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Financial Pacific: Inflation, inflation, inflation (third party) december 20.2010


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  • 1. Brian OReilly, strategist, UBS AG Caroline Winckles, CFA, analyst, UBS AG Mark Bulsing, strategist, UBS AGWealth Management Research 17 December 2010UK economicsInflation, inflation, inflation s Inflationary pressures continue to build in the UK economy. November inflation data showed an increase in CPI to 3.3% y/y, while the broader measure of RPI rose to 4.7%y/y. Headline inflation has now beaten expectations in 22 of the last 32 months. s The Bank of England (BoE) maintain their mantra that inflation pressures will subside in the medium-term, but in our opinion they are underestimating the strength of inflation pressures, and are at risk of losing their inflation fighting credibility. s As we highlighted in our 2011 outlook, we believe inflation may once more surprise to the upside in 2011 before the BoE will be forced to raise rates next year.This will be the last weekly outlook for 2011. The next edition will beavailable on Friday 7th January. Fig. 1: Performance data for major markets Capital return performance, in %Market Overview Equity Markets Level % Week % YTDEquity markets reached their year high this week, with the FTSE 100 rising FTSE 100 5872 1.0 8.5to 5891, and ending the week at 5872, 1% up on last week. The S&P FTSE 250 11427 1.3 22.8500 stayed almost flat this week at 1242 at mid Friday trading. The major S&P 500 1242 0.1 11.4concern for investors as we move into the New Year is the outlook for Euro Stoxx 50 2821 -0.7 -4.9government bonds. Gilts continue to remain under significant pressure, CAC 40 3867 0.3 -1.8with bond yields moving higher again. DAX 6982 -0.3 17.2The 10-year Gilt yield is now at 3.56%, and the 10-year US treasury yields SMI 6538 0.3 -0.13.39%. We have long held the view that government bonds had become Nikkei 225 10304 0.9 -2.3a less attractive investment, particularly in the face of rising inflationary Commoditiespressures here in Britain. We continue to believe that Investors need to Gold (USD/Oz) 1371 -1.0 24.8re-examine their fixed income holdings where many should be considered Oil (USD/bl) 88.0 0.2 4.2anything but safe for the year ahead. Foreign ExchangeIn commodities, Gold moved slightly lower to USD 1371/oz, and oil remains GBPUSD 1.548 -2.0 -4.1at USD 88/bl. In FX, the pound weakened to end the week at GBPUSD 1.55 GBPEUR 1.177 -1.5 4.5and GBPEUR at 1.18. Fixed Income UK 10 yr Gilt 3.56% - -Next week sees a very light economic calendar in the run up to Christmas. US 10 yr Treasury 3.39% - -The most notable events are the release of the Bank of England MPCminutes on Wednesday, and revised figures for Q3 GDP. We still expect the Source: Bloomberg, UBS WMReconomy to have grown by 0.8%.This report has been prepared by UBS AG.Please see important disclaimers and disclosures that begin on page 4.
  • 2. UBS Wealth Management Research 17 December 2010UK economicsThe week in review...Further confirmation came this week that inflation pressures are building inthe UK economy with the release of CPI and RPI data. Retail sales also beatexpectations on Thursday, but house prices disappointed again on Monday. s Inflation pressures are once again building in the UK economy. This week we had further confirmation with headline CPI rising 0.4% in November to 3.3% y/y. Core CPI (ex-food and energy) came in at 2.7%, while RPI moved higher again and remains at an elevated 4.7%. Inflation has now beaten expectations for 22 out of the last 32 months, and remain well above the BoEs 2% inflation target. s In a speech this week Deputy Governor for the Bank of England Charlie Bean highlighted 3 reasons why he believed inflation was higher than expected. "First, energy and non-oil commodity prices are substantial- ly higher than a year previous….. The second factor behind the unex- pectedly high inflation appears to have been greater than expected pass-through into final prices from the depreciation of sterling….. The third potential ingredient behind higher inflation is a more moderate drag from the margin of spare capacity in the economy". s In the latest Quarterly Inflation report the BoE stick to their mantra about inflation pressures expected to moderate in the "medium term" due to spare capacity. But with CPI inflation expected to rise toward 4% in the first half next year, the BoE are at risk of losing their inflation fighting credibility with their 2% target looking distinctly remote. In our opinion the BoE are yet again underestimating the strength of inflation pressures. s Fuel prices have already surpassed record highs, and in January retail- ers are likely to bundle the VAT increase with higher commodity costs into prices, which could add up to 5% to final cost in some cases. The reality is that as a consequence of more robust growth, prices are be- ing passed onto consumers with relative ease, and with wage growth remaining muted, consumer real income is being eroded. As a result real income is falling. As we highlighted in our Outlook for 2011 we believe inflation may once more surprise to the upside before the BoE will be forced to raise rates in 2011. From an investors perspective inflation is now becoming an issue for savers and investors with cash rates still yielding next to nothing, which we expect to be a persistent theme in the year ahead. s UK retail sales on Thursday beat expectations coming in at 1.8% y/ y excluding fuel and 1.1% y/y including fuel. The market was look- ing for 1.4% and 0.7% respectively. We expect volumes coming in to Christmas to remain positive, particularly ahead of the 2.5% VAT increase in January. s The one area where we are not seeing inflation, is in UK house prices. On Monday, Rightmove reported house prices down 3% m/m for De- cember. The RICS house price balance survey, whilst slightly beating expectations is still bearish with a -44% balance of respondents re- porting house price declines. We expect continued house price weak- ness through 2011, to end the year 5-10% lower. UK economics - 2
  • 3. UBS Wealth Management Research 17 December 2010UK economics s FOMC on hold: Unsurprisingly the FOMC left rates on hold at 0.25%, and did not extend its QE programme this month. Earlier in December, it had already outlined a further USD600bn of asset purchases. s Eurozone PMI data on Thursday came in broadly as expected at 55. The breakdown included slightly higher manufacturing, but slightly lower services. The German IFO business climate index on Friday however, reached its highest level since 1991. We expect the continued diver- gence between the strong and the weak countries to continue. s Eurozone Inflation: is a different picture to that in the UK. Year on year Eurozone CPI inflation came in at a mere 1.9%.The week ahead...Unsurprisingly, next week has a very light calendar. The most notable eventsare the Bank of England minutes on Wednesday, and the last revisions forthe third quarter US and UK GDP figures. s BoE remains split: The Bank of England minutes are likely to show again a three way split between its members with Adam Posen voting for further quantitative easing, and Andrew Sentance voting for a rate hike. In light of last weeks inflation data, it will be interesting to see if Sentance has gained any further support this past month. s 3Q really was that good: The last revisions to the third quarter GDP numbers on Tuesday, are expected to provide no change on the esti- mates of the strength of third quarter growth. The UK is expected to remain unchanged at 0.8% q/q, and the US unchanged at 2.5%q/q annualised.Key data and events this weekDate Time Event Survey Prior12/21/2010 00:01 UK GfK Consumer Confidence Survey -21.0 -21.012/21/2010 22:00 US ABC Consumer Confidence -- -4312/22/2010 09:30 UK Bank of England Minutes - -12/22/2010 09:30 UK GDP (QoQ) Final revision 0.8% 0.8%12/22/2010 09:30 UK GDP (YoY) Final revision 2.8% 2.8%12/22/2010 13:30 US GDP QoQ (Annualized) Third revision 2.8% 2.5%12/22/2010 15:00 US House Price Index MoM -0.1% -0.7%Source: Bloomberg UK economics - 3
  • 4. UBS Wealth Management Research 17 December 2010UK economicsAppendixGlobal DisclaimerWealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisions of UBS AG (UBS) or an affiliatethereof. 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, tobuy or sell any investment or other specific product. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materiallydifferent 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 forsale 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 representationor 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 aswell 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 contraryto 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 inthe 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 tothe 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 illiquidand 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 theflow 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 realizationyou 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 aninvestment. We are of necessity unable to take into account the particular investment objectives, financial situation and needs of our individual clients and we wouldrecommend 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 maynot 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 tothird 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 isfor 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. Austria: This publication is not intended to constitute a public offer or a comparable solicitation under Austrian law and will only be usedunder circumstances which will not be equivalent to a public offering of securities in Austria. The document may only be used by the direct recipient of this informationand may under no circumstances be passed on to any other investor. Bahamas: This publication is distributed to private clients of UBS (Bahamas) Ltd and is not intendedfor distribution to persons designated as a Bahamian citizen or resident under the Bahamas Exchange Control Regulations. Canada: In Canada, this publication isdistributed to clients of UBS Wealth Management Canada by UBS Investment Management Canada Inc.. Dubai: Research is issued by UBS AG Dubai Branch within theDIFC, is intended for professional clients only and is not for onward distribution within the United Arab Emirates. 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The contents ofthis report have not been and will not be approved by any authority in the United Arab Emirates including the UAE Central Bank or Dubai Financial Authorities, theEmirates Securities and Commodities Authority, the Dubai Financial Market, the Abu Dhabi Securities market or any other UAE exchange. UK: Approved by UBS AG,authorized and regulated in the UK by the Financial Services Authority. A member of the London Stock Exchange. This publication is distributed to private clients ofUBS London in the UK. Where products or services are provided from outside the UK, they will not be covered by the UK regulatory regime or the Financial ServicesCompensation Scheme. USA: Distributed to US persons by UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and anaffiliate of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US affiliate when it distributesreports 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 withUBS, 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. UK economics - 4