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Chief Investment Officer UBS Wealth Management March 2013 UBS CIO Monthly Letter Meteors and inflation Last week, as one meteor exploded over the would leave savers suffering a near 20% skies of Russia, a much larger one the size of loss in purchasing power over five years. the White House passed within 17,000 miles And even if inflation were to stay at its cur- Alexander S. Friedman of earth, a mere "stone's throw" in astro- rent ultra low level of 1.7%, in five years Global CIO UBS WM nomical terms. Fortunately, the skills of Hol- about 8% of a saver's real wealth would still lywood's action heroes were not required to be destroyed. avert disaster, but it was undoubtedly a close shave; it is widely believed that an asteroid However, we do not think it is time to worry collision resulted in the extinction of the about an inflation spiraljust yet. dinosaurs some 65 million years ago. We believe inflation will remain mild over It seems that even with all our technology, this year and that this economic environ- there will always be things falling from the ment remains supportive of corporate credit. sky that we do not see until it is too late, as Hence, we remain invested in some credit the residents of Chelyabinsk in Russia found sectors like US high yield, where valuations out. It might be a meteor or the proverbial relative to US Treasuries are attractive and "falling piano." US economic growth and monetary policy are supportive. Importantly, we are not see- So what should we, as investors, be looking ing the kind of sharp increases in leverage out for now? that would normally be associated with a turn in the credit cycle. For savers, the economic equivalent of a meteor strike would be an unexpected Overall, we maintain our moderate pro-risk period of high inflation. With the Fed stance. The ongoing improvement in the engaged in seemingly endless rounds of global economy, positive market momentum, quantitative easing, and other central banks and loose monetary policy remain supportive including the Bank of Japan and Bank of of the outlook for equities and corporate England firing up the printing presses too, credit. But, we refrain from adding to our risk many investors are understandably anxious positions further at this point. This week, that fixed income assets could go the way of NASA revealed it is monitoring 1,379 Poten- the dinosaurs in a big explosion of paper tially Hazardous Asteroids (PHAs), and in money. investment land we are closely monitoring four of our own PHAs. First, the Italian elec- If policymakers wait too long to normalize tions, where the February 24-25 vote could monetary policy once economies retum to lead to an unstable government unable to trend growth, it is very possible that inflation enact reforms. Second, the situation in could accelerate rapidly over a 3-5 year Cyprus, since German leaders are likely to be period. A rise of US inflation to 4.2%, for under internal pressure to resist a bailout, example, or double its average level of the given how much resistance voters have to yet past five years, with interest rates at zero, another rescue. Third, the bleak French this tenon has teen prepared by UBS AG. Please see important disclaimers and cbsclosi.res at the end of the docionent. Past performance is no mdcabon of future perfarnance. the market prices provided are closing poxes on the respective pmcipal stork exchange. This applies to all performance charts and rabies in this publication. EFTA01089672  UBS CIO Monthly Letter economic picture, where the February PMI fell to 42.3, the Higher risk of inflation over the long term lowest level since March 20O9. And finally, the March 1 One of the most frequent questions I get asked by inves- sequester in the US, where USD 85bn of automatic spend- tors goes as follows: if inflation is about "too much ing cuts are scheduled to go into effect. We await "safe money chasing too few goods," why has the huge passage" before we consider adding more risk. amount of liquidity provided by central banks not led to higher inflation? The following sections of our monthly investment letter delve more deeply into the inflation issue and also exam- The key to understanding why it has not is that the trans- ine the credit markets and, in particular, the high-yield mission mechanism between base money and the wider asset class. Finally, we describe our investment position- money supply (the banking system) is impaired. Using ing in detail. the US as an example, since the crisis, the Fed has increased base money supply by 220% (see Figure 2), Inflation likely to remain tame in the near term but banks have accumulated excess reserves of more In simple terms, inflation is determined by two factors: than USD 1.5 trillion at the Fed (see Figure 3), rather than the cost of producing goods, (in economist-speak, "cost- lending it to households and businesses. Similarly in the push" inflation), and the level of overall demand for Eurozone, credit growth is in negative territory. This is goods relative to supply ("demand-pull"). symptomatic of the ongoing deleveraging process, and shows commercial banks are reluctant or unable to use On the production side, a glance at the labor market tells all of the new money to create new credit. It is also illus- us we are unlikely to see rapid wage growth. Unemploy- trative of weak demand, resulting from a lack of confi- ment in the US is currently 7.9% (see Figure 1), far above dence among consumers and corporate leaders. the 5.5% that the Federal Reserve views as the "natural" rate of unemployment. This means that workers are in a In the longer run, however, we see a significant risk of weak bargaining position to negotiate higher wages. higher inflation as the credit channel is gradually restored. The story is similar in Europe, where unemployment is at And as house prices recover and the labor market a multi-decade high of 11.7%. And with over two mil- improves further, the production and employment gaps lion barrels of oil per day set to come on stream in the US will start to narrow. Some economists argue that the and Canada over the next two years, we expect oil prices level of potential growth in developed market economies to remain in check too. So the recent rise in US gasoline may have fallen since the recent crisis. Or put another prices towards USD 4 per gallon, a level that often wor- way, perhaps "full employment" in Europe and the US ries investors, is likely to be a temporary one. won't be as 'full' as it was before the crisis. This means we could begin to see wage pressures at higher levels of And on the demand side, it would appear that disinfla- unemployment than we have previously. tion or even deflation should be more of a concern than inflation. Taking the US as an example, the output gap In and of itself, this doesn't need to cause significantly (the gap between actual and potential GDP) is currently high inflation if central banks respond and raise interest 5.6%, the largest since the 1982 recession. Overall, our rates in time. But after a brush with deflation in 2008, global inflation barometer currently points to lower infla- we believe central banks will be reluctant to jeopardize tion in the near term and we expect US inflation to the economic recovery by raising interest rates too decline to around 1.6% for 2013. soon. And excessive levels of government debt mean Figure 1: Unemployment rate remains high Figure 2: US monetary base has surged 220% US dvilian unemployment rate (seasonaly adjusted) US base money (adjusted for changes in reserve requirements) 12 3000 10 1500 2000 1500 1000 2 500 0 0 ei a, „a 0,3 '7 '7 '7 '7 4 "4 41 41 4 4' 4 5 5 1 1 1 5 5 5 5 Sauce: Federal Resent as of January 2013 Source: Federal Reserve, as of 01 laruary 2013 UBS Chief Investment Office March 2013 2 EFTA01089673  UBS CIO Monthly Letter central banks are more likely to err on the side of looser do companies that directly own large amounts of real policy. To some extent, we have seen this already in the estate assets. UK, where the Bank of England has kept rates at record lows despite inflation being above target for three years Real estate has long been recognized as a valuable hedge already, and set to remain so until 2016. against inflation. In general, the higher the land compo- nent of a real estate investment, the greater its sensitivity The bottom line is that we do not consider inflation an to the inflation rate, and the greater the inflation protec- immediate concern. But the longer-term picture is more tion provided. Greater protection is also afforded when uncertain — if the Fed and other central banks were to the rent of an investment property is tied to a price index. mismanage their exit strategies, inflation could rise faster than expected. Commodity prices are themselves a cause of higher infla- tion, so unsurprisingly they show a positive correlation How to protect against inflation over the longer with inflation. Investment in most commodities involves term rolling futures contracts, meaning that total returns can The purest inflation hedge available is inflation-linked be unpredictable in high inflation environments, but bonds, which have an adjustable face value that is linked commodities which can be easily stored physically, such to consumer price index (CPI) movements. However, as gold, may offer more reliable protection. these bonds today are prohibitively expensive. The real yield on 10-year US TIPS is —0.55%, and we recommend The outlook for credit that investors wait for a better entry point. Fortunately, The performance of fixed rate bonds is always negatively there are other ways of protecting portfolios, such as correlated with the inflation rate, because their nominal equities, real estate, and commodities. None offer a return does not change over time. Therefore, the out- guaranteed link to inflation, but should offer some form look for inflation is a key consideration in assessing the of protection. attractiveness of corporate credit. As I mentioned earlier, inflation is not likely to prove a major risk in the near Equities represent claims on the future income produced term. But this is not preventing some investors from by the real assets of a business, which should rise over growing anxious that the corporate credit rally may have time with overall prices. Hence, they can offer an infla- gone too far. In particular, there appears to be concern tion hedge, as long as price rises remain moderate. In about US high yield. case of rapidly rising prices, the negative economic con- sequences of inflation more than offset the positive One of the most common reasons cited for worry about aspects of equities. Companies and sectors in which high yield is that you can lose in high yield whichever higher inflation has little impact on input prices generally way the economy goes. If the economy deteriorates, fare best in inflationary environments. These indude cap- then spreads widen; if the economy improves, bench- ital-intensive companies that have a high proportion of mark yields increase. Though seemingly logical, this fixed costs. Large-cap companies with dominant market argument falsely assumes that the global economy is a positions, strong pricing power and an ability to grow binary system. The US has not slipped into recession dividends also tend to offer good inflation protection, as since the 2008-09 crisis, but growth does remain Figure 3: US banks are sitting on massive reserves Figure 4: Corporate leverage remains below historical li cess resents of US depository institutions average Net debt! E81TDA of US hgh yield companies 1800 4.5 1600 4.3 1400 4.1 .tt,. 1200 39 3.7 Fe 800 ox 3.5 3.3 603 3.1 'a 400 29 203 0 2.7 2.5 hi 11 Illlllll I 0 en gaggliAiie S- ,VW., ; .5., 5,4 2 3 3 1 1 •- Average leverage ram (3.6x) Source: Board of Gammas of the federal Reserve, as of 01 January 2013 Noce: Data for 04 2012 is based on a sample of the unnene onlyO041y 40% of the total) and thus orelirninary Source: BolA Islernlirich Global Resea-th, as of 19 fetoran: 2013 L1B5 Chief Investment Office March 2013 3 EFTA01089674  UBS CIO Monthly Letter relatively weak. We expect to see GDP growth in the US support. Their actions will continue to force investors to this year of 2-3%. Such an environment is actually ideal "hunt for yield," a backdrop that should support the for credit: growth is too low to force benchmark yields asset class. up, yet high enough to prevent defaults. Furthermore, if investors are concerned about benchmark interest rate Fundamentals also remain positive. Corporate balance risk, they can easily hedge it. They can look at senior sheets are strong and the default rate for US high yield bank loans, for example, which reset interest rates every issuers ended 2012 at 1.5%, well below the long-term 90 days. Alternatively they can fund a high yield over- median of 4%. In addition, high yield issuance has been weight with an equivalent underweight in government strong, reaching a record USD 366bn last year, and bonds, as we advise doing in portfolios. already topping USD 50bn in 2013. Importantly, around 60% of this issuance has been used for refinancing. This Others argue that liquidity could thy up if there is a sud- means there is little expiring debt ahead to default on — den "rush to the exit" in a risk-off environment. While we estimate that less than USD 50bn will mature in the high yield liquidity does depend on the market environ- next two years. ment, the Fed is focused on keeping the credit market functioning, and any deterioration in market liquidity What would compel us to change our view on would likely prompt renewed policy easing. credit? Of course, we are not "married" to any of our positions, And some bears point to the declining quality of issuance including this one in high yield. Specifically, declining and an increase in buyout activity, citing recent cases credit spreads are leading indicators of future equity such as Michael Dell's USD 24.4bn acquisition of his for- returns, so if high yield spreads approached our 450bps mer company Dell, Inc. Isolated instances of leveraged target we would likely shift all or part of our high yield buyout activity do exist, but the important thing is that overweight into equities, continuing the move we began overall we are seeing no significant increase in net lever- in early January. Equally, were the macroeconomic out- age (see Figure 4). The interest coverage ratio of compa- look to deteriorate markedly we would likely remove our nies, currently 3.5x, has barely declined in the past three overweight position. But currently the economic cycle is years and remains above the 2007 level of roughly 3.0x. picking up and leading indicators are improving — the JP Issuer quality remains sound too, with less than 20% of Morgan Global Manufacturing PMI has been flat or ris- newly issued bonds rated CCC or lower, relative to some ing for five consecutive months. 35% in 2007 (see Figure 5). Our current tactical investment positioning Overall, we still see value in holding a position in US high Overall, an acceleration in global growth, low inflation yield. Valuations are reasonably attractive, especially and accommodative central banks continue to foster a compared with government bonds, offering a spread of positive backdrop for risk assets. 506 basis points over US Treasuries, and we expect this spread to tighten further over the next six months to In equities, we are maintaining our overweight, and con- 450bps. While a return to pre-crisis lows of below tinue to prefer the US and emerging markets. We 300bps is unlikely, we should not underestimate the increased our overweight in the US this month on the commitment of central banks to provide monetary back of positive economic data, as well as stronger Figure 5: Average quality of HY issuance remains relatively Figure 6: Euro looks overvalued relative to the British high pound DimitySai ol global high yield issuance by aeckt rang. in % EURGBP vs. Purchasing Power Parity (PPP) 100 1.00 90 1 1 1 1 111 1 1 I I I I I I I I 0.95 80 70 60 I1 111 1 1 1111 1 1111-1-1 11 1 1111 1 1111 1 111 0.90 0.85 50 11 1 1111 1 1111 1 1111 0.80 40 11 1 1111 1 1111 1 1111 0.75 30 11 1 1111 1 1111 1 1111 0.70 20 0.65 10 0.60 0 es 0.55 tg §§g 8 §§ tg §§§E, 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 BB CCC or lower — EURGBP 8 — PPP EURGBP Source: 8o14 Merril Lynch Glottal Research. as ol 19 February 2013 Source: Thomson Reuters, UBS CIO. as ol 19 February 2013 UBS Chief Investment Office March 2013 4 EFTA01089675  UBS CIO Monthly Letter earnings growth and momentum than in most other Governor Mark Carney recently backing away from regions. We expect US earnings to grow at a solid 6% nominal GDP targeting, this pressure should start to pace in 2013. ease. The increase in our US equities overweight is financed by Furthermore, we expect UK economic data to pick up in an underweight in Canada, where we have observed the months ahead, following encouraging news in Janu- weaker earnings growth and price momentum than in ary when the composite purchasing managers index the US. Another cause for concern about Canada is that (PMI) showed a modest pickup in activity. With investor financials account for roughly 1/3 of its equity market. sentiment toward the pound very negative and short Due to slower loan growth, and the risk of a downturn positioning at elevated levels, there is already a lot of bad in Canada's housing market, we expect Canadian finan- news priced into the currency; the pound is now 13% cials to lag their US peers. undervalued relative to the euro (our least preferred cur- rency) on a purchasing power parity basis (see Figure 6). In fixed income, we expect close to zero returns for high This means that even moderately positive news could grade government bonds this year. In line with this view, trigger a rebound. The timing of such a recovery is uncer- government bond returns have been slightly negative for tain, but we believe that over our six-month tactical 2013 to date, as yields have started to rise. We continue investment horizon, this contrarian call will be rewarded. to prefer high yield, investment grade and corporate However, as is often the nature with a call against con- emerging market bonds to high grade government sensus, patience may be required. bonds. Thanks for reading this letter and for giving us the oppor- In currencies this year we have seen an upsurge in volatil- tunity to work with you. ity, with exchange rates increasingly driven by idiosyn- cratic factors, rather than simple "risk-on, risk-off" con- siderations. We recently re-established a long position in the British pound, where traditional correlations have broken down. Weak economic data, speculation that the 7' Bank of England would adopt nominal GDP targeting, as well as talk of Britain exiting the European Union, have Alexander S. Friedman weighed on the currency. In the near term, such factors Global Chief Investment Officer could continue to create volatility, but with a referendum Wealth Management on EU exit not likely before 2017, and future BoE 21 February 2013 UBS Chief Investment Office %kr I EFTA01089676 UBS CIO WM Research is published by Wealth Management & Swiss Bank and Wealth Management Amerces, Business Divisions of 1185 AG (UBS) or an affiliate thereof. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment a other specific product. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible fa sale to all investors. 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