CIO Monthly Extended Monthly... · 2014-02-27 · Global tactical asset allocation . Source: UBS CIO WM Global Investment Office – as of 20.02.2014 . Tactical asset allocation deviations

March 2014

Published 20 February 2014

This report has been prepared by UBS AG. Please see important disclaimers and disclosures at the end of the document. Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication.

CIO WM Global Investment Office

CIO Monthly Extended

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1

Table of Contents

Section 1 Base slides 2

Section 2 Asset class views 12

2.A Equities 13

2.B Bonds 22

2.C Foreign exchange 32

2.D Commodities 36

2.E Alternative investments: Hedge funds & Private markets 40

Section 3 APAC tactical asset allocation 43

Section 4 Emerging market tactical asset allocation 47

Appendix Global portfolios 49

Section 1

Base slides


3

Summary

Please see important disclaimer and disclosures at the end of the document.

"Rising corporate earnings will likely push equity prices higher in 2014. We prefer US and Eurozone equities as well as US high yield bonds."

• Economy We expect global economic growth to accelerate at a faster pace this year than in 2013. Despite the recent weakness in US data – as seen from the fall in the ISM leading indicator and the slower-than-expected growth in employment – the economy remains on an improving trajectory. We attribute the slowdown partly to adverse weather, the negative effects of which should reverse over the coming months. The Eurozone economy also continues to improve. In China recent lending and trade data suggests a stabilization in growth.

• Equities We believe earnings will be the key driver for equity prices this year, and our constructive view was recently affirmed by the fourth-quarter results of US companies, which comfortably beat analysts' expectations. We foresee US earnings growth of around 8% in 2014. Eurozone companies have a good potential to catch up; margins are still depressed but are showing signs of a turnaround. We overweight both regions. Our least preferred market is the UK, where earnings have fallen significantly over the past months, burdened by the strong pound as large-cap UK companies generate 75% of their sales abroad.

• Bonds The latest weakness in US economic data has caused government bond yields to retreat. At ~2.7%, 10-year US Treasuries are ~30 basis points below their level at the beginning of the year. Still, we expect government bond yields to gradually rise above their recent highs, as economic growth improves and the Federal Reserve reduces its bond purchases. We believe corporate bonds have a better return outlook due to their still attractive yield carry and an environment of record-low defaults. We increase our US high yield overweight against high grade bonds as spreads are expected to tighten from 400 bps to 350 bps in six months.

• Foreign exchange We are overweight the US dollar against both the euro and the Japanese yen. The strong downtrend in the US unemployment rate should allow the Fed to continue to scale back monetary support. However the opposite is true for Japan and the Eurozone, where central banks are leaning toward further easing. Moreover, we prefer the British pound to the Swiss franc as the strong momentum of the UK economy will continue to support the currency, while its valuation still looks appealing and investor positioning is not stretched.

• Commodities Temporary weather-related price support has not changed our view that broadly diversified commodity indices will deliver negative returns this year. We expect gold to fall toward USD 1,150/oz in six months. Platinum and palladium are among our most preferred individual commodities.


4

Cross-asset preferences

• USD () • GBP

• Developed market high-grade bonds ()

• US high yield () • Global investment-grade credit • Corporate hybrids • Rising stars ()

Most preferred Least preferred

• US • Eurozone • US financials • US technology • US share buybacks and

dividends • Benefit from restructuring

measures in the Eurozone • Selected Eurozone banks • Water-linked investments • Bright prospects for LED ()

• UK ()

Recent upgrades Recent downgrades

Equities

Bonds

Foreign exchange

Commodities

• EUR () • JPY • CHF


Global portfolio (EUR)

Note: Portfolio weightings for a "EUR Balanced" profile. For portfolio weightings related to other risk profiles or currencies, please see the appendix (page 50) or contact your client advisor.

Alternative Investments

• Relative value and equity long/short hedge funds

Liquidity5%

High-grade bonds10%

Inv-grade corporates

bonds14%

High-yield bonds

9%

EM bonds3%

Equities others

2%

Equities EM4%

Equities Europe

23%

Equities US15%

Hedge Funds / Private Equity

15%


5

Cash

Equities total

US

Eurozone

UK

Switzerland

Japan

EM

Listed real estate

Bonds total

High grade bonds

Corporate bonds (IG)

High yield bonds

EM sovereign bonds (USD)

EM corporate bonds (USD)

EM bonds (local currencies)

Commodities

new old

neutral overweightunderweight

Global tactical asset allocation

Source: UBS CIO WM Global Investment Office – as of 20.02.2014

Tactical asset allocation deviations from benchmark* Currency allocation

* Please note that the bar charts show total portfolio preferences and thus can be interpreted as the recommended deviation from the relevant portfolio benchmark for any given asset class and sub-asset class.

The UBS Investment House View is largely reflected in the majority of UBS Discretionary Mandates and forms the basis of UBS Advisory Mandates. Note that the implementation in Discretionary or Advisory Mandates might deviate slightly from the “unconstrained” asset allocation shown above, depending on benchmarks, currency positions, and other implementation considerations.


Please find APAC tactical asset allocation weights on page 44 and emerging market weights on page 48.

USD

EUR

GBP

JPY

CHF

SEK

NOK

CAD

NZD

AUD

new old

neutralunderweight overweight


6

CIO preferred investment themes (1/2)

• US high-yield corporate bonds US high-yield corporate bonds are well supported in terms of fundamentals. The default rate is very low, and rising corporate earnings, robust balance-sheets, and low refinancing needs are likely to limit actual defaults. Against this backdrop, current yield spreads of about 400 basis points compensate well for the risks, and we expect total returns of 3–4% over the next six months. As an alternative, senior loans are exposed to similar positive fundamentals and offer floating rates.

• Yield pickup with corporate hybrids The corporate hybrid segment is a niche of the investment-grade corporate bond asset class. At current spread levels, investors are well compensated for assuming the risks associated with these instruments. As a consequence, we see attractive opportunities for investors with a suitable risk tolerance. We expect mid-single-digit returns on selected instruments over a 12-month period.

• Rising Stars When an issuer is upgraded from high yield to investment grade, its bonds' spreads usually tighten materially – often beyond the level implied by their higher rating – as a result of strong technical pressure. To investors who can hold individual, weaker-quality bonds, we recommend investing in bonds of issuers whom we see as potential rising stars over the next 18 months. In the event they are upgraded to investment-grade, we expect these issuers to outperform both the 'BB' and the 'BBB' rating category. In the absence of an upgrade, we still expect these issuers to outperform investment-grade corporates.

Fixed Income

The CIO preferred investment themes represent the CIO's highest conviction, thematic investment ideas. We aim to recommend ideas that are attractive on a risk-reward basis and expected to deliver positive absolute returns. It will include the best investment themes for each of our TAA overweights, further aligning the asset allocation and themes recommendations, along with a range of other short-, medium- and long-term, as well as SRI, themes.

Equities


• Profit from US share buybacks and dividends US companies generally have healthy balance-sheets, and many are sitting on significant cash reserves. Investors in companies that return capital through dividends and share buybacks have been rewarded by the stock market. They offer attractive yields and, as our data shows, outperform the underlying index. With borrowing costs currently low, companies are incentivized to return cash to shareholders, and the growing free-cash-flow yield is a key factor for the theme. Since share buybacks are at the discretion of individual management teams, we recommend investing in a diversified basket of stocks.

• US financials: On the road to recovery US financials are currently under-earning relative to their long-term potential. With the US economy and interest-rate backdrop likely to normalize further, financials' earnings should grow faster than the broad US equity universe. With valuations still attractive, US financials should outperform the overall US equity market.

• US technology: Secular growth, on sale Secular growth drivers (mobility, cloud computing, e-commerce, and big data) should power sector earnings growth over the coming years. More cyclically, US technology companies should benefit from a pickup in business spending on technology products and services as the outlook for global corporate profits improves. Sector valuations are near 20-year lows.

• Energy efficiency: Brighter prospects for LED The LED market, an important part of the energy-efficiency field, is at an inflection point driven by a perfect confluence of both supply and demand factors. After three years of significant overcapacity, we expect supply and demand to balance out this year, creating an attractive investment opportunity. We believe the tight supply should result in a better pricing outlook and a strong rebound in profitability across the supply chain, given the industry's high operating leverage. Based on consensus estimates, we expect industry net profits to increase by 25% in 2014 and 18% in 2015.

= New investment theme


7

CIO preferred investment themes (2/2)

Equities • Favoring equity long-short and relative-value strategies

Equity-hedge strategies should perform well in a low-correlation environment in which company-specific news drives market returns. Some stocks' inflated valuations will offer attractive shorting opportunities as well. The ability to balance net and gross market exposure will also be a key differentiating factor for this strategy in 2014.

Hedge Funds & Private Equity


• Water: Thirst for investments The demand for clean water should increase with a growing global population. However, the supply of clean water is constrained by the lack of water infrastructure in emerging markets. Climate change, urbanization, and emerging markets’ stronger focus on the industrial sector are also damaging the water supply. We have identified three short-term trends that should add to the earnings power of water-exposed companies: ship ballast water treatment, US shale development, and desalination.

• Restructuring to increase value We believe it is important to select Eurozone stocks that can deliver above-average earnings growth even amid subdued economic growth. In this new investment theme, we recommend stocks that can expand their margins and grow their earnings through cost controls and internal restructuring measures.

• Eurozone bank recovery: Selectivity is key We revisited the Eurozone's banks since they felt the most pressure during the euro crisis. Looking at banks' potential profitability, capitalization levels, and the likely impact of new regulatory requirements, we identify names that have already made reasonable progress on the most pressing issues and therefore present the best risk-return potential.

• Brighter times for the USD and GBP We open this new theme as the Fed and the Bank of England (BoE) are in the process of normalizing their monetary policies, while the European Central Bank (ECB) and the Bank of Japan are likely to keep their easing bias. We expect the Swiss National Bank will keep the euro-franc floor until the ECB starts hiking rates. Meanwhile, in the US and the UK, both the labor and real estate markets have gained pace, calling for a new, more cautious policy course for the Fed and the BoE.

Liquidity & Foreign Exchange

= New investment theme


8

25

30

35

40

45

50

55

60

65

07 08 09 10 11 12 13 14

No-change line Manufacturing Services Composite

Key points • We expect global growth to continue to accelerate in 2014, with contributions from all the major economies. • The acceleration will be led not only by the US, but also by the Eurozone after 1½ years of recession. • We expect inflation to remain subdued, particularly in the developed economies. • We see significant policy divergence among the major central banks.

CIO view (Probability: 70%*) Growth acceleration • Global growth is set to accelerate and 2014 should surpass the growth of the past three years. US GDP will likely expand 3% in 2014, while the Eurozone will likely deliver a meager yet positive growth rate of 1.1%, with all four of the region's large economies posting positive growth. The emerging markets had a turbulent start to 2014, but we are convinced that the currency turmoil is contained and will not derail growth. The "Fragile Five" countries (Brazil, India, Indonesia, Turkey, and South Africa) remain at risk of downward revisions, while the growth picture for China, South Korea, Mexico, and Russia is more solid. • Inflation will likely remain very low in the developed economies, with deflation being a possibility for the Eurozone. In emerging markets, inflation will likely stay significantly higher than in the developed world. We expect the recent weakness in several emerging market currencies to manifest in the form of moderately higher inflation rates over the coming quarters. • We expect the Fed to continue the taper its asset-purchase program (QE3) at a pace of USD 10bn in each of the future FOMC meetings, ultimately ending the program by fall 2014. However, we expect the first rate hike only in 1H15, depending on the evolution of the US labor market. The ECB, faced with deflation risks, is still in an easing mode and could cut interest rates further. Several emerging market central banks have already hiked rates since the beginning of the year, and we expect them to retain a bias toward moderately tighter monetary policy.

Global economic outlook – Summary Global growth to accelerate in 2014

For further information please contact CIO Chief Economist Andreas Hoefert, [email protected], or CIO economist Ricardo Garcia, [email protected], Please see important disclaimer and disclosures at the end of the document.

Global purchasing managers' indices consolidating at expansionary levels Global PMIs

Positive scenario (Probability: 15%*) Return to above-trend growth • The US economy grows 3.5–4% or above, with a strong acceleration in consumption. • Political risks in the Eurozone fade further, along with a smaller-than-expected drag from the bank stress-tests and fiscal tightening. Growth turns out better than forecast, especially in the European periphery. • Reform measures in fundamentally weaker emerging markets start to reduce their dependence on external finance, giving them wider room for fiscal and monetary policy maneuvre, and supporting their economic growth. Negative scenario (Probability: 15%*) Developed growth disappointments • Bad US economic data in December and January prove more than just weather-related, and the Eurozone crisis deepens again due to political turmoil, adverse effects from the asset-quality review, or heavier deflationary pressure. • The emerging market currency turmoil in January develops into a full-fledged current-account and currency crisis, with the Fragile Five hit the hardest. Growth in China weakens due to domestic policy tightening or weak exports.

Source: JP Morgan, Bloomberg, UBS, as of February 2014 Note: Past performance is not an indication of future returns. *Scenario probabilities are based on qualitative assessment.

Source: UBS, as of 20 February 2014 In developing the CIO economic forecasts, CIO economists worked in collaboration with economists employed by UBS Investment Research. Forecasts and estimates are current only as of the date of this publication and may change without notice.

Key dates 3 Mar US: ISM manufacturing index for February 6 Mar ECB press conference 7 Mar US labor market report for February 19 Mar FOMC meeting

2013F 2014F 2015F 2013F 2014F 2015FAmericas US 1.9 3.0 3.0 1.5 1.8 2.4

Canada 1.6 2.6 3.1 0.9 1.6 2.2Brazil 2.2 2.3 2.0 5.9 6.2 6.0

Asia/Pacific Japan 1.6 1.5 1.2 0.3 2.7 1.8Australia 2.4 3.0 3.3 2.4 2.8 2.4China 7.7 7.8 7.2 2.6 3.5 3.5India 4.7 5.7 5.3 9.6 7.6 6.8

Europe Eurozone -0.4 1.1 1.5 1.4 1.1 1.5 Germany 0.5 1.6 1.9 1.6 1.3 1.5 France 0.2 0.9 1.5 1.1 1.0 1.0 Italy -1.8 0.4 0.7 1.4 1.6 1.6 Spain -1.2 0.8 1.3 1.5 0.6 1.6UK 1.9 2.5 2.5 2.6 2.0 2.1Switzerland 1.9 2.1 2.4 -0.2 0.5 1.1Russia 1.3 2.5 2.8 6.8 6.1 5.2

World 2.5 3.3 3.4 2.4 2.7 2.8

Real GDP growth in % Inflation in %


9

CIO view (Probability: 70%*) Robust expansion • We expect US annualized real GDP growth of 2% in 1Q14 (consensus: 2.5%), followed by a pickup to 3.4% in 2Q14 (consensus: 2.8%) and 3.4% in 3Q14 (consensus: 3.0%), as growth in private demand accelerates and the drag from inventory and government spending fades. We anticipate a combination of falling unemployment, rising inflation expectations, and increasing costs associated with a growing Fed balance sheet to keep the Fed tapering its bond purchases at a measured pace of USD 10bn per meeting, and halt the bond-purchase program in 4Q14 with total purchases amounting to USD 1.62 trillion. We foresee the first Fed rate hike in mid-2015. • In FY2014, we project the federal deficit to narrow by about 1% compared with 3% in FY2013, with a negligible negative impact of 0.1% on GDP growth versus 1.1% in FY2013. • The increase in mortgage rates since summer 2013 has dampened the pace of housing construction, sales, and price gains, signaling less support for the economy. However, we expect the positive trend in housing activity to resume over the next six months as construction activity and housing prices remain below their long-run equilibrium. • The personal consumption expenditures (PCE) price index has fallen to 1.1% year-on-year, well below the Fed’s long-term target of 2%. We expect inflation to remain below this target over the next six months.

Key points • We expect US growth to be robust in 1H14, driven by stronger private-sector demand. • Inflation will likely stay below the Fed's target of 2% over the next six months. • The Fed's QE3 will likely last until 4Q14 with a tapering of USD 10bn per meeting, and total USD 1.62 trillion.

Key dates 3 Mar ISM manufacturing PMI for February 7 Mar Nonfarm payrolls and unemployment rate for February 13 Mar Advance retail sales for February 14 Mar Preliminary University of Michigan consumer sentiment index for March 18-19 Mar FOMC meeting

US growth likely robust in 1H14 US real GDP and its components, quarter-on-quarter annualized in %

For further information please contact US economist Thomas Berner, [email protected] Please see important disclaimer and disclosures at the end of the document.

US inflation currently well below target US headline and core PCE price index, year-on-year in %

Key financial market driver 1 – Robust US expansion

Note: PCE = personal consumption expenditures Source: Thomson Datastream, UBS, as of 10 February 2014

Positive scenario (Probability: 20%*) Strong expansion • Growth accelerates persistently above 3.5–4%, propelled by an expansive monetary policy, a rapidly fading fiscal drag, a positive and quick resolution to the debt-ceiling dispute, strong investment in housing, and improved business and consumer confidence. The Fed halts QE3 and raises rates sooner than mid-2015. Negative scenario (Probability: 10%*) Growth recession • A technical US Treasury default or an escalation of the Eurozone crisis upsets the private-sector recovery. Real GDP growth deteriorates, raising the fiscal deficit and leading to more aggressive bond-buying by the Fed.

Source: Thomson Datastream, UBS, as of 10 February 2014


10

25

30

35

40

45

50

55

60

65

07 08 09 10 11 12 13 14

No-change line Manufacturing Services Composite

CIO view (Probability: 60%*) Moderate growth • Following a sharp recent upswing, we expect the volatility in the economic growth rate to abate, with growth settling at 0.2–0.3% quarter-on-quarter (in line with consensus). Nevertheless, global disinflation and the high Eurozone unemployment rate are set to prevent inflation in the region from rising quickly. With an inflation outlook of only 1.1% for 2014, the ECB is likely to retain an easing bias in the foreseeable future. The German constitutional court's request for European Court of Justice advice on the ECB's outright monetary transactions (OMT) has increased the probability of a market-friendly "yes, but…" ruling. Finally, the European elections in May should result in a grand coalition, while the non-mainstream parties are expected to strengthen their positions. •German economic growth should see a sharp improvement this year, supported by a global growth acceleration (including in other Eurozone countries) and the highest consumer confidence in years. The French economy should defy weak business surveys and post positive sequential growth rates, benefiting from a substantial decline in fiscal austerity and a renewed push for reforms. • In Italy, the payment of government arrears, an improved global economic outlook, and the end of fiscal austerity should help the economy to definitively exit recession. In Spain, against a backdrop of its bank bailout program exit, newly gained competitiveness, and the global growth acceleration, the economy should post an even more dynamic recovery, despite still-substantial fiscal austerity. • In the coming months, Eurozone finance ministers are expected to finalize decisions on Portugal's exit from the bailout program and possibly the Enhanced Conditions Credit Line, and on more funding for Greece.

For further information please contact CIO Eurozone economist Ricardo Garcia, [email protected] or CIO analyst Thomas Wacker, [email protected] Please see important disclaimer and disclosures at the end of the document.

Key points • Economic growth will likely stabilize around the current rate of 0.3% quarter-on-quarter after its recent turnaround. • Inflation is set to remain below 1% in the coming months, before moving up again to around 1% in 2Q14. • The ECB provides a credible backstop against euro break-up risks and retains an easing bias amid low inflation.

Positive scenario (Probability: 20%*) Strong growth and fiscal stabilization • Bond yields converge closer than expected as peripheral countries consolidate their budgets and economic activity recovers faster. Italy and Spain follow a credible reform path at a faster pace and political risks fade further. Negative scenario (Probability: 20%*) Major shock • Political uncertainty and the bank stress-test remain the key risks for Italian bonds, while persistent deficit overshoots are the key risk for Spain. Other major risks include Spain or Italy requiring funding support; a negative court verdict on OMT; persistent disinflation or deflation; growing resistance from core countries against further debt support; Portugal requiring a debt restructuring; a Greek or Cypriot euro exit; and massive fiscal slippage in France.

Yields of Spanish and Italian five-year bonds, in %

Source: UBS, Bloomberg; as of 20 February 2014 Note: Past performance is not an indication of future returns. * Scenario probabilities are based on qualitative assessment.

Key financial market driver 2 – Eurozone economic recovery

Key dates 28 Feb Consumer price inflation for February (estimate) 6 Mar ECB press conference 12 Mar Eurozone industrial production for January 24 Mar PMI flash estimate for March

Source: Bloomberg, UBS; as of February 2014

Eurozone composite purchasing managers' index in expansionary territory

0

1

2

3

4

5

6

7

8

06/2011 12/2011 06/2012 12/2012 06/2013 12/2013

Italy Spain


11

Key financial market driver 3 – Chinese growth to stabilize

CIO view (Probability: 70%*) Stabilizing growth • Despite a slower growth momentum, we expect China's GDP to continue to expand above 7.5% in 1H14. Slower credit and infrastructure activity will likely hurt growth, but they will be partially offset by improvements in less-credit-intensive sectors like consumption and exports. We expect more small-scale investment-trust defaults to happen this year, but the pain should bring long-term benefits. Given tighter monetary policy to control rising financial risks, we see downside risks to our above-consensus 2014 GDP growth forecast of 7.8% (consensus: 7.4%). • Monetary policy will likely retain a tightening bias in 2014. The volatility in interbank rates will likely persist amid China's continued intention to both liberalize interest rates and control shadow-banking activity. We expect total social financing (TSF) to grow by about CNY 17 trillion in 2014 (similar to 2013), brining down the growth in outstanding TSF to about 15–16% in 2014 from 18.4% in 2013. • We believe the government will selectively allow small-scale and orderly credit events in the shadow-banking segment to change investors' perception of so-called "implicit guarantees." This should be viewed as long-term positive, as defaults in shadow-banking credit will reduce moral hazard, encourage more effective risk-pricing, and develop a more mature and disciplined financial market. The likelihood of systemic risk to the economy remains low. • The National People's Congress in March should deliver economic targets and details on the execution of planned reforms. We expect the 2014 GDP growth target to remain at 7.5%, higher than the earlier expectation of 7%, which should help lift domestic confidence and demand. The formation of a senior-level council on reforms should boost implementation. More details will likely be given on fiscal reforms, the one-child policy, and anti-corruption efforts.

For further information please contact CIO analysts Gary Tsang, [email protected], Glenda Yu, [email protected], and Patrick Ho, [email protected] Please see important disclaimer and disclosures at the end of the document.

Key points • Despite a slower growth momentum, we expect China's GDP to expand by more than 7.5% year-on-year in 1H14. • While we expect minor investment-trust defaults this year, the process should be gradual and pose no systemic risks. • The National People's Congress will release more details on reforms in March.

Key dates 5 Mar National People's Congress 8-9 Mar Trade and inflation data for February 13 Mar Industrial production, fixed-asset investment and retail sales data for January and February 10–15 Mar New bank loans, total social financing, and money supply data for February

Source: Bloomberg, UBS; as of February 2014 Note: Past performance is not an indication of future returns. * Scenario probabilities are based on qualitative assessment.

Downtrend in credit growth continues…

Source: CEIC, UBS; as of February 2014

Positive scenario (Probability: 15%*) Growth acceleration • Economic growth accelerates significantly above 8% in the coming quarters as a result of more substantial fiscal, monetary, and credit policy support from the government, or a strong pick-up in external demand. Negative scenario (Probability: 15%*) Sharp economic downturn • The government heavily reins in shadow banking; interbank rates surge for a prolonged period; a rapid rise in residential property prices or inflation triggers aggressive policy tightening; demand for Chinese exports plunges.

…and investment growth slows down

-10%

0%

10%

20%

30%

40%

50%

60%

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

Yea

r-to

-dat

e (%

y/y

)

Manufacturing Real estate development Infrastructure


12

Section 2

Asset class views


13

Section 2.A

Asset class views

Equities


14

Equities overview Preferences (six months)

Note: Preference in hedged terms (excl. currency movements) Global equity sectors – Key points • We have a preference for global IT given attractive valuations, accelerating cash returns to shareholders, an improving outlook for global corporate profits, and supportive product cycles. • We like financials globally. Despite ongoing regulatory challenges, we think earnings trends are sound and valuations are cheap. We like US financials which boast healthy balance-sheets and earnings prospects, as well as Eurozone financials which benefit from a brightening macroeconomic picture. • We like consumer discretionary. Revenue and earnings growth remains superior due to increased consumer spending in major regions globally. • Our preferred defensive sector is healthcare, as it offers superior long-term earnings growth with low volatility and high free-cash-flow generation. Companies have strong balance-sheets and attractive prospects for dividend growth. • We dislike telecoms and utilities as revenue growth and earnings growth are weak. Utilities face a tough business environment (weak demand, regulatory pressure, lower power prices), while telecoms are under heavy margin pressure. • We dislike energy as earnings momentum is weak, free-cash-flow generation is relatively low, and margins are under pressure. • We dislike consumer staples as valuations are stretched, and the earnings-growth outlook is weakening due to currency headwinds and exposure to emerging markets, where growth expectations are less optimistic in the near term. • We are neutral on industrials as valuations are fair even as we expect the sector to benefit from a manufacturing activity uptick. • We are neutral on materials as valuations are attractive but earnings risks are high and free-cash-flows are weak.

For further information please contact CIO asset class specialists Markus Irngartinger, [email protected] or Carsten Schlufter, [email protected] Please see important disclaimer and disclosures at the end of the document.

Global equity markets – Key points • We recommend an overweight allocation to equities via overweight positions in US and Eurozone equities. We are underweight UK equities. US equities are well supported by robust earnings growth. Global economic growth is forecast to improve in the coming quarters, bringing good earnings-improvement potential for Eurozone cyclical sectors. In contrast, UK large-caps' earnings suffer from the strong currency given the large share of revenues generated abroad. • We are overweight US equities. Earnings continue to broadly advance. While recent activity data have been negatively affected by the harsh winter, we continue to forecast the domestic economy to strengthen. • We are overweight Eurozone equities. Economic growth is strengthening and leading indicators point to a further expansion in manufacturing activity. Monetary policy remains supportive. Profit margins especially in the periphery are depressed relative to historical levels, but are showing signs of turning around and may improve in 2014. • We have a neutral stance on emerging market equities. Their earnings dynamics lag those of developed markets. Downside stock-market risks remain especially for countries with current-account deficits and that depend on capital inflows. • We are neutral on Japanese equities. Earnings are recovering strongly, but economic and earnings growth faces risks from the expected severe fiscal tightening in April, when the consumption tax is hiked from 5% to 8%, and from the expiry of some fiscal stimulus measures from previous years. • We are neutral on Canadian equities. Company earnings have stabilized over the last three months. On a trailing price-to-earnings (P/E) basis, the market is trading in line with global equities and its own 10-year average. • We are neutral on Australian equities. The Australian dollar's recent weakness supports exporters, and company earnings are improving. However, structural headwinds from the slowdown in mining-sector investments remain a burden for the economy. • We are neutral on Swiss equities. Swiss equities benefit less than global peers from a pickup in global activity, as about 58% of the market consists of defensive sectors like consumer staples and healthcare. Still, solid earnings generation supports the market. • We are underweight UK equities. Trailing earnings per share (EPS) continue to fall and lag those of the other markets in our universe. The pound's strength is a headwind to companies, as 75% of overall revenues are generated abroad. Thus, a strengthening UK economy provides only very limited support to earnings of the large-cap companies.

Sector preferences within global equity markets

Current most preferred sectors

Current least preferred sectors

Consumer Discretionary Consumer Staples Financials Energy Healthcare Telecom IT Utilities

Source: UBS

Equities total

USA

Canada

EMU

UK

Switzerland

Australia

Hong Kong

Japan

Singapore

Global EM (in USD)

No

rth

Am

eric

aEu

rop

eA

PAC

EM

new old



15

US equities Preference: overweight

S&P 500 (19 Feb): 1,828 (last publication: 1,845) UBS view S&P 500 (six-month target): 1,900 • Despite recent near-term market concerns over both emerging market vulnerabilities and the growth trajectory of the US economy, we continue to believe that US equity market fundamentals remain on solid footing. S&P 500 earnings continue to advance, monetary conditions should remain accommodative despite the Fed slowing the pace of asset purchases, and broad US market valuation gauges are not stretched. • While select economic indicators, such as the December and January non-farm payrolls and the January ISM manufacturing index, suggest that growth is slowing, we believe that both adverse weather conditions and payback from recently expanding inventories have weighed on the data. More broadly, household and business fundamentals have improved and should drive real GDP growth of 3% in 2014 compared to 1.9% in 2013. • Earnings momentum is improving; 4Q13 S&P 500 EPS increased 9%, the fastest growth rate in over two years. Our forecast for 2014 EPS of USD 120, or 8% growth, appears well supported and may prove conservative. • History suggests that US equity valuations tend to rise as monetary policy and interest rates normalize from extreme levels. The unwinding of QE3 and a measured rise in bond yields – driven by improving growth fundamentals – are consistent with stable to moderately higher equity valuations relative to current levels. • We prefer cyclical over defensive sectors, specifically IT and industrials. Historically, these sectors have benefited from accelerating capital spending during the mid-to-late stages of an economic expansion. We also expect financials to outperform driven by accelerating loan growth and a sustained upturn in housing.

For further information please contact CIO asset class specialists Jeremy Zirin, [email protected] and David Lefkowitz, [email protected] Please see important disclaimer and disclosures at the end of the document.

Positive scenario S&P 500 (six-month target): 2,125 • A synchronized global growth acceleration, coupled with a benign public policy setting, unleashes pent-up consumer and business spending in the coming months. S&P 500 EPS increases 12–15% in 2014, and the trailing P/E multiple expands close to 18x (or 16x forward earnings). Negative scenario S&P 500 (six-month target): 1,525 • Earnings fail to meet expectations due to weaker-than-expected capital spending, renewed sovereign stress in the Eurozone, and sluggish growth in emerging markets. Continued political disagreement regarding US government tax and spending policies becomes acute and derails the US expansion. Earnings stagnate or decline moderately, confidence sags, and trailing P/E contracts to about 14x (or 13.5x forward earnings). Note: Scenarios refer to global economic scenarios (see slide 8)

What we're watching Why it matters

The Fed

Additional insight regarding the pace of withdrawal of accommodative policy. Key date: 17-18 Mar, FOMC rate decision

Labor market Improvement in the labor market supports stronger consumption. Key date: 7 Mar, payroll report

Business sentiment The ISM is the key leading indicator for US manufacturing and services. Key dates: 3 Mar, ISM manufacturing; 5 March, ISM non-manufacturing

Summary (six-month tactical view) We are overweight US equities. While recent economic indicators have been mixed, we believe the recovery is durable and US equity market fundamentals remain on solid footing. S&P 500 earnings continue to advance, monetary conditions remain accommodative despite Fed tapering of bond purchases, and broad US market valuation gauges are not stretched. Further market gains are likely to be driven primarily by corporate earnings growth, especially in financials, IT, and industrials.

Continued improvement in available credit suggests earnings growth is durable

Fed Senior Loan Officer Survey percent of banks tightening standards vs. S&P 500 EPS growth

Source: FactSet, UBS CIO, as of February 2014 Note: Past performance is not an indication of future returns.

Current most preferred sectors

Current least preferred sectors

Financials Cons. Staples Industrials Energy IT Telecom

Utilities Source: UBS


16

Eurozone equities Preference: overweight Euro Stoxx (19 Feb): 320 (last publication: 320) UBS view Euro Stoxx (six-month target): 330 • We hold an overweight stance on Eurozone equities. Leading indicators point to further improvements in Eurozone economic activity in the coming quarters. Conditions in Southern Europe have improved. GDP growth accelerated in Spain and Italy in 4Q13. Business sentiment suggests continued expansion and peripheral bond yields have been falling to the lowest levels in more than six years. External demand from Asia and the US is holding up well. The ECB's monetary policy stance continues to have an easing bias. • European margins are showing signs of improvement. As we expect economic growth to rise in Europe and globally, earnings should follow in the next six months and achieve double-digit growth rates in 2014. Given its cyclicality, we expect the Eurozone market to benefit disproportionally from an uptick in global growth. Earnings in the consumer discretionary sector in particular should benefit from increasing demand. • Superior earnings growth, falling provisions, and attractive valuations favor financials. • Healthcare is our preferred defensive sector due to its high free-cash-flow and solid revenue and earnings growth. We are cautious on utilities and telecom due to their negative earning trends, which put dividends at risk. Valuations of consumer staples are high relative to their own 10-year history and Eurozone equities as a whole. • The results of the ECB's asset-quality review will not be published until October 2014. We expect the additional capital needs of major banks to be manageable. • Given that the ECB has reiterated its easing bias, refinancing costs should come down in peripheral countries.

For further information please contact CIO asset class specialists Markus Irngartinger, [email protected] and Carsten Schlufter, [email protected] Please see important disclaimer and disclosures at the end of the document.

Positive scenario Euro Stoxx (six-month target): 375 • Economic growth reaccelerates worldwide. The Eurozone benefits from stronger global trade and domestic demand. Earnings rise at an upper-mid-single-digit rate in the next six months. The Euro Stoxx trailing P/E ratio rises to about 17.0x from 15.8x currently. Negative scenario Euro Stoxx (six-month target): 260 • Recession and the debt crisis lead to renewed market pressure, though downside risks due to the debt crisis are less severe given the ECB's OMT program and the recent improvement in several countries' current-account balances. • Earnings fall 5–10% and the average trailing P/E ratio drops to around 13.8x over six months. Note: Scenarios refer to global economic scenarios (see slide 8)

What we’re watching Why it matters

Growth indicators Economic growth is key to improving corporate earnings. Key dates: 24 Feb and 25 Mar, Ifo business climate index, Germany; 3 Mar, final PMI manufacturing, EMU; 5 Mar, final PMI services, EMU; 24 Mar, flash PMI manufacturing, EMU; 24 Mar, flash PMI services, EMU

Policy action ECB monthly policy meeting Key date: 6 Mar

Summary (six-month tactical view) We have an overweight position on Eurozone equities. The region's economic growth momentum, combined with an uptick in global manufacturing, bodes well for the Eurozone corporate earnings outlook. Coming from a low base, Eurozone earnings have considerable upside potential. We prefer the consumer discretionary and healthcare sectors as they offer good revenue and earnings growth and generate high free-cash-flows. Financials offer attractive valuations and superior earnings growth.

Source: Thomson Reuters, UBS, as of February 2014 Note: Past performance is not an indication of future returns.

Margins gradually improving (in %)

Sector preferences within Eurozone equity markets

Current most ppreferred sectors

Current leastt preferred sectorss

Consumer Discretionary Consumer Staples Financials Materials Healthcare Telecom Utilities

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UK equities Preference: underweight

Trailing earnings per share are falling For MSCI UK index, in British pound

FTSE 100 (19 Feb): 6,797 (last publication: 6,826) UBS view FTSE 100 (six-month target): 6,850 • We have an underweight stance on UK equities relative to global equities. We expect UK equities to underperform global peers as the market's earnings dynamics clearly lag those of global equities. • Defensive sectors account for slightly more than half of the MSCI UK market cap, and their weight in the UK equity market is about 15 percentage points higher than that in the global market. Thus, UK companies benefit less from a cyclical recovery than global peers. • UK trailing company earnings continued to fall in the past three months, severely lagging the earnings dynamics of global equities and the earnings advance in the US in particular. • 75% of FTSE 100 sales are derived overseas, and the pound's recent strength weighs on earnings. • The UK's economic recovery is gathering momentum, driven by domestic demand. We expect domestically exposed cyclical stocks and financials to continue to benefit from this recovery. Investors wishing to gain from the recovery should focus on UK mid-cap stocks, which generate more revenues in the UK than do UK large-caps stocks. • The FTSE 100 trades at a trailing P/E of 14.7x, which is about a 10% discount to global equities. This discount is broadly in line with the average 13% discount over the last 15 years. As UK equities are not currently cheap relative to historical levels, equity returns are likely to be driven by earnings growth, which we forecast to be in the low-single-digit range over the next six months.

Source: Thomson Reuters, UBS as of February 2014 Note: Past performance is not an indication of future returns.

Positive scenario FTSE 100 (six-month target): 7,500 • A rapid increase in global growth and recovering demand from emerging markets lead to sharp increases in commodity prices, helping the energy and materials sectors push the market higher. The market re-rates to a P/E multiple of about 15x, and earnings growth approaches 7% over the next six months. Negative scenario FTSE 100 (six-month target): 5,725 • A global recession drags down UK earnings by 5% in the next six months. The market's traditionally defensive characteristics only partly offset its strong exposure to commodity-related sectors, and the trailing P/E multiple drops toward 13x. Note: Scenarios refer to global economic scenarios (see slide 8)


Growth indicators

Business survey indicators and consumer spending data provide insight on economic developments. Key dates: 26 Feb, 4Q13 GDP; 3 Mar, PMI manufacturing; 4 Mar, PMI construction; 5 March, PMI services

Commodity prices Energy and materials comprise about 25% of the UK market. Developments in commodity prices affect earnings estimates.

Policy action The BoE's loose monetary policy supports equities. Key dates: 6 Mar, MPC meeting; 19 Mar, unemployment rate; 25 Mar, consumer price inflation

For further information please contact CIO asset class specialist Caroline Winckles, [email protected] Please see important disclaimer and disclosures at the end of the document.

Summary (six-month tactical view) We have an underweight stance on UK equities relative to global equities. The UK's overall earnings dynamics lag those of global markets. The strong pound is a drag on earnings given the high portion of FTSE 100 sales generated abroad. Energy and materials earnings in particular are falling. The UK's valuation discount to global equities is slightly less than in the past. Investors wishing to benefit from the UK's domestic recovery should invest in UK mid-cap companies via the FTSE 250 index.

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18

SMI (19 Feb): 8,411 (last publication: 8,467) UBS view SMI (six-month target): 8,600 • We are neutral on Swiss equities relative to global equities. While the Swiss equity market benefits less from an economic recovery due to its more-defensive sector exposure, earnings are holding up relatively well. Especially in a European context, Swiss equities are showing good earnings trends, while those of the UK in particular are very weak. • Swiss stocks trade only at a minor premium to global equities. Based on trailing earnings, their P/E of slightly above 16x is about 3% higher than for global equities (measured for MSCI World). This is broadly in line with the average premium over the last 15 years. • Defensive sectors like consumer staples and healthcare comprise about 58% of MSCI Switzerland's market cap – almost 20 percentage points higher than for global equities. This supports relatively stable earnings trends. • Swiss companies are globally diversified. They generate just over one-third of operating profits from Western Europe, one-third from emerging markets, and one-quarter from North America. This leads to currency losses in their Swiss franc-based earnings. We estimate the franc-related drag with respect to the US dollar and emerging market currencies will last through 1H14.

Swiss equities Preference: neutral

For further information please contact CIO asset class specialist Stefan Meyer, [email protected] Please see important disclaimer and disclosures at the end of the document.

Source: Thomson Reuters UBS; as of 17 February 2014 Note: Past performance is not an indication of future returns.

Positive scenario SMI (six-month target): 9,200 • Eurozone economic growth increases considerably, supporting Swiss financials and exporters. Defensive sectors are left behind in a strong global equity market rally. Market P/E expands moderately to 17.0x (versus 16.6x currently) and earnings grow 6% over the next six months. Negative scenario SMI (six-month target): 7,700 • The global economy slides into a recession. Despite offering less cyclically sensitive products, Swiss companies feel the drop in global demand. Corporate earnings fall slightly over the next six months, with market P/E contracting toward 15.5x. Note: Scenarios refer to global economic scenarios (see slide 8)

Solid earnings development For MSCI Switzerland, in Swiss franc


Interest rates and exchange rates

Announcements of domestic interest rates and exchange-rate decisions. Key dates: 20 Mar, Swiss National Bank meeting

Economic indicators Announcements of key domestic economic indicators. Key dates: 28 Feb, KOF Swiss leading indicator; 3 Mar, PMI manufacturing

Corporate announcements Announcements of important corporate results. Key dates: In March one last SMI-company will report its 4Q13 results

Summary (six-month tactical view) We are neutral on Swiss equities relative to global equities. The Swiss market offers more steady earnings growth than its key peer markets, especially in Europe. Currency effects continue to affect earnings, i.e., modestly negative in 1H14. The market is less volatile and shows a resilient price momentum. We favor mid-caps due to their above-average balance-sheet strength, better growth potential, and attractive valuations relative to the Swiss market average.

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MSCI Switzerland I/B/E/S trailing EPS


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Japanese equities Preference: neutral

Topix and yen moving closely in step

Topix (19 Feb): 1,219 (last publication: 1,300) UBS view Topix (six-month target): 1,240 • We have a neutral stance on Japanese equities. We believe corporate earnings growth will start to slow as the effect of the yen's weakness peters out. We expect EPS to advance 5–10% over the next six months, a clear slowdown from the forecast 55% growth in the fiscal year ending March. Also, the consumption tax hike in April and the expiry of some stimulus measures will post severe fiscal drags in 2Q14. • The Bank of Japan (BoJ) aims to end deflation and achieve 2% inflation by mid-2015. With the import price push fading in 2Q14, the BoJ will face difficulty in reaching its goals. Coupled with economic weakness due to the consumption tax hike, the BoJ is likely to ease its monetary policy again no earlier than 2Q14. It might buy more real assets such as exchange-traded funds and Japanese REITs. • We expect the BoJ’s actions and Japan's structural trade deficit to lead to further yen weakness. Given the forecast economic recovery in Europe and growth acceleration in the US, we prefer Japanese exporters. • We expect the Shinzo Abe government to set up special economic zones in March and start a deregulation process. • We expect the Topix trailing P/E to drop to around 14.3x in the next six months from about 15.1x currently, mainly due to further sharp increases in company earnings. • All in all, we forecast the Topix to move in line with global equity markets.

For further information please contact CIO asset class specialist Toru Ibayashi, [email protected] Please see important disclaimer and disclosures at the end of the document.

Source: Thomson Reuters, UBS; as of February 2014 Note: Past performance is not an indication of future returns.

Positive scenario Topix (six-month target): 1,400 • Stronger global demand and stabilizing European markets lead to increased risk-taking, which results in a further

weakening of the yen and provides an additional boost to earnings. Earnings grow about 12% in the next six months, with the Topix target based on 15.5x trailing P/E. Negative scenario Topix (six-month target): 970 • Sluggish global economic growth leads to weak exports and a stronger yen, triggering earnings disappointment.

The USDJPY goes below 95 on a sustained basis. With the BoJ committed to bold quantitative easing, the downside risk to the yen is limited. That said, the P/E ratio could contract to 11.5x and consensus earnings expectations would be trimmed.

Note: Scenarios refer to global economic scenarios (see slide 8)

Summary (six-month tactical view) We are neutral on Japanese equities. Earnings growth is likely to slow to the upper-single-digit range as the effect of the yen's weakness peters out. A severe risk for the next six months is a worse-than-expected impact from the consumption tax hike in April. We expect the BoJ to be reactive and not act before 2Q14. Given the forecast economic recovery in Europe and growth acceleration in the US, we prefer Japanese exporters.


Government decision on special economic zones

The government will decide on where to build new special economic zones. More relaxed regulations and lower tax rates will be applied to these zones. Key date: March decision

BoJ’s monetary policy changes

The upcoming BoJ monetary policy meetings may give hints on how the monetary easing will be implemented. We expect the bank's monetary policies to remain unchanged. Key dates: 10-11 Mar, BoJ policy meeting

Japan's CPI The BoJ’s next move depends on whether it can achieve 2% core CPI in mid-2015. Japan’s January core CPI should remain moderately positive at 1.2–1.4% y/y. Key date: Feb 28

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Emerging market equities Preference: neutral

MSCI EM (19 Feb): 959 (last publication: 976) UBS view MSCI EM (six-month target): 980 • We expect real GDP growth in emerging markets (EM) to average just below 5% in 2014 and 2015. Emerging Asia is forecast to grow slightly above 6% this year, whereas Latin America and emerging Europe, the Middle East, and Africa (EMEA) should grow around 3%. • The consensus expectation is for EM earnings to grow 11.3% over the next 12 months. We are more cautious, however, and expect an increase of around 9%. • The weakness in EM earnings is currently counterbalanced by relatively attractive valuations on a historical basis and relative to developed-market valuations. This matters for longer-term investors, but is not a short-term trigger. • We do not expect a material re-rating of EM equities in the next six months. We expect the P/E multiple of the MSCI EM Index to stay close to current levels of around 11x based on realized earnings. • In China, we expect reforms to improve the long-term efficiency and sustainability of the economy. In Mexico, we believe that structural reforms will create a new positive driver for the economy. In Russia, valuations and a more competitive currency are supportive in the near term. In South Korea, the market continues to be one of the most cyclically leveraged to the US economy. • Our current least preferred equity markets are India, Thailand, and Turkey. The latter two face higher political risks. The current-account deficits of India and Turkey make them more vulnerable as the Fed continues to taper.

For further information please contact CIO asset class specialist Costa Vayenas, [email protected] Please see important disclaimer and disclosures at the end of the document.

Positive scenario MSCI EM (six-month target): 1,100 • The outlook for the global economy improves, boosting emerging markets' ability to grow earnings in the next 12 months by over 15%, higher than what is currently priced in. Investor confidence improves and produces a better P/E multiple of about 12.0x trailing earnings. Negative scenario MSCI EM (six-month target): 770 • EM prospects are hit by deteriorating global growth due to weakness in the Eurozone or the US, or by a sharp deceleration of the Chinese economy. EM earnings decline by 10% over six months, with more-defensive Malaysia doing better while more-cyclical South Korea and Russia underperform. The EM P/E multiple stabilizes at around 10.0x trailing earnings, with central banks providing liquidity around the globe.

Note: Scenarios refer to global economic scenarios (see slide 8)


Industrial production Investors are trying to see which EM countries are growing faster and which might be stagnating or weakening. Key dates: 1-5 Mar, PMI manufacturing surveys for Brazil, China, India, Russia, South Africa, South Korea, and Turkey

Inflation, interest rates We do not see any sustained inflationary pressure in the next six months that would require a big change in the stance of EM monetary policy from what is currently priced in. But markets will continue to look for evidence that this could change later in 2014 and into 2015. Externally, US tapering will raise EM rates, too.

Summary (six-month tactical view) We are neutral on EM equities. The consensus expectation is for EM earnings to grow 11.3% over the next 12 months. We are more cautious, however, and expect around 9%. We do not foresee a material re-rating of EM equities over the next six months, and we expect the P/E multiple of the MSCI EM index to stay close to its current level of about 11x based on realized earnings. We prefer China, Russia, Mexico, and South Korea to India, Thailand, and Turkey.

Country preferences within emerging markets (relative to MSCI EM)

Source: UBS Note: Past performance is not an indication of future returns.


21

Listed real estate Preference: neutral

Positive scenario FTSE EPRA/NAREIT Developed TR USD (six-month target): 4,000 • Rental income growth positively surprises the market, while still-attractive interest rates allow asset values to increase. Cash flows grow from attractive real estate portfolio deals that remain appropriately financed. Investors move out of bonds into real estate as a moderate increase in inflation expectations favors properties. Negative scenario FTSE EPRA/NAREIT Developed TR USD (six-month target): 3,600 • The US recovery pushes global interest rates higher, hurting real estate markets across the world that have benefited from the low US rates. Higher rates provoke a tightening of credit standards and increase credit risks. Inflation rises unexpectedly fast and capitalization rates increase. Note: Scenarios refer to global economic scenarios (see slide 8).

For further information please contact CIO asset class specialist Thomas Veraguth, [email protected] Please see important disclaimer and disclosures at the end of the document.

FTSE EPRA/NAREIT Developed TR USD (07 Feb) 3,662 (last month: 3,737) UBS view FTSE EPRA/NAREIT Developed TR USD (six-month target): 3,830 • Listed real estate is currently outperforming global equities amid renewed market concerns about economic growth, slightly lower interest rates, and a flattening interest-rate curve. The latter has eased investors' concerns over future property values and debt refinancing costs. In the short term, we expect a range-bound market until investors have coped with the expected interest-rate hikes. We subsequently expect listed real estate to become more attractively valued than equities. • The direct real estate market is in its best shape since 2008–2009. A 20–25% absorption growth of new surfaces will likely be constrained by the paucity of new supply. We see diminishing vacancy rates and increasing rental incomes. Over 12 months, REITs' net asset values should grow by about 6%. REITs pay an attractive 2014 estimated dividend yield of 4.3%. • We prefer Japanese properties to Japanese REITs. We are cautious on Hong Kong and Singapore developers due to mounting fears about a property price correction. We favor Continental Europe, which is relatively cheap and less sensitive to interest-rate increases. We prefer the UK for growth and are neutral on the US.


Global transaction volumes and rental growth in direct markets

Investor sentiment, especially among institutions, significantly improves. Global transaction value is expected to strongly increase to USD 650bn from USD 560bn last year despite gradually rising interest rates. Buyers are showing greater appetite for risk by moving into secondary cities and targeting core-plus and value-added assets. With more buyers than sellers, optimism will translate into low-single-digit value gains. Global rental income growth will reach 2–3% p.a. Some major corporate occupiers remain in consolidation phase, still putting a slight drag on rental growth. Given shortages in high-quality properties, rental growth could yet accelerate.

Yield spreads and capitalization rates Credit markets and financing costs

Spreads between capitalization rates and government bond yields are at long-term averages overall. Spreads are supportive of property values. Yet, higher interest rates are gradually priced into valuation models, thus softening the value upside. Spreads to financing costs remain very favorable, allowing accretive acquisitions or mergers. The real estate investment market is displaying high liquidity in both equity and debt, with a significant amount of money chasing commercial property worldwide.

* This is our relative preference within the global real estate markets based on UBS Global Real Estate Index domestic total return, which is not the overall sector view Source: UBS, as of 07 February 2014 Note: Past performance is not an indication of future returns

Our market preferences (six months) For listed real estate relative to global real estate*

Summary (six-month tactical view) We are neutral on listed real estate relative to equities, view cyclical stocks as more attractive, and favor real estate over bonds. Valuations are mildly attractive although investors have already priced in slight increases in rates and lowered their expectations. Rental income will gradually improve. Yield spreads remain comfortably wide. We rate Australia, Hong Kong, and Singapore property as least preferred. We favor Europe and the UK. In the US, we prefer outlets, industrials, and multifamily.

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Section 2.B

Asset class views

Bonds


23

Bonds total

High grade bonds

USD corporate bonds (IG)

EUR corporate bonds (IG)

USD high yield bonds

EUR high yield bonds


EM corporates bonds (USD)

Emerging market local bonds

new old


Bonds overview

For further information please contact CIO asset class specialists Achim Peijan, [email protected] and Philipp Schoettler, [email protected] Please see important disclaimer and disclosures at the end of the document.

Preferences (six months) High-grade, corporate, and emerging market bonds – Key points • We prefer investment-grade (IG) corporate bonds over high-grade (HG) bonds (i.e., those rated 'AA-' or higher). The yield pickup of IG over HG bonds, and an expected modest spread-tightening should lead to outperformance of both EUR and USD IG over their HG counterparts. Moderate economic growth, low inflation, and expansionary monetary policy in the Eurozone and the US provide a supportive backdrop for IG corporate bonds. As company earnings grow and balance-sheets are still robust, credit-rating downgrades are likely to remain rare. • We are overweight US high-yield (HY) bonds versus HG bonds. The continued expansion of the US economy, supportive monetary policy, and robust corporate fundamentals will likely keep a lid on default rates. US HY spreads are expected to tighten toward 350 basis points (bps) in six months (from about 390 bps currently) as the credit cycle progresses, leading to attractive returns. A gradual rise in benchmark rates could be absorbed by tighter spreads on US HY. European HY also offers attractive single investment opportunities as the economic backdrop is improving and monetary policy remains very easy, supporting declining defaults. • EM bonds denominated in USD are somewhat attractively valued compared to USD HG bonds. However, the economic environment has deteriorated over the past months as several central banks tightened monetary policy that should weigh on economic growth going forward. In addition, financial vulnerabilities in countries like Ukraine and Venezuela have also increased.

Source: UBS CIO WM Global Investment Office


24 For further information please contact CIO asset class specialist Daniela Steinbrink Mattei, [email protected]


US rates

US 10-year yields and forecasts

Positive scenario for US economy/negative scenario for US bonds US 10-year (six-month range): 3.3–3.9% • US growth recovers more rapidly, with a quickly improving labor market and an earlier end to QE3 or earlier rate hikes, resulting in significantly higher yields. • A stronger Eurozone economic recovery presents an upside risk. Negative scenario for US economy/positive scenario for US bonds US 10-year (six-month range): 2.0–2.8% • The key economic downside risks include a stagnant labor market; re-escalation of the European debt crisis, which leads to wider European peripheral sovereign bond spreads; and a sharp deterioration in Chinese growth, weighing on US and global growth. • Persistence of the recent turmoil in emerging markets may drag down US/EU growth and in turn interest rates.

Note: Scenarios refer to global economic scenarios (see slide 8).

Source: Bloomberg, UBS; as of 10 February 2014 Note: Past performance is not an indication of future returns.

Summary (six-month tactical view) Yields are expected to rise over the next six months. We see upward pressure stemming from an improving global and domestic economic outlook and QE3 gradually drawing to a close in late 2014.

US 10-year (19 Feb): 2.7% (last month: 2.8%) UBS view US 10-year (six-month forecast): 3.2% • We expect the 10-year US Treasury yield to trend higher in the next six months. We see upward pressure stemming from a further improvement in the global and domestic economic outlook as the recent weakness in US growth proves temporary. Monetary policy will also be successively less accommodative as the Fed tapers its asset purchases by USD 10bn per meeting, with a likely end to QE3 in 4Q14. We forecast the Fed to start hiking rates in mid-2015. • We expect nominal yields to rise further in the next 12 months. Robust growth will result in markets readjusting their expectations on the first Fed hike, which in turn will result in higher yields. In addition, inflation rates are likely to bottom, lifting PCE prices (the Fed's preferred measure for inflation). This factor will add to pressure on yields to rise over the next 12 months.


Fed policy/labor market

The Fed’s assessment of the labor market largely determines its policy stance and is key to yields. Key dates: 7 Mar, nonfarm payrolls; 18–19 Mar FOMC meeting

Growth outlook Sentiment and growth outlook: Key dates : 3 Mar US ISM

Inflation expectations Breakeven inflation expectations have stabilized. A more significant change would add to yield volatility.


25 For further information, please contact CIO asset class specialists Daniela Steinbrink Mattei, [email protected],

Teresa Sardena, [email protected] and Nina Gotthelf, [email protected] Please see important disclaimer and disclosures at the end of the document.

European rates

Positive scenario for Eurozone economy/negative scenario for bonds 10-year (6-month range): 2.2–2.5% • A stronger Eurozone economic recovery kicks in. Inflation surprises on the upside, driving Bund yields higher. • Eurozone moves toward a transfer union. Negative scenario for Eurozone economy/positive scenario for bonds 10-year (6-month range): 1.6–1.9% • The European debt crisis re-escalates. • Further non-standard policy measures by central banks support lower yields. • Lower inflation than the ECB's current forecast represents a downside risk. • Persistence of the recent turmoil in emerging markets weighs on Eurozone growth and interest rates. Note: Scenarios refer to global economic scenarios (see slide 8)

Summary (six-month tactical view) We expect yields to rise, driven by the modest recovery and the expected stabilization of the recent inflation downtrend. However, low inflation, the ECB's easing bias, and structurally fragile growth limit the yield increase.

EUR (DE) 10-year (19 Feb): 1.7% (last month: 1.8%) UBS view EUR (DE) 10-year (six-month forecast): 2.0% • We expect 10-year Bund yields to rise in the next six months given their high correlation to US yields, combined with a modest improvement in Eurozone growth prospects. We forecast Bund yields to rise on a more sustainable basis in the next 6–12 months. • However, in the very near term, yields will remain vulnerable to the ECB easing bias and very low inflation rates. The ECB's attempt to decouple rates from the US has been more successful at the short end of the curve than at the long end. For longer-term Bund yields, economic growth and US Treasury yields remain the key drivers. The Bund curve thus remains exposed to volatility from the US. • In the UK, we forecast a modest recovery, pushing yields slightly higher over a six-month period. • In Switzerland, given the EURCHF floor and the robust domestic economy, we believe Swiss yields will trend sideways to slightly higher over six months.

European 10-year yields and forecasts



Central banks Key dates: 6 Mar, ECB meeting and release of staff projections; ongoing EC reports on the periphery; weekly LTRO repayments

Economic variables Economic growth, inflation, and credit conditions (ECB bank lending survey)

Political risks Capital needs arising from the bank asset-quality review, Greek and Portuguese debt sustainability issues, and improved but persistent fragmentation.

Eurozone yield spreads The level of spreads of peripheral bonds to German Bunds reflects risk-aversion and thus the safe-haven discount placed on Bunds.

mailto:[email protected]


26

High-grade bonds Preference: underweight

EUR AA+ 5–7y expected 6m total return: -1% (last month: 0.1%) USD AA+ 5–7y expected 6m total return: -1% (last month: 1.0%) UBS view CHF AA+ 5–7y expected 6m total return: -1% (last month: -0.2%) • EUR HG bonds (based on Barclays AA+ 5–7 year index) started well into the new year and returned almost 2% so far. With HG credit spreads currently very tight (roughly 0.4%) and expected to remain stable, the outlook will be driven by slightly rising underlying Bund yields. The index currently offers a yield of 1.2%, but we expect overall performance to be negative over the next six months due to falling prices. • USD HG bonds (based on Barclays AA+ 5–7 year index) gained 1.8% ytd. The performance of indices with shorter maturities was close to zero. Currently, credit spreads are very tight (roughly 0.5%) and we expect them to remain stable. We expect overall performance to be around –1% over the next six months. • CHF HG bonds (based on Barclays AA+ 5–7 year index) delivered 1.7% since the beginning of the year. The 7-10-year index outperformed slightly (2.6%). Currently, credit spreads are very tight (roughly 0.4%) and we expect them to remain stable. We expect overall performance to be negative (–1%) over the next six months. • Given the muted performance outlook of high grade bonds we have a strong preference for corporate investment grade as well as and high yields bonds.

Duration preferences within high-grade bonds

For further information please contact CIO asset class specialist Achim Peijan, [email protected] Please see important disclaimer and disclosures at the end of the document.

Positive scenario for economy/negative for HG Performance target (%) EUR/USD/CHF: -2% / -2% / -2% • A strong recovery in global growth and expectations of an earlier tightening of US monetary policy cause yields to increase more substantially. Negative scenario for economy/positive for HG Performance target (%) EUR/USD/CHF: 0.5% / 0.5% / 0.5% • Economic data disappoint and inflation expectations fall. Note: Scenarios refer to global economic scenarios (see slide 8).


US labor market We expect wage growth to be more important than the unemployment rate for the Fed. Key date: 7 Mar, US average hourly earnings

Inflation If inflation increases more substantially, the Fed will become marginally more restrictive. Key dates: 18 Mar, US consumer price inflation

Summary (six-month tactical view) We are underweight high-grade bonds versus investment-grade and high-yield bonds (see bond overview). We expect higher coupons and roll-down in the longer maturity segments to compensate much of the expected bond price decline stemming from the moderate expected increase in the yield curve. Thus, we recommend a neutral duration stance, especially when also considering transaction costs.


27

0

100

200

300

400

500

600

2009 2010 2011 2012 2013 2014

US investment grade EUR investment grade

Investment grade corporate bonds Preference: overweight

UBS view Spreads (19 Feb): 111 (USD) / 116 (EUR) bps (last publication: 111 / 113 bps) * Spread targets (six-month): 100 (USD) / 100 (EUR) bps

Expected total returns (six-month): 0-1% (USD) / 0-1% (EUR) • Spreads of investment-grade (IG) corporate bonds, both in EUR and USD, tightened significantly in late 2013 but have by and large stabilized recently. The fall in benchmark rates over recent weeks supported total returns and made IG one of the best-performing asset classes year-to-date (total returns +2% USD; +1.6% EUR). • Over the next six months, we expect IG bonds to achieve higher returns than high-grade (HG) bonds due to their yield pickup. We believe spreads will tighten slightly, but we are close to fair levels. We are overweight USD IG corporate bonds which should perform slightly better than EUR bonds (on our indexes*) due to their roll and carry advantage. • The economic backdrop for credit as an asset class remains constructive. Robust economic growth in the US and Europe, ongoing monetary support, and low interest rates keep demand for credit up. • Nonfinancial corporations: In the US, leverage has picked up toward long-term average levels. European corporations are at an earlier stage in the cycle than their US peers, but their balance sheets are also deteriorating slightly. Expected positive company earnings in 2014 should support balance-sheets. • Financials: We believe determined action by central banks provides a liquidity backstop for financials. Regulatory hurdles constitute a headwind particularly in Europe, but are unlikely to prevent spreads from tightening moderately. US banks are in a more robust state and are again trading at tighter spread levels than non-financials.

Yield spreads over government bonds (bps)*

Source: Bloomberg, UBS; as of 10 February 2014 Note: Past performance is not an indication of future returns. * Data based on Barclays Corporate Aggregate indexes

For further information please contact CIO asset class specialist Philipp Schöttler, [email protected] Please see important disclaimer and disclosures at the end of the document.

Summary (six-month tactical view) We prefer investment-grade (IG) corporate bonds in EUR and especially USD relative to high-grade (HG) bonds. While total returns of IG corporate bonds will be moderate, their yield carry and expected slight narrowing of spreads will lead to outperformance of HG. Bonds from the lower IG rating segments (BBB) offer better return potential than higher-rated issuers. Selected subordinated (hybrid) bonds of high-quality nonfinancial issuers offer a yield gain at moderate additional risk.

Positive economic scenario Spread targets (six-month): 85 (USD) / 85 bps (EUR) • Accelerating global growth compresses spreads closer to pre-crisis levels around 75bps. But rising benchmark yields lead to negative absolute total returns over six months. IG corporate bonds do well compared to HG bonds. A strong pickup in M&A activity weighs on credit quality in the medium term. Negative economic scenario Spread targets (six-month): 350 (USD) / 400 bps (EUR) • Major risks include a sharp slowdown of the US or Eurozone economy, reducing asset quality and weighing on financials' balance-sheets. EUR banks are most at risk. Note: Scenarios refer to global economic scenarios (see slide 8).


Core market yields

Developed market sovereign yields are only expected to increase gradually while the Fed scales back bond purchases. A sudden rise in yields and high volatility would hurt IG credit. Key dates: 19 Mar, FOMC rate decision; 6 Mar ECB rate decision

Corporate fundamentals

Robust corporate earnings and corporate leverage near average long-term levels should help prevent downgrades and defaults.

New issuance As financial companies continue to deleverage in Europe, net supply in the IG market is expected to remain low. A strong increase in net supply would be a technical hurdle.


28

0

500

1'000

1'500

2'000

2'500

2009 2010 2011 2012 2013 2014

US high yield EUR high yield

High yield corporate bonds Preference: overweight

UBS view Spreads (19 Feb): 395 (USD) / 343 (EUR) bps (last publication: 382 / 350 bps) * Spread targets (six-month): 350 (USD) / 300 (EUR) bps

Expected total returns (six-month): 3-4% (USD) / 2-3% (EUR) • Spreads of USD and EUR high-yield (HY) bonds rallied to new post-crisis lows in late January before widening again on the back of the recent turmoil stemming from emerging markets. This latest spread-widening was mainly driven by falling Treasury yields and had only a limited effect on total returns. HY bonds are up 1.3% year-to-date (both in Europe and the US). Our case against high-grade bonds improved as spreads widened somewhat after last month. • With no defaults recorded in January, the US trailing default rate fell to 0.3% (capital weighted). We expect the default rate to remain well below 2% through 2014 in the US, and to fall below 2% in Europe, supported by our constructive economic outlook, solid corporate fundamentals, and favorable funding conditions. This should clear the way for tighter spreads over the next six months, and we recommend an overweight in USD HY bonds. • HY issuers have used open primary markets in recent years to refinance outstanding debt and benefit from low interest rates, making them resilient to shorter-term economic volatility. • In terms of regions, we think the relative valuation of US and EUR HY is close to fair. US companies are more advanced in the credit cycle, but not to a worrying degree. Our slightly better return outlook as well as the higher degree of diversification favors the US HY market overall. We see attractive opportunities in select EUR HY issuers. • Secondary-market liquidity is a risk, causing temporary illiquidity and large price swings in times of market distress.

Yield spreads over government bonds (bps)*

Source: Bloomberg, UBS; as of 10 February 2014 Note: Past performance is not an indication of future returns. * Data based on BoAML High Yield indexes

For further information please contact CIO asset class specialist Philipp Schöttler, [email protected] Please see important disclaimer and disclosures at the end of the document.

Positive economic scenario Spread targets (six-month): 300 (USD) / 250 bps (EUR) • Spreads could tighten more than in our base case but are unlikely to tighten to pre-crisis lows (e.g., US below 250bps) due to lower total yields and a higher liquidity premium. On the other hand, a sharper-than-expected rise in benchmark rates could cause negative returns and outflows from HY funds. Negative economic scenario Spread target (six-month): 900 (USD) / 1000 bps (EUR) • A US recession is the major risk for US HY bonds. In this scenario, spreads widen to usual recession levels, but spikes above this level are likely, and defaults soar. Note: Scenarios refer to global economic scenarios (see slide 8).


Credit quality/ default cycle

Corporate fundamentals are backed by a high interest coverage. Against this backdrop, the default rate should stay far below its long-term average of 4%, thus supporting attractive total returns and low volatility.

New issuance

For now, favorable conditions in the primary market have mainly been used for refinancing. More aggressive issuance activity will ultimately weigh on credit quality and can add to market volatility.

Bank lending standards Bank lending provides an important source of funding. Easier lending conditions signal banks' increased confidence in firms' creditworthiness. US banks continued to relax standards in 1Q14, and European banks are expected to start easing standards in 1H14.

Summary (six-month tactical view) US high-yield corporate bonds offer an attractive return outlook, and we advise an overweight position versus high-grade bonds. Moderate economic growth, tepid inflation, and an expansionary monetary policy provide a supportive backdrop. Importantly, defaults are expected to remain well below 2% for 6–12 months as corporate fundamentals are still robust. US corporates are in the midst of the credit cycle, usually accommodating gradually higher leverage and tighter spreads.


29

EMBIG spread (19 Feb): 371 bps (last month: 342 bps) Asset class view EMBIG spread target (six-month): 350 bps; Expected 6m return 2.3% • EM hard-currency sovereign bonds had a volatile month, with increased volatility and higher credit spreads. Lower-rated countries with significant financial vulnerabilities and political risks such as Venezuela, the Ukraine, and Argentina underperformed the investment-grade segment by a wide margin. • EM PMI data declined again in January, highlighting the fragile economic recovery in EM. Monetary policy tightened in several countries following the broad-based weakness of EM currencies, and a tightening policy bias remains, in our view. In addition, EM bank lending continues to be restrictive. • We expect EM USD sovereign bond spreads to trend only slightly lower over the next six months, driven by higher-rated countries. As we expect US reference rates to rise, a total return of just 2.3% is likely for the next six months. We have a neutral view on sovereign bonds although they still provide yield pickup over HG bonds. Spread and return targets (6m): EMBIG IG: 200 bps (19 Feb: 222 bps) / 1.8% Investment Grade versus High Yield EMBIG HY: 800 bps (19 Feb: 818 bps) / 3.0% • Gradually higher US Treasury yields will continue to weigh on the total return outlook of IG EM sovereign bonds, not least due to their comparatively long average duration. At 230bps, spreads are slightly too high, and we expect a moderate tightening over the next six months as the EM recovery continues. • After the significant widening of EM HY spreads in recent weeks, we expect spreads to trend sideways around current levels of 800bps. Risks remain still skewed to the upside, however, as fundamentals in several important countries, including Venezuela, Argentina, and the Ukraine could deteriorate. We prefer EM IG sovereign issuers over their HY peers, given the lower expected volatility for the IG universe. Uncertainty surrounding the strength of the recovery and fundamental improvements in EM support our more cautious view. Sovereign views • In EMEA, we prefer Hungary and Russia, given their current-account surpluses and solid fiscal positions. The better backdrop in the Eurozone lifts the Hungarian economy, whereas elevated oil prices support Russia's external side. In Latin America, we prefer Mexico for its manageable current-account deficit. The recently approved energy reforms should increase foreign direct investment inflows and raise Mexico's growth potential, triggering a sovereign rating upgrade that is not yet fully reflected by valuations. • In Asia, we prefer the Philippines for its strong current-account position via foreign direct investment inflows and solid remittances. We also see value in Indonesia due to better economic and trade data and cheaper valuations. • We remain cautious on Argentina, given deteriorating fundamentals and the risk of a technical default not reflected in current valuations. We also advocate caution on Brazil, South Africa, and Turkey where fundamentals are weak and political risks are on the rise ahead of the 2014 elections in each country, as well as on expensive Peru.

Emerging market sovereign bonds in USD Preference: neutral

For further information please contact CIO asset class specialists Bernhard Obenhuber, [email protected] (asset class view), Michael Bolliger, [email protected] (IG vs. HY) and Kilian Reber, [email protected] (sovereign views)


EM bank lending remains restrictive EM bank lending standards; values below 50 indicate

tighter lending standards

Source: IIF, UBS; as of 10 February 2014 Note: Past performance is not an indication of future returns.

Positive scenario Stronger-than-expected EM economic data and improved sentiment toward EM bonds provide a favorable backdrop for EM fixed-income spreads. Issuers of lower credit quality fare better, and average spreads tighten to below 310bps. Negative scenario An environment of greater global risk aversion, deteriorating EM funding markets, weakening global growth prospects, and lower commodity prices affect EM credit negatively. Liquidity dries up, spreads spike. Note: Scenarios refer to global economic scenarios (see slide 8).

Summary (six-month tactical view) Emerging market sovereign bonds denominated in USD are attractively valued compared to USD high-grade bonds. However, the fragile economic recovery and financial vulnerabilities in lower-rated countries are headwinds for EM sovereign bonds, pointing toward further bouts of high price volatility. We prefer sovereign issuers with current-account surpluses or manageable, small deficits, coupled with attractive valuations. Please refer to our EM bond list for bond-specific guidance.

EMBIG spread targets (six-month): 310 bps EMBIG IG: 180 bps EMBIG HY: 670 bps

EMBIG spread targets (six-month): 400 bps EMBIG IG: 250 bps EMBIG HY: 800 bps

40

42

44

46

48

50

52

54

56

58

60

09Q4 10Q2 10Q4 11Q2 11Q4 12Q2 12Q4 13Q2 13Q4


30

Emerging market corporate bonds in USD Preference: neutral

For further information please contact CIO asset class specialists Bernhard Obenhuber, [email protected] (asset class view), Michael Bolliger, [email protected] (IG vs. HY) and Kilian Reber, [email protected] (credit segment views)


EM HY corporate default rate declined in January In %

Source: BAML, UBS; as of 10 February 2014 Note: Past performance is not an indication of future returns.

Summary (six-month tactical view) Emerging market corporate bonds denominated in USD are fairly valued compared to USD high-grade bonds. However, corporate credit indicators such as leverage ratios and rating trends have weakened in recent quarters, especially in the lower-rated segment. New issuance activity is expected to remain strong. We prefer selected Russian corporate issuers, Mexican issuers, and Chinese blue-chip companies. We are cautious on Indian and Turkish banks. Please refer to our EM bond list for bond-specific guidance.

CEMBI Broad spread (19 Feb): 337 bps (last month: 322 bps) Asset class view CEMBI Broad spread target (six-month): 350 bps; Expected 6m return 1.2% • EM hard-currency corporate bonds continued to perform better than sovereign peers over the last month. Falling reference rates compensated for somewhat higher credit spreads. Higher-rated EM corporates fared better. • Issuance activity was off to a strong start as USD 33bn of new corporate bonds were issued in January. However, EM bond funds continued to show outflows. • EM HY corporate default rates declined from 3.4% to 3.0% as no credit event was registered in January. Latin America continues to have the highest rate of default (4.2%), followed by Asia (2.5%) and EMEA (2.2%). Credit-rating trends turned neutral for the IG segment but remained negative for the HY segment. • We expect EM USD corporate bond spreads to trend sideways, and produce a total return of about 1.2% over the next six months. The performance is likely to be driven by the carry. Rising US reference rates will provide some headwinds for all EM fixed-income segments over the next six months. Spread and return targets (6m): CEMBI Broad IG: 260 bps (19 Feb: 253 bps) / 1.0% Investment Grade versus High Yield CEMBI Broad HY: 550 bps (19 Feb: 521 bps) / 1.6% • Investment-grade and high-yield EM corporate bonds in USD have had similar performances in recent months. We think both segments are fairly priced, and expect spreads to trend sideways over the next six months. • Relative to their IG peers, we think the return outlook for EM HY corporate bonds in USD has deteriorated in risk-adjusted terms. In the months ahead, we think higher interest rates and weaker currencies in several EM countries might weigh more strongly on HY corporate bonds than on IG issuers. Credit segment views • In line with our sovereign preference for Russia, we like select corporate issuers that are close to the government and benefit from their systemic importance. At the same time, they benefit from Russia's solid current-account and fiscal position. We mainly prefer issuers in the oil and gas and the financial sectors. • In line with our sovereign preference for Mexico, we recommend select corporate issuers that should benefit from the recently approved energy reforms via foreign direct investment inflows and a likely sovereign upgrade over the coming months. The petrochemical sector should be one of the biggest beneficiaries of these reforms. • In China, ongoing reforms have decreased systemic risks for the corporate credit market. We prefer established blue-chip issuers, such as Hong Kong subsidiaries of Chinese banks as well as select Chinese state-owned enterprises and property developers. We remain more cautious on the lower-rated property segment. • We also remain cautious on Indian and Turkish banks, given weak fundamentals in the former and much higher interest rates in the latter. Further weakness in these two segments over the coming months is likely.

Positive scenario Stronger-than-expected EM economic data and improved sentiment toward EM bonds provide a favorable backdrop for EM fixed-income spreads. In such an environment, issuers of lower credit quality fare better, and average spreads tighten to below 300bps. Negative scenario An environment of greater global risk-aversion, deteriorating EM funding markets, weakening global growth prospects, and lower commodity prices affect EM credit negatively. Liquidity in EM bonds dries up, spreads spike. Note: Scenarios refer to global economic scenarios (see slide 8).

CEMBI Broad spread targets (six-month): 300 bps CEMBI IG: 220 bps CEMBI HY: 470 bps

CEMBI Broad spread targets (six-month): 485 bps CEMBI IG: 315 bps CEMBI HY: 870 bps

0

5

10

15

20

25

30

35

1999 2001 2003 2005 2007 2009 2011 2013

LatAm HY Asia HY EMEA HY


31

GBI-EM yield (19 Feb): 7.0% (last month: 6.8%) UBS view GBI-EM yield and return targets (six-month): 7.3% / 2.6% • Adverse developments in several emerging markets led to a 20bps year-to-date increase in yields of EM local-currency bonds. Despite the negative correlation between US and EM interest rates in recent weeks, we think the upward trend in US rates will drive EM yields higher over the next six months. A fragile EM economic recovery, the increased risk of further rate hikes in several countries, and EM currencies that are unlikely to appreciate against the USD in the months ahead also weigh on the attractiveness of the asset class. • Recent exchange-rate weakness will raise inflationary pressure in several countries, and some EM central banks will have to further hike policy rates in the months ahead. We think the risk of further bouts of currency weakness has increased, forcing more EM central banks to hike policy rates and increasing the downside of the asset class. • Brazil and South Africa face the risk of a credit-rating downgrade over the next six months, and Turkey's credit outlook was recently revised to negative by S&P. Although credit spreads of several issuers are trading at elevated levels, we still consider a substantial spread-narrowing as unlikely. • Over the next six months, we expect yields of EM government bonds in local currency to increase by 20bps, from around 7.1% to 7.3%, resulting in an expected return of roughly 2.6%. Over this period, investors will earn the interest-rate carry return of roughly 3.5%, while we expect bond prices to decrease slightly and currencies to trend sideways against the USD on average. Given the uncertainty regarding the Fed's upcoming policy decisions and the fragile fundamentals in several EM countries, bouts of higher volatility remain likely. This reduces the attractiveness of the asset class in risk-adjusted terms, and we thus keep a neutral stance toward EM sovereign bonds in local currency.

Emerging market bonds in local currency Preference: neutral

For further information please contact CIO asset class specialists Michael Bolliger, [email protected] and Jonas David, [email protected] Please see important disclaimer and disclosures at the end of the document.

Positive scenario GBI-EM yield and return targets (six-month): 7.5% / 2.0% • Stronger-than-expected EM economic data would improve sentiment toward EM assets, including bonds and currencies. However, it would also imply rising upward pressure on local yields, which could be amplified by positive growth surprises in the US. We think the net effect of higher yields and slightly stronger currencies will be negative. Negative scenario GBI-EM yield and return targets (six-month): 8% / -4.0% • EM rates would rise and currencies would weaken against the US dollar if global growth deteriorates and risk aversion spikes. At the same time, prospects for renewed policy measures by major central banks could partly offset the pressure on EM interest rates and currencies, mitigating part of the downside for the asset class. Note: Scenarios refer to global economic scenarios (see slide 8).

Yields expected to remain under pressure Yields of EM bonds in local currency, in %


Global interest rates

The direction of US Treasury yields is important for yields of EM bonds in local currency. Key dates: 19 Mar, FOMC rate decision and communication of tapering action

Monetary policy cycles in emerging markets

Inflation and growth dynamics and monetary-policy decisions in emerging markets are important drivers of EM bonds in local currency. We therefore monitor central-bank decisions, inflation prints, and growth momentum in countries that are important issuers. Upcoming policy rate decisions: 13 Mar, Indonesia; 14 Mar, Russia; 18 Mar, Turkey; 27 Mar, South Africa; 2 Apr, Brazil

Credit risk and exchange rate determinants

EM exchange rates and credit spreads are important drivers of the performance of EM bonds in local currency.

Source: JP Morgan, UBS, as of 11 February 2014 Note: Past performance is not an indication of future returns.

Summary (six-month tactical view) Rising global interest rates will continue to put upward pressure on EM local-currency yields. Moreover, the economic recovery in emerging markets is still fragile, the risk of further rate hikes is elevated, and currencies are not expected to add any significant return contribution. In sum, these factors weigh on the return outlook and will keep the volatility of the asset class elevated, reducing its attractiveness in risk-adjusted terms. We therefore keep a neutral stance on EM bonds in local currency.

4.0

5.0

6.0

7.0

8.0

Feb-11 Aug-11 Feb-12 Aug-12 Feb-13 Aug-13

GBI-EM yield


32

Section 2.C

Asset class views

Foreign exchange


33

USD

EUR

GBP

JPY

CHF

SEK

NOK

CAD

NZD

AUD

new old


Foreign exchange overview Preferences (six months)

Source: UBS CIO WM Global Investment Office

Foreign exchange – Key points G10 currencies: • We expect the USD to enter a strengthening phase versus the euro, and to appreciate toward our six-month target

of 1.28. Investors will prepare step by step for the first rate hike by the Fed, which we expect to happen in mid-2015. Meanwhile, monetary policy in the Eurozone is likely to remain easy well beyond that point. The Bank of Japan is expected to counteract a tax hike in April with easier monetary policy, weighing further on the yen. We thus overweight USD versus EUR as well as USD versus JPY. The declining unemployment trend in the US and the UK strengthens the resistance of their economies to financial market stress. The Swiss franc remains closely tied to the euro. We overweight GBP versus CHF.

EM currencies: • Recent policy rate hikes and volatile exchange rates will weigh on growth in fundamentally weaker countries,

including Turkey, South Africa, Russia, and Brazil. The downside risks to EM growth have increased compared to a month ago. But despite weak fundamentals and the fragile recovery in EM, as well as the key risk of an upward trend in US interest rates, we still expect the US and Eurozone recovery to remain supportive of EM growth in 2014. Within the emerging markets, we maintain our preference for currencies with better external positions, such as the Polish zloty, Mexican peso, Chinese yuan, and Korean won.

For further information please contact CIO asset class specialists Thomas Flury, [email protected]; Teck Leng Tan, [email protected]; Constantin Bolz, [email protected]; or Daniel Trum, [email protected]



34 For further information please contact CIO asset class specialists Thomas Flury, [email protected];

Teck Leng Tan, [email protected]; Constantin Bolz, [email protected]; or Daniel Trum, [email protected] Please see important disclaimer and disclosures at the end of the document.

G10 currencies UBS View See table for current exchange rates and CIO forecasts

• The Fed's tapering of its asset purchases should support the USD eventually, even though the immediate reaction to it was muted. The fall in the US unemployment rate and improvement in the fiscal balance should ensure that the Fed continues to normalize its policy. The recent trends that lifted EURUSD are about to fade as we don't expect the Eurozone economy to accelerate from current levels and diminished political risks have already been priced in now.

• UK growth trends remain positive and supportive of the GBP, which we expect to appreciate further. The labor-market improvement is strong, with unemployment approaching the BoE's 7% threshold. The economic rebound has raised rate-hike questions for the BoE, which supports GBP further.

• Rising expectations about additional monetary stimulus from the Bank of Japan should send the USDJPY higher within the 100–110 range. The BoJ would need to push USDJPY toward 110 to come closer to its 2% inflation goal.

• The CAD has weakened sharply against the USD. The economy has recovered and commodity prices have also stabilized as of late, but a deteriorating trade balance and policy concerns have hurt the currency. As data start to improve in response to stronger US growth, we continue to look for long-term CAD strength.

• EURCHF is locked within the 1.21–1.25 range. We recommend keeping a short CHF versus GBP position. • The SEK and NOK have lost some of their appeal due to a declining real interest rate advantage over the EUR, and

the Eurozone partly closing the growth gap to the Scandinavian countries. The NOK is further exposed to several domestic issues hampering growth. The SEK is currently in a better position to profit from an improved global economic environment and should continue to outperform the NOK.

• The AUD and NZD are still overvalued. Australian data remain mixed and the Reserve Bank of Australia is likely to keep policy unchanged, as long as the broad AUD index stays around current levels or falls even lower. We expect only a slight depreciation of the AUD versus the USD based on broad USD strength. The NZD is in a better position and unlikely to depreciate. We therefore expect only a small decline in NZDUSD over 12 months, once the Fed rate hikes become imminent.

Source: Thomson Reuters, UBS; as of 20.02.2014 Note: Past performance is not an indication of future returns.

Positive scenario FX targets: EURUSD >1.40 / USDJPY>110

• A stronger-than-expected acceleration of European growth or further European integration supports EURUSD. The Bank of Japan increasing its asset-purchase program more forcefully than expected would weaken the yen further.

Negative scenario FX targets: EURUSD <=1.20 / USDJPY <=95

• US growth is accelerating so quickly that the Fed considers to hike the target rate soon. Such a surprise would propel a strong demand for USD. It would signal to the market that the Fed does not mind the tightening of monetary conditions that come on the back of a USD rally. Note: Scenarios refer to global economic scenarios (see slide 8).

UBS CIO FX forecasts

What we're watching Why it matters

US growth and Fed policy response

Key releases: Weekly and monthly employment data; level of US Treasury yields. Fed meeting on 19 Mar.

Summary (six-month tactical view) • Long USD vs. short EUR: We expect EURUSD

to trade down toward 1.28 as the Fed tapers QE3 amid falling unemployment, whereas the ECB will likely keep an easing bias.

• Long USD vs. short JPY: The US is recovering from the financial crisis and the Fed is normalizing monetary policy. Japan is likely to expand its stimulus program further. Therefore, USDJPY is likely to rise further within the 100–110 range.

• Long GBP vs. short CHF: The UK's growth momentum should be strong enough for the BoE to become more optimistic. This should lift the GBP. The CHF is expected to stay weak as long as European growth and politics remain steady.


35

Emerging market currencies and money market Preference: neutral

UBS CIO EM FX forecasts

ELMI+ yield (19 Feb): 3.3% (last month: 4.1%) UBS view ELMI+ return target (six-month): 2.5% • The EM FX benchmark index (ELMI+) fell in recent months as money market returns did not compensate for exchange-rate losses versus the USD. While Asia has been relatively resilient year-to-date, several currencies in Latin America and EMEA have depreciated significantly. As growth prospects improve moderately, we think EM currencies will recover some of their recent losses. However, we do not recommend increasing exposure just yet. The recovery in EM looks fragile, fundamentals in several countries remain weak, and rising global interest rates limit the attractiveness of the asset class. Short-term changes in the global interest-rate outlook will likely trigger further bouts of higher volatility, weighing on risk-adjusted return expectations. We continue to prefer EM currencies with relatively sound fundamentals and exposure to the global recovery via exports. • EMEA: We think the Polish zloty (PLN) and the Hungarian forint (HUF) will continue to benefit from the Eurozone recovery, but the easing cycle in Hungary limits HUF upside for now. We expect the EURCZK exchange-rate floor to remain in place over our 12-month forecast horizon. Although the fundamental outlook points toward a weaker Russian ruble (RUB), we think a stabilization versus the USD in the short term is likely. The South African rand (ZAR) and the Turkish lira (TRY) remain vulnerable due to large current-account deficits and structural challenges. Political tensions in Turkey remain a concern and strikes in South Africa are increasingly likely in the run-up to the elections. • Asia: We favor the Chinese yuan (CNY) and the South Korean won (KRW). China and Korea have strong current-account surpluses, making their currencies relatively resilient to capital outflows, and allowing them to benefit from a global growth recovery due to their export orientation. While we still dislike the Indian rupee (INR) as recent reforms represent only temporary measures, we turn increasingly constructive on the Indonesian rupiah (IDR) as fundamentals start to improve. We also remain cautious on the Thai baht (THB) due to political unrest. • Latin America: We think the Mexican peso (MXN) remains supported by trade links to the US and domestic reform prospects, but see positive positioning as a near-term risk factor. We think the Brazilian real (BRL) offers some room for appreciation versus the USD in the short term, not least as nominal and real interest rates remain among the highest in the EM universe. However, economic imbalances point toward BRL weakness in the longer term.

For further information please contact CIO asset class specialists Michael Bolliger, [email protected], Teck Leng Tan, [email protected], and Jonas David, [email protected]



Positive scenario ELMI+ return target (six-month): 3% to 5% • Economic data comes in stronger than expected, especially in China, while the US and Europe improve further. In combination with stable expectations for global interest rates, EM currencies appreciate against major currencies. Negative scenario ELMI+ return target (six-month): 0% to -2% • Global growth prospects suffer a prolonged weakening and sentiment toward risky cyclical assets deteriorates. EM currencies experience a temporary sell-off across regions.



Monetary policy decisions in emerging markets

Inflation dynamics are important in forecasting central banks' policy rate decisions. Monetary easing typically weighs on EM currencies, while rate hikes tend to be supportive. Upcoming key policy rate decisions: 26 Feb, Brazil; 28 Feb, Colombia; 13 Mar, Indonesia; 14 Mar, Russia; 18 Mar, Turkey

Global interest rates / growth momentum

Interest rates and growth prospects in the US and the Eurozone are key to risk sentiment as well as the EM outlook. Key dates: 19 Mar, FOMC rate decision and communication of tapering actions; 6 Mar, ECB rate decision

Summary (six-month tactical view) Though we think the downside for EM currencies is limited due to improving growth prospects, we do not recommend a broad exposure to the asset class just yet. The recovery still looks fragile, fundamentals in several countries remain weak, and rising global interest rates are a headwind. Within EM, our preferred currencies include the MXN, PLN, CNY, KRW, and IDR. Currencies with weak fundamentals like the INR, THB, ZAR, TRY, and BRL will likely continue to see higher volatility.


36

Section 2.D

Asset class views

Commodities


37

Commodities overview

For further information please contact CIO asset class specialists Dominic Schnider, [email protected] or Giovanni Staunovo, [email protected] Please see important disclaimer and disclosures at the end of the document.

Commodities – Key points

• Summary: Weather-related price support for commodities does not change our view that broadly diversified commodity indices should deliver negative low-single-digit returns this year. The price decline in energy, precious metals, and agricultural commodities over the next 12 months is unlikely to be compensated by a positive performance contribution due to roll-yield gains in energy and stronger base metal prices.

• In energy, non-OPEC supply is anticipated to outpace global demand growth by 0.4 mbpd in 2014. Fewer unplanned production outages should also improve available supply. To prevent a strong buildup in inventories, we believe OPEC will lower production by 0.5–1.0 mbpd and stabilize Brent crude oil prices around USD 100/bbl in 2014. Harsh winter temperatures in the US have resulted in strong natural gas inventory draws. To curb demand and incentivize additional supply during the storage injection period (end-March to October), US natural gas prices are likely to remain well supported in 1H14, before declining toward USD 4/mmbtu at the end of 2H14.

• For precious metals, US monetary policy normalization, fewer economic and financial tail risks, and a favorable growth-inflation mix in the developed world reduce the need for an insurance asset such as gold. We therefore expect further ETF outflows in gold by 400–500 tons, which should push the gold price to USD 1,050/oz this year. The current gold price offers investors the opportunity to reduce exposure, as softer equity markets and considerations of a slower US monetary policy normalization should only render short-term price support. A lower gold price tends to have negative spillover effects on silver, especially as the silver market is confronted with fabrication surplus. Platinum and palladium are alternatives to gold and silver. Both metals have a better chance for a deficit market, with supply expansion being challenged and demand improving due to stronger economic activity.

• Accelerating global economic activity will allow base metals to deliver positive returns in 1H14, followed by price pullbacks as supply reacts to higher prices, and global economic growth momentum peaks over the next two quarters. Within base metals, the focus is on minor metals like zinc and especially lead. Both metals are expected to see a deficit in the refined market as industrial production accelerates in a more synchronized fashion. Even copper is becoming an interesting investment, with prices trading at or below USD 7,000/mt. The lack of refined copper supply and a downward-slopped forward curve provide a positive risk-reward profile for the metal in the short run.

• An improved inventory backdrop across most agricultural commodities in early 2014 and a strong harvest in the southern hemisphere over the coming months suggest downward pressure on agricultural commodity prices, especially the grains. Most at risk of lower prices are soybeans, as farmers in South America are likely to undercut US prices due to a record harvest. Corn prices could receive some short-term price support due to higher US exports and domestic demand. However, a cap on corn-based ethanol production and a rather modest rotation in US planting away from corn to soybeans are likely to keep the corn market well supplied in 2014. The softs, on the other hand, have performed strongly, primarily driven by a heat wave affecting Brazil. Given our initial assessment, we believe this heat wave will not flip the supply and demand balances for sugar or coffee, with weather normalizing in the coming weeks. Although we acknowledge a potential reduction in supply, we still advise investors to avoid the sub-sector or cut positions in the absence of an El Niño weather pattern developing.

Source: Bloomberg, UBS, as of February 2014 Note: Past performance is not an indication of future returns.

Commodity prices have bounced back from a weak start, driven by adverse weather in the US and Brazil DJ UBS Commodity Total Return Index and UBS Bloomberg CMCI Total Return Index; indices are standardized to 100

Single commodity preferences – six months

For a more detailed overview, please see our monthly commodity update.

Current most preferred commodities

Current least preferred commodities

Platinum Lead Zinc

Silver Gold Soybeans

Source: UBS as of 10 February 2014



Platinum Lead Zinc



Palladium Platinum Lead

Silver Gold Soybeans

70

80

90

100

110

Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14

DJ UBS Commodity Index TR UBS Bloomberg CMCI Index TR


38

Gold Summary (six-month tactical view) US monetary policy normalization, a favorable growth-inflation mix in the developed world, and less economic and financial tail risks lower investors' need for insurance assets like gold. Along with a firmer USD, we expect the price of the yellow metal to drop to USD 1,150/oz in six months, followed by more weakness.

Gold (19 Feb): USD 1,315/oz (last month: USD 1,254/oz) UBS view Gold six-month target: USD 1,150/oz • Monetary policy normalization in the US holds the key for the outlook for gold – and silver – in 2014. The Fed has begun slowing down quantitative easing at a time when the country's economic growth and inflation mix is looking more favorable. Economic activity is expected to accelerate while inflationary pressure in the US remains very tame. We believe this combination will result in negative investment returns of up to 15% for gold this year if QE3 ends in 2H14 and rate-hike talks start to pick up at the end of 2014. • Outflows from ETF holdings of gold and silver remain a price burden. These holdings, once a key source of demand, became a big source of supply to the gold market last year. A trend reversal in these flows is unlikely in 2014. • Bloated central bank balance-sheets and negative real interest rates still prevail, but have become less of a concern to investors. Economic activity strengthening in the US and Europe, the Fed further reducing its unorthodox monetary policies, the ECB shrinking its balance-sheet, and less economic and financial tail risks lower investors' need for insurance assets. Thus, finding gold buyers will be a daunting task unless prices drop further. • Although China alone could theoretically balance the gold market, investors who thought gold was a bargain when it crashed in April 2013 paid a heavy price by losing 10–20% of their investment. We believe this lesson is likely to dent Chinese demand in 2014 unless new buyers are offered another round of lower gold prices. • At marginal production costs, we expect gold to find a new equilibrium by incentivizing new demand in the East (especially China), curb mine production, and balance ETF selling.


Source: Bloomberg, UBS, as of February 2014 Note: Past performance is not an indication of future returns.

Physically backed ETF gold positions are expected to decline further this year Gold holdings as a share of expected mine supply in 2014

Positive scenario six-month target: USD 1,450/oz • Economic growth in the US fails to materialize, providing the backdrop for continued Fed stimulus measures. A 180-degree turn in the markets’ stance on the Fed’s QE tapering intention would trigger investment demand (mainly ETFs). Negative scenario six-month target: USD 800/oz • The Fed turns extremely hawkish, with indications of rate hikes in 2014, triggering a sell-off in investment positions. Additional gold import duties/restrictions in India and weaker EM currencies in general curb regional gold demand.


Physical demand/supply Indian and Chinese gold imports will indicate the resilience of Asian gold demand. India is expected to review its gold import restrictions after the end of its fiscal year/elections. We expect the restrictions to be loosened. Supply and demand data from the IMF and the World Gold Council give us insights on gold purchases by central banks, which we expect to be around 300 tons in 2014 (ex-China). On the supply side, we will look out for reports from high-cost South African and Australian producers. In the current environment, gold mine output needs to decline to help balance the market. Key date: May, WGC 1Q14 report.

Investment flow We expect ETF outflows in the range of 400–500 tons or 13–17% of this year's mine supply. Short-term price support is coming from elevated gross short positions by non-commercial accounts, driven by equities' mixed start into the year. The unwinding of these holdings and less ETF outflows caused gold prices to strengthen in January.

Monetary policy & inflation Key dates: 19 Mar, FOMC meeting; monthly inflation and interest rate releases

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Nov-03 Nov-05 Nov-07 Nov-09 Nov-11 Nov-13


39

Crude oil Summary (six-month tactical view) A firm increase in crude oil production by non-OPEC countries in 2014 suggests a well-supplied crude oil market. Non-OPEC supply growth should outpace demand growth this year and force OPEC to reduce its output. We believe this will bring crude oil prices down to USD 100/bbl, with temporary dips further below. We therefore favor investment strategies that are positioned for a moderate decline in oil prices over the next 4–6 months.


Non-OPEC supply is expected to rise at the fastest pace in 36 years Values in mbpd

Positive scenario Brent six-month target: USD 130–165/bbl • Global supply loses an additional 1.0–2.0mbpd due to an escalation of conflict and intensified violence or social tension in the MENA region. Negative scenario Brent six-month target: USD 80–90/bbl • The global economy fails to grow, and economic growth in emerging markets decelerates swiftly. Stronger supply growth from non-OPEC countries (US related) and a sharp decline in existing supply outages (including those in Iran) lead to excessive supply, with OPEC unable to balance the market fast enough.

Brent (19 Feb): USD 110.0/bbl (last month: USD 106.5/bbl) UBS view Brent six-month target: USD 100/bbl • Crude oil supply outside OPEC is likely to flex its muscle this year, with production rising 1.6–1.7mbpd, marking the fastest pace of annual increase since 1978. North America will likely remain the biggest supplier, contributing 1.2mbpd of the incremental non-OPEC supply, followed by Asia Pacific (0.25mbpd) and South America (0.15mbpd). • These supply numbers do not include a return of absent supply, i.e., unplanned production outages, due to sanctions or civil strife. Libya restored a fraction of its production in January, and the Iran nuclear deal came into force on 20 January, potentially allowing the return of additional Iranian oil to the market in 2H14. Hence, a decline in production outages from 3.1mbpd in late 2013 to 2.0–2.5mbpd in 2014 would lead to a wall of supply. • Oil demand growth should only increase 1.2–1.3mbpd this year and be purely due to non-OECD demand, mainly from Asia (China adding 0.4mbpd) and the Middle East. OECD demand is expected to stay unchanged, with a bias toward a positive surprise. • To prevent an oil glut, OPEC will likely lower production by 0.5–1.0mbpd and stabilize Brent crude oil prices around USD 100/bbl in 2014. We expect the supply reduction to come mainly from Saudi Arabia and partly from Kuwait, Qatar, and the UAE. This should allow OPEC's spare capacity to rise above 3mbpd in 2014. • WTI should trail Brent crude oil with a USD 5–7/bbl discount in order to incentivize less US crude oil imports and increase product exports on the back of more attractive US refinery margins.

Source: BP, IEA, UBS, as of February 2014 Note: Past performance is not an indication of future returns.


Middle East and African tensions

As long as spare capacity in crude oil supply remains below 3mbpd, the political instability in several MENA countries will keep the price risk premium in oil around USD 5–10/bbl.

Supply Unplanned production outages totalled 3.1mbpd in December. With non-OPEC supply growth outpacing global demand growth and unplanned production outages declining, OPEC will likely reduce its production quota from 30mbpd to 29–29.5mbpd at the next meeting on 11 Jun.

Demand We expect oil demand to rise by 1.2–1.3mbpd in 2014, mainly driven by emerging Asia. We track oil flows to this region closely, to see how strongly EM currency moves and administrative price changes (including taxes) affect EM demand. China and the "Fragile Five" countries should account for around 50% of global oil demand growth in 2014.

Oil market reports Key dates: 11 Mar, EIA short-term energy outlook; 14 Mar, IEA oil market report

10

15

20

25

30

35

40

45

50

(1.5)

(1.0)

(0.5)

0.0

0.5

1.0

1.5

2.0

2.5

1966 1974 1982 1990 1998 2006 2014E

Non-OPEC supply growth (y/y -lhs) Non-OPEC supply (rhs)


40

Section 2.E

Asset class views

Alternative investments: Hedge funds & Private markets


41

Hedge funds UBS view Prefer equity hedge strategies

• We expect global equity markets to appreciate further in 2014, but expected equity returns are lower, valuations (based on 12-month forward P/E multiples) are close to long-term averages in most markets, and there is potential risk for margin contraction. Given this scenario, we favor equity-hedge strategies, particularly those running moderate net exposures which are focused on generating returns more from security selection than market beta.

• Fundamentals-based equity hedge managers are well positioned to generate returns from long and short positions, as individual valuations and share prices respond more to company-specific fundamentals than overall market movements. The environment for short-selling has been challenging in recent years but now offers an even more attractive opportunity set in both thematic and single name shorts.

• Macro/trading strategies overall are less attractive. Managed futures strategies in particular continue to face headwinds due to the continuing lack of persistent trends in financial markets outside of equities. Discretionary macro managers should be able to capitalize on rates and currency opportunities arising from policy and growth divergences across developed and emerging economies, but this is not enough to offset our view on systematic strategies.

For further information please contact CIO asset class specialist Cesare Valeggia, [email protected] Please see important disclaimer and disclosures at the end of the document.

Positive scenario Prefer equity hedge and event-driven strategies • Robust economies and equity markets drive increased return contribution from market beta, which would benefit fundamental equity-oriented strategies including equity hedge and event-driven to an extent. A strong economy provides corporate managers with the confidence to pursue transactions in greater volume, creating more opportunities for event-driven managers who can anticipate and position for the outcome of these events. Negative scenario Prefer macro/trading (Global Macro + CTA) • The emerging market crisis escalates further; the Eurozone crisis reignites; disinflationary trends intensify and potentially turn into deflation; and the global economic recovery proves unsustainable. Less correlated liquid strategies like macro/trading should perform well in these situations. Note: Scenarios refer to global economic scenarios (see slide 8).


Global equity direction/ economic cycle

The outlook for global equities is a performance driver, particularly for equity-oriented strategies. The economic cycle impacts individual strategies differently.

Correlation Correlation is an important performance/alpha driver for equity long-short, the primary hedge fund strategy according to assets under management.

Leverage Gross and net leverages are key to monitoring risk.

Volatility The direction and magnitude of volatility impact many HF strategies (e.g., convertible arbitrage).

Summary (strategic view)

Equity hedge strategies are attractive in a low-correlation environment in which company-specific fundamentals, rather than market movements, drive share-price returns. Event-driven and relative value strategies should generate risk-adjusted returns in line with the hedge fund composite index. Macro/trading strategies overall will continue to be challenged by a lack of persistent market trends outside of equities.

Note: Past performance is not an indication of future returns.

Investment preferences

Current most Current least preferred strategies preferred strategies

value

Current most Current least preferred strategies preferred strategies Equity hedge Macro / Trading

Source: UBS CIO, February 2014


42

Private markets

For further information please contact CIO asset class specialist Stefan Brägger, [email protected] Note: We emphasize the equal importance of fund manager selection and the commitment strategy. Please note that private equity is an illiquid asset class and must be held at least until the end of the fund (10+ years). Please note that UBS might not have a product available which reflects our UBS CIO private equity recommendations.

Private equity is only suitable for qualified investors (> USD 5m investable assets). Please see important disclaimer and disclosures at the end of the document.

Positive scenario Prefer small-/mid-cap buyouts and secondaries • An abating Eurozone debt crisis and improved business confidence increase deal flow and exit opportunities for private equity managers, but also increase entry prices. In such a scenario, we would consider commitment to secondary funds as an attractive strategy for building exposure to an invested private equity portfolio. Negative scenario Prefer distressed debt • A renewed escalation of the debt crisis significantly impacts deal activity, the availability of debt, and corporate owners' willingness to sell. At the same time, it would offer even more attractive opportunities within distressed strategies and lower entry prices for long-term private equity investors.


Prefer small-/mid-cap buyouts in US and emerging markets; UBS view direct lending strategies in Europe • The current economic environment offers attractive opportunities for illiquid private equity strategies, particularly in the US and emerging markets. We prefer small-/mid-cap transactions which trade at a discount to large-cap transactions. We are cautious on venture capital in Europe as performance has disappointed in recent years. • Direct lending to companies in Europe is attractive as the market is still illiquid and dominated by banks reducing lending. Growth and buyout capital in emerging markets is a good way to access superior long-term growth and attractive consumer dynamics. Within real assets, we like opportunistic strategies in US real estate and lending strategies within European commercial real estate, which are attractive as banks shrink their loan portfolios. • Global M&A volume is only recovering moderately, and last year's activity (as of September 2013) is still more than 50% below the 2007 peak. Private equity activity is holding up, and sponsors continue to find attractive deals globally. Exit activity also continues at a healthy pace, with diversified private equity investors obtaining attractive distributions from their mature portfolios.


Credit markets Leveraged loan issuance, an important component of PE activity, reached record levels in 2013 in the US. Europe also saw strong activity and companies raised more debt than the entire volume seen in 2011 and 2012. The US debt market, which raised over EUR 378bn of senior leveraged debt, is much deeper than the European one, which raised only EUR 54bn in the first nine months of 2013.

Exit activity Exit activity is an important indicator of the health of the PE market and a key return driver for investors. In line with a better macro environment, 2013 distributions from portfolio sales (USD 307bn, up 5% y/y) were a clear improvement.

Prices for LBOs Average purchase prices for new buyouts in the US are at 8.4x EBITDA (YTD Sept 2013), in line with the levels seen in 2012. Prices for new transactions in Europe (8.5x) remain above the levels seen in the US, but have come down from the 2012 peak (9.3x)

Investment preferences (new PE commitment strategies)

Summary (strategic view) We prefer buyout strategies in North America given its liquid debt market, better relative pricing, and our house view of economic outperformance versus Europe. Emerging markets continue to offer compelling opportunities for long-term private equity investors, especially as short-term speculative capital is flowing back to developed markets and reducing pricing pressure. Direct lending to companies is also attractive in Europe, where debt markets are less liquid and still dominated by banks, which continue to reduce leverage.

Current most preferred strategiesCurrent least preferred strategies

Direct lending (Europe) Large-cap buyout (Europe)

Small/mid-cap buyout (US, Latin America, South-East Asia)

Venture capital (Europe)



43


43

Section 3

APAC asset allocation


44

Cash

Equities total

US

Eurozone

UK

Switzerland

Japan

Asia ex Japan

EM ex Asia

Bonds total

USD high grade bonds

USD corporate bonds (IG)

USD high yield bonds

Asian bonds (USD)


EM corporate bonds (USD)

EM bonds (local currencies)

Commodities

new old


APAC tactical asset allocation


Tactical asset allocation deviations from benchmark* Asia ex-Japan equity strategy

(relative to MSCI Asia ex-Japan)

* Please note that the bar charts show total portfolio preferences and thus can be interpreted as the recommended deviation from the relevant portfolio benchmark for any given asset class and sub-asset class.

The UBS Investment House view is largely reflected in the majority of UBS Discretionary Mandates and forms the basis of UBS Advisory Mandates. Note that the implementation in Discretionary or Advisory Mandates might deviate slightly from the “unconstrained” asset allocation shown above, depending on benchmarks, currency positions and other implementation considerations.


China

Hong Kong

India

Indonesia

South Korea

Malaysia

Philippines

Singapore

Taiwan

Thailand

new old



45

China

Hong Kong

India

Indonesia

South Korea

Malaysia

Philippines

Singapore

Taiwan

Thailand

new old



45

Asian equities (ex-Japan)

For further information please contact Regional CIO APAC (South) Kelvin Tay, [email protected] Please see important disclaimer and disclosures at the end of the document.

MSCI Asia ex-Japan (19 Feb): 535 (last publication: 541) UBS view MSCI Asia ex-Japan (six-month target): 547 • The outperformance of manufacturing- and export-oriented North Asia over the credit-driven Southern Asia should

continue, especially as the Fed continues to slow its pace of quantitative easing. • Further details on reform policies and work-plans, continued stable economic growth, and better-than-expected

corporate earnings should be supportive for China. Overall liquidity conditions should stabilize with shorter-term rates easing after the Lunar New Year, and credit expansion should adjust to a more sustainable pace of 15.5% in 2014 from 19% in 2013. We expect China to outperform Asia ex-Japan. South Korea remains one of the markets to benefit strongly from the forecast acceleration of the US economy in 2014. Its current low valuations, coupled with robust economic growth in the US, should attract net foreign fund inflows. The South Korean government's supplementary budget and loose monetary policy should boost the Korean economy.

• We are underweight Thailand as the political overhang has delayed the implementation of the much-anticipated infrastructure bill. While past political tensions have had relatively limited economic impact, this time is different as infrastructure spending has become one of the key drivers of GDP, together with the sensitive tourism sector. Resolution seems unlikely while the majority of Thais continue to support Thaksin Shinawatra.

• We are underweight India as political uncertainty ahead of the upcoming elections creates an overhang over Indian equities. Some economic indicators are starting to improve but we still expect a slow recovery given that the much-needed reforms have been stalled ahead of the elections. We expect renewed weaknesses in the INR over the coming quarters.

Positive scenario MSCI Asia ex-Japan (six-month target): 615 • More supportive monetary and fiscal policies, more benign inflation, sustained domestic demand growth, and an improved global growth outlook lead to a better earnings outlook. Earnings growth reaches 15% for 2014 with a forward P/E of about 12x (versus 10.6x now). The trailing P/E moves up to 13x from 12.2x currently. Negative scenario MSCI Asia ex-Japan (six-month target): 430 • A sharp deceleration of the Chinese economy, a significant escalation of the Eurozone debt crisis, or a faster-than-expected tapering of QE3 precipitates a significant downturn in the global economy and leads to AxJ trading down to 11x trailing P/E.


Country preferences within Asia ex-Japan (relative to MSCI Asia ex-Japan)

Summary (six-month tactical view) We expect North Asia to outperform, benefiting from the global recovery boosting Asian exports. Our preferred markets are China and South Korea. Our least preferred markets are India and Thailand.

Source: UBS


Earnings growth Consensus foresees AxJ earnings growth of 12.5% in FY2014, which might be a tad optimistic should GDP growth disappoint, especially in China.

10-year UST yields 10-year US Treasury yields have started to rise again, putting pressure on the countries with intractable current-account deficits such as Indonesia and India.

Policy responses Some countries in the region have near-term macroeconomic issues to deal with amid fiscal and current-account deficits, as well as hiccups in market and economic reforms. Policy responses are often ad hoc.

Preference: neutral


46


46

JACI spread (19 Feb): 276 bps (last month: 267 bps) UBS view JACI spread target (six-month): 260 bps; Expected 6m return 2.5% • Returns from Asian credit bonds (JACI) were solid over the last month as lower reference rates more than offset higher credit spreads. Lower-rated bonds underperformed investment-grade bonds over the last month by a wide margin given EM volatility, strong bond issuance from Chinese companies, and worries around China's trust products. • EM Asia PMI data showed a mixed picture in January, with countries like India, South Korea, and Indonesia releasing better data, and China, the largest weight in the JACI benchmark index, declining for another month. Overall, we expect a gradual acceleration of economic growth in 2014 and that Asia is strongest among other EM regions. • EM Asia high-yield corporate default rate was 2.46% in January, lower from the previous month as no credit event was registered. Rating migration of EM Asian investment-grade and high-yield corporates improved in January but remains negative. EM Asian corporates have been active in the primary market and issued around USD 16bn. • We have a six-month spread target of 260bps for Asian credit bonds. We expect total returns of about 2.5% over the next six months, with performance to be mainly driven by carry. Rising US reference rates will provide some headwinds over the next six months and uncertainties related to Chinese trust products may keep volatility elevated.

Asian bonds in USD Preference: neutral

For further information please contact CIO asset class specialists Bernhard Obenhuber, [email protected] and Lili Fan, [email protected] Please see important disclaimer and disclosures at the end of the document.

Positive scenario JACI spread target (six-month): 230 bps • Stronger-than-expected EM Asian economic data and improved sentiment toward EM bonds provide a favorable backdrop for EM fixed-income spreads. In such an environment, issuers of lower credit quality fare better, and average spreads tighten to around 230bps. Negative scenario JACI spread target (six-month): 390 bps • Deteriorating economic growth in the major Asian countries such as China, and tighter EM funding markets affect EM credit negatively. Liquidity in EM bonds dries up, and spreads spike.


EM Asia HY corporate default rate increased in 2013 but less so than in other EM regions In %


Market yields

The direction of US Treasury yields is important for Asian credit spreads. Key dates: 19 Mar, FOMC rate decision; 6 Mar, ECB interest rate decision

Elections and external vulnerabilities

India's election results will drive investor sentiment and rating agencies' downgrade decision on India. A stabilization of the current account position of India and Indonesia would indicate changes in external vulnerabilities.

China economic momentum & credit conditions

China and Hong Kong constitute roughly 30% of the overall JACI. Hence, the growth momentum and credit conditions in China are an important driver of the outlook for Asian hard-currency bonds. Key date: 20 Feb HSBC China Flash PMI

Source: BAML, UBS; as of 10 February 2014

Summary (six-month tactical view) Asian bonds denominated in USD are attractively valued compared to history. EM Asia PMI has recovered in recent months, and we expect the economic momentum to accelerate in the coming quarters. However, financial vulnerabilities remain in countries with large external imbalances (i.e., India, Indonesia), and recent trust problems in China signal deleveraging and higher defaults in the shadow-banking segment. Please refer to our EM bond list for issuer- and bond-specific guidance.

Note: The JACI bond index tracks total returns for US dollar-denominated bonds issued by Asia sovereign, quasi-sovereign, and corporate borrowers. Countries included are China, Hong Kong, India, Indonesia, Malaysia, Macau, Mongolia, Pakistan, the Philippines, Taiwan, Thailand, Singapore, South Korea, Sri Lanka and Vietnam.

Note: Past performance is not an indication of future returns.

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47

Section 4

Emerging market asset allocation


48

Emerging market tactical asset allocation Tactical asset allocation deviations from benchmark*

* Please note that the bar charts show total portfolio preferences and thus can be interpreted as the recommended deviation from the relevant portfolio benchmark for any given asset class and sub asset class.

The UBS Investment House view is largely reflected in the majority of UBS Discretionary Mandates and forms the basis of UBS Advisory Mandates. Note that the implementation in Discretionary or Advisory Mandates might slightly deviate from the "unconstrained" asset allocation shown above, depending on benchmarks, currency positions and for other implementation considerations.

** Within the emerging market reference portfolio, equity positions (over- and underweights) can be implemented by single country selections and/or by an allocation to the MSCI EM index.

Emerging market equity strategy (countries relative to MSCI EM)**



Presenter

Presentation Notes

Section2_TAAcharts.xls


49


49

Appendix

Global portfolios


50


Global portfolios


Note: Portfolio weightings are for a "CHF Balanced" profile. For portfolio weightings related to other risk profiles or currencies, please contact your client advisor.

EUR Balanced

Note: Portfolio weightings are for a "EUR Balanced" profile. For portfolio weightings related to other risk profiles or currencies, please contact your client advisor.

USD Balanced

Note: Portfolio weightings are for a "USD Balanced" profile. For portfolio weightings related to other risk profiles or currencies, please contact your client advisor.

CHF Balanced

Source: UBS; as of 20 February 2014

Liquidity5%

High-grade bonds10%


bonds14%

High-yield bonds

9%

EM bonds3%

Equities others

2%

Equities EM4%

Equities Europe

23%

Equities US15%


15%

Liquidity5% High-grade

bonds10%


bonds14%

High-yield bonds

9%

EM bonds3%

Equities others

4%

Equities EM6%

Equities Europe

11%

Equities US23%


15%

Liquidity5% High-grade

bonds10%


bonds14%

High-yield bonds

9%

EM bonds3%

Equities others

9%

Equities EM4%

Equities Switzerland

17%

Equities US15%


15%


51

Contact list

UBS WM Global Chief Investment Officer Alexander Friedman [email protected] UBS WM Global Head of Investment Mark Haefele [email protected]

UBS CIO WM Global Investment Office

Switzerland Daniel Kalt [email protected]

Asia-Pacific (South) Kelvin Tay [email protected]

Asia-Pacific (North) Yonghao Pu [email protected]

Emerging Markets Jorge Mariscal [email protected]

Europe Andreas Höfert [email protected]

Alternative Investments Andrew Lee [email protected]

Chief Investment Officer, UHNW Simon Smiles [email protected]

Asset Allocation Discretionary Mads Pedersen [email protected]

Asset Allocation Advisory Mark Andersen [email protected]

Head Investment Themes Philippe G. Müller [email protected]

UBS CIO WM Regional Chief Investment Officers

CIO Region APAC Min Lan Tan [email protected]

CIO Region Europe Themis Themistocleous [email protected]
















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CIO Monthly Extended Monthly... · 2014-02-27 · Global tactical asset allocation . Source: UBS CIO WM Global Investment Office – as of 20.02.2014 . Tactical asset allocation deviations