investment strategy guide · 2013-11-21 · economic surprises are less likely to be forthcoming,...

Investment Strategy GuideWealth Management Research

18 January 2012 Monthly

Less tail risk, stiff headwinds

Reduced European tail risks give way to cyclical challenges

Positive economic surprises to wane

Defensive portfolio stance still warranted

Erratum Please note that the report published on 18 January 2012 has been republished. In the Bond re-gions chart in Figure 17, the US is moderate overweight versus the benchmark.

Contents

Highlights Focus .............................................3

Our Best Ideas at a Glance ..........8

Asset Allocation Overview ..........9

Market Scenarios ........................10

Economic Outlook ......................11

International Markets……............13

US Equities: Sectors .......................15

US Equities: Size, Style & REITs ....16

US Fixed Income .........................17

Chartbooks .................................20

Detailed Asset Allocations.........24

While we acknowledge the improvement in recent economic

data as well as the reduced tail risk in the eurozone resulting from the ECB’s long-term refinancing operations, we retain a defensive stance toward risk assets, in particular European as-sets.

Equity valuations reflect improved conditions, and positive economic surprises are less likely to be forthcoming, especially in the US. At the same time, eurozone-related risks are still not off the table, and the global economy remains vulnerable to external shocks such as a credit crunch or an oil shock.

While we believe the time for a more broad-based redeploy-ment of funds into risk assets has not yet arrived, for investorsinterested in taking on some cyclical risk, we favor emergingmarket equities, and US corporate bonds.

We have made slight tactical changes including a reduction in US equity exposure and a corresponding increase in emerging markets equities, which we view as attractively valued and no longer as vulnerable as central banks begin to cut rates.

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

Less tail risk, stiff headwinds

Economic data has strengthened globally over the past month, and the aggressive liquidity provision by the European Central Bank has alleviated the risk of a bank funding crisis. Nonetheless, we still see substantial risk emanating from Europe and believe that US economic data is less likely to surprise positively going forward. We recommend maintaining a defensive portfolio positioning.

Global equity markets continued to trend higher over the past six weeks amid stronger than expected eco-nomic data, evidence that emerging market central banks are poised to adopt a less restrictive policy stance and the most aggressive steps yet by the European Cen-tral Bank (ECB) to address the sovereign debt crisis. Eco-nomic surprise indicators for both the US and Europe have been rising recently, with the US even exceeding prior peaks, as somewhat more constructive economic data handily outpaced overly pessimistic consensus fore-casts (see Fig. 2). Meanwhile, the cresting of inflation pressures across the most critical emerging market na-tions appears to have finally triggered a reversal in monetary policy as central banks begin their shift toward a more accommodative stance. But perhaps most heart-ening to investors were the steps taken by the ECB at the December 8th meeting of the Governing Council aimed at easing bank funding pressures. The commit-ment by the ECB to provide long-term (36-month) bank financing operations, coupled with both an expansion in

the pool of eligible collateral and a reduction in reserve requirements, has mitigated the “tail risk” associated with a potential full blown financial crisis. But while markets may have reacted favorably in the near-term to this string of constructive developments, we elect to retain our defensive positioning amid a still challenging macro backdrop, prospects for further fall-out from the eurozone sovereign crisis and a decelera-tion in corporate earnings growth. The ECB may well have reduced the tail risks associated with a bank fund-ing crisis, but the headwinds from the ongoing balance sheet adjustment process across both the private and public sectors remain fairly stiff. Although equity markets appear attractively priced relative to historical bench-marks (see Fig. 3), compromised longer-term growth prospects and elevated political risk limit the prospects for any material “re-rating.” Meanwhile, corporate profit gains appear to be decelerating amid sluggish top line growth and peak margins.

Fig. 1: Benchmark and current allocation

Percentage of portfolio (moderate risk portfolio)


3.0

40.0

41.0

4.012.0

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 18 January 2012. 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 24 and 25 in the Appendix also show asset allocations appli-cable to risk profiles other than the moderate risk profile shown here, both

ith and without nontraditional assets. w

Fig. 2: Less support from positive economic surprises likely

UBS Economic Surprise Indexes

100

110

120

130

140

150

160

170

180

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

50

55

60

65

70

75

80

85

US (lhs) Eurozone (rhs)

Source: Bloomberg, UBS, as of 17 January 2012

Focus


We therefore continue to underweight global equities and com-modities, and recommend corresponding moderate overweights to both fixed income and cash. Still challenging macro backdrop That the economy was able to exceed growth forecasts that had been sharply reduced probably shouldn’t have come as all thatmuch of a surprise. Keep in mind that most economists scaledback growth expectations following the economic “soft patch,”effectively “lowering the bar” for subsequent data releases. How-ever, with these same economists having once again “reset” theirgrowth projections to reflect a somewhat more upbeat cyclicalbackdrop, it would appear that there is now some room for dis-appointment. The surge in growth during the fourth quarter seems to have been driven in large part by the willingness of con-sumers to reduce savings (see Fig. 4). This suggests that the ef-fects were likely just temporary and that upside surprises in therelease calendar will be harder to come by as growth returns to the lower “trend rate” during the first half of this year. Our eco-nomics team is looking for the US economy to expand at a 1.5% pace during the first quarter and at a 2.0% clip for Q2. Global growth prospects are even less certain, however, as theeffects from the sovereign crisis and ongoing austerity measures begin to weigh upon the European economy. The threat that aeurozone recession might be the catalyst behind a broader andmore protracted economic slump has been greatly reduced by theECB’s policy actions. Still, the financial turmoil in Europe has be-gun to impact growth in both developed and developing nations.The World Bank recently revised its global growth forecast for2012 down from 3.6% to just 2.5% and also cut its estimate for2013 from 3.6% to 3.1%. Eurozone challenges linger The moves by the ECB to ease collateral restrictions and initiatelonger-term refinancing operations have eased funding stresseswithin the banking system and further expanded the centralbank’s balance sheet (see Fig. 5 and 6). But the ECB’s action –while critical to averting a broader credit crunch – does little to change the underlying challenges across the eurozone. The region still appears headed for a recession of unknown depth and dura-tion as austerity measures are imposed as part of agreed uponbudgetary reforms and banks begin to delever bloated balancesheets. Our economics team estimates that the fiscal drag acrossthe region could amount to as much as 2.0 % of GDP. The most recent actions taken by Standard & Poor’s to down-grade nine of the seventeen eurozone sovereign credits under-scores the dilemma confronting policymakers (see Table 2). Failure

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

Range: -3 (very unsupportive) to +3 (very supportive) Source: UBS WMR, as of 18 January 2012 Fig. 3: Global stocks appear cheaper than averageMSCI all countries World, Price-Earnings ratio

57

911

1315

1719

21

1990 1995 2000 2005 2010

23

25

Global equity 12-month forward P/E ratioAveragePE with WMR earnings estimatesPE under global recession

Average

Source: Datastream, IBES, UBS WMR, as of 17 January 2012 Fig. 4: Declining savings rate driving consumptionUS personal savings rate, in %

012345

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

Ja

6789

n-12

Source: Datastream, UBS WMR, as of 17 January 2012 Fig. 5: Rapid expansion of ECB’s balance sheet Total assets of ECB, in EUR billions

0

500

1,000

1,500

2,000

2,500

3,000

2007 2008 2009 2010 2011 2012 Source: Bloomberg, UBS WMR, as of 17 January 2012

Focus

to reduce deficits could trigger further ratings cuts and compro-mise the integrity of any eurozone fiscal agreement. On the otherhand, if deficits are cut too rapidly – or in ways that further un-dermine growth prospects – the recession will be deeper and thepotential budget shortfall could grow even larger. So while themove by S&P had been so clearly signaled in advance that theinitial market reaction was decidedly muted, the longer term im-plications for fiscal consolidation and the potential for furtherdowngrades are not so easily dismissed. Keep in mind that this will all take place at the same time that banks are looking to shed assets and improve capital ratios as partof the deleveraging process. The European banking system stillappears overleveraged with significant exposure to sovereign debtin stressed eurozone countries. In our recent report, The Great Deleveraging (January 6, 2012), we estimated that the gross andnet sovereign exposure of the European banks to the troubledeurozone countries, excluding Greece, was approximately EUR600bn and 515bn, respectively, versus core Tier 1 capital of just EUR 428bn. We believe most European banks do not intend toissue equity under these stressed conditions and will insteadachieve their capital requirements through a combination of as-sets sales and retained earnings. Given this significant deleverag-ing need, banks are unlikely to give much of a boost to economicgrowth through increased lending activity and may even inhibiteconomic activity by restricting credit availability. Earnings growth to decelerate One of the most important sources of support for risk assets in general and equity markets in particular has been the remarkable resilience of corporate profits. Despite a still challenging macrobackdrop, increasingly uncertain policy environment and down-right dysfunctional political landscape, corporate managers havemanaged to post impressive profit growth. Corporate profits inthe US rose by 37% in 2010 and are estimated to have risen by12-14% for 2011. In fact, S&P 500 profits have nearly doubledfrom their post crisis lows. But we envision a more challenging backdrop for corporate profits in 2012 and expect “flattish” earn-ings growth in the US and an outright decline in profit growth forEuropean corporations in aggregate. Three factors that will con-strain S&P 500 earnings in 2012 include: • Decelerating global GDP growth: UBS forecasts global

GDP to slow to 2.7% in 2012 from 3.1% last year withEurope expected to be in recession. With approximately one-third of S&P 500 revenues derived outside of the US – 15% from Europe – slowing end-market economies will weakentop-line growth.

• Modest contraction in profit margins: Profit margins for

Fig. 6: Eurozone bank funding conditions have eased EURIBOR - Overnight Index Swap spreads; EUR basis swap, both in basis points

020406080

100120140160

Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11

-

-

-

-

0

180200 -350

-300

250

200

150

100

-50

EURIBOR - OIS spread EUR Basis Swap (rhs, inversted, in basis points)

Source: Bloomberg, UBS WMR, as of 17 January 2012

Table 2: European credit trends pose a challengeLast week’s S&P downgrades of eurozone sovereigns

Old Rating New Rating

Austria AAA AA+

Cyprus BBB BB+

France AAA AA+

Italy A BBB+

Malta A A-

Portugal BBB- BB

Slovakia A+ A

Slovenia AA- A+

Spain AA- A Source: S&P and UBS WMR, as of 17 January 2012

Fig. 7: Earnings have not exceeded expectations more recently Percent by which actual quarterly S&P 500 EPS exceeded (missed) consensus expectations at quarter-end

-2%

0%2%4%

6%8%

10%12%

14%16%

1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11*

*Excludes debt valuation adjustments by Financials which positively skewed aggregate S&P 500 by USD 1.00 – 1.10 per share (ap-proximately 4%) in 3Q11. Compares actual S&P 500 operating earnings to the consensus estimate at quarter-end. Source: FactSet, UBS WMR, as of 17 January 2012


Focus

non-financial companies are at peak levels but as the rate ofsales growth slows, it will be difficult for corporations to fur-ther “right-size” costs after aggressively doing so for the last three years.

• A stronger dollar: In 2011, the trade-weighted dollar fell 6%, boosting sales for US multinationals. But the dollar hasstrengthened materially over the past few weeks given thesovereign stresses – and lower short-term interest rates – in Europe. At current levels, the trade-weighted dollar is 4%above its average level in 2011.

While it is still early, results thus far during fourth quarter 2011earnings season have not been inspiring. “Bottom-up” consensus estimates for 4Q11 S&P 500 EPS continue to fall and now stand atUSD 23.70 – just 5% above their level a year ago. This represents a sharp deceleration from the 13% growth delivered by corporateAmerica in the third quarter (adjusted for financials debt valuation adjustments), despite the fact that seasonal factors typically biasfourth quarter earnings higher. While the final fourth quarter re-sults may end up being somewhat stronger than the current con-sensus, it is clear that earnings growth is in fact decelerating, a trend that we expect to continue in 2012 (see Fig. 7). Some modest portfolio adjustments While we haven’t altered our overall defensive posture, we havemade slight tactical changes including a reduction in US equity exposure and a corresponding increase in emerging markets equi-ties: • It is our view that equity markets in the US are now fully re-

flecting the positive news flow that accumulated since lastsummer. At this stage, we find valuations uncompelling bothin absolute terms and relative to other regional markets. TheS&P 500 is now trading at our year-end 2012 price target of 1300. Economic surprise indices, which capture the extent towhich economic data releases have been beating consensusexpectations, are at the top of their range. Moreover, US con-sensus growth estimates have risen over the last month, sug-gesting that the bar for further positive surprises has been re-set to higher levels. We believe that the data flow will there-fore no longer be a positive catalyst for US stocks over the next 1 to 2 quarters.

• In contrast, EM equities offer an attractive opportunity in ouropinion. EM stocks underperformed developed markets sig-nificantly in 2011, declining by 18%, while US stocks werejust about flat over the year. As Fig. 8 indicates, EM equities trade at a lower price-earnings multiple than the US, while of-fering higher longer-term earnings growth potential. Thissuggests that EM stocks are undervalued at this stage. While

Fig. 8: Emerging markets appear cheap to US eq-uities Valuation and long-term earnings growth expectations

0

2

4

6

8

10

12

14

Price-Earnings ratio 5-year consensus earnings growth(in %)

US Emerging Markets

Source: Datastream, IBES, UBS WMR, as of 17 January 2012


Focus


the significant setback they experienced last year highlightsthe risks that remain when investing in EM equities, we be-lieve the tide is about to turn. The overheating in EM econo-mies and the resulting need for their central banks to tightenpolicy was the key reason for last year’s underperformance. With the inflationary pressures from food prices in particularnow waning and as slower global growth reduces overheat-ing symptoms, we believe that the stronger valuation andearnings fundamentals should carry the day once again thisyear.

Conclusion While we acknowledge the improvement in recent economic dataas well as the reduced tail risk in the eurozone resulting from the ECB’s long-term refinancing operations, we retain a defensivestance toward risk assets, in particular European assets. Equityvaluations reflect improved conditions and positive economic sur-prises are less likely to be forthcoming, especially in the US. At thesame time eurozone-related risks are still not off the table and theglobal economy remains vulnerable to external shocks such as acredit crunch or an oil shock. For investors interested in taking onsome cyclical risk, we favor emerging market equities, and, as dis-cussed in the US fixed income section of the report, US corporate bonds. We believe the time for a more broad-based redeploymentof funds into risk assets has not yet arrived. Michael P. Ryan, CFA, Chief Investment Strategist and Head WMR Americas, UBS FS Inc. Stephen R. Freedman, PhD, CFA, Strategist, UBS FS Inc. Jeremy Zirin, CFA, Strategist, UBS FS Inc.

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

Preference for cash and bonds over equities and commodities

Currencies

Avoid Japanese yen. Preference for SEK, NOK, GBP, among developed currencies. Selected Emerg-ing Market currencies for long-term appreciation potential.

Equities

International markets • UK and Emerging Market equities • Within Emerging Market equities: China, India and Brazil

Within US equities • Consumer Staples: household products, cosmetics, and beverages companies with high emerg-

ing market exposure • Information Technology: semi-conductors, data centers • Healthcare: managed care, generic manufacturers, drug distributors • Within Consumer Discretionary: cable & satellite, lodging, apparel • Within Energy: oil services • Within Telecom: wireless towers, enterprise and rural telecom carriers • Within Utilities: transmission-focused utilities • Within Financials: regional banks, exchanges, P&C insurers • Within Industrials: capital goods companies that are outgrowing the market • Within Materials: industrial gas • Preference for growth over value stocks • Preference for large cap over mid cap and small cap stocks

Fixed Income

Within US dollar fixed income

• Investment Grade single A and BBB-rated credits in particular: managed care, mining, oil and gas, communications, and technology

• Investment Grade senior unsecured debt of well-diversified US banks and select insurance com-panies

• Emerging markets sovereign debt with emphasis on Brazil and Mexico • High yield corporate bonds • High quality municipal bonds in particular: essential purpose revenue bonds in the water/sewer

and public utility sector, broad based sales tax bonds with ample coverage and a conservative additional bonds test, major established transportation agency issuers, and voter-approved general obligation bonds.

Commodities

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



Asset Allocation Overview Asset Class Comments

WMR Tactical View Model Portfolio

Moderate Risk Profile (in %)

Benchmark Allocation

Tactical Deviation

Change Current Allocation

Equities Equity valuations are attractive relative to bonds but slowing economic growth and prob-lems in the eurozone create downside risks for earnings.

Moderate Underweight 44 -4.0 40.0

US Equities Valuations are less attractive than in overseas markets and positive economic surprises are unlikely to continue accruing.

Moderate Underweight l 32 -1.5 30.5

US Large Cap Value Valuations, our sector tilts and our defensive positioning suggest preference for growth over value. Large caps cheap relative to small and mid caps.


US Large Cap Growth Valuations, our sector tilts and our defensive positioning suggest preference for growth over value. Large caps cheap relative to small and mid caps.

Moderate Overweight 11 +2.0 13.0

US Mid Cap Valuations expensive vs. large caps, and little support from M&A activity.


US Small Cap Valuations expensive vs. large caps, and little support from M&A activity.


US Real Estate Investment Trusts (REITs) Valuations remain stretched but the prospect of interest rates remaining low is positive for the REIT industry.

Neutral 2 +0.0 2.0

Non-US Developed Equities Valuations more attractive than US. Eurozone recession not reflected in earn-ing expectations. Remaining tail risk suggests a more cautious stance.


Emerging Market (EM) Equities Growth likely to continue slowing in first half of 2012 but monetary policy has turned toward loosening which could allow P/E multiples to rebound.


Fixed Income Yields at historically low levels but many central banks will maintain loose policy to offset negative impact of deleveraging. Useful portfolio hedge in the case of adverse scenarios.


US Fixed Income Within fixed income we favor the US vs. non-US. The dollar may gain in the short term as the Fed holds steady while other central banks loosen policy.


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) Store of value for the short term and dry powder, while waiting for opportunities else-where.


Commodities Decelerating global demand growth suggests further near-term downside for commodity prices.


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 18 January 2012.

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


Market Scenarios (next 12 months)

A eurozone recession alongside weaker than normalgrowth in the US and emerging markets are our base casefor 2012. While stronger economic data suggest that global recession risks have receded, the US remains vulnerable to external shocks. For the next 12 months we distinguish thefollowing four scenarios for growth and inflation. Slow growth: Base Case Scenario Probability: 60% (up from 55% in December)

While the eurozone enters a relatively shallow recession, the US recovery proves to have enough momentum to keep growth positive though sluggish.

Deleveraging pressures keep growth below historical trends in most developed countries, with unemployment rates re-maining far above their pre-financial crisis levels.

Growth in emerging markets continues to outpace devel-oped markets, though their growth slows as well.

Renewed recession: First Alternative Scenario Probability: 20% (down from 25% in December)

Bank deleveraging and fiscal consolidation triggers a nega-tive feedback loop, driving Europe into a deeper recession.

Stress in bank funding markets result in a global credit crunch, which forces consumers and businesses to cut back on spending in the US and globally.

Weak demand generates deflationary pressure. Stagflation: Second Alternative Scenario Probability: 10%

An energy price shock and/or rising inflation expectations create inflationary pressures. Higher prices erode consumers’ purchasing power curbing demand. The US follows Europe into recession.

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

Strong expansion: Third Alternative Scenario Probability: 10%

Loose monetary policy, as well as credible resolution of the eurozone crisis restores the flow of credit. Business and con-sumer confidence improve, leading to a pickup in spending.

Improvements in the labor and housing market set the stage for a more dynamic consumer recovery.

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

Slow growth HighGrowth

LowGrowth

NegativeGrowth

Negative inflation Low inflation High inflation

HighGrowth

LowGrowth

NegativeGrowth


Renewed recession HighGrowth

LowGrowth

NegativeGrowth

HighGrowth

LowGrowth

NegativeGrowth

Negative inflation Low inflation High inflationNegative inflation Low inflation High inflation

Stagflation HighGrowth

LowGrowth

NegativeGrowth

HighGrowth

LowGrowth

NegativeGrowth

Negative inflation Low inflation High inflationNegative inflation Low inflation High inflation

Strong expansion HighGrowth

LowGrowth

NegativeGrowth


HighGrowth

LowGrowth

NegativeGrowth

Negative inflation Low inflation High inflation Source: UBS WMR

Economic Outlook


Resilient US economy amidst global slowdown

US growth picked up in late 2011 and is starting to feed onitself. But the US economy is still highly vulnerable to ex-ternal shocks, as the deleveraging cycle remains a fierce headwind for growth. Outside the US, in most countries weexpect both growth and inflation to be lower in 2012. For the developed markets, fiscal tightening will weigh ongrowth and inflation should be low. With policy rates al-ready near zero in many countries, there is little room formonetary stimulus. In contrast, most emerging markets canstill use fiscal or monetary policy to support growth. US income multiplier effect galvanizes domestic strength After the summer 2011 growth scare, the US economy has re-bounded remarkably in late 2011. The underlying strength cannotbe brushed aside easily, as income multipliers might finally be atwork. Income multipliers are self-reinforcing positive feedbackloops between spending and income. Spending of consumers,businesses and the government generate income for the suppliersof the purchased goods and services. In turn, the suppliers are consumers themselves. After earning said income they use it in full or partially to finance their consumption, setting in motion a growth-supportive income multiplier effect. So despite a nastycombination of negative shocks – oil price surge, the Arab Spring,the Japanese tsunami and relentless eurozone sovereign debtwoes – US growth remained positive and even accelerated in late2011. The income multiplier effect is reflected in an accelerationin employment growth, improvement in small business confi-dence and hiring, robust trends in business investment and posi-tive real GDP growth despite inventory depletion in 3Q11. But not all growth acceleration in late 2011 is based on the solidfoundation of the income multiplier effect. US consumer spend-ing growth accelerated but was not corroborated by an accelera-tion in real income growth. It was financed mainly from savingsand rising consumer debt. We doubt this is sustainable and there-fore expect a deceleration in US consumer spending growth in early 2012. US economy is still highly vulnerable to external shocks Despite a seemingly stronger growth foundation, the US economyis still highly vulnerable to external shocks, especially an intensify-ing eurozone crisis if it ripples through the banking system and financial markets. The vulnerability stems from the US debt leg-acy, as deleveraging of the balance sheets of households, finan-cial institutions and the government continues to create fierce headwinds for growth.

Table 3: Growth and inflation forecasts in % GDP Growth Inflation '11 F '12 F '13 F '11 F '12 F '13 FWorld 3.2 2.7 3.4 3.9 3.0 3.0 US 1.7 2.1 2.6 3.1 2.1 1.9 Canada 2.4 2.0 2.4 3.0 2.4 2.6 Japan -0.8 2.5 1.8 -0.3 -0.1 0.3 Eurozone 1.6 -0.7 0.8 2.7 1.7 1.8 UK 0.9 -0.1 1.1 4.4 2.7 2.0 China 9.2 8.0 8.0 5.3 3.5 4.0 India 6.8 7.3 7.8 7.7 6.8 7.0 Russia 4.1 3.0 3.8 8.7 6.8 6.5 Brazil 2.8 3.3 4.8 6.5 5.8 6.5 APAC ex Japan 6.7 6.0 6.7 5.2 3.9 4.4

Note: F= forecast; APAC=Asia Pacific Source: UBS WMR, as of 17 January 2012 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. 9: Small business growth indicators are im-proving Small business optimism index (in levels) and employment growth (3-month-over-3-month growth rate)

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

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

75

80

85

90

95

100

105

ADP small business employment growth (lhs)

NFIB small business optimism index (rhs)

Note: ADP = Automatic Data Processing Inc.; NFIB = National Federation of Independent Business


Economic Outlook


Moderate US growth to persist In sum, we expect some growth moderation in early 2012. Weestimate a real GDP growth slowdown from a 3% annualizedquarterly rate in 4Q11 to 1.5% in 1Q12. The key driver of thisgrowth moderation is weaker private consumption growth. For2012 as a whole, we expect growth of 2.1%. As we additionally expect core CPI inflation to trend sideways, we think the Fed willabstain from further quantitative easing. Instead, the Fed will pol-ish its communication strategy. The first step will be to publish theFOMC members’ projections for the fed funds rate following the 24-25 January meeting. Eurozone in recession Eurozone GDP growth slowed to 0.1% q/q in the third quarter of 2011 and it appears that a recession started in the fourth quarter.Recent indicators suggest that the recession is mild so far, but downside risks for the economy remain. We expect Greece todefault by March, potentially leading to contagion effects. Fiscal austerity measures will continue to create serious headwinds forthe economy, especially in countries that are struggling to find buyers for their sovereign debt. A credit crunch looms as bankstry to shrink their balance sheets, although aggressive action by the European Central Bank may help to limit the damage. UK slumping on austerity measures While UK government bonds have not come under pressure, the“voluntary” decision to implement fiscal austerity has hurtgrowth. A further round of spending cuts in 2012 will keep de-mand weak. The Bank of England has conducted quantitativeeasing and could do more if the economy continues to struggle. Reconstruction spending will boost growth in Japan Government spending on reconstruction following last year’s earthquake and tsunami should boost growth to around 2% in2012. Despite its dire fiscal situation, Japan continues to find will-ing domestic buyers for its bonds, allowing it to put off seriousefforts at narrowing its budget gap. Less inflation in the emerging markets Many developing economies experienced inflationary pressure in2011 as food and energy prices spiked at the start of the year.Inflation has been slowing in recent months, and this trend should continue as long as there is not another surge in commod-ity prices. Although monetary policy is already loose by historicalstandards, lower inflation should allow for interest rate cuts incountries that need them. In 2012, growth rates are likely to belower due to weaker exports to the developed markets, but weexpect domestic demand to hold up reasonably well.

Thomas Berner, CFA, Economist, UBS FS Inc. Brian Rose, PhD, Strategist, UBS FS Inc.

Fig. 10: US consumer sentiment rebounded Consumer sentiment and retail sales (year-over-year in %)

-15

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

20 -10

-505

1015

40

60

80

100

120

Total retail sales (lhs) Core retail sales (lhs)UoM expectations index (rhs) CB expectations index (rhs)

Note: Core retail sales exclude sales at gas stations, auto dealers and for building materials; UoM = University of Michigan; CB = Conference Board


Fig. 11: German economy under pressure Ifo and ZEW business climate (index level) and factory orders (year-over-year in %)

-40

-20

0

Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11

-4.0

-3.0

-2.0

-1.0

0.020

40

1.0

2.0

Factory orders (lhs)Ifo business climate expectations index (rhs)ZEW business climate expectations index (rhs)

Source: European Central Bank, as of 17 January 2012

Fig. 12: Headline inflation has peaked Global consumer price inflation rates, year-over-year in %

-4

-2

0

2

4

6

8

10

1998 2002 2006 2010USA Eurozone UK Japan China


International Markets


Time for emerging market stocks to catch up

We have upgraded emerging markets (EM) equities and re-duced the US within our global equity portfolio. We prefer EM equities over developed markets given their reasonablevaluations and prospects for continued growth. Within in-ternational fixed income, we find US bonds more attractive than non-US bonds despite the historically low level of US yields. We remain cautious on all eurozone assets as politi-cians struggle to find a solution to the sovereign debt crisis. Economic backdrop and reasonable valuations favor emerg-ing market equities Price declines in 2011 have left EM equity valuations looking rela-tively attractive, especially compared to the US, which significantlyoutperformed non-US markets. We have therefore increased thesize of our overweight in EM equities, while lowering the US to neutral within our global equity portfolio. US stocks, which have outperformed over the past year, are among the most expensiveacross regions and are less likely to benefit from positive eco-nomic and earnings surprises going forward. The main problem for EM equities in 2011 was overheating and higher inflation, especially in the larger EM economies, forcing central banks to hike interest rates. With inflation already sub-stantially down from its peak, this pattern could reverse itself in2012, allowing EM equities to outperform. While somewhatslower economic growth will constrain profit expansion, EM earn-ings growth should still be better than in the developed markets. The other main risk for EM equities in 2012 is the Chinese prop-erty market. While we believe that the risks of a hard landing in the near future are reasonably low, the news is likely to get worsebefore it gets better, and this could make investors reluctant to put money into the market. Despite these risks, we continue to favor China within EM equities, as valuations look too low for acountry with such strong growth prospects. Our other favored markets within EM equities are India and Brazil. India was hit particularly hard by inflationary pressure in 2011, leading to a 37% drop in the market. Inflation may remain moreof an issue than in other EM countries, but the central bank should still be able to start easing policy in the next couple ofmonths. In our view, India has the best long-term growth poten-tial in the world and last year’s drop offers an investment oppor-tunity. Over the past several years, Brazil has been benefiting from higher prices for its commodity exports and better government policy. While growth may not be that high relative to the rest of EM, valuations look attractive.

Fig. 13: Equity regions Tactical deviations from benchmark, incl. view on currency.

Emerging Markets

UK

US

Other Developed

Japan

Eurozone

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

Source: UBS WMR, as of 18 January 2012. Scale explained in Ap-pendix. Note: arrows indicate changes adopted as of this report.

Fig. 14: Regional valuations and earnings momen-tum 12-month forward Price-Earnings Ratio; 3-month change in 12-month forward consensus earnings-per-share

12.110.5

9.4 9.7 9.511.311.7

-6

-3

0

3

6

9

12

US

on-U

S deve

loped

Euroz

one UK

Japan

Emerg

ing M

arkets

World

-6%

-3%

0%

3%

6%

9%

12%

NPrice/Earnings ratio (left)Earnings momentum (right)

Source: Datastream, IBES, UBS WMR, as of 17 January 2012

Fig. 15: US surprises to turn less supportive Economic surprise indexes

-150

-100

-50

0

50

100

150

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

US Eurozone Japan Emerging markets

Source: Bloomberg, Citigroup economic surprise indexes, UBS WMR, as of 17 January 2012


International Markets

We remain underweight eurozone assets Given the ongoing eurozone debt crisis, we recommend an un-derweight position in eurozone equities and bonds. Althoughequity valuations appear attractive, the shrinking economy is likelyto cause earnings to fall far short of consensus forecasts. While there may be long-term value in the market, the short-term tail risks, while reduced, are still too big to be ignored. As for euro-zone bonds, the high yields available on some countries’ sover-eign debt may appear tempting, but in our view they do not offeradequate compensation for the high risks involved. The euro hasbeen under pressure recently, and in the short-term we expect this trend to continue, hurting returns for dollar-based investors. We believe that Greece will default by the end of March as large bond redemptions come due. If this can be handled without sub-stantial contagion to other eurozone countries, then it could al-low the markets to bottom. However, given the high degree of uncertainty, we recommend waiting until there are actual signs ofprogress before moving back into eurozone assets. UK relatively attractive despite economic woes Government austerity measures are likely to keep domestic eco-nomic conditions weak in 2012. Despite this, we find UK equitiesand bonds to be attractive relative to the other non-US developed markets. Equity valuations are inexpensive, and the high depend-ence on overseas earnings should help to offset weak domesticgrowth. The pound also looks inexpensive among the major cur-rencies, offering the potential for exchange rate movements tocontribute to returns in dollar terms. Japan not attractive for long-term investors Equity valuations are much less expensive than they have beenhistorically, but they are still not particularly attractive. Japan’s loweconomic growth potential should once again become clear oncethe boost from reconstruction spending is over. We recommend a neutral position within global equity portfolios on our 9-12 month tactical time horizon, but would be more negative for investorswith a long-term investment horizon. For most investors, Japa-nese government debt should be avoided. Neutral on other developed market equities Among the other main developed markets, we are neutral onboth equities and bonds. While these markets do have some at-tractive points, individual countries have their drawbacks witheither equity valuations (Canada) or exchange rates (Australia, Switzerland) appearing over-stretched.

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

Fig. 16: US dollar is cheap on a trade-weighted basis USD real broad effective exchange rate

50

60

70

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

80

90

100

110

120

130

USD Real Broad Effective Exchange Rate 10-year averageAverage +1 standard deviation Average -1 standard deviationAverage +2 standard deviation Average -2 standard deviation

Source: JPMorgan, Bloomberg, UBS WMR, as of 31 December 2011

Fig. 17: Bond regions Tactical deviations from benchmark, incl. view on currency.

US

UK

Other

Japan

Eurozone

+ ++ +++–– –– – – n

underweight overweight

Note: Arrows indicate changes adopted in this report. Source: UBS WMR, as of 18 January 2012. 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: Sectors


Further shifts towards defensive growth

Despite the recent encouraging US economic data and con-structive steps by European policymakers to prevent abanking crisis, the nearly 20% S&P 500 rally since early Oc-tober leaves little margin for error going forward on bothfronts. We increase our allocation to Consumer Staples andHealthcare and downgrade Utilities to underweight. Downgrade Utilities—shifting away from defensive yield… Utilities were the best performing sector in 2011. We believe fal-ling interest rates were one of the principal drivers of the sector’s outperformance (Fig. A13 in appendix chartbook). But with 10-year Treasury yields already below 2.0%, we see limited scope for further rate declines (in fact, our fixed income team expects longterm rates to modestly rise in 2012). The recent fall in natural gasprices will also weigh on the sector (power prices are highly corre-lated with natural gas prices) and earnings estimates look vulner-able. Power demand growth has also disappointed (Fig. A15), reducing the need for new infrastructure projects. With the sec-tor’s P/E now at a 20% premium to the market, we believe un-derperformance is likely. We reduce our weighting from neutral to underweight. …and focus on defensive growth Within the defensive sectors we increase Healthcare and Con-sumer Staples (the two “growthier” defensives) from overweight to strong overweight. The Healthcare sector carries the lowestvaluation of all four defensive sectors and is the only one trading at a P/E discount to the S&P 500 (Fig. A17). Fifty percent of themarket value of the sector is comprised of large-cap pharma. The “drug patent expiration wave” is cresting this year and there isscope for a positive valuation re-rating as investors get more com-fortable with the sector’s earnings power after the patent cliffpeaks. Healthcare services, notably managed care stocks, mayalso benefit should sentiment surrounding the election begin tofavor the Republican candidate (potential repeal of healthcarereform). The Consumer Staples sector typically outperforms when earningsgrowth outpaces that of the S&P 500, which we expect in 2012(Fig. 19). Within Consumer Staples we upgrade Food & StaplesRetailing. This industry group has very little foreign exposure insu-lating it from the drag of a stronger dollar. Also, a still challengingUS economy should support the earnings for discount retailers,which dominate Food & Staples Retailing by market value. Jeremy Zirin, CFA, Strategist, UBS FS Inc. David Lefkowitz, CFA, Strategist, UBS FS Inc.

Fig. 18: Focus on defensive growth not yield Tactical deviations from benchmark

Materials

Industrials

Financials

Utilities

Energy

+ ++ +++–– –– – – n

underweight overweight

Cons Discretionary

Telecom

Technology

Healthcare

Consumer Staples

Note: Arrows indicate changes adopted as of this report Source: UBS WMR, as of 18 January 2012. See explanations in the Appendix regarding the interpretation of the suggested tactical deviations from benchmark.

Fig. 19: We expect strong relative earnings to boost the Consumer Staples sector in 2012 Average annual relative performance of Consumer Staples versus the S&P 500 based on relative annual earnings growth

-3.7%

9.3%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

Consumer staples earningsgreater than market

Consumer staples earningsless than market

Source: FactSet and UBS WMR, as of 17 January 2012

US Equities: Size, Style and REITs


Small caps and Value still too risky

Modest equity market returns and weak corporate buyoutactivity favors larger companies. Value stocks require aturnaround in Financials – still too risky for our taste. REITsremain attractive for their yield, but be selective. Weak M&A a big hurdle for small-cap stocks While recent dollar strength will hurt earnings for large-cap mul-tinationals, many other factors continue to favor large caps oversmall caps in the current environment. First, our expectation formodest market returns should prove beneficial for large-caps out-performing smaller companies. Since 1979, when annual broad market gains have been less than 10%, the median outperfor-mance of large caps over small caps has been 2.7 percentagepoints. Second, valuation continues to favor large caps, which have both a lower price-to-earnings ratio and a higher dividend yield than small caps. Lastly, strong merger and acquisition activity typically bodes well for small-cap outperformance (Fig. 21). De-spite a rebound in equity prices during the fourth quarter of 2011, M&A activity levels continue to weaken. We would not expect a meaningful pickup in M&A given the ongoing Europeandebt crisis and continued uncertainty over numerous domestic policy concerns including potential comprehensive corporate andindividual tax reform as well as changes to long-term government entitlement programs. Bottom line: stay overweight large caps. Growth remains a safer choice The Russell 1000 Growth Index outperformed the Russell 1000Value Index by 3.2 percentage points in 2011 marking the thirdconsecutive year growth outpaced value. Slowing corporate earn-ings growth points to another year of outperformance for com-panies with stronger relative earnings growth, which have greaterrepresentation in growth indices (Fig. A14). Finally, given the highweighting of Financials in the value index, a rebound in this be-leaguered sector would be required. This appears to be an unlikely and certainly risky proposition. REITs yield remains attractive, but be selective The S&P 500 REIT industry group delivered strong gains in 2011,rising 8% (price appreciation only) and 11.5% including divi-dends, easily outpacing the S&P 500. While REIT valuations arehigh both relative to history and compared to the S&P 500, mod-erate economic growth coupled with ultra-low interest rates benefits commercial real estate valuations. The multifamily group is currently the most attractive REIT sector, in our view.

Jeremy Zirin, CFA; David Lefkowitz, CFA Strategists, UBS FS Inc.

Fig. 20: We continue to prefer Growth over ValueSize, style, and REITs recommended allocation, deviation from benchmark

Small-Cap

Large-Cap Value

Mid-Cap

REITs

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

Large-Cap Growth

Source: UBS WMR, as of 18 January 2012

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

Fig. 21: Sluggish recovery in M&A limits upside for small-caps Global M&A activity and relative performance of small-caps versus large-caps

0

200

400

600

800

1,000

1,200

1,400

1,600

2001 2003 2005 2007 2009 2011 2013

70

75

80

85

90

95

100

105

110

3 month M&A volume ($ billions, LHS)Small-caps relative to large-caps (RHS)

Source: Bloomberg and UBS WMR as of 13 January 2012

US Fixed Income


Corporate credit: Off to a strong start

Although we look for credit spreads to experience bouts ofvolatility during the course of the year, we continue to see a great deal of relative value in corporate bonds. We look for both the investment grade and high yield sectors of the bond market to deliver total returns that outpace Treasur-ies in 2012. With Fed policy likely to remain accommodative into 2013 and the European debt crisis at a critical stage,we expect Treasury yields to remain low. There’s value in credit The corporate bond market got off to a strong start in January as investors entered the year with cash balances that needed to be put to work. Although we look for credit spreads to experiencebouts of volatility, we continue to see a great deal of relativevalue in corporate credit. We look for both investment grade (IG)and high yield (HY) sectors of the US bond market to deliver totalreturns that outpace Treasuries in 2012. Relative to Treasuries, IGcorporate credit has the additional advantage of higher overallyield. The IG index yield is at 3.8% compared to the dismal1.07% yield on the Treasury index. We believe that the highercoupon income on corporate bonds, plus an expected tightening of credit spreads, could produce IG total returns of roughly 4% in2012. If credit spreads do not tighten as we expect but remainflat at roughly today’s 250 basis points (bps) starting levels, thenIG would produce returns of 1.1% based on our interest rate pro-jections. Within IG, our recommendations from our 2012 fixed incomeoutlook remain in place. We see value in certain mid-beta sectors that offer a combination of attractive credit spread and mild vola-tility characteristics. This includes select single A and BBB-rated credits. Our sector preferences include Managed Care, Mining, Oil & Gas, Communications and Technology. Due to high spreadvolatility, we remain neutral overall when it comes to Financials,but see value in short to intermediate maturity bonds issued bylarge diversified US banks and select insurance companies. For more information, please see our bi-weekly Corporate Bond Valuation report. Potentially higher returns in HY The total return prospects for HY credit are also compelling, given current spread valuations of roughly 700bps and our outlook for default rates to remain below historical averages. In fact, we es-timate that HY spreads are currently pricing in a projected default rate close to 9% compared to the 3.5% average default rate thatwe forecast over the course of 2012. Coupon income in the HYmarket is over 8% to compensate for the higher credit risk of

Table 4: US interest rate forecasts, in %

17 Jan. in 3 monthsin 6

months in 12

months

3-month LIBOR 0.53 0.30 0.30 0.30

2-year Treasury 0.26 0.20 0.20 0.50

5-year Treasury 0.97 1.00 1.00 1.30

10-year Treasury 2.09 2.00 2.10 2.50

30-year Treasury 3.08 3.30 3.40 3.80


Fig. 22: 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

Total TFI non-Credit

Total TFI Credit

+ ++ +++–– –– – – n

Underweight Overweight

Note: Arrows indicate changes adopted as of this report. Source: UBS WMR, as of 18 January 2012. See the appendix for a detailed asset allocation illustration in the context of a moderate-risk taxable US dollar fixed income portfolio and explanations regarding the interpretation of the suggested tactical deviations from bench-mark.

US Fixed Income


those issuers rated below investment grade. We believe the cou-pon advantage should allow HY to outperform IG credit. We wouldn’t rule out the potential for HY to deliver double-digit total returns under a more constructive market scenario than our base case. We believe this could be achieved despite the less than stel-lar backdrop in the US, characterized by below-average economic growth and downwards earnings revisions. The key to HY exhibit-ing strong performance, in our view, will be a containment ofsystemic risk factors that could cause periods of illiquidity in HYmarkets. Should European debt contagion fears flare up, wewould expect a flight-to-quality move into Treasuries and out ofcredit-sensitive sectors such as HY. However, our baseline fore-cast, where the European crisis drags on without leading to con-tagion in the US, should be satisfactory enough for HY to outper-form IG credit, in our view. EM sovereign debt, remain neutral with a Latin flavor Under normal circumstances, we would have a bullish outlook onemerging markets (EM), given their relatively strong fundamentals and their ability to grow faster than the developed world. How-ever, the outlook for EM bonds is overcast because of growing uncertainty in Europe. Despite EM’s relatively strong fundamen-tals, the price action in recent months demonstrates a high corre-lation between the performance of EM sovereign debt and inves-tor sentiment, which is far from upbeat. We are also concerned that an escalation of the European debtcrisis could exacerbate fears about a possible hard-landing in China. This is not our base case, but we cannot ignore the risk either. Until visibility in Europe improves, we believe that a more cautious stance is warranted. Therefore, we reiterate our neutral tactical allocation to dollar-denominated EM sovereign debt. However, not all EM regions should perform equally. EasternEurope, which accounts for about 30% of outstanding EM sover-eign debt, will likely be the most negatively affected, while Asia and Latin America are likely to be affected to a lesser degree. In that respect, we believe investors should avoid exposure to East-ern Europe. Although we anticipate faster growth in Asia (6.0%year-over-year) than in Latin America (3.6% year-over-year), we believe the latter offers better credit quality than the former and,therefore, some desirable defensive characteristics within an EMcontext. Interest rate outlook: range-bound and low The slow and steady economic growth outlook that UBS econo-mists forecast implies that Treasury yields should move higher in 2012. In the near term, however, the deepening of the European debt crisis, the prospect of disorderly Greek default, and the re-cent downgrade of the credit ratings of several EU sovereigns by S&P have sent Treasury yields to new lows. If Europe muddles

Fig. 23: Investment grade corporate bond spreadsOption-adjusted spread, in basis points

0

100

200

300

400

500

2000 2002 2004 2006 2008 2010 2012

600

700

IG spread Avg (2000-present) Avg (2000-2007) Avg (crisis)

Source: Bank of America Merrill Lynch, as of 17 January 2012

Fig. 24: High yield corporate bond spreads Option-adjusted spread, in basis points

0

500

1,000

1,500

2000 2002 2004 2006 2008 2010 2012

2,000

2,500

HY spread Avg (2000-present) Avg (2000-2007) Avg (crisis)


Fig. 25: Treasury yields have fallen over the last six months 10-year Treasury yield, in %

1.5

2

2.5

3

3.5

2011 Jul 2011 Sep 2011 Nov 2012 Jan

Source: Bloomberg, UBS WMR as of 17 January 2012


US Fixed Income

through and the fallout of the debt crisis has a limited negativeimpact on the US, we believe Treasury yields will rise later thisyear. In the meantime, though, we expect Treasury yields will re-main range-bound and low, given accommodative Fed policy and flight-to-quality buying on the uncertain outlook in Europe.Against this backdrop, we recommend that investors retain a neu-tral duration position. Municipal bond outlook positive Municipal bonds are off to a firm start in the early weeks of theNew Year against a backdrop of tight new issue supply and asharp rally occurring in US Treasuries. Supply is anticipated tostay light over the next month with the 30-day visible supply indi-cator at just USD 5.9bn. That compares to an average of USD8.6bn for the past 60 days. Relative to Treasuries, AAA muni-to-Treasury (M/T) yield ratios still exceed 100% at the front portionof the curve and on long-dated securities. Meanwhile, at the mid-section of the curve, the most sought after range by investors, yield ratios have dipped below the 100% mark. AAA M/T ratios atthe 5-year, 10-year and 30-year maturity points stand at 102.5%,91.9% and 110% respectively. Anne Briglia, CFA, Strategist, UBS FS Inc. Barry McAlinden, CFA, Strategist, UBS FS Inc. Donald McLauchlan, Strategist, UBS FS Inc. Kathleen McNamara, CFA, CFP®, Strategist, UBS FS Inc.

Fig. 26: Duration recommendation Duration deviation from benchmark, in years

-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5

Duration

Current Previous


Fig. 27: Municipal credit quality spreads In basis points

0

75

150

225

300

375

Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12BAA GO 10 yr - AAA GO 10 yrA GO 10 yr - AAA GO 10 yrAA GO 10 yr - AAA GO 10 yr

Note: GO= General Obligation Source: MMD, UBS WMR as of 17 January 2012

Chartbook

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


3.1%

1.9%

0.5%

-0.4%

0.0%

0.6%

1.0%

-11.8%

7.8%

4.4%

0.1%

-13.3%

6.2%

-18.2%

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

US Equities

Non-US Dev. Equities

EM Equities

US Fixed Income

Non-US Fixed Income

Cash (USD)

Commodities

year-to-date 2011

Source: Bloomberg and UBS WMR, as of 17 January 2012

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

3.1%

1.9%

2.0%

0.9%

0.4%

6.2%

1.0%

-11.8%

-16.9%

-2.5%

-14.2%-18.2%

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

US Equity

Non-US Developed

EMU

UK

Japan

Emerging Markets

year-to-date 2011


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

0.5%

-0.4%

-1.2%

-0.5%

0.2%

7.8%

4.4%

-0.1%

12.6%

7.4%

-5% 0% 5% 10% 15%

US Fixed Income

Non-US Fixed Income

EMU

UK

Japan

year-to-date 2011


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

3.1%

3.1%

3.1%

3.5%

3.3%

2.0%

0.4%

2.6%

1.5%

-1.5%

7.3%-4.2%

-5% 0% 5% 10%

Large Cap Value

Large Cap Growth

Large Cap

Mid Cap

Small Cap

REITs

year-to-date 2011


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

0.3%1.0%

0.2%0.9%1.2%

2.7%0.4%

-0.4%2.0%

9.8%14.1%

5.3%7.5%

4.4%4.1%

6.1%8.2%

11.2%

-2% 0% 2% 4% 6% 8% 10% 12% 14% 16%

TreasuriesTIPS

AgenciesIG Corporates

HY CorporatesPreferreds

MortgagesEM Sovereigns

Municipal bonds

year-to-date 2011

Source: BoAML, UBS WMR, as of 17 January 2012

Fig. A6: Currencies Appreciation vs. USD in %

-0.4%

0.1%

0.6%

-1.1%

2.5%

4.3%

-3.2%

-0.3%

-2.3%

-0.1%

-11.0%

-1.3%

-0.4%

5.5%

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

EUR

GBP

JPY

CAD

CHF

AUD

BRL

year-to-date 2011


Chartbook

Economic Outlook and Asset Classes Fig. A7: US real GDP growth to moderate soon US real GDP growth and components (quarter-over-quarter annualized)

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1 2012

UBS WMR forecasts


Consumption Commercial real estate investmentCapital expenditures Residential investmentInventories Net ExportsGovernment Real GDP (q/q annualized)


Fig. A8: Manufacturing climate is recovering Global manufacturing climate, standardized (mean=0, standard devia-tion=1)

-4

-3

-2

-1

0

1

2

3

1998 2002 2006 2010USA Eurozone UK Japan China

Source: JPMorgan, Bloomberg, UBS WMR, as of 17 January 2012

Fig. A9: Investor sentiment has turned bullish AAII Individual Investor net bullish sentiment, in %

-60

-40

-20

0

20

40

60

80

90 92 94 96 98 00 02 04 06 08 10 12Net bullish sentiment 3-month averageLong-term average Last data point

Individual investors bullish

Individual investors bearish

Source: Bloomberg, American Association of Individual Investors (AAII), and UBS WMR, as of 17 January 2012

Fig. A10: Low yields on bonds in US and abroad Global and US aggregate bond index, yield to maturity, in %

0

1

2

3

4

5

6

7

Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11US Global

Source: Bloomberg, JP Morgan and UBS WMR, as of 17 January 2012

Fig. A11: US stocks no longer oversold Percentage of stocks above their 200-day moving average

0200400600800

1,0001,2001,4001,6001,800

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

0

20

40

60

80

100

S&P 500 index (lhs)Percentage of NYSE stocks above their 200-day moving average (rhs) 5% Percentile95% percentileLast point


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 18 Jan. 2012. See explanations in the Appendix re-garding the interpretation of the suggested tactical deviations from benchmark. Note: Arrows indicate changes adopted as of this report

Chartbook

US Equities Fig. A13: Utilities are highly correlated with interest ratesRelative (rel) performance of Utilities sector vs.10-year Treasury yield


90

95

100

105

110

115

120

125

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

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

Utilites rel to S&P 500 (left) 10yr treas rate (inverse, right)

Source: FactSet and UBS WMR, as of 17 January 2012

Fig. A14: Growth outperforms when profits are “flattish” Average relative performance of Russell 1000 Growth vs. Value

-4%

-2%

0%

2%

4%

6%

8%

10%

Profits grow < -5% Profits growbetween -5% - 5%

Profits grow > 5%

Source: DataStream and UBS WMR, as of 17 January 2012

1

Fig. A15: Weak power demand means less need to invest in new infrastructure…and lowers Utilities sector earningsTrailing 12 month US power demand, in gigawatt-hours

55,000

60,000

65,000

70,000

75,000

80,000

85,000

1995 1997 1999 2001 2003 2005 2007 2009 2011

flat demand

Source: Edison Electric Institute and UBS WMR, as of 17 January 2012

Fig. A16: Growth stocks are attractively valued Relative price-earnings ratio (P/E) - growth vs. value, since 1979

100%

110%

120%

130%

140%

150%

160%

170%

180%

1979 1983 1987 1991 1995 1999 2003 2007 2011

latest datapoint: 123%

Average ex Tech bubble

Source: DataStream, Russell Investment Group, UBS WMR, as of 17 Jan. 2012

Fig. A17: Healthcare is the cheapest defensive sector P/E relative to the market versus 5 year average

0%

5%

10%

15%

20%

25%

30%

35%

Telecom Utilities ConsumerStaples

Healthcare


Fig. A18: Homeownership rates still elevated, supports multi-family REITS US homeownership rate, in percent

62

63

64

65

66

67

68

69

70

1965 1975 1985 1995 2005 20151965 - 2000 average



Chartbook

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

0

1

2

3

4

5

6

Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-132-year Treasury note 10-year Treasury note

Source Bloomberg, UBS WMR, as of 17 January 2012

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

Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-1310s/2s Curve


Fig. A21: Brazil and Mexico offer defensive characteristicsIndex option-adjusted spreads over US Treasuries, in basis points

0

100

200

300

400

500

600

700

2007 2008 2009 2010 2011 2012

US IG Corporates Brazil Mexico


Fig. A22: Declining default rate signals tighter HY spreadsHY option adjusted spread (OAS), in basis points and default rates, in %

0%

3%

6%

9%

12%

15%

2012201020082006200420022000

0

500

1000

1500

2000

2500

TTM Default Rate (2012 projected) Forecast OAS

Source: BAML, Moody's, UBS WMR, as of 17 January 2012; Note: TTM= Trail-ing 12-month

Fig. A23: TIPS breakeven inflation rates recently declined Breakeven yield, in %

-1

0

1

2

3

4

Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-125-year breakeven 10-year breakeven 30-year breakeven


Fig. A24: Municipal visible supply and yields Left hand axis yield in %, right hand axis in millions

1

1.5

2

2.5

3

3.5

4

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

Yiel

d

2,500

7,500

12,500

17,500

22,500

30-Day Visible Supply (right side axis)Treasury 10 yr (left side axis)AAA GO 10 yr (left side axis)

Source: Bloomberg, UBS WMR as of 17 January 2012

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 -2.0 17.0 32.0 -3.0 29.0 44.0 -4.0 40.0 54.0 -5.0 49.0 62.0 -6.0 56.0 71.0 -6.0 65.0

US Equity 0.0 +0.0 0.0 14.0 -0.5 13.5 23.0 -1.0 22.0 32.0 -1.5 30.5 39.0 -2.0 37.0 44.0 -2.5 41.5 52.0 -3.0 49.0

Large Cap Value 0.0 +0.0 0.0 8.0 -0.5 7.5 8.0 -1.0 7.0 11.0 -1.5 9.5 11.0 -2.0 9.0 11.0 -2.5 8.5 13.0 -3.0 10.0

Large Cap Growth 0.0 +0.0 0.0 5.0 +0.5 5.5 8.0 +1.5 9.5 11.0 +2.0 13.0 11.0 +3.0 14.0 11.0 +3.5 14.5 13.0 +4.5 17.5

Mid Cap 0.0 +0.0 0.0 1.0 -0.5 0.5 4.0 -0.5 3.5 5.0 -0.5 4.5 9.0 -1.0 8.0 11.0 -1.0 10.0 13.0 -1.5 11.5

Small Cap 0.0 +0.0 0.0 0.0 +0.0 0.0 2.0 -1.0 1.0 3.0 -1.5 1.5 5.0 -2.0 3.0 7.0 -2.5 4.5 8.0 -3.0 5.0

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 -1.5 3.5 9.0 -2.0 7.0 12.0 -2.5 9.5 15.0 -3.0 12.0 18.0 -3.5 14.5 19.0 -3.0 16.0

Developed 0.0 +0.0 0.0 5.0 -1.5 3.5 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 -6.0 8.0

Emerging Markets 0.0 +0.0 0.0 0.0 +0.0 0.0 1.0 +1.0 2.0 2.0 +1.5 3.5 3.0 +2.0 5.0 4.0 +2.5 6.5 5.0 +3.0 8.0

Fixed Income 81.0 +1.0 82.0 67.0 +2.0 69.0 51.0 +3.0 54.0 37.0 +4.0 41.0 24.0 +5.0 29.0 11.0 +6.0 17.0 0.0 +0.0 0.0

US Fixed Income 74.0 +1.0 75.0 59.0 +2.0 61.0 43.0 +3.0 46.0 29.0 +4.0 33.0 18.0 +5.0 23.0 9.0 +6.0 15.0 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 +1.0 3.0 2.0 +2.0 4.0 2.0 +2.0 4.0 2.0 +2.0 4.0 2.0 +3.0 5.0 2.0 +9.0 11.0

Non-traditional Assets 9.0 -1.0 8.0 12.0 -1.0 11.0 15.0 -2.0 13.0 17.0 -2.0 15.0 20.0 -2.0 18.0 25.0 -3.0 22.0 27.0 -3.0 24.0

Commodities 2.0 -1.0 1.0 3.0 -1.0 2.0 4.0 -2.0 2.0 5.0 -2.0 3.0 5.0 -2.0 3.0 6.0 -3.0 3.0 7.0 -3.0 4.0

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 18 January 2012



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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Traditional Assets

Equity 0.0 +0.0 0.0 22.0 -2.0 20.0 37.0 -3.0 34.0 52.0 -4.0 48.0 67.0 -5.0 62.0 83.0 -6.0 77.0 98.0 -6.0 92.0

US Equity 0.0 +0.0 0.0 16.0 -0.5 15.5 26.0 -1.0 25.0 37.0 -1.5 35.5 48.0 -2.0 46.0 59.0 -2.5 56.5 72.0 -3.0 69.0

Large Cap Value 0.0 +0.0 0.0 9.0 -0.5 8.5 9.0 -1.0 8.0 13.0 -1.5 11.5 14.0 -2.5 11.5 15.0 -2.5 12.5 18.0 -3.0 15.0

Large Cap Growth 0.0 +0.0 0.0 6.0 +0.5 6.5 9.0 +1.5 10.5 13.0 +2.0 15.0 14.0 +3.0 17.0 15.0 +3.5 18.5 18.0 +4.5 22.5

Mid Cap 0.0 +0.0 0.0 1.0 -0.5 0.5 4.0 -0.5 3.5 6.0 -0.5 5.5 11.0 -0.5 10.5 15.0 -1.0 14.0 18.0 -1.5 16.5

Small Cap 0.0 +0.0 0.0 0.0 +0.0 0.0 3.0 -1.0 2.0 3.0 -1.5 1.5 6.0 -2.0 4.0 9.0 -2.5 6.5 11.0 -3.0 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 5.0 +0.0 5.0 7.0 +0.0 7.0

Non-US Equity 0.0 +0.0 0.0 6.0 -1.5 4.5 11.0 -2.0 9.0 15.0 -2.5 12.5 19.0 -3.0 16.0 24.0 -3.5 20.5 26.0 -3.0 23.0

Developed 0.0 +0.0 0.0 6.0 -1.5 4.5 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 -6.0 14.0

Emerging Markets 0.0 +0.0 0.0 0.0 +0.0 0.0 2.0 +1.0 3.0 2.0 +1.5 3.5 4.0 +2.0 6.0 6.0 +2.5 8.5 6.0 +3.0 9.0

Fixed Income 90.0 +0.0 90.0 76.0 +2.0 78.0 61.0 +3.0 64.0 46.0 +4.0 50.0 31.0 +5.0 36.0 15.0 +6.0 21.0 0.0 +0.0 0.0

US Fixed Income 82.0 +4.0 86.0 67.0 +2.0 69.0 51.0 +3.0 54.0 36.0 +4.0 40.0 23.0 +5.0 28.0 12.0 +6.0 18.0 0.0 +0.0 0.0

Non-US Fixed Income

8.0 -4.0 4.0 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 +6.0 8.0

“WMR tactical deviation” legend: Overweight Underweight Neutral Source: UBS WMR and Investment Solutions, as of 18 January 2012


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 employees 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 a moderate-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 -1.5 -1.5 20.5 Mortgages 20.0 +1.0 +1.0 21.0 Investment grade corporates 22.0 +1.0 +1.0 23.0 High yield corporates 10.0 +1.5 +1.5 11.5 Preferred securities 4.0 +0.0 +0.0 4.0 Emerging Market sovereign bonds in US dollar 5.0 +0.0 +0.0 5.0 Total TFI non-Credit 59.0 -2.5 -2.5 56.5 Total TFI Credit 41.0 +2.5 +2.5 43.5

Source: UBS WMR and Investment Solutions, as of 18 January 2012

Non-US Developed Equity Module, in %



Previous Current

Current allocation3

EMU / Eurozone 26.0 -25.0 -25.0 1.0 UK 20.0 +15.0 +15.0 35.0 Japan 19.0 +5.0 +5.0 24.0 Other 35.0 +5.0 +5.0 40.0

Source: UBS WMR and Investment Solutions, as of 18 January 2012

Non-US Fixed Income Module, in %



Previous Current

Current allocation3

EMU / Eurozone 40.0 -7.5 -7.5 32.5 UK 9.0 +7.5 +7.5 16.5 Japan 35.0 -7.5 -7.5 27.5 Other 16.0 +7.5 +7.5 23.5

Source: UBS WMR and Investment Solutions, as of 18 January 2012 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 10.8 +0.0 +0.0 n n 10.8

Auto & Components 0.8 -0.7 -0.8 – – 0.0

Consumer Services 2.1 +1.0 +1.0 + + 3.1

Media 3.2 -1.0 -1.0 – – 2.2

Retailing 3.7 +0.7 +0.8 + + 4.5

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

Consumer Staples 11.1 +2.0 +3.0 ++ +++ 14.1

Food, Beverage & Tobacco 6.3 +1.0 +1.0 + + 7.3

Food & Staple Retailing 2.4 +0.0 +1.0 n + 3.4

Household & Personal Products 2.4 +1.0 +1.0 + + 3.4

Energy 12.0 +0.0 +0.0 n n 12.0

Financials 14.1 -2.0 -2.0 – – – – 12.1

Banks 2.9 +0.0 +0.0 n n 2.9

Diversified Financials 5.5 -1.0 -1.0 – – 4.5

Insurance 3.6 -1.0 -1.0 – – 2.6

Real Estate 2.0 +0.0 +0.0 n n 2.0

Health Care 11.8 +2.0 +3.0 ++ +++ 14.8

HC Equipment & Services 4.0 +1.0 +1.5 + ++ 5.5

Pharmaceuticals & Biotechnology 7.8 +1.0 +1.5 + ++ 9.3

Industrials 11.0 -2.0 -2.0 – – – – 9.0

Capital Goods 8.5 -1.0 -1.0 – – 7.5

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

Transportation 2.0 -1.0 -1.0 – – 1.0

Information Technology 19.1 +2.0 +2.0 ++ ++ 21.1

Software & Services 9.3 +1.0 +1.0 + + 10.3

Technology Hardware & Equipment 7.4 +0.0 +0.0 n n 7.4

Semiconductors 2.4 +1.0 +1.0 + + 3.4

Materials 3.7 -2.0 -2.0 – – – – 1.7

Telecom 2.8 +0.0 +0.0 n n 2.8

Utilities 3.6 +0.0 -2.0 n – – 1.6


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 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. 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 onlyby 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 andthere 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 endorsed by, 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 fund and should consider an alternative investment fund as a supplement to an overall investment program. In addition to the risks that apply to alternative investments generally, the following are additional risks related to an investment in these strategies: Hedge Fund Risk: There are risks 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 of funds 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. They involve risks associated with debt, adverse changes in general economic or local market conditions, changes in governmental, tax,real estate and zoning laws or regulations, risks associated with capital calls and, for some real estate products, the risks 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 byother 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 fromyour 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 andfundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly interms 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 thesis predicated 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; creditarbitrage 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 movementsin 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 between securities. In a similar way, while both macro and equity hedge managers may hold equity securities, the overriding investment thesis is predicated on the impact movements in underlying 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 employdebt (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, as opposed 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 UBSclients. 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 thebroad asset classes are computed that provide the highest level of expected return for each level of expected risk. A qualitative judgmental overlay is then applied to the output of the optimization process to arrive at the benchmark allocation. The capitalmarket 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 by country of Non-US Developed Equity and Non-US Fixed Income in proportion to each country’s market capitalization, and determined the benchmark allocation by Sector and Industry Group of US Equity in proportion to each sector’s market capitalization. WMR, inconsultation 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 allocation was 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 a pure 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.

Appendix

Disclaimer

Wealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business 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 does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, financial situation and needs of any spe-cific recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. We recommend that you obtain financial and/or tax advice as to the implications (including tax) of investing in the manner described or in any of the products mentioned herein. Certain services and products are subject to legal re-strictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). All information and opinions as well as any prices indicated are cur-rently only as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. At any time UBS AG and other companies in the UBS group (or employees thereof) may have a long or short position, or deal as principal or agent, in relevant securities or provide advisory or other services to the issuer of relevant securities or to a company connected with an issuer. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are ex-posed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is con-sidered 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 re-quired to pay more. Changes in FX rates may have an adverse effect on the price, value or income of an investment. This document may not be reproduced or copies circulated without prior authority of UBS or a subsidiary of UBS. UBS expressly prohibits the distribution and transfer of this document to third parties for any reason. UBS will not be liable for any claims or lawsuits from any third parties arising from the use or distribution of this document. This report is for distribution only under such circumstances as may be permitted by applicable law. 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 prepared by a non-US affiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned 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 securi-ties or investment authority in the United States or elsewhere. Version as per October 2011. © 2012. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.


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