Thomas Berner, CFA, economist, thomas.berner@ubs.com, +1 212 713 4108, UBS FS
Wealth Management Research 25 October 2010
F...
with August. Given our outlook for only a moderate recovery, we think the
index will likely stay within the healthy range,...
UK financial health (updated monthly, last update 22 October 2010):
Please see the Appendix for a detailed explanation of ...
Appendix
Financial health thermometers
The financial health thermometer is a weekly gauge of financial stress. Con-
ceptua...
s To make the measurements easier to interpret, we introduced a
Fahrenheit degree scale, where 100° indicates normal body ...
US economic health thermometer
The economic health thermometer gauges the stance of the US economy
in a single and timely ...
The interpretation of the economic health thermometer is as follows:
s The average of the entire sample from February 1969...
US credit health thermometer
The credit health thermometer gauges credit conditions in the US on a
monthly basis. It summa...
Appendix
Global Disclaimer
Wealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management...
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Financial Pacific: Financial crisis thermometers (third party) october 26.2010

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Financial Pacific: Financial crisis thermometers (third party) october 26.2010

  1. 1. Thomas Berner, CFA, economist, thomas.berner@ubs.com, +1 212 713 4108, UBS FS Wealth Management Research 25 October 2010 Financial crisis thermometers Monthly update s In this monthly report, we measure financial, economic and credit health with the help of "thermometers." s The financial health thermometer deteriorated in the US and Eurozone, but improved in the UK and Japan. s The US economic health thermometer deteriorated a bit in September but remains firmly within the healthy zone. s The US credit health thermometer deteriorated slightly in September and continues to stand at a slightly worse level than normal. US financial health (updated monthly, last update 22 October 2010): Please see the Appendix for a detailed explanation of this thermometer. The US financial health thermometer deteriorated visibly from 100.9° on 17 September to 101.3° on 22 October. All four components of the thermometer except equity volatility deteriorated. The corporate credit spread deteriorated the most, as the corporate yield rose and the Treasury yield fell. The spread widening will likely not persist, as an ongoing expansion will likely improve corporate credit fundamentals. The thermometer's current level is close to the upper limit of the range that has been established since the escalation of the Greek fiscal crisis in April. Before that crisis erupted, it stood at 100.5°. However, it is still much closer to healthy territory than the levels recorded at the height of the financial crisis in October 2008. To reflect a full normalization, it will have to improve further to a level of 100°. US economic health (updated monthly, last update 22 October 2010): Please see the Appendix for a detailed explanation of this thermometer. The US economic health thermometer deteriorated from 99.3° in August to 99.1° in September. At that level, it is marginally below the midpoint of the healthy range which is consistent with real GDP growth between 0% and 3%. The ISM Manufacturing Purchasing Managers' Index (PMI) and the Conference Board consumer confidence index fell in September and while non-farm payroll growth was slightly weaker in September compared US financial health thermometer DETERIORATED Normal index (sample: 1 Jan 06 – 20 Jul 07) =100 Source: Thomson Datastream, UBS WMR, as of 22 October 2010 US economic health thermometer DETERIORATED Normal index (sample: Feb 1969 – present) = 100 Source: Thomson Datastream, UBS WMR, as of 22 October 2010 Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication. This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures that begin on page 9.
  2. 2. with August. Given our outlook for only a moderate recovery, we think the index will likely stay within the healthy range, with a tendency to be closer to 100° than 98.5°. US credit health (updated monthly, last update 22 October 2010): Please see the Appendix for a detailed explanation of this thermometer. The US credit health thermometer deteriorated slightly from 100.3° in August to 100.4° in September. The contraction in commercial bank lending was a bit more pronounced, and corporate credit spreads widened in September. On a trend basis, credit health has improved from a historical high of 104.5° in November 2008 and now stands at a level slightly worse than normal. In our view, it will probably stay close to a normal reading of around 100°. US credit health thermometer DETERIORATED Normal index (sample: Jan 1973 – present) = 100 Source: Thomson Datastream, UBS WMR, as of 22 October 2010 Eurozone financial health (updated monthly, last update 22 Octo- ber 2010): Please see the Appendix for a detailed explanation of this ther- mometer. The Eurozone financial health thermometer deteriorated slightly from 101.0° on 17 September to 101.1° on 22 October, effectively fully re- versing its improvement over the prior measurement period. Only the mon- ey market spread deteriorated, but it rose strong enough to offset small gains in the other three components. The current level of the thermometer is within the range established after the Greek fiscal crisis in April, and is not terribly alarming compared to its level in late 2008. Eurozone financial health thermometer DETERIORATED Normal index (sample: 1 Jan 06 – 20 Jul 07) =100 99 100 101 102 103 104 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Thermometer Thermometer (excl. CDS) Unhealthy Healthy Source: Thomson Datastream, UBS WMR, as of 22 October 2010 UBS Wealth Management Research 25 October 2010 Financial crisis thermometers Financial crisis thermometers - 2
  3. 3. UK financial health (updated monthly, last update 22 October 2010): Please see the Appendix for a detailed explanation of this thermometer. The UK financial health thermometer improved visibly from 101.0° on 17 September to 100.7° on 22 October. All four components of the ther- mometer improved, with the corporate credit spread improving the most. The level of the thermometer is fairly healthy. UK financial health thermometer IMPROVED Normal index (sample: 1 Jan 06 – 20 Jul 07) =100 99 100 101 102 103 104 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Thermometer Thermometer (excl. CDS) Unhealthy Healthy Source: Thomson Datastream, UBS WMR, as of 22 October 2010 Japan financial health (updated monthly, last update 22 October 2010): Please see the Appendix for a detailed explanation of this ther- mometer. The Japan financial health thermometer improved a bit from 100.5° on 17 September to 100.4° on 22 October. All four components of the thermometer except the credit default swap spread improved. Out of all four measured regions, Japan has suffered the least from the Greek crisis and also has the lowest (i.e. healthiest) level. Japan financial health thermometer IMPROVED Normal index (sample: 1 Jan 06 – 20 Jul 07) =100 99 100 101 102 103 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Thermometer Thermometer (excl. CDS) Unhealthy Healthy Source: Bloomberg, UBS WMR, as of 22 October 2010 UBS Wealth Management Research 25 October 2010 Financial crisis thermometers Financial crisis thermometers - 3
  4. 4. Appendix Financial health thermometers The financial health thermometer is a weekly gauge of financial stress. Con- ceptually, we constructed it in the same way for all four regions: the US, the Eurozone, the UK and Japan. Due to data limitations in Japan, however, the construction of the Japanese thermometer is a little bit different. The financial health thermometer is the weighted average of four "standard- ized" indicators, where standardized means that the original series were transformed to have a mean of zero and a standard deviation (volatility) of one. The weights are assigned according to the explanatory power of each indicator of the variance in the whole data set (Principal Component Analysis). The four indicators are: s Bank liquidity: measured by the difference between money market rates and central bank rates. Specifically, it is the spread of the 3-month London Interbank Offered Rate (LIBOR) interest rate over the respective central bank target rate. The higher the spread goes, the harder it is for banks to get liquidity. s Corporate default: measured by the difference between corporate bond rates and government bond rates. Specifically, it is the spread of the investment grade 10-year corporate bond yield over the 10-year government bond yield. The higher the spread goes, the higher the risk of corporate default. s Financial intermediaries default: measured by the five-year credit default swap (CDS) spread of the financial intermediaries sector. The CDS spread measures the cost of insuring an underlying credit security against default over a certain period (in our case, five years). The higher the spread goes, the higher the aggregate risk of default of financial intermediaries. In Japan, a CDS spread for the financial intermediaries sector was not available. We used the average CDS spread of the three biggest banks in Japan (Mitsubishi UFJ, Sumitomo Mitsui and Mizuho) instead. s Equity volatility: measured by the implied volatility of the major stock market indexes. The implied volatility indexes are based on the implied volatility as priced into option prices on the underlying stock indexes. The higher the implied equity volatility goes, the more investors are willing to pay to hedge against equity volatility and, thus, the higher the perceived equity risk is in the market. The interpretation of the financial health thermometer is constructed as follows: We used the period between 1 January 2006 and 20 July 2007 as the benchmark for “normal” (the benchmark period). In late July 2007, the first financial market dislocations occurred following the US subprime mortgage crisis. While any choice for a benchmark is arbitrary, we are inter- ested in knowing when we will reach the financial health that existed be- fore the July 2007 liquidity crisis. Each regional financial health thermome- ter in this report averages 100 over the normal benchmark period, so an index level of 100 is considered normal. US financial health thermometer Normal index (sample: 1 Jan 06 – 20 Jul 07) =100 99 100 101 102 103 104 105 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Thermometer Thermometer (excl. CDS) Unhealthy Healthy Source: Thomson Datastream, UBS WMR, as of 22 October 2010 Eurozone financial health thermometer Normal index (sample: 1 Jan 06 – 20 Jul 07) =100 99 100 101 102 103 104 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Thermometer Thermometer (excl. CDS) Unhealthy Healthy Source: Thomson Datastream, UBS WMR, as of 22 October 2010 UK financial health thermometer Normal index (sample: 1 Jan 06 – 20 Jul 07) =100 99 100 101 102 103 104 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Thermometer Thermometer (excl. CDS) Unhealthy Healthy Source: Thomson Datastream, UBS WMR, as of 22 October 2010 UBS Wealth Management Research 25 October 2010 Financial crisis thermometers Financial crisis thermometers - 4
  5. 5. s To make the measurements easier to interpret, we introduced a Fahrenheit degree scale, where 100° indicates normal body temper- ature. Each Fahrenheit degree deviation from 100° equals 10 stan- dard deviations from the mean that existed during the normal bench- mark period. For example, a financial health thermometer that stands at 103° is 30 standard deviations above its mean during the normal benchmark period. This might seem like a lot, but we are comparing the current financial health to the normal benchmark period, when volatility was very low. s Each Fahrenheit degree also has its own color zone, with a higher de- gree associated with a higher temperature and thus poorer health. The color scheme goes from green (healthy) to increasingly darker shades of yellow and up to dark orange or red (unhealthy). Since we used the same normal benchmark period and methodology for all four regions, the levels of each regional financial health thermometer are comparable. Keep in mind, however, that the Japanese thermometer was constructed slightly differently. Japan financial health thermometer Normal index (sample: 1 Jan 06 – 20 Jul 07) =100 99 100 101 102 103 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Thermometer Thermometer (excl. CDS) Unhealthy Healthy Source: Bloomberg, UBS WMR, as of 22 October 2010 All financial health thermometers Normal index (sample: 1 Jan 06 – 20 Jul 07) =100 99 100 101 102 103 104 105 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 US Eurozone UK Japan Unhealthy Healthy Source: Thomson Datastream, Bloomberg, UBS WMR, as of 22 October 2010 UBS Wealth Management Research 25 October 2010 Financial crisis thermometers Financial crisis thermometers - 5
  6. 6. US economic health thermometer The economic health thermometer gauges the stance of the US economy in a single and timely measure on a monthly basis. This gauge will help investors assess whether the US economy is moving out of recession before it shows up in the GDP figures. The economic health thermometer is the weighted average of three “stan- dardized” indicators, where standardized means that the original series were transformed to have a mean of zero and a standard deviation (volatil- ity) of one. The weights are assigned according to the explanatory power of each indicator of the variance in the whole data set (Principal Component Analysis). The three indicators are: s Business climate: measured by the level of the Institute for Supply Management (ISM) Manufacturing Purchasing Managers’ Index (PMI). The ISM surveys purchasing managers at manufacturing firms every month on changes in new orders, unfilled orders, production, employ- ment, supplier delivery times, inventory, export orders, imports and prices paid. The ISM Manufacturing PMI is the average of the sub-in- dexes for new orders, production, employment, supplier delivery times and inventories. A level above/below 50 signals an expansion/contrac- tion in the national manufacturing sector. The ISM index correlates strongly with real GDP year-over-year growth and is thus seen as a good proxy for overall economic activity. However, manufacturing cy- cles can sometimes diverge from the overall business cycle. Thus, care is required when interpreting the level of the ISM index. s Consumer sentiment: measured by the level of the Conference Board (CB) consumer confidence index. The CB index gauges how consumers assess their present and future situation. The index is con- structed as the average of the indexed answers to five questions about consumers’ assessment of the current and future employment situa- tion, current and future business conditions and future total family in- come. The answers can be positive, negative or neutral. For each ques- tion, the sub-index is derived by calculating the ratio of the proportion of the positive answers to the sum of the positive and negative an- swers. This number is then indexed, with 1985 equaling 100. Thus, the level of the CB consumer confidence index is not readily interpretable as positive or negative, but has to be compared to its history to assess whether or not the value is conducive to real consumption growth. The index dates back to February 1969 and averaged 95.4 through February 2009. A level of around 90 is consistent with trend growth of about 3.5% in real consumption. s Labor market health: measured by the monthly growth rate in non- farm payrolls, which count the number of jobs in the entire economy, excluding the farm sector. Although non-farm payrolls tend to get re- vised rather sharply, they swing more in line with real economic activity than the unemployment rate, which typically lags the overall business cycle. Non-farm payroll growth of 0.16% per month, or about 2% annually, is considered normal employment growth or commensurate with trend growth in real GDP. US economic health thermometer Normal index (February 1969 – present) = 100 96 97 98 99 100 101 102 103 Feb-69 Feb-79 Feb-89 Feb-99 Feb-09 US economic health thermometer Unhealthy Unhealthy Healthy Source: Thomson Datastream, UBS WMR, as of 22 October 2010 UBS Wealth Management Research 25 October 2010 Financial crisis thermometers Financial crisis thermometers - 6
  7. 7. The interpretation of the economic health thermometer is as follows: s The average of the entire sample from February 1969 to the current month equals 100. s To make the measurement easier to interpret, we introduced a Fahren- heit degree scale, where 100° implies normal body temperature. Each Fahrenheit degree deviation from 100° equals one standard deviation from the mean over the entire sample. For example, an economic health thermometer that stands at 102° is two standard deviations above its sample mean. s There are three color zones. s The green zone (from 98.5° to 100°) is commensurate with real GDP growth between zero and 3%, with the latter being trend growth over the sample period. s The dark orange zone (100° or higher) is commensurate with real GDP growth above 3%, or an overheating economy. s The blue zone (98.5° or lower) is consistent with contracting real GDP, or a recessionary economy. We classify both an overheating and a recessionary economy as un- healthy, and see normal growth between zero and 3% as healthy. Note that the boundaries between healthy and unhealthy are blurred. Ideally, the US economy should be growing at potential growth of around 3%. However, we wanted to mark the line between contrac- tion and expansion (zero growth or 98.5°). That does not mean that we think that it would be healthy for the US economy to expand at +0.5% per year for several years. UBS Wealth Management Research 25 October 2010 Financial crisis thermometers Financial crisis thermometers - 7
  8. 8. US credit health thermometer The credit health thermometer gauges credit conditions in the US on a monthly basis. It summarizes information on the price, availability and flow of credit. The credit health thermometer is the weighted average of five “standardized” indicators, where standardized means that the original se- ries were transformed to have a mean of zero and a standard deviation (volatility) of one. The weights are assigned according to the explanatory power of each indicator of the variance in the whole data set (Principal Component Analysis). The five indicators are: s Bank liquidity: measured by the spread of the 3-month Eurodollar deposit rate over the fed funds rate. We used the 3-month Eurodollar deposit rate instead of the 3-month LIBOR rate since it has a longer history. They correlate very closely, however. The higher the spread goes, the harder it is for banks to get liquidity. s Corporate default: measured by both the spread of the Moody’s Aaa 20-year corporate bond yield over the 20-year government bond yield and the spread of the Moody’s Baa 20-year corporate bond yield over the 20-year government bond yield. The higher that any of these spreads goes, the higher the risk of corporate default in the respective segment of the investment grade corporate bond market. s Availability of credit: measured by commercial bank lending stan- dards for consumer installment loans. The higher the standards are, the tougher it is for consumers with low credit ratings to get credit. s Loan volume: measured by the real (inflation-adjusted) monthly growth rate of commercial bank loans (real estate, business and con- sumer loans). The higher the growth rate goes, the more rapidly loan volumes on banks' balance sheets are rising. The interpretation of the credit health thermometer is as follows: s The average of the entire sample from January 1973 to the current month equals 100. s To make the measurement easier to interpret, we introduced a Fahren- heit degree scale, where 100° implies normal body temperature. Each Fahrenheit degree deviation from 100° equals one standard deviation from the mean over the entire sample. For example, a credit health thermometer that stands at 102° is two standard deviations above its sample mean. s Each Fahrenheit degree has its own color zone, with a higher degree associated with a higher temperature and thus poorer health. The col- or scheme goes from green (healthy) to increasingly darker shades of yellow and up to red (unhealthy). We consider credit conditions be- tween 98° and 100° as generally healthy, with the healthiest credit conditions closest to 100°. Credit conditions are looser as the ther- mometer approaches 98°. Credit conditions that are too loose (such as extending credit to insolvent borrowers) can also create problems. US credit health thermometer Normal index (sample: Jan 1973 – present) = 100 97 98 99 100 101 102 103 104 105 106 Jan-73 Jan-83 Jan-93 Jan-03 US credit health thermometer Unhealthy Healthy Source: Thomson Datastream, UBS WMR, as of 22 October 2010 UBS Wealth Management Research 25 October 2010 Financial crisis thermometers Financial crisis thermometers - 8
  9. 9. Appendix Global Disclaimer Wealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisions of UBS AG (UBS) or an affiliate thereof. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). All information and opinions as well as any prices indicated are current as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. At any time UBS AG and other companies in the UBS group (or employees thereof) may have a long or short position, or deal as principal or agent, in relevant securities or provide advisory or other services to the issuer of relevant securities or to a company connected with an issuer. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is considered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income of an investment. We are of necessity unable to take into account the particular investment objectives, financial situation and needs of our individual clients and we would recommend that you take financial and/or tax advice as to the implications (including tax) of investing in any of the products mentioned herein. This document may not be reproduced or copies circulated without prior authority of UBS or a subsidiary of UBS. UBS expressly prohibits the distribution and transfer of this document to third parties for any reason. UBS will not be liable for any claims or lawsuits from any third parties arising from the use or distribution of this document. This report is for distribution only under such circumstances as may be permitted by applicable law. Australia: Distributed by UBS Wealth Management Australia Ltd (Holder of Australian Financial Services Licence No. 231127), Chifley Tower, 2 Chifley Square, Sydney, New South Wales, NSW 2000. 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UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US affiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through a US-registered broker dealer affiliated with UBS, and not through a non-US affiliate.Version as per January 2010. © UBS 2010.The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. UBS Wealth Management Research 25 October 2010 Financial crisis thermometers Financial crisis thermometers - 9

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