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UBS investor’s guideWealth Management Research27 May 2011

Eurozone debt crisis “Investors are underestimating the impact of a Greek sovereign default”New head of IMF Yes, why not an emerging market candidate?Market outlook Beyond the uncertainty

Analyst certifi cation and required disclosures begin on page 41.UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the fi rm may have a confl ict of interest that could aff ect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Strong currencies to the fore

Research evolution: See inside front cover for important information on this report.

ContentsEditorial ............................................. 3

Focus ............................................... 4-7

Interview ........................................ 8-9

Asset allocation .......................... 10-11

Economy ..................................... 12-16

Fault lines ........................................ 17

Stock recommendations ............ 18-21

Technical analysis ....................... 22-23

Equity market ............................. 24-29

Bond market ............................... 30-33

Currencies ................................... 34-35

Commodities .............................. 36-38

Readers’ questions .......................... 39

Market scenarios ............................. 40

Appendix .................................... 41-43

This report has been prepared by UBS AG and UBS Financial Services Inc. (UBSFS)

UBSFS accepts responsibility for the con-tents of this report. US persons who re-ceive this report and wish to eff ect any transactions in any security discussed in this report should do so with UBSFS and not UBS AG.

Research evolution!Two of WMR’s fl agship publications are joining forces. Beginning next month, we will combine the content you have come to expect in this report with the compre-hensive market guidance of an improved Investment Strategy Guide – our most popular publication. While this edition of the Investor’s Guide will be the last, we are confi dent you will enjoy our new pub-lication and welcome your feedback as we continually work to improve our off ering. For more information, please contact your Financial Advisor.

8 June 2011 Wealth Management Research publishes a UBS research focus on infl ation.

UBS investor’s guide 27 May 2011 3

For our weekly market outlook, please see the UBS Weekly Guide. It fea-tures a focus article with in-depth thematic commentary, the week’s most important economic/market indicators and an overview of market per-formance and WMR investment strategy.

Andreas HöfertChief Economist

Editorial

“Emerging markets need to work together a lot better to have a bigger impact in international policy-making.”

Dear readers,

So far, 2011 has been stirred by dense news fl ow. Catastrophes and unsavory events have pursued each other, especially across the weekend stage, with regularity in the last couple of months. However, beside the billowing threat of Icelandic volcanic ash, one undisputed serial recurs almost weekly and delivers continual drama: the tragedy of Greek debt.

Regular readers know our unaltered conviction for over a year now that Greece will ultimately have to restructure its debt and that bond-holders will receive he y haircuts. A year ago the call was still rather bold – many then saw us as too pessimistic – but now it is market con-sensus. Much of available research and commentary on Greece now begins by saying, “it is not a question of whether but of when.” In this edition of the UBS Investor’s Guide, credit analyst Thomas Wacker, among the earliest to signal warning, answers questions on the Greek situation and its impact on the Eurozone.

Another long-time call of WMR has been to prefer smaller currencies to the big four – USD, EUR, JPY and GBP – each with its own problems. The question stemming from this view for internationally exposed inves-tors is how to optimally structure currency portfolios that were previ-ously heavily weighted in USD or EUR. Currency expert Thomas Flury discusses this in the focus article. He delivers a catchy rule of thumb that should enable investors to navigate the traditionally rough seas of cur-rency amid heaving storms of bad news.

4 UBS investor’s guide 27 May 2011

Focus

Last arguments for strong currencies

The world does not have a reserve cur-rency that inspires confi dence.In arguing the case for a strong currency, taking the size of fi nancial markets as a benchmark, one must plea on behalf of a strong US dollar and strong euro. The prospects of achieving this, however, are poor.We, therefore, make the argument that investors should gain exposure to strong, liquid currencies other than the big two in order to hedge against a depreciation in the dollar and euro.

Thomas Flury, Analyst, UBS AG

Debating whether the dollar will forfeit its sta-tus as the world’s anchor currency is idle in our view, as it has long given up this role in the re-serve management domain. Although the dol-lar continues to be the principal means of pay-ment and invoicing in international trade, as a store of value it has long since ceased to be the center of interest. It lost its dominance as an investment currency at the end of the 20th century. The turn of the century marked the end of the Asia crisis, the long-term integration of the largest emerging markets and the crea-tion of the euro. It also saw the bursting of the Internet bubble, which at the time represented the severest collapse of the capital markets since World War Two.

Up to that point the dollar mirrored the growth of the world economy. The sustained expansion of the emerging markets and the common fi nancial market in the Eurozone have weakened the standing of the US. The dollar will only be able to regain its role as the sole re-serve currency if global economic development shi s into reverse.


Focus

A downward trendThe dollar index, a measure of the dollar’s strength against key, highly developed trading partners, set an interim high in 2002. Since then the trend has been downward. The negative trend relative to other liquid currency alterna-tives has not only caught the attention of cur-rency specialists in the centers of fi nance, it has become very evident in the emerging markets.One of the main reasons behind the long-term depreciation in the dollar has been the ever-ex-panding US foreign trade defi cit and foreign trade debt. In addition, the fi nancial crisis has seen US government debt jump from 60% of GDP to 100%. If investors are to believe once more in the leading role of the United States and regain trust in the dollar and the US Treas-ury, the US national debt will need to fall to 60% of GDP again.

New perspectives for investors in the emerging marketsThe stability of emerging market currencies since the Asia crisis has led investors there to look more closely at the parities of the dollar to alternatives such as the euro, the British pound, Swiss franc and Australian dollar. In the period between World War Two and the Asia crisis, most emerging markets had to deal with the problem of being overindebted and/or of severe downward pressure on their currencies. From the perspective of a company in an emerging market with its own risks, the fl uctuations be-tween the US dollar and D-mark, pound and franc were of negligible importance. The discus-sion over whether the dollar, franc or D-mark was the best investment appeared to take a backseat, as the dollar was the currency that was most accepted on the market and the one in which transactions were invoiced. There were hardly any advantages in holding another freely convertible currency. Only in the past fi ve to 10 years, with the sustained upturn in the BRIC economies (Brazil, Russia, India and China) and

the stabilization of their currencies, has irritation over the steady depreciation of the US dollar be-come widespread.

Lack of a logical alternative forces diversifi cationThe fate of the dollar as the reserve currency would have been sealed long ago if there had been an obvious alternative to the greenback. But the globalized world of the 21st century is not so neatly organized. The fi nancial crisis hit all major currency areas hard: the Eurozone, the United Kingdom and Japan. Soaring levels of debt in all regions are both a brake on growth and an infl ationary risk. Confi dence in all major currency areas has been dented. As a result, none of the big four can assume the role of the dominant reserve currency.

US dollar – an illusory safe havenSome currency analysts believe the dollar is still a safe haven for investors in uncertain times even though its value has declined in recent years. In this view, the dollar will remain pre-dominant for cautious portfolio allocations. We have serious doubts. During the fi nancial crisis, the greenback appreciated strongly on two oc-casions, but the peak of its recovery in 2008 and 2010 was still far below 2000-2006 levels. The appreciation of the dollar in times of crisis is nothing more than a counter-reaction to strong downward pressure on the dollar during periods of growth. The recovery in the dollar is based not so much on the strengths of the US econo-my, but on temporary weaknesses of the growth regions in the emerging markets. The two major fi nancial crises, the bursting of the Internet bub-ble in 2002 and the fi nancial crisis of 2008, both had their origins in the United States and badly shook the stock market there. We are therefore skeptical as to whether the dollar will inspire much confi dence in future crises. There are ob-jective reasons why investors should look for other havens.


Focus

Financial crisis submits no proof of safe havensThe key question is this: What benefi t do inves-tors derive from “safety” when during the crisis of the century this safety has failed to recoup even the losses of the past ten years? The recov-ery of the dollar was temporary and short-lived. Newsfl ow and price movements during the cri-sis suggest that long-term orientated investors, such as central banks and sovereign wealth funds, wound down their dollar holdings in phases of strength. The legacy of the US accu-mulation of debt to overseas creditors over the past 15 years has been to make the dollar vul-nerable in times of crisis. Even now the US gov-ernment has no convincing strategy for reduc-ing its foreign debt. Consequently, we believe international investors will sell the dollar in the next crisis-induced boom as well. Each time round the dollar will fi nd it harder to recover.

50-50 rule no longer applies The fi nancial crisis has also pushed the euro into a crisis of confi dence. Before the fi nancial crisis, we could follow the 50-50 rule with a clear con-science. This rule states that an investor with 50% euros and 50% US dollars can ensure a bal-anced portfolio and have some protection against the fl uctuations of the currency markets. The reasoning behind this was the euro would appreciate in periods of growth, counterbal-anced by the gains made by the dollar in periods of crisis. For an investor with the USD as a refer-ence currency, our 50-50 rule would have come under serious strain even before the crisis. Eu-rope’s debt crisis, the a ermath of which will continue to aff ect the region for a long time, has held back the upward potential of the euro so much that investors need to look for additional diversifi cation.

Why should anyone diversify if their invest-ment income, expenses and assets are all in US dollars? We would, of course, argue in favor of a rigorous matching of income and expenses

(currency matching). This requires holding a cer-tain percentage in the reference currency. But additional assets should be held in a range of currencies. An investor exposed purely to dol-lars would have seen the erosion of purchas-ing power caused by the increase in the cost of living and energy over the past few years eat away at the (real) value of his assets. Interest income was well below infl ation. Investment in commodity currencies – the Norwegian krone, Australian dollars and Canadian dollars – would have reduced losses. Exposures to other liquid currencies from very stable countries, such as Swiss francs or Swedish krone, would of course have limited these losses.

The fi ve friends…Making the claim to be a reserve currency must be backed by value stability and liquidity, mean-ing a currency can be easily sold in all market environments. Because of liquidity requirements, freely convertible currencies, such as the Austral-ian dollar (AUD), the Canadian dollar (CAD), the Swedish krona (SEK), the Norwegian krone (NOK) and the Swiss franc (CHF), have muscled their way in. All fi ve have in recent years been stable in times of crisis, and they should benefi t from lower levels of debt and high growth po-tential going forward. Our pragmatic advice is to hold more or less equal weightings of the fi ve currencies. Each of the fi ve currencies has its own specialties and will appear more attractive depending on the cycle. The NOK and CAD are heavily linked to oil prices. The AUD is more de-pendent on China, coal and base metals. The CHF is a safe haven and benefi ts from diversifi ed exports in banking and industry. As for the SEK, it is closely correlated with the stock market. The CHF, SEK and NOK benefi t from any appreciation in the euro, while the CAD is positioned against the dollar. Depending on the economic cycle and the focus of global growth, any one of these cur-rencies should be particularly strong and off er scope for profi t-taking.


Focus

Recipes for currency diversifi cationWe advise investors whose reference cur-rency is the Swiss franc to fi rst compare planned expenditure and income to de-termine how much investment capital they have available for investing in cur-rencies other than the franc. Investors should set a cautious home bias for this available amount and invest the rest sys-tematically in foreign currencies. We consider a very cautious home bias to be around 50-70%. There are two key fac-tors involved in allocating assets to for-eign currencies: the size of a currency area in terms of GDP and the equity mar-ket capitalization of the individual coun-try. Focusing on the size of the equity market has the advantage of ensuring that investors are exposed to currencies that have well-developed capital mar-kets. For example, diversifi cation curren-cies such as the Australian dollar are fi nding their way into investor portfolios as Australian share prices rise. A long-term performance comparison shows that a currency portfolio diversifi ed strongly along equity market lines out-performs a pure Swiss franc portfolio over long periods.

…and their relationship to the BRIC countriesThe diff erent characteristics of the “fi ve friends” allow genuine diversifi cation. But they have one characteristic in common: All create a link in one way or another between the G4 currencies and the largest emerging markets, the BRIC nations. As relatively small countries, the fi ve are heavily dependent on exports. Since the 1990s trading ties to the emerging markets have been expand-ed everywhere. As a result, by gaining exposure to the fi ve currencies, investors are gaining ex-posure to the currencies of emerging markets without the downside of restrictions on the movement of capital.

There are other currencies besides the dol-lar, euro, pound and yen. A combination of fun-damentally stable and liquid currencies should, in our view, prove to be a more successful strat-egy in the long run than placing all one’s chips on the dollar or euro. Investors with no such ex-posure at present should start building one up now. We therefore make the case for substitut-ing the 50-50 rule with a 30-30-30 rule in favor of the US dollar, euro, and the fi ve friends.


Interview

Investors are underestimating the impact of a Greek sovereign default

Thomas Wacker, Credit Analyst at Wealth Management Research, expects Greece to declare itself insolvent at the earliest next year.

Interview: Simone Hofer Frei, Editor, UBS AG

Mr. Wacker, how likely is it that Greece will leave the Eurozone? In the short term, very unlikely, as leaving would cast Greece into an even deeper crisis and would be seen as a sign that the Euro-zone had failed.

What would be the likely impact of Greece taking itself out of the Eurozone? Economically speaking, leaving would enable Greece to devalue against other currencies and so become more competitive again relatively quickly, which would be far less painful than try-ing to do it by slashing wages. The fi rst country to leave could trigger the same course of action by others if they came to see that it brought more than just disadvantages with it, provided they could remain in the European Union. That sort of scenario is probably rather less critical from an economic point of view than from a political one. The Eurozone could even become economically stronger if weaker countries were to leave it.

Greek debt adds up to something like EUR 340 billion, owed to the following lenders that we know of: EUR 14.6 billion to the International Monetary Fund, EUR 29.2

billion to the Eurozone, approximately EUR 70 billion to the European Central Bank, EUR 58 billion to Greek banks, EUR 30 billion to other EU banks and EUR 15 billion to insurers. It has not been possi-ble to trace the lenders of the remaining EUR 110 billion. What are the risks inherent in this? We see the unknown part of the debt as a se-rious risk, as any restructuring would at once raise the question of who would have to bear the losses associated with these EUR 110 bil-lion and whether this might make it diffi cult for other debtors to pay up.

Even though Greece is small compared to, say, Spain, is there a systemic risk here? There certainly is – a er all, EUR 340 billion, which is what the debts add up to, is a very large amount of money. More to the point, knock-on eff ects – such as Greek banks and companies going bankrupt and a downturn in the prices of bonds issued by other fi nancially weak countries – would batter the fi nancial sys-tem still further.

If Greece were to default, would we have to expect the same sort of shock wave on the markets that set in a er Lehman Brothers went down? The problem common to both these examples is that most market players seem to assume that another rescue is on the way. Announcing re-


Interview

structuring would take a lot of investors by sur-prise, and I think a very large number of them underestimate just how far-reaching the eff ects of a sovereign default would be.

What would a Greek default mean for the future of the Eurozone? It would certainly put it to a serious test, but in the long term it could also give impetus to the reforms that the Eurozone needs, thus making the EU stronger. A fi scal union with constant transfer payments would be needed to stop this sort of thing happening in the future. Whether there will be a strong EU or one that partially disintegrates depends on whether or not the member states are willing to take this step in-volving fi scal transfers.

How does the restructuring of sovereign debt in an orderly manner actually work? Unfortunately, there actually isn’t a proper proc-ess for it, as bankruptcy is the result of the par-ties concerned not being able to agree on fur-ther support measures. Once the government has admitted that its debts are unmanageable and that they need to be restructured, it has to make an off er to its creditors, for example a pro-posal to exchange the debt for new bonds with lower coupons and longer maturities. As lend-ers want to lose as little as possible of what’s owed to them, several rounds of talks are gener-ally needed before an agreement on a creditors’ meeting is reached. Quite o en the process takes several years.

If it does restructure its debts, what are the prospects for Greece?As I see it, it will take Greece at least 10 years to make a lasting recovery. To do that it will need two things – fundamental reforms and a reduc-tion in its debt burden.

Why is the restructuring being delayed? The other countries on the EU’s periphery em-barked on their own consolidation programs just a few months ago. So far they haven’t

made the sort of progress that would make it possible to decouple from Greece. Quite apart from that, the banking sector is still too fragile. I think it makes sense to wait another year un-til banks can be expected to digest these losses without additional support.

What is the danger if restructuring is drawn out for too long? As long as the debt burden remains excessive, most eff orts to cut back on spending will come to nothing, as the debt that has to be serviced is far too great. Simply paying the interest requires new indebtedness. I don’t think it encourages market players to manage risks sensibly if tax-payers’ money keeps on being used to keep highly risky investments from defaulting.

How great is the risk of other highly indebted Eurozone countries – Portugal, Ireland and Spain, for example – going the same way? At the moment, the risk is very great, and I think Belgium and Italy would also be aff ected if re-structuring were to happen too quickly. We be-lieve this risk should become less pronounced over the next two years, provided these coun-tries can manage to get their consolidation plans off the ground.

The US and Japan are just as indebted. Is there a risk of this problem spreading to them? A default in Europe would spark renewed worldwide debate about the long-term safety of US government bonds. Japan, on the other hand, sells its bonds almost exclusively on the domestic market, so there’s no immediate risk of contagion.


Asset allocation Outlook

Beyond the uncertainty

Global economic growth shows signs of a slowdown as infl ation picks up. This marks a more mature stage in the business cycle, but it does not mean the end of equity performance. We expect higher market volatility in coming months but recommend holding on to positions in attractively valued stocks and corporate bonds.

Philipp Schöttler and Mark Andersen, Strategists, UBS AG

Economy moderates next stageThe increase in economic output has been fast-paced in recent quarters, in a traditional recov-ery a er an un-traditional hard recession during 2008 and much of 2009. The next stage of the cycle is emerging with moderate growth and ris-ing infl ation. This is not unusual, but it marks the next stage for fi nancial asset returns as well: equity investors should expect high single-digit annual returns in this period. Alongside the end of the US central bank’s extraordinary liquidity injection (the so-called Quantitative Easing 2 program), market volatility is expected to rise. We advise investors to stick to equities through-out as they are still backed by attractive valua-tions and corporate earnings growth.

Greece in the news againThe Eurozone debt drama now includes specula-tion about the early restructuring of Greek sover-eign debt. The euro consequently weakened and government bond yields of the large developed countries declined. We see some form of default as inevitable to unravel the situation, but we up-hold our base case that such an event will not occur before the European Financial Stability Fa-cility (EFSF) runs out in 2013. Premature or disor-derly restructuring poses a substantial risk to the European fi nancial sector and other peripheral countries, foremost Spain, behooving European politicians to avoid such a scenario. Given the diverging political interests, the risks are clearly to the downside and should not be disregarded.

Markets may be shaken at times as this story inevitably unfolds. In such a risk scenar-io, our call for German equities will most likely suff er as well, though that market should still perform well compared to others in the Euro-zone. For the euro, we expect further weakness ahead with EURUSD trading back toward the 1.30 to 1.40 range over the next few months. Our 12-month horizon foresees more US dollar weakness in store.

Cherry-pick from “fi ve friends” currenciesBetter alternatives to the troubled major curren-cies can still be found in our “favorite 5.” The Canadian dollar and the Swedish and Norwe-gian krona have corrected recently, approaching

Asset allocation strategy

Equity

Fixed income

Cash

Commodities

underweight neutral overweight

Source: UBS WMR, as of 25 May 2011. For more information, please read the most recent US Investment Strategy Guide. See Scale for Investment Strategy in the Appendix for an explanation of the strategy.

--- -- - n + ++ +++


Outlook Asset allocation

levels that make entry positions attractive. The Swiss franc and the Australian dollar still look expensive; we advise against chasing their rally.

Diversify into corporate bondsWe still prefer corporate bonds over govern-ment bonds, where we expect the recent price appreciation to revert. While corporate bond yields are at fairly low levels, we believe their spreads versus government paper are reason-ably priced. Given strong corporate balance sheets, we expect rating and default trends to remain supportive. Corporate bonds, both in In-vestment Grade and High Yield, should be able to outperform Treasuries in line with the yield advantage that they provide.

Commodity setback opens selected opportunitiesMost commodities were hit hard during the fi rst week of May. In our view, the strong downward move was an overreaction, as we do not share the pessimism that is currently getting priced into commodities. Although global growth con-cerns are likely to persist in the short run and commodities may remain volatile in coming weeks, we believe the price correction can be used to build up selected long positions. Our fa-vorites include crude oil, gold and copper.

Extended asset allocation

Asset class Tactical view* Comment

US equities + Solid earnings growth and loose monetary policy to persist. This currently off sets valuations, which are less attractive than abroad.

Non-US developed market equities

– While valuations are more attractive than in the US, sovereign debt con-cerns in the Eurozone and recession in Japan off set the valuation argument.

Emerging market (EM) equities

+ Strong valuation, earnings growth and fi scal fundamentals are partly off set by the risk of infl ation and monetary tightening.

US fi xed income – We prefer US over non-US fi xed income as the dollar has started to rebound from very low levels.

Non-US fi xed income

– – Extremely low yields and overvalued yen make Japanese debt unattractive. Euro under pressure from ongoing debt crisis and structural issues.

Cash (USD) + We prefer cash to non-US Fixed Income.

Commodities n While we expect commodity prices to rise further this year, negative roll yields (resulting from contango term structure of futures prices) should sig-nifi cantly trim total returns.

Source: UBS WMR and Investment Solutions, as of 25 May 2011. *See Scale for Investment Strategy in the Appendix for an explanation. For more information, please read the most recent US Investment Strategy Guide.


Economy US

Economic data has been patchy recently. The disasters in the southern US as well as the Japanese earthquake are showing their undoing here and there in the data. The apparently much more mixed picture represents mostly transitory noise, in our view. We still expect real GDP growth to rebound in 2Q11 a er decelerating in 1Q11.

Thomas Berner, Analyst, UBS Financial Services Inc.

Patchy data belie solid underlying growth trend

Real GDP decelerated to 1.8% q/q annualized in 1Q11 from its 3.1% pace in 4Q10. With nominal GDP growth remain-ing fairly steady (3.8% in 1Q11 versus 3.5% in 4Q10), it seems fair to conclude that it was main-ly the energy-led surge in infl ation that sapped real

purchasing power. In our view, the underlying growth rate is still closer to 3% than 2% in real terms. The oil price has already retreated from

its recent peak of almost USD 115/barrel to around USD 100/barrel. Data has not painted a signifi cant change in the fundamentals for oil. That leaves a speculative run for the exits a er the signifi cant surge as the most likely reason for the sell-off . In any case, we still expect an oil price of USD 110/barrel in 12 months, but the rapid rise in infl ation in the fi ve months through April will very likely not be repeated. If we are right about the underlying growth resilience in real terms and infl ation also moderates again, we should see a decent rebound in real GDP growth in 2Q11.

US economic forecasts (see latest WMR Forecast Tables for additional US and global forecasts)

*year-end level

Source: Datastream, UBS WMR, as of 24 May 2011

About these forecasts: In developing the forecasts set forth above, WMR economists worked in collaboration with economists employed by UBS Investment Research (INV). INV is published by UBS Investment Bank. Forecasts and estimates are current only as of the date of this publica-tion and may change without notice.

in % 2007 2008 2009 2010 2011F 2012F

Real GDP year-over-year (y/y) 1.9 0.0 -2.6 2.9 2.7 2.7

CPI (y/y) 2.9 3.8 -0.3 1.6 2.6 1.4

Core CPI (y/y) 2.3 2.3 1.7 1.0 1.2 1.6

Unemployment rate 4.6 5.8 9.3 9.6 8.7 8.4

Fed funds rate* 4.25 0.25 0.20 0.10 0.25 1.75


US Economy

New clouds have already risen on the hori-zon. The most recent batch of data has made it hard to confi rm or refute our expectations for a growth rebound, as indicators for April have been aff ected by the disasters in the southern US and Japan. Initial jobless claims, one of the timeliest and important indicators, have risen visibly since April. School breaks in New York and New Jersey, a new unemployment program in Oregon, and auto manufacturing disruptions related to Japan all distorted the data higher. Only the most recent report showed modera-tion and builds the case for data aberrations rather than a worsening trend. We continue to expect the downtrend to resume, in line with overall improvement in labor market conditions. The other rather negative development was a plunge in the ISM Non-Manufacturing index from a lo y 57.3 in March to 52.8 in April. Key growth sub-indexes for new orders, business activity and employment all sagged in similar fashion but remained above 50 and are there-fore signaling growth. In sharp contrast, the ISM Manufacturing index stayed at an elevated level of 60.4 in April. Historically, the ISM Manufac-turing index is more important to signaling cy-clical turning points in the business cycle. Even though manufacturing makes up only about

12% of the economy, it is a much more volatile industry than services and thus dictates the busi-ness cycle fl uctuations. In the past, the ISM Non-Manufacturing index has tended to lag the ISM Manufacturing index by up to three months dur-ing sharp turning points. For these reasons, we think the plunge in the ISM Non-manufacturing index should not command too much atten-tion. What’s also important to correctly gauge the most recent economic data landscape is the fact that the April labor market report was very solid. No signs of weakness here. Finally, and this is probably the biggest concern regarding data weakness, the three regional manufactur-ing climate indexes that have been reported so far for May showed substantial drops. The Rich-mond Fed index even fell into contraction terri-tory. We continue to think that the underlying growth trend is solid, but these developments bear close monitoring. One reason for comfort is that these regional indexes can be rather vola-tile and during the spring months of last year they also deteriorated sharply, but the national ISM Manufacturing index never fell below 55. A similar pattern is very likely this year. We con-tinue to call for real GPD growth of 3.5% q/q annualized in 2Q11 and for 3% in 2H11.

Fig. 1: Regional manufacturing climate indexes weakened in MayThree regional and national ISM manufacturing climate indexes

Source: Bloomberg, UBS WMR, as of 27 May 27 Source: Bloomberg, UBS WMR, as of 27 May 2011

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Empire State (lhs) Philly Fed (lhs)Richmond (lhs) ISM (rhs)

Another so patch?

Fig. 2: Initial jobless claims’ surge seems overInitial jobless claims and non-farm payrolls, in thousands

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Non-farm payrolls (lhs) Initial jobless claims (rhs)


Economy Global

Global

A healthy mid-cycle development

Emerging markets

Infl ation peak awaited

Global leading indicators are rolling over. Purchasing managers’ indices (PMIs) saw a cyclical peak just before recent shocks in March, which included the “Arab spring” uprisings and the earthquake in Japan. While perceptions view the current environ-ment as generally high, expectations in the economy have cooled somewhat. As part of the cycle it is normal that an economy bounces back strongly from a recession, but indicators eventually need to stabilize at a more sustainable level. This normalization runs parallel to infl ationary pressures due to rising commodity prices – an unattractive combination for investors. Sensing this dy-namic, fi nancial markets make discounts, which have led to the sell-off of risky assets such as commodities. Ironically, this sup-ports the economy, as lower commodity prices reduce production costs and the need of central banks to engage in more aggressive monetary tightening. Depend-ing on how commodity prices develop fur-ther, headline infl ation numbers may peak in many countries in coming months. This would yield a better growth-infl ation mix in the second half of the year with leading in-dicators at more sustainable levels. We therefore see current dynamics as a healthy mid-cycle development and remain opti-mistic for the medium term.

Ricardo Garcia, Economist, UBS AG

For buyers of emerging market assets, infl a-tion has been a key concern for several months now: How much central bank tightening still lies ahead? What if the au-thorities tighten too much and thereby cause a hard landing?

It appears that, for several reasons, the year-on-year infl ation numbers in the big-ger emerging economies are likely to peak in the second half of 2011 and trend lower into 2012.

The fi rst reason is that monetary pol-icy tightening has been ongoing there for some time now. Brazil began hiking rates more than a year ago and has increased its policy rate by 3.4 percentage points over that period to around 12%. China has raised its banks’ reserve ratio by 5.5 per-centage points over the past 18 months, thereby making it more diffi cult for people to get credit. Both countries also tightened monetary policy through additional meas-ures, including via the exchange rate. We have thus seen impressive tightening in the emerging markets.

A technical factor should also help infl ation. Given that food and commodity prices have risen dramatically over the past year, this makes it more likely that the year-on-year infl ation profi le should peak soon and fall into 1H 2012 because of the base eff ect.

Costa Vayenas, Analyst, UBS AG


Regions Economy

UKJapan

Asia Eurozone A er Spain apparently decoupled from troubled Eurozone countries, speculation about Greece reopened earnest debt dis-cussion. Hobbled progress in Greece and the stubbornly high market interest rate ef-fectively preclude public market refi nancing in 2012, meaning a liquidity shortfall would occur next year. We believe restructuring will be necessary at some point. However, the Ecofi n meeting and remarks from Ger-man Chancellor Angela Merkel have elimi-nated a full-scale, near-term restructuring for now, in our view.

Striking the balance between growth and infl ation remains the biggest challenge for the Bank of England. In April, headline CPI jumped from 4.0% to 4.5%, while core CPI rose from 3.2% to 3.7%. Solid retail sales data also confi rmed that consumers are still willing to spend despite the government’s austerity program. The British Retail Con-sortium reported year-on-year, like-for-like sales for April of 5.2%. This surprsingly strong number was boosted by several fac-tors including the extra bank holiday and the Royal Wedding, but most importantly the unusually warm weather. Long may it last.

First-quarter GDP data surprised on the downside, falling 0.9% q/q (an annualized decline of 3.7%). On a contribution basis, inventory liquidation was the biggest drag on activity, accounting for -0.5 percentage point (ppt), followed by private consump-tion of -0.3 ppt. It is likely that GDP also contracted in the second quarter, which would be the third consecutive quarter of negative growth. Therefore, Japan’s growth rate is likely be negative in 2011 (the fi rst time since 2009), although economic activ-ity should turn up signifi cantly later in the year thanks to reconstruction demand and the normalization of supply chains.

1Q11 GDP growth in North Asia generally surprised on the upside, while countries in South Asia mostly trailed expectations. Despite the volatility in global commod-ity prices and concerns about the supply chain disruptions caused by Japan’s earth-quake and nuclear crisis, recent data sug-gested that production weakness should be short-lived. Moreover, external demand for Asian exports remains strong. Adjusted sea-sonally, Asian exports rose 11.8% m/m in March, following a 9.6% decline in Febru-ary. However, momentum is likely to slow in the near term given that leading indicators like PMI data for China and India moder-ated in April.


Investors should be aware that Emerging Market assets are subject to, among 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 liquid-ity conditions can abruptly worsen. WMR generally recommends only those securities it believes have been registered under Federal U.S. registration rules (Section 12 of the Securities Exchange 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 US or 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 see the WMR Education Notes, “Investing in Emerging Markets (Part 1): Equities,” 27 August 2007, “Emerging Market Bonds: Understanding Emerging Market Bonds,” 12 August 2009 and “Emerging Markets Bonds: Understanding Sovereign Risk,” 17 December 2009. Clients interested in gaining exposure to emerging markets sovereign USD bonds may either buy a diversified fund of such bonds (preferably an actively managed portfolio of such bonds), or they may wish to select bonds from specific countries.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 minimize 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 that have a higher risk profile and who seek to hold higher-yielding bonds for only shorter periods.

China Power shortages have emerged in some Chinese provinces in recent weeks. While this could slow the short-term growth of some heavy industries (like cement, non-ferrous metals, iron, steel, etc.), we do not expect power shortages to translate into a hard-landing scenario for the Chinese economy. This is mainly due to a strong in-ventory build-up during the fi rst quarter, which is likely to off er a good buff er to the slowdown in production. We expect GDP growth to decelerate in the second quarter, followed by an acceleration of growth mo-mentum in the latter part of the year as the power supply issues are addressed.

BrazilEconomic activity slowed in 1Q 2011. Growth dropped to 1.5%, down from 7.0% in the last quarter of 2010. Mean-while, growth in retail sales also slackened, expanding only by 4.1% in March, com-pared to 8.2% in February. Notably, infl a-tion continues to rise, induced for example by construction prices, which surged 1.67% in May, themselves impacted by a 2.90% rise in labor costs. While these dynamics boost the Brazilian real, they also highlight the risk of more drastic monetary policy ad-justments going forward, which could weigh on growth prospects

RussiaSigns of a slowing US economy and con-cerns that the Eurozone debt crisis could escalate further are pushing the price of oil lower and weakening the rouble. Though we expect the Russian central bank to raise interest rates in coming months to bring them towards positive territory, we do not see the rouble strengthening over the me-dium to long term. Higher infl ation than in the US and pre-election pressures for a weaker rouble from exporters should all di-minish support for the rouble versus the US dollar.

India The Indian economy had an undeniably good year 2010-11 with real growth of 8.7% y/y. Solid activity numbers, fueled by a large fi scal defi cit, brought infl ation right back to the levels seen before the fi nancial crisis. Both supply and demand factors have kept infl ation elevated. The Reserve Bank of India has hiked rates nine times in the present cycle, but the impact on prices has been minimal. Since some indicators (indus-trial activity) have remained fairly robust, wholesale price infl ation is likely to stay above 8% year-on-year in coming months.

Economy Emerging markets


Fault lines

Head of IMF: Yes, why not an emerging market candidate?Andreas Höfert, Chief Economist, UBS AG

The doors of Rikers Island jail facility in New York City were barely closed behind Dominique Strauss-Kahn, the former Managing Director of the International Monetary Fund, before the fi erce fi ght for his succession began. An unwrit-ten rule holds that a European leads the Interna-tional Monetary Fund, while an American heads the World Bank.

Emerging market representatives criticize this situation, arguing that their increasing weight in the world economy calls for better representation on the management boards of international economic organizations.The Europeans counter-argued with three main points: 1) the quality of the potential candidate, 2) Europe’s leading proportion of IMF funding contributions, and 3) that the present Greek – or more broadly, Eu-ropean sovereign debt crisis – is better under-stood and managed by a European. What should we make of these arguments?

Granted, there are very good candidates from Europe: current French Finance Minister Christine Lagarde, former British Prime Minister Gordon Brown, former Bundesbank President Axel Weber, or even the Swiss CEO of Deutsche Bank, Joe Ackermann, were among the widely quoted names. But in emerging markets there were equally good potential candidates. Turkish economist and former Head of the United Na-tions Development Program, Kemal Derviş, for instance. Trevor Manuel, current South African Minister of Planning, is another. We can also consider Zhou Xiaochuan, the current governor of the People’s Bank of China, who has also written profoundly on reforming the Interna-tional Monetary System.

The argument that Europe is still the IMF’s main fi nancial contributor has diminishing va-lidity. The truth is that China, the world’s top emerging market, is now the sixth main con-tributor to the IMF, but by 2013 China will rank third behind the US and Japan. Moreover, by then Brazil, Russia and India will also rank among the top ten contributors.

The fi nal argument for a European head of the IMF was stated most prominently by German Chancellor Angela Merkel: “Given that we have considerable problems with the euro and that the IMF is very strongly involved here, much can be said for the possibility of install-ing a European candidate.” In my view, this is intellectually slightly dishonest. One could ask: Why then was the IMF head not chosen from Latin America during the Argentinean crisis, or from Asia during the Asian crisis? Further, isn’t there a confl ict of interest if the IMF head during the European crisis comes from Europe? And if Europeans are such experts at solving their own problems, why do they need the IMF at all?

Nevertheless, as I write this article, it seems that the Europeans will have their way once again. Here the emerging markets should take note: They need to work together a lot better to have a bigger impact in international policy-making. That Mr. Strauss-Kahn would leave soon in any case was known; he had eyes for the French presidency. Hence, what were the emerging markets waiting for? Where is their agreed candidate? They should take a lesson from Europe’s experience in inter-governmental co-ordination.


Stock recommendations

Source: FactSet, Thomson Financial and UBS WMR. Prices and performance as of 20 May 2011. Since inception, the U.S. Top 25 Stock List has included 132 stock recommendations, of which 77 advanced and 55 declined while on the list. See the Appendix for important information regard-ing performance calculations. For adetailed discussion of the methodology underlying the U.S. Top 25 Stock List and updates to the list, please see the most recent U.S. Top 25 Stock List.Stocks which are only covered by UBS Investment Research are annotated as such with a “+” sign. UBS Investment Research is part of UBS Invest-ment Bank (the UBS business group that includes, among others, UBS Securities LLC).** 2006 data include the total return from the list’s inception on 18 January 2006.

Recommendation list Data as of 20 May 2011

Company Ticker Sector Price

Adobe Systems ADBE Technology $35.31

Ameriprise AMP Financials $62.17

Apple AAPL Technology $335.22

Applied Materials AMAT Technology $14.09

Broadcom BRCM Technology $33.51

Coca-Cola KO Consumer Staples $68.30

Colgate-Palmolive CL Consumer Staples $86.55

Dow Chemical DOW Materials $36.01

Emerson Electric EMR Industrials $54.09

FedEx FDX Industrials $93.82

General Mills GIS Consumer Staples $39.72

Halliburton HAL Energy $47.18

Hewlett-Packard HPQ Technology $35.98

Humana HUM Healthcare $79.79

Illinois Tool Works ITW Industrials $57.09

Intel INTC Technology $23.22

Lear Corp LEA Consumer Disc. $49.98

McDonald’s MCD Consumer Disc. $82.33

Medtronic MDT Healthcare $42.21

MetLife MET Financials $44.22

Schlumberger SLB Energy $83.50

Starwood HOT Consumer Disc. $59.21

Teva Pharmaceuticals TEVA Healthcare $49.87

Thermo Fisher Scientifi c TMO Healthcare $65.18

US Bancorp USB Financials $25.20

PerformanceSince inception on 18 January 2006

Period Top 25 S&P 500

Since inception 24.1% 16.1%

2011 year-to-date 4.1% 6.8%

2010 9.7% 15.1%

2009 29.5% 26.5%

2008 -39.9% -37.0%

2007 20.6% 5.5%

2006** 15.8% 12.4%

U.S. Top 25 Stock List

Stock recommendation lists and performance can be found in the UBS Weekly Guide in the future. For more information, ask your Financial Advisor.



Source: FactSet, Thomson Financial and UBS WMR. Prices and performance as of 20 May 2011. Since inception, the ADR Top List has included 47 stock recommendations, of which 27 advanced and 20 declined while on the list. See the Appendix for important information regarding perform-ance calculations. For adetailed discussion of the methodology underlying the ADR Top List and updates to the list, please see the most recent ADR Top List.For additional information, see Education Note: Understanding ADRs, 29 Nov. 2007. Stocks are covered by UBS Investment Research. UBS Invest-ment Research is part of UBS Investment Bank (the UBS business group that includes, among others, UBS Securities LLC).** 2009 data include the total return from the list’s inception on 26 October 2009.

Recommendation list Data as of 20 May 2011

Company Ticker Country Price

ABB ABB Switzerland $26.32

American Movil AMOV Mexico $51.20

Anheuser-Busch InBev BUD Belgium $60.44

Banco Santander Brasil BSBR Brazil $10.84

Bank of Nova Scotia BNS Canada $60.13

Barrick Gold ABX Canada $45.60

BHP BHP Australia $93.18

Bombardier BDRBF Brazil $6.87

British American Tobacco BTI UK $89.47

China Unicom CHU China $21.24

Eni E Italy $48.10

Honda Motor HMC Japan $37.29

ING ING Netherlands $11.70

Lloyds Banking LYG UK $3.33

Magna International MGA Canada $49.07

Nestle NSRGY Switzerland $62.24

Nexen NXY Canada $22.89

Novartis NVS Switzerland $61.39

Repsol YPF REPYY Spain $31.65

Rio Tinto RIO UK $66.59

Royal Dutch Shell RDS.A UK $69.64

SAP SAP Germany $61.72

Taiwan Semiconductor TSM Taiwan $13.41

Talisman Energy TLM Canada $20.87

Telefonica TEF Spain $23.77

Teva Pharmaceutical TEVA Israel $49.87

Veolia Environnement VE France $29.98

PerformanceSince inception on 26 October 2009

Period ADR List S&P ADR Index

Since inception 13.6% 13.9%

2011 year-to-date 3.3% 3.7%

2010 7.2% 7.5%

2009** 2.5% 2.2%

ADR (American depository receipt) top list



Q-GARP (quality growth at a reasonable price)The Q-GARP stock list provides investors with stocks that we believe should be included in a well-balanced portfolio to take advantage of the fundamental and cyclical trends that are likely to favor true secular growth stocks in the current market environment. We believe these companies off er attractive valuations relative to their high levels of sustainable growth, relative margin stability, and high profi tability. In our view, at this stage of the recovery, the risk-reward trade-off favors higher-quality stocks.

Source: FactSet, Thomson Financial and UBS WMR. Prices and performance as of 20 May 2011. Since inception, the Q-GARP stock list has included 93 stock recommendations, of which 56 advanced and 37 declined while on the list. See the Appendix for important information regarding performance calculations. For a detailed discussion of the methodology underlying the Q-GARP stock list and updates to the list, please see the most recent “The world according to Q-GARP” report.Stocks which are only covered by UBS Investment Research are annotated as such with a “+” sign. UBS Investment Research is part of UBS Investment Bank (the UBS business group that includes, among others, UBS Securities LLC).** 2007 data include the total return from the list’s inception on 31 May 2007

Recommendation List Data as of 20 May 2011

Company Ticker Price

3M MMM $93.56

Adobe Systems ADBE $35.31

AFLAC AFL $49.57

Apple AAPL $335.22

Bed Bath & Beyond BBBY $53.83

Coach COH $59.48

Coca-Cola KO $68.30

Colgate-Palmolive CL $86.55

Danaher DHR $54.66

Darden Restaurants DRI $51.52

Emerson Electric EMR $54.09

Exxon Mobil XOM $81.57

General Mills GIS $39.72

Home Depot HD $37.05

Illinois Tool Works ITW $57.09

McDonald’s MCD $82.33

Medco Health Solutions MHS $64.30

Medtronic MDT $42.21

Microso MSFT $24.49

Murphy Oil MUR $66.88

Nike NKE $85.05

PepsiCo PEP $71.30

Procter & Gamble PG $67.36

Rockwell Collins COL $61.66

Starbucks SBUX $36.61

United Parcel Service UPS $74.05

United Technologies UTX $87.50

Walgreen WAG $44.37

PerformanceSince inception on 31 May 2007

Period Q-GARP S&P 500

Since inception 18.4% -5.0%

2011 year-to-date 6.6% 6.8%

2010 17.2% 15.1%

2009 28.3% 26.5%

2008 -27.7% -37.0%

2007** 2.1% -3.0%

Stock recommendation lists and per-formance can be found in the UBS Weekly Guide in the future. For more information, ask your Financial Advisor.



Dividend Ruler StocksOver the past 100 years, dividends have contributed nearly half of the total return from US equity markets. We believe investors likely will be more attracted to stocks where they are “paid to wait.” The Dividend Ruler Stocks screen for companies that off er a reasonable current dividend yield and have a strong track record of dividend growth. Dividend growth is important since it not only showcases the ability of the current management, but provides some infl ation protection for investors who receive an income stream that grows over time.

Source: FactSet, Thomson Financial and UBS WMR. Prices and performance as of 20 May 2011. Since inception, the Dividend Ruler Stock list has included 206 stock recommendations, of which 140 advanced and 66 declined while on the list. See the Appendix for important information regarding performance calculations. For a detailed discussion of the methodology underlying the Dividend Ruler Stock list and updates to the list, please see the most recent “ Dividend Ruler Stock list “ report.Stocks which are only covered by UBS Investment Research are annotated as such with a “+” sign. UBS Investment Research is part of UBS Invest-ment Bank (the UBS business group that includes, among others, UBS Securities LLC).** 2003 data include the total return from the list’s inception on 17 October 2003.

Domestic companies Data as of 20 May 2011

Company Ticker Dividend yield Price

3M MMM 2.4% $93.56

AFLAC AFL 2.4% $49.57

Air Products & Chemicals APD 2.5% $91.27

AT&T T 5.5% $31.32

Boeing BA 2.2% $77.52

Coca-Cola KO 2.8% $68.30

Colgate-Palmolive CL 2.7% $86.55

Emerson Electric EMR 2.6% $54.09

ExxonMobil XOM 2.3% $81.57

General Mills GIS 2.8% $39.72

Home Depot HD 2.7% $37.05

Illinois Tool Works ITW 2.4% $57.09

Intel INTC 3.6% $23.22

Johnson & Johnson JNJ 3.5% $65.69

Medtronic Inc. MDT 2.1% $42.21

McDonald’s MCD 3.0% $82.33

NextEra Energy NEE 3.8% $57.78

Northeast Utilities NU 3.0% $36.10

PepsiCo PEP 2.9% $71.30

Praxair PX 1.9% $104.47

Procter & Gamble PG 3.1% $67.36

Raytheon RTN 3.5% $49.45

United Parcel Service UPS 2.8% $74.05

United Technologies UTX 2.2% $87.50

International companies Data as of 20 May 2011

Company Ticker Dividend yield Price

British American Tobacco + BTI 4.2% $89.47

National Grid + NGG 5.8% $51.45

Nestle + NSRGY 3.6% $62.24

Novartis + NVS 4.1% $61.39

Ntt Docomo + DCM 3.8% $17.90

Pearson + PSO 3.4% $18.71

Sanofi -Aventis + SNY 4.6% $38.29

Veolia Environnement + VE 5.4% $29.98

Performance of Dividend Ruler Stocks Since inception on 17 October 2003

Period Div. ruler S&P 500 S&P Global 1200

Since inception 105.6% 49.4% 71.1%

2011 year-to-date 9.3% 6.8% 5.8%

2010 10.9% 15.1% 11.9%

2009 23.2% 26.5% 31.7%

2008 -23.8% -37.0% -40.1%

2007 5.6% 5.5% 10.2%

2006 22.8% 15.8% 21.5%

2005 5.3% 4.9% 10.2%

2004 23.4% 10.9% 14.9%

2003** 7.2% 7.4% 8.1%


Technical Analysis

Every year at about this time the “sell in May and go away” trading theory makes its way into the front pages of business publications and receives widespread coverage from the media. And eve-ry year traders/investors fret about a major market setback during the sum-

mer months. So is this trading phenomenon a reliable indicator? Our technical study on the S&P 500 (SPX) dating back to 1929 suggests the three consecutive months during the sum-

Infl ection points across fi nancial markets

Concerns over Europe’s sovereign debt crisis, weakness across various commodity sectors and select Emerging Markets equities, as well as subtle shi s towards more defensive sectors of the US equities market, may give investors pause as we approach the summer months. We think now is a good time to review the technical situation across various fi nancial markets.

Jon Beck, Technical Strategist, UBS Financial Services Inc.

mer (June, July and August) are indeed a chal-lenging period generating average SPX gains of 0.45%. However, we are pleasantly surprised to fi nd that if we delve further into this study, we notice that during pre-election years (2011) the SPX returns are decisively stronger as the “sell in May and go away” approach did not work as advertised. During the three consecutive months over the summer, SPX produced cumu-lative average gains of 2.92%, coming close to the cumulative average gains of 4.36% during the three strongest consecutive months during the fall (November to January). Since this year is another pre-election year cycle, we suspect the market may be upwardly biased. So what is the

Test of key S&P 500 suggests an infl ection point

Source: Bloomberg and UBS WMR (prices of 23 May 2011)

1249

1269

1289

1309

1329

1349

1369

Mar Apr May

upside gap


Technical Analysis

market tape telling us about the future techni-cal outlook for US equities? The convergence of a number of our short-term technical indicators strongly suggests SPX may be approaching an infl ection point. It appears the 2+ week correc-tion is nearing a critical phase and the outcome of this battle between the bulls and the bears. We suspect 1,313-1,318 is a signifi cant near-term support zone as there are approximately a half dozen technical indicators converging at this area. The ability to fi nd support here may set the stage for the next sustainable rally. Our 2011 technical projection remains basically the same; 1,440-1,460 as early as the next 1-3 months. On the downside, a convincing viola-tion of 1,313-1,318 warns of a near-term top leading to another decline to 1,294.70 and a retest of the pivotal April 2011 low. 1,220-1,250 remains key intermediate-term support. Violation here confi rms a major top and the start of a major downturn.

It remains our contention that the US Dollar Index remains in a longer-term structural bear market, evident by a multi-decade complex head and shoulders distribution top pattern. However, on a near-term basis an extreme over-sold condition can o en produce a sharp and explosive rally. The recent two-week rally is one of these powerful countertrend rallies partly driven by short covering and by the unwinding of carry trades, in our view. Similar to the key test taking place in the US equities market, the

US dollar is also nearing a critical juncture as it tests important supply near 76-78.

Ten-year Treasury yields are also undergo-ing a critical test as they approach important support near 3.15% +/- .05%. A convincing break of support here would confi rm a short-term head/shoulders top and suggests down-side risks for TNX toward key secondary support at 2.75%-2.80%. The top of a three-year sym-metrical triangle at 3.8% provides key supply. We suspect that TNX will be locked in a volatile trading range between 2.5% and 3.8% over the intermediate-term horizon.

Our longer-term structural bullish call for the commodities market in general remains in-tact. However, the sharp sell-off s over the past few weeks have been unnerving for traders/investors. We suspect that they will become in-creasingly selective as dispersions are develop-ing within commodities. Sharp sell-off s in silver and crude oil suggest a transition into wide trading ranges.

SPX has been relatively outperforming its foreign counterparts including Europe (EAFE), Japan (Nikkei 225) and Emerging Markets (MSCI Emerging Index). However, the structural trends still favor outperformance coming from Emerg-ing Markets in the years ahead.

S&P 500 DJIA NASDAQ 10-Yr. Treasury (%)

Support 1313-1319 12100-12300 2700-2710 3.10-3.15%

1290-1295 11555.48 2603.5 2.75-2.80%

Resistance 1350-1360 12600-12700 2800 3.30%-3.40%

1370.58 12876 2887.75 3.75%-3.80%

Technical levels

Source: UBS WMR as of 23 May 2011


Below are excerpts from our US Equity Sector monthly reports which, along with updates, are located in the Equity section of the Online Services Research website. For sector strategy, see the most recent Investment Strategy Guide.

Equity market US sectors

High Conviction Calls Sector analysts are required to have at least one “high conviction” outperform or underperform call for each sector they cover. Analysts have discretion over the selection of a recommendation as high conviction and the grounds for selection (e.g., greatest upside/downside to price target, most/least compelling investment case, etc.). The basis for each high conviction call is set forth in any research report identifying a recommendation as such.

Industrials

The answer to trailing sector performance may lie in 2Q11E expectations

Tallying the results from the fi rst quarter 2011 earnings season for the both the S&P Industrial sector and the S&P 500 suggest the market may have already discounted the sector’s good re-sults, leading to a sell on the news event. The S&P Industrials sector posted sales and earnings growth of 9% and 35%, versus the 9% and 21% logged by the S&P 500. Despite posting better earnings growth, the S&P Industrials sec-tor’s total return performance has substantially lagged the S&P 500 since our last report (27 April – 23 May). During this period the S&P In-dustrials sector has fallen 4.8% versus a 2.8% decline in the total return for the S&P 500.

We believe the relative underperformance may lay in the 2Q11E consensus expectations that appear to have lapped the period of rela-tive outperformance. At present, the consensus estimates for sales and earnings growth peg the S&P Industrials sector’s sales and earnings growth at 7% and 14% slightly behind the 10% and 14% anticipated for the S&P 500.

Andrew Sutphin, Jonathan WoloshinAnalysts, UBS Financial Services Inc.

High Conviction Calls

3M Co. Outperform

Danaher Outperform

FedEx Outperform

Illinois Tool Works Outperform

United Technologies Outperform

Consumer Staples

Should continue to outperform

Our equity strategy group recently raised its recommended weighting for US Consumer Sta-ples from Moderate Overweight to Overweight. On balance, the sector’s fundamental outlook appears sound. Near-term earnings growth has been tempered as input costs rise more quickly than companies can pass through pric-ing. However, we continue to believe earnings growth should accelerate as the year unfolds, and we view the sector’s relative valuation as undemanding.

Our top picks continue to refl ect our bias toward consumer packaged goods companies with emerging markets exposure and our view that leading brands are best poised to grow in developed and emerging markets. We look for companies with successful productivity or cost savings initiatives that can fund investments to drive future growth. Taken together, these at-tributes should contribute to a company’s ability to post upside to earnings expectations. Other important considerations include management quality, fi nancial fl exibility, solid dividend yields, and attractive valuation.

Among consumer packaged goods compa-nies, we see the most appealing opportunities in household products/cosmetics and beverage stocks, refl ecting their generally higher weight-ing in international markets. Sally DesslochAnalyst, UBS Financial Services Inc.


Coca-Cola Outperform


US sectors Equity market

Consumer discretionary

Despite bad weather, consumer spending is healthy

Year-to-date, the Consumer Discretionary sec-tor posted a 6.0% gain (as of May 24, 2011), outperforming the S&P 500 by 1.3 percentage points. We have a moderate underweight on the Consumer Discretionary sector. Our sector thesis refl ects our view that macroeconomic factors, including the recent spike in gas prices, continue to weigh on consumers.

Spring started without much to celebrate. April weather was cool and very rainy across the US. In isolated areas, tornadoes caused natural disaster zones. Despite the seemingly unfavora-ble conditions, consumer spending stayed on its positive trajectory (year/year) through the end of April. According to the US Census Department, retail and food service sales grew 7.6% year/year (adjusted for seasonal variation, holidays and trading-day diff erences). Early indications for May do not signal major deterioration from April, despite continued bad weather. However, our sense is the consumer environment has not sig-nifi cantly picked up since the end of last month.

We prefer the sub-sectors of Autos & Auto Components and Consumer Services (restau-rants, hotels).

Alexandra Mahoney, George Lambertson, Jon WoloshinAnalysts, UBS Financial Services Inc.


Comcast Outperform

Dana Holdings Outperform

Dollar General Outperform

Lear Corp Outperform

Magna International Outperform

Starbucks Outperform

Starwood Hotels & Resorts Outperform

Information technology

Climbing the wall of worry!

Intel has taken a prominent place in the news of late. First it was the blow-out earnings num-bers and strong guidance. Second was the an-nouncement of a fundamental change in their construction of transistors to a tri-gate technol-ogy. Most recently was a downgrade of their stock by a prominent sell-side analyst and the pall it casts over much of the technology sec-tor. Do you think Intel would provide aggres-sive guidance if they actually stuff ed the channel with product? We’ve seen consumer PC weak-ness at Hewlett-Packard and Dell but they’re also seeing PC strength continue within the en-terprise as the refresh cycle continues.

Investor worries are exacerbated by mixed commentary from the PC supply chain as well as the source of demand strength. Both are based mostly in Asia. Is the weakness at one notebook manufacturer actually market share loss to an-other manufacturer? Do market research serv-ices that most analysts used for unit demand forecasts really have as good a handle on sales in Sichuan Province or Bangalore as they do in New York or London?

The uncertainties create the wall of worry, the uncertainty. But that’s the technology sec-tor and for it to be anything diff erent would be abnormal. So we’ll stick with our strategy of fo-cusing on stocks with product-centric catalysts and/or market share gains. We believe these stocks should outperform.

Bob FaulknerAnalyst, UBS Financial Services Inc.


Qualcomm Underperform



Financials

Sector overviewWe remain neutral on the banks. The group has underperformed the market in 2Q to date on concerns, we believe, related to a weak loan growth and revenue outlook, based on sluggish macroeconomic trends, continued weak hous-ing data and the impact of regulation. Yet, as-set quality continues to improve and we have seen signs of improving loan trends in 2Q. In addition, capital levels and liquidity are at high levels and valuations are more attractive given the weakness in the quarter.

Our positive view on the Insurance industry group is based on attractive valuations, stable to growing earnings and solid capital positions. Although we prefer Life over P&C Insurers as they have more positive catalysts, P&C insurers could benefi t from higher premium rates driven by recent catastrophe losses. Asset Managers have benefi ted from rising equity markets and improved fl ows. Exchanges continue to be im-pacted by mergers and acquisitions activity and speculation.

Real Estate Investment Trusts (REIT) contin-ue to benefi t from low interest rates, access to capital, generally improving fundamentals and a relative yield advantage. Our concern centers on REITs’ prices and what funds from operations and net operating income growth rates are cur-rently being discounted. We continue to believe the multifamily group is the most attractive sub-sector in the REIT industry group. For a further discussion on this topic, we wish to highlight our report, “Housing’s pain is multifamily’s gain,” 8 September 2010.

Michael Dion, Dean Ungar and Jonathan WoloshinAnalysts, UBS Financial Services Inc.


Ameriprise Financial Outperform

Camden Properties Outperform

JPMorgan Chase Outperform

Metlife Outperform

Piedmont Office Realty Underperform

US Bancorp Outperform

Wells Fargo Outperform

Healthcare

Valuation catch-up Year-to-date, healthcare was the best perform-ing sector of the S&P 500—up 12.6% com-pared to the S&P 500 Index of 4.7%—begging the question of whether anything has changed in the healthcare marketplace since last year when healthcare stocks were the worst per-forming sector of the S&P 500. Fundamentally, we believe little has changed in healthcare mar-kets and, if anything, we continue to think that the seemingly never-ending focus on healthcare costs will lead to increased pricing pressure and low healthcare utilization (e.g., fewer hospital admissions and physician visits) for a sustained period.

However, the appeal of defensive stocks, especially those with attractive valuations such as healthcare, has led to stellar performance year-to-date of the sectors. The best perform-ing healthcare subsector has been managed care organizations (MCOs), up 40% this year, partly because of lower medical costs. Mid-cap healthcare subsectors, such as mid-cap pharma-ceuticals, biotechnology and healthcare IT, have also done quite well, because of improving fun-damentals.

Many other healthcare subsectors, particu-larly large-cap pharmaceuticals, medical technol-ogy and biotechnology, have also outperformed the market index. However, such performance is mostly not related to improving fundamentals and, in our opinion, is mostly valuation catch up from underperformance from last year.

Jerome BrimeyerAnalyst, UBS Financial Services Inc.


Celgene Corp. Outperform

Teva Pharmaceuticals Outperform


US sectors Equity market

Energy

Improved risk/reward

With oil prices now below USD 100/bbl, we be-lieve that current oil and refi ned product prices are sustainable from a demand perspective. In the last week, the national average retail gaso-line price has fallen once again to below USD 4.00/gallon. This should halt negative demand trends and remove some of the risk of a further decline in oil prices.

We continue to estimate an average oil price of USD 105/barrel (bbl) for 2011. We project stronger oil market fundamentals in the second half of this year, driven by positive eco-nomic trends that would support worldwide oil demand growth. Under this scenario, which is healthier than when oil price shocks are driven by supply concerns, we expect oil demand to be more resilient.

We estimate that energy equities refl ect just USD 90/bbl oil. We believe the risk/reward for oil levered equities has turned positive for the next twelve months. Further downside in oil prices might be limited by Middle East uncertainty, as well as by the positive near-term fundamental outlook. Assuming oil prices stabilize around current levels over the intermediate term, we believe energy equities hold some unrealized value.

Nicole DeckerAnalyst, UBS Financial Services Inc.


Andarko Petroleum Outperform

Devon Energy Outperform

Halliburton Outperform

Hess Outperform

Schlumberger Outperform

Utilities

Why so excited?We recently lowered our rating on the Utilities sector from Moderate Underweight to Under-weight. Year-to-date, the sector is up 7.0%, outperforming the S&P 500 by more than 220 basis points (bps). We believe this outperform-ance, which is a reversal from the 270 bps of year-to-date underperformance as of the last monthly sector report published on 28 April, has been largely sentiment-driven and is unsup-ported by fundamentals.

We believe the recent rotation into defensive sectors (and regulated utilities in particular), due to concerns about a period of slower economic growth, has largely run its course. We expect this to reverse in the coming months as lower interest rates and slightly lower oil prices provide a mod-est boost to consumer spending. Importantly, we believe the economy is in a sustainable economic expansion driven by moderate but durable labor market gains. Within the regulated utility sub-group we prefer companies that can benefi t from continued investments in transmission infrastruc-ture or have low relative valuations.

Merchant power generators—which com-prise 40% of the Utilities benchmark—per-form best when natural gas prices rise (there is a strong correlation between gas and power prices). Natural gas prices remain depressed, and our commodity team expects them to rise only modestly this year. That being said, there are some select merchant power generators that should see volumes increase as power mar-kets begin to tighten. In the big picture, power markets are getting into better balance and we expect a cyclical upturn in merchant power gen-erator earnings to materialize at some point in the next 12 to 24 months.

David LefkowitzAnalyst, UBS Financial Services Inc.


Calpine Outperform

ITC Holdings Corp Outperform

NextEra Energy Outperform



Telecommunications services

AT&T supports telecom sector outperformanceThe S&P 500 Telecommunications Index reg-istered a 3% total return over the last month compared to -1.4% for the S&P 500. It has also outperformed the S&P 500 year-to-date, with a total return of 7.5%. The outperformance is signifi cantly due to the strong performance of AT&T, which is up 9.1% on a total return basis year-to-date and has the largest market cap in the telecom index. We expect AT&T to benefi t from substantial merger synergies, an improved wireless pricing environment, an improved spec-trum position and an attractive merger valuation.

We think it has recently become more of a consensus view that wireless telecom opera-tors need to be in a position to cover the costs of a robust telecom network that will be more important as data traffi c increases and custom-ers and companies use increasingly powerful smart phones with data intensive consumer and enterprise applications. Therefore, we are increasingly positive about the likelihood of the AT&T/T-mobile merger to be approved by the Federal Communications Commission and the Department of Justice. But we also think that there will be plenty of conditions for approval of the merger. These conditions are likely to in-clude divestitures of markets and spectrum as well as behavioral conditions such as privacy, pricing for specifi c wireless plans, and possibly unbundled broadband.

George LambertsonAnalyst, UBS Financial Services Inc.


American Tower Outperform

CenturyLink Outperform

Materials

Great expectations met in 1Q11 results, but the dollar hurts

In the fi rst quarter (1Q11) reporting period, the S&P Materials sector posted sales growth of 17% and earnings growth of 55%, surpassing the S&P 500’s growth of 9% and 21% respec-tively. In fact, 77% of the S&P Materials sector exceeded sales expectations for the quarter and 73% beat earnings expectations. This compares favorably to the 1Q11 results posted by the S&P 500, which saw 64% of reporting companies surpass sales expectations and 66% beat antici-pated earnings estimates.

Despite these strong 1Q11 results posted by the Materials sector, their total return per-formance lagged the overall market. While the S&P 500 has posted year-to-date and monthly (11 April - 12 May) total returns of 8.0% and 2.0%, the Materials sector has lagged with to-tal returns of 2.5% and (1.3%) over the same periods.

Investor concern focused on: 1. potential slowing global economic growth; 2. continued monetary tightening by China; 3. the end of the second round of Quantitative

Easing; and 4. tensions in the Middle East, which may have

contributed to the recent strength in the US dollar and the slide in commodity prices.

Andrew SutphinAnalyst, UBS Financial Services Inc.


Alcoa Underperform

Celanese Corp Outperform

Dow Chemical Outperform

Potash of Saskatchewan Outperform

Air Products Outperform


Emerging marketsInvestors still scared by infl ation

For emerging market equities buyers, infl ation has been a key concern for several months: How much further will central banks tighten to slay the infl ation dragon, and what if authorities tighten too much and cause a hard landing? These concerns cloud the investment outlook and are cited as reasons why emerging market equities are up by only 1%, 5% behind devel-oped stock markets.

Outlook expected to improve in second half of the yearIf investors see beyond today’s uncertainties, the argument goes, emerging market assets, and equities in particular, should gain support. Recognizing present investor concerns, there are several factors that we believe will support emerging market equities in the year ahead. First, we see infl ation peaking in many emerging market countries in the second half of 2011 and

declining into 2012. Central banks in many emerging countries have been tightening mon-etary policy for a while now. China and Brazil began hiking rates more than a year ago, and Brazil increased its policy rate by more than 350 bps over that period. We expect falling year-on-year infl ation rates in 2H 2011 and into 1H 2012 due to the base eff ect. Second, the recent set-back in commodity prices is likely to drag down headline infl ation near-term. Combining both factors we expect lower infl ation rates into the second half to support emerging equity mar-kets. As a result, commodity-export oriented markets such as Russia might experience less appealing returns, whereas commodity-import oriented countries are likely to benefi t.

Growth should support equity marketsThird, the economic growth outlook looks sup-portive for both 2011 and 2012, when we ex-pect average emerging market real GDP growth to outperform that in the developed markets by around 4% per year. If we add in the higher av-erage infl ation rates in the emerging markets, we get average nominal GDP growth rates of around 12% (6% growth + 6% infl ation) for this year and next – three times as much as the 4% projected for developed countries (2% growth + 2% infl ation). Since equities are ulti-mately about earnings growth, we expect emerging market equity prices to eventually validate this higher growth outlook. In addition, the 10% valuation discount of emerging market equities indicates that higher growth expecta-tions are not yet discounted in emerging market stock market prices.

Oliver Dettmann, Analyst, UBS AG

Emerging markets Equity market

125

115

105

120

110

95100

9085

Source: Thomson Finacial, UBS WMR, as of 25 May 2011

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

Emerging MarketsWorld

MSCI Emerging markets vs. MSCI World 12-month performance, local currencies


Bond market US Sectors

Healthcare: Patient is healing

The political battle over the Patient Protection and Aff ordable Care Act (healthcare reform) is be-hind us, and short-term visibility has improved. However, as discussed in our “The Decade Ahead” publication, we believe the sector is bound for further major changes.

Aging individuals have greater demand for healthcare services, putting pressure on costs. In addition, a population that is aging at a faster pace than medical schools’ ability to provide the system with new doctors is likely to eventually result in a shortage of physicians. Addressing this probable scenario will require innovative measures such as the development of compre-hensive electronic health records, and genetic analysis to determine disease potential and drug selection among others.

Healthcare spending in the US is already high relative to other members of the Organi-zation for Economic Cooperation and Develop-ment (OECD). Curing this situation will require better coordination between sector participants to avoid the ineffi cient use of technology, and unnecessary tests to name a few. O entimes, apparently unnecessary tests are conducted preemptively as protection against possible mal-practice-related lawsuits, suggesting that tort reform is also well overdue.

Some of the managed care organizations (MCOs) we follow are already moving in the right direction by acting as consolidators in a sector that is still fragmented. New payment schemes are emerging with fee-for-service

gradually giving way to bundled payment. More MCOs are now reimbursing for the entire epi-sode of care, rather than for each component of the episode, resulting in better coordination between participants involved, and signifi cant cost savings.

Although encouraging, the road ahead for MCOs will not be pothole-free. Stubbornly high unemployment in the US will likely continue to constrain MCOs’ commercial business growth. Most have been successful in imposing cost discipline, delivering lower-than-expected medi-cal loss ratios (MLRs) and stable margins. How-ever, effi ciency gains may have some negative side-eff ects. The healthcare reform mandates a minimum payout of 80% of premiums for in-dividuals and small groups, and 85% for large groups eff ective 1 January 2011. MCOs that consistently deliver below-mandate MLRs will have to eventually lower premiums to comply with the law.

All things considered, we continue to see more value in MCOs and pharmacy ben-efi t managers than in drug producers (pharma). Pharma credits boast strong fundamentals, but valuations are relatively tight, and credit ratings for several drug producers have come under pressure due to large acquisitions, and/or a shi toward a more aggressive fi nancial strategy de-signed to boost equity returns at the expense of bondholders. That said, if an investor has a preference for pharma, we suggest generics-levered credits.

Donald McLauchlan, Analyst, UBS Financial Services Inc.


US Sectors Bond market

Technology: A new found fondness for debt

As the market anticipates an end to cheap credit af-ter the end of QE2, more companies have issued debt to take advantage of historically low rates. This has been pronounced in the tech space, with com-panies such as Google announcing an inaugural USD 3 bn debt off ering.

We expect that these companies will continue to be frequent issuers in the future as, in most instances, balance sheets can accommodate ad-ditional debt, and debt fi nancing may be the most cost-eff ective method of fi nancing trans-actions in an industry that has been very active with M&A activity.

The largest business risk for companies in this sector is technology risk – the risk that in a rapidly changing sector, a company’s technol-ogy is surpassed by its rivals, thus leading to a precipitous drop in fi nancial results, and thus credit ratings. However, we view the probability of such an event as unlikely, given the ability of many of these companies to become entrenched in the operations of their business customers, and the daily lives of retail customers.

Other risks to the sector that have been highlighted in the media include potential dis-ruptions to technology supply chains due to the earthquake in Japan, further unrest in the Mid-dle East, North Africa region, and a secular slow-down in PC sales. Still, corporate earnings re-ports have provided little evidence that this is the case thus far. As demonstrated by recent earn-ings announcements, PC sales remain strong, despite a secular shi to smartphone and tab-

let usage. Nonetheless, consumer demand has been so in developed economies, though this is partially off set by stronger demand in emerg-ing markets, and corporations have remained somewhat cautious with regard to IT spend due to the volatile macroeconomic climate and con-tinued high unemployment rates.

While management teams have historically been rather conservative in balancing business needs versus the demands of shareholders, the allocation of funds to shareholder-friendly activi-ties has increased in the past year. Companies have taken to instituting or increasing dividends, and share repurchase programs have been revi-talized. In general, we think the ability of these companies to generate cash will allow them to fund these activities through operations and maintain very strong investment grade ratings.

Tech companies have been extremely active in recent years in acquiring new technologies from smaller players that added new capabilities or brought potential threats in-house. The M&A front remains active in 2011 with companies making bolt-on acquisitions that diversify their business or sometimes entering new business segments that are in direct competition with others in the industry. We see the rapid pace of M&A transactions continuing, especially in the so ware and services spaces due to the lack of organic growth.

David Wang, Associate, UBS Financial Services Inc.

Credit Sector reports and our Corporate Bond Valuation Reports are located in the Credit section of the Online Services Re-search website.


Bond market US Sectors

Finance: A shell of its former self

The Non-bank Financial sector has experienced meaningful change over the past few years as credit rating downgrades, changing business mod-els, and business unit sales have resulted in a number of issuers being dropped from the index. Today, only three issuers comprise over

95% of the index with General Electric Capital Corp (GECC) making up the vast majority.

This sector once featured a number of captive and non-captive specialty lenders that fi nanced a range of asset purchases for retail consumers and businesses both large and small. At that time, most of these entities relied on wholesale funding markets, issuing debt at fa-vorable rates in the capital markets, and then profi tably lending to customers.

This business model was tested by the fi -nancial crises from 2008-2010, and many is-suers in this sector failed this test. For a period of time, debt capital markets grew more fi ckle. Only the highest-quality borrowers were able to tap the markets. Less credit-worthy entities were eventually able to do so as well, but at un-favorable rates. As a result, issuers in this sector that relied on readily accessing cheap funding in the debt markets found that they were un-prepared for a credit crisis, and their business models were no longer viable.

Credit ratings downgrades ensued en masse and companies found debt markets in-creasingly more diffi cult to access. The response to this new world varied by issuer. Some were able to convert their business models and

achieve bank holding company (BHC) status. Though more cumbersome operationally, BHC status off ers greater access to liquidity and al-lows for deposit funding, which is less volatile than a pure wholesale funding model.

Other issuers were less fortunate as asset quality deteriorated and showed little sign of im-provement over time. As a result, many former index constituents have been downgraded out of the investment-grade category. These include issuers such as AIG affi liates, International Lease Finance and American General, as well as lender CIT Group, all of which had signifi cant positions in the index as recently as 2008. Many continue to struggle to adapt to this more restrictive lend-ing environment, where customer credit con-cerns remain paramount, and access to capital remains diffi cult.

Going forward, we believe this sector is un-likely to revert to its pre-credit crisis form. Spe-cialty lenders appear to be less viable in a more credit-restrictive environment, and lending ac-tivities will more likely be conducted with larger, deposit-funded entities.

Michael Tagliaferro, Analyst, UBS Financial Services


Municipal bonds Bond market

Major health system merger

In April, the nation’s larg-est Catholic healthcare system – Ascension Health – announced its intent to acquire the Alexian Broth-ers Health System - a large tertiary provider located in the northwest Chicago suburbs. The combination would result in a system

with 81 hospitals and health-related facilities in 20 states and the District of Columbia. As of 30 June 2010, the combined systems reported USD 14.9 bn of total revenues, USD 1.2 bn of operat-ing cash fl ow, USD 7.412 bn of cash and invest-ments on the balance sheet, and combined debt of approximately USD 4.6 bn.

The transaction mirrors the trend of con-solidation currently underway in the for-profi t healthcare sector. Community Health Systems (CHS) has been engaging in an ongoing ef-fort to acquire Tenet Healthcare. Transactions including mergers and acquisitions between non-profi ts as well as the acquisition of formerly non-profi t institutions by for-profi t providers have increased in the last year. These include the sale of substantially all of the assets of Mercy Health Partners in Scranton, PA to CHS that was recently announced earlier and the acquisition of bankrupt Forum Health, in Youngstown, OH. Saints Medical Center in Lowell, MA is set to be acquired by Steward, a for-profi t provider based in Boston that had previously acquired six facili-ties operated by the non-profi t Caritas Christi system. The long-troubled non-profi t Detroit Medical Center in MI was acquired in December, 2010 by the for-profi t Vanguard Health Systems.

The theme of consolidation and size being

an important characteristic of stronger ratings for not-for-profi t hospital systems versus those of stand-alone credits – especially small rural providers – has been a consistent one from WMR Municipals as health reform legislation was enacted and implemented.

Joseph Krist, Analyst, UBS Financial Services Inc.


Currencies Spotlight

Structural uptrend remains intact, despite recent pullbackAsian dollar index versus US dollar

Asia FX Foreign Reserves (in USD bn) Aggressive FX intervention keeps Asian currencies undervalued

Temporary weakness in Asia ex-Japan currencies

Asia ex-Japan currencies made some gains ver-sus the USD in recent weeks, as risk sentiment lowered due to several events. Speculation of a Greek debt restructuring fueled fears of conta-gion eff ects in peripheral nations. Commodities such as crude oil and silver experienced price drops, the speed and magnitude of which spooked some fi nancial investors. As markets curbed risk-taking, the USD rebounded smartly as investors bought back the greenback used as a fi nancing currency for risky trades.

Does this mark a turning point for Asia ex-Japan currencies, which have trended up against the USD since March 2009? Several factors signal this is unlikely. In contrast to the sluggish economic activity in some developed countries, economic growth in Asia stays robust, with Singapore and Taiwan recently raising GDP forecasts for 2011. Resilient export growth, and

high fuel and food prices continue to push in-fl ation higher; it stands at multi-year highs in countries such as Malaysia and South Korea.

Central banks in Asia are known to inter-vene in the FX markets to keep their currencies from strengthening too much. However, with the balance of risks tilted strongly towards in-fl ation rather than growth concerns, we expect Asian monetary authorities to welcome curren-cy appreciation to counter infl ation. We see Asia ex-Japan currencies gaining around 5% versus the USD over the next 12 months.

Teck-Leng Tan, Analyst, UBS AG

120

115

110

Source: Bloomberg, UBS WMR, as of May 2011

May 09 Nov 09 May 10 Nov 10 May 11

Source: Bloomberg, UBS WMR, as of May 2011

6000

5000

3000

4000

2000

1000

1997 1999 2001 2003 2005 2007 2009

Source: Bloomberg, UBS WMR, as of 24 May 2011 Source: Bloomberg, UBS WMR, as of 24 May 2011


Currency pairs

GBPUSD British pound per US dollar

EURUSD Euro per US dollar

AUDUSD Australian dollar per US dollar

USDJPY US dollar per Japanese yen

AUDUSD fell around 5% to the 1.05 level a er reaching a 29-year high of 1.101 in early May, pressured by falling commod-ity prices and a strengthening USD. The growth-sensitive AUD is prone to further profi t-taking amid renewed concerns about Eurozone peripheral issues and worries about over-tightening in China.

Despite high infl ation and low GDP fi gures, the UK is moving slowly towards a fi rst rate hike. The USD rallied briefl y on Eurozone problems and advancing data. However, this should be short-term and we advise selling the USD below GBPUSD 1.60 and aim for 1.70 in six months.

Short-term pressure on the euro is rising af-ter local elections in Spain led to extreme losses by the ruling socialist party and dis-cussion about debt restructuring in Greece surged again. We expect EURUSD to revert to the 1.30–1.40 range.

The Japanese economic situation is weaker than initial expectations a er the earthquake suggested. Markets therefore showed a lot of respect for the 80 USDJPY intervention level. We believe risk aversion and repatria-tion, however, prevent a more meaningful depreciation of the yen.

Source: Thomson Reuters, UBS WMR

Forward

Forecast

Volatility Range

Volatility Range

1.70

1.50

1.60

1.40

1.30

1.20

Sep 11 Jan 12 May 12 Sep 12Sep 10May 10 Jan 11 May 11


Forward

Forecast

Volatility Range

Volatility Range

100

95

90

75

70

80

85



Forward

Forecast

Volatility Range

Volatility Range

1.9

1.8

1.7

1.6

1.5

Sep 11 Jan 12 May 12 Sep 12Sep 10May10 Jan 11 May 11


Forward

Forecast

Volatility Range

Volatility Range

1.20

1.10

1.00

0.90

0.80



Commodities Spotlight

Investors cautious on commodities

Commodity prices dropped in recent weeks, the Dow Jones UBS Composite Index down some 10% from April highs. So macroeconomic data triggered global growth concerns. Eco-nomic activity in the US signals sharper modera-tion; strong infl ation in China requires more monetary policy tightening. Broad stimulus will eventually fade, so lower growth momentum induced investors to take risks off the table. This situation off ers investment opportunities, in our view.

The sharp drop in crude oil prices is unlikely to persist. The supply side is struggling to com-pensate for losses in Libyan oil production by 1.2 mbpd while crude production in the North Sea has failed to meet market expectations. European supply will thus remain tight. On the demand side, China’s projected electricity short-age should trigger fi rm crude oil demand. We uphold our view that WTI prices will move to-wards USD 110/bbl in 12 months, with Brent prices to rise above USD 120/bbl.

Silver has seen greater pressure than crude oil, but the metal is not yet a buy. The price run-up this year is driven by short-term investors and lacks liquidity. The fabrication balance remains in fi rm surplus, which should allow prices to rea-lign towards USD 30/oz.

What can investors do? Option volatility in silver, which jumped above 50%, off ers the op-portunity to sell insurance (put option) for an

attractive premium above money market rates. With a gold price above USD 1500/oz, a sharp drop in the silver price below USD 30/oz is not expected. At these levels we expect fi nancial demand to show renewed interest and China’s net import of silver to remain elevated. Chinese silver imports were key in the metal’s rise to USD 30/oz in the fi rst place.

Dominic Schnider, Analyst, UBS AG


Outlook Commodities

Arrows indicate whether the commodity is expected to strengthen, weaken or trend sideways.

LeadPrices of lead dropped 20% since April to USD 2,345/mt. LME inventories continue to climb, reaching 316kt in May. The domi-nant long position of warrants dropped from 90-100% to 80-90%. We believe this decline could go on and weaken near-term prices. The latest production data from Chi-na show refi ned lead output climbed 31.8% year-on-year in April to 398kt. Thus, present metal supply is suffi cient, especially as production growth of vehicles in China braked sharply. These demand and supply trends result in downward risk to our 12-month forecast at USD 2,650/mt.

CopperShanghai Futures Exchange (SHFE) copper inventories continue to fall; price diff eren-tial to the London Metal Exchange (LME) narrowed considerably. While the import arbitrage window remains closed for 3-month contracts, it has opened recently on a cash basis; this suggests a tightening Chinese copper market. If China’s produc-tion of copper products goes on improving, then prices could move towards USD 11,500/mt. The nation’s power supply problems are a risk that could result in pow-er rationing and disruptions. Thus copper output and consumption could be nega-tively aff ected, inducing price volatility.

SugarSince early February, sugar prices have plunged some 35% on larger output esti-mates for 2011–12. However, given the record low stock-to-use ratio, surplus pro-duction is required to rebuild depleted in-ventories next year. In Brazil, the world’s largest producer, diversion of sugarcane to ethanol or to sugar production will draw market focus. Presently, ethanol is being fa-vored, and recent talks on abolishing the ethanol import duty in the US promotes cane diversion to the fuel sector. To impede this, sugar prices need to stay above USD 0.22/lb.

WheatWheat prices appreciated more than 10% over the last few days. Unfavorable weath-er conditions in the US and Europe could severely impact yield prospects. Given lower US exports for 2011–12, exports from Euro-pean countries will gain attention. On the demand side, expensive corn protein should support feed substitution from corn to wheat. As the global stock-to-use ratio stays slightly above 25%, global inventories for 2011–12 remain tight. Prices could ap-proach USD 8.5/bu in the short run.

24.05.2011USD 8776/mt

24.05.2011USD 2465/mt

24.05.2011USD 8.07/bu

Forecast3 months

Forecast3 months

Forecast3 months

Forecast9–12 months



24.05.2011USD 0.215/lb

Forecast3 months



Commodities Investment idea

Opportunity from oil price volatilityWe view the sharp price drop in West Texas Intermediate (WTI) as overdone, as it is inconsistent with the latest supply and demand as well as inventory data. Global economic activity should remain robust in the short run and demand supportive.

Dominic Schnider, Analyst, UBS AG, Giovanni Staunovo, Strategist, UBS AG

Price correction off ers opportunitiesA set of disappointing economic data releases across the globe dragged WTI temporarily to around USD 95/bbl, followed by a small bounce in prices. We view the magnitude of the price correc-tion as overdone, as it is inconsistent with the lat-est supply and demand as well as inventory data.

Oil supply not keeping pace with demandGlobal crude oil demand reached 90 million bar-rels per day (mbpd) in March this year and brought year-over-year demand growth above 3%. We think this picture goes in line with fi rm Chinese import demand growing around 11% year-over-year in the fi rst three months of 2011. Moreover, the US has seen some stronger-than-expected declines in crude oil related product inventories. Since the OPEC supply in April was down by 0.95mbpd compared to February, crude oil fundamentals should allow prices to recover to balance supply and demand trends. With crude oil demand growth not showing signs of fl ipping into negative territory and sup-

ply constraints prevailing, we expect WTI to move towards USD 120/bbl.

RecommendationWe like to sell volatility for a premium. Option volatility soared sharply (around 30%-40% in put options), making insurance selling in crude oil attractive. We would use crude oil price levels below USD 85/bbl when selling volatility.

Selling crude oil option volatility remains attractiveVolatility in crude oil (WTI)

50

45

35

40

30

25

Source: Boomberg, UBS WMR

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

3-month option volatility3-month historical volatility1-month option volatility

At a glanceWe view the sharp price drop in WTI as over-done, as it is inconsistent with the latest sup-ply and demand as well as inventory data. With crude oil demand growth not showing signs of fl ipping into negative territory and supply constraints prevailing, we expect WTI to move towards USD 120/bbl. We think that, under these circumstances, selling vola-tility in crude oil remains a very attractive in-vestment strategy.

Source: Bloomberg, UBS WMR


What’s on your mind?

> Ask the expert at: [email protected]

Readers’ questions

A reader from Sion, Switzerland

Giovanni Staunovo, Dominic Schnider, Analysts, UBS AG

The most important exchanges for commodities are all located in the US. As a consequence, commodities are mainly quoted in US dollars (USD). This does not make them a USD asset per se. Most commodities are consumed and pro-duced by countries that do not use the USD as their legal tender, so a commodity’s value tran-scends the USD. However, a broad weakening of the USD due to excessive printing of money impacts commodity prices directly. The positive impact on commodities requires that suppliers have the choice to export them to other coun-tries, refl ecting competition for supply. Interna-tionally traded goods should therefore directly mimic changes in USD value. Markets that are more regional or where supply is largely USD-based should show a much better reaction. US natural gas is one good example. The lack of export capabilities and ample domestic supply makes it more a USD asset than gold or oil. It therefore cannot be used as a tool to hedge USD weakness.

High volatility in commodities results from supply and demand behavior and inventory lev-els. Low inventories imply a smaller buff er to off set supply outages by drawing from stocks. Lower inventories induce greater swings in price. Goods that cannot be stored, like electric-ity, should thus exhibit high volatility, and the price of electricity in fact has among the highest of volatilities.

Other factors have infl uence too, such as storage costs. High investment cost, such as for a mine or a refi nery, is also important. Low elasticity on the supply or the demand side lim-

its market balancing based on small changes in price, requiring instead large price swings to clear the market. Food and energy provide examples. Consumers are unlikely to change their habits before costs rise prohibitively. On the supply side, high upfront investment costs are only taken into consideration if a price move seems permanent and suffi cient to cover sizable expansion costs. The reverse occurs if demand slumps sharply. To cover some fi x costs, suppli-ers may sell commodities at large discounts to total production costs. The resulting ups and downs in prices have nothing to do with fi nan-cial speculation. That said, fi nancial demand can temporarily exacerbate price trends.

Are commodities a USD asset and why are they so volatile?



High Growth

Low Growth

Negative Growth

Goldilocks Supercycle

Deflation Stagflation

High Negative Inflation

Low Inflation Inflation

Market scenarios (next 12 months)

High Growth

Low Growth

Negative Growth





High Growth

Low Growth

Negative Growth





High Growth

Low Growth

Negative Growth





60%

The global economy appears headed for moderate growth in the months ahead. Both fi scal and monetary policies remain generally supportive of growth although most countries have started the normalization process. Strong corporate profi ts and balance sheets off er upside potential for investment spending. However, recent economic data has been generally weaker than expected, raising the probability of a renewed downturn.

Brian Rose, Strategist, UBS Financial Services Inc. and Stephen R. Freedman, Strategist, UBS Financial Services Inc.

Moderate Recovery

10%

RenewedDownturn

15%

Strong Recovery

15%Stagfl ation

• The global economy remains on a self-sus-taining but unspectacular expansion course.

• Rapid growth in the emerging markets helps to sustain global aggregate demand.

• The recovery in developed countries is more subdued than in prior cycles because of deleveraging pressures on the consumer and the fi nancial sector.

• The abundant slack in the US economy keeps infl ationary pressures from build-ing up despite easy monetary policy. Food price infl ation abates during the second half of 2011.

• High profi t margins and low interest rates encourage a surge in investment spending.

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

• Global GDP growth accelerates in the sec-ond half of 2011.

• Commodity prices rise further due to spreading political instability in the Middle East and/or poor agricultural harvests, set-ting an infl ationary process in motion.

• Rising price levels and weak growth pros-pects pose signifi cant challenges to most fi nancial assets.

• The fragile recovery in the developed world stalls as tighter fi scal and monetary policy creates additional headwinds.

• Credit markets take a turn for the worse, making it diffi cult for borrowers to take advantage of low interest rates.

• Falling commodity prices and a rise in ex-cess capacities lead to negative consumer price infl ation (defl ation).

(down from 20%)

(up from 5%)

Source: UBS WMR, as of 25 May 2011


Required disclosuresAnalyst Certifi cationEach research analyst primarily responsible for the content of this research report, in whole or in part, certifi es that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately refl ect his or her per-sonal views about those securities or issuers; and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specifi c recommendations or views expressed by that research analyst in the research report.

For a complete set of Required Disclosures relating to the companies that are the subject of this report, please mail a request to UBS Wealth Management Research Business Management, 1285 Avenue of the Americas, 13th Floor, New York, NY 10019.

Statement of riskStock and bond market returns are diffi cult to forecast because of fl uctuations in the economy, investor psychology, geopolitical conditions and other important variables.

Stock Recommendation SystemAnalysts provide a relative rating, which is based on the stock’s total return potential against the total estimated return of the appropriate sector benchmark over the next 12 months.

Industry Sector Relative Stock View Outperform (OUT) Expected to outperform the sector benchmark over the next 12 months.Marketperform (MKT) Expected to perform in line with the sector benchmark over the next 12 months.Underperform (UND) Expected to underperform the sector benchmark over the next 12 months.

Under review: Upon special events that require further analysis, the stock rating may be fl agged as “Under review” by the analyst. Suspended: An outperform or underperform rating may be suspended when the stock’s performance materially diverges from the performance of its respective benchmark.Restricted: Issuing of research on a company by WMR can be restricted due to legal, regulatory, contractual or best business-practice obligations which are normally caused by UBS Investment Bank’s involvement in an investment banking transaction in regard to the concerned company.

Sector bellwethers, or stocks that are of high importance or relevance to the sector, that are not placed on either the outper-form or underperform list (i.e., are not expected to either outperform or underperform the sector benchmark) will be classifi ed as marketperform. Stocks that are rated Marketperform that are not sector bellwethers are not assigned a price target.

The overweight and underweight recommendations repre-sent tactical deviations that can be applied to any appropriate benchmark portfolio allocation. They refl ect WMR’s short– to medium–term assessment of market opportunities and risks in the respective asset classes and market segments. The bench-mark allocation is not specifi ed here. It should be chosen in line with the risk profi le of the investor.

For more information, please read the most recent US Invest-ment Strategy Guide.

Symbol Description/Defi nition

Symbol Description/Defi nition

+ moderateoverweight vs.

benchmark

– moderateunderweight vs.

benchmark

++ overweight vs.benchmark

– – underweight vs.benchmark

+++ strongoverweight vs.

benchmark

– – – strongunderweight vs.

benchmark

n neutral, i.e.,on benchmark

Source: UBS WMR

Scale for Investment Strategy charts

Disclosures


Disclosures

UBS Financial Services Inc. Technical Research Dept.: Defi nitions and Distribution

UBS FinancialServices Rating

Defi nition and Criteria CorrespondingRating Category

Bullish Well–defi ned, reliable uptrend, an increase in the rate of change (or strong momentum) and confi rming technical indicators

Buy

Mod. Bullish Positive overall trend, momentum and confi rming technical indicators

Buy

Neutral Trading range trend, a fl at rate of change and confi rming technical indicators

Neutral/Hold

Mod. Bearish Weakened trend, momentum and confi rming technical indicators

Sell

Bearish Negative trend, momentum and confi rming technical indicators

Sell

N/A Not enough historical data to make an evaluation N/A

PerformanceThe indicated performance for Dividend Ruler Stocks, Quality Growth at a Reasonable Price, U.S. Top 25 Stock List and ADR Top List is based on capital appreciation plus dividends of an equal weight portfolio, but does not include transaction costs, such as commissions, fees, margin interest and interest charges. Actual transactions adjusted for such transaction costs will result in reduced total returns.

Prices of stocks used in performance calculations generally refl ect closing prices one trading day a er the addition or deletion to ensure that changes to the list are announced in a manner that allows clients to match the list’s performance. For ADR Top List, we will typically publish changes to the list a er the close and prices used for performance calculation purposes are the closing prices on the following trading day a er the date on the published report. In cases where we publish the ADR Top List in the morning prior to the New York Stock Exchange open, as was the case for our initial report on 26 October 2009, we will use the closing price of the date on the report for performance calculation purposes, which still refl ects one full day of trading a er the publication of the report.

A complete record of all the recommendations upon which the performance calculations are based is available from UBS Finan-cial Services Inc. upon written request. Past performance is not an indication of future results.

UBS Investment ResearchFor information on the ways in which UBS manages confl icts and maintains independence of its research product; historical performance information; and certain additional disclosures concerning UBS research recommendations, please visit www.ubs.com/disclosures.

Global Equity Rating Defi nitions

UBS 12–Month Rating Defi nitionBuy FSR is > 6% above the MRA.Neutral FSR is between –6% and 6% of the MRA.Sell FSR is > 6% below the MRA.

KEY DEFINITIONSForecast Stock Return (FSR) is defi ned as expected percentage price appreciation plus gross dividend yield over the next 12 months. Market Return Assumption (MRA) is defi ned as the one–year local market interest rate plus 5% (a proxy for, and not a forecast of, the equity risk premium). Under Review (UR) Stocks may be fl agged as UR by the analyst, indicating that the stock’s price target and/or rating are subject to possible change in the near term, usually in response to an event that may aff ect the investment case or valuation.

EXCEPTIONS AND SPECIAL CASESCore Banding Exceptions (CBE): Exceptions to the standard +/–6% bands may be granted by the Investment Review Com-mittee (IRC). Factors considered by the IRC include the stock’s volatility and the credit spread of the respective company’s debt. As a result, stocks deemed to be very high or low risk may be subject to higher or lower bands as they relate to the rating. When such exceptions apply, they will be identifi ed in the Companies Mentioned or Company Disclosure table in the relevant research piece.


Disclosures

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