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UBS global outlookWealth Management ResearchDecember 2010

Global economy divided in 2011Equities our preferred investment New rules: No major currency should be considered safe New rules: Reevaluation of “risk-free” within fixed incomeLook beyond traditional investments

2011A fractured world

2

Content

UBS global outlook 2011

This report has been prepared by

UBS AG. Please see the important

disclaimer at the end of the document.

Past performance is not an indication of

future returns. The market prices

provided are closing prices on the

respective principal stock exchange.

Chief Economist and Global Head of Wealth Management ResearchDr. Andreas Höfert

Head of Investment StrategyMark Andersen

PublisherUBS AG, Wealth Management Research,

P.O. Box, CH-8098 Zurich

Editor in chiefMark Andersen

E-mail: [email protected]

EditorSimon Taylor

Editorial deadline19 November 2010

Project managementValérie Iserland

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SAP No. 82251E–1002

Key investment views ....................................................... 5

Investment outlook .......................................................... 6

Equities: The place to be in 2011 .................................... 11

Currencies: A search for safety ........................................ 14

Fixed income: The traditional rules no longer apply ......... 17

Non-traditional asset classes ........................................... 19

Financial market performance ........................................ 21

Selection of research publications ................................... 23

UBS global outlook 2011 3

Dear reader,

Looking back at 2010, we are proud of our investment views. We have been calling for a rise in corporate bond and equity prices, the need for an investment focus on emerging markets and the rising Asian consumer demand, and a careful stance on investments into Europe’s periphery. What we did not expect – and what should keep investors on their toes in 2011 – has been the extraordinary expansionary tactics deployed by the world’s leading central banks, leaving us with unsustainably low interest rate levels.

The scale of governments’ issuing – and purchasing – of their own debt is unprec-edented in peacetime, and the pace is set to continue in 2011. The idea is to spur investment and spending via low interest rates – but the long-term effects are not clear. Alan Greenspan arguably laid the groundwork for the US housing market bubble with the historically low interest rates that followed the 2001 recession. Whether today’s central bankers are repeating that mistake remains to be seen. Currently, cheap credit is being channelled towards the world’s growth regions in emerging economies, fanning the potential for a future bubble. But we are not there yet. Prices have not yet overshot despite increasing investor interest and capital flows. We think emerging markets offer rewarding investment opportunities in 2011.

The aftermath of the economic crisis has revealed structural weaknesses within some countries that previously were considered rather strong, while other econo-mies proved surprisingly resilient. Governments and central bankers across the globe are likely to face some tough political and economic choices, with each likely to cross over into each other’s territory, with growing international trade and currency tensions as a consequence.

In the UBS global outlook 2011, we argue that no investment should be considered “safe” as inflation and currency weakness for indebted nations loom. Investors need to reorient their understanding of “safe” fixed income investments, as many are now anything but. In the end, when the facts change, investment strategies should change as well. What else should they do?

All the best for 2011

Editorial

Andreas Höfert

Mark Andersen

Andreas Höfert

Global HeadWealth Management Research

Mark Andersen

Head of Investment StrategyWealth Management Research

5UBS global outlook 2011

Key investment views

Global economy divided in 2011The global economy is becoming more fractured – not down the traditional lines of West versus East or Developed versus Developing, but the strong versus the weak. Record deficit levels, previously unheard of stimulus measures and uneven levels of economic growth will force many countries to make hard political choices to shape the investment environment in 2011.

Equities our preferred investment Equities are well-positioned for a year of accommodative central banks, are able to weather the risks of inflation better than most, and offer attractive value going into 2011. Companies that sell products or services, generate cash and have profit margins are unlikely to go out of fashion soon. We favor equities in the larger emerging markets (BRICs) and Core Europe.

New rules: No major currency should be considered safe “It’s the economy stupid” was once a popular slogan during the US presidential campaign in 1992, and is the economic reality for currency investors. The traditional Big Four currencies (USD, EUR, GBP and JPY) will be challenged in 2011. We recommend diversifica-tion, and many investors may wish to consider the currencies of commodity producers and emerg-ing markets.

New rules: Reevaluation of “risk-free” within fixed incomeThe rules have changed within fixed income – government bonds are far from risk-free. Arguably, the fracturing of the global economy can be best seen in the developments of bonds issued by peripheral European economies. We therefore prefer debt held in countries with low public deficits and healthy external balances – with no respect to geography or development classification – and with a short to medium maturity.

Look beyond traditional investmentsWith global economic imbalances and inflation on the horizon, we think investors should look beyond traditional equities and bonds. Investments in commodities, hedge funds and real estate could be appropriate, where suitable. Such investments do have different risks, but also different sources of return.

“Investors should not just continue straight ahead in

2011. A new economic environment calls for a new

investment route.”

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A fractured world means treading carefully in 2011 A general market recovery dominated 2010, at least on the surface (see Fig. 1). However, in 2011, investors will need to dig deep to find investments in a fractured world that will be entering year four of the financial crisis. It will be a year when politicians face a number of tough decisions on issues shaping the eco-nomic and investment environment. Investors are advised to seek a mix of attractively valued equities – in specific areas – and “safer” bond exposure in order to reap positive investment performance in 2011.

Governments and central banks spent 2009 battling the aftermath of the worst global financial crisis since the 1930s. This year should have been a year of recovery and normaliza-tion. However, growth remained anemic for many developed economies, with only the developing world managing to take another leap forward.

Whereas 2010 was another year of reasonable returns for most investors, the investment environment in 2011 is likely to be shaped by difficult political choices. We see three major “trilemmas” – a choice among three options, where only two can have favorable outcomes at the same time, and where something will have to give. This is what we see as determin-ing the investment environment for 2011.

If political uncertainties exist, some economic certainties remain, as the gap between weaker and stronger economies and their divergent growth paths becomes more evident in 2011 (see Fig. 2). The US, for so long the engine of world economic growth, is in the camp of the weak economies, while China and its South-east Asian neighbors are in the camp of the strong economies, as are commodity exporters like Canada, Australia, and Brazil. Meanwhile, the fracture line between weak and strong economies runs through Europe – with the UK, France and the Mediterranean countries struggling, while Germany, Switzerland, the Benelux countries and Scandinavia are pulling ahead.

This has consequences for the selection of fixed income and currency investments, which should be placed in stronger economies, whereas equity exposure should continue to be directed to the world’s stronger growth regions.

The US is in a difficult placeDespite monetary and fiscal measures unheard of in peacetime, the US recovery has been rather dismal so far. The financial crisis has led to an ongoing deleveraging of US households, tighter regulations on financial intermediaries, and ballooning US government debt – all of which are likely to lead to significantly lower growth rates for the US economy.

Investment outlook

Andreas HöfertChief economist, UBS AG

Mark AndersenStrategist, UBS AG

8 12 16

CashFixedincome

Equities

Non-traditionalasset classes

0-4 4

Fig. 1: Performance of main asset classes

Note: As of 30 November 2010.Source: Bloomberg, Thomson Reuters, BoA Merrill Lynch, UBS WMR

Annual total return in local currency and %

CashInflation-linked (Global)

Global government bondsGlobal corporate bonds

High-yieldEm. market bonds

Em. market equitiesGlobal equities

Listed real estateCommoditiesHedge funds

Jan–Nov 20102005–2009 (annualized)

Fig. 2: Global growth led by emerging economiesReal annual GDP growth and forecasts in %

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WorldAdvanced economies

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Forecast

Note: As of 15 November 2010.Source: IMF, UBS WMR

Past performance is not an indication of future returns.


Investment outlook

In an attempt to solve lower growth rates and stubbornly high unemployment, the US Federal Reserve announced another round of purchas-ing its own debt (see Fig. 4). This program aims to “artificially” lower interest rates for longer-term debt and thereby foster credit activity and exports via a falling US dollar. While we doubt that these doses of quantitative easing will kick-start the US economy, one thing is clear: Faith in the US dollar is diminishing. At the same time, inflation risks are rising and gold prices are likely to go higher as a consequence.

We therefore think that the US is trying to solve their current trilemma – pursuing a balanced budget, buoyant consumer activity and a trade surplus all at the same time – by downplaying the value of the dollar. This,

however, is likely to bite the consumer in the tail via rising commodity prices, and investors should pay attention to protecting portfolio values from rising inflation and a falling dollar. Investments into so-called “real assets” (e.g., equities, commodities and real estate) should be sought after. Another consequence is that US Treasury bonds should, at this stage, no longer be considered a safe-haven investment, and investors with large US exposure should look for safer alternatives, for example, in Canada.

Stick to the European coreThe European debt crisis is not over yet and financial markets are increasingly dividing debt in the region into safe and unsafe as a conse-quence, and rightfully so (see Fig. 5).

Economy: Divergence between weak and strong

The divide between weak and strong countries to dominate investments in 2011, in our viewThe aftermath of the economic crisis has revealed structural weaknesses within some countries that were previously considered rather strong, while other economies have proved surprisingly resilient. Two major areas of concern over the last year were interna-tional trade imbalances and high fiscal deficits, where a wide global divergence was observed. To separate the weaker from the stronger economies, we grouped selected countries according to their expected current account and fiscal balances for 2011. Figure 3 shows the result of this analysis, where the size of the bubbles represents the size of the respective economy. Economies in the right upper part of the graph can be considered strong, whereas those in the lower left-hand corner are on the weak side. Not surprisingly, European periph-erals Portugal and Greece can be found at the very bottom. However, as their economies are small, the global impact should rather be

limited. More worryingly, some of the big economies – first and foremost the US, but also France, Japan and the UK – find themselves in poor condition. At the other end of the scale, Switzerland, Sweden, Germany and several emerging economies look well prepared for the challenging economic environment ahead.

Fig. 3: Divergence between weak and strong countries

Note: The size of the bubble reflects GDP in USD.Source: IMF, Bloomberg, UBS

Selected countries grouped according to expected fiscal and current account balance 2011 in % of GDP

MexicoKorea

NetherlandsIndia

France

SwedenAustralia

Portugal

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Investment outlook

Fig. 4: The US central bank remains on an expansionary course

Note: As of 15 November 2010.Source: Thomson Reuters, UBS WMR

Base money in billion US dollars (UBS WMR estimates for 2011)

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Fig. 5: European peripherals’ debt issues remain a major source of concern


Additional yield over a German government bond

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In Germany and other successful European nations, export-fueled growth has now spilled over to domestic demand, leading to virtuous growth cycles. In Sweden and Norway, like in Australia and Canada, this has opened a new hiking cycle by the central banks.

These economies could use higher interest rate levels from the European Central Bank (ECB) to cool growth – in stark contrast to a still-depressed southern Europe, where even

a 1% ECB policy rate is too high. The ECB will have to manage this situation cautiously, as every rate hike could trigger further tensions within the eurozone.

Investors based in Europe should in the mean - time seek strategically safer investments in German and northern European bonds and equities, where balance sheets and domestic consumers are strong. Switzerland remains a safe-haven investment, and interest rates are likely to increase during 2011.

Asian consumption on the rise


Investment outlook

The impossible trinity in Asia and other emerging marketsChina continues to pull ahead after success-fully cooling down its economy in spring 2010, and growth in Asia is likely to be solid as we go forward. However, inflation pressures could continue to mount, even though the People’s Bank of China has surprisingly raised interest rates. At some stage, Chinese monetary policy will be confronted with the impossibility of having no capital controls, a fixed exchange rate, and an independent (and hence inflation-fighting) central bank all at the same time.

Which of the three objectives will have to give will be one of the most important questions for 2011. Brazil has already introduced capital controls, and some Asian countries are starting similar measures. In our view, given the objec-tive of the 12th Five-Year Plan to reorient the Chinese economy from export-led growth to spur domestic demand, the ongoing real

appreciation pressures on the Chinese yuan will be partly met by higher inflation and only partly by letting the currency appreciate.

Investors should therefore seek their growth exposure in emerging markets in a diversified way, and to some extent also indirectly via developed market companies with a strong accent on Asia and Latin America, in particular.

2011 a year for equitiesAsset flows during 2010 were mainly directed out of cash into bond funds – within corporate and emerging market bonds, in particular. For 2011, the game has changed. The upside has become more limited for corporate and emerging market bonds, as coupons will not rise in the event of higher inflation rates, and bonds are now trading closer to fair value. The opposite is true for equities that still haven’t unlocked their full valuation potential. In addition, many sectors should be able to raise

Investment strategy: What’s in it for me?

Return outlook 2011: equity ahead of credit this timeThis was a year of considering investments aimed at answering the question: Where can I achieve returns ahead of the uninteresting yields of government bonds?

Within fixed income, the answer was to add credit risk to the portfolio, which generated up to double-digit returns in the higher- yielding corporate bond and emerging market spaces. For 2011, there is still some upside potential and we envisage reasonable single-digit returns.

Equity investors reaped returns in 2010 – but investor interest remained muted, with net asset flow into equities being modest at best. We expect this to change in 2011, where equities’ relatively attractive valuations, and their inherent inflation hedge, should lead to inflows from cash and bonds.

A difficult political environment leaves plenty of risks for 2011. Therefore, we are keen to highlight the uncertainty that always surrounds return forecasts.

Fig. 6: A good year expected for equities, negative outlook for government bonds

Note: Historical return ranges show +/– one annualized standard deviation from 2011 expected return, based on monthly returns from the past 10 years.Source: Bloomberg, BoA Merrill Lynch, Thomson Reuters, UBS WMR

UBS expected returns for 2011 and historical return ranges

0 10 3020–10 40

Government bonds

Cash

Corporate bonds

Emerging market bonds

High-yield bonds

Commodities

Listed real estate

Developed market equities

Emerging market equities

Historical return rangesUBS expected returns for 2011



Investment outlook

dividends along with potentially rising price levels. Therefore, companies with stable earnings generation and attractive dividend yields should be seen as an alternative to some corporate and government bond investments.

The outperformance for 2011 is still likely to be in the emerging market space, but risks remain – as highlighted by recent moves to counter high inflows and currency appreciation in some countries. A diversified investment approach in a challenging and ever-evolving world should never be neglected. Exposure to commodities, either via commodity funds or investments into commodity-producing companies, should be one source of diversifica-tion – as should private equity, listed real estate and hedge fund investments where suitable, all of which share a positive outlook for 2011.

Fig. 7: UBS macroeconomic forecastsReal GDP growth in % Inflation in %

2010F 2011F 2012F 2010F 2011F 2012F

Americas US 2.8 2.7 2.8 1.6 1.6 2.1

Canada 3.1 2.8 2.6 1.8 2.1 2.0

Brazil 7.9 5.4 5.1 5.8 5.4 4.8

Asia/Pacific Japan 3.5 1.4 2.0 –0.7 –0.3 0.4

Australia 3.4 3.8 3.4 2.9 3.0 3.0

China 10.0 9.0 9.0 3.3 4.3 4.0

India 9.0 8.0 8.6 9.2 6.0 6.8

Rest of Asia 5.3 4.3 4.3 2.7 3.2 3.2

Europe Eurozone 1.8 1.9 1.9 1.9 1.8 2.1

Germany 3.3 2.2 2.0 1.4 1.6 1.7

France 1.7 2.0 1.9 1.6 1.8 1.7

Italy 1.2 1.6 1.4 2.0 2.0 2.2

Spain 0.0 0.5 0.8 2.1 1.5 1.8

UK 1.6 2.3 2.2 3.3 2.7 1.9

Switzerland 2.7 2.3 2.1 0.7 0.9 1.7

Russia 4.1 4.8 4.5 6.9 8.5 7.7

World 4.1 3.7 3.8 3.0 3.0 3.4

Note: F = Forecasts as of 30 November 2010¹ 7-day Interbank rate instead of 3-month LIBOR2 Purchasing power paritySource: UBS Past performance is not an indication of future returns.

Interest rates 3-month LIBOR 10-year govt. bondin % 6 mths 12 mths 6 mths 12 mths

US 0.30 0.50 3.00 3.25

Eurozone 1.00 1.50 2.75 3.25

Japan 0.20 0.30 1.20 1.40

UK 0.75 1.00 3.50 3.75

Switzerland 0.50 1.00 2.00 2.25

Australia 5.25 5.50 5.50 5.75

Canada 1.50 2.00 3.50 3.75

Sweden 2.00 2.75 3.00 3.50China1 2.90 3.30 3.80 4.00

Exchange rates 6 mths 12 mths equilibrium2

EURUSD 1.35 1.39 1.24

USDJPY 85 89 87

GBPUSD 1.60 1.66 1.66

USDCHF 0.96 0.96 1.18

USDCAD 0.97 0.95 1.03

AUDUSD 0.96 0.96 0.70

NZDUSD 0.73 0.71 0.58

USDSEK 6.59 6.33 7.57

USDNOK 5.63 5.47 7.06USDCNY 6.45 6.25 n.a.

2011 a year for equities


Equities The place to be in 2011

Global equities have performed solidly in 2010, particularly in emerging markets, and this trend is likely to continue in 2011 on the back of rising corporate earnings and accommodative central banks. We still favor Germany and emerging markets.

In 2010, three major themes emerged that investors should continue to consider in 2011. Firstly, the sovereign debt crisis in the eurozone reminded investors that Europe is not a homogenous region. There is a divide between the economically strong Core Europe and southern Europe, which is coping with auster-ity measures. Secondly, recent further monetary policy easing by the US central bank and the Bank of Japan implies low interest rates through 2011. And, finally, companies – espe-cially those with large sales exposure to Asia and Core Europe – reported strong earnings growth in 2010. Going forward, it will be important for investors to focus on those areas of sustainable earnings growth that did not become too expensive in 2010 (see Fig. 8). Conversely, it is also important to remain cautious with respect to cheap stocks that offer no earnings growth – so-called value traps.

Core Europe: not just driven by export demand in 2011As most austerity measures will show their major impact in 2011, the growth divide across Europe is likely to persist in 2011. We would recommend focusing on economically strong core eurozone countries like Germany, where strong enterprise spending continues to fill the order books and earnings are expected to improve (see Fig. 9). In addition, the German unemployment rate is at its lowest level since unification and personal income growth is sound, which should support equity markets. A further interesting segment is medium-sized German companies – many are industrials with stronger sales tilts toward Asia than the larger companies.

Switzerland also falls into the category of having a strong economy. However, the Swiss index is heavily tilted toward healthcare companies, which offer low earnings growth. The consumer staples sector benefits from Asian consumer demand but is not cheap anymore. As such, we expect Swiss equity market performance to be in line with global equities.

Fig. 8: Attractive valuation of equity markets


P/E ratio based on consensus earnings forecasts bars indicate 20-year average

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Fig. 9: Improving 2011 earnings expectations for Germany and emerging markets


Consensus forecasts for earnings per share in 2011; normalized to 100 in Feb 2009

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Markus IrngartingerStrategist, UBS AG

Lena Lee AndresenStrategist, UBS AG

Kilian ReberAnalyst, UBS AG



A special case is the UK equity market, which we continue to recommend. Although the economy will suffer from austerity measures, 70% of large-cap companies’ sales revenue is generated outside the UK. In addition, the market has a strong weighting in commodity-related sectors, providing a good hedge against inflation going forward.

US equities: focus on companies benefiting from corporate spending US equities are as a whole likely to perform in line with global equities. We would recom-mend focusing on companies with interna-tional exposure benefiting from increased corporate spending (see Fig. 10). This holds particularly for the IT sector, which is also attractive from a valuation perspective.

Emerging market equities: attractive returns in 2011, but not everything a buyWith central banks in the developed world keeping interest rates low for longer and high growth continuing in emerging markets, “cheap money” will keep flowing towards superior returns in emerging markets in 2011. While we deem emerging markets equities to be attractive overall, not everything is a buy.

Asia will likely still see the strongest growth and earnings potential in 2011. Having said that, some markets have recently done so well that investors might want to wait for cheaper

entry points. We recommend exposure to the attractively valued BRIC countries (Brazil, Russia, India, and China). The markets we are less positive on include Indonesia, Malaysia, and Hungary.

Latin America should closely follow Asia in terms of growth and earnings potential, while emerging Europe’s need to deleverage will likely earn the region the last rank within emerging markets for another year. Still, growth and earnings are expected to improve in emerging Europe in 2011.

While this is mainly good news, 2011 may also bring new emerging markets capital inflow taxes – most likely in Asian and Latin American countries – which have the potential to increase volatility and reduce returns in the short term. We would therefore recommend good diversification across and within emerg-ing equity markets.

Equity sectors: It’s all about growth, but not at any priceWhat is true of individual emerging markets also holds for some sectors with good earnings growth prospects. Certain sectors performed strongly in 2010 and are not cheap anymore. This is particularly the case for Consumer Discretionary, Consumer Staples and Industri-als. While the earnings expectations for these sectors seem intact, their valuations are in

Equities

Fig. 10: Catch-up potential for enterprise spending


US nonresidential private fixed investment as a percentage of GDP

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1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Equipment and sowareTotal

Fig. 11: Basic Materials sector offers upside potential

Source: Thomson Reuters, UBS WMR

Comparison of 12-months forward P/E ratios across selected global sectors

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Nov 09 Feb 10 May 10 Aug 10 Nov 10

Consumer staplesBasic materials

Consumer discretionaryIndustrials



Equities

Share buybacks, dividends and M&A on the menuWhen the financial crisis hit, companies started heavy cost-cutting programs and strongly reduced debt. Now, with earnings recovering, they are accumulating increasing amounts of cash. With borrowing costs at almost negligible levels and equity valuations low, share buybacks and acquisitions are becoming particularly attractive. We find this trend supportive of overall equity prices into 2011.

Besides investing excess cash in fixed capital, a company can also buy back its own shares (thus increasing earnings and price per share). Another alternative is to increase dividends, either as a special dividend or by permanently increasing dividend payments – however, companies have to make sure that these increases are well-covered, as markets usually punish dividend cuts. Finally, high cash levels and low borrowing costs

could lead to more mergers and acquisitions activity (M&A). News about an M&A deal usually causes a takeover candidate’s share price to skyrocket.

Fig. 12: Plenty of cash and strong balance sheets


European companies’ free cash flow vs. net debt to EBITDA

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Equities

some areas rather high. However, the Basic Materials sector still has strong earnings growth potential and is attractively valued (see Fig. 11). The sector should benefit from renewed infrastructure building in China. In addition, low US interest rates encourage money to flow into emerging markets in search of yield – leading to increased investment activity, which should benefit commodity prices and hence the materials sector.

Equity sectors: Some are cheap for a reasonWhile valuation is important, cheap valuations do not always indicate a bargain – sometimes, they imply poor earnings growth for a com-pany. From a sector perspective, European Utilities could be such a “value trap”. Providing water and electricity is a largely stable business, but excess profits might be taxed by govern-ments – as already planned in Germany and Spain. Growth prospects also look dire for the healthcare sector – as long as positive news flow on the drug pipeline is lacking. Within banking, the impact of regulatory change and Basel III will likely weigh on the sector as banks retain earnings, cut dividends and raise funds to meet the new capital requirements.


2010 challenged all four major currencies as the US dollar, the euro, the British pound and the Japanese yen, at times, came under severe pressure. We expect this trend to continue in 2011.

The important consequences of the profound weakness of the major reserve currencies have been that investors have started to move into the currencies of commodity producers and emerging markets. The motives differ from the simple yield hunting and carry trades that dominated activity before the financial crisis. Today, the run into emerging markets and commodity producers is driven by a search for safety and exposure to economic growth.

The challenge for 2011 and for currency markets is that the obvious targets for diversifi-cation have become very expensive. Currencies like the Australian dollar, the Swiss franc and the Brazilian real have reached extreme levels.

QE2 is not a friend of the US dollar The implementation of a second round of quantitative easing (QE2) by the US Federal Reserve (Fed) has enhanced the need to find a safe alternative to the US dollar. Before QE2, the US dollar tended to fall versus the euro when economic conditions improved, as risk

aversion fell and equities gained (see Fig. 13). Now, with QE2, the Fed has indicated it will increase money supply in adverse times. As a result, when the global economy rises, the dollar is likely to weaken because other countries will offer a better growth environ-ment; and when the economy falters, investors will flee the US dollar as the Fed is likely to increase the speed of money printing. The Fed has therefore left the US dollar in dire straits, and only an expected policy change toward tighter rates will be able to change this process, in our view. However, increases in interest rates in 2011 are unlikely and, as a consequence, the US dollar is likely to continue on a downward path.

The euro is also not a favoriteThe euro is not the best alternative to the US dollar. Europe is challenged by some members struggling to service their debts. In 2011, we expect the bond-issuing schedule of Spain, Ireland and others will challenge investors in the euro. In contrast, the economic environ-ment is extremely friendly for the strong exporters of Germany, the Netherlands and even Austria. For this reason, we believe the European Central Bank (ECB) will not want to overly strengthen the euro. As long as the central bank has the choice, it would rather

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Fig. 13: The euro tends to benefit when equities gain

Note: As of 15 November 2010.Source: Bloomberg, UBS WMR

S&P 500 equity index vs. EURUSD exchange rate

Fig. 14: Commodity currencies (AUD and NZD) show strength

Source: Fitch, Bloomberg, UBS WMR

Valuation according to PPP versus 3-month interest rate

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Thomas FluryStrategist, UBS AG

Michael BolligerAnalyst, UBS AG


CurrenciesA search for safety


keep interest rates low to help the challenged countries, rather than bring a more restrictive stance to the others via a strong euro.

Diversify on dips We continue to advise investors to seek alternatives to the US dollar and euro. Given the strength of alternatives (see Fig. 14) such as the Australian dollar or the Swiss franc, we recommend investors add these currencies on the dips. Although buying into weakness carries downside risk, we expect these curren-cies to appreciate over the long term. Secondly,

diversified investments in the smaller devel-oped world (e.g., Swedish krona and Norwe-gian krone) and in emerging market currencies (see below) may be prudent.

In terms of the EURUSD, we expect the rate to fluctuate in a broad 1.50–1.20 range. We expect European debt problems to limit the euro’s rise above 1.50. On the other hand, should the EURUSD go against our expectations and dip below 1.20, we expect US dollar-rich Asian and Middle Eastern investors to unwind their greenback exposure and limit the rise.

Emerging market currencies

Still attractive despite interventionStrong economic growth and higher interest rates in emerging markets next year, coupled with low rates in many developed countries for longer, should continue to see capital flowing to emerging markets in 2011. We expect Asian and Latin American currencies, in particular, to remain supported. Additionally, for some currencies, higher foreign exchange reserves and rising interest rates suggest appreciation potential over the long term.

However, as emerging markets currencies grow stronger, particularly in the face of quantitative easing in developed markets, we expect increasing central bank interven-tion and the introduction of capital controls in emerging markets in 2011. Such concerns are focused to a greater extent on Asia and Latin America and less so on emerging Europe. These measures will likely lead to

higher exchange rate volatility going forward, but should not fundamentally affect the longer-term attractiveness of emerging markets currencies.

Currencies

Fig. 15: High FX reserves and high interest rates suggest appreciation potential

Source: Bloomberg, UBS WMR

FX reserve changes in the last 6 months and real interest rates

Brazil

Chile Mexico

China

India

Indonesia

Malaysia PhilippinesKoreaCzech Rep.

Hungary

Poland

Russia

S. Africa

Attractive

Unattractive

Turkey

0

1

2

3

4

5

–10 –5 0 5 10 15 20FX reserves changes (last 6 months)

Real

inte

rest

rate

s (1

0-yr

gov

. bon

ds)


“Investors need to tread carefully in 2011.”


Investors should look beyond the tradi-tional classification of risky versus “risk-free” when selecting bond markets. We prefer high-yield debt, emerging market government debt, corporates and selective short-maturity government debt.

Traditionally, government bonds of developed countries were characterized as “risk-free” investments, while emerging market bonds, among others, were classified as risky invest-ments. This seemingly clear-cut distinction has become questionable today, as the recent financial crisis has deteriorated public finances in some developed markets.

Beyond the old classificationMany emerging countries were only affected marginally by the crisis. With stronger economic growth and less exposure to toxic banking assets, several emerging markets actually became stronger, in relative terms, against several developed economies. China, Russia and Indonesia all exhibit low budget deficits and current account surpluses, which makes them the best positioned within the emerging markets. Brazil and Turkey also do not seem to be overly at risk. Several countries within the Europe, Middle East, Africa region (EMEA), however, tend to be less well-positioned –

South Africa, for example, but also Hungary, due to its high debt-to-GDP ratio (see Fig. 16).

Regarding the eurozone, financial markets have recognized that several member countries are in particularly vulnerable positions. We reiterate our recommendation to sell Greek sovereign debt, as we think there is a high likelihood of a debt restructuring during the next couple of years. Similarly, we have sell recommendations on bonds issued or guaran-teed by Portugal and Spain, and medium- to longer-term bonds of Ireland, despite seem-ingly attractive yields.

Risks arising from high debt and global imbalancesIn 2011, a number of countries will have to implement further austerity measures and incur more social and political tension. In countries where austerity measures might need to be postponed for political reasons, yields are likely to go up as investors assume an increased likelihood of default and/or inflation.

Rising international tensions are likely to remain prominent in 2011. Frictions in trade or capital flows would be particularly unfavorable for countries running large current account deficits (such as the US) that will have to rely

Fig. 16: Risk map for selected developed and emerging bond markets

Source: UBS, IMF, Bloomberg

The size of the bubble reflects the level of real interest rates

Budg

et d

eficit

201

1 Turkey

MalaysiaSouth Africa

Poland

IndonesiaHungary

SwedenAustralia

Portugal

Higher risk

Lower risk

Greece

Spain

US

BrazilCanada

UK

Russia

China

Germany

Switzerland

–15

–13

–11

–9

–7

–5

–3

–1

1

–15 –10 –5 50 10 15Current account 2011

Developed marketsEmerging markets

Fig. 17: Corporate, high yield and emerging market bonds are still attractive

Note: As of 15 November 2010.Source: BoA Merill Lynch, JP Morgan, UBS WMR

Yield to maturity of selected USD bond market segments

0

5

10

15

20

25

Yiel

d-to

-mat

urity

Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11

Treasury bills 3mUS Government bonds

Corporate bonds Emerging marketsHigh-yield bonds

Achim PeijanStrategist, UBS AG

Philipp SchöttlerStrategist, UBS AG


Fixed incomeThe traditional rules no longer apply


Fixed income

further on foreign capital. To replace foreign savings and stimulate domestic savings, interest rates would need to increase if international tensions resulted in trade or capital restrictions. On the other hand, countries enjoying trade and current account surpluses (e.g., Switzerland, Sweden, Germany, Japan) will find that savings would need to be invested more intensively domestically, which could support bond prices to some degree.

Focus on short and medium maturitiesOverall, we prefer countries with low public deficits and healthy external balances in emerging and developed markets. However,

even here prices could come under pressure as the offered yield-to-maturities have dropped to unattractive levels. Another drag for bonds could be inflation, which may well overshoot current market expectations in the medium to long term even though some central banks are likely to start (e.g., Swiss National Bank) or continue (e.g., Sweden, Australia, Canada) to retreat from the ultra-loose monetary policy of 2010. We thus recommend focusing on bonds with short and medium maturities. Also, selected emerging markets and corporate bonds (see box) are, in general, likely to outperform most developed government bond markets (see Fig. 17).

Corporate bonds

The rally is over – but a solid year is expectedInvestment-grade and high-yield corporate bonds had a stellar performance in 2010. The yield-to-maturity advantage over government bonds declined further from its 2008 historical high, and has returned close to long-term averages.

We believe this search for yield will continue in 2011. However, the risk of rising interest rates and inflation has increased compared to a year ago, which could start to weigh on corporate bonds, as the buffer from higher yields is limited going forward. We recom-mend investment-grade corporate bonds with shorter durations in light of increased interest rate risk.

Generally, the yield advantage of corporate bonds over government bonds remains attractive, but the appreciation potential is now limited. In particular, strong balance

sheets and rising cash flows remain supportive for high-yield bonds and should help to keep the company default rate low. Overall, we envisage decent but more “normal” total returns over the coming year.

Fig. 18: Few defaults expected to keep yields low in 2011

Note: As of 15 November 2010.Source: Moody’s, BoA Merrill Lynch, UBS WMR

US high-yield default rate vs. global high-yield spread

20

468

141210

16

0

5

20

15

10

25

20022000 2004 2006 2008 2010 2012

Default rate WMR forecast (le scale)High-yield default rate (le scale)

High-yield bond yield in excess of government bonds (right scale)



Non-traditional asset classes

Hedge fundsNew structures make accessing hedge funds easier

An evolving trend in the hedge fund world is the growth of UCITS (Undertakings for Collective Investment in Transferable Securi-ties), a legal structure in the European Union that requires funds to fulfil three key require-ments: transparency, liquidity and diversifica-tion. It aims to give investors some security and enhance their risk management.

The picture for hedge funds remains bright (see Fig. 19) with the accent on global macro and event-driven strategies, in our view. We continue to expect a bipolar world, in other words strong economic growth in the emerg-ing markets and below-average performance in the developed economies, offering opportuni-ties for global macro managers. Event-driven strategies, on the other hand, are currently able to take advantage of a pick-up in transac-tion activities (e.g., acquisitions) or balance sheet restructurings (debt refinancing, asset sales and stock issuances). Given less competi-tion in the hedge fund space – from fewer hedge funds and bank trading desks – we continue to be supportive of the sector.

Listed real estateReal estate equities poised for further solid performance

Good monetary conditions, easing lending standards and better-than-expected market fundamentals have acted supportively for the global real estate market. The new round of quantitative easing by the US Federal Reserve is fueling the market by putting downward pressure on long-term interest rates. In addition, investors have raised their inflation expectations and extended their exposure to listed real estate, which is viewed as a natural hedge against inflation.

US real estate equities have accordingly recorded the best performance compared to peers on a year-to-date basis (see Fig. 20). In Europe, the environment has also become more favorable with a number of stocks establishing new highs. However, rental growth is now needed globally for further improvements. We therefore like real estate equities with above-average dividend yields, especially in Germany, Sweden, France and the US, while the UK’s attractive valuation reflects risks. We expect commercial real estate to outperform in Hong Kong, Singapore and Australia on strong employment and con-strained supply.

Fig. 19: Hedge funds continued to succeed in 2010

Note: As of 15 November 2010.Source: CS Tremont

Year-to-date performance in %

–15 –10 –5 0 5 10

Long/short equity

Global macro

Multi-strategy

Event-driven

Equity market neutral

Dedicated short bias

Dow Jones Credit Suisse Hedge Fund Index

Fig. 20: Listed real estate strongly supported by further monetary easing

Note: indexed: 01.01.2005 = 100; As of 15 November 2010.Source: Bloomberg, GPR, UBS WMR

Performance of global equities and global listed real estate

0

50

100

150

200

250

2005 2006 2007 2008 2009 2010 2011

EuropeAsia

Americas Global EquitiesOceania

Cesare ValeggiaAnalyst, UBS AG

Thomas VeraguthEconomist, UBS AG


NTAC investments may not be suitable for all clients, please contact your client advisor for further information.



CommoditiesWell-positioned for 2011

The sweet spot for commodities in the last quarter of 2010 still leaves room for higher prices during 2011. Loose monetary policy and abundant liquidity should allow a reaccelera-tion in commodity demand, especially from emerging markets. While developed world growth is likely to remain moderate and bumpy, overall demand should hold up. In addition, financial investors in search of protection against currency and inflation risks are likely to favor commodities.

As such, commodity prices across all sectors are expected to rise further (see Fig. 21). We favor commodities where supply growth is limited, such as gold, copper and corn, and where prices haven’t seen exponential increases, such as cotton and silver. The reduction in OPEC spare capacity on the back of firm Asian oil demand should pave the way for price moves to USD 100/bbl over the next 12 months. As a consequence of a lack of trust in the major currencies and inflation concerns, further price rises are likely, with gold seeing peak levels at around USD 1,650/oz, in our view.

Private equityGetting back in vogue, probably too much

We advocate 2011 to be a busy time for exits by private equity firms as market conditions improve. From an investor standpoint, this means that the window of opportunity is, arguably, beginning to close.

The profitability of traditional private equity deals benefits from low debt financing costs, a positive economic environment and attractive prices. While the former are supportive aspects, the acquisition price is more questionable. Private equity firms already have considerable reserves of investable capital at their disposal due to the elevated inflows of funds before the economic downturn. In tandem with the increased interest from asset managers (see Fig. 22), private equity valuations may creep up (and the potential entry point for investors may become more expensive).

Sector-wise, investors have been paying attention to later-stage companies and information technology overall is responsible for the largest number of venture deals. There is also activity in medical services and we see potential growth in the leveraged buyout market as access to finance becomes easier.

Fig. 21: A very strong year for precious metals and so commodities

Note: indexed: 01.01.2008 = 100; As of 15 November 2010.Source: DJ UBS, Bloomberg, UBS WMR

Commodity performance by sector

0204060

160140120100

80

180

Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11

EnergyPrecious metals

Industrial metals SosLivestockGrains

Fig. 22: 2011 should see inflows into private equity

Source: Preqin

Amount of capital investors plan to commit to private equity funds in 2011 compared to 2010

12%

39%

49%

More capital in 2011 than in 2010Same amount of capital in 2011as in 2010Less capital in 2011 than in 2010

Dominic SchniderStrategist, UBS AG

Cesare ValeggiaAnalyst, UBS AG


NTAC investments may not be suitable for all clients, please contact your client advisor for further information.


Note: Information through 30 November 2010. Returns over five years are annualized. Past performance is not an indication of future returns. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication. Source: Bloomberg, GPR, HFR, J.P. Morgan, Merrill Lynch, MSCI, Thomson Reuters, UBS WMR

Financial market performance

Equities

Total return, in local currency and % Total return, in USD and %Markets YTD 3-mo 1-yr 5-yr YTD 3-mo 1-yr 5-yr

Global 4.6 9.5 8.5 0.4 4.6 10.8 6.5 2.0US 8.2 13.5 10.4 1.1 8.2 13.5 10.4 1.1Japan –3.4 5.6 5.3 –8.9 7.4 6.8 8.2 –2.2Canada 10.2 8.4 13.1 6.6 12.5 11.3 16.1 9.4Eurozone –1.9 4.2 3.7 –0.6 –11.0 6.9 –10.1 1.4UK 5.1 6.8 9.7 4.0 1.4 7.4 4.1 1.8Sweden 20.8 10.8 22.3 7.1 22.6 16.3 21.5 10.2Switzerland –0.2 1.9 4.4 –0.7 3.5 4.7 5.2 5.0Australia –2.7 3.6 0.7 4.5 3.7 10.9 5.5 10.1Emerging markets 9.5 9.0 14.1 11.9 11.2 11.1 15.7 12.9 Asia 10.2 8.7 15.1 13.0 12.3 10.9 17.4 13.4 Emerging Europe, Middle East & Africa 12.4 10.8 19.6 3.7 9.1 10.0 13.9 4.4 Latin America 5.7 9.2 8.2 16.0 8.0 11.7 10.2 18.6

SectorsConsumer discretionary 18.0 17.3 25.8 1.1 19.2 18.4 23.9 3.3Consumer staples 8.3 5.9 11.2 6.9 7.8 7.0 9.0 8.3Energy 3.5 15.5 5.8 4.2 2.2 16.6 3.5 4.8Financials –3.7 2.5 –2.8 –8.7 –3.7 4.3 –4.7 –7.0Healthcare –1.8 5.5 1.8 0.9 –1.9 6.4 0.1 2.0Industrials 13.5 13.2 18.5 1.4 14.4 14.5 16.6 3.6IT 3.6 15.2 10.7 1.1 4.5 15.6 10.4 2.6Materials 8.9 15.2 14.4 7.8 9.2 17.7 12.2 10.3Telecom 7.8 4.7 11.5 4.7 5.7 6.1 6.7 5.9Utilities –2.6 –0.3 3.0 3.1 –4.6 0.7 –1.8 4.6

Fixed income

Total return, in local currency and % Historical 3-month LIBOR rates, in %Money market YTD 3-mo 1-yr 5-yr Current 3-mo 1-yr 5-yr

US 0.4 0.1 0.4 3.4 0.3 0.3 0.3 4.4Japan 0.4 0.1 0.4 0.7 0.2 0.2 0.3 0.1Eurozone 1.0 0.3 1.1 3.3 1.0 0.8 0.7 2.5UK 0.9 0.3 0.9 4.2 0.7 0.7 0.6 4.6Switzerland 0.3 0.1 0.4 1.8 0.2 0.2 0.3 1.0

Government bonds Historical 10-year govt. yields, in %US 8.1 –0.5 5.2 6.2 2.8 2.5 3.2 4.5Japan 1.8 –1.1 1.9 1.9 1.2 1.0 1.3 1.4Germany 7.7 –2.2 6.7 4.8 2.7 2.1 3.2 3.5UK 7.7 –2.1 4.8 5.2 3.2 2.9 3.5 4.2Switzerland 4.7 –1.6 4.8 3.5 1.6 1.2 1.8 2.2

Total return, in USD and %YTD 3-mo 1-yr 5-yr

Global inflation-linked bonds 2.4 0.8 –1.0 5.5 5.2 –0.4 3.8 5.0

Total return, in local currency and % Option-adjusted spread, in bpsInvestment-grade corporate bonds YTD 3-mo 1-yr 5-yr Current 3-mo 1-yr 5-yr

USD-denominated 10.6 0.2 9.5 6.4 182 192 221 97EUR-denominated 5.2 –1.6 5.1 3.4 187 179 173 47

High-yield corporate bondsUSD-denominated 13.2 4.2 16.7 8.6 622 689 765 367EUR-denominated 11.9 0.8 14.6 7.0 653 678 813 365

Emerging markets USD sovereign bondsGlobal 12.6 0.2 12.8 9.0 322 321 342 237Asia 14.1 –0.8 15.6 10.5 193 190 278 217Eastern Europe 10.4 0.3 11.5 8.2 316 312 332 224Latin America 13.1 0.4 12.3 8.3 388 388 383 274


Total return, in local currency and % Total return, in USD and %

YTD 3-mo 1-yr 5-yr YTD 3-mo 1-yr 5-yrListed real estate 13.8 7.1 20.3 0.2 15.3 8.6 19.4 2.5Commodities – – – – 5.5 11.0 7.5 –11.8

Currencies

Change versus the USD, in % Exchange ratesYTD 3-mo 1-yr 5-yr Current Current

EUR –9.4 2.5 –13.3 2.0 EURUSD 1.30 USDCNY 6.67GBP –3.6 0.7 –5.1 –2.1 GBPUSD 1.56 NZDUSD 0.74JPY 11.3 1.1 3.1 7.4 USDJPY 84 EURCHF 1.30CAD 1.9 3.3 3.0 2.6 USDCAD 1.03 EURGBP 0.83CHF 3.1 2.3 0.3 5.6 USDCHF 1.00 EURJPY 109SEK 1.8 5.4 –0.1 2.8 USDSEK 7.03 EURSEK 9.13AUD 6.8 7.5 5.1 5.4 AUDUSD 0.96 EURNOK 8.06

3-month YTD

1050–5–10 2520151050–5–10 252015

12840–4 1612840–4 1612840–4 16

12840–4 16

86420–2–4 1086420–2–4 10

–8–12 –4 0 84 12

0–4 4 8 12 16

6420–2–4 168


Wealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisions of UBS AG (UBS) or an affili-ate thereof. In certain countries, UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). All information and opinions as well as any prices indicated are current as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. At any time, UBS AG and other com-panies in the UBS group (or employees thereof) may have a long or short position, or deal as principal or agent, in relevant securities or provide advisory or other services to the issuer of relevant securities or to a company connected with an issuer. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is consid-ered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income of an investment. We are of necessity unable to take into account the particular investment objectives, financial situation and needs of our individual clients and we would recommend that you take financial and/or tax advice as to the implications (including tax) of investing in any of the products mentioned herein. This document may not be reproduced or copies circulated without prior authority of UBS or a subsidiary of UBS. UBS expressly prohibits the distribution and transfer of this document to third parties for any reason. UBS will not be liable for any claims or lawsuits from any third parties arising from the use or distribution of this document. This report is for distribution only under such circumstances as may be permitted by applicable law.

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UBS research focusUBS research focus examines how major global trends affect personal wealth planning decisions. Each issue is devoted to a specific subject spanning the fields of economics, financial markets and investment. Available in: English, German, French, Italian, Spanish, and Portuguese.Sept 2010 The rush for resources

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