1. Wealth Management Research
Monthly Market Outlook
28 August 2009
This report has been prepared by UBS Financial Services Inc. (“UBS FS”).
2. Summary: Monthly Market Outlook
Investment
Economics Equities Fixed Income
Strategy
We reiterate our On the backdrop of Reasonable While we continue
view of a cyclical our anticipation of a valuations and to like corporate
growth recovery global economic cyclical and municipal
starting in 3Q09, recovery, we improvement should bonds, valuation is
followed by a continue to support further not as compelling.
moderate structural recommend that gains. Add TIPS
recovery. investors tilt their
Q2 S&P 500 earnings opportunistically.
We don’t expect a portfolios toward While inflation is
have handily
strong business fixed riskier asset classes, not a near-term
exceeded consensus
investment recovery regions and sectors. concern, the risk of
expectations, driving
as capacity utilization We still favor recent market rally. a policy mistake is
is very low, equities and high.
consumption growth commodities over Tight cost controls
Industrials rated
will likely be only fixed income and drove 2Q09 earnings
BBB and
moderate and the cash. beats, revenues to
systemically
cost of capital is pick up as economy
Our expectations of important
high. turns during 2H09
continued dollar Financials offer
The core CPI through 2010. additional income.
weakness supports
disinflation cycle will our thesis for Small-cap Use non-Financials
continue further preferring non- as a core holding.
fundamentals
until around mid- dollar-denominated remain challenged, In agencies, we
2010. Headline CPI assets. We have earnings estimates prefer callables to
inflation is poised to strengthened our continue to fall. bullets, where
rise out of negative tilt toward non-US spreads are tight.
territory but not developed equities Sector strategy is
accelerate over US equities. We geared towards
threateningly. still like emerging cyclical, globally-
market equities. focused sectors.
ab3 1
3. Economics
US Cyclical Recovery on Track
Cyclical recovery in 2H09 followed by moderate structural recovery
in 2010.
8 % q/q annualized
UBS WMR As expected, 2Q09 real
6 forecasts GDP showed clear
recession abatement,
4 contracting by 1% q/q
2 annualized after a
downward revised drop
0 of 6.4% in 1Q09.
-2 We reiterate our view of
a cyclical growth recovery
-4 starting in 3Q09, followed
-6 by a moderate structural
recovery in 2010.
-8
We revised higher our
-10 real GDP growth forecast
-12 from +2.5% to +3.5% q/q
annualized in 3Q09 and
Q2 2004 Q2 2005 Q2 2006 Q2 2007 Q2 2008 Q2 2009 from +2.2% to +3% in
Consumption Investment in nonresidential structures 4Q09. However, we keep
our 2010 forecast of +2%
Investment in equipment & software Residential investment
and expect moderating
Inventories Net exports
growth throughout 2010.
Government Real GDP (% q/q annualized)
Source: Thomson Datastream, UBS WMR
ab3 2
4. Economics
Vigorous US Investment Cycle?
A strong investment recovery is unlikely without a strong
consumer recovery.
95 Capacity utilization in the
% industrial and the
90 manufacturing sector just
rebounded in July, but
remains extremely
85
depressed.
80 Businesses can
reincorporate ample idle
75 capacity into their
production processes
70 before having a need to
invest vigorously in new
65 production capacity.
Additionally, the prospect
60 of a moderate consumer
recovery and the higher
Jan-67 Jan-77 Jan-87 Jan-97 Jan-07 cost of capital will likely
make companies wary of
Industrial capacity utilization committing too many
Industrial capacity utilization (historical average) resources to new
Manufacturing capacity utilization production capacity.
Manufacturing capacity utilization (historical average)
Source: Thomson Datastream, UBS WMR
ab3 3
5. Economics
Vigorous US Investment Cycle?
Investment shares are not particularly far away from long-term
averages.
11 in % of GDP The share of investment in
10 equipment and software in
GDP is below its long-term
9 average, but the share of
8 investment in non-residential
structures in GDP is in line
7 with its long-term average.
6 The share of investment in
5 equipment and software in
GDP is sufficiently low to
4 speak for a pick up in
3 investment spending in this
category. However, other
2 factors (low capacity
utilization, tepid consumer
Q1 1950 Q1 1960 Q1 1970 Q1 1980 Q1 1990 Q1 2000
recovery, high cost of
Nominal investment in equipment and software capital) are massive
Nominal investment in equipment and software (historical average) headwinds that will likely
Nominal investment in non-residential structures keep the investment
Nominal investment in non-residential structures (historical average) recovery muted.
Real investment in equipment and software
Real investment in non-residential structures
Source: Thomson Datastream, UBS WMR
ab3 4
6. Economics
US Inflation Outlook
Core CPI disinflation cycle to continue.
6 % y/y UBS Core CPI inflation has
WMR
continued to trend lower
5 forecasts
recently. We reiterate our
view that core CPI inflation
4 will moderate further and
will likely dip below +1%
3 y/y in mid-2010. A
moderate increase to
2 +1.2% by year-end 2010
will likely follow.
1
Headline CPI inflation has
likely reached its nadir and
0 is poised to rise going
forward. We expect it to
-1 reach +1.5% y/y by year-
end 2009 and +2.4% y/y by
-2 year-end 2010.
-3
Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08
CPI Core CPI
Source: Thomson Datastream, UBS WMR
ab3 5
7. Investment Strategy
Recent Financial Market Performance
As of 25 August 2009, in US dollars
The S&P 500 continues to rally,
now up approximately 56% from
17.2%
US Equities 4.4%
trough to peak since Mar ‘09.
During that time the market has
26.1% yet to correct more than 10% on
Non-US Developed Equities 5.0% 54.5% any given pullback. Although
some form of correction appears
Emerging Markets Equities 1.9% possible in the near term, we still
4.2% believe that a sustainable
US Fixed Income 0.7% recovery is underway.
5.6%
Non-US Fixed Income 1.6% The dollar has continued to slide,
helping non-US stocks and bonds
0.1%
Cash 0.0%
outperform dollar assets.
8.4% Emerging markets equities
Commodities 0.4% continue to outperform their
developed country counterparts
YTD, however they have
-10% 10% 30% 50% generally underperformed over
year-to-date month-to-date the last month..
Commodities Commodity prices
are still 48% below their peak,
Source: Bloomberg: Russell for US equities, MSCI for foreign equities, Barclays indexes for fixed
and broadly at 2003 levels,
income, DJ UBS for commodities.
however Valuations are starting
to appear slightly expensive vs.
marginal costs of production .
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8. Investment Strategy
Tilt toward Equities and Commodities
Tactical deviations from benchmark, in %
We maintain our
moderate overweight in
Equity
global equities, as we
expect them to
outperform fixed income
and cash over a 9-12
Fixed Income
months.
Equity valuations remain
attractive, though clearly
less so than in the spring.
Cash
We believe that equities
should continue to benefit
given clear signs of cyclical
recovery.
Commodities
In addition, there remains
significant cash on the
sidelines, which could
-10 -8 -6 -4 -2 +0 +2 +4 +6 +8 +10 continue to enter equity
markets.
Source: UBS WMR
ab3 7
9. Investment Strategy
Global equities
Equity valuation is still attractive
Our Dividend Discount
Model indicates a 7%
upside to global
equities, even under
fairly conservative
estimates of the
earnings level and
medium-term real
earnings growth.
Other valuation metrics
also suggest
moderately attractive
value. The Equity Risk
Premium remains
abnormally high,
suggesting that
equities offer better
value than high grade
bonds.
Source: Reuters Ecowin, WMR
ab3 8
10. Investment Strategy
Recovery supportive of Equities
Average pattern around market bottoms: Since mid-1960s
160 65
The phase of the cycle that we
150 believe we are now in is
We believe we are here 60 typically supportive for equity
market returns.
140
Although the market has
55 already rallied substantially
130
from its March bottom, equity
markets typically outperform
120 fixed income and cash for more
50
protracted periods than a
110 quarter following a trough in
the economy.
45
100
90 40
-24 -20 -16 -12 -8 -4 0 4 8 12 16 20 24 28 32 36
S&P 500 Trailling real earnings ISM (right scale)
In the above chart, the S&P 500 is indexed to 100 at t=0, which is market lows around the
average bear market since 1964. The chart indicates equity prices bottom first, then the ISM,
and finally real earnings
Source: Thomson Financial, Bloomberg, WMR
ab3 9
11. Investment Strategy
Dollar to remain under pressure
Inverse relation to equity market performance
We expect the dollar to
110 230 depreciate against
105 210 most currencies during
the rest of the year.
100 190 The magnitude of US
170 monetary and fiscal
95 policy initiatives will, in
150 our view, put the US
90 dollar under pressure.
130
85 The Fed’s low rate
110 policy has made the
80 90 dollar a funding
currency for so called
75 70 “carry trades.” This
will contribute to
downward pressure on
70 50 the greenback
00 01 02 03 04 05 06 07 08 09 Our bearish view on the
dollar is the main
US dollar nominal effective exchange rate (LHS) reason why we hold a
Carry trade index (RHS) preference for non-US
equities over US
Source: Bloomberg and UBS WMR equities and a
preference for foreign
bonds over US bonds.
ab3 10
12. Investment Strategy
International Equities
Equity Valuations – 12 month forward P/E Ratios
We prefer Emerging
20.0 Market equities as well as
non-US developed
18.0 26.8 equities to US stocks.
16.0 14.6 14.5 14.6 Mounting evidence of a
14.0 12.0 12.1 12.8 global recovery should
continue to benefit EM
12.0 equities in relative terms
10.0 even though their
valuations has become
8.0 less attractive.
6.0
Within non-US developed
4.0 markets our preference is
2.0 for the Eurozone.
Valuations there are
0.0 attractive and economic
indicators, which are
surprising to the upside,
UK
US
ld
n
e
ed
ts
n
pa
ke
or
signal that a recovery is
zo
op
Ja
W
ar
underway.
ro
el
M
v
Eu
de
gn
S
gi
-U
er
n
Em
No
Source: IBES, UBS WMR
ab3 11
13. Investment Strategy
Commodities
Further upside potential for commodities
Commodities have pulled
back somewhat in Aug,
80 15 but are still up year-to-
date on a total return
60 basis. They are also
10 trading roughly 48% off
of their 2008 peak.
40
We believe that the
5
20 cyclical recovery should
prove supportive for
commodities during the
0 0 next 12 months.
Global demand for
-20
-5 commodities is likely to
improve as the global
-40 Commodities (S&P GSCI, 12-month total return economy returns to
in % and USD) -10 positive growth. In
-60 OECD leading indicators (6-month change particular, a growth
annualized in %) recovery in Emerging
-80 -15 Market countries should
be supportive.
82 84 86 88 90 92 94 96 98 00 02 04 06 08
We believe that, on
average, commodities are
Source: Bloomberg, UBS WMR trading slightly above
their marginal costs of
production. They are no
longer very cheap on this
measure.
ab3 12
14. Equities
US Equity Strategy
Cost cutting drove Q2 earnings to exceed expectations
Tight cost controls helped drive
80% over 2/3 of the S&P 500 to beat
68% 2Q09.
70%
Top-line growth should improve
60% in the second half of 2009 and
50% 2010 as nominal GDP rebounds.
50%
40%
30%
20%
10%
0%
2Q09 earnings 2Q09 revenues
% of S&P 500 companies beating consensus estimates
Source: FactSet and UBS WMR
ab3 13
15. Equities
US Equity Strategy
Market gains have been fundamentally driven
2Q09 earnings season has been
1050 $16.50 unambiguously positive relative to
low expectations, coming in 15%
$16.00 higher than expected. Recent
1000
$15.50 market rally driven by improving
fundamentals.
950 $15.00
$14.50
900 $14.00
$13.50
850
$13.00
800 $12.50
Jul 2009 Aug 2009 Sep 2009
S&P 500 (LHS) 2Q09 S&P 500 EPS (RHS)
Source: FactSet and UBS WMR
ab3 14
16. Equities
US Equity Strategy
Valuations are fair, cyclical environment continues to improve
45 Valuations have increased, but
remain below-average.
40 Combination of reasonable
Average P/E 16.0x valuations and cyclical
35 improvement should support
Current P/E 14.4x
30 further equity market gains.
25
20
15
10
5
0
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
S&P 500 P/E on 10-year average of real operating EPS
Source: S&P, Thomson Financial and UBS WMR
ab3 15
17. Equities
US Equity Strategy
Small-cap fundamentals remain challenged
Large-cap S&P 500 earnings
$50 $120 estimates have stabilized, small-
caps (Russell 2000) estimates
continue to fall.
$40 $100
Fundamentals for small-caps
$80 remain challenged relative to
$30 large-caps: expensive relative
valuations, lack of international
$60 exposure, difficulty in attaining
$20 favorable financing, greater
$40 exposure to credit losses.
$10 $20
$0 $0
Mar 2008 Jul 2008 Nov 2008 Mar 2009 Jul 2009 Nov 2009
Russell 2000 consensus 2009 EPS estimates (LHS)
S&P 500 consensus 2009 EPS estimates (RHS)
Source: FactSet and UBS WMR
ab3 16
18. Equities
US Equity Strategy
WMR US Sector Strategy - Pro-cyclical, Pro-Global
Energy We continue to favor US sectors
that should benefit from
Technology Deviation from continued improvement in the
Benchmark domestic economy, stronger
Industrials growth trends in emerging
markets, rising commodity
Materials prices and a weakening US
dollar.
Consumer Disc
Consumer Staples
Financials
Telecom
Utilities
Health Care
underweight neutral overweight
Source: Bloomberg and UBS WMR
ab3 17
19. Fixed Income
US Duration Strategy
Real, nominal, and break even yields
6.0 We recommend investors
retain a duration
US 10 Year Breakeven Inflation US 10 Year Real Yield US 10 Year Nominal Yield
underweight (-0.5 years).
5.0
Real yields and inflation
expectations should
continue to normalize, as
4.0
the global economy
stabilizes and on fears
that an imperfect exit
3.0
strategy for quantitative
easing will lead to higher
inflation.
2.0
If inflation overshoots
the Fed’s target over the
1.0 next 3 to 5 years,
Treasury yields look
expensive.
0.0
Heavy supply, a reversal
May-07
Nov-07
Feb-07
Aug-07
May-08
Nov-08
Feb-08
Aug-08
May-09
Feb-09
Aug-09
of the flight-to-quality-
bid, and uncertain
demand from overseas
Source: Bloomberg, UBS WMR as of 27 August 2009 investors should also
pressure yields higher.
ab3 18
20. Fixed Income
US Fixed Income Strategy
Rate development and WMR forecast
8.0%
WMR
7.0% forecast US interest rate forecasts (%)
US interest rate forecasts (%)
6.0% In 3 In 6 In 12
27 June
17 Aug
month month month
5.0%
3-m
4.0% 0.36
0.61 0.40 0.30 0.30
LIBOR
3.0% 2-year 1.05 1.90 1.70 2.60
2.0% 5-year 2.48 3.10 2.60 3.50
1.0%
10-year 3.46 4.00 3.50 4.25
0.0%
30-year 4.23 4.80 4.30 5.00
Aug-99
Aug-00
Aug-01
Aug-02
Aug-03
Aug-04
Aug-05
Aug-06
Aug-07
Aug-08
Aug-09
Aug-10
2 year yield 10 year yield
Source: Bloomberg, UBS WMR, as of 27 August 2009
ab3 19
21. Fixed Income
US Fixed Income Strategy
Strong rally has sapped much of the valued from corporates
We continue to favor
900 Industrials Investment Grade
corporate bonds over
800 Financials other Fixed Income
700 segments, though much
Industrials - Prior Max of the value has been
600 eroded given the strong
500 Financials - Prior Max rally this year.
Corporate bonds have
400 YTD total returns of over
14% with Industrials and
300 Utilities outperforming
200 Financials by 300bps and
650bps respectively.
100
From a valuation
0 perspective, Financials
appear to be the most
Aug-99
Aug-00
Aug-01
Aug-02
Aug-03
Aug-04
Aug-05
Aug-06
Aug-07
Aug-08
Aug-09
attractive segment as
non-Financials now trade
inside of historic
recessionary levels.
Sources: Moody's, Barclays Capital, UBS WMR, 27 August 2009
ab3 20
22. Fixed Income
US Fixed Income Strategy
Investment grade credit spreads
Within the non-Financial space,
900 BBB Index we continue to recommend
800 AA / A Composite Index
adding investment grade bonds
rated ‘BBB’. Despite compressing
700 Difference over the past few months, a
600 Average Difference spread differential of 130bps
remains. This differential
500 continues to be well above
400 historical levels.
300 ‘BBB’s offer an effective way to
increase yield while only
200 moderately increasing credit risk.
100 Should credit spreads continue
0 to tighten as we forecast, bonds
rated ‘BBB’ are likely to benefit
(100)
disproportionately and
Aug-99
Aug-00
Aug-01
Aug-02
Aug-03
Aug-04
Aug-05
Aug-06
Aug-07
Aug-08
Aug-09
demonstrate the highest total
returns.
Source: Barclays Capital, UBS WMR, 27 August 2009
ab3 21
23. Fixed Income
US Fixed Income Strategy
Muni ‘A’ revenue and ‘AAA’ GO yield curves (%)
A significant imbalance
between supply and
6.0 AAA GO A Electric
demand continues to help
drive positive performance
5.0 in the tax-exempt market,
with a year-to-date total
4.0
return near 10%.
Despite the market’s run
3.0 up, we see value in munis,
particularly for high-net
2.0
worth investors.
Yield on ‘A’ rated essential
1.0 purpose revenue bonds in
the 7 to 12 year area range
0.0
from 3.53% to 4.48%
translating into taxable
equivalent yields of 5.43%
1 2 3 4 4 6 67 78 89101112131415161718192021222324252627282930
2 3
5 9 111213 26272829
to 6.89% assuming the
current 35% top federal
tax bracket.
Source: MMD Interactive, UBS WMR, as of 27 August 2009
ab3 22
24. Fixed Income
US Fixed Income Strategy
The agency spread curve is very steep
2-year bullet agencies
are very tight from an
75 historical perspective.
65
The credit spread
55 between 2 and 10-year
45 agencies is 43bps, the
widest in five years.
35
25 We favor bullets in the 3
to 5 year area, where
15
the spread curve and
5 Treasury curve is steep.
-5
Bonds issued under the
-15 TLGP have converged
-25 with agency bullets.
-35 2/10-yr Agency Spread Curve Investors with a greater
-45 tolerance for risk may
wish to swap into the
-55
senior debt of
-65 uninsured but
Sep-00
Sep-01
Sep-02
Sep-03
Sep-04
Sep-05
Sep-06
Sep-07
Sep-08
Sep-09
Mar-01
Mar-02
Mar-03
Mar-04
Mar-05
Mar-06
Mar-07
Mar-08
Mar-09
systemically important
banks.
We prefer callables to
Sources: Bloomberg, UBS WMR, 27 August 2009 bullets for investors
who can tolerate
maturity uncertainty.
ab3 23
25. Fixed Income
US Fixed Income Strategy
Value in TIPS over nominal Treasuries
5.00 % 5-year breakeven TIPS breakeven rates
remain below 2%
10-year breakeven
throughout the short to
4.00 30-year breakeven intermediate portion of
the TIPS curve.
3.00 We believe that TIPS in
this segment will
generate a higher
2.00 return than nominals as
actual inflation rates
1.00 are likely to come in
above the breakeven.
We favor adding TIPS
0.00
opportunistically to
guard against future
-1.00 inflation in 2011 and
beyond.
Oct-05
Apr-06
Oct-06
Apr-07
Oct-07
Apr-08
Oct-08
Apr-09
Oct-09
Laddering TIPS in the 3
to 10 year maturity
range will also protect
the real purchasing
Sources: Bloomberg, UBS WMR, 27 August 2009
power of each bond as
it comes due.
ab3 24
26. Strategic Calls
Strategic Calls seek to exploit investment opportunities among a wide
range of asset classes based on long-term trends and themes
Pricing power: Key to profitability – opened 16 Sept 2008, last updated
12 August 2009.
Agribusiness: Enhancing productivity to yield attractive investment returns
– opened 29 April 2008; last updated 27 April 2009.
Wallflowers: Finding value in shunned stocks – opened 22 May 2008; last
updated 21 May 2009.
Favor large-caps: Smaller companies, bigger problems – opened 14 March
2008, last updated 12 August 2009.
Corporate Bonds: Credit where credit is due – opened 30 May 2008; last
updated 4 December 2008.
Energy Efficiency: Investing in Sustainable Energies Part II – opened 23
June 2008; last updated 27 April 2009.
To access Strategic Calls from Online Services, click:
RESEARCH FOR INDIVIDUALS STRATEGIC CALLS (left column)
ab3 25
27. Monthly Client Conference Calls
Now you have direct access to our top Wealth Management Research
analysts and strategists.
As a UBS client, you are invited to pose your questions directly to our senior analysts and strategists on the
UBS Market Watch client call. The interactive conference calls also feature timely commentary on the markets
and the economy.
Note: The WMR Market Watch call is now on a monthly schedule. See dates and times of 2009 calls below:
Wednesday, September 16 – 1PM EST Wednesday, November 11 – 1PM EST
Wednesday, October 14 – 1PM EST Wednesday, December 16 – 1PM EST
To access the call dial:
US Phone: 866-288-0542 To access the replay dial:
International Phone: 913-312-6669 U.S. Phone: 1 888 203 1112
Verbal Passcode: Market International Phone: +1 719 457 0820
Passcode: 2439294
ab3 26
28. WMR Investment Strategy and Key Forecasts
Emerging M arkets
Euro zone
UK
Other Develo ped
Japan
US
––– –– – n + ++ +++
Treasuries
TIP S
A gencies
P referred Securities
M ortgages
Inv. Grade Corpo rates
High Yield Corpo rates
Emerg. M arket
––– –– – n + ++ +++
ab3 27
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to the clients of UBS (Italia) S.p.A., via del vecchio politecnico 3 - Milano, an Italian bank duly authorized by Bank of Italy to the provision of financial services and
supervised by «Consob» and Bank of Italy.
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