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Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
Financial Pacific: Wealth Management Research (third party), july 29.2010
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Financial Pacific: Wealth Management Research (third party), july 29.2010

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  • 1.  Michael P. Ryan, CFA, Head WMR Americas, mike.ryan@ubs.com Stephen R. Freedman, PhD, CFA, Strategist, stephen.freedman@ubs.com Wealth Management Research 28 July 2010 Investment Strategy Guide Region: US From “tail risk” to “trail risk”  Having highlighted near-term “tail risks” two months ago as a Contents Page reason to position portfolios more cautiously, we now believe that Focus 1 some of these risks have abated, in particular those arising from Asset allocation overview 5 the European sovereign crisis. Market scenarios 6  We are therefore adopting a more neutral tactical stance across Equity and bond regions 7 asset classes. At the same time, we stress that the soft patch wit- US equity sectors 8 nessed in recent economic data may well last for some time, thereby limiting the upside potential for equities and other cyclical US equity size, style and REITs 9 assets. US fixed income 10 Tactical changes: Chartbooks 12 Detailed asset allocation 16  We are upgrading equities and fixed income from moderate un- derweight to neutral while downgrading cash from overweight to neutral. Fig. 1: Tactical deviations across asset classes Deviations from benchmark  Within our regional fixed income allocation, we upgrade Eurozone bonds and as a result non-US Fixed Income from moderate under- weight to neutral, while downgrading US Fixed Income to neutral. Equity  Among US Equity sectors, we’ve made various adjustments. We have increased our overweight in Tech, increased our underweight Fixed Income in Materials, closed our moderate overweight in Energy and our moderate underweight in Health Care. We have also reduced the Cash magnitude of our underweight in Consumer Discretionary and in- troduced a moderate underweight in Telecom. Commodities  Within our US Equity size/style/REITs allocation, we have closed our moderate overweight on Mid Cap stocks, and reduced the magni- ––– –– – + ++ +++ n tude of our underweight in REITs. underweight overweight  In US Fixed Income, we are extending our recommended duration, while continuing to recommend a below-benchmark duration. Source: UBS WMR, as of 28 July 2010. See Deviations from bench- mark allocation in the Appendix for a detailed explanation of these Among fixed income segments, we are increasing our overweight suggested deviations. in credit-sensitive areas, by reintroducing moderate overweights in High Yield Corporates and Preferred securities. Fig. 2: Benchmark and current allocation Percentage of portfolio (moderate risk portfolio) Benchmark allocation Current allocation A shift in focus In the wake of the mini “flash crash” of May 6th, investors began to 5.0 12.0 5.0 12.0 focus once again upon the occurrence of extreme events or so called 2.0 2.0 “tail risks.” While a technical glitch related to algorithmic trading may or 44.0 44.0 may not have been primarily responsible for the steep selloff in the mar- ket that day, the violent price shifts within equity markets rekindled con- 37.0 37.0 cerns of credit meltdowns, liquidity events and market dislocations. The deepening of the sovereign debt crisis across the Eurozone, increased belligerence on the part of North Korea and Iran, and the uncertainties Equity Commodities associated with financial regulatory reform only served to reinforce those Fixed Income Cash Altern. Investments fears. This was clearly reflected by a surge in market volatility and further declines in government bond yields. But with the successful completion Source: UBS Investment Solutions and WMR, as of 28 July 2010. See Sources of benchmark allocations and investor risk profiles in the of the European bank “stress tests” and passage of financial regulatory Appendix for a detailed explanation regarding benchmarks and their reform in the US, some of the worries over extreme outcomes have be- suitability. The current allocation is the sum of the benchmark alloca- tions and tactical deviations. gun to fade and the acute sense of risk aversion has eased. As a result, The Tables on pages 16 and 17 in the Appendix also show asset markets have rebounded off their recent lows, risk appetite has im- allocations applicable to risk profiles other than the moderate risk profile shown here, both with and without nontraditional assets. proved and volatility has eased. This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimer and disclosures at the end of the document.
  • 2. Wealth Management Research 28 July 2010 Investment Strategy Guide But even as “tail risks” are beginning to fade, evidence of “trail risks” Fig. 3: Asset Class Scorecard has started to surface. Recently released economic data suggest that the Valuation Cyclical Timing economic recovery is showing signs of moderating. It’s not surprising to see growth ease somewhat following an initial surge in activity as the Equities +1 -1 0 economy emerges from recession. However, the current deceleration in Commodities 0 0 0 growth is somewhat more troubling in that the rebound in activity is far Fixed Income -1 0 0 shallower than normal and the slowdown is occurring more rapidly than Range: -3 (very unsupportive) to +3 (very supportive) is typically the case. Figure 4 compares the current recovery with others Source: UBS WMR, as of 28 July 2010 of the post-war era at a similar phase of the business cycle. As this figure clearly illustrates, the current pace of growth trails the levels that would normally be expected given the depth of the recession and the aggres- Fig. 4: A trailing recovery sive nature of the response by policymakers. This sluggish pace of Current US recovery compared to others in the post-war era growth will likely serve to both limit job creation as well as further at a similar phase of the business cycle dampen improvements in consumer sentiment. Attention will therefore 8% necessarily shift away from event-driven “tail risks” and toward eco- nomic-centered “trail risks.” 6% Real GDP recovery Against this backdrop, we have opted to both remove our underweight 4% position in equities and redeploy a portion of low-yielding idle cash bal- 2008/09 ances. We still see significant structural challenges ahead ranging from 2% the deleveraging of consumer balance sheets, to an ongoing recapitaliza- tion of the financial sector, to a growing need for fiscal consolidation. 0% What’s more, while valuation remains undemanding, the upside earnings 0% 1% 2% 3% 4% surprises that have been one of the principal catalysts behind market Real GDP loss gains are likely to be mixed going forward. Still, the more acute threat Note: Real GDP loss is measured as peak-to-trough decline during from an event-driven market meltdown has now abated. Ironically, even recessions, real GDP recovery is measured as the cumulative gain in as the economic recovery process has shown some clear signs of slow- the first year after the end of recessions. ing, the risks that a locking up of credit markets and/or reflexive de- Source: Datastream and UBS WMR, as of 27 July 2010 risking will lead to an adverse outcome have likely diminished. We now see equity markets as largely range-bound, with the S&P 500 likely to Fig. 5: Growth and inflation forecasts trade within plus/minus 7% of the current 1100 level for the balance of the year. While this hardly constitutes a compelling near-term buying in % GDP Growth Inflation opportunity, the downside appears more limited and the returns are '09 '10 F '11 F '09 '10 F '11 F competitive with the modest yields on competing asset classes such as World -1.1 4.1 3.8 1.3 2.9 2.9 bonds and cash. US -2.4 3.0 3.0 -0.3 1.7 1.6 Canada -2.5 3.5 3.2 0.3 1.8 2.4 Stress pause in Europe The much awaited stress tests for European banks were released on July Japan -5.2 3.4 1.7 -1.3 -0.6 -0.1 23. While the results were hardly convincing, their publication does ap- Eurozone -4.1 1.5 1.9 0.3 1.5 1.5 pear to have restored some confidence in the European financial system, UK -4.9 1.3 2.4 2.2 3.1 2.1 as the decline in bank and sovereign spreads indicates (see Figure 6). The China 8.7 10.0 8.7 -0.7 3.0 4.0 results were disappointing to the extent that a very limited number of India 7.4 9.0 8.0 6.4 8.6 5.9 banks were found to have failed the test (7 out of 91) and the aggre- gate capital shortfall of EUR 3.5 bn clearly fell short of expectations. The Russia -7.8 7.5 6.0 11.7 5.9 5.8 fact that the test did not assume a sovereign default, but merely a sover- Brazil -0.2 8.2 5.4 4.3 5.4 5.2 eign debt market stress situation, helped to set the bar rather low. The Asia ex-Jp/Chi/Ind -0.6 5.3 4.3 1.8 2.7 3.2 vast majority of banks’ exposure to sovereign credit risk, which is located F: forecast. Source: UBS WMR, as of 28 July 2010 in their banking book rather than their trading book, was thereby ex- In developing the forecasts set forth above, WMR economists cluded from the stress scenario. From this perspective, the stress tests worked in collaboration with economists employed by UBS Invest- were a bit lacking in terms of the rigor applied to testing the true impact ment Research (INV). INV is published by UBS Investment Bank. of sovereign losses. Forecasts and estimates are current only as of the date of this publi- cation and may change without notice. What the operation did achieve, however, is to increase transparency in the European banking system by requiring considerable disclosure re- garding banks’ exposures to sovereign risk. This will allow investors and analysts to better separate the wheat from the chaff among European financial institutions, which is typically a significant step toward restoring confidence. Therefore, while the exercise missed an opportunity to serve as a catalyst toward recapitalizing the banking system, the greater trans- parency does reduce the systemic risk arising from Europe to an impor- tant extent. Keep in mind that the stress tests of the US banks repre- sented a critical turning point for the recovery in financial assets. While Investment Strategy Guide 2
  • 3. Wealth Management Research 28 July 2010 Investment Strategy Guide the conditions and stakes are much different this time around, the suc- Fig. 6: Improving confidence in European banks cessful completion of the European stress tests does eliminate one im- European banks average 5 year Credit Default Swap spread, portant source of tail risk for the market and, therefore, can be viewed in basis points as a constructive development. 400 Gauging the slowdown 350 As we’ve already noted, activity typically surges at the early stage of an 300 economic recovery / expansion – only to be followed by a mid-cycle moderation as the economy slows toward a more sustainable growth 250 path. Yet the current cycle has been anything but typical. Faced with 200 daunting structural challenges, uncertain public policy actions and a still 150 fragile cyclical outlook, businesses and consumers alike are taking a far more cautious approach this time around. Although non-farm payrolls 100 have shown signs of improvement and the unemployment rate has Mar May Jul Sep Nov Jan Mar May Jul ticked lower, these encouraging signs mask underlying weakness in pri- 09 09 09 09 09 10 10 10 10 vate sector job creation. As figure 7 illustrates, the level of private sector Source: Bloomberg and UBS WMR, as of 27 July 2010 jobs being added lags behind the pace seen during other recoveries as employers are careful about adding to headcount. This subdued level of Fig. 7: Lack of private payroll growth is trouble- employment growth will, in turn, further weigh upon consumer confi- some dence and restrain demand. Keep in mind that one of the most impor- tant drivers of consumption is personal income growth, which is highly 110 correlated with the pace of job creation. US nonfarm private payrolls (recession trough = 100) Manufacturing activity also shows signs of decelerating. The ISM Manu- 105 facturing index has softened a bit following the initial surge as the econ- omy emerged from recession. Once again, there is nothing terribly sur- prising about a mid-cycle slowdown. According to our economics team, 100 the ISM index typically peaks during the early stages of the recov- # of months (recession ery/expansion, and then drops. However, given how highly dependent trough = 0) this recovery has been upon an aggressive policy mix – and considering 95 the daunting nature of the structural challenges we face – the current 0 4 8 12 16 20 24 slowdown has understandably drawn a bit more attention. Keep in Postwar recessions (average) 2008/09 recession mind, equity markets often take their cues from leading indicators, such Source: Datastream and UBS WMR, 27 July 2010 as the ISM. Still, the prospects for a “double-dip” recession remain low. Private sector demand has been reignited with the boost from monetary and fiscal policy, as evidenced by eight consecutive months of positive Fig. 8: Business and consumer confidence have consumption. The US consumer has benefited from a rebound in net declined recently wealth, lower interest rates and falling inflation which has supported real purchasing power. The savings rate has stabilized at around 3.5% since 150 70 July 2009, indicating that the correction in savings behaviour has likely 130 run its course. The positive feedback loop between consumption, em- 110 60 ployment and labour income may be weaker than normal but should still 90 50 prove strong enough to avoid a double-dip, in our view. 70 50 40 Still a range-bound market 30 30 Within this still sluggish growth environment, the “margin of error” for 10 investors will remain especially tight. The potent mix of policy drivers that (10) 20 drove the reflation rally through March is no longer adequate to lift all 1990 1994 1998 2002 2006 2010 risk assets. What’s more, the tail winds from upside earnings surprises Consumer Confidence, Conference Board (left) have tapered off as expectations have been reset. While it’s a bit of a Business Confidence, ISM Manufacturing PMI (right) cliché to say that selectivity is critical, range-bound markets by definition Source: Bloomberg and UBS WMR, 27 July 2010 demand a more discriminating approach. Consider the following:  Valuation: While equity markets are trading nearly 10% below the highs reached back in late April, there is little to suggest that valua- tion has become especially compelling. According to our own valuation models, equities currently trade just about 13% below fair value. Current P/E ratios are only slightly below the average seen over the past decade, suggesting that stocks are well within ranges consistent with a neutral market weighting. On the other hand, valuation isn’t very demanding either, suggesting that any material setback in equity prices from here would have to be driven Investment Strategy Guide 3
  • 4. Wealth Management Research 28 July 2010 Investment Strategy Guide by either a sharp earnings deceleration, material rate increases, Fig. 9: Equities attractively valued vs. bonds marked policy tightening or a disruptive exogenous event. Equity risk premium (earnings yield minus real bond yield) 18% US Equity Risk Premium (Average 10 year real earnings)  Profits: Second quarter profits have come in a bit better than ex- average pected, with about 3/4s of companies once again beating analyst US Equity Risk Premium (Forward earnings) average expectations. However, amid more cautious company guidance 13% and an overly rosy profit picture, analysts have begun to scale back Equities attractive their earnings estimates. Consensus estimates for 2011 earnings 8% relative to bonds currently stand at about $96. This is well above our own $88 fore- cast, and suggests there is additional room for downward revisions. 3% Overall, while we expect profits to grow 10% next year following a Equities unattractive near 30% rise this year, significant earnings beats are less likely to -2% relative to bonds materialize looking forward (see figure 10). -7%  Rates: Despite both a rebound in risk assets and a recovery in eco- 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 nomic activity, interest rates across the board remain low by histori- Source: IBES, Shiller and UBS WMR, as of 28 July 2010 cal standards. It is our view that the current low rate environment is largely a function of accommodative monetary policy, sluggish Fig. 10: Earnings beats supportive until now, less growth prospects, diminished inflation risks, limited capital re- likely looking forward quirements from the private sector and a continued sense of risk % of S&P 500 companies beating consensus estimates aversion. While yields would be expected to drift higher over the course of the next year, the overall interest rate environment is 80% likely to remain low for an extended period. 70% 60%  Policy: Chairman Bernanke has made it clear both in his testimony 50% before Congress as well as the statements following meetings of 40% the FOMC that the Fed has no intention of shifting policy any time 30% soon. In fact, the Chairman even raised the prospects for the de- 20% ployment of additional extraordinary policy options in the event the 10% economy slowed sharply or deflationary pressures began to build. It 0% would therefore appear that the policy backdrop – at least from the 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 est monetary side – will remain supportive of both economic growth Sales Earnings and risk assets. Note: After 60% of companies reporting 2Q 2010 earnings. Source: FactSet and UBS WMR, as of 27 July 2010 Uncertainties abound While “tails risks” may have faded, that is not to say that uncertainties have been eliminated. The approach of the congressional mid-term elec- tions and the prospects for a change in the composition of Congress Fig. 11: Benign inflation backdrop means rates represents both a risk and an opportunity for markets. While “gridlock” to stay low for longer US consumer price inflation, year-over year, in % in DC is viewed favorably, a deeply dysfunctional divide on Capitol Hill is not. Likewise, the expiration of the Bush tax cuts at the end of this year 16 14 pose another potential challenge. In the absence of either a reform bill or 12 extension of the tax cuts, rates would automatically revert back to the 10 Clinton era levels. This would be a significant blow to a recovery that has 8 already had enough difficulty in gaining traction. Although we still view 6 that prospect of a double-dip as low, the fallout from the Eurozone crisis 4 and a tightening of policy in Asia still have the potential to push the 2 economy into a ditch. 0 -2 Michael P. Ryan, CFA, Head WMR Americas, UBS FS Inc. -4 60 65 70 75 80 85 90 95 00 05 10 Source: Bureau of Labor Statistics and UBS WMR, as of 27 July 2010 Investment Strategy Guide 4
  • 5. Wealth Management Research 28 July 2010 Investment Strategy Guide Asset Allocation Overview WMR Tactical Model Portfolio Asset Class Comments View Moderate Risk Profile (in %) Benchmark Tactical Change Current Allocation Deviation Allocation Equities Upgraded from moderate underweight to neutral. Moderately attractive Neutral 44.0 +0.0  44.0 valuation offset by more challenging cyclical environment. Systemic risk from European financial sector has abated. US Equities Valuations have turned attractive but less so than in other re- Neutral 32.0 +0.0  32.0 gions. Solid earnings growth, but 2011 consensus estimates appear too high, leaving room for disappointments. US Large Cap Value Moderate Large-cap relative valuations remain attractive. The segment 11.0 +1.0  12.0 Overweight should benefit from lingering risk aversion. US Large Cap Growth Large-cap relative valuations remain attractive. The segment Moderate 11.0 +2.0  13.0 should benefit from lingering risk aversion. Valuations and our Overweight sector tilts suggest modest preference for Growth over Value. US Mid Cap Expensive vs Large Cap. The expected pick-up in M&A activity, Neutral 5.0 +0.0  5.0 which benefits Mid Cap, appears delayed. US Small Cap Moderate 3.0 -2.0 1.0 Expensive vs. large caps and more challenging earnings picture. Underweight US Real Estate Investment Trusts (REITs) Expensive after this year's outperformance. Commercial real es- Moderate 2.0 -1.0  1.0 tate market still faces challenges. Upgraded due to modest im- Underweight provement in fundamentals. Non-US Developed Equities Valuations more attractive than US, especially in Europe. More Moderate 10.0 -2.0  8.0 sluggish European recovery and fiscal concerns, as well as ex- Underweight pensive valuations in Japan suggest more cautious stance. Emerging Market (EM) Equities Moderate EM equities are more attractively valued than developed mar- 2.0 +2.0  4.0 Overweight kets and more immune to fiscal risk. Fixed Income Upgraded from moderate underweight. While we expect bond yields to Neutral 37.0 +0.0  37.0 progressively rise, monetary policy normalization has been delayed well into 2011, creating a more supportive fixed income environment. US Fixed Income Neutral 29.0 +0.0  29.0 Currency considerations no longer favor the dollar. Non-US Fixed Income While the euro main remain under pressure in the near term, Neutral 8.0 +0.0  8.0 we expect it to appreciate modestly vs. the dollar over the next year. The yen is set to weaken in the medium term, in our view. Cash (USD) Neutral 2.0 +0.0  2.0 Downgraded to neutral. Low yields create high opportunity costs. Commodities Valuations are broadly in line with marginal costs of production. Supply and Neutral 5.0 +0.0  5.0 demand fundamentals suggest price appreciation, but negative roll yields should trim total returns. Alternative Investments Neutral 12.0 +0.0 12.0 No tactical view. Included into portfolio for diversification purposes. The benchmark allocations are provided for illustrative purposes only by UBS for a hypothetical US investor with a moderate investor risk profile and total return objective. See "Sources of benchmark allocations and investor risk profiles" in the Appendix for a detailed explanation regard- ing the source of benchmark allocations and their suitability and the source of investor risk profiles. The current allocation is the sum of the benchmark allocation and the tactical deviation. See "Deviations from benchmark allocation" in the Appendix regarding the interpretation of the suggested tactical deviations from benchmark. “WMR tactical deviation” legend: Overweight Underweight Neutral “Change” legend: ▲ Upgrade ▼ Downgrade Source: UBS WMR and Investment Solutions, as of 28 July 2010. For end notes, please see appendix. UBS FS Investment Strategy Guide 5
  • 6. Wealth Management Research 28 July 2010 Investment Strategy Guide Market Scenarios (next 12 months) While we continue to view a moderate recovery as the most Moderate recovery likely scenario, we have further increased the probability of the High double dip recession scenario and trimmed the likelihood of a V- Growth Goldilocks Supercycle shaped recovery. This reflects the recent slight downward ad- justment in our economic growth forecasts. Low Moderate recovery: Base Case Scenario Growth Probability: 65%  The global economy remains on expansion course. Stagflation Deflation  The recovery is more subdued than in prior cycles because of de- Negative Growth leveraging pressures on the consumer and the financial sector. Negative Low High Inflation Inflation Inflation  However, private pent-up demand is strong enough to allow growth to become self-sustaining. Source: UBS WMR  The Eurozone crisis remains contained and its impact on the fi- nancial sector is limited. Double-dip recession  The abundant slack in the economy keeps inflationary pressures High Growth from building up. Goldilocks Supercycle Double-dip recession: First Alternative Scenario Probability: 25% (previously 20%) Low Growth  New bouts of weakness in the housing market, a weak labor market, a retrenched consumer, and first steps toward fiscal con- solidation create additional headwinds. Negative Deflation Stagflation  The economy returns back into contraction mode for several Growth quarters, as consumer and investment demand decline once Negative Low High Inflation Inflation Inflation again. Source: UBS WMR  Falling commodity prices and a rise in excess capacities lead to negative consumer price inflation (deflation). V-shaped recovery V-shaped recovery: Second Alternative Scenario High Growth Goldilocks Supercycle Probability: 5% (previously 10%)  The strong policy impulse continues to filter through the eco- nomic and financial system. Low Growth  Beyond the build-up in inventories, further fiscal impulses, and a marked pickup in investment spending, improvements in the la- bor market and in credit conditions allow a more dynamic con- Deflation Stagflation sumer recovery. Negative Growth  Improving conditions abroad drive export growth. Negative Low High  Commodity prices rise moderately without derailing the recovery. Inflation Inflation Inflation Source: UBS WMR Stagflation: Third Alternative Scenario Stagflation Probability: 5% High Growth Goldilocks Supercycle  Rising commodity prices set an inflationary process in motion and contribute to choking the emerging recovery.  Higher inflation expectations become entrenched. Low  The combination of rising price levels and weak growth prospects Growth poses significant challenges to most financial assets. Stephen R. Freedman, PhD, CFA, Strategist, UBS FS Inc. Deflation Stagflation Negative Growth Negative Low High Inflation Inflation Inflation Source: UBS WMR UBS FS Investment Strategy Guide 6
  • 7. Wealth Management Research 28 July 2010 Investment Strategy Guide Equity and bond regions Keep preference for Emerging Market Equities We maintain a preference for emerging market equities over Fig. 13: Equity regions developed markets. Within international fixed income we are Tactical deviations from benchmark, incl. view on currency. taking a more neutral view between US and non-US bonds. Emerging Markets Emerging Market (EM) Equities: keeping an overweight UK We continue to view the prospects for Emerging Market (EM) stocks as superior to those of their developed market peers. Valuations remain Other Developed attractive. EM Price-Earnings (PE) ratios at 10.5 times forward earnings US compare favourably with 12.0 in the US. Moreover, consensus earnings Eurozone growth expectations remain broadly similar in both regions, while EM appear better position to deliver on these expectations. Finally, in a Japan context where fiscal risks have taken center stage among investors’ ––– –– – n + ++ +++ concerns, EM sovereigns are in a much more solid position than they underweight overweight have been in the past, whereas developed economies have yet to begin dealing with their fiscal problems in earnest. Source: UBS WMR, as of 28 July 2010. Scale explained in Appendix. Tail risk reduced in Eurozone but structural challenges remain Fig. 14: Bond regions As discussed in the lead article, we believe that systemic risk has been Tactical deviations from benchmark, incl. view on currency. reduced within the European banking system for the immediate future. However, we believe that the structural issues that the Eurozone is Other facing, in particular the need to adopt fiscal austerity measures sooner than other countries, is likely to mute growth prospects. Therefore, US even though Eurozone equities are trading at an attractive discount vs. UK US stocks, we are not inclined to shift into the region. Eurozone Japan and UK Equities Japanese stocks have lagged other markets during the last month. A Japan slightly stronger yen did little to offset this underperformance. We re- ––– –– – n + ++ +++ main cautious on Japanese stocks and stick to a moderate underweight stance within the international equity portion of the portfolio. Valua- underweight overweight tions are among the most demanding across markets, and we expect Note: Arrows indicate changes adopted in this report. earnings momentum to decelerate as global leading indicators have Source: UBS WMR, as of 28 July 2010. Scale explained in Appendix. likely passed their peak. We are neutral on UK equities. Their valuations See appendix for detailed asset allocations. See explanations in the are the most attractive among the major regions, and the equity index Appendix regarding the interpretation of the suggested tactical is very heavily geared toward international demand rather than the deviations and the procedure for combining asset class and country struggling UK economy. However, the markets sector composition with allocations. Materials, Financials and Energy accounting for half of market capitali- zation offsets some of the appeal from valuations. Fig. 15: Regional equity valuations and earnings momentum Neutral view between US and non-US Fixed Income 12-month forward Price-Earnings Ratios The diminished systemic risk concerns in the Europe have reduced the 3-month change in 12-month forward Consensus Earnings likelihood of a further tailspin in the euro. Our view on the dollar is 24 Price/Earnings ratio (left) 18% more balanced over the next twelve months. While we see the euro 20 Earnings momentum (right) 15% strengthening somewhat, we expect the Japanese yen to weaken vs. 16 13.9 13.1 12% the dollar. Overall, this suggests taking a less defensive stance on non- 12.0 11.6 11.3 12 10.2 9.5 10.5 9% US Fixed Income. From a currency perspective, we prefer various smaller international bond markets such as Switzerland, Canada, Swe- 8 6% den and Norway. 4 3% 0 0% -4 -3% Stephen R. Freedman, PhD, CFA, Strategist, UBS FS Inc. US lia UK ne nd n da ts pa ke ra zo la na Ja st ar er ro Ca Au M itz Eu Sw ng gi er Em Source: IBES, UBS WMR, as of 27 July 2010. UBS FS Investment Strategy Guide 7
  • 8. Wealth Management Research 28 July 2010 Investment Strategy Guide US equity sectors Buy stability Weakening leading economic indicators suggest a rotation into Fig. 16: Sector strategy – a moderate defensive more defensive market sectors. Commodity-sensitive sectors, tilt particularly Materials, are the most vulnerable to waning global Tactical deviations from benchmark growth momentum. We remain positive on Technology as earn- Consumer Staples ings reports continue to confirm strong end-market demand. Tech Focus on secular growth—Increasing Tech overweight, trimming Utilities Consumer Discretionary underweight Energy Financials We upgrade the Consumer Services industry within the Consumer Dis- HealthCare cretionary sector to Moderate Overweight from Neutral. The fast food Telecom restaurants represent almost two-thirds of the Consumer Services indus- Industrials try group. We believe this group of companies can continue to post solid Consumer Discretionary earnings in a tepid domestic recovery given the low cost of the average Materials ––– –– fast food meal. Additionally, we also like the group’s relatively high expo- underweight – n + ++ overweight +++ sure to faster-growing emerging markets. We remain underweight Re- tailing and Consumer Durables within the Consumer Discretionary sector Note: Arrows indicate changes adopted in this report. (see Appendix 4 for complete table of US sector allocations). Source: UBS WMR, as of 28 July 2010. See explanations in the Appendix regarding the interpretation of the Apple, Cisco and Hewlett Packard represent over 60% of the Tech suggested tactical deviations from benchmark. Hardware & Equipment industry which we upgrade from neutral to moderate overweight. Commentary from key technology companies Fig. 17: Defensive outperformance has more during second quarter earnings season has confirmed our thesis that the room to run rebound in enterprise technology spending is gaining traction. Performance of cyclicals vs defensives; 100 = ISM peak 115 Dialing back commodity exposure—downgrade Energy and Mate- Defensives outperform rials 110 On the heels of our recently reduced expectations for commodity prices 105 (see “Commodity Markets: A haircut to expectations” 22 July 2010), we are reducing the Energy sector to Neutral from Moderate Overweight 100 and reducing Materials to Underweight from Moderate Underweight. 95 Cyclicals outperform With regards to Energy, our commodities team now projects oil prices to 90 average $79 and $85 in 2010 and 2011, roughly a $10 reduction from m m m m m m m m m 0m 1m 2m 0 our prior twelve month ahead forecast. The new estimates suggest only +1 +2 +3 +4 +5 +6 +7 +8 +9 +1 +1 +1 an 8% increase in oil prices in 2011. Given the close correlation between Historical average Current cycle (peak April 30, 2010) oil prices and Energy sector earnings, we believe there is downside risk to Note: Defensives = Consumer Staples, HealthCare, Telecom and consensus Energy sector earnings estimates, which currently assume over Utilities; Cyclicals = Consumer Discretionary, Industrials, Materials 20% growth in 2011. In addition, the political fallout from the oil spill in and Tech the Gulf of Mexico will likely lead to tougher regulations and ultimately Source: Bloomberg, DataStream and UBS WMR, as of 26 July 2010 higher costs, potentially further crimping earnings growth and limiting upside for sector valuations. Fig. 18: Tech is the most under-leveraged sector and well below its historical average The Materials sector has rallied sharply over the past month, benefitting Net debt / assets—S&P 500 current constituents from expectations that the Chinese government is nearing the end of its 40% policy tightening campaign to reign in price inflation in its property mar- ket. However, we believe the slowing developed market growth com- 30% bined with full valuations will lead to underperformance. 20% 10% Swapping defensives—Health Care to Neutral, Telecom to Moder- 0% ate Underweight -10% We reduce Telecom to Moderate Underweight from Neutral and up- -20% grade the Healthcare sector to Neutral from Moderate Underweight. Energy Discretionary Telecom Tech Materials Staples Industrials Utilities Health Care While the telecom sector carries an attractive dividend yield, its recent outperformance of over 10 percentage points over the past three months leaves sector valuations stretched. Following Health Care’s recent Current Avg since 1990 underperformance, we believe that the risk-reward trade-off is more Source: FactSet and UBS WMR, as of 26 July 2010 attractive. Jeremy Zirin, CFA, Strategist, UBS FS Inc. UBS FS Investment Strategy Guide 8
  • 9. Wealth Management Research 28 July 2010 Investment Strategy Guide US equity size, style and REITs Growth is valuable Downgrade mid-caps to neutral; maintain preference for large- Fig. 19: Favor large-caps caps Size, style, and REITs recommended allocation, deviation The Russell Midcap index has outperformed large-caps year-to-date from benchmark driven by strong stock price gains in the recovering consumer sectors (both cyclical and non-cyclical), a pickup in M&A activity, and the Large-Cap Growth strengthening US dollar. In this report we downgrade mid-caps to Neu- Large-Cap Value tral from Moderate Overweight. Economic growth momentum is mod- erating and given the myriad of uncertainties, a pickup in M&A activity Mid-Cap may take more time to gain traction. We expect corporate manage- ment teams will likely continue to conserve cash rather than aggres- REITs sively bid up potential targets. In fact, we found it noteworthy that, so far in 2Q earnings reporting season, the market has punished compa- Small-Cap nies that have ramped up spending in order to support revenue ––– –– – n + ++ +++ growth. In terms of valuation, after posting multiple years of outper- underweight overweight formance, mid-cap valuations appear stretched versus large-caps. We Note: Arrows indicate changes adopted in this report. continue to prefer large-caps over both mid and small given their far Source: UBS WMR, as of 28 July 2010. more attractive valuation, defensive characteristics, higher emerging See explanations in the Appendix regarding the interpretation of the market exposure and higher-quality balance sheets which should prove suggested tactical deviations from benchmark. valuable in the current market environment. Fig. 20: Mid-cap valuations appear stretched Sector strategy and attractive valuations support Growth over Value Average mid-cap Z-score relative to large-cap Over the last month, the Russell 1000 Growth and Value indices have 3.0 Mid-caps cheap relative to large-caps performed in line. We have often cited that sector influences are a very 2.0 strong determinant of the relative performance between Growth and Value. Broadly, the sector changes that we are making in this report 1.0 improve the attractiveness for Growth. Our two largest overweight 0.0 positions—Technology and Consumer Staples—have far greater repre- sentation in the Growth index, while we have a neutral view on the (1.0) two largest Value contributors, Energy and Financials. Assessing aggre- gate index level valuations, Growth also is clearly more favorable. The (2.0) Mid-caps expensive relative to large-caps relative valuation premium that Growth commands over Value (by (3.0) definition) is low relative to history across varying valuation metrics. 85 87 89 91 93 95 97 99 01 03 05 07 09 11 Note: Z-Score includes an average of: Price to Book, Price to Sales, Reduce Real Estate Investment Trusts (REITs) underweight and P/E on forward EPS REITs have been one of the strongest S&P sub-sectors thus far in 2010. Source: DataStream, Russell Investment Group and UBS WMR, as of We remain skeptical on further outperformance, however, as: 1) valua- 26 July 2010 tions are near historical peak levels; 2) a large percentage of commer- cial real estate loans mature in the coming years and property owners Fig. 21: REIT valuations remain stretched, but may become forced sellers if they cannot refinance; and 3) industry improving pricing power will likely remain weak given stubbornly high unem- US REIT price to forward FFO multiple ployment and vacancy rates. Despite these concerns, we are increasing our allocation to REITs by upgrading the sector from Underweight to 25 Moderate Underweight. Admittedly, our long-standing bearish position 20 on the group has not worked out this year as REITs have benefitted from improved access to capital (somewhat underpinned by strong 15 flows into dedicated REIT mutual funds) and on a relative basis its greater domestic exposure (i.e., practically zero exposure to Europe). 10 While we remain concerned about valuation, fundamentals have mod- estly improved, particularly in the multi-family and central business 5 district properties. Additionally, with strong market price gains unlikely, REITs high dividend (compared to the market dividend yield) is appeal- 0 ing to investors. 93 95 97 99 01 03 05 07 09 11 Source: DataStream, SNL and UBS WMR, as of 28 July 2010. Jeremy Zirin, CFA, Strategist, UBS FS Inc. UBS FS Investment Strategy Guide 9
  • 10. Wealth Management Research 28 July 2010 Investment Strategy Guide US fixed income Increase credit exposure After touching 4.0% in early April, Treasury yields quickly Fig. 22: US dollar taxable fixed income (TFI) trended lower. Initially, the catalyst was a flight-to-quality bid strategy triggered by Greece’s sovereign debt woes, and fears of conta- Tactical deviations from benchmark gion to peripheral countries and the European banking system. As these fears surrounding sovereign debt receded, however, a Treasuries new worry emerged, as investors fretted that the US recovery TIPS was stalling. The 2-year Treasury yield remains stuck near a his- Agencies toric low of 0.6% as the short end of the curve remains an- Mortgages chored by a Fed that remains on hold for an extended period, while the ten-year Treasury hovers near 3% due to weaker US economic data and a benign inflation backdrop. Historically, Inv. Grade Corporates Treasury yields at these levels have been a precursor for future High Yield Corporates economic weakness (“double dip”) or concerns of deflation. Preferred Securities However, we believe that the current level of low yields instead provides confirmation that the recovery will be a modest one, Emerg. Market marked by low inflation and heightened risk aversion. TFI non-Credit Not too hot, not too cold TFI Credit In our opinion, the combination of decelerating economic data, coun- ––– –– – n + ++ +++ tered by respectable news flow from the corporate world and a legisla- tive picture coming into focus offers a supportive backdrop for fixed underweight overweight income, and more specifically, for overweighting credit sectors over Note: Arrows indicate changes adopted in this report. non-credit sectors. Second quarter earnings reports have continued to Source: UBS WMR, as of 28 July 2010. Scale explained in Appendix. demonstrate balance sheet strengthening trends. Although companies See the appendix for a detailed asset allocation illustration in the context of a moderate-risk taxable US dollar fixed income portfolio. have been cautious on their guidance for future revenue and earnings See explanations in the Appendix regarding the interpretation of the projections, the fundamental variables that impact creditors such as suggested tactical deviations from benchmark. leverage ratios, capital levels, and funding availability appear more than adequate to support credit spreads. Finalization of Financial sector re- Fig. 23: US interest rate forecasts, in % form legislation has provided much needed clarity, lending to firming of Financial sector corporate bonds and preferred securities. Reduced 27 July in 3 in 6 in 12 2010 months months months volatility in asset prices has resulted in a stronger bid for High Yield (HY) corporate bonds, while default rate forecasts continue to drop. 3-month LIBOR 0.48 0.50 0.75 1.00 This comes against an outlook for benchmark Treasury rates that may 2-year Treasury 0.63 1.00 1.25 1.50 be lower for longer, and expectations for little inflation in the near fu- 5-year Treasury 1.79 2.25 2.50 2.75 ture. 10-year Treasury 3.05 3.25 3.50 3.75 Putting it together, we see the remainder of 2010 offering outperfor- 30-year Treasury 4.09 4.00 4.25 4.50 mance of credit sectors due to range-bound Treasury yields and the Source: Bloomberg, UBS WMR, as of 27 July 2010 potential for modest spread tightening in the investment grade, high yield, and preferred security segments of the market. With price volatil- Fig. 24: Treasury yields remain anchored by Fed ity expected to be relatively modest and credit spreads still above long- policy, slower growth, and low inflation. term averages, we are raising our recommended total allocation to Two and ten-year Treasury yields (%) credit sectors (+4%) – maintaining an overweight of Investment Grade 4.50 (IG) corporates (+2%) and adding increased exposure to HY (+1%) and 4.00 preferreds (+1%) at the expense of treasuries (-1%) and TIPS (-1%). 3.50 We believe that accommodative new issue markets, low default rates, 3.00 and high income levels will be positive attributes for the HY. We are 2.50 also more comfortable with preferred securities following the signing 2.00 1.50 of the US financial reform bill and the stress tests that were conducted 1.00 on European banks. The US bill phases out the regulatory treatment for 0.50 US bank trust preferreds, which will likely add technical support to this 0.00 portion of the market. At the same time, there were no negative sur- Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 prises among the large European banks that have preferreds out- 10-Year Treasury Note 2-year Treasury Note standing. Preferreds should also fare better in a more benign environ- Source: Bloomberg, UBS WMR, as of 27 July 2010 ment for Treasury yields since they exhibit high duration characteristics. UBS FS Investment Strategy Guide 10
  • 11. Wealth Management Research 28 July 2010 Investment Strategy Guide But where has the yield gone? Fig. 25: Duration recommendation Although credit spreads remain above-average for IG, HY, and pre- Duration deviation from benchmark, in years ferred securities, the decline in benchmark rates has resulted in lower levels of absolute yields. This trend has been most pronounced for the IG market. For example, the average yield level of the Barclays Capital US Credit Index has declined to 4.08%, which is very close to the low- -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 est historical levels that were last seen in mid-2003 and early 2004. 28-Jul Previous month Preferred security yields remain near 7.20% on average, however Source: UBS WMR, as of 28 July 2010 higher-quality issuers have seen yields dip below 7%. HY bonds aver- age about 8.75%, but are far below the double digit rates of 2009. Fig. 26: IG has firmed up in recent weeks Overall, we look for more modest levels of returns, but also believe that US IG Corporate credit spreads, in basis points these yield-enhanced credit sectors in fixed income should continue to offer incremental value relative to government-related sectors such as 800 agencies and mortgages that offer less spread-tightening potential. 700 600 Pare duration underweight 500 Following WMR’s reassessment of growth prospects in the US and 400 modified expectations that the Federal Reserve will keep the target fed 300 funds rate unchanged at zero to 25 basis points until June 2011, we 200 revised our interest rate forecasts lower in mid-July. Over the next few 100 quarters, we believe yields are apt to stay range bound at very low lev- 0 els. Although we expect Treasury yields to move higher over a 12- 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 All IG Corporates Industrial Financials month horizon, we now see a lower trajectory for the rate path for all maturities. Given these changes to our forecast, we recommend that Source: Barclays Capital, UBS WMR, as of 27 July 2010 investors pare back the duration underweight to a moderate under- weight (0.5 year short) from a full underweight (1 year short). From a Fig. 27: Corporate bond yields near 10-year low practical standpoint, this means that investors with new money to in- IG bond index yield to maturity, in % vest may consider extending the maturity range they consider for pur- 10 chases. Specially, in the Treasury, agency, and corporate bond market, 9 we favor extending maturities to the 4 to 7-year range, a modest ex- 8 tension from our previously recommended range of 3 to 7 years. In the 7 muni market, we favor the 7 to 12-year range. While yields are histori- 6 cally low, very muted inflation and a steep yield curve suggests that 5 investors are being compensated to extend. In addition, investors could 4 potentially benefit from rolling down the curve over time. 3 00 01 02 03 04 05 06 07 08 09 10 Munis march on despite credit concerns Source: Barclays Capital, UBS WMR, as of 27 July 2010 In July, muni bond performance picked up along with the broader fixed income markets. Supported by thin net tax-exempt supply and low US Treasury yields, muni sector returns outpaced Treasuries and edged Fig. 28: Taxable BABs continue to shift share Taxable BAB volume (USD billions) and market share ahead of the performance seen on investment grade corporate bonds. As shown in Figure 28, taxable Build America Bond (BAB) issuance con- 35 BABs (bln's) BABs/total muni% 27% tinues to shift share from the traditional tax-exempt muni market. 30 Flows into muni mutual funds have been positive and consistent as 25 investors seek after-tax returns above money market rates and are will- ing to take on some additional risk to meet investment objectives. 20 15 12.5 11.8 In terms of relative value, AAA muni-to-Treasury (after-tax) yield ratios 9.5 9.0 8.3 10 7.6 7.5 7.5 are near the lower end of historical ranges on the earliest maturities 5.0 6.7 6.1 6.9 6.2 and are at fair-to-cheap valuations on intermediate and longer-dated 5 2.7 3.5 3.72 securities. A rated muni-to-Treasury (after-tax) ratios are at cheap rela- 0 tionships at the 5, 10 and 30-yr maturity points. Compared to corpo- April July October January April July mtd rate bonds (after-tax), muni yields remain expensive for low maturities yet have become more attractive at the longer segment of the curve. Source: MMD Interactive, UBS WMR as of 27 July 2010 Anne Briglia, CFA, Strategist, UBS FS Inc. Barry McAlinden, CFA, Strategist, UBS FS Inc. Mike Tagliaferro, CFA, Strategist, UBS FS Inc. Kathleen McNamara, CFA, CFP, Strategist, UBS FS Inc. UBS FS Investment Strategy Guide 11
  • 12. Wealth Management Research 28 July 2010 Investment Strategy Guide Financial Market Performance Chartbook Fig. A1: Asset Classes Fig. A2: International Equity Total Return in USD and % Total Return in USD and % US Equities 1.6% 8.2% US Equity 1.6% -4.1% 8.2% Non-US Dev. Equities -4.1% 9.2% Non-US Developed 9.2% EM Equities 1.7% -10.4% 8.3% EMU US Fixed Income 5.9% 13.8% 0.5% -2.8% UK 13.5% Non-US Fixed Income -0.3% 3.9% -1.2% 0.1% Japan 1.5% Cash (USD) 0.0% -7.4% Emerging Markets 1.7% Commodities 2.4% 8.3% -15% -10% -5% 0% 5% 10% 15% -15% -10% -5% 0% 5% 10% 15% 20% year-to-date quarter-to-date year-to-date quarter-to-date Source: Bloomberg, UBS WMR, as of 27 July 2010 Source: Bloomberg, UBS WMR, as of 27 July 2010 Fig. A3: International Fixed Income Fig. A4: US Equity Total Return in USD and % Total Return in USD and % US Fixed Income 5.9% 2.4% 0.5% Large Cap Value 7.9% Non-US Fixed Income -0.3% Large Cap Growth 0.1% 3.9% 8.4% -6.5% Large Cap 1.2% EMU 8.1% 6.4% Mid Cap 6.3% 1.0% 8.5% UK 2.9% Small Cap 6.6% 8.7% Japan 9.2% 1.7% REITs 15.9% 9.8% -15% -10% -5% 0% 5% 10% 15% -5% 0% 5% 10% 15% 20% year-to-date quarter-to-date year-to-date quarter-to-date Source: Bloomberg, UBS WMR, as of 27 July 2010 Source: Bloomberg, UBS WMR, as of 27 July 2010 Fig. A5: US Fixed Income Fig. A6: Currencies Total Return in USD and % Appreciation vs. USD in % Treasuries year-to-date 5.7% -0.2% quarter-to-date 3.4% EUR -9.9% TIPS -1.0% 5.6% 4.2% GBP -3.6% Agencies 0.2% 3.6% 7.2% JPY 6.0% IG Corporates 1.1% 0.8% CAD 1.7% HY Corporates 3.2% 2.7% Preferreds CHF -2.5% 4.0% 1.4% 5.4% Mortgages AUD 0.2% 0.7% 5.7% EM Sovereigns 3.8% BRL -1.4% 4.6% 2.1% Municipal bonds 1.2% -15% -10% -5% 0% 5% 10% -8% -6% -4% -2% 0% 2% 4% 6% 8% year-to-date quarter-to-date Source: Thomson Financial, UBS WMR, as of 27 July 2010 Source: Bloomberg, UBS WMR, as of 27 July 2010 UBS FS Investment Strategy Guide 12
  • 13. Wealth Management Research 28 July 2010 Investment Strategy Guide Economic and Asset Class Chartbook Fig. A7: Moderate recovery underway Fig. A8: Spare capacity prevents pickup in core inflation US GDP growth and component contributions Capacity utilization and US consumer price index (CPI) 8% q/q annualized UBS 85 6 6% WMR 83 5 forecast 4% 81 4 2% 79 3 0% 77 2 -2% 75 -4% 1 73 -6% 0 71 -8% 69 US Capacity Utilization (in %, LHS) -1 CPI (yoy in %, RHS) -10% Core CPI (yoy in %, RHS) -2 67 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 65 -3 Consumption Commercial real estate investment Capital expenditures Residential investment 88 91 94 97 00 03 06 09 Inventories Net Exports Government Real GDP (q/q annualized) Source: Thomson Financial, UBS WMR, UBS WMR, as of 28 July 2010. Source: Thomson Financial, UBS WMR, as of 27 July 2010. Fig. A9: Depressed Individual Investor sentiment Fig. A10: Typical pattern around market bottoms AAII net bullish sentiment (individual investors) Average cycle since mid-1960s 160 65 80 Individual investors bullish 150 We believe we are here 60 60 140 40 130 55 20 120 50 0 -20 110 45 -40 100 Individual investors bearish 90 40 -60 24 -20 -16 12 8 4 0 4 8 12 16 20 24 28 32 36 90 92 94 96 98 00 02 04 06 08 10 S&P 500 Trailing real earnings Net bullish sentiment 3-month average Long-term average Last data point Business confidence (ISM Manufacturing right scale) Source: Thomson Financial, Bloomberg, UBS WMR, as of 28 July 2010. Source: American Association of Individual Investors, Bloomberg, UBS WMR, as of 28 July 2010. Fig. A12: Asset Classes and Regional Preferences Fig. A11: Euro bearishness has abated somewhat Tactical Deviations from Benchmark Net speculative long futures position divided by open interest US Equity 80% Non-US Developed Eq. 60% 40% Emerging Market Eq. 20% US Fixed Income 0% -20% Non-US Fixed Income -40% Cash (USD) -60% -80% Commodities Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 ––– –– – n + ++ +++ Yen net long % Open interest EURO net long % Open interest underweight overweight GBP net long % Open interest USD net long % Open interest Source: UBS WMR, as of 28 July 2010. See explanations in the Appendix regard- Source: CFTC, Bloomberg, UBS WMR, as of 28 July 2010 ing the interpretation of the suggested tactical deviations from benchmark. UBS FS Investment Strategy Guide 13
  • 14. Wealth Management Research 28 July 2010 Investment Strategy Guide US Equity Chartbook Fig. A13: Our two largest sector overweights, Tech and Fig. A14: Growth appears cheap relative to Value Consumer Staples, support our pro Growth bias Relative discount / premium growth vs. value Share of Growth and Value indices, in % 1.6 35% 1.4 30% 1.2 Growth Value 1.0 25% 0.8 0.6 20% 0.4 15% 0.2 0.0 10% P/E Trailing Price to Book Price to Sales P/E Forward Current (1yr) 5% Long-Term Average 0% Long-Term Average ex Tech Bubble Tech Consumer Staples Note: Long-term average since 1979. Note: Russell 1000 Growth and Value indices Source: DataStream, Russell Investment Group and UBS WMR, as of 26 July Source: Bloomberg, FactSet, Russell Investment Group and UBS WMR, as of 26 2010 July 2010 Fig. A15: Large-caps are inexpensive versus small-caps Fig. A16: Current market environment has historically Average Z-score large-cap relative to small-cap favored large-caps Average performance following historical bear market troughs 1.5 Large-caps cheap relative to small-caps 60% 1.0 52% 0.5 50% 0.0 40% (0.5) 26% (1.0) 30% (1.5) 20% 14% (2.0) 9% 11% 10% 6% (2.5) (3.0) 0% Large-caps expensive relative to small-caps (3.5) 12 months after market 6 mo. return 1 year 12 mo. return 1 year trough after market trough after market trough 85 87 89 91 93 95 97 99 01 03 05 07 09 11 Large Caps Small-caps Note: Z-Score includes an average of: Price to Book, Price to Sales, and P/E on Note: Average performance during nine bear markets 1928-2003, excluding the forward EPS current cycle. Source: DataStream, Russell Investment Group and UBS WMR, as of 26 July Source: Bloomberg, DataStream and UBS WMR, as of 26 July 2010 2010 Fig. A17: We continue to prefer higher quality, which Fig. A18: Commercial property prices are moderately supports large-caps improving Percent of companies with investment grade and non-investment grade credit ratings Moody’s / REAL Commercial Property Index (CPPI) 90% 200 83% 80% 70% 70% 61% 175 60% 50% 150 39% 40% 30% 30% 17% 125 20% 10% 100 0% Large-caps (Russell Mid-caps (Russell Small-caps (Russell 1000) Mid-cap) 2000) 75 Investment Grade Non Investment Grade 01 03 05 07 09 11 Note: Includes only companies with credit ratings issued by Standard & Poor’s. Source: Bloomberg, UBS WMR, as of 26 July 2010 Source: Bloomberg and UBS WMR, as of 26 July 2010 UBS FS Investment Strategy Guide 14
  • 15. Wealth Management Research 28 July 2010 Investment Strategy Guide US Fixed Income Chartbook Fig. A19: Treasury yields should rise over the next 12 Fig. A20: Yield curve may flatten in H2 2010 but remain months steep Rate development and UBS WMR forecasts (in %) US Treasury yield curve, 10 minus 2 year yield, and WMR forecast (in basis points) 7.00 WMR 300 WMR 2-year Treasury note 10-year Treasury note Forecasts Forecast 6.00 10s/2s Curve 250 5.00 200 4.00 150 3.00 100 2.00 50 1.00 0 0.00 Jul- Jul- Jul- Jul- Jul- Jul- Jul- Jul- Jul- Jul- Jul- Jul- (50) 00 01 02 03 04 05 06 07 08 09 10 11 Jul- Jul- Jul- Jul- Jul- Jul- Jul- Jul- Jul- Jul- Jul- Jul- 00 01 02 03 04 05 06 07 08 09 10 11 Source: Bloomberg, UBS WMR, as of 27 July 2010 Source: Bloomberg, UBS WMR, as of 27 July 2010 Fig. A21: Relationship between IG and HY is roughly in Fig. A22: US Corporates still cheap to munis for short line with long-term averages maturities Credit spreads of IG and HY corporate bonds (basis points) Municipal to Corporate (M/C) yield ratio (after tax) 2,000 1.6 1.4 1,500 1.2 1,000 1.0 Muni to Corporate (M/C) yield ratio 1-10yr (after tax) Average 1-10yr 500 0.8 Muni to Corporate (M/C) yield ratio 10yr + (after tax) Average 10yr+ 0.6 Future tax M/C ratio 1-10yr AT (RHS) 0 Future tax M/C ratio 10yr+ AT (RHS) 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 0.4 IG HY Difference 10-yr Average Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Source: Barclays Capital, UBS WMR, as of 27 July 2010. Source: MMD Interactive, BofAML, UBS WMR, as of 27 July 2010 Fig. A23: TIPS breakeven inflation rates have declined Fig. A24: Preferred security yields have declined recently (in %) (in %) 11.0 4.00 10.0 3.00 9.0 2.00 8.0 1.00 7.0 0.00 6.0 Aug- Sep- Oct- Nov- Dec- Jan- Feb- Mar- Apr- May- Jun- Jul- Aug- 09 09 09 09 09 10 10 10 10 10 10 10 10 (1.00) Aug-06 Feb-07 Aug-07 Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 Non-US Preferreds US Financial Trust Preferreds REIT Preferreds Senior Notes 5-year breakeven 10-year breakeven 30-year breakeven Source: Bloomberg, UBS WMR, as of 27 July 2010 Source: Bloomberg, UBS WMR, as of 27 July 2010. UBS FS Investment Strategy Guide 15
  • 16. Wealth Management Research 28 July 2010 Investment Strategy Guide Appendix 1 Detailed asset allocations with non-traditional assets (NTAs) Investor Very Moderate Moderate Very Risk Profile1 conservative Conservative conservative Moderate aggressive Aggressive aggressive Cas h Cas h Cas h Cas h Cas h Cas h Cas h Bonds Bonds Bonds Bonds Bonds Bonds Bonds All figures in % Equities Equities Equities Equities Equities Equities Equities NTAs NTAs NTAs NTAs NTAs NTAs NTAs WMR tactical deviation3 WMR tactical deviation3 WMR tactical deviation3 WMR tactical deviation3 WMR tactical deviation3 WMR tactical deviation3 WMR tactical deviation3 Benchmark allocation2 Benchmark allocation2 Benchmark allocation2 Benchmark allocation2 Benchmark allocation2 Benchmark allocation2 Benchmark allocation2 Current allocation4 Current allocation4 Current allocation4 Current allocation4 Current allocation4 Current allocation4 Current allocation4 Change Change Change Change Change Change Change Traditional Assets        Equity 0.0 +0.0  0.0 19.0 +0.0  19.0 32.0 +0.0  32.0 44.0 +0.0 44.0 54.0 +0.0 54.0 62.0 +0.0 62.0 71.0 +0.0 71.0 US Equity 0.0 +0.0  0.0 14.0 +0.5  14.5 23.0 +0.0  23.0 32.0 +0.0 32.0 39.0 +0.0 39.0 44.0 +0.0 44.0 52.0 +0.0 52.0 Large Cap Value 0.0 +0.0  0.0 8.0 +0.0  8.0 8.0 +0.5  8.5 11.0 +1.0 12.0 11.0 +1.5 12.5 11.0 +1.5 12.5 13.0 +2.0 15.0 Large Cap Growth 0.0 +0.0  0.0 5.0 +1.0  6.0 8.0 +1.5  9.5 11.0 +2.0 13.0 11.0 +2.5 13.5 11.0 +3.0 14.0 13.0 +4.0 17.0 Mid Cap 0.0 +0.0  0.0 1.0 -0.5  0.5 4.0 +0.0  4.0 5.0 +0.0  5.0 9.0 +0.0  9.0 11.0 +0.0 11.0 13.0 +0.0 13.0 Small Cap 0.0 +0.0  0.0 0.0 +0.0  0.0 2.0 -1.5  0.5 3.0 -2.0  1.0 5.0 -2.5  2.5 7.0 -3.0  4.0 8.0 -4.0  4.0 REITs 0.0 +0.0  0.0 0.0 +0.0  0.0 1.0 -0.5  0.5 2.0 -1.0  1.0 3.0 -1.5  1.5 4.0 -1.5  2.5 5.0 -2.0  3.0 Non-US Equity 0.0 +0.0  0.0 5.0 -0.5  4.5 9.0 +0.0  9.0 12.0 +0.0 12.0 15.0 +0.0 15.0 18.0 +0.0 18.0 19.0 +0.0 19.0 Developed 0.0 +0.0  0.0 5.0 -0.5  4.5 8.0 -1.5  6.5 10.0 -2.0  8.0 12.0 -2.5  9.5 14.0 -3.0 11.0 14.0 -4.0 10.0 Emerging Markets 0.0 +0.0  0.0 0.0 +0.0  0.0 1.0 +1.5  2.5 2.0 +2.0  4.0 3.0 +2.5  5.5 4.0 +3.0  7.0 5.0 +4.0  9.0 Fixed Income 81.0 +0.0  81.0 67.0 +0.0  67.0 51.0 +0.0  51.0 37.0 +0.0 37.0 24.0 +0.0 24.0 11.0 +0.0 11.0 .0 +0.0  .0 US Fixed Income 74.0 +0.0  74.0 59.0 +0.0  59.0 43.0 +0.0  43.0 29.0 +0.0 29.0 18.0 +0.0 18.0 9.0 +0.0  9.0 .0 +0.0  .0 Non-US Fixed 7.0 +0.0  7.0 8.0 +0.0  8.0 8.0 +0.0  8.0 8.0 +0.0  8.0 6.0 +0.0  6.0 2.0 +0.0  2.0 .0 +0.0  .0 Income Cash (USD) 10.0 +0.0  10.0 2.0 +0.0  2.0 2.0 +0.0  2.0 2.0 +0.0  2.0 2.0 +0.0  2.0 2.0 +0.0  2.0 2.0 +0.0  2.0 Non-traditional 9.0 +0.0  9.0 12.0 +0.0  12.0 15.0 +0.0  15.0 17.0 +0.0  17.0 20.0 +0.0  20.0 25.0 +0.0  25.0 27.0 +0.0  27.0 Assets Commodities 2.0 +0.0  2.0 3.0 +0.0  3.0 4.0 +0.0  4.0 5.0 +0.0  5.0 5.0 +0.0  5.0 6.0 +0.0  6.0 7.0 +0.0  7.0 Alternative 7.0 +0.0  7.0 9.0 +0.0  9.0 11.0 +0.0  11.0 12.0 +0.0  12.0 15.0 +0.0  15.0 19.0 +0.0  19.0 20.0 +0.0  20.0 Investments5 “WMR tactical deviation” legend: Overweight Underweight Neutral “Change” legend: ▲ Upgrade ▼ Downgrade Source: UBS WMR and Investment Solutions, as of 28 July 2010. For end notes, please see appendix. UBS FS Investment Strategy Guide 16
  • 17. Wealth Management Research 28 July 2010 Investment Strategy Guide Appendix 1 Detailed asset allocations without non-traditional assets (NTAs) Investor Very Moderate Moderate Very Risk Profile1 conservative Conservative conservative Moderate aggressive Aggressive aggressive Cas h Cash Cas h Cas h Cas h Cas h Cash All figures in % Bonds Bonds Bonds Bonds Bonds Bonds Bonds Equities Equities Equities Equities Equities Equities Equities WMR tactical deviation3 WMR tactical deviation3 WMR tactical deviation3 WMR tactical deviation3 WMR tactical deviation3 WMR tactical deviation3 WMR tactical deviation3 Benchmark allocation2 Benchmark allocation2 Benchmark allocation2 Benchmark allocation2 Benchmark allocation2 Benchmark allocation2 Benchmark allocation2 Current allocation4 Current allocation4 Current allocation4 Current allocation4 Current allocation4 Current allocation4 Current allocation4 Change Change Change Change Change Change Change        Equity 0.0 +0.0  0.0 22.0 +0.0  22.0 37.0 +0.0  37.0 52.0 +0.0 52.0 67.0 +0.0 67.0 83.0 +0.0 83.0 98.0 +0.0  98.0 US Equity 0.0 +0.0  0.0 16.0 +0.5  16.5 26.0 +0.0  26.0 37.0 +0.0 37.0 48.0 +0.0 48.0 59.0 +0.0 59.0 72.0 +0.0  72.0 Large Cap Value 0.0 +0.0  0.0 9.0 +0.0  9.0 9.0 +0.5  9.5 13.0 +1.0 14.0 14.0 +1.5 15.5 15.0 +1.5 16.5 18.0 +2.0  20.0 Large Cap Growth 0.0 +0.0  0.0 6.0 +1.0  7.0 9.0 +1.5  10.5 13.0 +2.0 15.0 14.0 +2.5 16.5 15.0 +3.0 18.0 18.0 +4.0  22.0 Mid Cap 0.0 +0.0  0.0 1.0 -0.5  0.5 4.0 +0.0  4.0 6.0 +0.0  6.0 11.0 +0.0 11.0 15.0 +0.0 15.0 18.0 +0.0  18.0 Small Cap 0.0 +0.0  0.0 0.0 +0.0  0.0 3.0 -1.5  1.5 3.0 -2.0  1.0 6.0 -2.5  3.5 9.0 -3.0  6.0 11.0 -4.0  7.0 REITs 0.0 +0.0  0.0 0.0 +0.0  0.0 1.0 -0.5  0.5 2.0 -1.0  1.0 3.0 -1.5  1.5 5.0 -1.5  3.5 7.0 -2.0  5.0 Non-US Equity 0.0 +0.0  0.0 6.0 -0.5  5.5 11.0 +0.0  11.0 15.0 +0.0 15.0 19.0 +0.0 19.0 24.0 +0.0 24.0 26.0 +0.0  26.0 Developed 0.0 +0.0  0.0 6.0 -0.5  5.5 9.0 -1.5  7.5 13.0 -2.0 11.0 15.0 -2.5 12.5 18.0 -3.0 15.0 20.0 -4.0  16.0 Emerging Markets 0.0 +0.0  0.0 0.0 +0.0  0.0 2.0 +1.5  3.5 2.0 +2.0  4.0 4.0 +2.5  6.5 6.0 +3.0  9.0 6.0 +4.0  10.0 Fixed Income 90.0 +0.0  90.0 76.0 +0.0  76.0 61.0 +0.0  61.0 46.0 +0.0 46.0 31.0 +0.0 31.0 15.0 +0.0 15.0 .0 +0.0  .0 US Fixed Income 82.0 +0.0  82.0 67.0 +0.0  67.0 51.0 +0.0  51.0 36.0 +0.0 36.0 23.0 +0.0 23.0 12.0 +0.0 12.0 .0 +0.0  .0 Non-US Fixed 8.0 +0.0  8.0 9.0 +0.0  9.0 10.0 +0.0  10.0 10.0 +0.0 10.0 8.0 +0.0  8.0 3.0 +0.0  3.0 .0 +0.0  .0 Income Cash (USD) 10.0 +0.0  10.0 2.0 +0.0  2.0 2.0 +0.0  2.0 2.0 +0.0  2.0 2.0 +0.0  2.0 2.0 +0.0  2.0 2.0 +0.0  2.0 “WMR tactical deviation” legend: Overweight Underweight Neutral “Change” legend: ▲ Upgrade ▼ Downgrade Source: UBS WMR and Investment Solutions, as of 28 July 2010. For end notes, please see appendix. UBS FS Investment Strategy Guide 17
  • 18. Wealth Management Research 28 July 2010 Investment Strategy Guide Appendix 2 Wealth Management Americas Investment Committee (WMA IC)  The WMA IC is the primary decision making body within WM Americas for recommended asset allocations across investor risk profiles. As explained more fully below, the WMA IC vets the flagship tactical asset allocation recommendations which appear in this publication, the Investment Strategy Guide (ISG). The WMA IC also reviews and approves (i) inputs relating to WM Americas’ strategic asset allocations, and (ii) other tactical asset allocation recommendations which may be developed for ultra high net worth and other specific client groups by business areas other than WMRA. Composition  The WMA IC currently has six voting members, and two non-voting members. The voting members include: Mike Ryan – Head of Wealth Management Research – Americas (WMRA); Stephen Freedman – WMRA Global Investment Strategist; Jeremy Zirin – WMRA Equities Head; Anne Briglia – WMRA Taxable Fixed Income Head; Tony Roth – Head of Investment Strategies and Wealth Planning, within Wealth Management Advice and Platforms (*) Mihir Bhattacharya – Head of Strategic Projects and Services, Wealth Management Solutions (*) (*) Business areas distinct from WMRA The two non-voting members are employee of UBS Global Asset Management, an affiliate of UBS Financial Services Inc. They are: John Dugenske – Global Fixed Income, Head of US Fixed Income; Andreas Koester – Global Investment Solutions, Head of Asset Allocation and Currency. Vetting of WMRA flagship TAA recommendations  At least monthly, WMRA presents to the WMA IC for its review a flagship TAA proposal and supporting investment case for a moderate-risk profile investor. In order to be published in the ISG, the flagship TAA must be accepted by the WMA IC and be supported by a majority of the WMRA members. The flagship TAA recommendations across other risk profiles published in the ISG are further calculated in accordance with a methodology approved by the WMA IC. UBS FS Investment Strategy Guide 18
  • 19. Wealth Management Research 28 July 2010 Investment Strategy Guide Appendix 3 Other Asset Allocation US Taxable Fixed Income Allocation, in % WMR Tactical Benchmark deviation2 Current allocation1 allocation3 Previous Current Treasuries 12.0 -1.0 -1.0 11.0 TIPS (Treasury inflation-protected securities) 5.0 -1.0 -1.0 4.0 Agencies 22.0 -1.0 -1.0 21.0 Mortgages 20.0 -1.0 -1.0 19.0 Investment grade corporates 22.0 +2.0 +2.0 24.0 High yield corporates 10.0 +0.0 +1.0 11.0 Preferred securities 4.0 +0.0 +1.0 5.0 Emerging Market sovereign bonds in US dollar 5.0 +0.0 +0.0 5.0 Total TFI non-Credit 59.0 -4.0 -4.0 55.0 Total TFI Credit 41.0 +4.0 +4.0 45.0 Source: UBS WMR and Investment Solutions, as of 28 July 2010 Non-US Developed Equity Module, in % WMR Tactical Benchmark deviation2 Current allocation1 allocation3 Previous Current EMU / Eurozone 27.0 -5.0 -5.0 22.0 UK 19.0 +5.0 +5.0 24.0 Japan 21.0 -5.0 -5.0 16.0 Other 33.0 +5.0 +5.0 38.0 Source: UBS WMR and Investment Solutions, as of 28 July 2010 Non-US Fixed Income Module, in % WMR Tactical Benchmark deviation2 Current allocation1 allocation3 Previous Current EMU / Eurozone 44.0 -7.5 +0.0 44.0 UK 9.0 +2.5 +0.0 9.0 Japan 32.0 -12.5 -10.0 22.0 Other 15.0 +17.5 +10.0 25.0 Source: UBS WMR and Investment Solutions, as of 28 July 2010 1 The benchmark allocation refers to a moderate risk profile. See “Sources of Benchmark Allocations and Investor Risk Profiles” in the Appendix for an explanation regarding the source of benchmark allocations and their suitability. 2 See "Deviations from Benchmark Allocations" in the Appendix for an explanation regarding the interpretation of the suggested tactical deviations from benchmark. The “current” column refers to the tactical deviation that applies as of the date of this publication. The “previous” column refers to the tactical deviation that was in place at the date of the previous edition of the previous edition of Investment Strategy Guide or the last Investment Strategy Guide Update. 3 The current allocation column is the sum of the benchmark allocation and the WMR tactical deviation columns. UBS FS Investment Strategy Guide 19
  • 20. Wealth Management Research 28 July 2010 Investment Strategy Guide Appendix 4 Equity Industry Group Allocation US equity industry group allocation (%) WMR Tactical deviation2 S&P 500 Benchmark Numeric Symbol Current allocation3 allocation1 Previous Current Previous Current Consumer Discretionary 10.2 -2.0 -1.0 –– – 9.2 Auto & Components 0.7 +0.0 +0.0 n n 0.7 Consumer Services 1.8 +0.0 +1.0 n + 2.8 Media 3.2 +0.0 +0.0 n n 3.2 Retailing 3.4 -1.0 -1.0 – – 2.4 Consumer, Durables & Apparel 1.1 -1.0 -1.0 – – 0.1 Consumer Staples 11.5 +2.0 +2.0 ++ ++ 13.5 Food, Beverage & Tobacco 6.2 +1.0 +1.0 + + 7.2 Food & Staple Retailing 2.5 +0.0 +0.0 n n 2.5 Household & Personal Products 2.8 +1.0 +1.0 + + 3.8 Energy 10.8 +1.0 +0.0 + n 10.8 Financials 16.4 +0.0 +0.0 n n 16.4 Banks 3.2 +1.0 +1.0 + + 4.2 Diversified Financials 7.7 +0.0 +0.0 n n 7.7 Insurance 4.0 +0.0 +0.0 n n 4.0 Real Estate 1.4 -1.0 -1.0 – – 0.4 Health Care 11.4 -1.0 +0.0 – n 11.4 HC Equipment & Services 3.8 -0.5 +0.0 – n 3.8 Pharmaceuticals & Biotechnology 7.6 -0.5 +0.0 – n 7.6 Industrials 10.6 -1.0 -1.0 – – 9.6 Capital Goods 7.9 -0.5 -0.5 – – 7.4 Commercial Services & Supplies 0.6 +0.0 +0.0 n n 0.6 Transportation 2.0 -0.5 -0.5 – – 1.5 Information Technology 19.0 +1.0 +2.0 + ++ 21.0 Software & Services 8.7 +1.0 +1.0 + + 9.7 Technology Hardware & Equipment 7.6 +0.0 +1.0 n + 8.6 Semiconductors 2.7 +0.0 +0.0 n n 2.7 Materials 3.5 -1.0 -2.0 – –– 1.5 Telecom 3.0 +0.0 -1.0 n – 2.0 Utilities 3.7 +1.0 +1.0 + + 4.7 Source: UBS WMR, as of 28 July 2010. The benchmark allocation, as well as the tactical deviations, are intended to be applicable to the US equity portion of a portfolio across investor risk profiles. 1 The benchmark allocation is based on S&P 500 weights. 2 See "Deviations from Benchmark Allocations" in the Appendix for an explanation regarding the interpretation of the suggested tactical deviations from benchmark. The “current” column refers to the tactical deviation that applies as of the date of this publication. The “previous” column refers to the tactical deviation that was in place at the date of the previous edition of the Investment Strategy Guide or the last Investment Strategy Guide Update. 3 The current allocation column is the sum of the S&P 500 benchmark allocation and the WMR tactical deviation columns. UBS FS Investment Strategy Guide 20
  • 21. Wealth Management Research 28 July 2010 Investment Strategy Guide Appendix 5 End notes for table labeled detailed asset allocations with non-traditional assets (NTAs) 1 See “Sources of benchmark allocations and investor risk profiles” on next page regarding the source of investor risk profiles. 2 See “Sources of benchmark allocations and investor risk profiles” on next page regarding the source of benchmark allocations and their suitability. 3 See "Deviations from benchmark allocations" in the Appendix regarding the interpretation of the suggested tactical deviations from benchmark. 4 The current allocation row is the sum of the benchmark allocation and the WMR tactical deviation rows. 5 UBS WMR considers that maintaining the benchmark allocation is appropriate for alternative investments. The recommended tactical deviation is therefore structurally set at 0. See “Sources of benchmark allocations and investor risk profiles” on next page regarding the types of alternative investments and their suitability. End notes for table labeled detailed asset allocations without non-traditional assets (NTAs) 1 See “Sources of benchmark allocations and investor risk profiles” on next page regarding the source of investor risk profiles. 2 See “Sources of benchmark allocations and investor risk profiles” on next page regarding the source of benchmark allocations and their suitability. 3 See "Deviations from benchmark allocations" in the appendix regarding the interpretation of the suggested tactical deviations from benchmark. 4 The current allocation row is the sum of the benchmark allocation and the WMR tactical deviation rows. Emerging Market Investments Investors should be aware that Emerging Market assets are subject to, amongst others, potential risks linked to currency volatil- ity, abrupt changes in the cost of capital and the economic growth outlook, as well as regulatory and socio-political risk, interest rate risk and higher credit risk. Assets can sometimes be very illiquid and liquidity conditions can abruptly worsen. WMR gener- ally recommends only those securities it believes have been registered under Federal U.S. registration rules (Section 12 of the Securities Exchange Act of 1934) and individual State registration rules (commonly known as "Blue Sky" laws). Prospective in- vestors should be aware that to the extent permitted under US law, WMR may from time to time recommend bonds that are not registered under US or State securities laws. These bonds may be issued in jurisdictions where the level of required disclosures to be made by issuers is not as frequent or complete as that required by US laws. For more background on emerging markets generally, see the WMR Education Notes "Investing in Emerging Markets (Part 1): Equities", 27 August 2007, "Emerging Market Bonds: Understanding Emerging Market Bonds," 12 August 2009 and "Emerging Markets Bonds: Understanding Sovereign Risk," 17 December 2009. Investors interested in holding bonds for a longer period are advised to select the bonds of those sovereigns with the highest credit ratings (in the investment grade band). Such an approach should decrease the risk that an investor could end up holding bonds on which the sovereign has defaulted. Sub-investment grade bonds are recommended only for clients with a higher risk tolerance and who seek to hold higher yielding bonds for shorter periods only. Alternative Investments An investment in alternative investment funds (the "Funds") involves significant risks, including but not limited to, a loss of capi- tal. There can be no assurance that the Funds' respective investment objectives will be achieved or that its investment program will be successful. In particular, limited diversification, the use of leverage, foreign currency fluctuations and the limited liquidity of the respective portfolio securities and other factors can, in certain circumstances, result in or contribute to significant losses to the Funds. The Funds charge administrative and management fees, which they will earn irrespective of profits, if any. UBS FS Investment Strategy Guide 21
  • 22. Wealth Management Research 28 July 2010 Investment Strategy Guide Appendix 6 Explanations about asset allocations Sources of benchmark allocations and investor risk profiles  Benchmark allocations represent the longer-term allocation of assets that is deemed suitable for a particular investor. Except as described below, the benchmark allocations expressed in this publication have been developed by UBS Investment Solu- tions (IS), a business sector within UBS Wealth Management Americas that develops research-based traditional investments (e.g., managed accounts and mutual fund options) and alternative strategies (e.g., hedge funds, private equity, and real es- tate) offered to UBS clients. The benchmark allocations are provided for illustrative purposes only and were designed by IS for hypothetical US investors with a total return objective under seven different Investor Risk Profiles ranging from very conserva- tive to very aggressive. In general, benchmark allocations will differ among investors according to their individual circum- stances, risk tolerance, return objectives and time horizon. Therefore, the benchmark allocations in this publication may not be suitable for all investors or investment goals and should not be used as the sole basis of any investment decision. As al- ways, please consult your UBS Financial Advisor to see how these weightings should be applied or modified according to your individual profile and investment goals.  The process by which UBS Investment Solutions has derived the benchmark allocations can be described as follows. First, an allocation is made to broad asset classes based on an investor’s risk tolerance and characteristics (such as preference for in- ternational investing). This is accomplished using optimization methods within a mean-variance framework. Based on a pro- prietary set of capital market assumptions, including expected returns, risk, and correlation of different asset classes, combi- nations of the broad asset classes are computed that provide the highest level of expected return for each level of expected risk. A qualitative judgmental overlay is then applied to the output of the optimization process to arrive at the benchmark al- location. The capital market assumptions used for the benchmark allocations are developed by UBS Global Asset Manage- ment. UBS Global Asset Management is a subsidiary of UBS AG and an affiliate of UBS FS.  In addition to the benchmark allocations IS derived using the aforementioned process, WMR determined the benchmark allocation by country of Non-US Developed Equity and Non-US Fixed Income in proportion to each country’s market capitalization, and de- termined the benchmark allocation by Sector and Industry Group of US Equity in proportion to each sector’s market capitalization. WMR, in consultation with IS, also determined the benchmark allocation for US dollar taxable fixed income. It was derived from an existing moderate risk taxable fixed income allocation developed by IS, which includes fewer fixed income segments than the benchmark allocation presented here. The additional fixed income segments were taken by WMR from related segments. For ex- ample, TIPS were taken from Treasuries and Preferred Securities from Corporate Bonds. A level of overall risk similar to that of the original IS allocation was retained.  Nontraditional asset classes include alternative investments and commodities. Alternative investments include hedge funds, private equity and managed futures investments. An allocation to alternative investments as illustrated in this report may not be suitable for all investors. In particular, minimum net worth requirements may apply. For more background, see the WMR Education Note, “Nontraditional assets go mainstream” 12 February 2007. The background for the benchmark allocation at- tributed to commodities can be found in the WMR Education Note, “A pragmatic approach to commodities,” 2 May 2007. Deviations from benchmark allocation  The recommended tactical deviations from the benchmark are provided by WMR. They reflect our short- to medium-term as- sessment of market opportunities and risks in the respective asset classes and market segments. Positive / zero / negative tactical deviations correspond to an overweight / neutral / underweight stance for each respective asset class and market segment rela- tive to their benchmark allocation. The current allocation is the sum of the benchmark allocation and the tactical deviation.  Note that the regional allocations on the International Equities page are provided on an unhedged basis (i.e., it is assumed that investors carry the underlying currency risk of such investments). Thus, the deviations from the benchmark reflect our views of the underlying equity and bond markets in combination with our assessment of the associated currencies. The two bar charts (“Equity regions” and “Bond regions”) represent the relative attractiveness of countries (including the currency outlook) within a pure equity and pure fixed income portfolio, respectively. In contrast, the detailed asset allocation tables in- tegrate the country preferences within each asset class with the asset class preferences stated earlier in the report. As the tac- tical deviations at the asset class level are attributed to countries in proportion to the countries’ market capitalization, the relative ranking among regions may be altered in the combined view. Scale for tactical deviation charts Symbol Description / Definition Symbol Description / Definition Symbol Description / Definition + moderate overweight vs. bench- ­ moderate underweight vs. bench- n neutral, i.e., on benchmark mark mark ++ overweight vs. benchmark ­­ underweight vs. benchmark n/a not applicable +++ strong overweight vs. benchmark ­­­ strong underweight vs. benchmark UBS FS Investment Strategy Guide 22
  • 23. Wealth Management Research 28 July 2010 Investment Strategy Guide Appendix 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 currently only 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 realisable 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 realisation 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 License No. 231127), Chifley Tower, 2 Chifley Square, Sydney, New South Wales, NSW 2000. Bahamas: This publication is distributed to private clients of UBS (Bahamas) Ltd and is not intended for distribution to persons designated as a Bahamian citizen or resident under the Bahamas Exchange Control Regulations. Canada: In Canada, this publication is distributed to clients of UBS Wealth Management Canada by UBS Investment Management Canada Inc.. Dubai: Research is issued by UBS AG Dubai Branch within the DIFC, is intended for professional clients only and is not for onward distribution within the United Arab Emirates. France: This publication is distributed by UBS (France) S.A., French “société anonyme” with share capital of € 125.726.944, 69, boulevard Haussmann F-75008 Paris, R.C.S. Paris B 421 255 670, to its clients and prospects. UBS (France) S.A. is a provider of investment services duly authorized according to the terms of the “Code Monétaire et Financier,” regulated by French banking and financial authorities as the “Banque de France” and the “Autorité des Marchés Financiers.” Germany: The issuer under German Law is UBS Deutschland AG, Stephanstrasse 14-16, 60313 Frankfurt am Main. UBS Deutschland AG is authorized and regulated by the “Bundesanstalt für Finanzdienst- leistungsaufsicht.“ Hong Kong: This publication is distributed to clients of UBS AG Hong Kong Branch by UBS AG Hong Kong Branch, a licensed bank under the Hong Kong Banking Ordinance and a registered institution under the Securities and Futures Ordinance. Indonesia: This research or publication is not intended and not prepared for purposes of public offering of securities under the Indonesian Capital Market Law and its implementing regulations. 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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 October 2009.  UBS 2010. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. UBS FS Investment Strategy Guide 23

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