-yield companies have issued a record USD their near record-high profit margins, particularly with 150bn in bonds year-to-date, more than twice the aver- commodity prices falling and unemployment still high. age amount issued at this point in the year over the last decade. Despite these robust fundamentals, spreads of We also remain positive on the US dollar, as a combina- c.650bps are compensating investors for defaults of tion of stronger growth and safe-haven flows emanating about 7.5% of high yield companies each year over the from the Eurozone should support the currency. Longer- next five years. This default rate is significantly worse term, continued stimulus from the Federal Reserve and than our forecasts and recent observations. Over the last concerns over the "fiscal cliff" could limit upside poten- 12 months, 3.1% of US high yield companies defaulted, tial into the latter half of 2012. and we expect a moderate increase to 3.5% by the end of the year. We remain underweight European assets We have long maintained a preference for US over Euro- Part of the reason for this attractive fundamental picture zone assets, due to relatively stronger growth in the US is that markets today place a high premium on liquidity, and the Eurozone's well documented troubles. This strat- and US high yield could suffer if market liquidity tempo- egy has served us well, particularly in recent months as rarily dries up in a significant "risk-off" event. Therefore, Eurozone growth deteriorated — last week's flash PMI fell US high yield credit is most suitable for investors with the from 45.4 to 44.8, the lowest level since June 2009. In tolerance to hold over our six-month investment horizon the last three months, the S&P500 has outperformed the or longer. For these investors, the ability to hold positions EuroStoxx 50 by 8.8%, and the USD is up 4.7% against over a longer period of time is very helpful, since the ele- the EUR. From here, the question we face is whether vated liquidity premium continues to offer an attractive Eurozone assets are now cheap enough to merit more investment opportunity. US high yield credit has tradi- investment. In short, we believe valuations are not yet tionally quickly recovered its losses from illiquidity-in- attractive enough, barring a more comprehensive solu- duced bouts of weakness, and has exhibited resilient tion to the crisis or an economic re-acceleration. performance in the recent market turbulence. US high yield is both a CIO asset allocation overweight and a CIO One of the few areas we recommend within Europe is preferred theme. investment grade credit; here we are overweight globally. Despite investment grade credit's relative safety, credit The US remains our preferred global equity market. US spreads have widened recently to their highest levels of equities are priced at a premium to other global markets, the year. At current levels, spreads are compensating but we believe this is warranted. Realized earnings have investors for extreme default scenarios which have not continued to grow in recent months, in contrast to the been observed since records began (over ninety years). Eurozone, where earnings have fallen (see Figure 5). Pro- Within investment grade we believe investors should keep spective earnings should be supported by a still-growing a core focus on non-financial corporates, which offer economy, and we believe US companies can maintain comparatively safe and attractive total returns. Figure 5: Resilient earnings support US equities Figure 6: Global demand for oil is flat over the year Realised earnings (rebased) Crude oil demand growth (1H 2012 n IH 2010, n % 125 8 6.9% 120 6 115 110 4 105 2 100 0 95 2 90 cis -4 —6 China Latin OECD Europe US Japan Wodd — EMU — Brazil America — US — CNra Source: Thomson Reuters, UBS Source: If& UBS Please see imponant disclaimer and disclosures at the end of the document. UBS Chief Investment Office July 2012 4 EFTA01089769  UBS CIO Monthly Letter Asset allocation We have made only one change following this month's Overall, we maintain our preference for credit over equi- Global Investment Committee, removing our slight ties, specifically US high yield, global investment grade underweight duration stance. While fundamental valua- credit, and emerging market USD-denominated bonds. tions of core government bonds remain far above fair Within our neutral equities position, we prefer the US to value, with economic growth weakening and central Europe, and are modestly overweight the UK and emerg- banks tending toward looser policy, the near-term trigger ing markets, where valuations are attractive and central for higher yields is unclear. banks are relatively more supportive. We remain underweight commodities, expressed through Kind regards, positions in energy, which remains oversupplied relative to sluggish demand growth (see Figure 6), and agricul- tural commodities, where high inventory levels are likely to depress prices in the third quarter. Our largest foreign exchange overweight is in the Canadian dollar, which may seem counterintuitive given our negative stance on commodities. However, we believe the Canadian dollar is now acting more as a US-proxy, and positive growth Alexander S. Friedman dynamics could give rise to expectations of an interest Global Chief Investment Officer rate hike later in the year. We also continue to prefer Wealth Management USD and GBP to EUR and CHF. 28 June 2012 Please see important disclaimer and disclosures at the end of the document. UBS Chief Investment Office July 2012 5 EFTA01089770 Disclaimer This document has been prepared by UBS AG, its subsidiary or affiliate CUBS". 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