DS9 Document EFTA01089665

UBS Chief Investment Officer Wealth Management May 2013 Alexander S. Friedman Global CIO UBS WM UBS CIO Monthly Letter The rubber ducks Gold's recent decline can help us grasp the interplay between major market perfor- mance and central bank stimulus efforts. In the last few weeks, gold garnered a great deal of attention as its price fell approxi- mately 10% (see Fig. 1). This led many inves- tors to reconsider their notions of a "safe haven," and to reassess what fair value might be. Buyers of gold have long known that its price is divorced from the fundamen- tal factors that move pure commodities, and is driven instead by more ethereal dynamics like private investor demand. Valuing gold as a simple commodity would imply a fun- damental price of USD 1,150/oz. At that price, 10% of gold mines would be loss making, and the metal would trade 19% below current levels and 40% below 2011's all-time peak. It would be wrong to conclude, however, that investing in assets purely based on fun- damental value will always work. There may be good reason for asset prices to diverge from pure fundamental value. In the case of gold, investor demand to diversify away from paper money has helped gold rise by more than 300% in the past decade, and long-term holders are still sitting on tidy profits. John Maynard Keynes's quip that "markets can remain irrational a lot longer than you and I can remain solvent," is an enduring lesson. The volatility in gold reminds us that inves- tors must employ a critical eye when prices are divorced from pure fundamental value. In such cases, it is important to assess whether the "other" factors that are prop- ping up prices are going to persist. This applies whether we are looking at gold, government bonds or bitcoins. And it is particularly pertinent in a world where central banks are perceived as driving the prices of many asset markets, particularly the fixed income market. I have now written four paragraphs of my monthly letter without employing a meta- phor, but I can resist no longer. We can picture markets today as a bunch of rubber ducks floating in bathtubs. The water flowing from the tap represents central bank liquidity, the ducks signify market perfor- mance, and the plug stands for the funda- mental strength of the economy. Concerns over the fundamental strength of the economy have grown in regions around the world. This concern is evident in the recent weakness in commodity prices and in the declines in some economic growth trends, like the purchasing managers indi- ces, across the US, the Eurozone and China. Therefore, in each region, we must carefully assess: (i) the velocity of the flowing water; (ii) how long the tap will remain turned on; and (iii) whether the plug is secure. Broadly, as long as we're comfortable with two of these three factors, it can make sense to bet on the duck rising. In the American bath, the tap remains on. There is some debate about how long the US Federal Reserve (the Fed) will keep it on, but over our tactical time frame of the next six months we are confident the water will keep flowing. Moreover, we believe the plug is secure given the recovery in the housing market and good corporate earnings growth. As such we feel comfortable with our overweight positions in US equities and US high yield credit. This report has been prepared by UBS AG. Please see important dulaimers and chsclosins at the end of the docionent. Past performance is no indcaticn of future performance. The market paces worded are closing prices on the respective principal stork exchange. This applies to all performance charts and tables in this puttication. EFTA01089665 UBS CIO Monthly Letter In the Japanese bathtub, the plug has been out of place for years, but with the Bank of Japan (Bo.° now turning the tap fully open, the bath water is rising fast, and we are adding an overweight position in Japanese equities. We will fund this overweight position in Japan by reduc- ing emerging markets to neutral. In our Chinese bath, the government has become wor- ried the duck is floating too near the top, so it has turned off the tap, and other emerging markets could suffer weaker earnings if commodity prices remain at current levels. Finally, in the Eurozone tub, the European Central Bank (ECB) has put in place a secure temporary plug, but the tap is producing little more than a trickle and we know that longer term, the temporary plug must be replaced with a better one, a long-term structural solution (a big unknown at this point), so we are maintaining an under- weight position in the euro. There are many subtleties in each regional bath, and in the remainder of this letter I will discuss in more detail the underlying economic picture and the impact and future evolution of central bank stimulus measures. The mighty US duck In last month's letter, I described how the US economy and its consumers represent the most important driver for the global outlook. Since then there has been rela- tively weak data, with non-farm payrolls rising by just 88,000 in March (after climbing by 268,000 in February), retail sales declining 0.4% in the month (from +1.0%), and the ISM Manufacturing index dropping to 51.3 from 54.2. This has led many to question the stability of the US economic recovery, at the same time as investors have become worried that the Fed might "turn the tap off," by ending quantitative easing (QE), or even by starting to sell its USD 3trn pile of Treasuries and mortgage-backed Fig. 1: Gold price falls sharply Gold prize IUS0. oz) 2000 1900 1800 1700 1600 1500 1400 1300 1200 1100 1000 a 4' .1 A 4• Sc A securities (MBS). This kind of market noise regarding the Fed is worrisome, as some investors believe the market is divorced from fundamental value, with even the Fed minutes stating that "a lengthy period of low long-term rates could encourage excessive risk-taking." So we need to assess whether US asset prices are indeed divorced from fundamental value and, if so, what impact a withdrawal of Fed stimulus could have. Our conclusion is that the strength of US risk assets year- to-date reflects an improved fundamental economic pic- ture. However, the USD 60bn "sequester" series of auto- matic spending cuts has begun to have an impact on the wider economy. The direct negative hit of around 0.4% of GDP is manageable, but indirect effects could be higher. For example, consumer and corporate confidence is hardly likely to be boosted by the recent air travel dis- ruption. As a result, we expect real consumption growth to slow in the second quarter to 2.4% annualized, from 2.9% in the first quarter. However, the underlying pri- vate sector remains healthy, and recent soft data has been largely attributable to lower government spending and inventory destocking (see Fig. 2). Over the balance of the year consumption should accelerate as a result of the improving labor market, lower gasoline prices, and stronger capital formation as businesses finally begin to invest their unprecedented cash balances. Finally, higher house prices have the potential to boost GDP growth through a combination of the wealth effect and con- struction spending; March saw the fastest pace of new home construction since June 2008. In the near term, there are a number of reasons we do not expect the Fed to scale down its stimulus. First, the Fed should remain accommodative while the full impact of the sequester spending cuts lies ahead. Second, the US labor market has improved, but the 7.6% unemploy- ment rate remains well above the 6.5% threshold the Fig. 2: US underlying demand stable US GOP Icraq, annualised. %) 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 Om 0211 0311 0411 0112 0212 0312 0412 — US GDP — Final sales Source: Bloomberg, UBS, as 0124 Apra 2013 Source: Bloomberg, U8S. as of 24 A20 2013 UBS Chief Investment Office May 2013 2 EFTA01089666 UBS CIO Monthly Letter Fed set as its target before it will consider tightening pol- icy. Third, the Fed is well aware that, while funding costs have improved, overall credit availability remains tight. Recent results from the US banks show decelerating loan growth and declining net interest margins. And, finally, continued weakness in the Eurozone economies and flux in the European political situation support a continued loose monetary stance by the Fed. Therefore, we expect only a steady tapering off of eco- nomic stimulus, and foresee the Fed reducing monthly asset purchases by USD 10bn per month starting around October, leaving the rate of asset purchases at USD 65bn by year-end. This is unlikely to have a major negative impact on risk assets. Ironically, if the Fed were to consider withdrawing its stimulus more aggressively, the "safest" assets could prove the most dangerous. Merely signaling a sale of the Fed's Treasury holdings would risk bond market partici- pants pricing almost USD 2trn of new supply, and could lead to disorderly bond markets. Chairman Ben Ber- nanke is well aware of this and Fed members have recently sought to highlight the interest rate mechanism as the primary "exit" tool. This would nonetheless be detrimental to (if not catastrophic for) the Treasury mar- ket, but, provided it came in response to better-than- expected growth, it is unlikely to affect riskier assets meaningfully. In sum, we don't believe the Fed will turn off the bath tap and stop its support for our American rubber duck until it is confident of a more self-sustaining recovery. In the meantime, US assets will continue to benefit from the rather enviable situation of strong central bank sup- port coinciding with an improvement in economic activity. Fig. 3: The Bank of Japan impacting earnings estimates Japan equtties earnings growth (yay, 60 so 40 30 20 10 0 Japan calls in the fire truck hoses If some believe the US market may be divorced from fun- damentals, then the more than 50% rise in the Nikkei 225 equity index (calculated in yen) since November begs for discussion. The rally has taken on new impetus since the BOJ announced it would double its monetary base within the next two years. Using my rubber duck anal- ogy, this is the equivalent of the BoJ turning the tap on full and then calling in the fire trucks to use their hoses as well. It is no surprise the water is rising. To put this in context, the Fed is making annual net pur- chases of 7% of GDP. Japan will be purchasing assets at close to twice this rate, or about 13% of GDP. Addition- ally, the BoJ is not focusing purely on fixed income assets like government bonds and mortgage-backed securities, but is instead also buying equities through exchange- traded funds, as well as real estate investment trusts. But will it help Japan achieve its 2% inflation target? It will be difficult, and indeed many economists would sug- gest that 2% consumer price inflation (CPI) in Japan is impossible. The country's output gap sits at roughly 3%, and, after a generation of deflation, resetting inflation expectations is extremely difficult. The most recent labor market data showing a 0.7% fall in wages for the first few months of this year is evidence of this. However, there is an argument that 2% inflation may be achievable. First, the yen's 25% fall in the past six months should translate into a 0.5% boost to inflation, and should "Abenomics," the economic policy promoted by Japanese Prime Minister Shinzo Abe, begin to have an effect, the yen could fall a further 10%. Second, there are signs that there may not be as much spare capacity in the labor market as deflating wages might suggest — the Tankan survey actually indicates the labor surplus is Fig. 4: Emerging markets seeing divergent performance Index Insbased. ytc0 125 120 115 110 105 100 95 90 85 ao 1 — EPS grmh FY 2013 — EPS grmh FY 2014 is '7 '7 47. A - Brazil Russia Phippines — China Indonesia ? ? ? Source: Thomson Reuters. UBS• as of 24 .4pnl 2013 Source: eaoorriaerg. UBS• as of 24 April 2013 UBS Chief Investment Office May 2013 3 EFTA01089667 UBS OO Monthly Letter turning into a labor shortage. Third, inflation expecta- tions are starting to rise, and the five-year inflation rate Lnplied by the inflation-protected bond market is 1.5% up from 0.5% just a year ago. Returning to my bathtub analogy, it is unclear if Abenomics will be successful in "securing the plug" and transforming the Japanese economy after more than a decade of malaise. But the Bar tap is clearly having an impact. The weakness in the yen has helped earnings growth estimates for the Nikkei for the financial year to March 2014 rise to over 50% in the past six months alone (see Fig. 3) from around 20%. If the yen remains at current levels we could even see earnings upgraded by a further 10%. The Nikkei has run ahead of these earnings upgrades, but on a 14.9x one-year forward price-to-earnings ratio, it is not obviously overvalued relative to its 10-year average of 16.3x. Finally, the Bar is nothing if not determined to give Japan a fighting chance with its massive dose of new liquidity. We therefore are initiating an overweight position in Jap- anese equities, and within this market we believe the best way of taking advantage of the Japanese reflation theme is through positions in Japanese exporters. Emerging markets = diverging markets? If the return of Japanese equities has been one of the great surprises of the past six months, the stark under- performance of emerging market equities is certainly one too. It seems almost counterintuitive that the region of the world with the fastest economic growth also suf- fers from the lowest equity valuations. But after a 12% underperformance year-to-date, emerging market equi- ties are now trading on a 2013 price-to-earnings ratio of just 10.1x. In the earlier discussion on gold, I said that investing in assets based purely on fundamental value is not an Fig. 5: Weak German manufacturing data Purchasing Managers' lodes a .6 en en te & g LL cc en en optimal strategy. In this same vein, it should be noted that just because emerging markets as a whole are "cheap" doesn't mean their underperformance will cor- rect in the near term. One of the most striking features about emerging mar- kets this year, aside from their underperformance as a whole, has been the stark divergence between the mar- ket performance of individual countries. It has been less a case of emerging markets, and more a case of diverg- ing markets. After a strong start to the year, Chinese equities have fallen sharply in recent months due to signs of policy tightening, particularly with respect to increased government regulation of wealth manage- ment products and the property sector. Furthermore, there are signs that economic growth is slowing — GDP data disappointed expectations, rising by only 7.7% in the first quarter (consensus 7.9%), and this week's HSBC purchasing managers' index fell to 50.5 in April from 51.6 in March. The associated weakness in com- modity prices has weighed on Brazil and Russia too. Meanwhile, Korea's competitiveness has been chal- lenged by the Japanese yen's 20% depreciation against the Korean won in the past six months. Partially as a result, Korean equities have lagged Japanese equities by close to 25% (in constant currency terms) year-to- date. Conversely, the more domestically oriented mar- kets, such as the Philippines and Indonesia, have per- formed very strongly (see Fig. 4). With such divergence, emerging markets as a group are testing investors. Near-term uncertainties over global growth, the future of Chinese policy, and the outlook for commodities all combine to make it hard to foresee a near-term catalyst to help emerging mar- kets realize their significant longer-term valuation potential. Given this, it makes sense to focus on selected countries. Specifically, on a tactical basis, we recommend that investors seek exposure to the Fig. 6: Positioning speaks in favor of the CAD vs AUD sAi postai% n 100 contacts 1503 1003 CO 0 —S00 s s it S — CAD — AUD Source: Blcomterg UBS, as o124 Apnl 2013 Source: Bloomberg CFI( U8S, as of 24 Apr' 2013 UBS Chief Investment Office May 2013 4 EFTA01089668 UBS 00 Monthly Letter domestic recovery stories in Brazil and India, the out- of-favor Russian and Korean equity markets, and also to broader emerging market growth through Western corporations, via Western Winners from Emerging Market growth. On a strategic basis, however, an adequate allocation to emerging markets overall remains important. Valuations are attractive, and emerging markets will continue to offer the world's highest GDP growth rates, with the lowest sovereign leverage. And, outside of equities, we continue to hold an overweight position in corporate emerging market credit, and emerging market curren- cies remain a 00 preferred theme. Calm on the surface in the Eurozone It is ordinarily a positive sign if I can get through the bulk of my monthly letter without lots of discussion of the Eurozone. The "good news" is the Eurozone appears to be diminishing in importance in terms of driving global markets, with the near-term fear of a break-up falling away. Spanish and Italian bond yields have begun to move more independently of wider risk sentiment, and the inverse correlation between their yields and global equity markets is near the weakest level it has been in a year. Sadly, this calm on the surface does not reflect an improvement in the Eurozone's underlying prospects. This week's sentiment indices show the ongoing weak- ness in the economy: the German Manufacturing PMI fell to 47.9 from 49.0 (see Fig. 5), and the German Ifo business climate index dropped to 104.4 from 106.7. Structural solutions remain elusive, and ahead of the German elections in September, progress is likely to be non-existent. Italy has finally found a new prime minister, but he faces challenges in enacting reforms. Elsewhere, credit rating agency Moody's retains a negative outlook on Spain, threatening it with a downgrade to junk sta- tus, potentially exacerbating an already difficult funding situation for the country's corporations. Cyprus retains its capital controls, which if maintained for a long period of time, endanger the integrity of the euro. And there is speculation that Slovenia could be the "next domino to fall;" a potential loss of access to the bond market could force the country into an ESM bailout. These dim economic prospects lead us to believe the ECB will cut its refinancing rate from 0.75% to 0.5% at its upcoming meeting on May 2. If this materializes, it would support our underweight position in the euro. Troubling commodities The problems in the Eurozone may not be influencing global equities as strongly as they have previously, but they have had a huge influence on the price of gold in recent weeks. ECB President Mario Draghi's comments that the profits of any gold sales by the Central Bank of Cyprus must be used to cover any losses made on its loans to commercial banks appeared to send the gold market into a tailspin, with prices dropping as much as 15% over three trading sessions. To be clear, Draghi's comments were misinterpreted. It was always the case that if the Cypriot central bank sold its gold it would have to cover its own losses before transferring any money to the Cypriot government. Draghi was merely clarifying this, not ordering the asset sale. As such, we believe the move is overdone. However, with over one-third of global gold demand attributable to investment demand, gold relies greatly on the trust among investors that it can truly act as a hedge against expansionary central bank policies. The recent gold price move may have dented that trust, and so we are main- taining a neutral position, forecasting gold to trade in a range of USD 1,150-1,550 per ounce over the next three months. Asset allocation and themes Within equities, we are replacing our tactical overweight position in emerging markets with one in Japan, for the reasons described earlier. We also are maintaining our overweight position in the US relative to Canada, since the Canadian housing market recovery is likely to lag that of the US, and since the sharp downward move in the gold price is likely to hinder Canada's large gold min- ing sector. Elsewhere, within fixed income we remain overweight global investment grade credit as well as US high yield bonds, which continue to offer an attractive premium of 466bps over US Treasuries. We expect low corporate default rates, and a strong appetite for yield from inves- tors to offer support for the sector. We are making a number of additions to our currency positioning. First, we are adding an overweight position in the US dollar. Economic growth is stronger than in other regions, and discussions over a potential reduction in QE could support the currency, particularly relative to the euro where an ECB refinancing rate cut is likely. With economic growth expected to stay weak in the Euro- zone, we will increase our underweight in the region, but instead of adding to our euro short, we will intro- duce a long USDCHF position. The EURCHF 1.20 floor remains solid, and as such the franc could weaken fur- ther from current levels. Second, we are taking an overweight position in the Canadian dollar. Canadian consumer confidence, busi- ness sentiment, and investment spending are picking up, while the recent rise in inflation should calm any dovish- ness at the Bank of Canada. Meanwhile, positioning data suggests the market is very short the Canadian dol- lar (see Fig. 6), meaning positive surprises could have an outsized impact. We suggest setting this against the Australian dollar. It is overvalued, its positioning is long UBS Chief Investment Office May 2013 5 EFTA01089669 UBS CO Monthly Letter and Australia's most recent economic data suggests a potential slowdown in employment growth. These two currency positions also will help diversify our overall portfolio. While a return to a "risk-off" environ- ment is not our base case, such currency positions should perform particularly well if global growth deteriorates, balancing some of the potential weakness that could be seen in our overweight positions in equities and credit. Finally, we continue to favor the British pound over the euro. This week's announcement of an extension to the Funding for Lending scheme could see some Monetary Policy Committee members back away from calls for more QE, and concerns over a change in Bank of England policy should continue to recede following March's Budget Statement. Thank you for your consideration in making it all the way through this letter. As always, any comments are appreciated. Alexander S. Friedman Global Chief Investment Officer Wealth Management 25 April 2013 UBS Chief Investment Office May 2013 6 EFTA01089670 UBS CIO WM Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisions of 1185 AG (UBS) or an affiliate thereof. In certain countries U8S AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment a other specific product. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be efigble fa sale to all investors. 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