Financial Pacific - Stay the Course (third party)


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Financial Pacific - Stay the Course (third party)

  1. 1. Investment Strategy GuideWealth Management Research31 August 2011 Monthly es copi p rint thly l e* Mon availabStay the course US economy to avert Eurozone remains key Maintain benchmark recession by a thin margin risk to market outlook allocation to equities*Print copies are not available for ad-hoc intra-month updates.
  2. 2. Contents HighlightsFocus .............................................3  We continue to recommend that investors stay the course andOur Best Ideas at a Glance ..........9 retain a balanced portfolio with benchmark weightings across each of the major asset classes (stocks, bonds, cash, commodi-Asset Allocation Overview ..........10 ties, alternatives investments).Market Scenarios ........................11  Stocks are cheap relative to history, and certainly relative toEconomic Outlook ......................12 bonds. While it remains our view that neither the US nor theInternational Markets……............14 broader global economy will lapse into recession, sluggish eco-US Equities: Sectors .......................16 nomic growth prospects, falling earnings estimates, and ele- vated systemic risks suggest that a sharp and sustained equityUS Equities: Size, Style & REITs ....17 market rally over the remainder of 2011 is unlikely.US Fixed Income .........................18  We retain our overweights to both US and emerging marketChartbooks .................................21 equities – while at the same time keeping an outright under-Detailed Asset Allocations.........25 weight of non-US developed markets, in particular the Euro- zone.  The next challenge we see for the Eurozone are the upcoming votes among member nations to approve an expansion in the European Financial Stability Facility (EFSF).  While much of the political focus has centered upon the Euro- zone, we also need to keep a watchful eye on developments in Washington related to the Joint Select Committee on Deficit Reduction.Michael P. Ryan, CFA, Chief InvestmentStrategist and Head, WMR – Americasmike.ryan@ubs.comStephen R. Freedman, PhD, CFA, Strategiststephen.freedman@ubs.comBrian Rose, PhD, Strategistbrian.rose@ubs.comThis report has been prepared by UBS Finan-cial Services Inc.Please see important disclaimer and dis-closures at the end of the document. Investment Strategy Guide 2
  3. 3. FocusStay the courseWith the global economy likely to avert a renewed recession and equity valuationsat attractive levels, stocks would appear to have upside from here. However, slowgrowth prospects and significant systemic risks suggest that the upside is likely to belimited compared to the equity rally seen in the second half of 2010 and that down-side risks remain. We recommend sticking to a benchmark allocation on equities.Sloppy & choppy Against this backdrop we continue to recommend that investors stay the course and retain a balanced portfolioFinancial markets experienced a level of volatility during with benchmark weightings across each of the majorthe month of August that had not been seen since the asset classes (stocks, bonds, cash, commodities, alterna-dark days of the global financial crisis. The VIX volatility tives investments). It remains our view that stocksindex breached the 45 mark for the first time since reached oversold conditions in August and that a furtherMarch 2009 (see Fig. 1), as market participants were recovery from current distressed levels is likely. Even afterforced to sort through a stream of weaker than expected having rallied nearly 8% from the August lows, the S&Peconomic data, an especially caustic political debate over 500 is still trading at undemanding valuation multiples ofthe extension of the federal debt ceiling, the first down- just 11.7x our estimates for 2012 earnings - and justgrade of the US sovereign credit rating from AAA, and a 10.7x twelve-month consensus earnings (see Fig. 2).broadening of the Eurozone debt crisis to Italy and Keep in mind, however, that analysts and strategists areSpain. While volatility will likely ratchet lower in coming likely to begin reducing their earnings estimates in theweeks, few of the catalysts that prompted the broad- weeks and months ahead as the impact from the mostbased market sell-off have been fully addressed - let recent hit to both consumer and business confidence isalone resolved. This suggests that markets will remain increasingly reflected in the profit picture. In our view,“choppy & sloppy” in the short/intermediate term, and any “re-rating” of equities will therefore be both limitedthat relief rallies are likely to be more episodic than sus- and gradual.tained.Fig. 1: Volatility spiked in August Fig. 2: World Price-Earnings ratio cheaper than averageVIX volatility index S&P 500 Price-Earnings ratio. EPS is Earnings Per Share 90 25 80 70 20 60 50 15 40 30 10 20 10 5 0 85 89 93 97 01 05 09 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 S&P 500 12-month Fwd PE PE on WMR EPS VIX volatility index PE on $80 EPS (recession) AverageSource: Bloomberg, UBS WMR, as of 30 August 2011 Source: Datastream, IBES, UBS WMR, as of 29 August 2011 Investment Strategy Guide 3
  4. 4. FocusThat said, while recommending a neutral tactical allocation to eq-uities as an asset class, we have opted to retain our moderate Fig. 3: Benchmark and current allocationoverweights to both US and emerging market equities – while at Percentage of portfolio (moderate risk portfolio)the same time keeping an outright underweight of non-US devel-oped markets, in particular the Eurozone. Although growth pros- Benchmark allocation Current allocationpects in the US have weakened, it remains our view that the 12.0 12.0 5.0 5.0economy won’t lapse back into recession. Meanwhile, the easing 2.0 2.0of inflation pressures within the emerging markets will allow cen- 44.0 44.0tral bankers greater latitude to shift toward a more neutral (andequity friendly) policy stance. We do, however, remain concerned 37.0 37.0about lingering debt problems within the Eurozone. Although theEuropean Central Bank (ECB) has played a critical role in stabiliz-ing sovereign bond yields in the near term, the inability of elected Equity Commodities Fixed Income Altern. Investmentsofficials to address the broader fiscal challenge and financial sec- Cashtor stability concerns within the region in a comprehensive anddecisive manner continues to pose a risk to Eurozone equities. Source: UBS Investment Solutions and WMR, as of 31 August 2011. See Sources of benchmark allocations and investor risk profiles inAssessing the rough patch the Appendix for a detailed explanation regarding benchmarks andThe weakness in economic data released over the past four weeks their suitability. The current allocation is the sum of the benchmarkhas raised concerns of a deeper nature than just the standard run allocations and tactical deviations.of the mill “soft patch”. What has compounded these cyclical The Tables on pages 25 and 26 in the Appendix also show asset allocations applicable to risk profiles other than the moderate riskfears is the fact that the recovery process was hardly on firm foot- profile shown here, both with and without nontraditional to begin with. Official GDP growth for both the first and sec-ond quarters was revised lower to an average of less than 1 per-cent, indicating broad-based weakness in demand growth duringthe first half of the year. While higher energy prices and the im- Table 1: Asset Class Scorecardpact from the Japanese earthquake played a role in the slow- Valuation Cyclical Timingdown, the fact is that the economy has simply failed to gain the Equities +2 -1 -1sort of traction that allows expansions to become self-sustaining. Commodities -1 0 0A further weakening of growth prospects from this already de- Fixed Income -2 +1 +1pressed level could therefore bring the economy perilously close Range: -3 (very unsupportive) to +3 (very supportive)to recessionary levels. Almost any significant shock could be Source: UBS WMR, as of 31 August 2011enough to create a US recession given the already weak pace ofgrowth momentum. It is this risk that has weighed most heavilyupon domestic equity markets of late. Fig. 4: Regional manufacturing climate deterio- rates further in August Regional manufacturing climate indexes, index levelsDespite the increased concern over recession, the economic re- 60 80lease data has actually been more mixed than the headlines alone Another soft patch or genuine weakness? 40 70might suggest. While several survey-based releases such as the 20 60Michigan consumer sentiment index and Philly Fed manufacturing 0 50survey have shown sharp drops consistent with recession, still oth- (20) 40ers such as the Kansas City, Richmond, Chicago and Dallas Fed (40) 30surveys suggest the economy is decelerating in line with last year’s (60) 20soft patch rather than simply rolling over (see Fig. 4). High fre- Jul-01 Jul-03 Jul-05 Jul-07 Jul-09 Jul-11quency data such as weekly unemployment claims, retail sales and Empire State (lhs) Philly Fed (lhs) Richmond (lhs)the personal consumption data for July also reflect a bit of a Kansas City (lhs) Dallas (lhs) Chicago (rhs)bounce back following a lull in activity during May and June. All Source: Bloomberg, UBS WMR, as of 31 August 2011things considered, it remains our view that the economy will averta recession – but that the sluggish substandard pace of growth is Investment Strategy Guide 4
  5. 5. Focusapt to prevail for the balance of this year and into next year aswell.Gentle Ben?Chairman Bernanke provided little in the way of fresh insight orclear guidance in his prepared remarks offered at the Fed’s annualpolicy symposium in Jackson Hole, Wyoming. Market participantsdidn’t appear overly troubled by the Chairman’s unwillingness tocommit to new policy measures, and instead took solace from asomewhat more upbeat assessment of the US economy. While hecontinued to warn that “financial stress has been and continuesto be a significant drag on the recovery, both here and abroad,”Bernanke also emphasized that growth in the second half waslikely to improve. The only tangible step the Fed Chairman ap-peared willing to take at this juncture was to expand the Septem-ber FOMC meeting from one day to two days in an effort to bet-ter assess both the health of the economy and potential policyresponses.Although Bernanke refused to explicitly commit to any specificpolicy action in Jackson Hole, he left the door wide open for anyand all measures should growth fail to reaccelerate, financial mar-kets come under additional stress, and/or asset prices declineanew. Virtually no one was looking for the Fed to pledge to a new Fig. 5: ECB buying has reduced yield spreads forphase of quantitative easing – and in this regard the Chairman Italy and Spain 10-year government bond yield spread vs. German Bunds, in %-didn’t disappoint. We already knew that the bar was set pretty ptshigh for “QE3,” so the fact that the Fed made no mention of a 4.0further expansion of its balance sheet should not be interpreted to 3.5mean that the Fed will sit idle should the business cycle take a 3.0turn for the worse. By stating that “the Federal Reserve has a 2.5range of tools that could be used to provide additional monetary 2.0stimulus,” Chairman Bernanke sent notice that Fed officials were 1.5both willing and capable of upping the ante as conditions require 1.0– despite dissenting votes within their own ranks. 0.5 0.0Eurozone risks remain Jan-10 May-10 Sep-10 Jan-11 May-11Meanwhile, policymakers in the Eurozone have yet to convince Spain Italyinvestors that they are able to adopt the sort of politically difficult Source: Bloomberg, UBS WMR, as of 30 August 2011measures needed to restore confidence in the stability of currencyunion. Far from standing idle, European leaders have in factadopted a number far reaching measures since the beginning ofthe crisis. However, their steps to-date have consistently been in-terpreted by market participants as being “too little, too late.”The very structure of the Eurozone makes it difficult to addressfiscal challenges in a timely and comprehensive manner. As a re-sult, policymakers on the Continent have failed to stem a crisisthat started in Greece, spread to a small group of countries on theperiphery of the Eurozone, and more recently has begun to im-pact larger members such as Italy, Spain and even France. Only Investment Strategy Guide 5
  6. 6. Focusthe actions of the European Central Bank have been successful inproviding support to beleaguered market participants through an Fig. 6: Funding tensions in European interbankexpansion in sovereign debt purchases - primarily Spain and Italy market(see Fig. 5). In the absence of ECB action, it is clear that markets Euribor-OIS 3 Month Spread, in %would have come under even more acute pressure. 2.0 1.8 1.6The next challenge we see for the Eurozone region going forward 1.4 1.2are the upcoming votes among member nations to approve an 1.0expansion in the European Financial Stability Facility (EFSF). Keep 0.8 0.6in mind that while the facility’s lending capacity was expanded in 0.4July to EUR 440 billion, the larger package still requires the ap- 0.2 0.0proval of the national legislatures across the Eurozone. There is Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11concern that at EUR 440 billion the EFSF is simply too small to Euribor-OIS 3 Month Spreadadequately deal with potential problems in states already under Source: Bloomberg, UBS WMR, as of 30 August 2011stress, and that a package of perhaps EUR 1 trillion may ultimatelybe required to placate market concerns about further contagion.But there is already some push back as member nations balk atthe potential cost associated with the EUR 440 billion facility – letalone EUR 1 trillion. Finland’s insistence that Greece provide col-lateral as a precondition for additional loan disbursements risksdelaying the process into October. Should legislatures fail to passthe current package, or even simply delay approval by anothermonth or so, Eurozone markets are apt to come under renewedpressure.As we’ve already noted, The European Central Bank currently ap-pears to be the only European institution capable of acting deci-sively to contain the spreading of the crisis. However, there arelegitimate doubts about whether the ECB can fulfill such functionin a sustainable manner over the coming months. The ECB hasalso been active in providing liquidity to the ailing European finan-cial system. Funding conditions in the interbank market have dete-riorated in recent weeks (see Fig. 6). While they are hardly compa-rable with the crunch experienced in 2008, they have clearly be-come a source of concern. So while the situation in the Eurozoneappears to have stabilized over the last several weeks, it is quiteapparent that there is very little room for any mistakes. Any ad-verse news from the financial sector or signs of disagreementamong policy makers is likely to create market jitters. We expectrenewed bouts of selling pressure in European markets before theend of the year and therefore remain underweight equities in theregion despite seemingly attractive valuations.Watchful eye on WashingtonWhile much of the political focus of late has rightly centered uponthe Eurozone, we need to keep a watchful eye on developmentsin Washington related to the Joint Select Committee on DeficitReduction (JSC or debt “super committee”) as well. On August 2,President Obama signed into law the Budget Control Act of 2011. Investment Strategy Guide 6
  7. 7. FocusTitle IV of that Act created the JSC which is composed of twelveMembers each from the Senate and House of Representatives (6Republicans and 6 Democrats). The Committee is under a tightdeadline to produce legislation cutting the deficit by at least $1.5trillion over ten years. In the absence of such an agreement, amandatory budget “sequestration” process would kick in andreduce spending by more than $1 trillion across discretionary, en-titlement and defense programs. The committee must meet bySeptember 16th at the latest, and new legislation must be ap-proved by both the House and Senate by December 23rd.Linda Lord, UBS’s Head of Legislative and Regulatory affairs re-cently published an insightful note highlighting both the chal-lenges and possible pathways toward a legislative solution. Lindapoints out that it is still possible to reach a compromise agreementfollowing a “dual track” legislative process where one set of fiscalmeasures is passed in the House, a separate set is passed in theSenate, and the two are ultimately reconciled. However, Lindaalso admits that the prospects for compromise are still limited.Keep in mind that the membership of the JSC largely reflects thehardened political positions of the two opposing camps on Capi-tol Hill - and excludes any of the so called “gang of six” senatorswho had tried to cobble together a bi-partisan budget resolution.It is difficult to see how this new panel will be any more effectivein hammering out an agreement on a new series of fiscal meas-ures to reduce the deficit by $1.5 trillion over the next 10 years.Instead, it’s more likely that the “automatic” spending cuts—required by the debt ceiling accord if an agreement cannot bereached—will be implemented.Keep in mind that the failure to agree upon meaningful and credi-ble fiscal reforms, even if the Budget Control Act is fully imple-mented, could prompt yet another downgrade of the US sover-eign credit rating. While Moody’s reaffirmed its Aaa rating in Au-gust, the rating agency did place the US on negative watch andwarned that a downgrade could occur within the next 12 monthsif constructive steps are not taken to address the federal debtlevel. It is unclear just how much additional damage a downgradeby Moody’s would inflict upon confidence given that S&P has al-ready taken action. However, it would certainly undermine theargument that S&P had been imprudent and premature in strip-ping the US of its AAA rating. This in turn would likely furtherundermine confidence in the political process, business outlookand investment environment in the US. So while the political is-sues in the US are neither as immediate nor as acute as those cur-rently afflicting the Eurozone, the process still merits close atten-tion. Investment Strategy Guide 7
  8. 8. FocusNo dumping zoneAs we noted in our intra-month update on August 19th, we rec-ommend that investors retain equity positions at current levelsdespite the more challenging macro backdrop and lingering politi- Fig. 7: Stocks recovered last year after Bernanke speech at Jackson Holecal risks. Keep the following in mind: S&P 500 index 1,400 Stocks are already pricing in a fair amount of economic and earnings weakness and therefore should outperform bonds in 1,300 the weeks ahead as the upcoming release data reflect weak- ness rather than an outright collapse in the economy. It re- 1,200 Jackson Hole mains our view that neither the US nor the broader global economy will lapse into recession. 1,100 While consensus earnings estimates are likely too high and 1,000 almost certain to be revised lower over the course of the next Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 several months, we still look for respectable profit growth of 14% ($97) for this year and 5% ($102) for 2012. Source: Bloomberg, UBS WMR, as of 30 August 2011 With expectations already set incredibly low for elected offi- cials across the developed world, there is ample room for a positive surprise if they are able to make any progress at all in addressing fiscal concerns in the months ahead. Although Chairman Bernanke refused to commit to any spe- cific policy action in Jackson Hole, he left the door wide open to providing “additional monetary stimulus” as needed. Recall that the recovery in risk assets last year tracks almost to the moment when the Fed first raised the prospects for QE2 at last years’ Jackson Hole Symposium (see Fig. 7). A benchmark weighting in bonds is still warranted amid slug- gish growth prospects, diminishing inflation risks and the Fed’s commitment to keep short rates at current levels through mid-2013. Meanwhile, any further expansion of the Fed balance sheet and/or extension in the portfolio duration will also serve to temper any near term rate pressure.ConclusionAs we’ve already noted, we continue to recommend that investorsstay the course and retain a balanced portfolio with benchmarkweightings across each of the major asset classes (stocks, bonds,cash, commodities, alternatives investments). Markets are apt toremain choppy in the near term as both macro and political risksremain. However, we elect to retain our overweights to both USand emerging market equities – while at the same time keepingan outright underweight for the Eurozone. It is our view that thecombination of US and Emerging Market exposure will allow in-vestors to outperform as the market recovers from oversold levels,but should also insulate portfolios on the downside should theEurozone crisis continue to deepen.Michael P. Ryan, CFA, Head WMR Americas, UBS FS Inc.Stephen R. Freedman, PhD, CFA, Strategist, UBS FS Inc. Investment Strategy Guide 8
  9. 9. Our Best Ideas at a GlanceThe following list represents investment strategy recommendations that we believe will provide attractiveopportunities over the next 9-12 months.Asset Classes Neutral tactical preference across equities and bondsCurrencies Avoid Japanese yen. Preference for SEK, NOK, GBP, CAD as well as selected Emerging Market cur- rencies.Equities International markets  Emerging Market equities, especially China, Russia, Thailand, and Poland  UK and US equities Within US equities  Information Technology: hardware and equipment, semis, data centers  Consumer Staples: companies with high emerging markets exposure, specifically within House- hold Products, Cosmetics, and Beverages  Within Healthcare: managed care, generic manufacturers, drug distributors  Within Financials: universal banks, asset managers, exchanges, insurers  Within Industrials: air freight and select capital goods manufacturers with mid-to-late cycle ex- posure  Within Materials: chemicals and industrial gas  Within Energy: oilfield services  Within Consumer Discretionary: auto suppliers, cable, lodging  Within Telecom: wireless towers, enterprise carriers  Preference for growth over value stocksFixed Income Within US dollar Fixed Income  Investment Grade BBB-rated credits in particular: managed care, insurance, mining and com- municationsCommodities We see upside potential for gold, platinum, and selected agricultural commodities. Investment Strategy Guide 9
  10. 10. Asset Allocation Overview Model Portfolio WMR Tactical ViewAsset Class Comments Moderate Risk Profile (in %) Benchmark Tactical Change Current Allocation Deviation AllocationEquitiesValuations attractive, especially relative to low yields on bonds. Weak economic data and Neutral 44 +0.0 44.0problems in the Eurozone present downside risks to earnings.  US Equities Moderate Solid earnings growth helped by the weak dollar and external demand, but 32 +2.0 34.0 valuations are less attractive than in overseas markets. Overweight  US Large Cap Value Moderate Valuations and our sector tilts suggest preference for Growth over Value. 11 -1.0 10.0 Large-caps cheap relative to small and mid Underweight  US Large Cap Growth Moderate Valuations and our sector tilts suggest preference for Growth over Value. 11 +3.0 14.0 Large-caps cheap relative to small and mid Overweight  US Mid Cap Neutral 5 +0.0 5.0 Valuations expensive vs. large-caps, but M&A activity should help.  US Small Cap Neutral 3 +0.0 3.0 Valuations expensive vs. large-caps, but M&A activity should help.  US Real Estate Investment Trusts (REITs) The Federal Reserve’s “pledge” to keep rates low thorough mid-2013 is posi- Neutral 2 +0.0 2.0 tive for the interest-rate sensitive REIT industry, offsetting stretched valua- tions  Non-US Developed Equities Valuations more attractive than US. Sovereign debt concerns in the Eurozone Underweight 10 -4.0 6.0 and potential for exchange rate losses suggest more cautious stance.  Emerging Market (EM) Equities Moderate High potential growth rates and reasonable valuations make EM equities 2 +2.0 4.0 more attractive than developed markets. Inflation likely to peak soon. Overweight Fixed IncomeYields at historically low levels but weak economic data likely to keep many central banks Neutral 37 +0.0 37.0on hold longer than previously anticipated.  US Fixed Income Within fixed income we are neutral on the US vs. non-US. The dollar trades Neutral 29 +0.0 29.0 near record-low levels against many major currencies but fundamentals re- main poor.  Non-US Fixed Income Extremely low yields and overvalued yen make Japanese debt unattractive. Neutral 8 +0.0 8.0 European sovereign debt concerns remain a risk. Cash (USD) Neutral 2 +0.0 2.0Yields likely to remain near into 2013. CommoditiesWe expect overall commodity prices to rise moderately over the next 12 months. Roll yields Neutral 5 +0.0 5.0(resulting from contango term structure of futures prices) have become less negative. Alternative Investments Neutral 12 +0.0 12.0No 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 returnobjective. See "Sources of benchmark allocations and investor risk profiles" in the Appendix for a detailed explanation regarding the source of benchmark alloca-tions 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 "De-viations 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 ▼ DowngradeSource: UBS WMR and Investment Solutions, as of 31 August 2011. For end notes, please see appendix. Investment Strategy Guide 10
  11. 11. Market Scenarios (next 12 months)Economic data has continued to disappoint. Many senti- Moderate recoveryment indicators have dropped sharply. Tighter fiscal policyand deleveraging in developed markets will create furtherheadwinds, making a strong recovery difficult to achieve.The recovery of Japan’s manufacturing sector is helping toease problems in global supply chains, giving a boost tooutput. Inflation should peak soon in many emerging mar-kets.Moderate recovery: Base Case ScenarioProbability: 55% (down from 65% in July)  The global economy remains on an expansion course as low real interest rates in most countries provides support. Renewed downturn  The recovery is more subdued than in prior cycles because of de-leveraging pressures, with unemployment rates remain- ing far above their pre-financial crisis levels.  Growth in emerging markets continues to outpace devel- oped markets.Renewed downturn: First Alternative ScenarioProbability: 30% (up from 20% in July)  The recent trend toward weaker growth continues as fiscal consolidation and higher interest rates create additional headwinds. Stagflation  Most countries suffer at least one quarter of negative growth as consumers cut back on spending.  Weak demand keeps inflation under control.  The Eurozone debt crisis represents a threat to global growth.Stagflation: Second Alternative ScenarioProbability: 10%  Loose monetary policy boosts commodity prices without helping the economy, setting an inflationary process in mo- tion.  The combination of rising price levels and weak growth prospects poses significant challenges to most financial as- Strong recovery sets.Strong recovery: Third Alternative ScenarioProbability: 5%  High profit margins and low interest rates encourage as surge in investment spending.  Improvements in the labor market and in credit conditions allow a more dynamic consumer recovery.Brian Rose, PhD, Strategist, UBS FS Inc. Source: UBS WMRStephen R. Freedman, PhD, CFA, Strategist, UBS FS Inc. Investment Strategy Guide 11
  12. 12. Economic OutlookNo recession in hard data as of yetThe verdict on whether the US economy is sliding into re- Table 2: Growth and inflation forecastscession or bouncing back from anemic growth in the first in % GDP Growth Inflationhalf of the year is still out. The most recent survey-based 10 F 11 F 12 F 10 F 11 F 12 Fsentiment data deteriorated, but hard data do not show World 4.3 3.3 3.3 2.9 3.6 2.9any substantial negative spill-over from weaker sentiment US 3.0 1.8 2.3 1.6 2.9 1.8yet. We continue to expect a rebound in growth, but have Canada 3.2 2.9 2.3 1.8 2.7 2.2increased our recession probability and see more downside Japan 4.0 -0.4 2.9 -1.0 -0.3 -0.2risk to our current growth forecasts than in July. Eurozone 1.7 1.8 1.0 1.6 2.5 1.8 UK 1.4 1.1 1.5 3.3 4.5 2.9Recession risk has increased China 10.3 9.0 8.3 3.3 5.1 3.5On balance, July growth data was stronger than over the India 8.5 7.2 7.8 12.1 7.4 6.8May/June period. Labor market conditions improved, industrial Russia 4.0 4.8 4.5 6.8 9.6 7.7production rebounded as Japan-related supply disruptions dissi- Brazil 7.5 3.1 3.6 5.9 6.3 5.4 Emerging Asia 8.7 6.7 6.5 4.9 5.1 4.0pated, consumption growth recovered and businesses continuedto invest at a moderate pace. However, the most recent survey- F: forecast. Source: UBS WMR, as of 29 August 2011 In developing the forecasts set forth above, WMR economistsbased sentiment data for August paints a dire picture. Leading worked in collaboration with economists employed by UBS Invest-the deterioration in sentiment are the regional Philadelphia Fed ment Research (INV). INV is published by UBS Investment Bank.manufacturing climate index and the University of Michigan con- Forecasts and estimates are current only as of the date of this publi-sumer sentiment index. The former plunged to -30.7, a level that cation and may change without the past has always been consistent with an economy-widerecession. The latter fell from 63.7 in July to 55.7 in August, a big Fig. 8: Data has been weaker than expectedback-to-back plunge from 71.5 in June. The August level is com- Citi economic surprise indexesparable with levels not experienced since the Great Recession in 1502008 and 2009. At face value consumer expectations suggest 100basically flat growth in real consumption. Other regional manu- 50facturing climate indexes have deteriorated as well but much less 0than the Philly Fed index. To reflect this precipitous drop in senti- -50ment, we have raised our recession probability from 20% to -10030%. -150 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11Sticking to growth rebound forecast, but downside risks US Eurozone Emerging markets Japanhave risen Source: Citi, Bloomberg, UBS WMR, as of 31 August 2011In contrast to the substantial further weakening in sentimentdata, hard data in the form of initial jobless claims and weekly Fig. 9: Consumer sentiment deteriorates furtherretail sales indexes have held up fairly well. Initial jobless claims, Consumer sentiment (index) and real consumption (y/y in %)continued to trend sideways through the week ended 20 August,with the Verizon strike distorting them slightly higher. Excluding 8 140 6 120the Verizon-induced layoffs, initial claims have hovered slightly 4 100above 400,000 since late July. Weekly retail sales indexes have 2 80deteriorated in August, but do not show weakness that would be 0 60consistent with US consumer spending rolling over. Having said (2) 40 (4) 20that, the weekly retail sales indexes will have to find a bottom Aug-98 Aug-01 Aug-04 Aug-07 Aug-10soon in order to continue to be consistent with our forecast for a Real consumption (lhs)rebound in real consumption in 3Q11. July real consumer spend- University of Michigan consumer expectations (rhs) Conference Board consumer expectations (rhs)ing growth was solid 0.5% m/m and gives the third quarter asolid start. But if consumer sentiment and weekly retail sales in- Source: Bloomberg, UBS WMR, as of 30 August 2011 Investment Strategy Guide 12
  13. 13. Economic Outlookdexes don’t recover soon, this could change rather quickly. Wecontinue to forecast real GDP growth of 2.5% q/q annualized in Fig. 10: Business climate points to about 0.5%3Q11, followed by 2% in 4Q11, after an anemic 1% in 2Q11. growthHowever, we think that the risk to our forecasts lies mainly on the ISM all-economy index and real GDP growthdownside. 8 65 6 60 4Fed on hold for longer, with higher threshold for QE3 2 55At its 9 August meeting the FOMC lengthened the time horizon it 0 50 -2thought that economic conditions would likely warrant keeping -4 45 -6its fed funds rate at an exceptionally low rate from “an extended -8 40period” to “at least through mid-2013”. In doing so it effectively -10 35priced out of markets any rate hike expectations before July 2013. Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Real GDP (q/q annualized, lhs) Real GDP (y/y, lhs)However, since core CPI inflation has been on the rise since early ISM all-economy index (rhs)2011, there is a high threshold for adopting further monetarystimulus on top of this change in language. In our view, the Note: The ISM all-economy index gives weights to manufacturingeconomy would have to show recessionary tendencies in order for (11%) and non-manufacturing (89%) according to their respective share in overall GDP.the FOMC to become relaxed about inflation and ready to sup-port growth with further stimulus. This is not our base case. Source: Bloomberg, UBS WMR, as of 29 August 2011Eurozone takes a turn for the worse Fig. 11: Eurozone has slowed in recent monthsRecent economic data from the Eurozone has been weak, leading Eurozone Purchasing Manager Indexes (PMI)us to slash our 2012 GDP growth forecast from 2% to 1%. GDP 65expanded by just 0.2% quarter-on-quarter in 2Q11, and with the 60composite PMI barely above 50 in July and August, 3Q11 is 55unlikely to be much better. Politicians have been unable to get 50ahead of the curve in dealing with the sovereign debt crisis, and 45 40the entire financial system is showing signs of strain. Sentiment 35has plunged rapidly, and with fiscal policy being tightened in 30most countries, there is a real danger that the Eurozone will fall 2006 2007 2008 2009 2010 2011back into recession. Composite Manufacturing Non-manufacturingJapan: another year, another prime minister Source: Bloomberg, UBS WMR, as of 29 August 2011About the only country showing better than expected economicdata recently is Japan, which continues to recover from the devas-tating earthquake and tsunami in March. Reconstruction spend-ing should provide a boost going forward, helping to offset thenegative impact of the strong yen. However, long-run prospectsare poor. Unstable politics (the prime minister was just replacedfor the sixth time in the last 5 years), huge government debt levelsand rapid population aging is likely to constrain growth in theyears ahead.Thomas Berner, CFA, Economist, UBS FS Inc.Brian Rose, PhD, Strategist, UBS FS Inc. Investment Strategy Guide 13
  14. 14. International MarketsReduce exposure to Eurozone riskWithin global equities we favor an overweight position on Fig. 12: Equity regionsthe US, Emerging Markets, and the UK. Our largest under- Tactical deviations from benchmark, incl. view on currency.weight is in the Eurozone, and we are also underweight Ja- USpan and other non-US developed markets. While Eurozoneequities are trading on attractive valuations after their re- Emerging Marketscent underperformance, the ongoing sovereign debt crisis UKand stress in the financial system raises red flags. Within in- Japanternational fixed income we view US and non-US bonds asequally attractive. While the dollar is extremely weak Other Developedagainst many other currencies, prospects for a rebound ap- Eurozonepear limited due to the Fed’s loose monetary policy. ––– –– – n + ++ +++ underweight overweightUS equities relatively expensive but carry less riskComparing price-earnings ratios across regions, the US now ap- Source: UBS WMR, as of 31 August 2011. Scale explained in Ap-pears to be one of the most expensive markets (see Fig. 13). How- pendix.ever, there are some factors which favor the US versus non-USequities. One is the solid earnings achieved by US companies sofar this year despite the soft economic backdrop. Another consid- Fig. 13: Regional equity PE ratios below normaleration is that the dollar has sunk to record or near-record levels 12-month forward Price-Earnings Ratiosagainst many currencies. This makes other markets seem more 20expensive in dollar terms, and raises the risk of exchange ratelosses should the dollar rebound to more normal levels. In our 15view, for dollar-based investors, US equities look relatively attrac- 10 12.5 11.8 11.9 11.6tive to non-US equities on a risk-adjusted basis. 10.1 8.5 9.0 10.6 9.4 10.9 5Overweight Emerging Markets and UK equities 0We maintain an overweight recommendation on both emerging ld d a v e da n EM US UK on de ali an pa or na str erl W roz Ja US Ca Au itzmarkets (EM) and the UK, which share several positive characteris- Eu n- Sw Notics. Given the political problems being caused by government Current PE Average PE (since 1990)debt in the US and Eurozone, the relatively healthy state of public Note: For Japan, average PE since 1990 is 30.finances in EM is an advantage. While the UK has higher debt Source: Datastream, IBES, UBS WMR, as of 30 August 2011levels, it has already passed austerity measures that should help torestrain debt issuance in the medium term. EM and the UK alsolook relatively good in terms of exchange rates versus the dollar.Intervention has helped to hold down the value of many emerg- Fig. 14: Eurozone equities have slumped in 3Qing market currencies, while the pound appears to have relatively Equity market returns, in USD and percentlittle downside risk against the dollar. Both EM and the UK trade Worldat a substantial valuation discount to global equity markets. An USadditional positive for the UK is its dividend yield of more than Eurozone Japan3%, which is attractive relative to the low yields being offered in UKbond markets. Canada AustraliaUnderweight other non-US developed equity markets SwitzerlandWe maintain an underweight recommendation on the Eurozone, -25 -20 -15 -10 -5 0Japan, and “other” developed markets (“other” includes Austra- Year-to-date Quarter-to-datelia, Canada, and Switzerland). Source: Bloomberg, UBS WMR, as of 30 August 2011 Investment Strategy Guide 14
  15. 15. International MarketsWhile the Eurozone trades on valuations that seem very attractive, Fig. 15: Pound not expensive versus US dollarthe ongoing sovereign debt crisis represents a tail risk that is too Real effective exchange rates, index 2000 = 100large to ignore. Even if there is not a full-blown catastrophe 180caused by an uncontrolled default in peripheral Europe, the con- 160stant threat of negative headlines in the months and years aheadmay continue to weigh on the market. Therefore in our 19 Au- 140gust update we made the Eurozone our largest underweight posi- 120tion. 100 80In Japan, the recovery from the devastating earthquake in March 60has been quicker than the market expected, making it one of the 2000 2002 2004 2006 2008 2010few countries offering positive economic surprises. This has US dollar British pound Swiss Franc Australian dollarhelped Japanese equities fall by less than most other markets dur- Source: JPMorgan, Bloomberg, UBS WMR, as of 31 August 2011ing the recent downturn. The market is also trading well below itshistorical valuations. However, it still looks expensive relative toother markets. Japan has severe public debt challenges of its own,and has the least growth potential among the major markets. We Fig. 16: Bond regionstherefore maintain an underweight position. Tactical deviations from benchmark, incl. view on currency.Among the other developed equity markets, we see relatively UKpoor investment prospects. Canadian valuations appear expen-sive. Both Australia and Switzerland have severely overvalued cur- Otherrencies which add substantial risk for dollar-based investors. We UScontinue to recommend an underweight position in these mar-kets. EurozoneLimited opportunities in international Fixed Income JapanWithin fixed income we remain neutral on the US versus non-US. ––– –– – n + ++ +++Although US fixed income yields are at historically low levels, we underweight overweightdo not see much better value in international markets, whereyields are also generally lower than normal. Dollar fundamentals Note: Arrows indicate changes adopted in this report.remain poor. The US is running twin current account and budget Source: UBS WMR, as of 31 August 2011. Scale explained in Ap-deficits, and the Fed is likely to keep rates near zero for at least pendix.another 2 years. However, we see limited room for the dollar to See appendix for detailed asset allocations. See explanations in the Appendix regarding the interpretation of the suggested tacticalweaken further from its current low levels against most other cur- deviations and the procedure for combining asset class and countryrencies. One exception is the pound, which appears reasonably allocations.priced against the dollar, and we recommend an overweight onthe UK. Japan is one of our least favorite bond markets, offeringthe combination of extremely low yields, extremely poor publicfinances and an over-valued currency. We have also moved to anunderweight on Eurozone fixed income, favoring the non-eurocountries in Europe that have relatively strong fundamentals.Brian Rose, PhD, Strategist, UBS FS Inc.Stephen R. Freedman, PhD, CFA, Strategist, UBS FS Inc. Investment Strategy Guide 15
  16. 16. US Equities: Size, style and REITsDowngrading cyclical riskDecelerating earnings growth and rising economic risks ar- Fig. 17: Tech and Consumer Staples offer bestgue for greater exposure to secular, rather than cyclical secular growthgrowth segments. Despite the strong relative outperfor- Tactical deviations from benchmarkmance by defensive sectors in August, higher dividend Technology Consumer Staplesyields and lower earnings risk is increasingly appealing in HealthCarethe current market environment. Financials Industrials EnergyA balancing act – upgrading high dividend payers UtilitiesWith the Fed likely to keep short-term interest rates pinned near Telecomzero for the next two years, higher yielding, lower risk segments Materials Cons Discretionaryof the equity market are increasingly attractive due to their rela- ––– –– – n + ++ ++tive yield advantages to fixed income alternatives. Regulated utili- underweight overweightties offer dividend yields ranging from 3-5% and steady, predict- Note: Arrows indicate changes adopted in this earnings. Telecoms high dividend yields also hold appeal, Source: UBS WMR, as of 31 August 2011.however, payout ratios for the largest telecom companies (which See explanations in the Appendix regarding the interpretation of thedominate the index) are fairly high, implying limited future divi- suggested tactical deviations from benchmark.dend growth. Our prior underweights in these sectors were predi-cated on both an expectation for higher interest rates, whichclearly did not develop, and expensive valuations. As such, weupgrade Utilities to neutral from underweight and reduce our Fig. 18: Defensive sectors receive a boost from Chairman Bernankeunderweight in Telecom to 1 percentage point from 2.5 previ- Current dividend yield by S&P 500 sector and 10-year Treasuryously. yield 6% 5.5%Still prefer Consumer Staples among defensives 5% 4.3%We continue to favor Consumer Staples among defensives. Con- 4% 3.0% 3% 2.4% 2.2% 2.2% 2.1% 2.1%sumer Staples offer attractive dividend yields and a healthy com- 1.7% 2% 1.1%bination of earnings and dividend growth via strong brands and 1%emerging market consumer exposure. We downgrade Healthcare 0% Industrials Consumer 10-year bond Technology Discretionary Telecom Health Care Utilities S&P 500 Materialsto neutral. While Healthcare is the cheapest defensive sector, we Consumer Stapleshave less conviction in the sector’s near-term performance givenuncertainty over potential government spending cuts—the Defensives CyclicalsBudget Control Act would trigger automatic 2% across-the-boardcuts to Medicare should the new Joint Select Committee not Source: FactSet and UBS WMR, as of 29 August 2011reach an agreement to reduce the deficit by $1.5 trillion.Still like Tech, but downgrading Materials and FinancialsTech remains unchanged as our most preferred sector, but we arereducing Materials to underweight from neutral due to slowerprojected global economic growth, lower commodity price fore-casts and poor recent earnings revision trends. We also move allsub-sectors within Financials to neutral. Despite very low valua-tions, elevated signs of stress in European (and to a lesser degreein US) funding markets, lower economic growth and high earn-ings risk make a recovery in this beaten-down sector less likely.Jeremy Zirin, CFA, Strategist, UBS FS Inc. Investment Strategy Guide 16
  17. 17. US Equities: Size & Style, REITsGrowth stocks still offer the best valueWe remain strongly in favor of growth over value stocks. Fig. 19: We continue to prefer Growth over ValueWeaker economic growth and lower stock market return Size, style, and REITs recommended allocation, deviation fromexpectations led us to downgrade small- and mid-caps back benchmarkto neutral on August 19. We also raised REITs to neutral at Large-Cap Growththat time as interest rates are now likely to be “lower forlonger”, supporting REIT’s high current valuations. Small-Cap Mid-CapA neutral stance between large, mid and smallWithin US equities, we closed our preference for small-caps over REITslarge-caps on August 19. Despite fairly high valuations relative to Large-Cap Valuelarge-caps, our preference for small- and mid-cap companies was ––– –– – n + ++ ++based on our view that smaller companies stood to benefit more underweight overweightfrom both a pickup in domestic economic activity and to overall Note: Arrows indicate changes adopted in this report.stock market movements, i.e. to outperform in rising and under- Source: UBS WMR, as of 31 August 2011.perform in falling markets. Acknowledging a more mixed outlook See explanations in the Appendix regarding the interpretation of thefor both economic growth and equity markets, we believe a neu- suggested tactical deviations from benchmark.tral stance is currently warranted. We would caution against be-coming overly bearish on smaller size segments. Small- and mid-caps should still benefit from improvements in M&A activity as Fig. 20: Technology to continue to drive growthlarger companies with strong balance sheets look to “buy Relative performance of Russell 1000 Growth vs. Russell 1000growth” rather than expand capacity in a slower growth world. Value and S&P Tech vs. S&P Financials 180 500Growth over value remains a high conviction call 160 400As market turbulence has increased, so has the strong relative 140 300performance of growth stocks over value stocks. One reason forthe stronger relative performance is due to sector tilts. Specifi- 120 200cally, Technology stocks (growth) have outperformed Financials 100 100(value) by over 6 percentage points since the end of the second 80 0quarter. More broadly, a slow growth and low interest rate envi- 60 -100ronment is an attractive cocktail for growth stocks. Slowing cycli- 1993 1997 2001 2005 2009 2013 Growth vs. Value (lhs) IT vs. Fin (rhs)cal growth increases the scarcity value of secular growers whilelow interest rates means that longer duration cash flows are dis- Source: Bloomberg, Russell Investment Group and UBS WMR, as ofcounted back at lower rates, increasing their value. With growth 29 August, 2011stocks trading at a very small valuation premium to value relativeto history, we remain overweight growth.Lower for longer interest rates a big plus for REITsOn August 19, we also decided to remove our moderate under-weight to REITs. The Federal Reserve’s “pledge” to leave the fed-eral funds rate at its current low target level thorough mid-2013is positive for the interest-rate sensitive REIT industry. Large-cap,higher quality REITs should benefit from both lower funding costs(boosting capitalization rates) and from additional fund flowsfrom investors seeking high relative dividend yields.Jeremy Zirin, CFA, Strategist, UBS FS Inc. Investment Strategy Guide 17
  18. 18. US Fixed IncomeReconfiguring the playbookEconomic growth has slowed to stall speed, raising the pos- Fig. 21: US dollar taxable fixed income (TFI) strat-sibility of recession. At the same time, the sovereign debt egycrisis is negatively affecting perceptions of the credit qual- Tactical deviations from benchmarkity of European banks. Against this challenging backdrop, Treasurieswe believe a less aggressive position is in order when it TIPScomes to credit-sensitive sectors. Within credit, we recom-mend pairing back exposure to dollar denominated sover- Agencieseign debt in the emerging markets. We also maintain a Mortgagesneutral allocation to high yield and preferreds, which arehigh beta credit sectors. Inv. Grade Corporates High Yield CorporatesThroughout much of this year, our fixed income recommenda-tions have largely favored corporate credit, including investment Preferred Securitiesgrade (IG) and high yield (HY) corporate bonds that we believed Emerg. Marketwould likely continue to deliver positive excess returns over Treas-uries in most scenarios. One scenario where corporate credit TFI non-Creditcould underperform would be if market events were to spark TFI Creditstrong selling across all risk assets. Although this was not our base ––– –– – n + ++ +++case outlook, this was exactly what transpired in August as a clas-sic credit market selloff ensued. underweight overweight Note: Arrows indicate changes adopted in this report.The reaction from the credit segments of the bond market was Source: UBS WMR, as of 31 August 2011. Scale explained in Ap-largely a reflection of the degree of credit risk each sector exhib- pendix. See the appendix for a detailed asset allocation illustrationits. In the IG market, credit spreads, as measured by the Barclay’s in the context of a moderate-risk taxable US dollar fixed incomeCorporate Index, widened from 150 basis points (bps) to 215bps, portfolio. See explanations in the Appendix regarding the interpreta-an enormous move for IG. The widening was led by Financials, tion of the suggested tactical deviations from benchmark.which gapped out by nearly 100bps, while Industrials and Utilities Fig. 22: US interest rate forecasts, in %were roughly 45bps and 35bps wider, respectively. However, in 6 in 12lower Treasury yields helped to cushion the blow and yields on IG 30-Aug. in 3 months months monthsmoved only modestly higher. The yield-to-worst (YTW) of the in- 3-month LIBOR 0.33 0.30 0.30 0.30dex increased from 3.5% to 3.7% and IG total returns were 2-year Treasury 0.19 0.30 0.50 0.60mostly flat for the month. 5-year Treasury 0.92 1.00 1.55 1.80We continue to believe that the direction of IG credit spreads will 10-year Treasury 2.18 2.30 2.75 3.00largely be a function of moves in rates and that spreads will re- 30-year Treasury 3.52 3.80 4.05 4.30main at the wider end of recent ranges should lower Treasury Source: Bloomberg, UBS WMR, as of 30 August 2011rates persist, as we expect. Nonetheless, at current spread levels,we believe IG valuations are attractive. Spreads remain well abovetheir pre-crisis average of 130bps despite the strong fundamentalshape of the corporate sector. We therefore increase our IG tac-tical weighting from +1% to +2% this month, making it our larg-est credit segment overweight. We believe IG offers the best up-side/downside qualities in different possible market environments.Should the economy turn out weaker then we expect, any widen-ing of IG spreads will likely be lower than what HY, EM andpreferreds may experience. However, should the economy mud- Investment Strategy Guide 18
  19. 19. US Fixed Incomedle through and investor risk taking resume, we believe IG will Fig. 23: TIPS cumulative excess returns are influ-also likely perform well on a relative basis. enced by the direction of breakeven inflation Excess return on TIPS versus nominal Treasuries, in %Moving down into riskier credit sectors, we observed much higher 5.00 2.7spread volatility in HY and preferreds. HY spreads gapped from 4.00 2.6 2.5540bps at the beginning of August to 736bps and the YTW of 3.00 2.4the Barclay’s HY Index increased from 7.15% to 8.8%. Preferreds 2.00 2.3exhibited a similar trend as thin trading conditions and investor 1.00 2.2risk aversion towards Financials contributed to a highly volatile 0.00 2.1and choppy trading environment as the sector exhibited intra- -1.00 2.0month price swings of nearly 10%. Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Tips excess return vs Treasuries (left) 10-yr breakeven rate (right)After being overweight HY and Preferreds since the beginning of Source: BofAML, Bloomberg, UBS WMR, as of 29 August 2011the year, we moved to a neutral allocation on 19 August to re-flect WMR’s more cautious view on risk assets stemming fromcontinued financial stress in the Eurozone and higher risk of a USrecession. Valuations of HY bond spreads are attractive relative to Fig. 24: Duration recommendationthe low level of forecasted corporate default rates over the next Duration deviation from benchmark, in yearsyear. However, we believe economic uncertainty will keep HYspreads elevated in the near-term and we continue to observe a previousvery high correlation between HY spreads and equities. Similarly, newwe believe the heightened focus on US and European banks’ sov-ereign exposures and funding availability will continue to cause a -1.5 -1.0 -0.5 +0.0 +0.5 +1.0 +1.5volatile trading environment for preferreds that will resemble eq- short neutral longuity-like price swings. Source: UBS WMR, as of 31 August 2011Adopt a neutral allocation to emerging marketsFinally, this month we also reduce our EM allocation to neutralfrom +1%. We established an overweight position last month Fig. 25: Preferred price change year-to-datebased on the improving fundamentals of many EM sovereigns, In %which we believe could lead to positive ratings actions relative to 10developed markets. While our positive fundamental view on EM 5hasn’t changed, we don’t expect EM to perform as well as it did 0in August should risk aversion pick-up again. Despite relatively -5strong fundamentals in most emerging market countries, manag- -10ers of foreign bond funds have reported USD 506 million in out- -15 -20flows over the last four weeks, as investors continue to shun risk- Dec-31 Jan-31 Feb-28 Mar-31 Apr-30 May-31 Jun-30 Jul-31 Aug-31ier asset classes. Although supply is expected to be limited (the REIT Preferreds Trust Preferreds Non-US QDIconsensus view is for negative net sovereign bond issuance DRD-Eligible Floating-Ratethrough year end), we are concerned about the lack of a credible Source: Bloomberg, UBS WMR, as of 30 August 2011solution to Europe’s ongoing debt crisis. We see significant po-tential for additional negative spillover effect to lower rated cred-its, and note that approximately 50% of the countries in mostbroadly followed emerging market indices are rated below in-vestment grade. Economic growth in emerging market countriesis likely to outstrip that of developed market countries, but wedoubt this will matter to risk adverse investors. Investment Strategy Guide 19
  20. 20. US Fixed IncomeSlower growth, sovereign debt fears should anchor yields Fig. 26: Financials sector bonds trade at a discountOn 16 August, we lowered our Treasury yield forecasts. The to Industrialschange was predicated on several developments. First, the FOMC Credit spreads, in basis pointsindicated at the 9 August meeting that it intends to hold the tar- 800 700get fed funds rate at zero to 25bps until mid-2013. We believe 600this policy change will shift the interest rate path downward and 500will keep Treasury yields lower for longer. In addition, the soft 400patch in the first half looks to be more persistent than we origi- 300 200nally believed, as the recent batch of economic data suggest. As a 100result, we believe the odds of recession have increased. Finally, 0we view the ongoing Eurozone sovereign debt crisis with concern. 2006 2007 2008 2009 2010 2011The inability of the political establishment to tackle the debt crisis Industrials Financialshas eroded investor confidence and contagion appears to be Source: Barclays Capital, UBS WMR, as of 26 August 2011spreading. Thus, the Treasury market should continue to benefitfrom flight-to-quality flows during periods when the sovereigndebt concerns flair. Against this backdrop, we continue to rec- Fig. 27: EM spread differentials edging widerommend investors maintain a neutral duration allocation. Credit spreads, EM debt and similarly rated US corporates, in basis pointsSharp Treasury gains send M/T ratios higher 1,200Earlier this month, exceedingly strong out-performance of Treas- 1,000ury securities drove AAA muni-to-Treasury (M/T) ratios to levels 800over 110% all along the curve. At these levels, municipals were 600attractive enough to draw crossover buyers. On 9 August, ratios 400at the 5-year, 10-year and 30-year maturity points stood at 200114.9%, 113.3% and 112.3%, respectively, before moving 0lower. A sharp change in Treasury yields—and not municipal 2001 2004 2007 2010yields—was the key driver behind volatility in the ratios. Although All EM EM IG IG corporatesabsolute muni yields are now at historic lows at most segments of Note: IG= Investment Gradethe curve, we believe munis offer value on a relative basis to Source: Barclays Capital, as of 29 August 2011Treasuries. Presently, AAA tax-exempt muni yields are still at orabove 100% all along the curve, with the exception of the 5-yearspot, which stands at 93.8%, while the 10-year and 30-year ratiostands at 103.6% and 109.6% respectively. We look for new is- Fig. 28: Municipal Yields and Ratio to Treasurysue volume to increase modestly in the fourth quarter, pressuring Yield in %yields slightly higher as is consistent with historical trends and 6 120when there is a rise in supply. That said, we are not looking for a 5 110repeat of the sharp rise in yields that occurred in the last three Yield Ratio 4 100months of 2010, which was due in large part to a surge in supply. 3 90Any sell-off in the Treasury bond market would likely negatively 2 80impact municipal bond values but the continued outlook for slow Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11economic growth, increased recession risk and the Eurozone debt AAA GO 10 yr Yieldscrisis should lend a flight-to-quality bid and temper a material rise AAA GO 30yr Yields Yield Ratio 10yr AAA GO to Treasuryin Treasury rates. Yield Ratio 30yr AAA GO to Treasury Note: GO stands for General ObligationAnne Briglia, CFA, Strategist, UBS FS Inc. Source: MMD, UBS WMR, as of 25 August 2011Barry McAlinden, CFA, Strategist, UBS FS Inc.Kathleen McNamara, CFA, CFP, Strategist, UBS FS Inc.Donald McLauchlan, Credit Analyst, UBS FS Inc. Investment Strategy Guide 20