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Chief Investment Officer UBS . Wealth Management November 2012 UBS CIO Monthly Letter The immutableforce of demographics There are two types of laws in this world: twin pillars of social security and Medicare, man-made laws that we shouldn't break, while in China, support for the ruling elite like the speed limit, and natural laws that has been rewarded with state-sponsored Alexander S. Friedman we can't break, like gravity. Austrian dare- growth that has helped lift hundreds of mil- CIO UBSVVM devil Felix Baumgartner recently illustrated lions of people out of poverty. Many citizens the latter when he jumped from a capsule view the man-made social contract as a rule 39km above the earth, becoming the first that shouldn't be broken, but the contract skydiver to break the sound barrier with can, and will have to, be renegotiated if gov- nothing more than gravity propelling him at ernments are to remain solvent. As protests speeds exceeding 1,340 kmph. in numerous European peripheral countries illustrate, this is a brutally difficult process. Like gravity, demographics are a natural law. As a result of increased longevity, declining In this letter we review the current invest- fertility, and the aging of the "baby boom" ment prospects for each of our key regional generation, the share of elderly in the global drivers. To do so effectively, we need to step population is rising. This trend is most back from the daily market swirl and con- advanced in wealthy economies, but it is sider how demographic changes not only also a growing concern in emerging markets affect the economy, but also impact the such as China. According to United Nations political debates and decisions of today and projections, the percentage of people over tomorrow - from controversy over the US 60 years old will double by 2050, to 22% of fiscal cliff, to debt sustainability in the Euro- the global population. zone, to the future of China's economic growth model. The implications for economies and public finances are profound. As populations age, US — demographics raise stakes on pension and healthcare liabilities soar, plac- fiscal reform ing additional pressure on already burdened The US is in the final stage of a great debate public finances. Governments cannot halt that will decide which party will lead the the forces of demographics — any more than country for the next four years, and how the skydivers can defy the force of gravity — and social contract will be rewritten in the future. aging populations will inevitably slow trend The nation's finances are already on an unsus- economic growth. But policymakers can tainable path, and with a demographic crunch take action to ensure that their liabilities looming, difficult decisions will have to be stop growing at an unsustainable pace rela- made about taxes and spending priorities. tive to their assets. Like other aging societies (see Figure 1), the The necessary reforms will be very difficult US will have a dwindling number of workers because they strike at the heart of the "social to support each retiree drawing on benefits. contract," the implicit agreement that gov- In 1950, there were 16 workers paying pay- erns the mutual obligations of citizens and roll taxes for each retiree collecting Social their governments. This contract has evolved Security benefits. Today, there are 3 workers differently in different regions. In Europe, it supporting the Social Security and Medicare has been founded on a generous welfare benefits of each retiree and in little over a state, in the US it has been supported by the decade, this ratio will be just 2 to 1. this repo, has been prepared by UBS AG. Please see imocciant declaimers and disc/enures at the e-tcl of tne document. Past performance is no iodate:in of future performance. The market prices provided are closing prices on the respechye mnopal stock exchange. TM applies to al performance charts and facies in this pi aeon. EFTA_R1_02073871 EFTA02702204  UBS CIO Monthly Letter The US has not run a budget surplus since 2001, and the not our baseline expectation. Still, given the binary nature accumulation of deficits since then has raised federal of the risk and the fact that in an election year politicians debt to more than 100% of GDP, the highest in over 60 can act less rationally than usual, it seems logical not to years (see Figure 2). When the present value of social add risk at this point in time. Furthermore, after an security and healthcare liabilities for the coming three extended period of inventory re-stocking, uncertainty over decades is taken into account, analysts estimate the the US political situation and global growth has led busi- debt-to-GDP ratio will climb to more than 300%. nesses to manage stocks more tightly and limit capital investment. These factors could prove to be somewhat of While a highly accommodative central bank and the a drag during the ongoing third quarter earnings season. safe-haven status of US government bonds are currently helping the government fund its deficit at historically low Eurozone — debt only made worse by demographics rates, such a benign environment will not last forever. In Europe, looming demographic pressures are even Among other steps, it will be critical to reduce healthcare more severe than in the US. For example, by 2050, 40% costs, since projected spending on Medicare makes up of Portugal's population will be over the age of 60, sec- over half of the US government's future liabilities. ond only to Japan in its ratio of elderly citizens. Italy, Spain and Germany will be close behind at 38%, all It is clear the US has to get its fiscal house in order. among the oldest populations in the world. The rapid pace of aging raises the urgency of finding a sustainable However, there is a danger that excessive fiscal tighten- solution to Europe's sovereign debt crisis. ing in the near term could cause a recession. The most pressing issue for the newly elected Congress will be to There are essentially two ways to achieve debt sustainabil- resolve the "fiscal cliff." Without an agreement between ity: fiscal austerity, or higher GDP growth. Peripheral coun- Democrats and Republicans, USD 607 billion (3.7% of tries have been forced to emphasize the former. As a result, GDP) of spending cuts and tax increases will be triggered the news is full of headlines about budget cuts, tax hikes, in January. We believe that the most likely outcome is a pension and salary cuts for public workers, and increases in "fiscal pothole," rather than a plunge over the fiscal cliff, the retirement age. As continued violent street protests in e.g. a deal to incrementally reduce the government defi- Greece and Spain attest the social contract is under threat. cit by c.0.7% of GDP. This would likely slow the econ- Also, over the past few months, a debate has intensified omy, but not tip the US into recession. over whether fiscal austerity could actually be harming debt sustainability by undermining growth prospects. The If confidence is to return in a sustainable manner, politi- International Monetary Fund recently stated that since the cians will need to pivot quickly to credible, longer-term start of the great recession, fiscal austerity has been more deficit reduction plans in 2013. The choices made over contractionary than many had expected. how to redefine the social contract will have critical implications for the investment landscape. A huge gap in competitiveness between the core and the periphery is at the root of the Eurozone's problems. Ger- What this means for an investor today. A risk remains that man labor costs rose by +18% in 2000-2009, significantly politicians may be willing to push the US over the fiscal less than Italy's +35% and Spain's +50%. Our estimates cliff, potentially using the debt ceiling as a bargaining chip, suggest that Italy and Spain would require a -20% real before negotiations reach an acceptable compromise. The exchange rate adjustment, while Portugal and Greece markets are not pricing in this result and, to be clear, it is would need more than —30% to get labor costs back on an Figure 1: Dependency ratios are rising around the world Figure 2: US debt-to-GDP ratio has risen above 100% °dope dependency %Orono0 pnpulatcn 65. no 100 papulaacn 15-641 (total gross central government debt/GDP) 80 in% 70 140 60 120 so 100 40 80 30 20 60 10 40 0 20 1950 19601970 1980 1990 2000x110 2920 2030 2060 20502060107020802090 2100 0 — China — Ewope 1790 1810 1830 1850 1870 189D 1910 1930 1950 1970 1990 2010 - Sl0an US Son tinted Nations, as of 31 Decerrher 2011 Sonny: oaf, World Bank ani OS ten'sy no' 31 Decent*. 70' UBS Chief Investment Office November 2012 2 EFTA_R1_02073872 EFTA02702205  UBS CIO Monthly Letter equal footing. This necessitates painful tradeoffs between China's leadership needs to shift the composition of deflation in the periphery and inflation in the core. growth from an excessive reliance upon investment towards greater consumption, and this economic transfor- Structural reforms, too, will be needed. According to the mation will inevitably impact the social contract. One way World Bank's "Doing Business" rankings, it is easier to of promoting such a shift would be increased public spend- do business in Mongolia than it is in Italy. On this front, ing on healthcare and pensions — establishing a safety net we are heartened by the announcement this year of a would likely help bring the household savings rate down. host of new reforms in Italy, including an overhaul of Another way would be to boost the purchasing power of labor market laws and deregulation in a range of sectors consumers by allowing a greater appreciation of China's from insurance to taxis. currency. The CNY hit a 19-year high in October, but mar- kets do not expect the rise to continue, and are currently What this means for an investor today: The key near- pricing in a depreciation of 1.7% over the next 12 months. term financial markets driver in Europe remains the Euro- pean Central Bank (ECB). The ECB is playing a crucial What this means for an investor today: Demographics and role in calming the markets long enough to allow politi- the political imperative of maintaining high levels of cians in Spain and other peripherals to hopefully imple- growth are pulling China's policy in opposite directions. ment reforms that restore competitiveness, growth, and The pace of the Chinese economic recovery and its global address debt sustainability. At present, markets are stuck impact will depend on whether China's new leadership in a holding pattern waiting for Spain to apply for assis- continues to stimulate fixed asset investment, or if it pur- tance — a move that could help lower its borrowing costs. sues rebalancing. The former would likely be positive from In the longer term, however, demographics will have a a short-term, tactical perspective, leading to improved big impact on trend growth and asset price returns. global economic data and a more positive view on risk. Without bold reforms to restore competitiveness and The latter path, however, would ultimately be the more enhance productivity, Europe may be destined for a new sustainable one - even if it involves some short-term pain. paradigm of subpar growth. Recent data shows no signs of a rebalancing towards pri- The fact remains that even as some tail risk recedes in vate consumption, with exports storming ahead at +9.9% Europe, the continent is in recession and a robust eco- WY (prior +2.7%) in September, and fixed asset investment nomic recovery is unlikely for some time. Thus, an inves- at +20.5% say. Overall, we expect infrastructure invest- tor looking for growth needs to look beyond the region; ment and other stimulus measures to support a "cyclical" quality Western blue-chip companies that benefit from upturn of China's economic momentum this quarter. exposure to faster-growing emerging market economies Hence, China remains a preferred market within emerging are one way to address this challenge. An alternative market equities, but we are carefully watching to see if its way is to focus on high-quality dividend stocks — in a policymakers make the right longer-term decisions. low-growth environment the contribution of dividends to total equity returns should increase. A note about Japan No discussion of the impact of demographics on invest- China - growth model must change ing would be complete without an observation about China's social contract has relied almost entirely upon Japan. Japan is the fastest-aging society on earth, its the maintenance of high GDP growth, which has helped population is expected to shrink by 30% in the next 50 lift approximately 600 million people out of poverty. This years and by 2050, 42% of citizens will be over 60 years growth has been fueled by fixed asset investment, the old. Japan also has the highest debt-to-GDP ratio in the mobilization of a huge pool of labor from the agricultural world, which it has been able to sustain due its high pri- sector into the industrial sector, and growth in the labor vate sector savings ratio. Unfortunately, as Japan's popu- force-to-population ratio facilitated by the "one child lation ages the savings ratio will inevitably drop as people policy." finance their retirement, and this makes its debt more difficult to sustain. Should Japan try to inflate its way out The one child policy led to working parents supporting a of this debt, this would destroy the fixed income savings single child. However, as the parents age, this dynamic of its increasingly elderly population. The falling savings will reverse and, within families, one working adult will ratio should support economic growth, but it remains to have to support two elderly parents. A weak social safety be seen if this will be enough to avert an eventual debt net in China makes this adjustment particularly difficult. crisis. Japan continues to serve as a poignant reminder of Chinese households need to save more for healthcare what can happen to even the strongest of economies and retirement, which helps explain their exceptionally when debt and demographics collide. high savings rate of almost 40%. As a result, it has proved difficult to boost private consumption, which Asset allocation accounts for just 35% of GDP, compared with roughly Overall, the fiscal challenges posed by aging societies con- 70% for Americans and 57% percent for Europeans. stitute a demographic-driven, new investment paradigm UBS Chief Investment Office November 2012 3 EFTA_R1_02073873 EFTA02702206  UBS CIO Monthly Letter that is likely to slow global growth and will be one of the corporate earnings, and further strength in business key trends of our lifetimes. A return to sustainable global fundamentals. economic growth will require policymakers around the world to confront these challenges head-on, in creative Within equities, our preference remains with the US and and effective ways. emerging markets (EM). Inflows into EM economies have started to pick up over the past month, supported by signs In the meantime, aggressive action by central banks has of economic recovery in key regions, most notably China greatly reduced tail risks and global growth is showing and Brazil. In addition, stronger commodity prices are signs of improvement, thereby supporting our "middle likely to support EM earnings, given the high tilt towards ground" strategy of focusing on corporate credit, and in the energy and materials sectors in many developing particular, US high yield. nations. And lastly, the traditional scare factor for EM equities, namely inflation, appears under control, which The US high yield sector has gained 14% year-to-date, leaves room for further central bank support. In our view, but the key question for investors is whether this rally will these factors all justify an overweight in EM equities. last. We expect prices to rise further as yield spreads tighten from their current level of around 5.4% towards For investors seeking EM exposure with a somewhat our target of 4.75%. While US corporate balance sheets lower level of volatility, we continue to highlight the have been repaired through deleveraging and cautious attractive yields offered by EM corporate bonds. business activity, the yield spread is still far from its pre- crisis low of 2.4%. In major currencies, we are maintaining our recommen- dation to underweight the Japanese yen. The Japanese Low refinancing needs, ongoing US growth, and a economy continues to weaken against its peers, raising healthy US banking sector are also supportive of US high pressure on the Bank of Japan to engage in further quan- yield bonds. In addition, we expect default rates to titative easing. We have also closed our preference for remain below the historical average (see Figure 3). the Canadian dollar, which is less attractively valued after solid gains against the US dollar in recent months. And Our research shows that over the longer term, the total finally, we have closed our remaining short position in returns of high yield corporate bonds are mainly driven by the Swiss franc. two factors: the "fixed" coupon component and the default rate (see Figure 4). Since 1990, 115% of the total Kind regards, return can be attributed to coupons, -30% to default losses and the remaining 15% to the decline in the Treas- ury yield. Consequently, as long as high yield bonds pro- vide a decent coupon, aggressive spread tightening is not needed from current levels to still earn a reasonable return. Why are we not overweight equities in the current envi- Alexander S. Friedman ronment? Global equities have rallied substantially since Global Chief Investment Officer June, but for this rally to be sustained, we would need to Wealth Management see clarity around the US fiscal cliff, a re-acceleration of 25 October 2012 Figure 3: US high yield default rates to stay low Figure 4: Coupon accounts for bulk of high yield bond returns Cumulatne reams of US high yield reme 1990, m % 250 200 ISO 100 SO „or' 6 4 -so 2 100 0 199D 1991 1994 1996 1998 2000 1031 1034 1006 2008 1010 1012 1999 2000 2001 1002 2003 2004 200S 2006 1007 2038 2009 2010 2011 2012 2013 - TOUT Spread — Defaults Athol detail race Insure nelh1O11 fcrecare — Treasury Coupon Source: Thomson Reuters. 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