financial pacific - stay the course (third party)

Investment Strategy GuideWealth Management Research

31 August 2011 Monthly

Monthly print copies

available*Monthly print copies

available*

Stay the course

US economy to avert recession by a thin margin

Eurozone remains key risk to market outlook

Maintain benchmark allocation to equities

*Print copies are not available for ad-hoc intra-month updates.

Contents

Highlights

Focus .............................................3

Our Best Ideas at a Glance ..........9

Asset Allocation Overview ..........10

Market Scenarios ........................11

Economic Outlook ......................12

International Markets……............14

US Equities: Sectors .......................16

US Equities: Size, Style & REITs ....17

US Fixed Income .........................18

Chartbooks .................................21

Detailed Asset Allocations.........25

We continue to recommend that investors stay the course and

retain a balanced portfolio with benchmark weightings across each of the major asset classes (stocks, bonds, cash, commodi-ties, alternatives investments).

Stocks are cheap relative to history, and certainly relative tobonds. While it remains our view that neither the US nor thebroader global economy will lapse into recession, sluggish eco-nomic growth prospects, falling earnings estimates, and ele-vated systemic risks suggest that a sharp and sustained equity market rally over the remainder of 2011 is unlikely.

We retain our overweights to both US and emerging marketequities – while at the same time keeping an outright under-weight of non-US developed markets, in particular the Euro-zone.

The next challenge we see for the Eurozone are the upcoming votes among member nations to approve an expansion in theEuropean Financial Stability Facility (EFSF).

While much of the political focus has centered upon the Euro-zone, we also need to keep a watchful eye on developments in Washington related to the Joint Select Committee on DeficitReduction.

Michael P. Ryan, CFA, Chief Investment Strategist and Head, WMR – Americas [email protected] Stephen R. Freedman, PhD, CFA, Strategist [email protected] Brian Rose, PhD, Strategist [email protected] This report has been prepared by UBS Finan-cial Services Inc. Please see important disclaimer and dis-closures at the end of the document.

Investment Strategy Guide 2

Focus

Stay the course

With the global economy likely to avert a renewed recession and equity valuations at attractive levels, stocks would appear to have upside from here. However, slow growth prospects and significant systemic risks suggest that the upside is likely to be limited compared to the equity rally seen in the second half of 2010 and that down-side risks remain. We recommend sticking to a benchmark allocation on equities.

Sloppy & choppy Financial markets experienced a level of volatility during the month of August that had not been seen since the dark days of the global financial crisis. The VIX volatility index breached the 45 mark for the first time since March 2009 (see Fig. 1), as market participants were forced to sort through a stream of weaker than expected economic data, an especially caustic political debate over the extension of the federal debt ceiling, the first down-grade of the US sovereign credit rating from AAA, and a broadening of the Eurozone debt crisis to Italy and Spain. While volatility will likely ratchet lower in coming weeks, few of the catalysts that prompted the broad-based market sell-off have been fully addressed - let alone resolved. This suggests that markets will remain “choppy & sloppy” in the short/intermediate term, and that relief rallies are likely to be more episodic than sus-tained.

Against this backdrop we continue to recommend that investors stay the course and retain a balanced portfolio with benchmark weightings across each of the major asset classes (stocks, bonds, cash, commodities, alterna-tives investments). It remains our view that stocks reached oversold conditions in August and that a further recovery from current distressed levels is likely. Even after having rallied nearly 8% from the August lows, the S&P 500 is still trading at undemanding valuation multiples of just 11.7x our estimates for 2012 earnings - and just 10.7x twelve-month consensus earnings (see Fig. 2). Keep in mind, however, that analysts and strategists are likely to begin reducing their earnings estimates in the weeks and months ahead as the impact from the most recent hit to both consumer and business confidence is increasingly reflected in the profit picture. In our view, any “re-rating” of equities will therefore be both limited and gradual.

Fig. 1: Volatility spiked in August

VIX volatility index


0102030405060708090

Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11 Aug-11VIX volatility index

Source: Bloomberg, UBS WMR, as of 30 August 2011

Fig. 2: World Price-Earnings ratio cheaper than average

S&P 500 Price-Earnings ratio. EPS is Earnings Per Share

5

10

15

20

25

85 89 93 97 01 05 09S&P 500 12-month Fwd PE PE on WMR EPSPE on $80 EPS (recession) Average

Source: Datastream, IBES, UBS WMR, as of 29 August 2011

Focus


That said, while recommending a neutral tactical allocation to eq-uities as an asset class, we have opted to retain our moderate overweights to both US and emerging market equities – while at the same time keeping an outright underweight of non-US devel-oped markets, in particular the Eurozone. Although growth pros-pects in the US have weakened, it remains our view that theeconomy won’t lapse back into recession. Meanwhile, the easingof inflation pressures within the emerging markets will allow cen-tral bankers greater latitude to shift toward a more neutral (andequity friendly) policy stance. We do, however, remain concernedabout lingering debt problems within the Eurozone. Although theEuropean Central Bank (ECB) has played a critical role in stabiliz-ing sovereign bond yields in the near term, the inability of electedofficials to address the broader fiscal challenge and financial sec-tor stability concerns within the region in a comprehensive anddecisive manner continues to pose a risk to Eurozone equities. Assessing the rough patch The weakness in economic data released over the past four weeks has raised concerns of a deeper nature than just the standard runof the mill “soft patch”. What has compounded these cyclicalfears is the fact that the recovery process was hardly on firm foot-ing to begin with. Official GDP growth for both the first and sec-ond quarters was revised lower to an average of less than 1 per-cent, indicating broad-based weakness in demand growth duringthe first half of the year. While higher energy prices and the im-pact from the Japanese earthquake played a role in the slow-down, the fact is that the economy has simply failed to gain thesort of traction that allows expansions to become self-sustaining. A further weakening of growth prospects from this already de-pressed level could therefore bring the economy perilously close to recessionary levels. Almost any significant shock could be enough to create a US recession given the already weak pace ofgrowth momentum. It is this risk that has weighed most heavilyupon domestic equity markets of late. Despite the increased concern over recession, the economic re-lease data has actually been more mixed than the headlines alonemight suggest. While several survey-based releases such as theMichigan consumer sentiment index and Philly Fed manufacturingsurvey have shown sharp drops consistent with recession, still oth-ers such as the Kansas City, Richmond, Chicago and Dallas Fed surveys suggest the economy is decelerating in line with last year’ssoft patch rather than simply rolling over (see Fig. 4). High fre-quency data such as weekly unemployment claims, retail sales and the personal consumption data for July also reflect a bit of abounce back following a lull in activity during May and June. All things considered, it remains our view that the economy will avert a recession – but that the sluggish substandard pace of growth is

Fig. 3: Benchmark and current allocation Percentage of portfolio (moderate risk portfolio)

5.0

44.0

37.0

2.0

12.0

CommoditiesAltern. Investments

Current allocation

12.0

2.0

37.0

44.0

5.0

EquityFixed IncomeCash

Benchmark allocation

Source: UBS Investment Solutions and WMR, as of 31 August 2011. See Sources of benchmark allocations and investor risk profiles in the Appendix for a detailed explanation regarding benchmarks and their suitability. The current allocation is the sum of the benchmark allocations and tactical deviations. The Tables on pages 25 and 26 in the Appendix also show asset allocations applicable to risk profiles other than the moderate risk profile shown here, both with and without nontraditional assets.

Table 1: Asset Class Scorecard Valuation Cyclical Timing Equities +2 -1 -1 Commodities -1 0 0 Fixed Income -2 +1 +1

Range: -3 (very unsupportive) to +3 (very supportive) Source: UBS WMR, as of 31 August 2011 Fig. 4: Regional manufacturing climate deterio-rates further in August Regional manufacturing climate indexes, index levels

(60)

(40)

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Jul-01 Jul-03 Jul-05 Jul-07 Jul-09 Jul-11

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30

40

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80Another soft patch or genuine weakness?

Empire State (lhs) Philly Fed (lhs) Richmond (lhs)Kansas City (lhs) Dallas (lhs) Chicago (rhs)


Focus

apt to prevail for the balance of this year and into next year aswell. Gentle Ben? Chairman Bernanke provided little in the way of fresh insight orclear guidance in his prepared remarks offered at the Fed’s annualpolicy symposium in Jackson Hole, Wyoming. Market participantsdidn’t appear overly troubled by the Chairman’s unwillingness tocommit to new policy measures, and instead took solace from asomewhat more upbeat assessment of the US economy. While hecontinued to warn that “financial stress has been and continuesto be a significant drag on the recovery, both here and abroad,”Bernanke also emphasized that growth in the second half waslikely to improve. The only tangible step the Fed Chairman ap-peared willing to take at this juncture was to expand the Septem-ber FOMC meeting from one day to two days in an effort to bet-ter assess both the health of the economy and potential policyresponses. Although Bernanke refused to explicitly commit to any specificpolicy action in Jackson Hole, he left the door wide open for anyand all measures should growth fail to reaccelerate, financial mar-kets come under additional stress, and/or asset prices declineanew. Virtually no one was looking for the Fed to pledge to a newphase of quantitative easing – and in this regard the Chairmandidn’t disappoint. We already knew that the bar was set prettyhigh for “QE3,” so the fact that the Fed made no mention of afurther expansion of its balance sheet should not be interpreted tomean that the Fed will sit idle should the business cycle take a turn for the worse. By stating that “the Federal Reserve has arange of tools that could be used to provide additional monetarystimulus,” Chairman Bernanke sent notice that Fed officials wereboth willing and capable of upping the ante as conditions require– despite dissenting votes within their own ranks. Eurozone risks remain Meanwhile, policymakers in the Eurozone have yet to convinceinvestors that they are able to adopt the sort of politically difficultmeasures needed to restore confidence in the stability of currencyunion. Far from standing idle, European leaders have in fact adopted a number far reaching measures since the beginning of the crisis. However, their steps to-date have consistently been in-terpreted by market participants as being “too little, too late.”The very structure of the Eurozone makes it difficult to address fiscal challenges in a timely and comprehensive manner. As a re-sult, policymakers on the Continent have failed to stem a crisisthat started in Greece, spread to a small group of countries on theperiphery of the Eurozone, and more recently has begun to im-pact larger members such as Italy, Spain and even France. Only

Fig. 5: ECB buying has reduced yield spreads for Italy and Spain 10-year government bond yield spread vs. German Bunds, in %-pts

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Jan-10 May-10 Sep-10 Jan-11 May-11Spain Italy



Focus

the actions of the European Central Bank have been successful inproviding support to beleaguered market participants through anexpansion in sovereign debt purchases - primarily Spain and Italy(see Fig. 5). In the absence of ECB action, it is clear that markets would have come under even more acute pressure. The next challenge we see for the Eurozone region going forwardare the upcoming votes among member nations to approve anexpansion in the European Financial Stability Facility (EFSF). Keep in mind that while the facility’s lending capacity was expanded in July to EUR 440 billion, the larger package still requires the ap-proval of the national legislatures across the Eurozone. There isconcern that at EUR 440 billion the EFSF is simply too small to adequately deal with potential problems in states already understress, and that a package of perhaps EUR 1 trillion may ultimatelybe required to placate market concerns about further contagion.But there is already some push back as member nations balk at the potential cost associated with the EUR 440 billion facility – let alone EUR 1 trillion. Finland’s insistence that Greece provide col-lateral as a precondition for additional loan disbursements risksdelaying the process into October. Should legislatures fail to passthe current package, or even simply delay approval by anothermonth or so, Eurozone markets are apt to come under renewedpressure. As we’ve already noted, The European Central Bank currently ap-pears to be the only European institution capable of acting deci-sively to contain the spreading of the crisis. However, there arelegitimate doubts about whether the ECB can fulfill such functionin a sustainable manner over the coming months. The ECB hasalso been active in providing liquidity to the ailing European finan-cial system. Funding conditions in the interbank market have dete-riorated in recent weeks (see Fig. 6). While they are hardly compa-rable with the crunch experienced in 2008, they have clearly be-come a source of concern. So while the situation in the Eurozone appears to have stabilized over the last several weeks, it is quiteapparent that there is very little room for any mistakes. Any ad-verse news from the financial sector or signs of disagreementamong policy makers is likely to create market jitters. We expectrenewed bouts of selling pressure in European markets before theend of the year and therefore remain underweight equities in theregion despite seemingly attractive valuations. Watchful eye on Washington While much of the political focus of late has rightly centered uponthe Eurozone, we need to keep a watchful eye on developmentsin Washington related to the Joint Select Committee on DeficitReduction (JSC or debt “super committee”) as well. On August 2,President Obama signed into law the Budget Control Act of 2011.

Fig. 6: Funding tensions in European interbank market Euribor-OIS 3 Month Spread, in %

0.00.20.40.60.81.01.21.41.61.82.0

Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11Euribor-OIS 3 Month Spread



Focus

Title IV of that Act created the JSC which is composed of twelveMembers each from the Senate and House of Representatives (6Republicans and 6 Democrats). The Committee is under a tightdeadline to produce legislation cutting the deficit by at least $1.5trillion over ten years. In the absence of such an agreement, amandatory budget “sequestration” process would kick in and reduce spending by more than $1 trillion across discretionary, en-titlement and defense programs. The committee must meet bySeptember 16th at the latest, and new legislation must be ap-proved by both the House and Senate by December 23rd. Linda Lord, UBS’s Head of Legislative and Regulatory affairs re-cently published an insightful note highlighting both the chal-lenges and possible pathways toward a legislative solution. Lindapoints out that it is still possible to reach a compromise agreementfollowing a “dual track” legislative process where one set of fiscalmeasures is passed in the House, a separate set is passed in theSenate, and the two are ultimately reconciled. However, Lindaalso admits that the prospects for compromise are still limited.Keep in mind that the membership of the JSC largely reflects thehardened political positions of the two opposing camps on Capi-tol Hill - and excludes any of the so called “gang of six” senatorswho had tried to cobble together a bi-partisan budget resolution.It is difficult to see how this new panel will be any more effectivein hammering out an agreement on a new series of fiscal meas-ures to reduce the deficit by $1.5 trillion over the next 10 years.Instead, it’s more likely that the “automatic” spending cuts—required by the debt ceiling accord if an agreement cannot bereached—will be implemented. Keep in mind that the failure to agree upon meaningful and credi-ble fiscal reforms, even if the Budget Control Act is fully imple-mented, could prompt yet another downgrade of the US sover-eign credit rating. While Moody’s reaffirmed its Aaa rating in Au-gust, the rating agency did place the US on negative watch andwarned that a downgrade could occur within the next 12 monthsif constructive steps are not taken to address the federal debtlevel. It is unclear just how much additional damage a downgradeby Moody’s would inflict upon confidence given that S&P has al-ready taken action. However, it would certainly undermine theargument that S&P had been imprudent and premature in strip-ping the US of its AAA rating. This in turn would likely furtherundermine confidence in the political process, business outlookand investment environment in the US. So while the political is-sues in the US are neither as immediate nor as acute as those cur-rently afflicting the Eurozone, the process still merits close atten-tion.


Focus


No dumping zone As we noted in our intra-month update on August 19th, we rec-ommend that investors retain equity positions at current levelsdespite the more challenging macro backdrop and lingering politi-cal risks. Keep the following in mind: Stocks are already pricing in a fair amount of economic and

earnings weakness and therefore should outperform bonds inthe weeks ahead as the upcoming release data reflect weak-ness rather than an outright collapse in the economy. It re-mains our view that neither the US nor the broader globaleconomy will lapse into recession.

While consensus earnings estimates are likely too high andalmost certain to be revised lower over the course of the nextseveral months, we still look for respectable profit growth of14% ($97) for this year and 5% ($102) for 2012.

With expectations already set incredibly low for elected offi-cials across the developed world, there is ample room for a positive surprise if they are able to make any progress at all in addressing fiscal concerns in the months ahead.

Although Chairman Bernanke refused to commit to any spe-cific policy action in Jackson Hole, he left the door wide opento providing “additional monetary stimulus” as needed. Recallthat the recovery in risk assets last year tracks almost to themoment when the Fed first raised the prospects for QE2 at last years’ Jackson Hole Symposium (see Fig. 7).

A benchmark weighting in bonds is still warranted amid slug-gish growth prospects, diminishing inflation risks and the Fed’s commitment to keep short rates at current levels through mid-2013. Meanwhile, any further expansion of theFed balance sheet and/or extension in the portfolio duration will also serve to temper any near term rate pressure.

Conclusion As we’ve already noted, we continue to recommend that investorsstay the course and retain a balanced portfolio with benchmarkweightings across each of the major asset classes (stocks, bonds, cash, commodities, alternatives investments). Markets are apt toremain choppy in the near term as both macro and political risksremain. However, we elect to retain our overweights to both USand emerging market equities – while at the same time keeping an outright underweight for the Eurozone. It is our view that thecombination of US and Emerging Market exposure will allow in-vestors to outperform as the market recovers from oversold levels, but should also insulate portfolios on the downside should the Eurozone crisis continue to deepen. Michael P. Ryan, CFA, Head WMR Americas, UBS FS Inc. Stephen R. Freedman, PhD, CFA, Strategist, UBS FS Inc.

Fig. 7: Stocks recovered last year after Bernanke speech at Jackson Hole S&P 500 index

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1,200

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

JacksonHole


Our Best Ideas at a Glance The following list represents investment strategy recommendations that we believe will provide attractive opportunities over the next 9-12 months. Asset Classes

Neutral tactical preference across equities and bonds

Currencies

Avoid Japanese yen. Preference for SEK, NOK, GBP, CAD as well as selected Emerging Market cur-rencies.

Equities

International markets Emerging Market equities, especially China, Russia, Thailand, and Poland

UK and US equities

Within US equities Information Technology: hardware and equipment, semis, data centers

Consumer Staples: companies with high emerging markets exposure, specifically within House-hold Products, Cosmetics, and Beverages

Within Healthcare: managed care, generic manufacturers, drug distributors

Within Financials: universal banks, asset managers, exchanges, insurers

Within Industrials: air freight and select capital goods manufacturers with mid-to-late cycle ex-posure

Within Materials: chemicals and industrial gas

Within Energy: oilfield services

Within Consumer Discretionary: auto suppliers, cable, lodging

Within Telecom: wireless towers, enterprise carriers

Preference for growth over value stocks

Fixed Income

Within US dollar Fixed Income

Investment Grade BBB-rated credits in particular: managed care, insurance, mining and com-munications

Commodities

We see upside potential for gold, platinum, and selected agricultural commodities.



Asset Allocation Overview Asset Class Comments

WMR Tactical View Model Portfolio

Moderate Risk Profile (in %)

Benchmark Allocation

Tactical Deviation

Change Current Allocation

Equities Valuations attractive, especially relative to low yields on bonds. Weak economic data and problems in the Eurozone present downside risks to earnings.

Neutral 44 +0.0 �

44.0

US Equities Solid earnings growth helped by the weak dollar and external demand, but valuations are less attractive than in overseas markets.

Moderate Overweight 32 +2.0

34.0

US Large Cap Value Valuations and our sector tilts suggest preference for Growth over Value. Large-caps cheap relative to small and mid

Moderate Underweight 11 -1.0

�10.0

US Large Cap Growth Valuations and our sector tilts suggest preference for Growth over Value. Large-caps cheap relative to small and mid


14.0

US Mid Cap Valuations expensive vs. large-caps, but M&A activity should help.

Neutral 5 +0.0 �

5.0

US Small Cap Valuations expensive vs. large-caps, but M&A activity should help.

Neutral 3 +0.0

3.0

US Real Estate Investment Trusts (REITs) The Federal Reserve’s “pledge” to keep rates low thorough mid-2013 is posi-tive for the interest-rate sensitive REIT industry, offsetting stretched valua-tions

Neutral 2 +0.0

�

2.0

Non-US Developed Equities Valuations more attractive than US. Sovereign debt concerns in the Eurozone and potential for exchange rate losses suggest more cautious stance.

Underweight 10 -4.0 �

6.0

Emerging Market (EM) Equities High potential growth rates and reasonable valuations make EM equities more attractive than developed markets. Inflation likely to peak soon.


�4.0

Fixed Income Yields at historically low levels but weak economic data likely to keep many central banks on hold longer than previously anticipated.

Neutral 37 +0.0 �

37.0

US Fixed Income Within fixed income we are neutral on the US vs. non-US. The dollar trades near record-low levels against many major currencies but fundamentals re-main poor.

Neutral 29 +0.0

�

29.0

Non-US Fixed Income Extremely low yields and overvalued yen make Japanese debt unattractive. European sovereign debt concerns remain a risk.

Neutral 8 +0.0 �

8.0

Cash (USD) Yields likely to remain near into 2013.

Neutral 2 +0.0 �

2.0

Commodities We expect overall commodity prices to rise moderately over the next 12 months. Roll yields (resulting from contango term structure of futures prices) have become less negative.

Neutral 5 +0.0 �

5.0

Alternative Investments No tactical view. Included into portfolio for diversification purposes.

Neutral 12 +0.0

12.0

The benchmark allocations are provided for illustrative purposes only by UBS for a hypothetical US investor with a moderate investor risk profile and total return objective. See "Sources of benchmark allocations and investor risk profiles" in the Appendix for a detailed explanation regarding the source of benchmark alloca-tions and their suitability and the source of investor risk profiles. The current allocation is the sum of the benchmark allocation and the tactical deviation. See "De-viations from benchmark allocation" in the Appendix regarding the interpretation of the suggested tactical deviations from benchmark.

“WMR tactical deviation” legend: Overweight Underweight Neutral Source: UBS WMR and Investment Solutions, as of 31 August 2011.

“Change” legend: ▲ Upgrade ▼ DowngradeFor end notes, please see appendix.


Market Scenarios (next 12 months)

Economic data has continued to disappoint. Many senti-ment indicators have dropped sharply. Tighter fiscal policyand deleveraging in developed markets will create further headwinds, making a strong recovery difficult to achieve.The recovery of Japan’s manufacturing sector is helping toease problems in global supply chains, giving a boost tooutput. Inflation should peak soon in many emerging mar-kets. Moderate recovery: Base Case Scenario Probability: 55% (down from 65% in July)

The global economy remains on an expansion course as low real interest rates in most countries provides support.

The recovery is more subdued than in prior cycles because of de-leveraging pressures, with unemployment rates remain-ing far above their pre-financial crisis levels.

Growth in emerging markets continues to outpace devel-oped markets.

Renewed downturn: First Alternative Scenario Probability: 30% (up from 20% in July)

The recent trend toward weaker growth continues as fiscal consolidation and higher interest rates create additional headwinds.

Most countries suffer at least one quarter of negative growth as consumers cut back on spending.

Weak demand keeps inflation under control. The Eurozone debt crisis represents a threat to global

growth. Stagflation: Second Alternative Scenario Probability: 10%

Loose monetary policy boosts commodity prices without helping the economy, setting an inflationary process in mo-tion.

The combination of rising price levels and weak growth prospects poses significant challenges to most financial as-sets.

Strong recovery: Third Alternative Scenario Probability: 5%

High profit margins and low interest rates encourage as surge in investment spending.

Improvements in the labor market and in credit conditions allow a more dynamic consumer recovery.

Brian Rose, PhD, Strategist, UBS FS Inc. Stephen R. Freedman, PhD, CFA, Strategist, UBS FS Inc.

Moderate recovery

Renewed downturn

Stagflation

Strong recovery

Source: UBS WMR

Economic Outlook


No recession in hard data as of yet

The verdict on whether the US economy is sliding into re-cession or bouncing back from anemic growth in the firsthalf of the year is still out. The most recent survey-based sentiment data deteriorated, but hard data do not showany substantial negative spill-over from weaker sentiment yet. We continue to expect a rebound in growth, but haveincreased our recession probability and see more downsiderisk to our current growth forecasts than in July. Recession risk has increased On balance, July growth data was stronger than over theMay/June period. Labor market conditions improved, industrialproduction rebounded as Japan-related supply disruptions dissi-pated, consumption growth recovered and businesses continuedto invest at a moderate pace. However, the most recent survey-based sentiment data for August paints a dire picture. Leadingthe deterioration in sentiment are the regional Philadelphia Fedmanufacturing climate index and the University of Michigan con-sumer sentiment index. The former plunged to -30.7, a level that in the past has always been consistent with an economy-wide recession. The latter fell from 63.7 in July to 55.7 in August, a bigback-to-back plunge from 71.5 in June. The August level is com-parable with levels not experienced since the Great Recession in2008 and 2009. At face value consumer expectations suggestbasically flat growth in real consumption. Other regional manu-facturing climate indexes have deteriorated as well but much lessthan the Philly Fed index. To reflect this precipitous drop in senti-ment, we have raised our recession probability from 20% to30%. Sticking to growth rebound forecast, but downside riskshave risen In contrast to the substantial further weakening in sentimentdata, hard data in the form of initial jobless claims and weeklyretail sales indexes have held up fairly well. Initial jobless claims,continued to trend sideways through the week ended 20 August, with the Verizon strike distorting them slightly higher. Excluding the Verizon-induced layoffs, initial claims have hovered slightlyabove 400,000 since late July. Weekly retail sales indexes have deteriorated in August, but do not show weakness that would be consistent with US consumer spending rolling over. Having saidthat, the weekly retail sales indexes will have to find a bottomsoon in order to continue to be consistent with our forecast for arebound in real consumption in 3Q11. July real consumer spend-ing growth was solid 0.5% m/m and gives the third quarter a solid start. But if consumer sentiment and weekly retail sales in-

Table 2: Growth and inflation forecasts in % GDP Growth Inflation '10 F '11 F '12 F '10 F '11 F '12 F World 4.3 3.3 3.3 2.9 3.6 2.9 US 3.0 1.8 2.3 1.6 2.9 1.8 Canada 3.2 2.9 2.3 1.8 2.7 2.2 Japan 4.0 -0.4 2.9 -1.0 -0.3 -0.2 Eurozone 1.7 1.8 1.0 1.6 2.5 1.8 UK 1.4 1.1 1.5 3.3 4.5 2.9 China 10.3 9.0 8.3 3.3 5.1 3.5 India 8.5 7.2 7.8 12.1 7.4 6.8 Russia 4.0 4.8 4.5 6.8 9.6 7.7 Brazil 7.5 3.1 3.6 5.9 6.3 5.4 Emerging Asia 8.7 6.7 6.5 4.9 5.1 4.0

F: forecast. Source: UBS WMR, as of 29 August 2011 In developing the forecasts set forth above, WMR economists worked in collaboration with economists employed by UBS Invest-ment Research (INV). INV is published by UBS Investment Bank. Forecasts and estimates are current only as of the date of this publi-cation and may change without notice.

Fig. 8: Data has been weaker than expected Citi economic surprise indexes

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Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11US Eurozone Emerging markets Japan

Source: Citi, Bloomberg, UBS WMR, as of 31 August 2011

Fig. 9: Consumer sentiment deteriorates further Consumer sentiment (index) and real consumption (y/y in %)

(4) (2)

024

68

Aug-98 Aug-01 Aug-04 Aug-07 Aug-10

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Real consumption (lhs)University of Michigan consumer expectations (rhs)Conference Board consumer expectations (rhs)


Economic Outlook


dexes don’t recover soon, this could change rather quickly. Wecontinue to forecast real GDP growth of 2.5% q/q annualized in 3Q11, followed by 2% in 4Q11, after an anemic 1% in 2Q11.However, we think that the risk to our forecasts lies mainly on the downside. Fed on hold for longer, with higher threshold for QE3 At its 9 August meeting the FOMC lengthened the time horizon it thought that economic conditions would likely warrant keepingits fed funds rate at an exceptionally low rate from “an extendedperiod” to “at least through mid-2013”. In doing so it effectivelypriced out of markets any rate hike expectations before July 2013. However, since core CPI inflation has been on the rise since early2011, there is a high threshold for adopting further monetarystimulus on top of this change in language. In our view, theeconomy would have to show recessionary tendencies in order for the FOMC to become relaxed about inflation and ready to sup-port growth with further stimulus. This is not our base case. Eurozone takes a turn for the worse Recent economic data from the Eurozone has been weak, leadingus to slash our 2012 GDP growth forecast from 2% to 1%. GDPexpanded by just 0.2% quarter-on-quarter in 2Q11, and with thecomposite PMI barely above 50 in July and August, 3Q11 isunlikely to be much better. Politicians have been unable to getahead of the curve in dealing with the sovereign debt crisis, andthe entire financial system is showing signs of strain. Sentimenthas plunged rapidly, and with fiscal policy being tightened inmost countries, there is a real danger that the Eurozone will fallback into recession. Japan: another year, another prime minister About the only country showing better than expected economicdata recently is Japan, which continues to recover from the devas-tating earthquake and tsunami in March. Reconstruction spend-ing should provide a boost going forward, helping to offset thenegative impact of the strong yen. However, long-run prospects are poor. Unstable politics (the prime minister was just replacedfor the sixth time in the last 5 years), huge government debt levelsand rapid population aging is likely to constrain growth in theyears ahead. Thomas Berner, CFA, Economist, UBS FS Inc. Brian Rose, PhD, Strategist, UBS FS Inc.

Fig. 10: Business climate points to about 0.5% growth ISM all-economy index and real GDP growth

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Real GDP (q/q annualized, lhs) Real GDP (y/y, lhs)ISM all-economy index (rhs)

Note: The ISM all-economy index gives weights to manufacturing (11%) and non-manufacturing (89%) according to their respective share in overall GDP.


Fig. 11: Eurozone has slowed in recent months Eurozone Purchasing Manager Indexes (PMI)

30

35

40

45

50

55

60

65

2006 2007 2008 2009 2010 2011Composite Manufacturing Non-manufacturing


International Markets


Reduce exposure to Eurozone risk

Within global equities we favor an overweight position onthe US, Emerging Markets, and the UK. Our largest under-weight is in the Eurozone, and we are also underweight Ja-pan and other non-US developed markets. While Eurozoneequities are trading on attractive valuations after their re-cent underperformance, the ongoing sovereign debt crisisand stress in the financial system raises red flags. Within in-ternational fixed income we view US and non-US bonds as equally attractive. While the dollar is extremely weakagainst many other currencies, prospects for a rebound ap-pear limited due to the Fed’s loose monetary policy. US equities relatively expensive but carry less risk Comparing price-earnings ratios across regions, the US now ap-pears to be one of the most expensive markets (see Fig. 13). How-ever, there are some factors which favor the US versus non-US equities. One is the solid earnings achieved by US companies sofar this year despite the soft economic backdrop. Another consid-eration is that the dollar has sunk to record or near-record levels against many currencies. This makes other markets seem more expensive in dollar terms, and raises the risk of exchange ratelosses should the dollar rebound to more normal levels. In our view, for dollar-based investors, US equities look relatively attrac-tive to non-US equities on a risk-adjusted basis. Overweight Emerging Markets and UK equities We maintain an overweight recommendation on both emergingmarkets (EM) and the UK, which share several positive characteris-tics. Given the political problems being caused by governmentdebt in the US and Eurozone, the relatively healthy state of publicfinances in EM is an advantage. While the UK has higher debtlevels, it has already passed austerity measures that should help torestrain debt issuance in the medium term. EM and the UK alsolook relatively good in terms of exchange rates versus the dollar.Intervention has helped to hold down the value of many emerg-ing market currencies, while the pound appears to have relatively little downside risk against the dollar. Both EM and the UK trade at a substantial valuation discount to global equity markets. Anadditional positive for the UK is its dividend yield of more than3%, which is attractive relative to the low yields being offered inbond markets. Underweight other non-US developed equity markets We maintain an underweight recommendation on the Eurozone, Japan, and “other” developed markets (“other” includes Austra-lia, Canada, and Switzerland).

Fig. 12: Equity regions Tactical deviations from benchmark, incl. view on currency.

US

Emerging Markets

UK

Japan

Other Developed

Eurozone

+ ++ +++–– –– – – nunderweight overweight

Source: UBS WMR, as of 31 August 2011. Scale explained in Ap-pendix.

Fig. 13: Regional equity PE ratios below normal 12-month forward Price-Earnings Ratios

10.99.4

11.612.510.611.9

9.08.510.111.8

0

5

10

15

US

Non-U

S dev

Euroz

one UK

Japan

Austral

ia

Canad

a

Switz

erlan

dEM

World

20

Current PE Average PE (since 1990) Note: For Japan, average PE since 1990 is 30.

Source: Datastream, IBES, UBS WMR, as of 30 August 2011

Fig. 14: Eurozone equities have slumped in 3Q Equity market returns, in USD and percent

-25 -20 -15 -10 -5 0

Switzerland

Australia

Canada

UK

Japan

Eurozone

US

World

Year-to-date Quarter-to-date Source: Bloomberg, UBS WMR, as of 30 August 2011

International Markets


While the Eurozone trades on valuations that seem very attractive, the ongoing sovereign debt crisis represents a tail risk that is toolarge to ignore. Even if there is not a full-blown catastrophe caused by an uncontrolled default in peripheral Europe, the con-stant threat of negative headlines in the months and years aheadmay continue to weigh on the market. Therefore in our 19 Au-gust update we made the Eurozone our largest underweight posi-tion. In Japan, the recovery from the devastating earthquake in Marchhas been quicker than the market expected, making it one of the few countries offering positive economic surprises. This has helped Japanese equities fall by less than most other markets dur-ing the recent downturn. The market is also trading well below itshistorical valuations. However, it still looks expensive relative to other markets. Japan has severe public debt challenges of its own, and has the least growth potential among the major markets. Wetherefore maintain an underweight position. Among the other developed equity markets, we see relativelypoor investment prospects. Canadian valuations appear expen-sive. Both Australia and Switzerland have severely overvalued cur-rencies which add substantial risk for dollar-based investors. We continue to recommend an underweight position in these mar-kets. Limited opportunities in international Fixed Income Within fixed income we remain neutral on the US versus non-US. Although US fixed income yields are at historically low levels, we do not see much better value in international markets, where yields are also generally lower than normal. Dollar fundamentals remain poor. The US is running twin current account and budget deficits, and the Fed is likely to keep rates near zero for at leastanother 2 years. However, we see limited room for the dollar to weaken further from its current low levels against most other cur-rencies. One exception is the pound, which appears reasonably priced against the dollar, and we recommend an overweight on the UK. Japan is one of our least favorite bond markets, offering the combination of extremely low yields, extremely poor publicfinances and an over-valued currency. We have also moved to anunderweight on Eurozone fixed income, favoring the non-euro countries in Europe that have relatively strong fundamentals. Brian Rose, PhD, Strategist, UBS FS Inc. Stephen R. Freedman, PhD, CFA, Strategist, UBS FS Inc.

Fig. 15: Pound not expensive versus US dollar Real effective exchange rates, index 2000 = 100

60

80

100

120

2000 2002 2004 2006 2008 2010

140

160

180

US dollar British pound Swiss Franc Australian dollar Source: JPMorgan, Bloomberg, UBS WMR, as of 31 August 2011

Fig. 16: Bond regions Tactical deviations from benchmark, incl. view on currency.

UK

Other

US

Eurozone

Japan

+ ++ +++–– –– – – n

underweight overweight

Note: Arrows indicate changes adopted in this report. Source: UBS WMR, as of 31 August 2011. Scale explained in Ap-pendix. See appendix for detailed asset allocations. See explanations in the Appendix regarding the interpretation of the suggested tactical deviations and the procedure for combining asset class and country allocations.

US Equities: Size, style and REITs


Downgrading cyclical risk

Decelerating earnings growth and rising economic risks ar-gue for greater exposure to secular, rather than cyclicalgrowth segments. Despite the strong relative outperfor-mance by defensive sectors in August, higher dividendyields and lower earnings risk is increasingly appealing in the current market environment. A balancing act – upgrading high dividend payers With the Fed likely to keep short-term interest rates pinned nearzero for the next two years, higher yielding, lower risk segmentsof the equity market are increasingly attractive due to their rela-tive yield advantages to fixed income alternatives. Regulated utili-ties offer dividend yields ranging from 3-5% and steady, predict-able earnings. Telecom's high dividend yields also hold appeal, however, payout ratios for the largest telecom companies (which dominate the index) are fairly high, implying limited future divi-dend growth. Our prior underweights in these sectors were predi-cated on both an expectation for higher interest rates, whichclearly did not develop, and expensive valuations. As such, weupgrade Utilities to neutral from underweight and reduce ourunderweight in Telecom to 1 percentage point from 2.5 previ-ously. Still prefer Consumer Staples among defensives We continue to favor Consumer Staples among defensives. Con-sumer Staples offer attractive dividend yields and a healthy com-bination of earnings and dividend growth via strong brands andemerging market consumer exposure. We downgrade Healthcare to neutral. While Healthcare is the cheapest defensive sector, we have less conviction in the sector’s near-term performance givenuncertainty over potential government spending cuts—the Budget Control Act would trigger automatic 2% across-the-board cuts to Medicare should the new Joint Select Committee notreach an agreement to reduce the deficit by $1.5 trillion. Still like Tech, but downgrading Materials and Financials Tech remains unchanged as our most preferred sector, but we arereducing Materials to underweight from neutral due to slowerprojected global economic growth, lower commodity price fore-casts and poor recent earnings revision trends. We also move allsub-sectors within Financials to neutral. Despite very low valua-tions, elevated signs of stress in European (and to a lesser degree in US) funding markets, lower economic growth and high earn-ings risk make a recovery in this beaten-down sector less likely. Jeremy Zirin, CFA, Strategist, UBS FS Inc.

Fig. 17: Tech and Consumer Staples offer best secular growth Tactical deviations from benchmark

Cons DiscretionaryMaterialsTelecomUtilities

+ ++ ++–– –– – – nunderweight overweight

EnergyIndustrialsFinancials

HealthCareConsumer Staples

Technology

Note: Arrows indicate changes adopted in this report. Source: UBS WMR, as of 31 August 2011. See explanations in the Appendix regarding the interpretation of the suggested tactical deviations from benchmark.

Fig. 18: Defensive sectors receive a boost from Chairman Bernanke Current dividend yield by S&P 500 sector and 10-year Treasury yield

5.5%4.3%

3.0%2.4% 2.2% 2.2% 2.1% 2.1% 1.7%

1.1%

0%1%2%3%4%5%6%

Tele

com

Utilit

ies

Cons

umer

Stap

les

Indu

stria

ls

Heal

th C

are

10-y

ear b

ond

S&P

500

Mat

eria

ls

Cons

umer

Disc

retio

nary

Tec

hnol

ogy

Defensives Cyclicals

Source: FactSet and UBS WMR, as of 29 August 2011

US Equities: Size & Style, REITs


Growth stocks still offer the best value

We remain strongly in favor of growth over value stocks.Weaker economic growth and lower stock market return expectations led us to downgrade small- and mid-caps back to neutral on August 19. We also raised REITs to neutral at that time as interest rates are now likely to be “lower forlonger”, supporting REIT’s high current valuations. A neutral stance between large, mid and small Within US equities, we closed our preference for small-caps over large-caps on August 19. Despite fairly high valuations relative tolarge-caps, our preference for small- and mid-cap companies was based on our view that smaller companies stood to benefit more from both a pickup in domestic economic activity and to overallstock market movements, i.e. to outperform in rising and under-perform in falling markets. Acknowledging a more mixed outlook for both economic growth and equity markets, we believe a neu-tral stance is currently warranted. We would caution against be-coming overly bearish on smaller size segments. Small- and mid-caps should still benefit from improvements in M&A activity aslarger companies with strong balance sheets look to “buy growth” rather than expand capacity in a slower growth world. Growth over value remains a high conviction call As market turbulence has increased, so has the strong relativeperformance of growth stocks over value stocks. One reason forthe stronger relative performance is due to sector tilts. Specifi-cally, Technology stocks (growth) have outperformed Financials(value) by over 6 percentage points since the end of the secondquarter. More broadly, a slow growth and low interest rate envi-ronment is an attractive cocktail for growth stocks. Slowing cycli-cal growth increases the scarcity value of secular growers whilelow interest rates means that longer duration cash flows are dis-counted back at lower rates, increasing their value. With growth stocks trading at a very small valuation premium to value relativeto history, we remain overweight growth. Lower for longer interest rates a big plus for REITs On August 19, we also decided to remove our moderate under-weight to REITs. The Federal Reserve’s “pledge” to leave the fed-eral funds rate at its current low target level thorough mid-2013 is positive for the interest-rate sensitive REIT industry. Large-cap, higher quality REITs should benefit from both lower funding costs(boosting capitalization rates) and from additional fund flowsfrom investors seeking high relative dividend yields. Jeremy Zirin, CFA, Strategist, UBS FS Inc.

Fig. 19: We continue to prefer Growth over Value Size, style, and REITs recommended allocation, deviation from benchmark

Large-Cap Value

REITs

Mid-Cap

+ ++ ++–– –– – – nunderweight overweight

Small-Cap

Large-Cap Growth

Note: Arrows indicate changes adopted in this report.

Source: UBS WMR, as of 31 August 2011.

See explanations in the Appendix regarding the interpretation of the suggested tactical deviations from benchmark.

Fig. 20: Technology to continue to drive growth Relative performance of Russell 1000 Growth vs. Russell 1000 Value and S&P Tech vs. S&P Financials

60

80

100

120

140

160

180

1993 1997 2001 2005 2009 2013

-100

0

100

200

300

400

500

Growth vs. Value (lhs) IT vs. Fin (rhs)

Source: Bloomberg, Russell Investment Group and UBS WMR, as of 29 August, 2011

US Fixed Income


Reconfiguring the playbook

Economic growth has slowed to stall speed, raising the pos-sibility of recession. At the same time, the sovereign debtcrisis is negatively affecting perceptions of the credit qual-ity of European banks. Against this challenging backdrop,we believe a less aggressive position is in order when it comes to credit-sensitive sectors. Within credit, we recom-mend pairing back exposure to dollar denominated sover-eign debt in the emerging markets. We also maintain a neutral allocation to high yield and preferreds, which arehigh beta credit sectors. Throughout much of this year, our fixed income recommenda-tions have largely favored corporate credit, including investment grade (IG) and high yield (HY) corporate bonds that we believedwould likely continue to deliver positive excess returns over Treas-uries in most scenarios. One scenario where corporate creditcould underperform would be if market events were to sparkstrong selling across all risk assets. Although this was not our basecase outlook, this was exactly what transpired in August as a clas-sic credit market selloff ensued. The reaction from the credit segments of the bond market waslargely a reflection of the degree of credit risk each sector exhib-its. In the IG market, credit spreads, as measured by the Barclay’s Corporate Index, widened from 150 basis points (bps) to 215bps, an enormous move for IG. The widening was led by Financials, which gapped out by nearly 100bps, while Industrials and Utilitieswere roughly 45bps and 35bps wider, respectively. However,lower Treasury yields helped to cushion the blow and yields on IGmoved only modestly higher. The yield-to-worst (YTW) of the in-dex increased from 3.5% to 3.7% and IG total returns weremostly flat for the month. We continue to believe that the direction of IG credit spreads willlargely be a function of moves in rates and that spreads will re-main at the wider end of recent ranges should lower Treasury rates persist, as we expect. Nonetheless, at current spread levels,we believe IG valuations are attractive. Spreads remain well abovetheir pre-crisis average of 130bps despite the strong fundamentalshape of the corporate sector. We therefore increase our IG tac-tical weighting from +1% to +2% this month, making it our larg-est credit segment overweight. We believe IG offers the best up-side/downside qualities in different possible market environments.Should the economy turn out weaker then we expect, any widen-ing of IG spreads will likely be lower than what HY, EM and preferreds may experience. However, should the economy mud-

Fig. 22: US interest rate forecasts, in %

30-Aug. in 3 months in 6

months in 12

months

3-month LIBOR 0.33 0.30 0.30 0.30

2-year Treasury 0.19 0.30 0.50 0.60

5-year Treasury 0.92 1.00 1.55 1.80

10-year Treasury 2.18 2.30 2.75 3.00

30-year Treasury 3.52 3.80 4.05 4.30 Source: Bloomberg, UBS WMR, as of 30 August 2011

Fig. 21: US dollar taxable fixed income (TFI) strat-egy Tactical deviations from benchmark

Treasuries

TIPS

Agencies

Mortgages

Inv. Grade Corporates

High Yield Corporates

Preferred Securities

Emerg. Market

TFI non-Credit

TFI Credit

+ ++ +++–– – n

underweight overweight

– – –

Note: Arrows indicate changes adopted in this report. Source: UBS WMR, as of 31 August 2011. Scale explained in Ap-pendix. See the appendix for a detailed asset allocation illustration in the context of a moderate-risk taxable US dollar fixed income portfolio. See explanations in the Appendix regarding the interpreta-tion of the suggested tactical deviations from benchmark.

US Fixed Income


dle through and investor risk taking resume, we believe IG willalso likely perform well on a relative basis. Moving down into riskier credit sectors, we observed much higherspread volatility in HY and preferreds. HY spreads gapped from540bps at the beginning of August to 736bps and the YTW ofthe Barclay’s HY Index increased from 7.15% to 8.8%. Preferreds exhibited a similar trend as thin trading conditions and investorrisk aversion towards Financials contributed to a highly volatileand choppy trading environment as the sector exhibited intra-month price swings of nearly 10%. After being overweight HY and Preferreds since the beginning ofthe year, we moved to a neutral allocation on 19 August to re-flect WMR’s more cautious view on risk assets stemming from continued financial stress in the Eurozone and higher risk of a USrecession. Valuations of HY bond spreads are attractive relative tothe low level of forecasted corporate default rates over the nextyear. However, we believe economic uncertainty will keep HY spreads elevated in the near-term and we continue to observe a very high correlation between HY spreads and equities. Similarly,we believe the heightened focus on US and European banks’ sov-ereign exposures and funding availability will continue to cause avolatile trading environment for preferreds that will resemble eq-uity-like price swings. Adopt a neutral allocation to emerging markets Finally, this month we also reduce our EM allocation to neutralfrom +1%. We established an overweight position last monthbased on the improving fundamentals of many EM sovereigns,which we believe could lead to positive ratings actions relative todeveloped markets. While our positive fundamental view on EMhasn’t changed, we don’t expect EM to perform as well as it didin August should risk aversion pick-up again. Despite relativelystrong fundamentals in most emerging market countries, manag-ers of foreign bond funds have reported USD 506 million in out-flows over the last four weeks, as investors continue to shun risk-ier asset classes. Although supply is expected to be limited (the consensus view is for negative net sovereign bond issuance through year end), we are concerned about the lack of a crediblesolution to Europe’s ongoing debt crisis. We see significant po-tential for additional negative spillover effect to lower rated cred-its, and note that approximately 50% of the countries in mostbroadly followed emerging market indices are rated below in-vestment grade. Economic growth in emerging market countriesis likely to outstrip that of developed market countries, but wedoubt this will matter to risk adverse investors.


Fig. 23: TIPS cumulative excess returns are influ-enced by the direction of breakeven inflation Excess return on TIPS versus nominal Treasuries, in %

-1.00

0.00

1.00

2.00

Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11

2.0

2.1

2.2

2.3

2.43.00

4.00

5.00

2.5

2.6

2.7

Tips excess return vs Treasuries (left) 10-yr breakeven rate (right) Source: BofAML, Bloomberg, UBS WMR, as of 29 August 2011

Fig. 24: Duration recommendation Duration deviation from benchmark, in years

-1.5 -1.0 -0.5 +0.0 +0.5 +1.0 +1.5

previousnew

neutral longshort Source: UBS WMR, as of 31 August 2011

Fig. 25: Preferred price change year-to-date In %

-20

-15

-10

-5

0

5

10

Dec-31 Jan-31 Feb-28 Mar-31 Apr-30 May-31 Jun-30 Jul-31 Aug-31

REIT Preferreds Trust Preferreds Non-US QDI

DRD-Eligible Floating-Rate

US Fixed Income


Slower growth, sovereign debt fears should anchor yields On 16 August, we lowered our Treasury yield forecasts. The change was predicated on several developments. First, the FOMCindicated at the 9 August meeting that it intends to hold the tar-get fed funds rate at zero to 25bps until mid-2013. We believe this policy change will shift the interest rate path downward and will keep Treasury yields lower for longer. In addition, the softpatch in the first half looks to be more persistent than we origi-nally believed, as the recent batch of economic data suggest. As aresult, we believe the odds of recession have increased. Finally,we view the ongoing Eurozone sovereign debt crisis with concern.The inability of the political establishment to tackle the debt crisishas eroded investor confidence and contagion appears to bespreading. Thus, the Treasury market should continue to benefitfrom flight-to-quality flows during periods when the sovereigndebt concerns flair. Against this backdrop, we continue to rec-ommend investors maintain a neutral duration allocation. Sharp Treasury gains send M/T ratios higher Earlier this month, exceedingly strong out-performance of Treas-ury securities drove AAA muni-to-Treasury (M/T) ratios to levelsover 110% all along the curve. At these levels, municipals wereattractive enough to draw crossover buyers. On 9 August, ratiosat the 5-year, 10-year and 30-year maturity points stood at114.9%, 113.3% and 112.3%, respectively, before movinglower. A sharp change in Treasury yields—and not municipal yields—was the key driver behind volatility in the ratios. Although absolute muni yields are now at historic lows at most segments ofthe curve, we believe munis offer value on a relative basis toTreasuries. Presently, AAA tax-exempt muni yields are still at orabove 100% all along the curve, with the exception of the 5-year spot, which stands at 93.8%, while the 10-year and 30-year ratio stands at 103.6% and 109.6% respectively. We look for new is-sue volume to increase modestly in the fourth quarter, pressuringyields slightly higher as is consistent with historical trends and when there is a rise in supply. That said, we are not looking for arepeat of the sharp rise in yields that occurred in the last threemonths of 2010, which was due in large part to a surge in supply.Any sell-off in the Treasury bond market would likely negativelyimpact municipal bond values but the continued outlook for sloweconomic growth, increased recession risk and the Eurozone debtcrisis should lend a flight-to-quality bid and temper a material risein Treasury rates. Anne Briglia, CFA, Strategist, UBS FS Inc. Barry McAlinden, CFA, Strategist, UBS FS Inc. Kathleen McNamara, CFA, CFP, Strategist, UBS FS Inc. Donald McLauchlan, Credit Analyst, UBS FS Inc.

Fig. 26: Financials sector bonds trade at a discount to Industrials Credit spreads, in basis points

0100200300400

2006 2007 2008 2009 2010 2011

500600700800

Industrials Financials Source: Barclays Capital, UBS WMR, as of 26 August 2011

Fig. 27: EM spread differentials edging wider Credit spreads, EM debt and similarly rated US corporates, in basis points

0

200

400

600

2001 2004 2007 2010

800

1,000

1,200

All EM EM IG IG corporates Note: IG= Investment Grade Source: Barclays Capital, as of 29 August 2011

Fig. 28: Municipal Yields and Ratio to Treasury Yield in %

2

3

4

5

6

Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11

Yiel

d

80

90

100

110

120

Ratio

AAA GO 10 yr YieldsAAA GO 30yr YieldsYield Ratio 10yr AAA GO to TreasuryYield Ratio 30yr AAA GO to Treasury

Note: GO stands for General Obligation Source: MMD, UBS WMR, as of 25 August 2011

Chartbook

Financial Market Performance Fig. A1: Asset Classes Total Return in USD and %


-6.0%

-8.8%

-13.2%

5.4%

9.4%

0.1%

-2.4%

-11.6%

-13.2%

-14.1%

2.6%

3.6%

0.0%

0.2%

-20% -15% -10% -5% 0% 5% 10% 15%

US Equities

Non-US Dev. Equities

EM Equities

US Fixed Income

Non-US Fixed Income

Cash (USD)

Commodities

year-to-date quarter-to-date

Source: Bloomberg and UBS WMR, as of 30 August 2011

Fig. A2: International Equity Total Return in USD and %

-6.0%

-8.8%

-10.6%

-4.8%

-13.0%

-13.2%

-11.6%

-13.2%

-21.1%

-9.8%

-8.7%

-14.1%

-25% -20% -15% -10% -5% 0%

US Equity

Non-US Developed

EMU

UK

Japan

Emerging Markets



Fig. A3: International Fixed Income Total Return in USD and %

5.4%

9.4%

10.6%

12.2%

6.9%

2.6%

3.6%

1.8%

7.1%

6.0%

0% 5% 10% 15%

US Fixed Income

Non-US Fixed Income

EMU

UK

Japan



Fig. A4: US Equity Total Return in USD and %

-7.3%

-3.7%

-5.5%

-7.6%

-11.0%

0.8%

-12.4%

-9.9%

-11.2%

-14.6%

-16.2%

-8.3%

-20% -15% -10% -5% 0% 5%

Large Cap Value

Large Cap Growth

Large Cap

Mid Cap

Small Cap

REITs



Fig. A5: US Fixed Income Total Return in USD and %

7.3%11.7%

4.2%

5.8%

1.3%

4.8%

5.1%

6.9%

7.5%

4.9%

5.6%

2.4%

2.4%

-3.4%

-0.6%

2.2%

1.9%

2.6%

-5% 0% 5% 10% 15%

TreasuriesTIPS

AgenciesIG Corporates

HY CorporatesPreferreds

MortgagesEM Sovereigns

Municipal bonds


Source: BoAML, UBS WMR, as of 30 August 2011

Fig. A6: Currencies Appreciation vs. USD in %

7.7%

4.9%

5.4%

1.1%

17.5%

2.4%

2.9%

-0.6%

2.0%

4.6%

-2.4%

5.6%

-2.3%

-3.1%

-5% 0% 5% 10% 15% 20%

EUR

GBP

JPY

CAD

CHF

AUD

BRL



Chartbook

Economic Outlook and Asset Classes Fig. A7: Growth should improve in second half of 2011 US GDP growth and component contributions, annualized change in %


-10%

-5%

0%

5%

10%

Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011Consumption Commercial real estate investmentCapital expenditures Residential investmentInventories Net ExportsGovernment Real GDP (q/q annualized)

q/q annualizedUBS forecast

Source: Bloomberg and UBS, as of 30 August 2011

Fig. A8: Leading indicators have rolled over Global leading indexes, August 2007 = 100

85

90

95

100

105

Aug-07

Dec-07

Apr-08

Aug-08

Dec-08

Apr-09

Aug-09

Dec-09

Apr-10

Aug-10

Dec-10

Apr-11

UBS WMR Index OECD Index

Source: JP Morgan, Bloomberg, and UBS WMR, as of 30 August 2011

Fig. A9: Slower growth may ease inflationary pressure Core CPI, year-on-year change in %

(3)

(2)

(1)

0

1

2

3

4

2005 2006 2007 2008 2009 2010 2011US EMU Japan UK China


Fig. A10: Low yields make bonds less attractive 10-year government bond yield, in %

0

1

2

3

4

5

Jan-10 May-10 Sep-10 Jan-11 May-11US Germany UK Japan


Fig. A11: US dollar weak against most currencies Exchange rates, higher figures reflect weaker US dollar

0.60.70.80.91.01.11.21.31.4

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

AUD/USD CAD/USD CHF/USD


Fig. A12: Asset Classes and Regional Preferences Tactical Deviations from Benchmark

US Equity

Non-US Developed Eq.

Emerging Market Eq.

US Fixed Income

Non-US Fixed Income

Cash (USD)

Commodities

+ ++ +++–– –– – – nunderweight overweight

Source: UBS WMR, as of 31 Aug. 2011. See explanations in the Appendix re-garding the interpretation of the suggested tactical deviations from benchmark.

Chartbook

US Equities Fig. A13: Defensive sectors outperforming recently Relative performance of cyclicals versus defensives, market-cap weighted

50

75

100

125

150

175

200

1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013


Note: Cyclical sectors: Materials, Industrials, Technology and Consumer Discre-tionary. Defensive sectors: Utilities, Telecommunications Services, Consumer Staples and Health Care. Higher figures indicate cyclical outperformance.

Source: DataStream and UBS WMR, as of 29 August 2011

Fig. A14: S&P 500 P/E may recover slowly S&P 500 P/E on consensus forward earnings

9

10

11

12

13

14

15

16

2007 2008 2009 2010 2011 2012 2013S&P 500 P/E Average (2007-11)

XX

Note: Each "X" represents our target P/E multiple on forward earnings.

Source: FactSet and UBS WMR, as of 29 August 2011

1

Fig. A15: Weak growth keeps P/E low relative to history S&P 500 P/E (trailing) and predicted P/E based on trailing 5-year annual-ized growth of S&P 500 EPS, lagged 2 years

5x

10x

15x

20x

25x

30x

1985 1990 1995 2000 2005 2010 2015S&P 500 P/E (trailing) Predicted P/E +/- 1 std dev

Source: Factset and UBS WMR, as of 29 August 2011

Fig. A16: Growth rallying versus value Russell 1000 Growth relative to Value, 2011 year-to-date

95

100

105

110

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Growth relative to Value


Fig. A17: Growth stocks continue to be underpriced Relative valuation - growth vs. value, since 1979

0%

50%

100%

150%

200%

P/E Trailing Price to Book Price to Sales P/E Forward (1yr)

Current Long-Term Average Long-Term Average ex Tech Bubble

Source: DataStream, Russell Investment Group, UBS WMR, as of 26 Aug. 2011

Fig. A18: REIT yield versus bonds increasingly attractive REITs dividend yield relative to 10-year treasury bond yield

0%

100%

200%

300%

400%

500%

1993 1998 2003 2008 2013

REITs dividend yield relative to 10-year treasury bond yieldAverage

Source: Datastream and UBS WMR, as of 29 August, 2011

Chartbook

US Fixed Income Fig. A19: Treasury yields to rise gradually Rate development and UBS WMR forecast, in %


0

1

2

3

4

5

6

7

Aug-00 Aug-02 Aug-04 Aug-06 Aug-08 Aug-10 Aug-122-year Treasury note 10-year Treasury note

Source Bloomberg, UBS WMR, as of 26 August 2011

Fig. A20: The yield curve should remain steep 10-year minus 2-year Treasury yield, and WMR forecast, in basis points

-50

0

50

100

150

200

250

300

Aug-00 Aug-02 Aug-04 Aug-06 Aug-08 Aug-10 Aug-1210s/2s Curve


Fig. A21: IG and HY now trade above 10-year averages Credit spreads, in basis points

0

150

300

450

600

750

900

2001 2003 2005 2007 2009 2011

0

400

800

1200

1600

2000

IG (LHS) 10-yr Avg IG HY (RHS) 10-yr Avg HY

Source UBS WMR, Barclays Capital, as of 26 August 2011

Fig. A22: Declining default rate signals tighter HY spreads HY credit spreads, in basis points; default rates, in %

0%

3%

6%

9%

12%

15%

2011200920072005200320011999

0

400

800

1,200

1,600

2,000

Trailing 12-month default rate (2011 projected) Credit spread

Source: BAML, Moody's, UBS WMR, as of 26 August

Fig. A23: Ten-year TIPS breakeven inflation rates are above their 5-year historical average Breakeven yield, in %

-1

0

1

2

3

4

Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11

5-year breakeven 10-year breakeven 30-year breakeven


Fig. A24: AAA municipal yield curve change AAA bond yields by maturity, in %

0

1

2

3

4

5 10 15 20 25 308/27/10 8/29/11

Source: MMD Interactive, UBS WMR, as of 30 August 2011

Appendix


Detailed asset allocations with non-traditional assets (NTAs)

Investor Risk Profile1

Very conservative

Conservative

Moderate conservative

Moderate

Moderate aggressive

Aggressive

Very aggressive

All figures in %

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Traditional Assets

Equity 0.0 +0.0 0.0 19.0 +0.0 19.0 32.0 +0.0 32.0 44.0 +0.0 44.0 54.0 +0.0 54.0 62.0 +0.0 62.0 71.0 +0.0 71.0

US Equity 0.0 +0.0 0.0 14.0 +0.5 14.5 23.0 +1.5 24.5 32.0 +2.0 34.0 39.0 +2.5 41.5 44.0 +3.0 47.0 52.0 +4.0 56.0

Large Cap Value 0.0 +0.0 0.0 8.0 -0.5 7.5 8.0 -0.5 7.5 11.0 -1.0 10.0 11.0 -1.5 9.5 11.0 -1.5 9.5 13.0 -2.0 11.0

Large Cap Growth 0.0 +0.0 0.0 5.0 +1.0 6.0 8.0 +2.0 10.0 11.0 +3.0 14.0 11.0 +3.5 14.5 11.0 +4.0 15.0 13.0 +5.5 18.5

Mid Cap 0.0 +0.0 0.0 1.0 +0.0 1.0 4.0 +0.0 4.0 5.0 +0.0 5.0 9.0 +0.5 9.5 11.0 +0.5 11.5 13.0 +0.5 13.5

Small Cap 0.0 +0.0 0.0 0.0 +0.0 0.0 2.0 +0.0 2.0 3.0 +0.0 3.0 5.0 +0.0 5.0 7.0 +0.0 7.0 8.0 +0.0 8.0

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

Non-US Equity 0.0 +0.0 0.0 5.0 -0.5 4.5 9.0 -1.5 7.5 12.0 -2.0 10.0 15.0 -2.5 12.5 18.0 -3.0 15.0 19.0 -4.0 15.0

Developed 0.0 +0.0 0.0 5.0 -0.5 4.5 8.0 -3.0 5.0 10.0 -4.0 6.0 12.0 -5.0 7.0 14.0 -6.0 8.0 14.0 -7.5 6.5

Emerging Markets 0.0 +0.0 0.0 0.0 +0.0 0.0 1.0 +1.5 2.5 2.0 +2.0 4.0 3.0 +2.5 5.5 4.0 +3.0 7.0 5.0 +3.5 8.5

Fixed Income 81.0 +0.0 81.0 67.0 +0.0 67.0 51.0 +0.0 51.0 37.0 +0.0 37.0 24.0 +0.0 24.0 11.0 +0.0 11.0 0.0 +0.0 0.0

US Fixed Income 74.0 +0.0 74.0 59.0 +0.0 59.0 43.0 +0.0 43.0 29.0 +0.0 29.0 18.0 +0.0 18.0 9.0 +0.0 9.0 0.0 +0.0 0.0

Non-US Fixed Income 7.0 +0.0 7.0 8.0 +0.0 8.0 8.0 +0.0 8.0 8.0 +0.0 8.0 6.0 +0.0 6.0 2.0 +0.0 2.0 0.0 +0.0 0.0

Cash (USD) 10.0 +0.0 10.0 2.0 +0.0 2.0 2.0 +0.0 2.0 2.0 +0.0 2.0 2.0 +0.0 2.0 2.0 +0.0 2.0 2.0 +0.0 2.0

Non-traditional Assets 9.0 +0.0 9.0 12.0 +0.0 12.0 15.0 +0.0 15.0 17.0 +0.0 17.0 20.0 +0.0 20.0 25.0 +0.0 25.0 27.0 +0.0 27.0

Commodities 2.0 +0.0 2.0 3.0 +0.0 3.0 4.0 +0.0 4.0 5.0 +0.0 5.0 5.0 +0.0 5.0 6.0 +0.0 6.0 7.0 +0.0 7.0

Alternative Investments5 7.0 +0.0 7.0 9.0 +0.0 9.0 11.0 +0.0 11.0 12.0 +0.0 12.0 15.0 +0.0 15.0 19.0 +0.0 19.0 20.0 +0.0 20.0

“WMR tactical deviation” legend: Overweight Underweight Neutral Source: UBS WMR and Investment Solutions, as of 31 August 2011


Appendix


Detailed asset allocations without non-traditional assets (NTAs)

Investor Risk Profile1

Very conservative

Conservative

Moderate conservative

Moderate

Moderate aggressive

Aggressive

Very aggressive

All figures in %

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Equity 0.0 +0.0 0.0 22.0 +0.0 22.0 37.0 +0.0 37.0 52.0 +0.0 52.0 67.0 +0.0 67.0 83.0 +0.0 83.0 98.0 +0.0 98.0

US Equity 0.0 +0.0 0.0 16.0 +0.5 16.5 26.0 +1.5 27.5 37.0 +2.0 39.0 48.0 +2.5 50.5 59.0 +3.0 62.0 72.0 +4.0 76.0

Large Cap Value 0.0 +0.0 0.0 9.0 -0.5 8.5 9.0 -0.5 8.5 13.0 -1.0 12.0 14.0 -1.5 12.5 15.0 -1.5 13.5 18.0 -2.0 16.0

Large Cap Growth 0.0 +0.0 0.0 6.0 +1.0 7.0 9.0 +2.0 11.0 13.0 +3.0 16.0 14.0 +3.5 17.5 15.0 +4.0 19.0 18.0 +5.5 23.5

Mid Cap 0.0 +0.0 0.0 1.0 +0.0 1.0 4.0 +0.0 4.0 6.0 +0.0 6.0 11.0 +0.5 11.5 15.0 +0.5 15.5 18.0 +0.5 18.5

Small Cap 0.0 +0.0 0.0 0.0 +0.0 0.0 3.0 +0.0 3.0 3.0 +0.0 3.0 6.0 +0.0 6.0 9.0 +0.0 9.0 11.0 +0.0 11.0

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

Non-US Equity 0.0 +0.0 0.0 6.0 -0.5 5.5 11.0 -1.5 9.5 15.0 -2.0 13.0 19.0 -2.5 16.5 24.0 -3.0 21.0 26.0 -4.0 22.0

Developed 0.0 +0.0 0.0 6.0 -0.5 5.5 9.0 -3.0 6.0 13.0 -4.0 9.0 15.0 -5.0 10.0 18.0 -6.0 12.0 20.0 -7.5 12.5

Emerging Markets 0.0 +0.0 0.0 0.0 +0.0 0.0 2.0 +1.5 3.5 2.0 +2.0 4.0 4.0 +2.5 6.5 6.0 +3.0 9.0 6.0 +3.5 9.5

Fixed Income 90.0 +0.0 90.0 76.0 +0.0 76.0 61.0 +0.0 61.0 46.0 +0.0 46.0 31.0 +0.0 31.0 15.0 +0.0 15.0 0.0 +0.0 0.0

US Fixed Income 82.0 +0.0 82.0 67.0 +0.0 67.0 51.0 +0.0 51.0 36.0 +0.0 36.0 23.0 +0.0 23.0 12.0 +0.0 12.0 0.0 +0.0 0.0

Non-US Fixed Income

8.0 +0.0 8.0 9.0 +0.0 9.0 10.0 +0.0 10.0 10.0 +0.0 10.0 8.0 +0.0 8.0 3.0 +0.0 3.0 0.0 +0.0 0.0

Cash (USD) 10.0 +0.0 10.0 2.0 +0.0 2.0 2.0 +0.0 2.0 2.0 +0.0 2.0 2.0 +0.0 2.0 2.0 +0.0 2.0 2.0 +0.0 2.0

“WMR tactical deviation” legend: Overweight Underweight Neutral Source: UBS WMR and Investment Solutions, as of 31 August 2011


Appendix


Investment Committee

The Wealth Management Americas Investment Committee (WMA IC) is the primary decision making body within WM Ameri-cas for recommended asset allocations across investor risk profiles. As explained more fully below, the WMA IC vets the flag-ship tactical asset allocation recommendations which appear in this publication, the Investment Strategy Guide (ISG). TheWMA IC also reviews and approves (i) inputs relating to WM Americas’ strategic asset allocations, and (ii) other tactical asset allocation recommendations which may be developed for ultra high net worth and other specific client groups by businessareas other than WMRA. Composition The WMA IC currently has seven voting members, and two non-voting members. The voting members include:

Mike Ryan – Head of Wealth Management Research – Americas (WMRA); Stephen Freedman – WMRA Investment Strategy Head; Jeremy Zirin – WMRA Equities Head; Anne Briglia – WMRA Taxable Fixed Income Head; Tony Roth – Head of Wealth Management Strategies, within Wealth Management Advice and Platforms (*) Mihir Bhattacharya – Head of Strategic Projects and Services, Wealth Management Solutions (*) Thomas Troy – Head of Market Executions, Wealth Management Solutions (*)

(*) Business areas distinct from WMRA

The two non-voting members are employee of UBS Global Asset Management, an affiliate of UBS Financial Services Inc. They are:

John Dugenske – Global Fixed Income, Head of US Fixed Income; Andreas Koester – Global Investment Solutions, Head of Asset Allocation and Currency. Vetting of WMRA flagship TAA recommendations At least monthly, WMRA presents to the WMA IC for its review a flagship TAA proposal and supporting investment case for amoderate-risk profile investor. In order to be published in the ISG, the flagship TAA must be accepted by the WMA IC and besupported by a majority of the WMRA members. The flagship TAA recommendations across other risk profiles published inthe ISG are further calculated in accordance with a methodology approved by the WMA IC.

Appendix


Additional Asset Allocation Models

US Taxable Fixed Income Allocation, in %

WMR Tactical deviation2

Benchmark allocation1

Previous Current

Current allocation3

Treasuries 12.0 -1.0 -1.0 11.0 TIPS (Treasury inflation-protected securities) 5.0 -1.0 -1.0 4.0 Agencies 22.0 -1.0 -1.0 21.0 Mortgages 20.0 +1.0 +1.0 21.0 Investment grade corporates 22.0 +1.0 +2.0 24.0 High yield corporates 10.0 0.0 0.0 10.0 Preferred securities 4.0 0.0 0.0 4.0 Emerging Market sovereign bonds in US dollar 5.0 +1.0 0.0 5.0 Total TFI non-Credit 59.0 -2.0 -2.0 57.0 Total TFI Credit 41.0 +2.0 +2.0 43.0

Source: UBS WMR and Investment Solutions, as of 31 August 2011

Non-US Developed Equity Module, in %



Previous Current

Current allocation3

EMU / Eurozone 28.0 -20.0 -20.0 8.0 UK 19.0 +20.0 +20.0 39.0 Japan 18.0 +0.0 +0.0 18.0 Other 35.0 +0.0 +0.0 35.0

Source: UBS WMR and Investment Solutions, as of 31 August 2011

Non-US Fixed Income Module, in %



Previous Current

Current allocation3

EMU / Eurozone 43.0 +1.5 -10.0 33.0 UK 9.0 +16.0 +10.0 19.0 Japan 32.0 -29.0 -10.0 22.0 Other 16.0 +11.5 +10.0 26.0

Source: UBS WMR and Investment Solutions, as of 31 August 2011 1 The benchmark allocation refers to a moderate risk profile. See “Sources of Benchmark Allocations and Investor Risk Profiles” in the Appendix for an explanation regarding the source of benchmark allocations and their suitability. 2 See "Deviations from Benchmark Allocations" in the Appendix for an explanation regarding the interpretation of the suggested tactical deviations from benchmark. The “current” column refers to the tactical deviation that applies as of the date of this publication. The “previous” column refers to the tactical deviation that was in place at the date of the previous edition of the previous edition of Investment Strategy Guide or the last Investment Strategy Guide Update. 3 The current allocation column is the sum of the benchmark allocation and the WMR tactical deviation columns.

Appendix

Equity Industry Group Allocation

US equity industry group allocation (%)


Numeric Symbol S&P 500 Benchmark

allocation1 Previous Current Previous Current

Current allocation3

Consumer Discretionary 10.7 -2.0 -2.0 – – – – 8.7

Auto & Components 0.7 +1.0 +1.0 + + 1.7

Consumer Services 2.1 +0.0 +0.0 n n 2.1

Media 3.1 +0.0 -1.0 n – 2.1

Retailing 3.8 -2.0 -1.0 – – – 2.8

Consumer, Durables & Apparel 1.0 -1.0 -1.0 – – 0.0

Consumer Staples 11.4 +2.0 +2.0 ++ ++ 13.4

Food, Beverage & Tobacco 6.5 +0.5 +0.5 + + 7.0

Food & Staple Retailing 2.4 +0.5 +0.5 + + 2.9

Household & Personal Products 2.5 +1.0 +1.0 + + 3.5

Energy 12.4 +0.0 +0.0 n n 12.4

Financials 14.3 +1.0 +0.0 + n 14.3

Banks 2.6 +0.0 +0.0 n n 2.6

Diversified Financials 6.3 +1.0 +0.0 + n 6.3

Insurance 3.6 +1.0 +0.0 + n 3.6

Real Estate 1.8 -1.0 +0.0 – n 1.8

Health Care 11.8 +1.0 +0.0 + n 11.8

HC Equipment & Services 4.2 +1.0 +0.0 + n 4.2

Pharmaceuticals & Biotechnology 7.7 +0.0 +0.0 n n 7.7

Industrials 10.4 +0.0 +0.0 n n 10.4

Capital Goods 7.9 +0.0 +0.0 n n 7.9

Commercial Services & Supplies 0.6 +0.0 +0.0 n n 0.6

Transportation 1.9 +0.0 +0.0 n n 1.9

Information Technology 18.7 +3.0 +3.0 +++ +++ 21.7

Software & Services 9.2 +0.0 +0.0 n n 9.2

Technology Hardware & Equipment 7.2 +2.0 +2.0 ++ ++ 9.2

Semiconductors 2.3 +1.0 +1.0 + + 3.3

Materials 3.5 +0.0 -2.0 n – – 1.5

Telecom 3.1 -2.5 -1.0 – – – – 2.1

Utilities 3.7 -2.5 +0.0 – – – n 3.7

Source: UBS WMR, as of 31 August 2011.

The benchmark allocation, as well as the tactical deviations, are intended to be applicable to the US equity portion of a portfolio across investor risk profiles.

1 The benchmark allocation is based on S&P 500 weights. 2 See "Deviations from Benchmark Allocations" in the Appendix for an explanation regarding the interpretation of the suggested tactical deviations from benchmark. The “current” column refers to the tactical deviation that applies as of the date of this publication. The “previous” column refers to the tactical deviation that was in place at the date of the previous edition of the Investment Strategy Guide or the last Investment Strategy Guide Update. 3 The current allocation column is the sum of the S&P 500 benchmark allocation and the WMR tactical deviation columns.


Appendix

Alternative Investment (AI) Benchmark Allocation

All figures in % of total portfolio

Risk Profile

Very Conservative Conservative Moderate

Conservative Moderate Moderate Aggressive Aggressive Very

Aggressive

Tactical Trading 1.0 1.0 1.0 2.0 2.5 3.5 4.0

Relative Value 1.5 2.0 2.0 2.0 2.0 2.0 2.0

Credit Strategies 1.5 2.0 2.0 2.0 2.5 3.0 3.0

Event Driven 1.5 2.0 2.0 2.0 2.0 2.5 3.0

Equity Hedge 1.5 2.0 2.0 2.0 2.0 3.0 3.0

Private Equity 0.0 0.0 2.0 2.0 2.0 2.0 3.0

Private Real Estate 0.0 0.0 0.0 0.0 2.0 2.0 2.0

Total Alternative Investments 7 9 11 12 15 19 20 See “Sources of Benchmark Allocations and Investor Risk Profiles” in the Appendix for explanations regarding the source of the benchmark allocations and their suitability.


Appendix

End notes for table labeled detailed asset allocations with non-traditional assets (NTAs) 1 See “Sources of benchmark allocations and investor risk profiles” on next page regarding the source of investor risk profiles. 2 See “Sources of benchmark allocations and investor risk profiles” on next page regarding the source of benchmark allocations andtheir suitability. 3 See "Deviations from benchmark allocations" in the Appendix regarding the interpretation of the suggested tactical deviations from benchmark. 4 The current allocation row is the sum of the benchmark allocation and the WMR tactical deviation rows. 5 UBS WMR considers that maintaining the benchmark allocation is appropriate for alternative investments. The recommended tacti-cal deviation is therefore structurally set at 0. See “Sources of benchmark allocations and investor risk profiles” on next page regard-ing the types of alternative investments and their suitability. End notes for table labeled detailed asset allocations without non-traditional assets (NTAs) 1 See “Sources of benchmark allocations and investor risk profiles” on next page regarding the source of investor risk profiles. 2 See “Sources of benchmark allocations and investor risk profiles” on next page regarding the source of benchmark allocations and their suitability. 3 See "Deviations from benchmark allocations" in the appendix regarding the interpretation of the suggested tactical deviations from benchmark. 4 The current allocation row is the sum of the benchmark allocation and the WMR tactical deviation rows. Emerging Market Investments Investors should be aware that Emerging Market assets are subject to, amongst others, potential risks linked to currency volatility, abrupt changes in the cost of capital and the economic growth outlook, as well as regulatory and socio-political risk, interest rate risk and higher credit risk. Assets can sometimes be very illiquid and liquidity conditions can abruptly worsen. WMR generally rec-ommends only those securities it believes have been registered under Federal U.S. registration rules (Section 12 of the Securities Ex-change Act of 1934) and individual State registration rules (commonly known as "Blue Sky" laws). Prospective investors should be aware that to the extent permitted under US law, WMR may from time to time recommend bonds that are not registered under USor State securities laws. These bonds may be issued in jurisdictions where the level of required disclosures to be made by issuers is not as frequent or complete as that required by US laws. For more background on emerging markets generally, see the WMR Education Notes "Investing in Emerging Markets (Part 1): Equi-ties", 27 August 2007, "Emerging Market Bonds: Understanding Emerging Market Bonds," 12 August 2009 and "Emerging Mar-kets Bonds: Understanding Sovereign Risk," 17 December 2009. Investors interested in holding bonds for a longer period are advised to select the bonds of those sovereigns with the highest credit ratings (in the investment grade band). Such an approach should decrease the risk that an investor could end up holding bonds on which the sovereign has defaulted. Sub-investment grade bonds are recommended only for clients with a higher risk tolerance andwho seek to hold higher yielding bonds for shorter periods only. Non-Traditional Assets Non-traditional assets include commodities and alternative investments. Alternative investments, in turn, include hedge funds, pri-vate equity, real estate, and managed futures. Interests of alternative investment funds are sold only to qualified investors, and only by means of offering documents that include information about the risks, performance and expenses of alternative investment funds, and which clients are urged to read carefully before subscribing and retain. An investment in an alternative investment fund is speculative and involves significant risks. Alternative investment funds are not mutual funds and are not subject to the same regula-tory requirements as mutual funds. Alternative investment funds' performance may be volatile, and investors may lose all or a sub-stantial amount of their investment in an alternative investment fund. Alternative investment funds may engage in leveraging and other speculative investment practices that may increase the risk of investment loss. Interests of alternative investment funds typically will be illiquid and subject to restrictions on transfer. Alternative investment funds may not be required to provide periodic pricing orvaluation information to investors. Alternative investment fund investment programs generally involve complex tax strategies and there may be delays in distributing tax information to investors. Alternative investment funds are subject to high fees, including management fees and other fees and expenses, all of which will reduce profits. Alternative investment funds may fluctuate in value.


Appendix

An investment in an alternative investment fund is long-term, there is generally no secondary market for the interests of a fund, andnone is expected to develop. Interests in alternative investment funds are not deposits or obligations of, or guaranteed or endorsedby, any bank or other insured depository institution, and are not federally insured by the Federal Deposit Insurance Corporation, theFederal Reserve Board, or any other governmental agency. Prospective investors should understand these risks and have the financialability and willingness to accept them for an extended period of time before making an investment in an alternative investment fundand should consider an alternative investment fund as a supplement to an overall investment program. In addition to the risks that apply to alternative investments generally, the following are additional risks related to an investment in these strategies: Hedge Fund Risk: There are risks specifically associated with investing in hedge funds, which may include risks associated with

investing in short sales, options, small-cap stocks, "junk bonds," derivatives, distressed securities, non-U.S. securities and illiquid investments.

Hedge Fund of Funds: In addition to the risks associated with hedge funds generally, an investor should recognize that the overallperformance of a fund of funds is dependent not only on the investment performance of the manager of the fund, but also onthe performance of the underlying managers. The investor will bear the management fees and expenses of both the fund offunds and the underlying hedge funds or accounts in which the fund of funds invests, which could be significant.

Managed Futures: There are risks specifically associated with investing in managed futures programs. For example, not all manag-ers focus on all strategies at all times, and managed futures strategies may have material directional elements.

Real Estate: There are risks specifically associated with investing in real estate products and real estate investment trusts. Theyinvolve risks associated with debt, adverse changes in general economic or local market conditions, changes in governmental, tax, real estate and zoning laws or regulations, risks associated with capital calls and, for some real estate products, the risks associ-ated with the ability to qualify for favorable treatment under the federal tax laws.

Private Equity: There are risks specifically associated with investing in private equity. Capital calls can be made on short no-tice, and the failure to meet capital calls can result in significant adverse consequences including, but not limited to, a total loss of in-vestment.

Foreign Exchange/Currency Risk: Investors in securities of issuers located outside of the United States should be aware that evenfor securities denominated in U.S. dollars, changes in the exchange rate between the U.S. dollar and the issuer’s "home" cur-rency can have unexpected effects on the market value and liquidity of those securities. Those securities may also be affected by other risks (such as political, economic or regulatory changes) that may not be readily known to a U.S. investor.

Options: Options are not suitable for all investors. Please read the Options Clearing Corporation Publication titled "Characteristics and Risks of Standardized Options Trading" and consult your tax advisor prior to investing. The Publication can be obtained from your Financial Services Inc., Financial Advisor, or can be accessed under the Publications Section of the Option Clearing Corpora-tion's website: www.theocc.com.

Description of Certain Alternative Investment Strategies Equity Hedge: Investment managers who maintain positions both long and short in primarily equity and equity-derivative securi-

ties. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. Equity hedge managers would typically maintain at least 50% and may, in some cases, be substantially en-tirely invested in equities, both long and short.

Event Driven: Investment managers who maintain positions in companies currently or prospectively involved in corporate transac-tions of a wide variety including, but not limited to, mergers, restructurings, financial distress, tender offers, shareholder buy-backs, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in thecapital structure to most junior or subordinated, and frequently involve additional derivative securities. Event-driven exposure in-cludes a combination of sensitivities to equity markets, credit markets and idiosyncratic, company-specific developments. Invest-ment theses are typically predicated on fundamental characteristics (as opposed to quantitative), with the realization of the thesispredicated on a specific development exogenous to the existing capital structure.

Credit Arbitrage Strategies: Employ an investment process designed to isolate attractive opportunities in corporate fixed income securities. These include both senior and subordinated claims as well as bank debt and other outstanding obligations, structuringpositions with little or no broad credit market exposure. These may also contain a limited exposure to government, sovereign, eq-uity, convertible or other obligations, but the focus of the strategy is primarily on fixed corporate obligations and other securities held as component positions within these structures. Managers typically employ fundamental credit analysis to evaluate the likeli-hood of an improvement in the issuer's creditworthiness. In most cases, securities trade in liquid markets, and managers are onlyinfrequently or indirectly involved with company management. Fixed income: corporate strategies differ from event driven; credit arbitrage in the former more typically involves more general market hedges, which may vary in the degree to which they limit


Appendix

fixed income market exposure, while the latter typically involves arbitrage positions with little or no net credit market exposure,but are predicated on specific, anticipated idiosyncratic developments.

Macro: Investment managers who trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets.Managers employ a variety of techniques, both discretionary and systematic analysis, combinations of top-down and bottom-up theses, quantitative and fundamental approaches and long- and short-term holding periods. Although some strategies employ relative value techniques, macro strategies are distinct from relative value strategies in that the primary investment thesis is predi-cated on predicted or future movements in the underlying instruments, rather than realization of a valuation discrepancy betweensecurities. In a similar way, while both macro and equity hedge managers may hold equity securities, the overriding investment thesis is predicated on the impact movements in underlying macroeconomic variables may have on security prices, as opposed to equity hedge, in which the fundamental characteristics of the company are the most significant and integral to investment thesis.

Distressed Restructuring Strategies: Employ an investment process focused on corporate fixed income instruments, primarily on corporate credit instruments of companies trading at significant discounts to their value at issuance, or obliged (par value) at ma-turity, as a result of either a formal bankruptcy proceeding or financial market perception of near-term proceedings. Managers are typically actively involved with the management of these companies, frequently involved on creditors' committees in negotiat-ing the exchange of securities for alternative obligations, either swaps of debt, equity or hybrid securities. Managers employ fun-damental credit processes focused on valuation and asset coverage of securities of distressed firms. In most cases, portfolio expo-sures are concentrated in instruments which are publicly traded, in some cases actively and in others under reduced liquidity but,in general, for which a reasonable public market exists. In contrast to special situations, distressed strategies primarily employ debt (greater than 60%) but also may maintain related equity exposure.

Relative Value: Investment managers who maintain positions in which the investment thesis is predicated on realization of avaluation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivative or other secu-rity types. Fixed income strategies are typically quantitatively driven to measure the existing relationship between instruments and, in some cases, identify attractive positions in which the risk-adjusted spread between these instruments represents an attractiveopportunity for the investment manager. Relative value position may be involved in corporate transactions also, but as opposed to event driven exposures, the investment thesis is predicated on realization of a pricing discrepancy between related securities, asopposed to the outcome of the corporate transaction.

Scale for tactical deviation charts

Symbol Description / Definition Symbol Description / Definition Symbol Description / Definition

+ moderate overweight vs. benchmark moderate underweight vs. benchmark n neutral, i.e., on benchmark ++ overweight vs. benchmark underweight vs. benchmark n/a not applicable

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


Appendix


Explanations about Asset Allocations Sources of benchmark allocations and investor risk profiles Benchmark allocations represent the longer-term allocation of assets that is deemed suitable for a particular investor. Except as

described below, the benchmark allocations expressed in this publication have been developed by UBS Investment Solutions (IS), a business sector within UBS Wealth Management Americas that develops research-based traditional investments (e.g., managed accounts and mutual fund options) and alternative strategies (e.g., hedge funds, private equity, and real estate) offered to UBS clients. The benchmark allocations are provided for illustrative purposes only and were designed by IS for hypothetical US inves-tors with a total return objective under seven different Investor Risk Profiles ranging from very conservative to very aggressive. In general, benchmark allocations will differ among investors according to their individual circumstances, risk tolerance, return ob-jectives and time horizon. Therefore, the benchmark allocations in this publication may not be suitable for all investors or invest-ment goals and should not be used as the sole basis of any investment decision. As always, please consult your UBS FinancialAdvisor to see how these weightings should be applied or modified according to your individual profile and investment goals.

The process by which UBS Investment Solutions has derived the benchmark allocations can be described as follows. First, an allo-cation is made to broad asset classes based on an investor’s risk tolerance and characteristics (such as preference for interna-tional investing). This is accomplished using optimization methods within a mean-variance framework. Based on a proprietary set of capital market assumptions, including expected returns, risk, and correlation of different asset classes, combinations of the broad asset classes are computed that provide the highest level of expected return for each level of expected risk. A qualitativejudgmental overlay is then applied to the output of the optimization process to arrive at the benchmark allocation. The capital market assumptions used for the benchmark allocations are developed by UBS Global Asset Management. UBS Global Asset Management is a subsidiary of UBS AG and an affiliate of UBS FS.

In addition to the benchmark allocations IS derived using the aforementioned process, WMR determined the benchmark allocation bycountry of Non-US Developed Equity and Non-US Fixed Income in proportion to each country’s market capitalization, and determined the benchmark allocation by Sector and Industry Group of US Equity in proportion to each sector’s market capitalization. WMR, in consultation with IS, also determined the benchmark allocation for US dollar taxable fixed income. It was derived from an existingmoderate risk taxable fixed income allocation developed by IS, which includes fewer fixed income segments than the benchmark allo-cation presented here. The additional fixed income segments were taken by WMR from related segments. For example, TIPS weretaken from Treasuries and Preferred Securities from Corporate Bonds. A level of overall risk similar to that of the original IS allocationwas retained.

Alternative investments (AI) include hedge funds, private equity, real estate, and managed futures. The total benchmark alloca-tion was determined by IS using the process described above. The Wealth Management Americas Investment Committee (WMA IC) derived the AI subsector benchmark allocations by adopting IS' determination as to the appropriate subsector benchmark al-locations with AI for the following risk profiles: conservative, moderately conservative, moderate, moderate aggressive and ag-gressive. The WMA IC then developed subsector allocations for very conservative and very aggressive risk profiles by taking the IS subsector weightings for conservative and aggressive risk profile investors and applying them pro rata to the IS AI total bench-mark allocations for very conservative and very aggressive, respectively. Allocations to AI as illustrated in this report may not be suitable for all investors. In particular, minimum net worth requirements may apply.

The background for the benchmark allocation attributed to commodities can be found in the WMR Education Note “A prag-matic approach to commodities,” 2 May 2007.

Deviations from benchmark allocation The recommended tactical deviations from the benchmark are provided by WMR. They reflect our short- to medium-term assess-

ment of market opportunities and risks in the respective asset classes and market segments. Positive / zero / negative tactical devia-tions correspond to an overweight / neutral / underweight stance for each respective asset class and market segment relative to their benchmark allocation. The current allocation is the sum of the benchmark allocation and the tactical deviation.

Note that the regional allocations on the International Equities page are provided on an unhedged basis (i.e., it is assumed that investors carry the underlying currency risk of such investments). Thus, the deviations from the benchmark reflect our views ofthe underlying equity and bond markets in combination with our assessment of the associated currencies. The two bar charts(“Equity regions” and “Bond regions”) represent the relative attractiveness of countries (including the currency outlook) within apure equity and pure fixed income portfolio, respectively. In contrast, the detailed asset allocation tables integrate the countrypreferences within each asset class with the asset class preferences stated earlier in the report. As the tactical deviations at theasset class level are attributed to countries in proportion to the countries’ market capitalization, the relative ranking among re-gions may be altered in the combined view.

Disclaimer

Wealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Busi-ness Divisions of UBS AG (UBS) or an affiliate thereof. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein is based on numerous assumptions. Different assumptions could result in ma-terially different results. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this documentwere obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). All information and opinionsas well as any prices indicated are currently only as of the date of this report, and are subject to change without notice. Opin-ions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result ofusing different assumptions and/or criteria. At any time UBS AG and other companies in the UBS group (or employees thereof) may have a long or short position, or deal as principal or agent, in relevant securities or provide advisory or otherservices to the issuer of relevant securities or to a company connected with an issuer. Some investments may not be readilyrealizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to whichyou are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information containedin one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is consid-ered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to paymore. Changes in FX rates may have an adverse effect on the price, value or income of an investment. We are of necessity unable to take into account the particular investment objectives, financial situation and needs of our individual clients and wewould recommend that you take financial and/or tax advice as to the implications (including tax) of investing in any of theproducts mentioned herein. This document may not be reproduced or copies circulated without prior authority of UBS or a subsidiary of UBS. UBS expressly prohibits the distribution and transfer of this document to third parties for any reason. UBSwill not be liable for any claims or lawsuits from any third parties arising from the use or distribution of this document. This report is for distribution only under such circumstances as may be permitted by applicable law. Distributed to US persons by UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and an affiliate of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report pre-pared by a non-US affiliate when it distributes reports to US persons. All transactions by a US person in the securities men-tioned in this report should be effected through a US-registered broker dealer affiliated with UBS, and not through a non-US affiliate. The contents of this report have not been and will not be approved by any securities or investment authority in the United States or elsewhere. Version as per June 2011. © 2011. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.


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