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Investment Strategy Guide

Risk and re� ation

Wealth Management ResearchFourth Quarter 2012

Central banks o� set structural risksIndiscriminate rally coming to an endOpportunities lie in corporate bonds rather than equities

Quarterly

Investment Strategy Guide Fourth Quarter 2012 1

Contents Editorial and Video Feature (electronic version only) . . . . . . . . . . . . . . . . . . . . . . 2

Summary & Highlights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Focus: Risk and re� ation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Will…May…or Won’t: A Progress Report . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Our Best Ideas at a Glance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

Asset Allocation Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Washington Watch . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Market Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Economic Outlook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Financial Market Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

Foreign Exchange. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

International Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

US Equities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

US Fixed Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

Commodities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

Alternative Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

Detailed Asset Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

Investment Committee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

Portfolio Analytics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

Additional Asset Allocation Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

Tactical Asset Allocation Performance Measurement . . . . . . . . . . . . . . . . . 51

Disclaimers/Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

Publication details

Publisher UBS Financial Services Inc.

Wealth Management Research

1285 Avenue of the Americas, 13th Floor

New York, NY 10019

This report has been prepared by UBS Financial

Services Inc. (“UBS FS”) and UBS AG. Please see

important disclaimers and disclosures at the end

of the document.

This report was published

on 27 September 2012.

Editor in ChiefStephen Freedman

EditorMarcy Tolko�

Donna Brodsky

Authors (in alphabetical order)

Thomas Berner

Rebecca Clarke

Stephen Freedman

Katie Klingensmith

David Le� owitz

Barry McAlinden

Donald McLauchlan

Kathleen McNamara

Brian Rose

Mike Ryan

Dominic Schnider

David Wang

Henry Wong

Andrew Yongvanich (UBS Alternative Investments)

Jeremy Zirin

Project ManagementPaul Leeming

Greg Rosman

Research AssistantDaniel Kenny

Desktop PublishingGeorge Stilabower

Cognizant Group – Basavaraj Gudihal,

Srinivas Addugula, Pavan Mekala

and Virender Negi

2 Investment Strategy Guide Fourth Quarter 2012

Dear reader,

Standing on the brink of the fourth quarter of an eventful year, we are struck by the persistent in� uence of three market driving forces: The � rst is the e� ect of balance sheet deleveraging, which the world has watched playing out in recent weeks in the renewed anxiety around the eurozone debt crisis and the continuing uncertainty that thrives in the shadow of a potential US � scal cli� . The second is the scope of political transition, which has exerted its in� uence throughout the year across Europe, Asia, and the Middle East…not to mention in the US where the main event is still to come. The third is the power of monetary policy, which central bankers have demonstrated throughout the year, most recently in market-moving actions from the European Central Bank and the US Federal Reserve.

These three forces have shaped an investment landscape balanced between risk and re� ation. So far in 2012 the latter has been the more important driver of market outcomes, leading to a meaningful rally in risk assets which has also bene� ted from a notable absence of “bad news” relative to the past two years.

So what’s next? In short, we see an environment with fewer tail risks but chal-lenging macro conditions and a political outlook that remains uncertain. In our view, these are the ingredients for continued sluggish growth de� ned by periods of increased market volatility—but not by major economic contractions or sus-tained market corrections.

With this in mind, we retain a largely neutral allocation across major asset classes and suggest that investors assume a more selective posture as the indiscriminate nature of the current rally fades into more speci� c opportunities.

Editorial

Mike Ryan

Mike Ryan, CFAChief Investment StrategistHead, Wealth Management Research – Americas

Stephen Freedman

Stephen Freedman, PhD, CFAHead, Investment StrategyWealth Management Research – Americas

To watch Chief Investment Strategist Mike Ryan give a summary of this report, please click the play button.

http://www.ubs.com/us/en/wealth/misc/isgriskandreflation.html

Investment Strategy Guide December 2011 3

We believe the phase during which the current re� ationary e� ort led to indiscriminate rally-ing of risk assets is nearing an end. Consider the following:• Little has changed: While policymakers have reduced the tail risks associated with

potential eurozone debt defaults, a US debt ceiling stalemate and a Chinese hard landing, the macro environment is still challenging and the political outlook uncertain.

• Absence of malice: The rally across equity and credit markets appears to have had less to do with improvement in the macro outlook or a reacceleration in corporate pro� ts than a lack of bad news—an “absence of malice.”

• All together now: With the exception of the Bank of China, each of the major cen-tral banks has shi�ed to an openly expansionary policy stance. This will be an important source of support for the real economy and global � nancial markets.

Rather than extrapolating the encouraging market behavior witnessed since July, investors should be more selective. We suggest the following recommendations:

• Neutral tactical allocation to global equities: Investors should remain allocated in line with their long-term oriented benchmarks.

• Favor the US and emerging markets, less cautious on eurozone: We continue to prefer the US for its defensive character and EM for deep value and growth potential. We have turned less cautious on eurozone assets given the reduction in tail risks.

• Prefer growth, small- and mid-cap, and cyclical stocks: Within US equities, we continue to prefer growth to value stocks, small- and mid-cap stocks to large-caps, and pro cyclical over defensive sectors.

• Upgrade commodities, downgrade � xed income: The downside for some commodity sectors is now more limited. As an o� set, we downgrade � xed income.

• No longer prefer US dollar-denominated bonds vs. foreign bonds: Reduced risks in the eurozone remove a pillar of support for the dollar

• Favor US corporate credit, reduce preference for EM sovereign bonds: Fundamentals support investment-grade and high-yield corporate bonds. We deempha-size EM sovereign bonds denominated in US dollars a� er a strong performance.

Re� ation e� orts may still be curtailed by a variety of risk factors:• US � scal cli� : Neither party has shown much appetite for compromise, so there is still

some risk that negotiations could break down.• Eurozone escalation: With Germany balking at further aid to any bailout funds, a re� ar-

ing of the eurozone sovereign debt crisis remains a distinct possibility.• China hard landing: The failure of policymakers to respond to a further so�ening of

growth would pose a daunting challenge to the global expansion.• Iranian-Israeli con� ict: Israel may feel compelled to act if e� orts by western powers to

compel Iran to abandon its nuclear ambitions are unsuccessful.• Corporate earnings decline: With margins near historically high levels, EM growth sub-

dued and ef� ciency gains likely to be more modest, companies will have a tough time beating estimates.

Summary & Highlights

Outlook

Investment recommendations

Risks



Focus

Focus: Risk and re� ation

Little has changedAs we re� ected upon the factors that would likely have the biggest impact on the investment outlook for the fourth quarter, we were struck by just how little had changed since the beginning of the year. In our 2012 Outlook report, we identi� ed three key trends that would most profoundly a� ect both the real economy and � nan-cial markets over the course of this year: 1) the pace of global balance sheet deleveraging (see Fig. 1); 2) the scope of political leadership changes; and 3) the scale of mon-etary policy easing by major central banks. A subpar eco-nomic recovery process (see Fig. 2), ongoing sovereign debt crisis within the eurozone and festering tensions across much of the Middle East vividly illustrate the chal-lenges associated with debt deleveraging and political leadership transitions. But it has been the actions of cen-tral bankers around the globe that have ultimately played the more important role in determining the outcome for

markets this year. So in a contest that has pitted “risk ver-sus re� ation,” re� ation has thus far won out.

So what does the balance of this year hold for investors then? While policymakers and elected of� cials may have reduced the tail risks associated with potential eurozone debt defaults, a US debt ceiling stalemate and a Chinese hard landing, the macro environment is still challenging and the political outlook remains uncertain. The European Monetary Union’s structural limitations, the dysfunctional character of the American political system and the rigid nature of the Chinese economy remain unresolved. We therefore look for continued sluggish growth, episodic increases in market volatility and less uniform performance prospects across risk assets. However, the deepening com-mitment by central bankers toward re� ationary policies suggests that the risks of either a global economic con-traction or a sharp sell-o� within � nancial markets are

Note: Liabilties are represented by total credit market debt. Figures are annual and seasonally adjusted. Government is the total of federal, state, and local.Source: Federal Reserve Board, UBS WMR, as of 2Q 2012

GovernmentHouseholds and nonprofits

FinancialsNonfarm nonfinancial corporates

120

100

0

60

40

20

80

140

1952 1958 1964 19761970 19881982 20001994 2006 2012

Fig. 1: Broad-based deleveraging in US economy

US liabilities by subsector as a share of GDP, in %

The tension between structural risks and policy-induced re� ationary forces will likely continue to generate large swings in � nancial markets. We believe that the phase during which the current re� ationary e� ort led to indiscriminate rallying of risk assets is nearing an end. Going forward, the bene� ts of re� ation are likely to accrue to risk assets on a more selective basis. Currently, we believe the opportunities lie in corporate credit rather than in equities.

Source: Bloomberg, UBS WMR, as of 24 September 2012

EurozoneUSA UK China

Japan

–1

–2

–4

–3

2

1

0

3

1998 2000 2002 2004 2006 2008 2010 2012

Fig. 2: Manufacturing activity has weakened

Global real activity, standardized (mean=0, standard deviation=1)


limited. Against this backdrop, we opt to retain a largely neutral allocation across most of the main asset classes—but with a continued pro-risk bias toward the credit-sen-sitive sectors of the � xed income markets. We also favor the more attractively valued cyclical sectors of the US equity market.

Absence of maliceRisk assets have rallied sharply o� their June lows with the S&P 500 and Euro Stoxx 600 indexes having posted gains of 10% and 16% respectively (see Fig. 3), while high-yield credit spreads have tightened by 120 basis points just since the beginning of June. This repricing across equity and credit markets appears to have had little to do with any meaningful improvement in the macro outlook. While the housing sector has shown signs of a rebound, labor mar-ket conditions have continued to languish, and third and fourth quarter US growth forecasts have been cut by 40 and 25 basis points respectively during the period. Nor has the impressive rally been attributable to a reacceleration in corporate pro� ts. While second quarter earnings came in slightly above consensus expectations, estimates had been reduced steadily since the end of the second quarter. The Street is now looking for S&P earnings of $103 for 2012 and $115 for 2013 compared to projected pro� ts of $106 and $119 as recently as May (see Fig. 4). Third quarter earnings are likely to post the � rst year-over-year decline since 2009 Q3.

Instead, the summer-long rally in stocks and corporate bonds appears to have been driven in large part by the lack of bad news—an “absence of malice.” A� er having su� ered through a series of geopolitical shocks, economic so� patches, natural disasters and political stalemates in each of the prior two summers, investors were under-standably cautious and sentiment depressed as the spring drew to a close. While there was still plenty of drama around the globe, the absence of any currency break-ups, political blowups or market meltdowns touched o� an impressive relief rally across risk assets. The European Central Bank (ECB) clearly played a role in this more benign backdrop by greatly reducing the tail risks associ-ated with a eurozone collapse. ECB President Mario Draghi has proven to be a much more pragmatic central banker than his predecessor, Jean-Claude Trichet.

Focus

Fig. 4: Earnings estimates have been steadily sliding

Source: FirstCall, UBS WMR, as of 24 September 2012

S&P 500 bottom-up consensus earnings-per-share estimates, in US dollars

110

108

106

104

102

100

112

114

124

122

120

118

116

114

112

126

2012 (le)2013 (right)

Jul-12May-12Mar-12Jan-12Nov-11Sep-11 Sep-12


1350

1300

1250

1200 220Jan-12 Mar-12 May-12 Jul-12 Sep-12

1450

1400

1500

260

250

240

230

270

280

Euro Stoxx 600 (right)S&P 500 (le)

Fig. 3: Equity markets have rallied sharply since June

S&P 500 Index and Euro Stoxx 600 Index

The question is how much of the

good re� ationary news has already

been incorporated into asset prices

and how much the risks can contain

any further repricing.

“

“


Focus

But for markets to extend the rally from here, more will be required than just a lack of bad things happening. Market participants will need to see some progress in one or all of the following areas: 1) an improvement, not simply further stabilization, in global macro conditions; 2) a continued easing of eurozone political risks; 3) some sort of agree-ment in the US on the “� scal cli� ”; 4) signs that Chinese policymakers are poised to step up e� orts to ease mon-etary and � scal conditions; and 5) evidence that corporate pro� ts are set to reaccelerate. So as we wait for some clar-ity on how each of these factors plays out over the bal-ance of the year, attention will likely continue to center upon the actions of the world’s central banks. E� ective re� ation e� orts will be crucial as elected of� cials seek to address mounting public sector de� cits and structural changes without jeopardizing the global expansion.

All together nowWhile monetary policy of� cials have played a prominent role within � nancial markets throughout the entire year, it was during the third quarter that they made their pres-ence most forcefully felt. With the notable exception of the People’s Bank of China (PBoC), each of the major cen-tral banks around the world has now shi� ed to aggres-sive monetary easing. This represents an important source of support for both the real economy and global � nancial markets. Consider the following:

• Under the leadership of President Mario Draghi, the ECB has adopted an increasingly aggressive approach toward monetary policy. In September, the ECB announced a new program designed to ease the pressure of esca-lating funding costs for critically vulnerable peripheral eurozone countries (e.g., Italy and Spain) by directly tar-geting the government bond risk premiums associated with a eurozone breakup. While the new purchase pro-gram entitled “Outright Market Transactions” (OMT) comes with plenty of conditions attached, it still repre-sents the ECB’s most important policy initiative to date. Keep in mind that the ECB speci� ed neither the timing and duration nor the magnitude of such a purchase pro-gram. So given the prospects for a more open-ended ECB commitment, peripheral yields are likely to remain within current tighter ranges and risk assets should be better supported.

The deepening commitment by

central bankers toward re� ationary

policies suggests that the risks of

either a global economic contraction

or a sharp sell-o� within � nancial

markets are limited.

“

“

Fig. 5: QE3 will further augment the Fed’s balance sheet


US Federal Reserve total assets, in USD bn

2500

3000

2000

1500

1000

500

0

3500

Fed’s total assets (historical)Fed’s total assets (projected)

2004200119981995 20132007 2010

Source: Bloomberg, UBS WMR, as of 31 August 2012

500

0

–500

–1000

–1500

–2000

–2500

1000

7

6

5

4

9

8

10

11

2012201120102008 2013

Fig. 6: US labor market continues to struggle

US nonfarm payrolls (3m rolling change, in 1000s) and unemployment rate (in %)

2009

US nonfarm payrolls (le)US unemployment rate (right)


• The US Federal Reserve (Fed) initiated a third phase of quantitative easing (QE3) in September amid continued disappointing labor market conditions (see Figs. 5 and 6). There is some concern that the latest e� ort by the Fed will have little impact upon the real economy, since each incremental policy step has tended to yield dimin-ishing returns.

• However, the most recent policy action by the Fed di� ers from prior moves in three important ways. First, since QE3 is open-ended, the magnitude of the Fed’s policy actions is theoretically unbounded. Not only has the Fed not speci� ed an aggregate total for purchases, but it also le� the timeline for such purchases unde� ned. Second, the conditions that the Fed set for determining policy success represent a radical departure from exist-ing policy protocols. While prior QE was based on the presumption that “if things get worse we will do more,” this time around it is based on the assurances that “if things don’t get materially better we will do more.” Speci� cally, the Fed has set a “substantial improvement in labor market conditions” as the standard by which policy e� orts will be measured. Finally, the Fed engaged in QE3 while in� ation expectations were rising and at the upper limit of the historical range rather than fall-ing. This suggests that the Fed has moved well beyond easing of credit channels, and is instead implicitly target-ing outright increases in the level of nominal economic activity as a policy objective.

Focus

• The Bank of England (BoE) and Bank of Japan (BoJ) have also done their part to support global re� ation e� orts (see Fig. 7). The BoE opted to increase its own quantita-tive easing (QE) program by another GBP 50 bn at the July gathering of its monetary policy committee (MPC). Although no additional expansion in the program was forthcoming at the August meeting, MPC members expressed a willingness to ease further—perhaps as early as the November meeting—if conditions don’t improve. Additionally, the BoE launched its Funding for Lending Scheme (FLS) in July. Under this program banks can get cheaper funding from the BoE which is tied to the banks’ pace of lending to UK households and busi-nesses. This directly incentivizes banks to lend more freely to the public. Meanwhile, the BoJ opted to ease policy on two fronts. Not only did it expand its own purchase program by an additional $126 bn, it also opted to eliminate the minimum required interest rate on the Japanese government bonds it purchases. The move came as something of a surprise, and essentially con� rms that central bankers in the developed world don’t want to be le� behind in the global re� ation sweepstakes.

• As we’ve already noted, the one exception here is the People’s Bank of China. Still smarting a bit from the backlash following the last major policy easing in 2009, the PBoC has moved far more cautiously in cutting rates compared to its counterparts around the world. Of� cial

Source: Bloomberg, UBS WMR as of 26 September 2012

ECBFed BOE

BOJ

400450

300350

50100150200250

500

2007 2008 2009 2010 2011 2012 2013

Fig. 7: Central banks have supported global reflation efforts

Size of central bank balance sheets, indexed to 100 at 1 January 2007


10

5

0 02006 2007 2008 2009 2010 2011 2012

20

15

25

30

20

10

40

50

China fixed assets investment - new construction, year-over-year (right)China required deposit reserve ratio for major banks (le)

Fig. 8: China has yet to ease aggressively

China reserve ratio and investment in new construction (year-over-year), in %


borrowing rates have barely budged this year, despite evidence that the Chinese economy continues to so� en. Keep in mind however that while growth has deceler-ated, it remains within the ranges outlined by public of� -cials earlier this year. Unlike the developed world where growth prospects remain so fragile that a 50 basis point reduction in GDP threatens the expansion, China is still working through what we continue to see as a bot-toming out in a so� landing. It was therefore unreason-able for the PBoC to adopt the same sort of “shock and awe” approach that other central banks have taken. However, if economic conditions so� en further, China certainly has the means to ease policy more aggressively and contribute meaningfully to global re� ation e� orts.

Risks haven’t gone awayAs we noted from the outset, re� ation e� orts have become necessary amid a persistent set of risk factors. Many of these risks, such as the US � scal cli� , are broadly visible and have already been exhaustively explored. That’s not to suggest, however, that these risks are already fully re� ected in asset prices—or that they can’t still threaten the durability of the expansion or the stability of global � nancial markets. It’s therefore important to re� ect upon the other half of the risk/re� ation equation. Consider the following:

• US � scal cli� — So much has already been said and written about the approaching US � scal cli� , that it is dif� cult to o� er much in the way of fresh insight here. We explored the topic in some detail as part of our Risk Watch series, and continue to view some sort of tempo-rary agreement on at least some of the expiring tax and spending measures as the most likely outcome (please see Global Risk Watch: from � scal cli� to � scal reform, 27 September 2012). However, the lead-up to any sort of agreement would still be a rather bruising and con-tentious process—especially in the lame duck session a� er the elections. Neither party has shown much appe-tite for compromise, so there is still some risk that nego-tiations could break down. There is also the potential that a deal might come only a� er the beginning of the new year—meaning there could still be a temporary � s-cal shock in early 2013. But keep in mind that while we don’t expect the US economy to bear the full potential

impact of the entire � scal cli� (~4% of GDP), some level of � scal contraction is all but certain, which could fur-ther undermine already sluggish growth prospects and weigh upon risk assets.

• Eurozone escalation — While the ECB has provided relief to beleaguered peripheral eurozone debt mar-kets, the respite could turn out to be an uncomfortably short one. Mario Draghi has continued to insist on cer-tain conditions in exchange for ECB action, including the need for vulnerable countries to formally request the support of the European Stability Mechanism (ESM). Spain and Italy might be unwilling to accept the required reform measures that would have to be implemented in exchange for such support and the ECB’s new program does not apply to Greece. With Germany balking at fur-ther aid to any bailout funds, a re� aring of the eurozone sovereign debt crisis remains a distinct possibility.

• China hard landing — It remains our view that the Chinese economy is bottoming out following an extended so� patch. However, the ongoing impact from the European crisis, coupled with both a leadership tran-sition and lagged impact from policy tightening, suggest the risks of a hard landing are not negligible. The failure of policymakers to respond in a timely manner to evi-dence of a further so� ening of growth would not only threaten the Chinese economy, but would also pose a daunting challenge to the global expansion.

• Iranian–Israeli con� ict — In his recent speech before the United Nations, Iranian President Mahmoud Ahmadinejad did little to ease concerns over the poten-tial for an escalation of tension between Iran and Israel.

Focus

The summer-long rally in stocks

and corporate bonds appears to

have been driven in large part by

the lack of bad news — an absence

of malice.

“

“


Keep in mind that Israel is unlikely to preemptively attack Iran in the period leading up to the US presiden-tial election. Israel would still need the logistical support of the US to successfully circumvent Iranian defenses and neutralize a counterstrike. However, once the elec-tion is over, Israel may feel compelled to act if e� orts by western powers to compel Iran to abandon its program to weaponize nuclear capabilities are unsuccessful.

• Corporate earnings collapse — Despite a subpar recovery and limited pricing power, US corporations have managed to post impressive earnings gains over the past three years. While the bar was admittedly set pretty low in the a� ermath of the � nancial crisis, com-panies have still demonstrated an uncanny ability to deliver solid earnings, even as revenue growth remained rather moderate. However, with corporate pro� t mar-gins near historically high levels, emerging market growth prospects increasingly subdued and further ef� ciency gains likely to be more modest, companies will have a tougher time beating consensus estimates. Were the economy to stumble—either because of the spillover from the eurozone crisis or a policy misstep in Washington—earnings could fall fairly sharply from cur-rent levels.

Re� ation news largely priced inIn view of the tug of war between investors’ fear of the risks highlighted above and their propensity to take

comfort in the re� ationary e� ort by policymakers, the question is how much of the good re� ationary news has already been incorporated into asset prices and how much the risks will contain any further upside. We believe that as far as equities are concerned, the repricing has largely hap-pened. As we wrote in our January 2012 report Decade Ahead: The Great Deleveraging, we think the current low-growth, high-risk environment suggests that histori-cal equity valuation levels need to be adjusted downward to gauge the attractiveness of equities. For the S&P 500’s price/earnings (PE) ratio on forward earnings, a range of 12 to 14 times would appear fair compared to its long-run historical average of 15 times (see Fig. 9). Based on our expectations for earnings over the next year, the PE for US stocks is close to the top of that range at 13.5, suggesting limited upside. Moreover, with market participants having shi� ed from being overly cautious to somewhat compla-cent about the risks, we believe the risks of a pullback into year-end are signi� cant.

Asset class implications:Against this backdrop, we are recommending the fol-lowing tactical asset allocation tilts in portfolios. While some of this month’s adjustments may be viewed as an increase in pro-risk orientation, others are more defensive in nature. Consider the following:

• Based on the comments above, we continue to recom-mend a neutral tactical allocation to global equities,

Focus


8x

12x

10x

14x

16x

18x

20x

1Q121Q11

Fair value P/E: 12–14x

1Q101Q091Q081Q071Q061Q05 1Q13

Fig. 9: US equities remain with our fair value range

S&P 500 P/E calculated using normalized earnings

Note: Arrows indicate changes adopted as of this report. Scale explained in Appendix.Source: UBS CIO/WMR, as of 27 September 2012

Non-US Developed Eq.

Emerging Market Eq.

US Fixed Income

Cash (USD)

Non-US Fixed Income

US Equity

Commodities

n– –– – – – + ++ +++

underweight overweight

Fig. 10: Asset classes and regional preferences

Tactical deviations from benchmark, including view on currency


i.e., investors should remain allocated in line with their long-term oriented benchmarks, but not beyond. From a regional perspective, we continue to prefer the US market for its defensive character and more stable growth prospects, and emerging markets for deep value and long-term growth potential (see Fig. 10). We have turned less cautious on eurozone assets given the reduc-tion in tail risks on the back of the ECB’s commitment to provide a backstop (see page 25). Within US equities, we continue to prefer growth stocks over value stocks, and small- and mid-cap stocks over large-caps (see page 33). And while we also continue to recommend that investors focus on attactrively valued procyclical sec-tors over the more expensive defensive sectors, in this report we tactically upgraded the defensive Utilities sec-tor to neutral following its recent underperformance. Overall, we like Information Technology, Industrials and Consumer Staples, while deemphasizing Telecom, Materials and Healthcare—which we downgraded from neutral. We have also downgraded Consumer Discretionary to neutral (see page 30).

• We incrementally add some cyclical risk to the portfolio by upgrading commodities from a moderate under-weight to a neutral stance. Broadly diversi� ed commod-ity indexes have appreciated by almost 5% over the last four weeks, with base and precious metals leading the pack. In an environment where key central banks pledge

their commitment to support economic growth, reduce unemployment or � nance government spending needs, the downside we were concerned about for some com-modity sectors is more limited and others may bene� t further. Note that while QE3 is positive for gold, we also believe that a lot of the solid performance leading up to and following the announcement already re� ects a good portion of the news.

• As an o� set, we downgrade � xed income from a moderate overweight to neutral. We also re� ect our belief that following the recent dollar sell-o� , curren-cies have readjusted to levels that we broadly consider fair. We are therefore no longer recommending a prefer-ence for US dollar-denominated bonds vs. foreign bonds


0

60

40

80

100

120

140

20

Jan-12Jul-11Jan-11Jul-10Jan-10 Jul-12

Fig. 11: Agency MBS spreads plummeted following QE3

30-year Fannie Mae current coupon spread over 10-year Treasuries, in bps

Note: AAII = American Association of Individual InvestorsSource: Bloomberg, UBS WMR, as of 26 September 2012

3-month averageNet bullish sentiment Long-term average

Last data point

40

60

20

0

–60

–40

–20

80

2000 2002 2004 2006 2008 2010 2012

Fig. 12: Investor sentiment has bounced back

AAII net bullish sentiment, in %

From a regional perspective, we

continue to prefer the US market

for its defensive character and more

stable growth prospects, and

emerging markets for deep value

and long-term growth potential.

“

“

Focus


(see pages 28). Within US dollar bonds, we maintain a preference for higher-yield, credit-sensitive paper in the corporate sector (both investment-grade and high-yield). However, we have reduced our recom-mended position in emerging market sovereign bonds denominated in dollars following their strong performance. As a result, our recommended � xed income portfolio, while still signi� cantly procyclical, has a reduced sensitivity to credit risk relative to last month (see page 35).

• Since it represents the most signi� cant tactical position in our model allocations, the case for high-yield and investment-grade corporate bonds is worth expanding on a bit more. Valuations still appear reasonably attrac-tive to us. The incremental yield on high-yield bonds (credit spread) is still over 5.5 percentage points. We believe that the Fed’s buying of mortgage-backed secu-rities (MBS) is likely to provide further support for the credit universe by encouraging investors to reach for yield (see Fig. 11). This should allow spreads on cor-porate bonds to narrow further, thereby providing an additional source of outperformance over government bonds beyond the yield pickup. From a fundamental perspective, the slow but persistent recovery of the US economy, healthy company balance sheets and still-robust earnings create a supportive environment for cor-porate bonds. Despite the recent uptick in defaults, in the absence of a renewed US recession, we expect the default rate to remain stable at 3.5% until the end of the year. A heavy load of new issuance so far this year means that high-yield companies will be faced with a lower risk of failed re� nancing going forward (i.e., in case of an unexpected economic slump).

ConclusionThe “Great Deleveraging” environment in which we believe we remain entangled is one in which bouts of optimism and pessimism are likely to remain the norm – much as we have witnessed over the last 3 years. While the current re� ationary e� orts of central banks may drive markets up from here, positive momentum can only be sustained if the recent absence of bad news persists. Unfortunately, the catalog of risks that could material-ize and derail the rally is long, ranging from the US � scal cli� , to a re-escalation of the euro crisis, to a � are-up in geopolitical tensions in the Middle East or East Asia – all this against a weak macroeconomic backdrop. Therefore, we believe that, rather than extrapolating the encourag-ing market behavior witnessed since July, investors should be more selective. From this perspective, we believe it is more advisable to position portfolios to reach for the yield advantage and possible capital gains in corporate bonds rather than to reach aggressively into equities.

Mike Ryan, CFA, Chief Investment Strategist; Stephen Freedman, CFA, PhD, Strategist

Focus


Will, may or won’t: a progress report

Will

European sovereign credit quality will deteriorate

TO DATE: Fundamentals in the periphery continue to worsen. A� er Greece, Ireland and Portugal, Spain now appears likely to eventually have to apply for a full-blown country program in order to obtain support from the European Central Bank. A� er a brief reprieve, Spanish debt yields are back at 6%.

�

Global earnings growth will stall

TO DATE: A� er a solid � rst half of 2012, which included a surprisingly strong Q2, con-sensus earnings estimates for both 2012 and 2013 have been trending steadily down-ward. Further, Wall Street analysts are expecting third quarter results to indicate a 0.5% contraction versus 3Q11 and a � at pro� le vs. the prior quarter.

�

Risk premiums will remain elevated

TO DATE: A� er widening out in the midst of a volatile summer, spreads on risk assets have since tightened as credit and equities continue their 2012 rally. Despite the run-up in equity markets, risk premiums have not declined signi� cantly and the asset class is still cheap relative to long-run averages. Credit spreads, on the other hand (high yield in par-ticular), have tightened more signi� cantly and are now somewhat below long-term aver-age levels.

?

Central banks will ease further

TO DATE: Global monetary easing moved into full swing in the third quarter, with the ECB, Fed, and Bank of Japan (BoJ) all instituting expansionary monetary policy. The ECB’s “Outright Monetary Transactions” (OMT) program allows it to buy an unlimited amount of short-term sovereign bonds in the secondary market. The Fed, meanwhile, embarked on a third round of quantitative easing, and the BoJ boosted bond purchases, while expressing a readiness to do more.

�

Economic growth prospects will decouple

TO DATE: Economic weakness has been fairly universal, though the US has seen less of a deceleration than other regions. Global manufacturing activity has trended downwards, and US labor markets remain weak. However, the US has seen a substantial pickup in the housing sector and recent upticks in consumer sentiment, two developments that sug-gest it may be the � rst main region to accelerate in the fourth quarter.

?

May

Bank deleveraging may create a global credit crunch

TO DATE: Despite stress in the global � nancial sector, a global credit crunch has not yet emerged, largely due to central banks’ willingness to expand their balance sheets in response to dif� culties in funding markets. However, in Europe a credit crunch is under-way in at least some countries and is one of the factors responsible for the ongoing recession throughout large parts of the continent.

?

Geopolitical tensions may lead to another energy shock

TO DATE: A� er some temporary appeasement, Middle East tensions have once again placed upward pressure on energy prices. Though this has certainly not reached “oil shock” proportions, US gasoline prices are now once again near the $4 per gallon price that has tended to weigh on the US consumer.

?

In keeping with our quarterly tradition, we check in on the forecasts we made in our 2012 Outlook on the � ve things that will, may, or won’t happen this year.


?

The eurozone may make decisive steps toward a � scal union

In mid-September, the EU Commission made an of� cial proposal for a single banking supervisor, which the Commission president described as a stepping stone to a pan-Euro-pean banking union and, in turn, to a “genuine, credible Community � scal capacity.” A German constitutional court decision in September paved the way for German rati� cation of the ESM (European Stability Mechanism). Finally, eurozone leaders opened talks over a centralized budget. These are all steps toward a � scal union.

�

US capital expenditure may accelerate

TO DATE: A� er a noticeable slowdown in the pace of growth of US capital expenditures (capex) from almost 10% in 4Q 2011 to about 4% in 2Q 2012, we only expect a moder-ate acceleration in 2H 2012. The unresolved eurozone debt crisis, pending US � scal cli� and a generally lukewarm consumer most likely have made businesses more cautious.

�

Crises may erupt in individual emerging market economies

TO DATE: As the violence in Syria continues, much of the Arab world is now roiled in anti-US demonstrations. Meanwhile, as China attempts to navigate an economic contrac-tion, it is caught up in an escalating con� ict with Japan over disputed islands. On the other side of the globe, Latin American countries have seen exports plummet this year due to the pullback in demand from Europe and China.

�

Won’t

The US will not achieve meaningful � scal consolidation

TO DATE: We think some sort of “grand bargain” (de� cit cuts of $4 trillion or more over the next 10 years) is likely, regardless of who wins in November, but we see minimal likeli-hood for this getting done in 2012. A short-term compromise may be reached to extend certain measures (such as the Bush tax cuts), but issues such as spending cuts from sequestration and comprehensive tax reform will likely be pushed back into 2013.

�

China will not experience a hard landing

TO DATE: While the Chinese economy is clearly disappointing, it is hard to argue that it is experiencing a hard landing. Consensus growth estimates are now between 7 and 8%, whereas they had started the year above 8%. The government has been stimulating the economy since last spring, but we have yet to see clear signs of a turnaround, with con-tinued so� ness in industrial activity and trade indicators.

?

Eurozone will not break up in 2012

TO DATE: ECB president Mario Draghi made good on his July pledge to do “whatever it takes” to maintain the eurozone as a going concern, instituting the OMT bond purchase program in September. While a so� Greek exit remains a distinct possibility next year, 2012 is unlikely to be the year the eurozone breaks up.

�

Social unrest will not subside

TO DATE: The year of geopolitical uncertainty continued, as tensions reached the tipping point in three major regions of the world in September – the Middle East, East Asia, and Europe. Mass anti-US protests � ared across much of the Arab world (targeting US embas-sies in various countries), an increasingly rancorous dispute over islands in the East China Sea spurred waves of anti-Japanese protests in China, and Spaniards and Greeks took to the streets en masse to protest against austerity.

�

The US dollar will not lose its safe haven status

TO DATE: As has been the trend throughout the year, the US dollar continues to be buoyed by the global demand for liquidity when risk aversion rises. A� er a slide that lasted through August and into September, the dollar has started bouncing back thanks to renewed worries over global economic data. Long term, the US will need to address structural � scal issues if it is to remain the world’s reserve currency.

�

Will, may or won’t: a progress report


Our Best Ideas at a Glance

Fixed Income

Current allocation: 37.0%

Within US dollar Fixed Income (29%)• Investment-grade non-� nancial corpo-

rates: in particular single A and BBB-rated credits in the managed care, mining, oil and gas, and communica-tions sectors.

• Investment-grade � nancial corporates: in particular diversi� ed insurers, higher-rated regional and money cen-ter banks, and REITs.

• Emerging market corporate bonds denominated in USD: in particular investment grade-rated Latin American USD-denominated corporate debt.

• High-yield corporate bonds• Within preferred securities: REIT

preferreds• Within municipals: essential purpose

utility revenue bonds, broad-based sales tax bonds and general obligation bonds accompanied by an enforceable ad valorem property tax pledge.

Within non-US (8.0%)• UK bondsPages 28, 35

Asset ClassesNeutral across the main asset classes: equities, � xed income, commodities and cash.

CurrenciesPreference for British pound and Canadian dollar among developed currencies. Among Emerging Market currencies, we like the Korean won, the Singapore dollar, the Mexican peso and the South African rand.

The following list represents investment strategy recommendations that we believe will provide attractive opportunities over the next 6-12 months.

Equities


Within US equities (33%)

• Preference for small- and mid-cap stocks over large caps

• Preference for growth over value stocks

• Consumer Staples: in particular com-panies with high emerging-market exposure

• Information Technology: in particular semiconductors, data centers

• Industrials: in particular capital goods companies that are outgrowing the market, railroads

• Within Consumer Discretionary: cable and satellite, lodging

• Within Energy: oil services• Within Financials: large regional

banks, exchanges, property and casu-alty insurers, Real Estate Investment Trusts (REITs) with growing dividends

• Within Healthcare: managed care, drug distributors and pharmacy ben-e� t managers

• Within Materials: industrial gas• Within Telecom: wireless towers,

enterprise and rural telecom carriers• Within Utilities: high-growth utilities

over expensive high-dividend yield plays

Within non-US dev. equities (8.0%)• UK equities

Emerging market equities (3.0%)• In particular, China, South Korea and

BrazilPages 25, 30, 33

Alternative InvestmentsCurrent allocation: 12.0%

Page 43

CommoditiesCurrent allocation: 5.0%• We see upside potential for precious

metals, gold in particular, some base metals and agriculture. Page 42

Cash


OverweightNeutralUnderweight

Source: UBS WMR (for asset class comments) and WMA Asset Allocation Committee (for the tactical view). The current allocation percentages are derived from the benchmark allocation (provided by Investment Solutions) and the tactical deviation (provided by the WMA Asset Allocation Committee). All content as of 27 September 2012. For an explanation of current allocation and the underlying benchmark allocation, please see the note on the following page.

WMA Asset Allocation Committee

Asset Allocation Overview Asset Allocation Overview2 Tactical View3 Model Portfolio Moderate Risk Pro� le (in %)

Benc

hmar

k A

lloca

tion

1

Tact

ical

Dev

iati

on3

Chan

ge

Curr

ent

Allo

cati

on

EquitiesEquities are attractively valued relative to bonds and could further bene� t from QE3. However, numerous risks and some complacency argue against chasing the summer rally.

Neutral 44 +0.0 44.0

US EquitiesValuations are less attractive than in overseas markets but economic recovery and earnings growth is more solid than in many other developed countries.

Moderate Overweight

32 +1.0 33.0

US Large Cap ValueValuations, our sector tilts and moderating earnings growth favor growth over value.

Moderate Underweight

11 -4.0 7.0

US Large Cap GrowthValuations, our sector tilts and moderating earnings growth favor growth over value.

Moderate Overweight

11 +1.0 12.0

US Mid CapShould bene� t relative to large caps as cyclical sectors are set to continue outperforming defensives and domestic plays bene� t from weakness abroad.

Moderate Overweight

5 +2.0 7.0

US Small CapShould bene� t relative to large caps as cyclical sectors are set to continue outperforming defensives and domestic plays bene� t from weakness abroad.

Moderate Overweight

3 +2.0 5.0

US Real Estate Investment Trusts (REITs)Improving fundamentals but valuations are high and interest rates could rise, creating headwinds.

Neutral 2 +0.0 2.0

Non-US Developed EquitiesValuations more attractive than US, but we expect to see headwinds for commodity-sensitive foreign markets such as Canada and Australia.

ModerateUnderweight

10 -2.0 8.0

Emerging Market (EM) EquitiesValuations are attractive and growth is expected to pick up.

Moderate Overweight

2 +1.0 3.0

Fixed IncomeYields at historically low levels but monetary policy easing by major central banks supports market. Useful portfolio hedge in the case of adverse scenarios.

Neutral 37 +0.0 � 37.0

US Fixed IncomeAs currency markets have adjusted to central bank easing, we are no longer bullish on the dollar. We prefer corporate bonds within US � xed income.

Neutral 29 +0.0 � 29.0

Non-US Fixed IncomeSimilarly unattractive valuations to US, but currencies no longer a headwind.

Neutral 8 +0.0 � 8.0

Cash (USD)Store of value for the short term and dry powder, while waiting for opportunities elsewhere.

Neutral 2 +0.0 2.0

CommoditiesCyclical commodities still facing headwinds, but QE3 should be supportive to precious metals.

Neutral 5 +0.0 � 5.0

Alternative InvestmentsNo tactical view. Included into portfolio for diversi� cation purposes.

Neutral 12 +0.0 12.0

“WMR tactical deviation” legend: Overweight Underweight Neutral “Change” legend: � Upgrade � DowngradeSource: 1Investment Solutions, 2UBS WMR and 3WMA Asset Allocation Committee as of 27 September 2012. For end notes, please see appendix.

The benchmark allocations are provided for illustrative purposes only by UBS for a hypothetical US investor with a moderate investor risk pro� le and total return objective. See “Sources of benchmark allocations and investor risk pro� les” in the Appendix for a detailed explanation regarding the source of benchmark allocations and their suitability and the source of investor risk pro� les. 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 devia-tions from benchmark.



With November 6 just six short weeks away, the outcome of the election is anything but certain, similar to the out-look for many policies. Indeterminate tax rates, stubbornly elevated unemployment and high government de� cits are some of the many issues that befuddle legislators. This ele-vated policy uncertainty is likely already holding down con-sumer con� dence and hindering the ability of business to make investment and hiring decisions. On the campaign trail, the presidential candidates are promising to address these challenges with radically di� erent approaches—so di� erent that the fundamental role of government in soci-ety appears to be in play.

We think many of the economic issues at stake are sig-ni� cant indeed, yet the next president and the 113th Congress will be constrained by the same economic and political factors, resulting in a similar outcome regard-less of who wins. Keep in mind that whoever occupies the White House will have to deal with a closely divided Senate, even if that chamber is held by his party. While major policy change may be dif� cult, the challenges are many, including those facing the last “lame duck” session of the 112th Congress. Against this backdrop, Washington Watch walks through likely outcomes of the election, the “� scal cli� ” and the potential for � scal and other policy reforms next year.

Washington Watch

Countdown to November 6

The election countdownCampaigns can change quickly, and the 2012 presidential race has already seen some signi� cant volatility. We expect an Obama victory, a narrowly Democratic Senate and a solidly Republican House. Despite a lackluster US economy and subdued approval ratings, the president has run an e� ective campaign and continues to enjoy the commit-ted support of many Americans. Although the tides have recently turned against him, we think Mitt Romney stands a plausible chance of unseating the president, and we expect the race to remain close. We think that a Romney victory would likely be accompanied by a very slight Republican majority in the Senate. However, recent polls have indicated that Romney has fallen behind in most swing states, including several that he must win to gain the 270 votes in the electoral college (see Fig. 1).

The � scal cli� and the debt ceilingBefore the victors descend on Washington, DC, on January 3, 2013, the agenda during the last remaining weeks of the 112th Congress will be ambitious to say the least. Congress was wise enough to pass a continuing resolu-tion in September, approving current spending on gov-ernment programs through March. While a government shutdown is therefore one less thing that Congress will have to address when it resumes in November, the � scal cli� still looms.

The � scal cli� refers to a series of measures that come into play in 2013 which reduce government spending and sharply increase taxes. Jointly, this � scal cli� amounts to $607bn of tightening in the 2013 government bud-get. If Congress allowed all of these measures to kick in, we think this could subtract as much as 4% from GDP growth, resulting in a 2013 GDP contraction of nearly 2% (see Fig. 2).

We think the chances of going o� the cli� and staying where we land are low. However, these measures could all kick in for a short period of time (temporary cli� ). Alternatively, it is quite possible that at least some of the provisions will go into e� ect permanently (mini cli� ). The most likely scenario, in our view, is a � scal pothole where Congress pushes out the deadline, extending many pieces of current legislation, namely the sequester and the

Fig. 1: Currently swinging Obama

The swing states’ current polls, unemployment rate, electoral votes

RCP Poll Average (in %)Obama Romney

Unemploy-ment rate (%)

Electoral votes

Colorado 48.3 46.0 8.2 9

Florida 48.3 46.4 8.8 29

Iowa 49.0 44.3 5.5 6

Michigan 49.0 41.0 9.4 16

Nevada 48.3 45.8 12.1 6

New Hampshire 46.0 45.0 5.7 4

North Carolina 46.6 48.4 9.7 15

Ohio 48.8 44.7 7.2 18

Virginia 49.6 45.1 5.9 13

Wisconsin 51.5 43.7 7.5 10

National 48.6 44.9 8.1 538

Source: Politico, US Bureau of Labor Statistics, UBS WMR as of 24 September 2012


majority of the “Bush tax cuts,” but probably phases out or lets lapse extended unemployment bene� ts and the payroll tax holiday. If all current policy were to lapse and a full-blown � scal cli� were to materialize, � nancial markets could react sharply.

The debt ceiling will add pressure to address � scal uncer-tainties quickly. The current ceiling is $16.4tn dollars, and Treasury currently estimates that the debt counted under this ceiling will reach the limit at the end of 2012 (see Fig. 3). Based on recent precedent, Treasury will likely � nd a way to adjust accounts such that the risk of hitting this ceiling is only realized several months later. We doubt the government will actually breach this limit and default on its Treasury obligations, but we could easily see another clif� anger, much as we did in summer 2011.

A grand bargain?Regardless of who wins the White House and controls the Senate, bipartisan support will be necessary to achieve most major reforms. Ironically, while we expect rancor-ous debate between the parties, we actually think there is good chance that under either Obama or Romney, we will see a bipartisan � scal deal that would trim $4tn from projected de� cits over the next 10 years. The very dis-cord between Republicans and Democrats may end up being bene� cial. Their di� erences could keep them at the negotiating table, and may incentivize them to agree to a bigger deal, such that each party can highlight what the

other sacri� ced. While current campaign rhetoric may sug-gest otherwise, there are quite a few areas of agreement, including the need for corporate tax reform, an overhaul of the personal tax code and the undesirability of the bud-get sequester. We expect that under Democratic leader-ship revenue increases might be higher, but that spending cuts would still constitute the bulk of � scal reform.

The tax code will be at the center of debates on � scal policy. Few in Washington want to see the Bush tax cuts expire fully, which would not only increase taxes on the highest earners, but also on low- and middle-income households. However, to lower marginal rates from the levels to which they will revert in 2013 without bring-ing down the overall revenue collected, some deductions would have to be reduced or eliminated. We expect that fundamental reform of the tax code is more likely under Republican leadership than Democratic. However, we believe that many previously sacrosanct deductions are now up for serious review under either administration. Speci� cally, we think the mortgage interest deduction on second homes, deductions for charitable donations and the tax-exempt status of municipal bonds could be vulnerable.

Washington Watch

For recent UBS election commentary, ask your � nancial advisor for a copy of…

• Election Watch 2012 Volume 1 – The Issues (February 2012)

• Election Watch 2012 Volume 2 – Global Elections (April 2012)

• Election Watch 2012 Volume 3 – The Implications (September 2012)

• Exchange: Election 2012 (September 2012)

• Washington Weekly (September 2012)

Stay current with UBS’s views on the election by visiting ubs.com/election.

Source: CBO, UBS WMR, as of 27 June 2012

1.0

0.0

2.0

3.0

4.0

Fig. 2: Fiscal cliff impact would be devastating for growth

Cumulative impact of “fiscal cliff” components, in % of UBS estimate of 2013GDP per category

Med

icare

“doc

fix”

Unem

ploy

men

tbe

nefit

s

Sequ

este

rsp

endi

ng c

uts

ACA

tax

Oth

er ta

xpr

ovisi

ons

Payr

oll t

ax

Bush

tax

cuts

and

AMT

fix

Oth

er c

hang

es


The pressure to maintain a top sovereign credit rating may also keep lawmakers up at night. S&P’s much pub-licized downgrade in August 2011 initially triggered sub-stantial consternation among market participants. Since then, Moody’s, S&P and Fitch have maintained a negative outlook on their Aaa/AA+/AAA ratings, respectively. We believe that only a credible $4tn de� cit reduction pack-age is likely to placate the rating agencies, but there could still be warnings about the long-term outlook and the commitment to control de� cits. In terms of timing, the debt ceiling limit presents a greater US credit rating risk than overall � scal reform because inaction and/or delays in raising the limit would lead to more immediate rat-ings actions. Moody’s, S&P and Fitch have intimated they would downgrade the US if Treasury were to miss an inter-est or principal payment, and even another debt ceiling stando� may result in a credit rating review.

Some sectors, overall economy a� ected by electionsThe next president and Congress will have many other issues to address beyond � scal policy, and while there are a few topics where di� erent electoral outcomes will result in sharp di� erences, in many other cases we do not expect major divergences. A Romney administration would likely repeal or change some important parts of the A� ordable Care Act, with mixed results for the Healthcare sector. In Financial Services, we would also experience some changes to Dodd-Frank, in our view, but most of this

Washington Watch

legislation has already been implemented and would be very dif� cult to reverse.

Some sectors of the economy would see very similar pol-icy outlooks, regardless of the results on November 6. We think prospects for energy policy would be similar. Equity sectors such as Technology and Consumer Staples sectors should remain attractive regardless of the elec-tions. Overall, we anticipate that a Romney administra-tion would be slightly more likely to pursue � scal reform and reduce policy uncertainty and regulations, which would be marginally positive for economic growth over the course of several years and for equity market perfor-mance. However, given the challenging � scal situation and the slow-growth economy either president would face, and given that we expect Congress to be closely divided between the two parties, we do not expect sweeping leg-islative changes or radically di� erent economic or � nancial market results.

Katie Klingensmith, analyst


Debt limitPublic debt

1210

86

0

141618

42

2010200520001995

Fig. 3: Debt ceiling debate to heat up in early 2013

US public debt and statutory debt limit, in trillions of US dollarsFig. 4: US credit rating in jeopardy

US sovereign rating agency guidance

Moody’s Investors Service

“Without further de� cit reduction measures, the rating could be placed on review for downgrade sometime in the coming year…the outlook change will most likely not occur until sometime in 2013.”

Standard & Poor’s “The negative outlook re� ects our opinion that U.S. sovereign credit risks, primarily political and � scal, could build to the point of leading us to lower our ‘AA+‘ long-term rating by 2014.”

Fitch Ratings “Fitch does not expect to resolve the Negative Outlook until late 2013. Fitch will take into account any de� cit reduction strategy that may emerge a� er Congressional and Presidential elections in addition to an updated assessment of the medium-term economic and � scal outlook.”

Source: Moody’s Investors Service, Standard & Poor’s, Fitch Ratings, as of 21 September 2012


Market Scenarios (next 12 months)Economic data have yet to show a decisive growth rebound and remain compatible with our sluggish expansion base case. Headwinds from tighter � scal policy and deleveraging in developed markets will continue in 2013, making a strong recovery dif� cult to achieve. On the positive side, monetary policy is extremely loose and some developing countries are implementing stimulus measures. For the next 12 months we distinguish the following four scenarios for global growth and in� ation.

High Growth

Low Growth

Negative Growth

High Negative Inflation

Low Inflation Inflation

High Growth

Low Growth

Negative Growth



• The global economy remains on a very fragile expan-sion course with government policies achieving low but positive growth, with the exception of the eurozone.

• Deleveraging pressures keep growth below historical trends in most developed countries, with unemploy-ment rates remaining far above their pre� nancial crisis levels.

• Growth in emerging markets continues to outpace developed markets, though their growth has slowed as well.

• A less likely but possible negative scenario is that the public loses faith in monetary policymakers or energy and/or food prices rise abruptly, leading to a pickup in in� ation expectations. This, in turn, would lead to a combination of weak growth and in� ation (stag� ation).

65%

5%Stag� ation

Source: UBS WMR

SluggishExpansion

High Growth

Low Growth

Negative Growth



• The global economy slides back into recession due to a signi� cant escalation of the eurozone sovereign debt crisis, a sharp US � scal contraction (� scal cli� ) or a hard landing in China. This leads to a reemergence of de� a-tionary pressures. 20%

Renewed Recession

High Growth

Low Growth

Negative Growth



• Loose monetary policy, as well as greater � scal policy clarity in the US and Europe, encourages a surge in hir-ing and investment spending and mitigates the � scal austerity drag.

• Improvement in both the labor and housing markets sets the stage for a more dynamic consumer recovery.

10%StrongExpansion


Against the backdrop of an ongoing slide in eco-nomic growth momentum, the European Central Bank (ECB) and the Fed decided to act with more resolve. The ECB’s conditional but unlimited bond purchase program and the Fed’s open-ended QE3 program mitigate downside growth risks, e� ec-tively behaving like an “at the money” put option on � nancial market activity. However, we doubt that they will strongly boost growth in the near term. It is more likely they will simply help the global economy to operate closer to its potential.

Tentative but fragile growth reboundKey global growth indicators have yet to con� rm a deci-sive growth rebound. In the US, the ISM manufactur-ing PMI, a guage of business climate remained slightly below the expansion-critical 50 level in August. Moreover, nonfarm payroll gains lost luster again in August, a� er brie� y jumping above 100,000 in July. The unemployment rate remains stuck above 8%. Our UBS Current Activity Indicator, which uses 25 indicators to estimate monthly real GDP growth, rose to an annualized 1.3% in August a� er 1% in July. This improvement is only tentative as not all August indicators that enter the calculation have been released. The moderate improvement suggests that we are on track for real GDP growth of annualized 1.5% in the third quarter a� er 1.7% in 2Q12.

The picture is similar in the eurozone, where in September the composite PMI fell slightly to 45.9, remaining below 50. The manufacturing climate improved a bit, led by Germany, but the service sector climate deteriorated. The ongoing growth malaise prompted us to lower our 2013 real GDP growth forecast from 0.4% to 0.2%. However, we kept our 2012 fore-cast at -0.4% and still see the second quarter as the trough with near-zero growth going forward.

More decisive signs of a growth rebound are also absent in China. While the second quarter brought about sequential growth improvement, the yearly growth rate is still slipping and will probably not � nd a bottom until the fourth quar-ter. And a� er having been stable for a few months, the Chinese PMI has taken a turn for the worse. We remain of the view that China will avoid a hard landing and growth will rebound, albeit only marginally.

More forceful monetary policy responsesThe pervasive loss in growth momentum has � nally prompted key central banks to take more decisive action to stem the weakness. The ECB and the Fed have announced policies that should signi� cantly miti-gate downside growth risks. The Fed rolled out an open-ended quantitative easing program (QE3) with monthly $40bn purchases of agency mortgage-backed securities

Economic Outlook

“At the money” policies

Fig. 1: Growth and in� ation forecasts

GDP Growth In� ationin % ’11 ’12F ’13F ’11 ’12F ’13FWorld 3.2 2.7 3.1 3.9 2.9 2.9

US 1.8 2.2 2.3 3.1 2.1 1.7

Canada 2.4 2.0 2.3 2.9 2.0 2.3

Japan -0.8 2.3 2.0 -0.3 0.0 0.3

Eurozone 1.5 -0.4 0.2 2.7 2.4 1.9

UK 0.8 -0.5 0.8 4.5 2.7 2.1

China 9.3 7.5 7.8 5.4 2.8 3.6

India 6.5 5.5 6.5 8.0 7.5 7.0

Russia 4.3 3.8 3.7 8.5 5.0 6.6

Brazil 2.7 1.6 4.8 6.5 5.3 6.5

Note: For full explanation of this table, please see appendix. F: forecast Source: UBS WMR, as of 25 September 2012

Fig. 2: US growth to stay moderate into 2013

Source: Thomson Datastream, UBS WMR as of 24 September 2012

US real GDP growth, quarter-over-quarter annualized in %

UBS WMRforecasts

5

0

–5

–10

10

Investment in equipment & sowareResidential investment

ConsumptionInvestment in nonresidential structures

GovernmentReal GDP (% q/q annualized)

InventoriesNet exports

Q3 2012Q3 2011Q3 2010Q3 2009Q3 2008Q3 2007Q3 2006 Q3 2013


(MBS). The Fed telegraphed that it would increase the dol-lar amount of the purchases unless there is a substantial improvement in the labor market outlook. This e� ectively makes the Fed more reactive to incoming data, curtail-ing the risk of a loss in growth momentum turning into a recession. Based on our unemployment rate forecasts, we estimate that QE3 could last until at least late 2013 with around $1.16tn in purchases of agency MBS and Treasuries. This � gure takes into account the inclusion in the QE3 program of purchases of $45bn per month of longer-dated Treasuries starting next January to substitute for Operation Twist purchases of an equal amount that are scheduled to expire at year-end.

The ECB has also curtailed the downside risks to growth by signaling unlimited sovereign bond purchases in the secondary market for countries that apply for a bailout. This has boosted the market’s perception of the ECB’s resolve to do whatever it takes to save the euro. Insofar as the ECB’s and Fed’s new policies mitigate downside growth risks by allowing them to react quickly to eco-nomic and � nancial weakness, they e� ectively behave like an at-the-money put option on � nancial market activity.

The economic outlook remains lacklusterWhile we think that the new policies mitigate down-side growth risks, we are skeptical whether they can

signi� cantly boost growth at this stage. The Fed’s QE3 program will at present simply help to o� set the recent growth weakness and li� growth back to a potential 2%-2.5% over the next few quarters assuming of course that the � scal cli� will be avoided. In the eurozone, the growth outlook continues to be muddied by a possible Greek exit and Spanish bailout.

Can in� ation become a problem?In such a weak growth environment, we continue to expect a rather benign development of in� ation across the globe. In� ation expectations crept higher a� er the ECB’s and Fed’s announcements, but they are still within a healthy historical range. As long as that is the case, central banks will likely continue to inject supportive liquidity. Eventually, these new policies could gain more traction and more meaningfully reignite the global econ-omy. If so, in� ation will become a bigger concern. But for the next few quarters, we doubt that growth can acceler-ate to the point where it would be a serious problem for the in� ation outlook.

Thomas Berner, CFA, Analyst

Economic Outlook

Fig. 3: US core CPI inflation to dri slightly higher


US inflation, year-over-year in %

4

2

0

–2

–4

6

Consumer Price IndexCore Consumer Price Index

201020082006200420022000 2012

UBSWMR

forecasts

Fig. 4: Inflation pressure is absent


Global CPI inflation rates, year-over-year in %

6

0

–2

–4

8

10

4

USAEurozone

UK ChinaJapan

2010200620021998

2


Economic Outlook: Chartbook

Fig. 7: US net wealth and the savings rate have stabilized

Note: Right scale is invertedSource: Thomson Datastream, UBS WMR as of 24 September 2012

US household net wealth and savings rate, in % of disposable income

12

10

8

6

4

2

0

–2

14

4.0

4.5

5.0

5.5

6.0

6.5

3.5

Savings rate (le)Net wealth to disposable income ratio (right)

200019901980197019601950 2010

Note: PMI = Purchasing Managers’ IndexSource: Thomson Datastream, UBS WMR, as of 24 September 2012

GermanyEurozone

ItalyFrance

50

45

40

35

30

55

60

65

Jan-11Jan-10Jan-09Jan-08Jan-07 Jan-12

Fig. 9: Eurozone growth picture marginally improving

Manufacturing PMIs for the eurozone, in levels

Fig. 6: US commercial bank lending growth is firmly positive


US commercial bank loans and leases, 3month-over-3month annualized in %

5

–10

–15

–20

15

10

20

0

US commercial bank loans and leases

Feb-12Feb-11Feb-10Feb-09Feb-08Feb-07Feb-06

–5

Note: PMI = Purchasing Managers’ IndexSource: Bloomberg, UBS WMR as of 24 September 2012

Manufacturing PMI (right)Real GDP (le)

8

7

6

9

10

12

11

13

444240

4648

56545250

58

Mar-11Mar-10Mar-09Mar-08Mar-07 Mar-12

Fig. 10: Chinese PMI deteriorates again

Chinese manufacturing PMI and real GDP growth (year-over-year in %)


Conference Board (le)University of Michigan (le) Bloomberg (right)

20

0

40

60

100

80

120

–60

–50

–10

–20

–30

–40

0

Jan-11Jan-10Jan-09Jan-08Jan-07 Jan-12

Fig. 8: US consumer sentiment has improved moderately

Three US consumer sentiment indexes

Fig. 5: Improvement in US labor market has yet to resume


Composite measure of nine key labor market indicators, in levels

–2

–5

–6

–7

1

0

–1

2

improvement

–3

Composite measure of key labor market indicators

Jan-12Jan-11Jan-10Jan-09Jan-08Jan-07

–4deterioration


Financial Market Performance

Fig. 1: Asset Classes


Total return in USD and %

US Fixed Income

Non-US Fixed Income

Commodities

Cash (USD)

Non-US Dev. Equities

EM Equities

US Equities

year-to-datequarter-to-date

1412108640 2 16

Fig. 3: International Fixed Income



UK

Japan

Non-US Fixed Income

EMU

US Fixed Income


2 64 8 100

Fig. 5: US Fixed Income

Source: BoAML, UBS WMR, as of 26 September 2012


IG CorporatesHY Corporates

MortgagesPreferreds

EM SovereignsMunicipal bonds

TIPSAgencies

Treasuries


8 10 126420 14

Fig. 2: International Equity



UK

Japan

Emerging Markets

Non-US Developed

EMU

US Equity


10 12 148642–2 0 16

Fig. 4: US Equity



Mid Cap

Small Cap

REITs

Large Cap Growth

Large Cap

Large Cap Value


1614121084 620 18

Fig. 6: Currencies


Appreciation vs. USD in %

CAD

CHF

BRL

AUD

GBP

JPY

EUR


–6 –2–4–8–10 6420


With the major currencies all undergoing debase-ment due to ultra-loose monetary policies, we continue to advocate that investors consider diversi-fying into minor currencies of commodity producers and emerging economies, adding them on dips.

Currencies tend to lose value when central banks increase their supply. So why has the US dollar remained fairly stable on both a trade-weighted basis and relative to the other big currencies? Keep in mind that not just the Federal Reserve has o� ered extra liquidity to the markets in di� erent forms; several other central banks, including the European Central Bank (ECB) and the Bank of Japan (BoJ) have also done so, with the Bank of England (BoE) suggesting it could provide even more.

While many of the major central banks have simultane-ously increased their balance sheets, thereby boosting their supply of liquidity, this may be o� set by the fact that their economies currently have a high demand for such liquid-ity. When interest rates are close to zero and investors are paid little to save or invest their funds, the opportunity cost of holding cash is very low. Additionally, demand for liquidity has remained high due to global economic head-winds and investors’ preference for high cash balances.

The “big four” currencies are all facing major challenges. It should therefore be of little surprise that the major curren-cies are trading close to their long-term fair values relative

Foreign Exchange

Easy monetary policy across the big currencies

to one another. Europe is still confronting political concerns about the integrity of the common currency, Japan still struggles with near de� ation, the US is experiencing high unemployment and � scal policy uncertainty—and all are facing lackluster economic activity. We encourage inves-tors to be well diversi� ed among the major currencies and beyond. Ultimately we would expect the currencies of countries with higher levels of in� ation to depreciate, especially when not compensated by an attractive inter-est rate. Only time will tell which central banks will be the most successful in reversing quantitative easing and other extraordinary monetary policies. However, we do not expect any of the four major currencies’ central banks to hike rates through the end of 2013.

Given the extraordinary commitment of many central banks to provide liquidity, some countries may ultimately experi-ence higher in� ation and pressure on their currencies. We suggest investors look to countries with more solid mon-etary and � scal policies in the developed and emerging spaces. Among the former, such currencies as the Australian and Canadian dollar have attractive economic and policy pro� les. Many emerging markets continue to o� er higher interest rates and healthier monetary and � scal pro� les. However, from a near-term perspective, commodity and emerging market currencies are already expensive; we rec-ommend adding them to portfolios on dips.

Katie Klingensmith, Analyst


CAD/USDAUD/USD

1

1.1

0.8

0.9

0.4

0.5

0.6

0.7

1.2

2002 2003 2004 2005 20072006 2008 2009 2010 2011 2012

Fig. 2: Australian and Canadian dollars near record high

Exchange rates, higher figures reflect weaker US dollar

1.0

Fig. 1: UBS WMR exchange rate forecasts

26-Sept in 3 months

in 6 months

in 12 months

PPP*

EURUSD 1.29 1.30 1.32 1.34 1.30

USDJPY 77.71 80 82 86 79

GBPUSD 1.62 1.65 1.68 1.70 1.69

USDCHF 0.94 0.93 0.92 0.92 1.03

USDCAD 0.98 0.94 0.94 0.92 0.98

AUDUSD 1.04 0.97 1.00 1.05 0.74

NZDUSD 0.82 0.78 0.80 0.83 0.60

USDSEK 6.59 6.31 6.06 5.97 6.83

USDNOK 5.75 5.62 5.45 5.37 6.58

*Relative Purchasing Power Parity; UBS WMR calculationsSource: Bloomberg, UBS WMR, as of 26 September 2012


International Equities

ECB sparks rally

The US underperformed international equity markets in the third quarter but we continue to prefer the US to other developed markets as earnings prospects appear more robust. More aggressive policy action in the eurozone sparked a rally, and we have removed our long-standing underweight recommendation. We favor the UK as it looks relatively inexpensive, especially for dollar-based investors. We remain overweight emerging markets. While China has con-tinued to disappoint, we still expect policy easing to deliver better growth in the quarters ahead.

Upgrading eurozone to neutral, downside risk remainsEurozone equities rebounded strongly in the third quar-ter, helped by the European Central Bank’s (ECB) decision to open up the possibility of buying sovereign bonds in unlimited amounts to bring yields down, at least at the short end of the curve. In addition, it now appears likely that the European Stability Mechanism (ESM) will be up and running by early October. Spain could apply for assis-tance from the ESM/ECB as soon as mid-October. These steps should greatly reduce the risk of a liquidity crisis hitting a eurozone government that loses access to the bond market.

Further, they should help to prevent a vicious circle of high interest rates pushing up budget de� cits leading to fur-ther increases in rates. It remains our view that Spain will

eventually be able to stabilize its public � nances, as long as the interest rates it needs to pay on its bonds remain at reasonable levels.

Even a� er their rally, eurozone equities trade on relatively attractive valuations, and given the reduction of tail risks, we decided to upgrade the market to neutral. However, it is important to keep in mind that the eurozone debt cri-sis is far from over. The situation in Greece remains highly uncertain, and a Greek exit from the eurozone could trig-ger contagion in other countries. We also see downside risks to earnings as analysts have recently raised some of their forecasts, despite the fact that many eurozone coun-tries remain mired in recession.

We favor the UK among the non-US developed marketsThe UK economy has fallen into a technical recession, with GDP contracting three quarters in a row. Domestic demand has been weak as � scal austerity measures cre-ate headwinds, and the downturn in the eurozone is weighing on exports. However, the labor market has con-sistently been stronger than the GDP � gures would sug-gest, and we expect growth to return to positive territory. Valuations are similar to eurozone equities, but consen-sus earnings forecasts appear less stretched, given that 70% of UK earnings are generated outside of the country, including considerable exposure to the emerging markets. Furthermore, the pound looks cheap against the dollar,


–2.0

2.0

1.00.5

1.5

0–0.5

2.5

–1.0–1.5

Switz

erla

nd

Aust

ralia

Cana

da

Japa

n

UK

Euro

zoneUS EM

Fig. 4: Eurozone, UK, EM look cheap

Sector-adjusted valuation premium, in P/E points

Expensive relative to world

Cheap relative to world

Note: arrows indicate changes adopted as of this reportSource: UBS CIO/WMR, as of 27 September 2012. Scale explained in Appendix.

n– –– – – – + ++ +++

UK

Emerging Markets

Eurozone

Other Developed

Canada

US

Japan

Australia

Switzerland

underweight overweight

Fig. 3: Equity Regions

Tactical deviation from benchmark, including view on currency


o� ering hope for exchange rate movements to add to returns in dollar terms. We therefore have a preference for the UK over the eurozone, and recommend a small over-weight position within global equities.

Japanese markets continue to languishJapan has been one of the worst-performing markets so far this year and largely missed the global rally in the third quarter. The economic data have been disappoint-ing recently, especially in the manufacturing sector, with industrial production falling to its lowest level of the year in July. The positive boost from reconstruction spend-ing has peaked, and political � ghts are causing some delays. A territorial dispute with China has caused prob-lems for Japanese � rms operating in China and is having a big impact on the tourism industry. Even more concern-ing than the negative short-term outlook is the prospect of weak growth in the long run. A rapidly aging popula-tion and shrinking labor force leave Japan with virtually no growth potential, and Japanese companies continue to lose market share in many of their core products. Public � nances are in a ruinous state, and the consumption tax will be doubled in 2014 and 2015 as a � rst step to cut the de� cit. Valuations are much cheaper than they have been in the past, but in our view are still not attractive given the lack of growth potential. The stock market may continue to languish unless the yen weakens, but that would hurt returns for dollar-based investors. We therefore remain underweight Japan within global equities.

International Equities


1000

500

0

2000

1500

3000

2500

2011

3500

2001 20061996199119861981

Fig. 5: Japanese equities near post-bubble low

TOPIX index

Canada solid but expensiveCanada is among the most expensive international mar-kets, especially on a sector-adjusted basis, a� er fairly heavy downgrades to analysts’ forecasts during the summer. Some valuation premium can be justi� ed by Canada’s relatively strong economic fundamentals and the positive outlook for its currency. With the eurozone in recession, the close link to the US economy is a posi-tive, as is the rebound in commodity prices during the third quarter. One positive is that the Bank of Canada is one of the few central banks in the world with a tighten-ing bias, and this could push the Canadian dollar toward its record-high against the US dollar. We downgrade Canada to underweight.

Australia: close links to China hurting recentlyGrowth has been sluggish since the tail end of 2011, but overall economic conditions are still strong relative to most other developed countries, as evidenced by Australia’s 5.1% unemployment rate. Investment spending to expand mining production should continue to boost the economy going forward, but lower commodity prices and the pros-pect of slower growth in demand from China have put some projects on hold. The return on Australian equities in dollar terms is heavily impacted by the Australian dol-lar/US dollar exchange rate, which is not too far from its all-time high. While we expect the relatively high level of interest rates to support the currency, there are downside risks. Valuations are somewhat more expensive than the

Source: Bloomberg, UBS WMR, as of July 2012

10

0

–10

30

20

60

70

40

50

2012

80

2009 2010 20112008200720062005

Fig. 6: Sluggish China a negative for Australia

Australian exports to China, year-over-year % change, 3-month moving average


outperformed developed markets over the last couple of weeks. EM equities trade at around a 20% discount to developed markets, and a� er the global rally in the third quarter, investors may be looking for assets that still appear cheap compared to historic norms. We therefore continue to recommend an overweight position on EM. Within this space, our favored markets are China, Brazil and Korea. Chinese economic data have continued to dis-appoint, but with the market trading at just 9-times for-ward earnings, we have decided to remain overweight. In Brazil, looser monetary policy should spur better growth in the quarters ahead. Valuations are in line with EM aver-ages and long-term growth prospects remain good. This month, we have upgraded Korea to overweight, and we also upgrade Taiwan from underweight to neutral. Both markets are similar in that they are relatively exposed to the global business cycle and have done well during peri-ods of QE. Please see the most recent Emerging Market Equities monthly for further details.

Brian Rose, PhD, Strategist

average for developed markets on a sector-adjusted basis. We maintain an underweight on Australia.

Switzerland: performance linked to euroSwiss companies o� er strong balance sheets and the market is heavily weighted toward defensive sectors like Healthcare and Consumer Staples. Equity valuations are in line with developed market averages. The Swiss cen-tral bank remains committed to preventing the EUR/CHF exchange rate from moving below 1.20, so if the euro has a renewed bout of weakness against the dollar, the peg would result in an equal decline in the franc, hurting equity returns in dollar terms. We downgrade Switzerland to underweight.

Emerging markets continue to disappoint Emerging markets (EM) got o� to a strong start in 2012, but have underperformed since then. The main problem has been the disappointing economic performance of the larger countries, including China, India and Brazil. In line with our expectations, in� ation has slowed, giving central banks the leeway to cut interest rates. However, policy eas-ing has not been enough to overcome headwinds such as the slowdown in exports caused by the recession in Europe. At this point, it seems unlikely that EM economic growth will improve dramatically before the end of the year.

One positive sign for EM equities is that money has started to � ow into EM equity funds, and EM has slightly

Fig. 7: Emerging market underperformance may be over


Market performance in USD, end-2011 indexed to 100

115

110

105

100

95

120

EM EM relative to DMDeveloped markets

Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12


Taiwan

Russia

Korea

China

India

Brazil

EM total

Year-to-dateQuarter-to-date

5 10 15 20 250

Fig. 8: Varied performance in emerging markets

Emerging market returns in US dollars, %


Riskier sovereign bonds, especially those in periph-eral Europe, rallied in the third quarter, while the safer bonds lost some of their premium. Exchange rate movements are likely to be the main driver of relative performance among the “safer” markets. We have moved to a neutral stance on US vs. non-US � xed income as downward pressure on the euro has been greatly reduced.

Weak growth to help rates stay lower for longerGlobal economic growth has generally been weaker than expected, making it likely that central banks will keep interest rates lower for longer. Amid overcapacity and high unemployment rates in many countries, core in� a-tion is generally low.

Upgrade eurozone bonds to neutral, focus on coreThe European Central Bank’s new program for bond pur-chases in the secondary markets has helped yields move lower in most of the weaker eurozone countries. Even Greece has seen a strong rally, bringing yields close to their post-restructuring lows. In the current low-yield environ-ment, the relatively high yields o� ered on government bonds in countries such as Greece, Portugal and Spain appear attractive. However, we continue to recommend that investors avoid these bonds. It is widely expected that Spain will seek assistance in the near future, but if political problems or other circumstances prevent this, yields may rise suddenly. We still think that Greece may be forced out

International Fixed Income

Yields contained by sluggish growth

of the eurozone, and another debt restructuring appears likely. We no longer expect the euro to weaken against the dollar, and this has led us to upgrade eurozone bonds, but investors should avoid taking on excessive risks in the peripheral countries.

No value in JapanJapanese government bonds o� er the worst of all worlds. The government’s debt-to-GDP ratio is above 200%, yet 10-year bond yields are below 1%. While we do not expect a major deterioration in 2012, at some point we expect a sell-o� in Japanese government bonds and the yen to weaken sharply. Although considered a safe haven by some, we recommend avoiding Japanese debt.

UK relatively attractiveThe UK has embarked on a multi-year plan to narrow its budget de� cit, which should give the country a chance to hold on to its AAA rating. The pound rallied against the dollar in the third quarter and is trading near its high for the year. We still see the potential for further appreciation against the dollar, although the prospect of another round of monetary easing by the Bank of England could be a short-term negative. If economic growth can return to posi-tive territory, this could signal the end of the easing cycle, allowing the pound to appreciate. We recommend an over-weight on the UK within non-US � xed income.

Brian Rose, PhD, Strategist

Source: UBS WMR, as of 26 September 2012

GermanyUS UK

Japan

5

4

0

2

1

3

6

2002 2003 2004 2005 2006 2007 2008 2009 2010 20122011

Fig. 10: Bond yields comparison

10-year government bond yields, in %

Note: arrows indicate changes adopted as of this reportSource: UBS CIO/WMR, as of 27 September 2012. Scale explained in Appendix.

n– –– – – – + ++ +++

US

Other

UK

Japan

Eurozone

Underweight Overweight

Fig. 9: Fixed Income Regions

Tactical deviation from benchmark, including view on currency


International markets: Chartbook

Fig. 13: Profit growth weak outside of US

Source: Datastream, UBS WMR, as of 25 September 2012

12-month trailing earnings per share, January 2011 indexed to 100

70

60

120

110

100

90

80

130

UK Emerging markets EurozoneUS Japan

Jun-12Apr-12Feb-12Dec-11Oct-11Aug-11Jun-11Apr-11Feb-11 Aug-12


EurozoneUS UK

Japan

64

–202

1412108

16

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Fig. 12: Equity risk premiums higher than usual

Earnings yield minus 10-year bond yield, in %

Fig. 14: Market perceives reduced eurozone tail risks


5-year government CDS spreads, in %

1.0

0.0

6.0

5.0

4.0

3.0

2.0

7.0

SpainItaly

Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12

Fig. 15: Dollar and pound look cheap, Aussie expensive


JP Morgan Real Effective Exchange Rate, CY2000 = 100

60

140

120

100

80

160

US dollar Swiss Franc EuroBritish pound Australian dollar

201020082006200420022000 2012

Fig. 16: Dollar has rallied against many EM currencies


Exchange rate versus US dollar, indexed end-2010 = 100

100959085

125120115110105

130

Brazil IndiaKorea Russia

Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12


EurozoneUS (le)

Emerging marketsJapan

0

–20–10

2010

60504030

70

–6–3

630

9

181512

21

Jul-12Jan-12Jul-11Jan-11Jul-10Jan-10

Fig. 11: Economic data so in Japan and eurozone

Change in UBS Economic Surprise Indexes since January 1, 2010


US Equities: Sectors

Still cautiously procyclical

Cyclical sectors still trade at a substantial discount to defensives, even a� er their more recent liquidity-fueled outperformance. But while central bankers are doing their part to promote economic growth, there are a number of near-term hurdles for cyclicals, such as uncertainty over � scal policy, less depressed relative valuations and sluggish pro� t trends.

As of 27 September 2012, the S&P 500 has gained nearly 7% during 3Q and is 14% above its June 2012 low. Not surprisingly, cyclical sectors have performed well during this period, recouping roughly half of their March through July underperformance versus defensives (Fig. 2). While we continue to favor cyclicals as we head into 4Q, in this report we trim our tactical tilt toward cyclicals by upgrad-ing Utilities from underweight to neutral and downgrad-ing Consumer Discretionary from moderate overweight to neutral. We also downgrade Healthcare from neutral to moderate underweight.

Cyclical sectors remain inexpensive relative to defensives and trade at a 14% valuation discount (see Fig. 3). But keep in mind that this valuation gap has narrowed over the past two months. In late July, cyclicals traded at a 21% discount to defensives—an 18-year low. The combination of cheap relative valuations, aggressive monetary accom-modation by the Fed, a reduction in European “tail risks” and signs of stabilization in the domestic economy helped

cyclical sectors to recover. Financials, Technology and Consumer Discretionary stocks have been the strongest performers over the past two months.

Over a 12-18 month period, we continue to believe that a moderate acceleration of economic growth, the avoidance of policy “shocks” and attractive relative valuations should drive cyclical sector outperformance. But over the remain-der of 2012, we are less convinced. We doubt that strong catalysts will be present to signi� cantly narrow the valua-tion gap as investors fret over the US “� scal cli� ” and slowing corporate earnings growth. Our allocation to the 10 S&P 500 sectors is as follows:

Information Technology (overweight)—outperformance to continueThe Technology sector has outperformed the S&P 500 both year-to-date and in 3Q. We expect this to continue given the sector’s low valuation, solid earnings growth and strong product cycles from the largest “tech titans.” Trading at just 12.5x forward earnings estimates, valuation is 4% lower than the market. Since 1995, Tech has traded at a discount to the market just 9% of the time. Tech earnings grew an impressive 9% during 2Q despite macro headwinds, disappointing PC sales and the sector’s rela-tively high exposure to Europe. Mobility and data centers have been strong end-markets. The introduction of Windows 8 in October should also provide some boost to


n– –– – – – + ++ +++

Consumer StaplesIndustrials

Cons DiscretionaryEnergy

Technology

FinancialsUtilities

MaterialsTelecom

Healthcare


Fig. 1: Slightly reduce cyclical overweight

Tactical deviations from benchmark

New Old

Fig. 2: Cyclicals have regained ground on defensives

Source: Thomson Datastream, UBS WMR, as of 25 September 2012

Relative performance of cyclicals versus defensives, indexed

1.10

1.05

1.00

0.95

1.15

Performance of cyclicals vs defensives

Jul-12May-12Mar-12Jan-12 Sep-12



PC manufacturers and the computing supply chain. Within the sector, we prefer tech hardware and semiconductor.

Consumer Staples (moderate overweight)—sustainable divi-dend growthConsumer Staples has lagged the S&P 500 in 2012. Sector fundamentals have been challenging as weak unit volume growth in developed markets, higher commodity input costs and a strong dollar all weighed on earnings. These headwinds appear to be easing as the trade-weighted dol-lar has weakened by 4% over the past eight weeks and many commodity prices have declined. Valuation is some-what high at a 22% premium to the market (compared with its 10-year average of 12%), but given the sector’s superior earnings and dividend growth relative to other defensives, a premium is warranted.

Industrials (moderate overweight)—weak momentum appears priced in Despite the recent cyclical rally, Industrials have lagged the S&P 500 in 3Q. We upgraded the sector to moderate overweight on 23 August 2012. Current sector fundamen-tals appear mixed. Earnings grew 14% in 2Q but are expected to slow to mid-single digits in the second half of the year. Global purchasing managers indexes (PMI) indi-cate sluggish end-market demand, but much of this already appears priced in with the sector trading at a 2% discount to the market—below the average 6% valuation premium of the past 10 years. Earnings revisions have

been negative but should stabilize or improve given our expectation for a near-term bottoming of manufacturing PMIs and incremental increases in infrastructure invest-ment in China.

Utilities (upgrade to neutral)—risk/reward getting more attractiveA� er underperformance of 11 percentage points since the market bottomed in early June, we upgrade Utilities from underweight to neutral. Our prior underweight stance was based on the sector’s extreme relative valuation premium and our outlook for higher interest rates (which compete with income-producing Utilities), as well as low power prices. The liquidity-driven rally on the heels of QE3 has prompted a rotation out of safe haven assets pressuring “bond substitutes” within equities such as the Utilities sector. While we believe rates will slowly dri� higher, the recent underperformance has driven Utilities sector valua-tions to less demanding levels. In addition, power prices have hit new lows and further downside will likely be more limited based on coal plant retirements and a bot-toming process in natural gas prices.

Consumer Discretionary (downgrade to neutral)—expectations getting lo� yWe downgrade Consumer Discretionary from moderate overweight to neutral, based on a more cautious outlook for the Retailing industry. Our change in view is based on elevated valuation and aggressive earnings growth

Fig. 3: Cyclicals near lowest valuations in two decades


Relative forward P/E ratio of cyclicals versus defensives, in %

160

140

120

100

80

60

180

Relative P/E - Cyclicals vs Defensives

2011

14% discount

20092007200520032001199919971995 2013


0.4

0.8

0.6

1.0

1.2

1.4

20112009200720052003 2013

Fig. 4: Valuation on utilities now less extreme

Relative forward P/E - Utilities vs. S&P 500


expectations. The Retailing group’s P/E multiple is near a 10-year high relative to the market and consensus earn-ings estimates call for growth to accelerate from 9% this year to 16% in 2013. We believe this is a high hurdle, especially with gasoline prices once again approaching $4 per gallon. We retain our positive view on the Media industry due to its solid pricing power and strong earn-ings trends.

Energy (neutral)—oil prices near fair valueOil supply is running ahead of demand as new US shale oil output has hit the market. Therefore, the market should be reasonably well supplied in the near term and Saudi Arabia will likely manage its output in order to target Brent crude prices of roughly $100, about 10% below current levels. Prices are likely higher than the Saudi target due to some risk premium based on possible military action in the Middle East. As a result, our commodity team is somewhat cautious on oil prices in the near term but believes prices will stabilize near current levels looking out 12 months. Financials (neutral)—very low valuation, but risks remainFinancials have rallied a� er actions by the European Central Bank which reduce the likelihood of a disruptive breakup of the eurozone. The sector has also been buoyed by an improving US housing market and a pickup in capi-tal markets activity. However, � nancial services companies still have to contend with a dif� cult regulatory environ-ment and limited aggregate loan demand as the house-hold sector continues to delever. While valuations remain low, industry pro� tability is likely to remain below average as well. The sector is also vulnerable if tensions in Europe � are again—an outcome that cannot be ruled out as European policymakers negotiate a banking union, Greece faces the prospect of needing additional support and the recession lingers across the continent.

Materials (moderate underweight)—earnings reductions likelyThe Materials sector has lagged over the last 18 months as the global economy has decelerated, notably in com-modity-intensive sectors. As a result, valuation has become more attractive but is not yet at levels that we � nd compelling. Relative to the market, the sector’s price-to-book value is still nearly 10% above its 10-year average. In addition, consensus earnings expectations

look lo� y at 21% growth in 2013. Aggressive central bank easing could buoy commodity prices in dollar terms in the near term, but signs of an actual acceleration in global economic activity—particularly in Asia—will need to surface in order to sustain higher commodities prices and Materials sector stocks.

Healthcare (downgrade to moderate underweight)—poor earnings momentum We downgrade Healthcare from neutral to moderate underweight based on a reduction in our outlook for Healthcare’s equipment & services industry. Relative earn-ings revisions for this subsector have deteriorated based on a worsening outlook for medical insurance companies and still-challenging environment for medical devices. Pro� tability in the medical insurance industry has declined as medical costs rise on the back of higher- than-expected utilization. Cycles in this industry tend to last several quar-ters as it takes time for the insurance carriers to adjust pricing. Pharmaceutical company valuations have risen to multi-year highs, but are still lower than other more expensive defensives such as Telecom and Utilities.

Telecom (underweight)—still expensiveTelecom remains the most expensive S&P 500 sector at a 40% premium to the market. In this low interest rate envi-ronment, investors have found the sector’s market-leading 4.4% dividend yield appealing. However we caution that interest rates are already at generational lows and our � xed income team believes rates will likely dri� higher over the next 12 months. Fundamentally, while wireless pro� t-ability has improved for the largest carriers, this could prove to be temporary as smaller players upgrade their networks to faster speeds, narrowing their competitive disadvantages.

Jeremy Zirin, CFA; David Le� owitz, CFA, Strategists



A� er lagging for most of 2012, small-caps have ral-lied since we moved to an overweight late last month. We believe further outperformance is likely. We maintain our long-standing preference for growth over value and continue to expect crosscur-rents for neutral-rated REITs.

Small- and mid-caps should continue to “close the gap”In last month’s Investment Strategy Guide (Back to work, 23 August 2012), we wrote that small- and mid-cap stocks were lagging large-caps despite the presence of several factors that typically coincide with smaller com-pany outperformance, such as broad equity market gains, declining market volatility and narrowing credit spreads. At that time, we upgraded our tactical allocation to small- and mid-caps to overweight. Over the course of the last few weeks, small-caps have outperformed, narrowing the “disconnect” from the fundamental drivers cited above. We believe further relative gains are likely for small- and mid-cap stocks.

First, though we are moderately scaling back our prefer-ence for cyclicals over defensives, we retain a clear pref-erence for the former given attractive relative valuations, stabilizing to improving economic data and additional measures by the Fed to spur risk-taking. As small-caps are more cyclical (and are exposed to more domestic cycli-cals) than large-caps, a rotation into economically sensitive

sectors should provide a tailwind for small-caps. Second, relative valuation is largely neutral and shouldn’t be a hur-dle for small-caps. Third, small-caps performed poorly on a relative basis versus large-caps as interest rates declined. Despite the Fed’s latest installment of QE, our US � xed income team is projecting moderately rising interest rates over the next 12 months as the economy gains traction and in� ation expectations rise. This will reduce the appeal of large-caps’ higher dividend yield.

Remain overweight growth and neutral real estateWe are not making any changes to style (maintaining our preference for growth over value) or to our neutral view of REITs. Growth performed in line with value in the third quarter and has outperformed by 110 basis points in 2012. In our view, the drivers for further outperformance for growth indexes remain in place: attractive relative valuation (growth is trading at a 30% premium to value, below its long-run average of 46%); positive sector in� u-ences (Technology over Financials); and the tendency for growth to outperform value as aggregate corporate earn-ings growth moderates. REITs continue to face the dual headwinds of interest rate risk in case of rising rates and stretched valuations, but fundamentals should remain solid in a moderate growth and still low interest rate envi-ronment. We remain neutral.

David Le� owitz, CFA; Jeremy Zirin, CFA, Strategists

US Equities: Size & Style, REITs

Small-caps perking up


n– –– – – – + ++ +++

Mid-Cap

Large-Cap Growth

REITs

Small-Cap

Large-Cap Value


Fig. 5: Favor growth over value; small over large

Size, style, and REITs recommended allocation, deviation from benchmark

New Old

Fig. 6: Rebounding cyclicals should boost small-caps

Source: FactSet, Bloomberg, UBS WMR, as of 20 August 2012

Relative performance of cyclical vs.defensive sectors

Relative performance ofRussell 2000 vs. Russell 1000

106

102

98

94

90

86

110

114

100

98

96

94

92

90

88

102

Cyclicals versus defensives (le)Small-caps relative to large-caps (right)

Jul-12Apr-12Jan-12Oct-11Jul-11Apr-11Jan-11 Oct-12


US Equities: Chartbook

Source: Datastream, UBS WMR, as of 25 September 2012

0.9

1.1

1.0

1.2

1.3

1.4

1.5

Sep-10Sep-08Sep-06Sep-04Sep-02 Sep-12

Fig. 9: Retailing valuations are stretched

Retailing forward P/E relative to S&P 500

Fig. 12: Small-caps have lagged despite low volatility


Relative performance of large-capsvs. small-caps (indexed)

VIX 13-week m.a.

100

95

90

85

105

110

50

40

30

20

10

60

correlation: 56%

Large-caps vs small-caps (le)VIX 13-week moving average (right)

Jul-12Jan-12Jul-11Jan-11Jul-10Jan-10Jul-09Jan-09 Jan-13

Fig. 10: High gasoline prices could crimp Retailing


US gasoline prices, in USD per gallon

4.0

3.5

3.0

2.5

4.5

US gasoline price national average

Jun-12Feb-12Oct-11Jun-11Feb-11Oct-10Jun-10 Oct-12

Fig. 11: Rising interest rates a risk for Utilities

Source: FactSet, UBS WMR, as of 14 September 2012

Regulated Utilities relative to S&P 500 10-year US Treasury yield, in %

1.4

1.3

1.2

1.1

1.0

0.9

0.8

1.5

1.6

1.5

2.0

2.5

3.0

3.5

4.0

4.5

1.0

0.5

Regulated utilities relative to S&P 500 (le)UBS WMR year-end Treasuries forecast (right)10 year Treasury yield inverted (right)

Jul-12Jan-12Jul-11Jan-11Jul-10Jan-10 Jan-13

Fig. 7: Tech is trading at a wide discount to average valuations


Relative forward P/E ratio by sector

1.4x

1.2x

1.0x

0.8x

0.6x

1.6x

Current relative P/E10 year average relative P/E

Ener

gy

Tech

nolo

gy

Heal

thca

re

Indu

stria

ls

Mat

eria

ls

Utili

ties

Cons

Disc

Cons

Stp

ls

Tele

com

Fina

ncia

ls

Fig. 8: Weak earnings momentum for Healthcare

Source: FactSet, UBS WMR, as of 24 September 2012

Positive earnings revisions minus negative revisions / total estimates,Healthcare Equipment and Services relative to S&P 500, in %

30

20

10

0

–10

–20

40

Relative earnings revisions Relative earnings revisions - 3 mo avg

2012201120102009200820072006 2013


Despite the signi� cant spread tightening that has taken place, credit-sensitive parts of the � xed income market should continue to bene� t from recent policy actions that limit � nancial market downside and push investors toward higher-yield-ing assets. We look for Treasury yields to return to slightly higher but stable ranges, and credit spreads to grind only moderately tighter into year-end. Despite very tight spreads, agency mortgage-backed securities (MBS) will likely continue to remain well bid with the Fed absorbing substantial gross supply. We lowered our emerging markets sovereign allocation to neutral as valuations are no longer compelling.

New Treasury yield forecast rangeWe recently increased our interest rate forecasts as we now expect rates to remain in a slightly higher range over the next three to six months. There are two main take-aways from the new Fed and ECB measures: First, the short end of the yield curve remains anchored at excep-tionally low levels, while longer-dated maturities are more likely to rise slightly. Second, the ECB measures represent a cap on Spanish and Italian sovereign yields that should reduce worries about the euro crisis and cause benchmark

US Fixed Income

Go with the policy � ows

Fig. 2: US interest rate forecastsIn %

27-Sept in3 months

in6 months

in12 months

3-month Libor 0.4 0.5 0.5 0.5

2-year Treasury 0.2 0.4 0.4 0.5

5-year Treasury 0.6 0.9 0.9 1.2

10-year Treasury 1.6 2.0 2.0 2.3

30-Year Treasury 2.8 3.0 3.0 3.5

Source: Bloomberg, UBS WMR, as of 27 September 2012Note: Bold numbers indicate the new rate forecasts published in Interest rates and bond markets, 14 September 2012.

Preferred Securities

Emerging Market

Most PreferredLeast preferred

Inv. Grade Corporates

High Yield Corporates

TIPS

Agencies

Mortgages

Treasuries

– – – – – – n + ++ +++

Note: Our TFI preferences are presented in a different format than in prior months. The focus is on the relative preference order rather than on deviations from a benchmark. See the appendix for a detailed asset allocation illustration in the context of a moderate-risk taxable US dollar fixed income portfolio and explanations regarding the interpretation of the suggested tactical deviations from benchmark. Source: UBS WMR, as of 27 September 2012

Fig. 1: USD taxable fixed income (TFI) strategy

Tactical deviations from benchmark

yields to be less impacted by safe haven � ows. While we are revising our expectations for interest rates slightly higher, we are not of the view that we have reached the beginning of a long-term bear market for bonds. However, the measures open the door for benchmark yields to return to their previously stable and slightly higher ranges. We have kept our 12-month forecasts in place, which are only moderately higher than our 6-month forecasts. Factors such as the ongoing structurally weak growth environment, the potential for political risks to � are up again, and the likelihood that the Fed will initiate outright Treasury purchases when its Operation Twist program ends next year should serve to put downward pressure on rates.

Real yields to remain low in the near termBreakeven rates increased due to the in� ationary implica-tions of expanding the Fed’s balance sheet and the Fed’s focus on bringing down unemployment. Most of this move in in� ation expectations has played out through real yields, which have been pushed lower. In contrast, the 10-year nominal Treasury stands close to its level prior to when the bond market began to expect QE3. The poten-tial for breakeven rates to remain elevated, albeit anchored near current levels, will likely keep real yields depressed in the near term. However, over the long term, both real and


nominal yields should respond to the growth e� ects of QE and rise if we get back on track to reach potential growth.

Agency debentures and MBS—high-quality alternativesPrices of agency MBS rose as the Fed stated it would make new MBS purchases at a pace of $40bn per month, while maintaining the policy of reinvesting principal payments of agency debt and MBS. Since the Fed announcement, the 30-year FNMA current coupon rate has fallen 58bps to a record low of 1.78%, while the spread to the Treasury 5yr/10yr blend has tightened to just 60bps. These pur-chases should add to an already favorable supply/demand backdrop that exists as the Fed is scheduled to accumu-late a substantial share of MBS gross issuance. In addi-tion, steps taken by the Federal Housing Finance Agency in mid-August helped raise the credit quality of agency debentures and MBS by strengthening the operational ties that Fannie Mae and Freddie Mac have with the govern-ment. We believe agency MBS will likely retain their lo� y valuations while the Fed remains an aggressive buyer. In the agency debenture space, we prefer callable bonds over bullets. In a period of lower volatility and range-bound yields, callable agency bonds allow investors to pick up incremental yield and may o� er higher total returns over non-callable bonds.

Credit to be a bene� ciary, yet againRecent policy actions in support of economic growth and

market liquidity are likely to maintain a positive tone for credit, while fundamentals remain robust. With invest-ment grade (IG) spreads having tightened by 18bps in September and 80bps year-to-date (YTD), overall yields remain near historically low levels with the IG index cur-rently exhibiting an average YTM slightly below 3%. This serves to increase the duration risk that is inherent in the IG market. The e� ective duration of the IG index currently stands close to 7 years, compared to a 10-year average of 6 years. Although we believe the average credit spread of this index, currently at 167bps, could decline to 150bps, this is only likely to occur in tandem with 10-year Treasury rates rising up to our 2.0% forecast level. While we see some further potential for spread tightening, this will likely be mixed with higher levels of volatility, as macro and political events weigh on the markets and risk tolerance. Continued solid new issuance volumes and strong investor demand are likely to follow in the fourth quarter, as long as market conditions remain supportive.

Financial bonds may compress further Our view on Financials heading into 4Q12 remains con-servative, as YTD returns for the sector are substantial, and spreads are now approaching the tights of 2011 but at a much lower overall yield. In the quarter to date, IG Financials have rallied substantially, with a total return of 4.7%, versus 2.8% for Industrials and leaving Financials within 30bps of their post-crisis low spread level of 171bps (11 April 2011). Although we have moved through our

US Fixed Income

Fig. 4: Breakevens have risen on QE3 expectations


10-year real, nominal, and breakeven rates, in %

2.5

1.5

0.5

–0.5

–1.5

3.5

0.0

4.5

10 year nominal yields 10 year breakeven10 year real yields

Jul-12Jan-12Jul-11Jan-11Jul-10Jan-10 Jan-13

August 2012 Fed minutes

Fig. 3: Duration and yield curve positioning

Duration Neutral

Corporate bond maturity range 3 to 7 years

TIPS maturity range 5 to 10 years

Municipal maturity range 6 to 9 years



US Fixed Income

previous year-end spread target of 200bps, we see sup-port for further tightening and compression relative to Industrials. During upcoming 3Q12 earnings, banks and insurers will face similar challenges posed by the low inter-est rate environment and tepid growth. Banks are likely to continue to report improvement in credit quality of loan portfolios while insurers are likely to bene� t from improved pricing. Among IG Financial issuers, we continue to favor well-capitalized money center banks and regional Financials, as well as diversi� ed insurance companies. Further down the capital structure, we remain neutral on preferred securities. While we believe preferred prices are currently at rich levels, we expect preferreds to remain well bid in the near term. We caution that current � xed-for-life coupon levels below 6% expose investors to long duration risk should rates move higher than we forecast.

Price ‘melt-up’... how much longer?Preferred securities exhibited another strong month of total return performance during August. The index for � xed-rate investment-grade preferreds returned 1.0% for the month and 12.7% YTD. A signi� cant portion of this solid YTD performance was attributed to price appre-ciation, contributing 7.2% out of the 12.7% during the period. Subsequently, we now see less room for fur-ther price appreciation from the current lo� y prices and believe the dividend or interest component will count more toward the total rate of return for the rest of 2012. We hold this view in spite of the recent monetary stimulus

announced by the Federal Open Market Committee (FOMC) on September 13. We do not see as much perfor-mance potential as � nancial market stress is muted, pre-ferred securities yields are lower and recent economic data has been coming in better than expected.

Prices of non-US preferred securities have increased another 1.4% since Mario Draghi’s “whatever it takes” comment on July 26. However, we believe the situation in the eurozone has not improved enough to support higher price levels without some risk of a credit-related pullback. The combination of the lingering eurozone problems, global growth concerns, uncertainty over US � scal policy and the still-recovering banking sector present multiple potential risk factors. That said, in the absence of a mar-ket shock, we look for the prices of non-US preferreds to remain at these well-bid levels, especially as the universe of high-yielding investment alternatives is scarce. With these varying forces at play, we believe income will similarly play a larger part of non-US preferreds total rate of return for the remainder of the year.

High yield, high coupons High yield (HY) credit has bene� ted tremendously from investors’ insatiable quest for income, which has resulted in strong fund � ow demand. Dissecting the 12.5% YTD total returns that the HY index has generated, roughly half of this stems from coupon income and half from price appreciation, as spreads have compressed 175bps


20

0

140

40

120

100

80

60

Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12

Fig. 5: Agency MBS spreads plummeted following QE3

30-year Fannie Mae current coupon spread over 10-year Treasuries, in basis pointsFig. 6: Projected six-month returns

Index Incomereturn (%)

Price return (%)

Total return (%)

Investment grade 2.2 -0.7 1.5

High yield 3.7 0.2 3.9

Source: BofAML, Yield Book, UBS WMR, as of 25 September 2012Note: Utilizes our 6-month interest rate forecasts and spread target assumptions of 150 basis points for IG and 500 basis points for HY


US Fixed Income

YTD. Average spreads currently stand at 535bps and have potential to decline below 500bps, in our view. However, given the strong correlation with equities, we think this will occur only in the context of a supportive environment for risk assets and in the absence of any negative market shocks. Further price gains will be limited by the fact that roughly 40% of the HY index trades above its call price, which constrains further upside. Nonetheless, given the relative income advantage and still reasonable spread valu-ations, we believe HY corporate bonds o� er an attractive return outlook and should be overweighted.

EM sovereign debt: move to neutralEmerging markets (EM) US dollar-denominated sovereign debt has been the top YTD performer among the seg-ments tracked in our US � xed income asset allocation. EM sovereign debt’s YTD total return stands at 14.1%, about 150bps and 160bps ahead of preferreds at 12.6% and US high-yield at 12.5%, respectively. The asset class continues to exhibit stronger fundamentals and better growth pros-pects than the developed world, in our view. Furthermore, in an environment of historically low benchmark rates, EM has remained a sought-a� er investment destination, which in turn has translated into strong investor in� ows and sup-portive technicals.

However, EM sovereign debt valuations look roughly in line with fundamentals, which should mean that further upside is likely to be rather limited. Therefore, we reduce our

tactical weighting for US dollar-denominated EM sovereign debt to neutral from overweight. That said, we continue to favor Latin America and Asia over Eastern Europe. We also favor investment vehicles (e.g., mutual funds and/or ETFs) that include EM corporate debt in their respective man-dates. We continue to expect a pickup in global economic activity in coming quarters, and EM corporate bonds tend to outperform their respective underlying sovereign when growth accelerates. Downside risks to our neutral allo-cation include the strong correlation between crude oil prices, which appear rather shaky nowadays, and Russian sovereign debt (about 10% of our benchmark index). On the upside, we have the October 7 presidential election in Venezuela (almost 7% of our benchmark index). Market participants seemed positioned for the incumbent’s reelec-tion, but recent news � ow out of Venezuela suggests there’s a possibility for a market-friendly surprise. Municipal securitiesFavorable technical factors related to manageable new issue supply and healthy investor demand helped munici-pals outperform Treasury securities throughout most of the summer. As a result of this strong performance, municipal-to-Treasury (M/T) yield ratios at the 10-year and 30-year maturity points have fallen to 101.7% and 103.4%, respectively, from 119.8% and 120.1% on June 1. In September, new issuance is estimated at $22.5bn through 28 September 2012, following $31.9bn in primary mar-ket supply occurring last month, according to The Bond

Fig. 8: Spreads are at YTD tights but above 2011 lows

Source: BofAML, UBS WMR, as of 25 September 2012

Option-adjusted spread, in basis points

240

200

160

120

280

800

700

600

500

400

900

Investment grade (le)High yield (right)

Apr-12Jan-12Oct-11Jul-11Apr-11Jan-11Oct-10Jul-10Apr-10Jan-10 Jul-12

Fig. 7: Duration risk increases as yields decline


Duration, in years

7.0

6.0

5.0

4.0

3.0

8.0

IG Corporates TreasuriesHY Corporates USD EM Sovereigns

2002 2004 2006 2008 2010 2012


Fig. 12: AAA muni-to-Treasury yield ratios

Source: MMD, UBS WMR as of 25 September 2012

in basis points

110

95

80

125

140

10 year30 year

Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12

Note: September flows are month-to-date, as of 12 September 2012Source: Investment Company Institute, UBS WMR, as of 25 September 2012

10000

5000

0

–5000

–10000

–15000

15000

May-09Sep-08 Sep-10 Jan-02May-11 Sep-12Jan-10

Fig. 11: Municipal mutual fund flows

In USD (millions)

“60 minutes”

Lehman Brother’sbankruptcy

Historically low yields

Monthly Net Inflows/Outflows

Fig. 10: HY spreads and equities have moved in tandem

Source: BofAML, Bloomberg, UBS WMR, as of 25 September 2012

S&P 500 Index, le, and HY option-adjusted spread, right, in basis points

1,350

1,300

1,250

1,200

1,500

1,450

1,400

1,550

500

550

600

650

700

750

450

S&P 500 Index (le)High yield spread (right)

Oct-12Sep-12Aug-12Jul-12Jun-12May-12Apr-12Mar-12Feb-12Jan-12

Fig. 9: Financials and Industrials spreads have compressed


Option adjusted spreads, in basis points

300

200

100

400

Industrials Financials

Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12

Buyer. On the demand side, investors continue to direct � ows to municipal mutual funds in pursuit of income. Net cash in� ows to muni mutual funds have now taken place for 25 consecutive weeks according to data reported by the Investment Company Institute, accumulating a total of $45.8bn YTD through 12 September 2012. On a monthly basis, the sector has not experienced out� ows since August 2011.

The broad muni market has posted a 6.2% YTD total return, outpacing the 1.9% return for the Treasury bond market over the same time frame. By contrast, tax-exempt munis have lagged investment-grade corporate bond per-formance of 8.6%. Some supply pressures are likely to build in the October/November time period. Presently, the 30-day Visible Supply stands at $9.3bn. By compari-son, the indicator has averaged $8.6bn in 2012 and re-cently attained its lowest reading YTD on 30 August 2012 ($2.6bn). We expect price volatility to increase a� er the presidential election as tax reform takes center stage and municipal tax exemption is closely scrutinized. In our view, the municipal tax exemption is likely to be among the tax expenditures targeted by Congress for a variety of reasons, as discussed in WMR’s Municipal Market Guide: Taxing times, 14 September 2012.

Rebecca Clarke; Barry McAlinden, CFA; Donald McLauchlan; Kathleen McNamara, CFA, CFP; Henry Wong, Strategists

US Fixed Income


Sector Comment Implementation

US Fixed Income

Taxable

Agency securities Callable agencies o� er incremental income and could outperform non-callable bonds should Treasury yields remain range-bound to slightly higher over the next 12 months.

3- to 7-year callable agency debentures

USD Emerging markets (EM) We remain of the view that Latin America and Asia are better positioned to weather the eurozone slowdown than Eastern Europe. We therefore recommend exposure to EM sovereign debt via bond funds and/or exchange-traded funds (ETFs) with emphasis on Latin America and Asia. Investors with a higher risk tolerance who want a more direct exposure to EM may want to consider investment-grade-rated credits, including quasi-sovereign oil conglomerates and large mining companies.

See the Corporate Bond Valuation Report

High yield corporates (HY) Average spreads currently stand at 535bps and have potential to decline below 500bps, in our view. However, given the strong correlation with equities, we think this will occur only in the context of a supportive environment for risk assets and in the absence of any negative market shocks. Given its relative income advantage and still reasonable spread valuations, we believe HY corporate bonds o� er an attractive return outlook and should be overweighted.

Diversi� ed exposure, through a mutual fund or closed-end fund.

Investment grade corporates (IG) IG would likely outperform during any market setbacks since performance is more highly correlated to the rate markets relative to HY, EM sovereigns and preferreds. Within IG non-Financials we favor single A and BBB-rated credits in the managed care, mining, oil and gas and communications sectors. Within IG Financials we favor diversi� ed insurers, higher-rated regional and money center banks, and REITS.

For individual corporate bonds, see the Corporate Bond Valuation Report

Mortgage-backed securities (MBS) Although spreads are rich, we believe agency MBS o� er incremental carry versus Treasuries, but with little credit risk. Lo� y price valuations are likely to be maintained while the Fed remains a buyer of substantial gross monthly supply.

Mutual funds

Preferred securities We favor preferreds likely to be called such as select US bank trust preferreds and high coupon DRDs. We believe select REIT preferreds o� er attractive valuation and diversi� cation in a space crowded by bank preferreds. When purchasing individual preferred securities, we recommend investors have a thorough understanding of the security’s structure, duration characteristics, and ability for early call risk. Broad asset class exposure to preferreds can be obtained through mutual funds, ETFs, or closed-end funds.

For individual preferred securities, see the Preferred Securities Valuation Report

Treasury In� ation-Protected Securities (TIPS)

The potential for breakeven rates to remain elevated, albeit anchored near current levels, will likely keep real yields depressed in the near term. However, over the long term, both real and nominal yields should respond to the growth e� ects of QE and rise if we get back on track to reach potential growth.

5 to 10 years

Municipal bonds

Tax exempt We favor intermediate-term maturities of six- to nine-years for new money purchases. Income-oriented investors with an ability to withstand a higher degree of price risk can be rewarded by allocating a portion of a municipal bond portfolio to longer maturities selectively.

6 to 9 years; add longer maturities 20 to 23 years selectively

Recommendations


US Fixed Income


US Fixed Income: Chartbook

Fig. 5: Municipal visible supply and yields


Le hand axis yield, in %, right hand axis in USD millions

3

2.5

2

1.5

1

3.5

Yiel

d 11,500

14,500

5500

8500

2500

17,500

30-Day Visible Supply (right)Treasury 10 year (le)

AAA GO 10 year (le)

May-12Mar-12Jan-12Nov-11Sep-11Jul-11 Jul-12 Sep-12

Fig. 3: Emerging Market sovereign bond spread


Option-adjusted spreads, in basis points

800

600

400

200

0

1000

EM spreadAvg (2000-present)

2009200620032000 2012

Fig. 4: TIPS breakeven inflation rates remain elevated


Breakeven inflation rate, in %

3

2

1

0

–1

4

5-year breakeven 30-year breakeven10-year breakeven

Sep-11Sep-10Sep-09Sep-08Sep-07 Sep-12

Fig. 1: Treasury yields to rise gradually


Rate development and UBS WMR forecast, in %

5

4

3

2

1

0

6

2-year Treasury note10-year Treasury note

Sep-11Sep-09Sep-07Sep-05Sep-03Sep-01 Sep-13

Fig. 2: The yield curve should remain steep


10-year Treasury yield minus 2-year Treasury yield, and WMR forecast, in basis points

250

200

150

100

50

0

–50

300

10s/2s Curve

Sep-11Sep-09Sep-07Sep-05Sep-03Sep-01 Sep-13

Fig. 6: US � xed-income yieldsYields, in %

Maturity Treasury TIPS Agencies IG Corp. Single-A

HY Corp. Double B

Muni AAA Muni TEY 35%

2-year 0.3 -1.5 0.3 0.7 2.6 0.3 0.5

5-year 0.6 -1.5 0.9 1.6 3.7 0.8 1.2

10-year 1.7 -0.8 1.9 3.0 5.1 2.0 3.1

20-year 2.4 -0.1 3.0 4.2 6.5 3.2 4.9

30-year 2.8 0.4 2.9 4.2 7.9 3.3 5.1

Note: TEY = tax equivalent yieldSource: Bloomberg, UBS WMR, as of 25 September 2012


The announcement by key central banks that they would further ease monetary policy in the com-ing quarters has had a mixed impact on commodity prices so far. Precious and industrial metals per-formed well, whereas energy and agricultural com-modities saw prices coming under pressure. We think this diverging behavior could continue in 4Q12.

Strong sector-speci� c price drivers are in a position to over-power the supportive impact of extremely loose monetary policy on real assets. Overall, this leaves us with an asset class return payo� that is only mildly positive for 4Q12.

Energy continues to weakenOn a sector level, we continue to forecast negative expected returns for Energy. Global crude oil supply should expand by 0.8-1 million barrels per day (mbpd) versus the prior quarter and therefore overcompensate incremen-tal demand. Lackluster crude oil demand growth (0.2 mbpd) has several sources of weakness, which range from structural factors in Europe and the US to cyclical issues in China. We think that will bring Brent crude oil prices toward $95/bbl while WTI slides toward $78/bbl in 4Q12. Ample supply should also keep US natural gas inventories � rmly above longer-term averages and lead to high single-digit investment losses.

Better news for metalsA more favorable situation can be found on the metal

Commodities

Caught between QE and sector-speci� c price drivers

side. With China’s growth deceleration coming to an end, metals should hold their ground. That said, the strong price increase witnessed a� er the QE3 announcement has yet to be followed by a real demand pickup. We think this will limit the sector’s performance. On an individual level, copper is our top pick. Stronger investment demand can quickly widen the metal’s supply de� cit.

A quite opposite return payo� can be found for gold. The Fed’s aggressive easing is likely to weigh on the US dollar and motivate a constant in� ow into gold-backed invest-ments over the next 3-6 months. Gold is likely to be the key bene� ciary of investors’ search for real assets. We think this should leave room for the gold price to rise fur-ther in the coming three months.

Grains under pressureA 15%-20% price increase for grains remains a highly probable outcome. Demand rationing for corn and soy-beans is still needed. With ethanol production and feed demand holding up, US grain inventories run the risk of declining more than envisaged by the USDA. Additional grain support comes from elevated planting expectations for South America’s crop, leaving room for disappoint-ments when planting becomes very weather-sensitive in late 4Q12. Risk to this view relates to ongoing US export weakness in the grains.

Dominic Schnider, Strategist

Fig. 1: Performance of different commodity sectors


UBS Bloomberg CMCI spot indices, standardized to 100

140

120

100

80

60

160

180

EnergyAgriculture

Industrial MetalsPrecious Metals

Livestock

Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12


150

100

50

0

–50

–100

200

–

–20011995198919831971 2007

Fig. 2: Negative real interest rates should continue to supporgold price

US real interest rates and annual returns on Gold (in %)

1977

US real interest rates (right)Gold price year-over-year change (le)

Most hedge fund strategies have been posting gains this year. However, performance across the industry, while improving, continues to disappoint and is trailing the overall equity markets by a sizeable margin. We have wit-nessed a truncated volatility pro� le across funds as manag-ers try to navigate a globally weak economy and indecision among policymakers. Funds of funds and equity long/short funds, the largest hedge fund strategy, are reevaluating their value proposition as they lag their passively managed long-only peers. As of August, the S&P 500 had returned 13.5% compared to just 3.5% according to the HFRI Equity Hedge Index. However, � xed income managers, particularly in the asset-backed area, have delivered strong, steady performance through aggressive asset purchases and bene� ting from low interest rates and limited defaults.

Leverage increased slightly amidst a slower trading envi-ronment. Correlations within asset classes came down and dispersion across securities increased, thereby creating a more favorable environment for security selection. As a result, equity managers with a fundamental approach and a net-long bias performed relatively well in August.

Equity hedge funds were up +3.5% year-to-date by August, rebounding slightly a� er a weak second quarter. Managers underperformed relative to market indexes. They entered 3Q defensively positioned, but eventu-ally ramped up exposure o� the back of the equity rally. As a result, a markedly greater upside capture emerged. Managers with short positions saw those rallying harder than their longs, which hurt performance. In terms of geography, managers with more US-centric positions seemed to outperform those invested in international markets, particularly Asia. Strong performance from equity-oriented managers is expected to continue if mar-kets remain � rm.

Event-driven funds were up +4.0% year-to-date. Event-driven managers have performed similarly to equity hedge managers as they su� ered from the same dif� cul-ties, including lower net exposure and lack of conviction. Managers rerisked their portfolios a� er the ECB’s commit-ment to save the euro. This resulted in gains across merger arbitrage and European � nancials, but these were o� set by European sovereign credits. Merger activity picked up

toward the end of summer as new deals were announced. Gains were also driven by equity and credit positions, par-ticularly in auto, mining, consumer and energy segments. Event plays are expected to materialize toward year-end with the US election and changes in tax policy.

Macro funds had risen a mere +0.95% by the end of August. A� er a dif� cult June, commodity trading advisors (CTAs) were the best-performing strategy in July, up over 3% for the month with most of the gains coming from currency and � xed income markets. The EUR declined against major currencies, which made money for many managers who were short EUR and long USD and AUD. Commodities also experienced signi� cant price movement as droughts in certain parts of the US created shortages in corn and wheat. CTAs gave back some performance in August as trends failed to materialize. Returns from dis-cretionary macro managers remained muted and are rela-tively � at for the year. A dif� cult trading environment for discretionary managers continues to persist as investors begin to lose interest.

Relative-value funds, in contrast, were up 6.6%. Fixed income and structured credit funds are the best-perform-ing hedge fund strategies in 2012. Spreads tightened across corporate and high-yield markets, aiding long- biased managers. Managers that posted positive perfor-mance pro� ted from yield curve positioning in the US and Europe. Credit-distressed managers had modestly positive results as core restructurings and post re-org equities con-tributed to performance. Capital has continued to � ow into this area including RMBS, CMBS and CLO paper as investors avoid equities in favor of yield.

Andrew Yongvanich, UBS Alternative Investments

Alternative Investments

Hedge fund review and outlook


Andrew Yongvanich is an employee of the UBS Alternative Investments team within UBS Wealth Management Solutions and is not a part of Wealth Management Research (WMR). WMR may have views that di� er or are contrary to the views expressed herein.

Fundraising environmentAs of mid-year, global fundraising across the private equity (PE) industry remained slightly below its three-year average. Since 2009, the PE industry has managed to raise on aver-age $73.2bn per quarter while 2012 netted $66.7bn per quarter. This remained signi� cantly below the 2005-08 bull market level. However, certain investors continue to allocate capital to PE with a preference for yield and capital appre-ciation, rather than liquidity. Larger funds, those greater than $1bn, are grabbing a bigger share of the overall pie. Fourteen funds held a � nal close with at least $1bn in com-mitted capital with the largest fund closing with $7.1bn in aggregate commitments. However, funds are delaying their closing in hopes of reaching their fundraising targets.

North America continued to be the primary market fund-raising, accounting for 51% of funds closed and 58% of committed capital. Europe accounted for 22% of fund closings and 27% of committed capital, while Asia along with the rest of the world closed 22% of funds and raised 14% of committed capital.

Buyout funds were the most in demand with $24.9bn in capital commitments, followed by natural resources. Six dedicated natural resources funds raised $8.8bn with four out of six raising more than $1bn. Real estate � ows appeared to slow, while appetite for venture capital remained constant.

Dry powder/� nancingPE funds have a lot of capital on hand from a lackluster deal environment driven by uncertain growth prospects. Overall, they are sitting on approximately $900bn dollars and the $51bn invested last quarter was the lowest total since 2009. Transactions dropped 29% from the previous quarter and PE � rms are on pace to execute the fewest deals since 2003.

Credit markets weakened around the world especially in Europe during the second quarter with both new high-yield issuance and new issue leverage loans down quarter over quarter. However, � nancing conditions for US lever-aged buyouts remain broadly favorable. Firms with big pools of capital have been able to opportunistically re� -nance and extend existing debt.

Subdued deal-making environment Deal-making remained muted in the � rst half, while sec-ond quarter deal � ow was the lowest level for any individ-ual quarter since 2008. Consistent deal-making that was present in 2011 fell in the � rst half of 2012. Secondary buyouts are returning to the market as PE � rms have bought more assets from other PE � rms this year, more than double 2011 volumes and the highest since 2007.

Energy infrastructure deals are experiencing a boom from changing supply/demand balances, technology advance-ments, new infrastructure, growth in low-cost supply of certain commodities (natural gas), higher levels of volatil-ity and new policy changes. Energy infrastructure funds are attracting interest by delivering attractive yield, sup-ported by real asset exposure and strong cash-� ow-based businesses. Investments include undeveloped oil and gas assets, mineral rights and royalties, and producing oil and gas properties.

Investments in Financial Services lagged as a result of the European crisis and economic slowdown. Deal-making in consumer products (retail, media, consumer durables/non-durables, services) remained weak, but speci� c sec-tors found activity. Retail represented 15% of consumer products deal � ow and accounted for 36% of capital invested. Consumer durables experienced the largest drop in invested capital, declining almost $10bn year over year. Exit activity was relatively strong, despite a drop from the � rst quarter. Corporate acquisitions with strategic partners appeared favored over IPO exits.

Exit volumes appear strong going into the second half of the year in hopes of tax avoidance, due to policy changes at year-end. Additionally, mega-cap deals came back at the end of the third quarter, pushing LBO volume up notably in Asia. While the market is coming back, deals are smaller and less visible as compared to the boom years.

Andrew Yongvanich, UBS Alternative Investments

Alternative Investments

Private equity landscape

Andrew Yongvanich is an employee of the UBS Alternative Investments team within UBS Wealth Management Solutions and is not a part of Wealth Management Research (WMR). WMR may have views that di� er or are contrary to the views expressed herein.



Investorrisk pro� le1

Very conservative Conservative Moderateconservative

Moderate Moderate aggressive

Aggressive Very aggressive

Cash Equities

Bonds NTAs

Cash Equities

Bonds NTAs

Cash Equities

Bonds NTAs

Cash Equities

Bonds NTAs

Cash Equities

Bonds NTAs

Cash Equities

Bonds NTAs

Cash Equities

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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 +1.0 24.0 32.0 +1.0 33.0 39.0 +1.0 40.0 44.0 +1.0 45.0 52.0 +1.0 53.0

Large Cap Value 0.0 +0.0 0.0 8.0 -2.0 6.0 8.0 -3.0 5.0 11.0 -4.0 7.0 11.0 -5.0 6.0 11.0 -6.0 5.0 13.0 -7.0 6.0

Large Cap Growth 0.0 +0.0 0.0 5.0 +1.0 6.0 8.0 +1.0 9.0 11.0 +1.0 12.0 11.0 +1.0 12.0 11.0 +1.0 12.0 13.0 +1.0 14.0

Mid Cap 0.0 +0.0 0.0 1.0 +1.5 2.5 4.0 +1.5 5.5 5.0 +2.0 7.0 9.0 +2.5 11.5 11.0 +3.0 14.0 13.0 +3.5 16.5

Small Cap 0.0 +0.0 0.0 0.0 +0.0 0.0 2.0 +1.5 3.5 3.0 +2.0 5.0 5.0 +2.5 7.5 7.0 +3.0 10.0 8.0 +3.5 11.5

REITs 0.0 +0.0 0.0 0.0 +0.0 0.0 1.0 +0.0 1.0 2.0 +0.0 2.0 3.0 +0.0 3.0 4.0 +0.0 4.0 5.0 +0.0 5.0

Non-US Equity 0.0 +0.0 0.0 5.0 -0.5 4.5 9.0 -1.0 8.0 12.0 -1.0 11.0 15.0 -1.0 14.0 18.0 -1.0 17.0 19.0 -1.0 18.0

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 -3.0 11.0

Emerging Markets 0.0 +0.0 0.0 0.0 +0.0 0.0 1.0 +0.5 1.5 2.0 +1.0 3.0 3.0 +1.5 4.5 4.0 +2.0 6.0 5.0 +2.0 7.0

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 � 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 � 0.0

Non-US Fixed Income 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 0.0

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 Assets 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

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 Investments5 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

“WMR tactical deviation” legend: Overweight Underweight Neutral “Change” legend: � Upgrade � DowngradeSource: Investment Solutions and WMA Asset Allocation Committee, as of 27 September 2012 For end notes, please see appendix.


Detailed asset allocation, with non-traditional assets (NTAs)

All figures in %



Detailed asset allocation, without non-traditional assets (NTAs)

Investorrisk pro� le1

Very conservative Conservative Moderateconservative

Moderate Moderate aggressive

Aggressive Very aggressive

Cash Equities

Bonds

Cash Equities

Bonds

Cash Equities

Bonds

Cash Equities

Bonds

Cash Equities

Bonds

Cash Equities

Bonds

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Traditional Assets

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 +1.0 27.0 37.0 +1.0 38.0 48.0 +1.0 49.0 59.0 +1.0 60.0 72.0 +1.0 73.0

Large Cap Value 0.0 +0.0 0.0 9.0 -2.0 7.0 9.0 -3.0 6.0 13.0 -4.0 9.0 14.0 -5.0 9.0 15.0 -6.0 9.0 18.0 -7.0 11.0

Large Cap Growth 0.0 +0.0 0.0 6.0 +1.0 7.0 9.0 +1.0 10.0 13.0 +1.0 14.0 14.0 +1.0 15.0 15.0 +1.0 16.0 18.0 +1.0 19.0

Mid Cap 0.0 +0.0 0.0 1.0 +1.5 2.5 4.0 +1.5 5.5 6.0 +2.0 8.0 11.0 +2.5 13.5 15.0 +3.0 18.0 18.0 +3.5 21.5

Small Cap 0.0 +0.0 0.0 0.0 +0.0 0.0 3.0 +1.5 4.5 3.0 +2.0 5.0 6.0 +2.5 8.5 9.0 +3.0 12.0 11.0 +3.5 14.5

REITs 0.0 +0.0 0.0 0.0 +0.0 0.0 1.0 +0.0 1.0 2.0 +0.0 2.0 3.0 +0.0 3.0 5.0 +0.0 5.0 7.0 +0.0 7.0

Non–US Equity 0.0 +0.0 0.0 6.0 -0.5 5.5 11.0 -1.0 10.0 15.0 -1.0 14.0 19.0 -1.0 18.0 24.0 -1.0 23.0 26.0 -1.0 25.0

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 +0.5 2.5 2.0 +1.0 3.0 4.0 +1.5 5.5 6.0 +2.0 8.0 6.0 +3.0 9.0

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 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 0.0

Non–US Fixed Income 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 0.0

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 � DowngradeSource: Investment Solutions and WMA Asset Allocation Committee, as of 27 September 2012 For end notes, please see appendix.

All figures in %


Global Investment Process and Committee DescriptionThe UBS investment process is designed to achieve replicable, high quality results through applying intellectual rigor, strong process governance, clear responsibility and a culture of challenge. Leading the process, the Chief Investment Of� cer formulates the UBS Wealth Management Investment House View at the Global Investment Committee (GIC) based on the analyses and assessments conducted and vetted throughout the investment process. Senior investment profession-als from across UBS, complemented by selected external experts, debate and rigorously challenge the investment strategy to ensure consistency and risk control.

Global Investment Committee CompositionThe Global Investment Committee is comprised of fourteen members, representing top market and investment expertise from across all divisions of UBS:

• Alex Friedman (Chair)• Mark Andersen• Mark Haefele• Andreas Höfert• Jorge Mariscal• Mads Pedersen• Mike Ryan• Simon Smiles• Larry Hathaway (*)• Bruno Marxer (*)• Curt Custard (*)• Andreas Koester (*)• Tom Daula (*)• Andrew Williamson (*)(*) Business areas distinct from CIO/WMR

WMA Asset Allocation Committee DescriptionWe recognize that a globally derived house view is most e� ective when complemented by local perspective and applica-tion. As such, UBS has formed a US Asset Allocation Committee responsible for translating the Global Investment Committee’s house views on asset classes into US speci� c asset allocation models. Any charts and tables that feature the guidance of the WMA Asset Allocation Committee are indicated with a lavender-tinted color block.

WMA Asset Allocation Committee CompositionThe WMA Asset Allocation Committee is comprised of seven members:

• Tony Roth (Chair)• Mike Ryan • Michael Crook • Stephen Freedman • Richard Hollmann • Brian Nick • Jeremy Zirin

Appendix

Investment Committee


In order to create the analysis shown, the rates of return for each asset class are combined in the same proportion as the asset allocations illustrated (e.g., if the asset allo-cation indicates 40% equities, then 40% of the results shown for the allocation will be based upon the estimated hypothetical return and standard deviation assumptions shown below).

You should understand that the analysis shown and assumptions used are hypothetical estimates provided for your general information. The results are not guaran-tees and pertain to the asset allocation and/or asset class in general, not the performance of speci� c securities or investments. Your actual results may vary signi� cantly from the results shown in this report, as can the performance of any individual security or investment.

Appendix

Portfolio AnalyticsThe portfolio analytics shown for each risk pro� le’s bench-mark allocations are based on estimated forward-looking return and standard deviation assumptions (capital mar-ket assumptions), which are based on UBS proprietary research. The development process includes a review of a variety of factors, including the return, risk, correlations and historical performance of various asset classes, in� a-tion and risk premium. These capital market assumptions do not assume any particular investment time horizon. The process assumes a situation where the supply and demand for investments is in balance, and in which expected returns of all asset classes are a re� ection of their expected risk and correlations regardless of time frame. Please note that these assumptions are not guarantees and are subject to change. UBS has changed its risk and return assump-tions in the past and may do so in the future. Neither UBS nor your Financial Advisor is required to provide you with an updated analysis based upon changes to these or other underlying assumptions.

RiskPro� le ==>>

Veryconservative Conservative

Moderate conservative Moderate

Moderate aggressive Aggressive

Very aggressive

With non-traditional assets

Estimated Return 4.81% 5.98% 6.89% 7.65% 8.36% 9.00% 9.56%

Estimated Risk 3.21% 4.70% 6.71% 8.69% 10.53% 12.16% 13.81%

Without non-traditional assets

Estimated Return 4.46% 5.67% 6.62% 7.44% 8.33% 9.22% 10.00%

Estimated Risk 3.45% 4.78% 6.93% 9.17% 11.73% 14.46% 16.94%

Asset Class Capital Market AssumptionsEstimated Risk Estimated Return

US Equity

Large Cap Value 16.4% 8.7%

Large Cap Growth 19.0% 9.3%

Mid Cap 18.4% 10.4%

Small Cap 21.4% 10.6%

REITs 23.0% 9.6%

Non-US Equity

Developed Markets Equities 17.7% 10.4%

Emerging Markets Equities 26.6% 12.6%

US Fixed Income 3.7% 4.4%

Non-US Fixed Income 8.8% 6.1%

Cash (USD) 0.5% 4.0%

Commodities 17.1% 7.6%

Alternative Investments 8.5% 8.7%


Appendix

Additional Asset Allocation Models

US Taxable Fixed Income Allocation, in %

Benchmark Tactical deviation2 Current allocation3

allocation1 Previous Current

Treasuries 12.0 -7.5 -5.0 7.0

TIPS (Treasury in� ation-protected securities) 5.0 -5.0 -5.0 0.0

Agencies 22.0 -9.5 -7.0 15.0

Mortgages 20.0 +1.5 +1.5 21.5

Inv. Grade Corporates 22.0 +7.0 +7.0 29.0

High Yield Corporates 10.0 +8.5 +8.5 18.5

Preferred Securities 4.0 +0.0 +0.0 4.0

Emerging Market sovereign bonds in US dollar 5.0 +5.0 +0.0 5.0

TFI non-Credit 59.0 -20.5 -15.5 43.5

TFI Credit 41.0 +20.5 +15.5 56.5

Non–US Developed Equity Module, in %

Benchmark WMR Tactical deviation2 Current allocation3


Eurozone 25.0 -5.0 5.0 30.0

UK 21.0 10.0 10.0 31.0

Japan 18.0 -5.0 -3.0 15.0

Australia 8.0 -2.0 -6.0 2.0

Canada 11.0 1.0 -3.0 8.0

Switzerland 8.0 1.0 -3.0 5.0

Other 9.0 0.0 0.0 9.0

Non–US Fixed Income Module, in %



Eurozone 40.0 -7.5 -0.0 40.0

UK 10.0 +7.5 +5.0 15.0

Japan 34.0 -7.5 -5.0 29.0

Other 16.0 +7.5 +0.0 16.0

Source: UBS WMR and Investment Solutions, as of 27 September 20121 The benchmark allocation refers to a moderate risk pro� le. See “Sources of Benchmark Allocations and Investor Risk Pro� les” 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 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.

Source: WMA Asset Allocation Committee and Investment Solutions, as of 27 September 2012

Emerging Markets Equity Module, in %



Brazil 13.0 3.0 3.0 16.0

China 18.0 3.0 3.0 21.0

India 6.0 0.0 0.0 6.0

Korea 15.0 0.0 3.0 18.0

Russia 6.0 0.0 0.0 6.0

South Africa 8.0 0.0 -3.0 5.0

Taiwan 11.0 -3.0 0.0 11.0

Mexico 5.0 0.0 0.0 5.0

Other 18.0 -3.0 -6.0 12.0


Appendix

Additional Asset Allocation Models Equity Industry Group Allocation, in %

S&P 500 WMR Tactical deviation2 Current Benchmark Numeric Symbol allocation3

allocation1 Previous Current Previous Current

Consumer Discretionary 11.0 +1.0 +0.0 + n 11.0

Auto & Components 0.6 +0.0 +0.0 n n 0.6

Consumer Services 1.9 +0.0 +0.0 n n 1.9

Media 3.5 +1.0 +1.0 + + 4.5

Retailing 4.0 +0.0 -1.0 n – 3.0

Consumer, Durables & Apparel 1.0 +0.0 +0.0 n n 1.0

Consumer Staples 10.9 +1.0 +1.0 + + 11.9

Food, Beverage & Tobacco 6.1 +0.5 +0.5 + + 6.6

Food & Staples Retailing 2.4 +0.0 +0.0 n n 2.4

Household & Personal Products 2.4 +0.5 +0.5 + + 2.9

Energy 11.3 +0.0 +0.0 n n 11.3

Financials 14.6 +0.0 +0.0 n n 14.6

Banks 2.9 +0.0 +0.0 n n 2.9

Diversi� ed Financials 5.7 +0.0 +0.0 n n 5.7

Insurance 3.8 +0.0 +0.0 n n 3.8

Real Estate 2.1 +0.0 +0.0 n n 2.1

Healthcare 12.1 +0.0 -1.0 n – 11.1

HC Equipment & Services 3.8 +0.0 -1.0 n – 2.8

Pharmaceuticals & Biotechnology 8.3 +0.0 +0.0 n n 8.3

Industrials 9.7 +1.0 +1.0 + + 10.7

Capital Goods 7.7 +0.5 +0.5 + + 8.2

Commercial Services & Supplies 0.5 +0.0 +0.0 n n 0.5

Transportation 1.6 +0.5 +0.5 + + 2.1

Information Technology 20.0 +2.0 +2.0 ++ ++ 22.0

So� ware & Services 9.6 +0.0 +0.0 n n 9.6

Technology Hardware & Equipment 8.4 +1.0 +1.0 + + 9.4

Semiconductors 2.0 +1.0 +1.0 + + 3.0

Materials 3.5 -1.0 -1.0 – – 2.5

Telecom 3.3 -2.0 -2.0 – – – – 1.3

Utilities 3.5 -2.0 +0.0 – – n 3.5

Source: S&P, UBS WMR, as of 27 September 2012

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 pro� les.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.

Alternative Investment (AI) Benchmark Allocation (All � gures in % of total portfolio)

Risk pro� le

Very conservative Conservative

Moderate conservative Moderate

Moderate aggressive Aggressive

Very aggressive

Tactical Trading 1.0 1.0 1.0 2.0 2.5 3.5 4.0

Relative Value 1.5 2.0 2.0 2.0 2.0 2.0 2.0

Credit Strategies 1.5 2.0 2.0 2.0 2.5 3.0 3.0

Event Driven 1.5 2.0 2.0 2.0 2.0 2.5 3.0

Equity Hedge 1.5 2.0 2.0 2.0 2.0 3.0 3.0

Private Equity 0.0 0.0 2.0 2.0 2.0 2.0 3.0

Private Real Estate 0.0 0.0 0.0 0.0 2.0 2.0 2.0

Total Alternative Investments 7.0 9.0 11.0 12.0 15.0 19.0 20.0

See “Sources of Benchmark Allocations and Investor Risk Pro� les” in the Appendix for an explanation regarding the source of the benchmark allocations and their suitability.


Table A re� ects the performance of the tactical asset allo-cation recommendations published in the Investment Strategy Guide during the time period speci� ed. The per-formance is based on the benchmark allocations with nontraditional assets for a moderate risk pro� le investor, and the benchmark allocation with the tactical shi� (see detailed asset allocation tables where benchmark alloca-tion with tactical shi� is referred to as “current alloca-tion”). Performance is calculated utilizing the returns of the indices identi� ed in Table B as applied to the respective allocations in the benchmark and the benchmark with the tactical shi� . For example, if cash were allocated 10% in the benchmark and 12% in the benchmark with the tacti-cal shi� , the cash index respectively contributed to 10% and 12% of the results shown.

The performance attributable to the WMR tactical devia-tions is re� ected in the column labeled “Excess return,” which shows the di� erence between the performance of the benchmark and the performance of the benchmark with the tactical shi� . The Information ratio is a risk-adjusted performance measure, which adjusts the excess returns for the tracking error risk of the tactical devia-tions. Speci� cally the information ratio is calculated as the ratio of the annualized excess return over a given time period and the annualized standard deviation of daily excess returns over the same period. Additional background information regarding the computation of the information ratio � gures provided below are available upon request.

Table A: Moderate Risk Pro� le Performance Measurement

Benchmarkallocation

Benchmark with tactical shift

Excess return Informationratio

(annualized)

Russell 3000stock index

(total return)

Barclays CapitalUS Aggregate bondindex (total return)

25 Aug. 08 to 31 Dec. 08 -16.59% -15.64% 0.96% +2.0 -29.00% 3.33%

2009 Q1 -5.52% -5.45% 0.07% +0.3 -10.80% 0.12%

2009 Q2 11.18% 11.37% 0.18% +1.0 16.82% 1.78%

2009 Q3 10.44% 11.07% 0.63% +2.1 16.31% 3.74%

2009 Q4 2.99% 3.30% 0.31% +1.1 5.90% 0.20%

2010 Q1 2.74% 2.56% -0.18% -0.9 5.94% 1.78%

2010 Q2 -4.56% -4.87% -0.31% -1.4 -11.32% 3.49%

2010 Q3 8.34% 7.99% -0.35% -2.1 11.53% 2.48%

2010 Q4 5.18% 5.17% -0.01% -0.1 11.59% -1.30%

2011 Q1 3.23% 3.15% -0.08% -0.4 6.38% 0.42%

2011 Q2 0.62% 0.47% -0.16% -0.9 -0.03% 2.29%

2011 Q3 -7.65% -8.56% -0.90% -2.5 -15.28% 3.82%

2011 Q4 4.66% 4.39% -0.27% -0.8 12.12% 1.12%

2012 Q1 5.89% 5.41% -0.48% -2.3 12.87% 0.30%

2012 Q2 -1.59% -1.57% 0.02% +0.2 -3.15% 2.06%

2012 Q3 until 26 Sep. 2012 3.90% 3.78% -0.12% -1.3 5.64% 1.66%

Since inception 21.05% 20.31% -0.74% -0.2 24.30% 30.88%


Appendix

Tactical Asset Allocation Performance Measurement

Calculations start on 25 August 2008. Prior to 25 August 2008, WMR published tactical asset allocation recommen-dations in the “US Asset Allocation Strategist” using a less comprehensive set of asset classes and sectors, which makes a comparison with the current models dif� cult. In addition, since 25 August 2008, the Investment Strategy Guide has at times published a more detailed set of tacti-cal deviations, whereby the categories “Non-US Developed Equities” and Non-US Fixed Income” were further subdi-vided into regional blocks. Only the cumulative recommen-dations at the level of “Non-US Developed Equities” and “Non-US Fixed Income” were taken into account in calcu-lating the performance shown below.

The calculations assume that the portfolios are rebalanced whenever changes are made to tactical deviations, typi-cally upon publication of the Investment Strategy Guide on a monthly basis. Occasionally, changes in the tactical deviations are made intra-month when warranted by mar-ket conditions and communicated through an Investment Strategy Guide Update. The computations assume port-folio rebalancing upon such intra-month changes as well. Performance shown is based on total returns, but does not include transaction costs, such as commissions, fees, margin interest, and interest charges. Actual total returns adjusted for such transaction costs will be reduced. A complete record of all the recommendations upon which this performance report is based is available from UBS Financial Services Inc. upon written request. Past perfor-mance is not an indication of future results.


Table B: IS benchmark allocations for moderate risk pro� le investor, and underlying indices (all � gures in %)

25 Aug 2008 to 23 Feb 2009 24 Feb 2009 to present

US Large Cap Value (Russell 1000 Value) 12.5 US Large Cap Value (Russell 1000 Value) 11.0

US Large Cap Growth (Russell 1000 Growth) 12.5 US Large Cap Growth (Russell 1000 Growth) 11.0

US Small Cap Value (Russell 2000 Value) 2.0 US Mid Cap (Russell Midcap) 5.0

US Small Cap Growth (Russell 2000 Growth) 2.0 US Small Cap (Russell 2000) 3.0

US REITs (FTSE NAREIT All REITs) 1.5 US REITs (FTSE NAREIT All REITs) 2.0

Non-US Dev. Eq (MSCI Gross World ex-US) 10.5 Developed Markets (MSCI Gross World ex-US) 10.0

Emerging Markets Eq. (MSCI Gross EM USD) 2.0 Emerging Markets (MSCI Gross EM USD) 2.0

US Fixed Income (BarCap US Aggregate) 30.0 US Fixed Income (BarCap US Aggregate) 29.0

Non-US Fixed Income (BarCap Global Aggregate ex-USD) 8.0 Non-US Fixed Income (BarCap Global Aggregate ex-USD) 8.0

Cash (JP Morgan Cash Index USD 1 month) 2.0 Cash (JP Morgan Cash Index USD 1 month) 2.0

Commodities (DJ UBS total return index) 5.0 Commodities (DJ UBS total return index) 5.0

Alternative Investments (HFRX Equal Weighted Strategies) 12.0 Alternative Investments (HFRX Equal Weighted Strategies) 12.0

Source: UBS WMR and Investment Solutions

Table C: US Equity Sector Strategy performance measurement

S&P 500 Benchmarkallocation

Benchmarkwith tactical shift

Excessreturn

Information ratio(annualized)

29 Oct. 2007 to 31 Dec. 2007 -4.32% -4.02% 0.30% +2.3

2008 -36.97% -36.98% -0.01% -0.2

2009 26.56% 26.28% -0.27% -0.3

2010 15.07% 14.22% -0.85% -1.4

2011 Q1 5.92% 5.97% 0.05% +0.4

2011 Q2 0.11% -0.22% -0.33% -2.8

2011 Q3 -13.88% -14.06% -0.18% -0.8

2011 Q4 11.83% 11.09% -0.74% -1.8

2012 Q1 12.57% 12.42% -0.15% -0.9

2012 Q2 -2.75% -2.64% 0.11% +1.0

2012 Q3 until 26 Sep. 12 5.80% 5.79% -0.01% -0.1

Since inception -4.00% -5.80% -1.79% -0.6


Table C similarly indicates the performance of WMR’s US Equity Sector Strategy, which has been published in comparable format since 29 October 2007. The Benchmark allocation is the S&P 500.

Appendix



Appendix


Table D: WMR US dollar Taxable Fixed Income Strategy performance measurement

Benchmarkallocation

Benchmarkwith tactical shift

Excessreturn

Information ratio(annualized)

Barclays CapitalUS Aggregate

31 Jan. 2007 to 31 Dec. 2007 4.69% 4.56% -0.12% -1.4 7.01%

2008 -1.17% -2.11% -0.94% -3.2 5.24%

2009 11.67% 12.96% 1.29% 2.8 5.93%

2010 7.97% 8.07% 0.10% 0.6 6.54%

2011 Q1 1.06% 1.16% 0.10% 2.5 0.42%

2011 Q2 2.13% 2.09% -0.04% -1.3 2.29%

2011 Q3 1.74% 1.42% -0.32% -3.4 3.82%

2011 Q4 1.87% 1.88% 0.01% 0.3 1.12%

2012 Q1 1.54% 1.69% 0.14% 4.7 0.30%

2012 Q2 1.98% 1.93% -0.04% -0.9 2.06%

2012 Q3 until 26 Sep. 2012 2.45% 3.01% 0.57% 4.9 1.66%

Since Inception 41.56% 42.37% 0.81% 0.4 42.65%


Table E : Benchmark allocation for US dollar Fixed Income Strategy and underlying indices used to calculate performance shown in Table D (all � gures in %)

31 Jan. 2007 to 30 July 2007

31 July 2007 to 24 Aug 2008

25 Aug 2008 to 30 March 2009

31 March 2009 to present

Treasuries (BoA ML Treasury Master Index) 10.0% 12.0% 12.0% 12.0%

TIPS (BoA ML Treasury In� ation-Linked Index) 5.0% 5.0% 5.0% 5.0%

Agencies (BoA ML Agency Composite Master Index) 20.0% 22.0% 22.0% 22.0%

Inv. Grade Corporates (BoA ML Corporate Master Index) 20.0% 21.0% 18.0% 22.0%

High Yield Corporates (BoA ML High Yield Master II Constrained Index) 10.0% 10.0% 8.0% 10.0%

Preferred Securities (BoA ML Preferred Stock Fixed Index) 10.0% 10.0% 10.0% 4.0%

Mortgages (BoA ML US Mortgage Master Index) 20.0% 20.0% 20.0% 20.0%

Emerg. Markets (BoA ML Emerging Sovereign Plus Index) 0.0% 0.0% 5.0% 5.0%

Cash (BoA ML US T-Bill 3-month Index) 5.0% 0.0% 0.0% 0.0%

Source: UBS WMR and Investment Solutions

Finally, Table D provides the performance of the US dollar Taxable Fixed Income Strategy, which has been published by WMR since 31 January 2007. The benchmark allocation and the underlying indices for each segment are available in table E.


Nontraditional AssetsNontraditional assets include commodities and alternative investments. Alternative

investments, in turn, include hedge funds, private equity, real estate, and managed

futures. Interests of alternative investment funds are sold only to quali� ed investors,

and only by means of o� ering documents that include information about the risks,

performance and expenses of alternative investment funds, and which clients are

urged to read carefully before subscribing and retain. An investment in an alterna-

tive investment fund is speculative and involves signi� cant risks. Alternative invest-

ment funds are not mutual funds and are not subject to the same regulatory

requirements as mutual funds. Alternative investment funds’ performance may be

volatile, and investors may lose all or a substantial amount of their investment in an

alternative investment fund. Alternative investment funds may engage in leveraging

and other speculative investment practices that may increase the risk of investment

loss. Interests of alternative investment funds typically will be illiquid and subject to

restrictions on transfer. Alternative investment funds may not be required to provide

periodic pricing or valuation information to investors. Alternative investment fund

investment programs generally involve complex tax strategies and there may be

delays in distributing tax information to investors. Alternative investment funds are

subject to high fees, including management fees and other fees and expenses, all of

which will reduce pro� ts. Alternative investment funds may � uctuate in value. An

investment in an alternative investment fund is long-term, there is generally no

secondary market for the interests of a fund, and none is expected to develop.

Interests in alternative investment funds are not deposits or obligations of, or guar-

anteed or endorsed by, any bank or other insured depository institution, and are not

federally insured by the Federal Deposit Insurance Corporation, the Federal Reserve

Board, or any other governmental agency. Prospective investors should understand

these risks and have the � nancial ability and willingness to accept them for an

extended period of time before making an investment in an alternative investment

fund and should consider an alternative investment fund as a supplement to an

overall investment program.

In addition to the risks that apply to alternative investments generally, the following

are additional risks related to an investment in these strategies:

• Hedge Fund Risk: There are risks speci� cally associated with investing in hedge

funds, which may include risks associated with investing in short sales, options,

small-cap stocks, “junk bonds,” derivatives, distressed securities, non-US securities

and illiquid investments.

• Hedge Fund of Funds: In addition to the risks associated with hedge funds gener-

ally, an investor should recognize that the overall performance of a fund of funds

is dependent not only on the investment performance of the manager of the

fund, but also on the performance of the underlying managers. The investor will

bear the management fees and expenses of both the fund of funds and the

underlying hedge funds or accounts in which the fund of funds invests, which

could be signi� cant.

• Managed Futures: There are risks speci� cally associated with investing in managed

futures programs. For example, not all managers focus on all strategies at all

times, and managed futures strategies may have material directional elements.

• Real Estate: There are risks speci� cally associated with investing in real estate

products and real estate investment trusts. They involve risks associated with debt,

adverse changes in general economic or local market conditions, changes in

governmental, tax, real estate and zoning laws or regulations, risks associated

with capital calls and, for some real estate products, the risks associated with the

ability to qualify for favorable treatment under the federal tax laws.

• Private Equity: There are risks speci� cally associated with investing in private

equity. Capital calls can be made on short notice, and the failure to meet capital

calls can result in signi� cant adverse consequences including, but not limited to, a

total loss of investment.

• Foreign Exchange/Currency Risk: Investors in securities of issuers located outside of

the United States should be aware that even for securities denominated in US

dollars, changes in the exchange rate between the US dollar and the issuer’s

Appendix

End notes for table labeled detailed asset allocations with non-traditional assets (NTAs)1 See “Sources of benchmark allocations and investor risk pro� les”on next page

regarding the source of investor risk pro� les.2 See “Sources of benchmark allocations and investor risk pro� les” on next page

regarding the source of benchmark allocations and their suitability.3 See “Deviations from benchmark allocations” in the appendix regarding the inter-

pretation of the suggested tactical deviations from benchmark. 4 The current allocation row is the sum of the benchmark allocation and the 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 pro� les” on next

page regarding the types of alternative investments and their suitability.

End notes for table labeled detailed asset allocations without non-tradi-tional assets (NTAs)1 See “Sources of benchmark allocations and investor risk pro� les”on next page

regarding the source of investor risk pro� les.2 See “Sources of benchmark allocations and investor risk pro� les” 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 tactical

deviation rows.

Emerging Market InvestmentsInvestors should be aware that Emerging Market assets are subject to, amongst

others, potential risks linked to currency volatility, 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 generally recommends only

those securities it believes have been registered under Federal US registration rules

(Section 12 of the Securities Exchange Act of 1934) and individual State registration

rules (commonly known as “Blue Sky” laws). Prospective investors should be aware

that to the extent permitted under US law, WMR may from time to time recom-

mend 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,” 30 July 2007, “Emerging

Market Bonds: Understanding Emerging Market Bonds,” 12 August 2009 and

“Emerging Market 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.


Appendix

“home” currency can have unexpected e� ects on the market value and liquidity

of those securities. Those securities may also be a� ected by other risks (such as

political, economic or regulatory changes) that may not be readily known to a US

investor.

• Options: Options are not suitable for all investors. Please read the Options Clearing

Corporation Publication titled “Characteristics and Risks of Standardized Options

Trading” and consult your tax advisor prior to investing. The Publication can be

obtained from your Financial Services Inc., Financial Advisor, or can be accessed

under the Publications Section of the Option Clearing Corporation’s website:

www.theocc.com.

Description of Certain Alternative Investment Strategies• Equity Hedge: Investment managers who maintain positions both long and short

in primarily equity and equity-derivative securities. A wide variety of investment

processes can be employed to arrive at an investment decision, including both

quantitative and fundamental techniques; strategies can be broadly diversi� ed or

narrowly focused on speci� c sectors and can range broadly in terms of levels of

net exposure, leverage employed, holding period, concentrations of market capi-

talizations and valuation ranges of typical portfolios. Equity hedge managers

would typically maintain at least 50% and may, in some cases, be substantially

entirely invested in equities, both long and short.

• Event Driven: Investment managers who maintain positions in companies currently

or prospectively involved in corporate transactions of a wide variety including, but

not limited to, mergers, restructurings, � nancial distress, tender o� ers, share-

holder buybacks, debt exchanges, security issuance or other capital structure

adjustments. Security types can range from most senior in the capital structure to

most junior or subordinated, and frequently involve additional derivative securities.

Event-driven exposure includes a combination of sensitivities to equity markets,

credit markets and idiosyncratic, company-speci� c developments. Investment

theses are typically predicated on fundamental characteristics (as opposed to

quantitative), with the realization of the thesis predicated on a speci� c develop-

ment exogenous to the existing capital structure.

• Credit Arbitrage Strategies: Employ an investment process designed to isolate

attractive opportunities in corporate � xed income securities. These include both

senior and subordinated claims as well as bank debt and other outstanding obli-

gations, structuring positions with little or no broad credit market exposure. These

may also contain a limited exposure to government, sovereign, equity, convertible

or other obligations, but the focus of the strategy is primarily on � xed corporate

obligations and other securities held as component positions within these struc-

tures. Managers typically employ fundamental credit analysis to evaluate the

likelihood of an improvement in the issuer’s creditworthiness. In most cases,

securities trade in liquid markets, and managers are only infrequently or indirectly

involved with company management. Fixed income: corporate strategies di� er

from event driven; credit arbitrage in the former more typically involves more

general market hedges, which may vary in the degree to which they limit � xed

income market exposure, while the latter typically involves arbitrage positions with

little or no net credit market exposure, but are predicated on speci� c, anticipated

idiosyncratic developments.

• Macro: Investment managers who trade a broad range of strategies in which the

investment process is predicated on movements in underlying economic variables

and the impact these have on equity, � xed income, hard currency and commodity

markets. Managers employ a variety of techniques, both discretionary and system-

atic analysis, combinations of top-down and bottom-up theses, quantitative and

fundamental approaches and long- and short-term holding periods. Although

some strategies employ relative value techniques, macro strategies are distinct

from relative value strategies in that the primary investment thesis is predicated on

predicted or future movements in the underlying instruments, rather than realiza-

tion of a valuation discrepancy between securities. In a similar way, while both

macro and equity hedge managers may hold equity securities, the overriding

investment thesis is predicated on the impact movements in underlying macroeco-

nomic variables may have on security prices, as opposed to equity hedge, in which

the fundamental characteristics of the company are the most signi� cant and

integral to investment thesis.

• Distressed Restructuring Strategies: Employ an investment process focused on

corporate � xed income instruments, primarily on corporate credit instruments of

companies trading at signi� cant discounts to their value at issuance, or obliged

(par value) at maturity, as a result of either a formal bankruptcy proceeding or

� nancial market perception of near-term proceedings. Managers are typically

actively involved with the management of these companies, frequently involved on

creditors’ committees in negotiating the exchange of securities for alternative

obligations, either swaps of debt, equity or hybrid securities. Managers employ

fundamental credit processes focused on valuation and asset coverage of securities

of distressed � rms. In most cases, portfolio exposures are concentrated in instru-

ments which are publicly traded, in some cases actively and in others under

reduced liquidity but, in general, for which a reasonable public market exists. In

contrast to special situations, distressed strategies primarily employ debt (greater

than 60%) but also may maintain related equity exposure.

• Relative Value: Investment managers who maintain positions in which the invest-

ment thesis is predicated on realization of a valuation discrepancy in the relation-

ship between multiple securities. Managers employ a variety of fundamental and

quantitative techniques to establish investment theses, and security types range

broadly across equity, � xed income, derivative or other security types. Fixed income

strategies are typically quantitatively driven to measure the existing relationship

between instruments and, in some cases, identify attractive positions in which the

risk-adjusted spread between these instruments represents an attractive opportu-

nity for the investment manager. Relative value position may be involved in corpo-

rate transactions also, but as opposed to event-driven exposures, the investment

thesis is predicated on realization of a pricing discrepancy between related securi-

ties, as opposed to the outcome of the corporate transaction.

About WMR economic forecastsIn developing the WMR economic forecasts, WMR economists worked in collabora-

tion with economists employed by UBS Investment Research (INV). INV is published

by UBS Investment Bank. Forecasts (F) are current only as of the dates of the publi-

cation and may change without notice.


Sources of benchmark allocations and investor risk pro� les• Benchmark allocations represent the longer-term allocation of assets that is

deemed suitable for a particular investor. Except as described below, the bench-

mark allocations expressed in this publication have been developed by UBS

Investment Solutions (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 estate) o� ered to UBS clients. The benchmark allocations

are provided for illustrative purposes only and were designed by IS for hypotheti-

cal US investors with a total return objective under seven di� erent Investor Risk

Pro� les ranging from very conservative to very aggressive. In general, benchmark

allocations will di� er among investors according to their individual circumstances,

risk tolerance, return objectives and time horizon. Therefore, the benchmark allo-

cations 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 always,

please consult your UBS Financial Advisor to see how these weightings should be

applied or modi� ed according to your individual pro� le and investment goals.

• The process by which UBS Investment Solutions has derived the benchmark allo-

cations 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 prefer-

ence for international investing). This is accomplished using optimization methods

within a mean-variance framework. Based on a proprietary set of capital market

assumptions, including expected returns, risk, and correlation of di� erent asset

classes, combinations of the broad asset classes are computed that provide the

highest level of expected return for each level of expected risk. A qualitative judg-

mental overlay is then applied to the output of the optimization process to arrive

at the benchmark allocation. The capital market assumptions used for the bench-

mark allocations are developed by UBS Global Asset Management. UBS Global

Asset Management is a subsidiary of UBS AG and an af� liate of UBS Financial

Services Inc.

• 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 determined 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 � xed income. It was derived from an existing moderate risk taxable

� xed income allocation developed by IS, which includes fewer � xed income seg-

ments than the benchmark allocation presented here. The additional � xed income

segments were taken by WMR from related segments. For example, 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.

Appendix

Explanations about Asset Classes

• Alternative investments (AI) include hedge funds, private equity, real estate, and

managed futures. The total benchmark allocation was determined by IS using

the process described above. The Global Investment Committee (GIC) derived

the AI subsector benchmark allocations by adopting IS’ determination as to the

appropriate subsector benchmark allocations with AI for the following risk pro-

� les: conservative, moderately conservative, moderate, moderate aggressive and

aggressive. The GIC then developed subsector allocations for very conservative

and very aggressive risk pro� les by taking the IS subsector weightings for conser-

vative and aggressive risk pro� le investors and applying them pro rata to the IS AI

total benchmark allocations for very conservative and very aggressive, respectively.

Allocations to AI as illustrated in this report may not be suitable for all investors. In

particular, minimum net worth requirements may apply.

• The background for the benchmark allocation attributed 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 the US

Asset Allocation Committtee. They re� ect the short- to medium-term assessment

of market opportunities and risks in the respective asset classes and market seg-

ments. Positive / zero / negative tactical deviations correspond to an overweight /

neutral / underweight stance for each respective asset class and market segment

relative 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 cur-

rency risk of such investments). Thus, the deviations from the benchmark re� ect

the views of the underlying equity and bond markets in combination with the

assessment of the associated currencies. The two bar charts (“Equity Regions”

and “Fixed Income Regions”) represent the relative attractiveness of countries

(including the currency outlook) within a pure equity and pure � xed income port-

folio, respectively. In contrast, the detailed asset allocation tables integrate the

country preferences within each asset class with the asset class preferences stated

earlier in the report.

Scale for tactical deviation charts

Symbol Description/De� nition Symbol Description/De� nition Symbol Description/De� nition

+ moderate overweight vs. benchmark – moderate underweight vs. benchmark n neutral, i.e., on benchmark

++ overweight vs. benchmark – – underweight vs. benchmark n/a not applicable

+++ strong overweight vs. benchmark – – – strong underweight vs. benchmark

Source: UBS WMR


Wealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisions of UBS AG (UBS) or an af� liate

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 o� er, or a solicitation of an o� er, to buy

or sell any investment or other speci� c product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment

objectives, investment strategies, � nancial situation and needs of any speci� c recipient. It is based on numerous assumptions. Di� erent assumptions could result in materi-

ally di� erent results. We recommend that you obtain � nancial and/or tax advice as to the implications (including tax) of investing in the manner described or in any of the

products mentioned herein. Certain services and products are subject to legal restrictions and cannot be o� ered worldwide on an unrestricted basis and/or may not be eli-

gible 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 representa-

tion or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its af� liates). All information and opinions as well

as any prices indicated are current only as of the date of this report, and are subject to change without notice. Opinions expressed herein may di� er or be contrary to those

expressed by other business areas or divisions of UBS as a result of using di� erent 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 securi-

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future performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to

pay more. Changes in FX rates may have an adverse e� ect on the price, value or income of an investment. This document may not be reproduced or copies circulated without

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mitted by applicable law.

Distributed to US persons by UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and an af� liate of UBS Financial Services Inc. UBS

Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US af� liate when it distributes reports to US persons. All transactions by a US person

in the securities mentioned in this report should be e� ected through a US-registered broker dealer af� liated with UBS, and not through a non-US af� liate. The contents of this

report have not been and will not be approved by any securities or investment authority in the United States or elsewhere.

Version as per October 2011.

© 2012. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

Disclaimer


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trademarks, service marks and registered service marks are of their respective companies.

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