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Wealth Management Research 26 February 2010 United States

UBS investor’s guide

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FocusThe curse of public debt

Financial marketsFundamentals should trump market fears

PortfolioShifts that matter

Commercial Real EstateNot the next shoe to drop

The Unspunnen Stone has been used in sporting competitions at the tradi-tional Unspunnen Festival in Interlaken, Switzerland since 1905. The aim is

to throw the stone, which weighs83.5 kg, as far as possible. Our Focusarticle deals with the burden of gov-ernment debt which, unlike theUnspunnen Stone, grows heaviereach year. Photo: Urs Flueeler/Keystone

Dear readers,

It was the late New York real estate developer and philanthropist Sey-mour B. Durst who, in 1989, invented the first “national debt clock.”It was hung on 42nd Street in New York City and his display, whenunveiled, showed 2,700,000,000,000, i.e. 2.7 trillion US dollars. Thisclock’s twenty-year history has been quite hectic. It was moved a cou-ple of blocks from its original location and now hangs in TimesSquare. In 2000, it began to run backwards as the US governmentwas, for once, running a surplus, which caused investors to start wor-

rying that 30-year US Treasury paper could someday just vanish. It had also a small moment of fame during the height of the financial crisis. Sometime

around the end of September 2008, it added a new digit to its figure by crossing the 10 tril-lion US dollar mark. It currently stands at around 12.4 trillion US dollars and every 50 sec-onds another million US dollars is added. The situation is not much better in other coun-tries. Frugal Germany has a public debt of 1.7 trillion euros, adding another million every 3minutes and 42 seconds. According to the Economist Intelligence Unit, the overall publicdebt worldwide is at 32.6 trillion US dollars, slightly more than half the world’s GDP, butincreasing at a very fast rate especially in the developed economies hardest hit by the finan-cial crisis.

Hence, the latest nervousness surrounding Greece’s fiscal sustainability should be viewedin a broader context: the small Mediterranean country being only the canary in a very fright-ening coalmine of ballooning government debt. In the focus article, my colleague Mike Ryan,Head of Wealth Management Research Americas, and I explore more in-depth the issuessurrounding government debt.

UBS investor’s guide 26 February 2010 3

Contents Editorial

This report has been prepared by UBS AG and UBS FinancialServices Inc.

ANALYST CERTIFICATIONAND REQUIRED DISCLO-SURES BEGIN ON PAGE 45.

UBS does and seeks to do busi-ness with companies covered inits research reports. As a result,investors should be aware thatthe firm may have a conflict ofinterest that could affect theobjectivity of this report. Investorsshould consider this report asonly a single factor in makingtheir investment decision.

UBSFS accepts responsibility forthe contents of this report. U.S.persons who receive this reportand wish to effect any transac-tions in any security discussed inthis report should do so withUBSFS and not UBS AG.

Editorial 3

Focus 4–7

Asset Allocation 8–9

Portfolio Principles 10–11

Economy 12–16

Equities 17–23

Technical Analysis 24–25

US Equity Sectors 26–30

Bonds 31–35

Currencies 36–38

Readers’ Questions 39

Commodities 40–41

Emerging Markets 42–43

Market Scenarios 44

Appendix 45–47

New ReportWMR launched a new report on 16 February 2010: Technical Review of Selected Stocks.This report provides technical analysis on stocks rated Outperform or Marketperform byWMR Sector Analysts. Included are key support levels, key resistance levels, overall tech-nical trend, and technical commentaries.

Andreas Hoefert

Chief Economist, UBS AG

UBS investor’s guide 26 February 2010 54 UBS investor’s guide 26 February 2010

FocusFocus

The curse of public debt

According to a recent study by the Interna-tional Monetary Fund (IMF), the debt-to-GDP ratio in the advanced economies willhave increased from 80% in 2007 to almost120% by 2014. In the US and UK thoseratios are currently heading toward the100% landmark, while Japan’s public debtwill reach twice the size of its GDP next year.

Projected debt to GDP ratios

JapanItaly

GreeceBelgium

FranceUSA

PortugalUK

GermanyIreland

AustriaNetherl.

SpainNorway

SwedenFinland

Switzerl.Australia

250

200

100

150

50

Source: OECD%

PIIGS

We should all care about public debt.In this article we explain how publicdebt evolves, what governments do toaddress the debt problem and whowill bear the consequences.

The recession brought about by the 2008financial crisis distinguished itself not only bybeing the most violent for many developedcountries since World War II, but also by forc-ing many governments to step in and pro-vide assistance on a massive, unprecedentedscale to prevent their economies from slidinginto depression.Budget deficits have exploded, running intothe trillions of dollars. Relative to GDP, theyhave reached double-digit percentages inmany countries, making them the biggest inpeacetime. According to a recent study bythe International Monetary Fund (IMF) thedebt-to-GDP ratios in the advancedeconomies will have increased from 80% in2007 to almost 120% by 2014. In the USand UK, debt to GDP is heading toward the100% landmark, while Japan’s public debtwill reach twice the size of its GDP next year.

How does debt evolve?According to the Organization of EconomicCooperation and Development’s (OECD) Eco-nomic Outlook database, the US nationaldebt grew 6.2% per year, with considerablevolatility, during 1989-2009. While a 6.2%annual increase in the national debt mightseem like a lot, it needs to be put into per-spective. When considering the evolution ofgovernment debt and the ability of govern-ments to sustain such levels of indebtedness,consideration must be given not only to theoverall debt load but also to how it relates tothe size and growth of an economy, i.e., thenominal Gross Domestic Product (GDP). If the national debt grows faster than nom-inal GDP, then the debt-to-GDP ratio willincrease. If debt grows at the same rate asnominal GDP, then the debt-to-GDP ratio willremain unchanged. During the last twodecades, US nominal growth averaged5.6%. So, at current prices the US govern-ment’s debt load increased by almost a fullpercentage point per year faster than theoverall economy. Hence, the US debt-to-GDPratio rose from about 50% in 1989 to almost70% in 2008.

The most profligate G7 country in termsof debt growth was neither Italy nor Japan –two countries famous for debt-to-GDP ratiossignificantly above 100% – but the UK.However, whereas Japan’s ratio increasedfrom roughly 68% in 1989 to an astonishing173% in 2008 (it is currently close to 200%),the UK managed to keep its debt-to-GDPratio relatively contained at 59% in 2008.What explains this apparent anomaly? Thedifference in nominal growth rates: 5.5% onaverage for the UK and only 1.2% for Japan.

A debt-to-GDP ratio above 100% is problematic When looking at the evolution of debt weneed to differentiate between governmentexpenditures for current activities and the

interest paid on any outstanding debt. Theprimary government balance is equal to thedifference between its revenues, usually inthe form of tax receipts, and its currentexpenditures interest payments. Addinginterest payments yields the overall govern-ment balance. If the primary balance is inequilibrium (in other words, if revenuesexactly cover current expenditures), then theoverall deficit would only equal the interestpayments the government has to pay on itsdebt obligations. In such a situation, govern-ments would issue new debt just to pay forthe accrued interest.

If a government balance sheet is in equi-librium, the growth rate of its new debt willcorrespond to the interest it has to pay on itsdebt. If the primary balance is in surplus, thegovernment will be able to pay back someof its debt. If the primary balance is in deficit,however, the government has to continuallyissue new debt.

For a country’s debt-to-GDP ratio to sta-bilize the government must at least get itsrevenues and expenditures (net of interest)back into balance, and the interest rate onthe debt must be below the growth rate ofthe economy.

A more fundamental rule of fiscal policywould be to never allow for any deficit at all.However, such a rule doesn’t take intoaccount that the economy fluctuates. Whenan economy is in a recession both the gov-ernment revenues will decline while the gov-ernment outlays (for example, spending onunemployment benefits) will increase. Thismeans that usually government budget bal-ances are negative in a recession. One wouldexpect a reversal in the case of a boomingeconomy. However, over the last 20 yearsthere was only one year, 2000, in which theOECD as a whole managed to have a govern-

More room for maneuver if debt is inown currencyDeveloped countries usually issue sovereigndebt in their own currencies, which meansthey can “monetize” the debt, if necessary.By contrast, emerging market countriesissue most of their debt in a major foreigncurrency like the US dollar or the euro.Therefore, large deficits can be destabiliz-ing. If an emerging market country lacks theforeign currency to repay or service its debt,it faces the risk of defaulting. The case ofcountries in the Eurozone is a bit more com-plex. On the one hand, the debt of Euro-zone countries is issued in their own cur-rency, the euro. On the other hand, theEuropean Central Bank being a suprana-tional entity and the euro the currency of 16countries, a Eurozone member country can-not monetize its debt. This explains the cur-rent nervousness about Greece and otherhighly indebted Eurozone countries.


Focus

6 UBS investor’s guide 26 February 2010

Focus

ment surplus. In the US only 1999-2001 wascharacterized by surpluses while countrieslike France or Japan have not shown any sur-plus at all over the last two decades.

What a government can do about its debtThere are only five possible ways a govern-ment can increase its primary surplus ordecrease its primary deficit:

1. Do nothingWhen questioned about rising governmentdebt the late US President Ronald Reaganonce famously remarked, “I am not worriedabout the deficit. It is big enough to take careof itself.” There is more behind this bon motthan one might think. Indeed, if the econ-omy grows faster than debt is accumulating,then obviously the debt-to-GDP ratioshrinks. Moreover, if the government deficitswere done in the first place to boost thegrowth prospects of an economy throughbetter infrastructure or lower taxes, then ulti-mately this growth boost could finance thedeficit. However, there are some flaws to thisline of thinking in the current environment.Developed economies, due to poor demo-graphic prospects and the ongoing delever-aging of the private sector, have rathermuted growth prospects over the next cou-ple of years, and the debt to GDP ratio is cur-rently very close to levels where it becomesnegative to growth. What’s more, given thata higher portion of government budgets arenow dedicated to entitlement spending anddebt servicing, simply doing nothing doesn’tappear to be a viable option.

2. Increase taxes Increasing taxes will obviously reduce thedeficit but this in turn can harm the growthprospects of an economy and would most

likely wind up prolonging any recession.Moreover, when it comes to increasing taxes,not all economies have the same room tomaneuver anymore. While, according toOECD statistics in countries like the US orJapan, total government tax revenues areslightly above 25% of GDP, the tax burdensin countries such as France and Italy stand atalmost 45% and are already at the limit ofwhat is bearable by taxpayers.

3. Decrease government spending Decreasing government spending will alsoreduce the deficit, but this action too willmost likely have a negative impact on theeconomy at least in the short run. Some ofthe current expenditures like the stimuluspackages and the bailouts of the financialsector will not last, reducing the current veryhigh deficits in the future. However, whenlooking at cutting government spending toreduce debt, the room for maneuvering isvery small unless government spending seenas mandatory or untouchable (social security,defense) is also considered.

4. DefaultDefault on debt is certainly also an option.While one would guess that if a country canissue its debt in its own currency, inflation(see below) would be the preferred option toradically tackle the debt problem. US econ-omists Carmen Reinhart and Kenneth Rogoffreport in their monumental study (“This timeis different”) 70 cases of default of govern-ments on debt issued in local currency. Whilethis is rarer than default on debt issued in aforeign currency (250 cases) it remains aremote possibility.

5. Monetize it (if debt is issued in yourown currency)

Given the poor political prospects of increas-ing taxes and/or decreasing governmentspending the most elegant way to tackledebt is to monetize it, i.e. to let the centralbank buy it. In most developed countries thecentral bank is independent from the gov-ernment and one of its objectives is to keepinflation in check. Monetizing the debtwould obviously contradict this objective.However, the incentive to monetize debtrises as a greater portion of the debt is heldby foreign investors, since they would end upbearing much of the costs in the form of lossof purchasing power from a currencydebasement.

The consequences of high debtHaving seen how difficult it is to tackle theissue of a high public debt, one might ask thefundamental question: why should we careabout it at all?

Several answers to this question arealready given in the previous paragraphs.Since there is an incentive to monetize debtburdens, a relatively high debt-to-GDP ratiocould be expected to weigh heavily uponinflation expectations. Moreover, to reducea high debt burden one will have to inflictmeasures such as higher taxes and lowergovernment expenditures which could tendto reduce growth in the short to mediumterm. But even looking at it from a static per-spective, a high debt level can negativelyimpact growth. Reinhart and Rogoff showedthat beyond a 90% debt-to-GDP ratiothreshold, the burden of debt alone will sig-nificantly reduce the growth rate of a coun-try.

There are at least two theoretical expla-nations to this finding. First, such a highdebt-to-GDP ratio could induce householdto consume less and save more, because

they believe that ultimately they will face taxincreases in the future. Second, a high debtlevel could push interest rates higher, lead-ing companies to invest less – the so called“crowding out” of the private investmentactivity by the public sector.

Moreover, the higher the debt level, themore that government actions will be con-strained by the need to service those debtpayments. In the mid-1990s Canada’s debtsituation was considered almost hopeless,but thanks to very harsh measures inducedby a newly elected government a spectacu-lar turnaround was managed. The mainargument, then Canadian Finance Ministry(later Prime Minister) Paul Martin used toconvince the broader public that harsh meas-ures were necessary was “that the servicingof excessive public sector debt was crowd-ing out needed social programs: health care,education and child welfare.”

A final argument is an ethical one. Publicdeficits and debts are basically an intergen-erational redistribution, where current peo-ple profit de facto from goods and servicesthat later generations, which cannot votenow, will have to pay. If we think deeplyabout it, it inherently appeals to our sense offairness.Andreas Hoefert


Mike Ryan

Head, WMR Americas

[email protected]


Outlook · Asset Allocation


Asset Allocation · Outlook

Asset allocation strategy

underweight neutral overweight

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

Commodities

Cash

Fixed income

Equity

Source: UBS WMR, as of 25 February 2010

For more information, please read the most recent US Investment Strategy Guide. See Scale for Investment Strategy in theAppendix for an explanation of the strategy.

We continue to favor equities and commoditiesover fixed income and cash. We believe signs that aglobal economic recovery is underway supportkeeping a pro-cyclical portfolio stance.

Fundamentals should trump market fears

Financial markets have been on a bum -py road since the beginning of 2010,driven most recently by fears over Greekdebt. While Greece will not solve itsproblems overnight, we find that, forstock markets, improving economicfundamentals globally will trump cur-rent market fears. We keep a prefer-ence for equities over bonds.

By 8 February, equity markets had sold offnearly 10% since mid-January on the backof rising market fears over Greek govern-ment debt issues. While acknowledgingthat elevated government debt levels couldbe a long-term drag on growth, we findthe market reaction overdone and considerit as a buying opportunity for risk-tolerantinvestors.

Economic recovery versus Greek debt fearsFinancial markets are currently questioningthe probity of Greek public finances. While thecoming months will be uncertain, we think arefinancing crisis will be avoided possibly withsome form of outside financial support. Mar-ket participants therefore need to weigh therisk posed by the fiscal situation in Greece toglobal financial markets against the currentlystrong momentum in the global economy ledby the US and Asia. In our opinion, financialmarkets are more likely to take the cue fromthe economic recovery. If one adds still mod-erately attractive valuation levels, risk assetssuch as equities and corporate bonds are setto perform well as we move further into 2010.

Government debt levels call for a well-diversified portfolioWhile we believe Greece is unlikely to defaulton its debt, we are concerned about risinggovernment debt levels globally. As such, wethink investors should hold a portfolio that isnot overly exposed to longer-term govern-ment debt or rising inflation. In our view, adiversified portfolio should include “realassets” that carry tangible intrinsic value

High-yield bonds: still some potential left

High-yield corporate bonds delivered a stellar performance in 2009 as rock-bottom priceslured investors back into this asset class. Improving corporate credit fundamentals, along-side still-attractive valuations, lead us to expect another solid year of returns for high-yield in 2010, though not to the same extent as seen in 2009. While the rally experiencedsince April 2009 has been partly driven by liquidity, this has not been the only improve-ment.

The uptick in global economic activity has had several positive side effects for corpo-rate credit. Corporate earnings have surprised positively, credit quality continues tosteadily improve and access to bank lending or debt capital markets further supports high-yield corporate bonds. These fundamental developments are reflected in falling defaultrates and increasing ratings upgrades. Corporate defaults have fallen significantly andcontinue to do so after hitting a peak of 14% at the end of 2009, leading us to believewe are past the worst in the yearly trailing default rates. In comparison, default ratesamong high-yield corporate bonds peaked around 12% during the previous two reces-sions.

As valuations are by no means stretched, we expect a solid performance for high-yieldbonds during 2010, with total returns in the high single digits. Investors looking to investin high-yield corporate bonds should diversify in order to avoid high exposure to individ-ual default events. (See our 11 February report, “High Yield: A more muted year aheadfor high-yield bonds”, for more details.)

such as commodities and real estate (and tosome extent equities). Gold is a valuableportfolio element that is likely to prove agood hedge against increasing governmentdebt levels and inflation expectations.Mark Andersen, Strategist, UBS AG

Stephen Freedman, CFA

Strategist, UBS Financial Services Inc.

[email protected]


Portfolio PrinciplesPortfolio Principles

Shifts that matter

Several turning points that can also be partially classified as “big shifts” arebecoming relevant to investors, in our view. Being well positioned for theseshifts could make the difference between a good or a rather average overallperformance this year.

From recovery to delivery2010 could well turn out to be a year where thefocus shifts away from macroeconomic concernsback to microeconomic issues. In other words, weare likely to observe a shift from recovery to deliv-ery. Using the basic equity valuation metric P/E, wethink this year's performance will more be drivenby the “E” (earnings and earnings growth) andmuch less by an expansion of the “P” (the valua-tion multiple). As a consequence, stock-pickingand active management are regaining importance,with performance likely to be supported for stocksable to deliver solid and sustainable earningsgrowth, as opposed to merely being driven by thenormalization of risk aversion or cost-cutting.

From steepening to flatteningDuring 2010, major central banks face the chal-lenge of finding the right exit strategies from theirmassive monetary stimulus and will start to hikeinterest rates. This should have an important effecton yield curves and might actually mark a turningpoint, where interest rate curves embark on amulti-year flattening trend, mainly driven by a nor-malization of short-term interest rates.

From major to minor currenciesWe assess the growing investor interest in smallercurrencies that has taken place for quite sometime. Currencies of commodity producers and suc-cessful emerging markets rank on top of the pick-list of investors, but we also note small currencyareas of advanced non-commodity producingmarkets like Switzerland, Singapore or Sweden. Inour view, this reflects investors' wish to increasediversification, their desire to participate in thegrowth of smaller countries, and a certain annoy-ance with the deficiencies of major economies.

on emerging market growth should allow them totrend higher, even if the developed world does notget up on its feet completely. Equity indices, on theother hand, are highly geared toward the devel-oped world and are therefore more exposed toweak OECD growth. Hence, we expect the diver-sification benefits of commodities in a portfolio tobecome more attractive and improve the risk-return profile.See Shifts that Matter, 26 Feb. 2010.Philippe G. Mueller

Analyst, UBS AG

From recoupling to re-decouplingIn 2007, the term “decoupling” was the newbuzzword. However, the financial crisis induced atruly global recession, where all business cyclesaround the globe were weakening simultaneously.By mid-2009, however, the decoupling phenom-enon regained traction with emerging markets(especially Southeast Asia) leading the recovery,and some developed countries like the UK clearlylagging. We expect this phenomenon to continuein the future and lead again to a more stable inter-national macroeconomic environment.

From high to low correlationThe correlation between commodities and equitiesreached record levels during 2009. We do notexpect these levels to be sustained. Moreover, webelieve the coming years will be characterized byhigh emerging market growth versus the devel-oped world. The high dependency of commodities

Extended asset allocation

Asset class Tactical view* Comment

US equities US equities are less attractiveley valued than international markets, but + earnings prospects are somewhat stronger than for non–US developed

equities.

Non–US developed Foreign equities, especially in Europe, are still attractively valued. equities + However, the cyclical recovery appears to be lagging behind the US.

Japanese equities are expensive.

Emerging markets Emerging market equities are no longer cheap but should continue to equities + benefit from the growth recovery in the underlying economies.

US fixed income Expensive and likely to come under pressure as economic conditions – normalize.

Non–US fixed income Though we expect dollar weakness in the longer term, foreign bonds are – not likely to benefit from currency movements during the next six months.

Cash (USD) – Unattractive cash returns due to exceptionally low policy interest rates.

Commodities We believe that the cyclical recovery should prove supportive for + commodities during the next 12 months. Source: UBS WMR, as of 25 February 2010

*See scale for Investment Strategy in the appendix for an explanation. For more information, please read the most recent US Investment Strategy Guide.

From firing to hiringA sustainable US recovery needs to see businesseshiring workers again. We think consumer spend-ing will not continue to expand unless laborincome growth stabilizes, which requires positiveemployment growth. As with any market, supplyand demand for labor dictates wages. Thus, areturn to hiring would break the downward trendin wage growth. After shedding over 7 millionjobs since the beginning of the recession, weexpect businesses to start adding to their payrollsin 2Q10.

From shrinking to growingStocks are more likely to get sincere applause if rev-enue (rather than earnings) expectations arebeaten. As a consequence, we anticipate increas-ing attention on revenue growth opportunities,whether through market share gains or industry-level growth.

From public to privateGovernments worldwide have intervened on amassive scale to prevent the recession caused bythe credit crunch from slipping into a full-fledgeddepression. So far these policies have been suc-cessful and at the beginning of 2010 all majoreconomies have started to grow again. However,public finances have been stretched to the limit (insome countries even beyond it), making it very dif-ficult to continue these policies. There is a risk thatonce the stimulus programs end, the private sec-tor will not be able to pick up the growth baton.This could ultimately lead to sub-trend growth forlonger, which is a risk that we see especially in thecountries that were the most exposed to the hous-ing boom and bust, namely the US, the UK andSpain.


Economy · US US · Economy

Avoiding the neutrality of money

in % 2006 2007 2008 2009 2010F 2011F

Real GDP (y/y) 2.7 2.1 0.4 –2.4 3.0 3.0

CPI (y/y) 3.2 2.9 3.8 –0.3 1.7 1.3

Core CPI (y/y) 2.5 2.3 2.3 1.7 1.0 0.9

Unemployment rate 4.6 4.6 5.8 9.3 9.9 9.8

Fed funds rate* 5.25 4.25 0.25 0.20 1.0 3.0* year–end level Sources: Thomson Financial, UBS WMR, as of 22 Feb. 2010

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

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

Real GDP is recovering; M2 still bloated

16000

8000

4000

10000

12000

14000

6000

2000

9000

4000

2000

5000

6000

7000

8000

3000

1000

1960 1980 2000 20201900 1920 1940

Source: Bloomberg

USD bn USD bn

Real GDP (lhs)M2 (rhs)

Most investors are familiar with the no-tion that a surge in money growth, if not reversed, will eventually lead toa rise in inflation. In economics, theconcept is called the neutrality of mo -ney, since the impact of moneygrowth on real activity is neutral inthe long run. The direct implication is that once a central bank has success-fully reignited growth, it should re -verse its monetary expansion to avoidinflation further down the road. Why is it then so surprising that the Fedis preparing the way for exactly suchan exit?

There are two key reasons for a central bankto become more restrictive after orchestrat-ing a successful economic recovery withlower rates and (if needed, like in the pastrecession) massive liquidity injections. First,the peak impact on real economic activity

takes place about six months after any givenrate cut or liquidity injection. After that theimpact on growth fades rather quickly. It istrue that keeping rates low forever will con-tinuously impact growth positively, but at adecreasing rate. Why? Because investors andborrowers will take advantage of lower ratesas they fall, but once the majority of themhave done so, the incremental impact ongrowth fades. Second, once a self-sustainingrecovery has been engineered, excessivemoney growth will eventually lead to infla-tion. This is called the neutrality of money, asthe impact of money growth on real activityis neutral in the long run. The key reason forthis is that any excess money growth in aneconomy that is operating at full potentialwill lift inflation, as supply is capped.

In the current cycle, several key signpostsfor a sustainable recovery are already in therearview mirror. The inventory cycle hasturned, production has been rising for sevenconsecutive months and consumption hasexpanded for a few months without addi-tional fiscal stimulus. The final building blockof a sustainable expansion is a return to pos-

itive employment growth. We expect pay-rolls to turn positive in 2Q10, as key leadingindicators such as temporary hiring and theaverage workweek have risen already andproductivity growth has soared, signaling afull usage of the existing workforce. If we areright and employment growth does indeedturn positive soon, then our confidence in aself-sustaining expansion will rise as well.After all, the virtuous cycle (rising employ-ment leads to rising labor income, resultingin rising consumption, causing rising produc-tion) is the core engine of any expandingeconomy.

With this expectation for positive employ-ment growth in mind, why then is it so bewil-dering to see the Fed preparing the way tonormalize its monetary stance. Once theeconomy can grow on its own, the wisestmove is to remove the monetary stimulus inorder to avoid rampant inflation furtherdown the road. After all, the positive impacton real economic growth is fading at bestanyway. We view the Fed’s announcement toraise the discount rate from 0.5% to 0.75%in this light. The discount rate is the loan rateat which commercial banks can get fundsfrom the Fed at the discount window against

prime-rated collateral. It is a liquidity back-stop for banks that cannot find funding onthe interbank fed funds market. Before thefirst liquidity crisis pertaining to toxic sub-prime paper in August 2007, the spreadbetween the discount rate and the fed fundsrate was 100 basis points (bps). To facilitatecheaper funding for banks in trouble, the Fedlowered that spread to 25 bps in two steps.Together with all the other liquidity facilities,this proved to be a welcome development.Particularly after the collapse of Lehman, dis-count borrowing soared to about USD110bn per day at its peak. The most recentnumber is closer to USD 14bn per day, a neg-ligible number. Thus, the increase in the dis-count rate will have only negligible economicrepercussions, as banks hardly use the dis-count window anymore and thus it will notaffect borrowing rates for business andhouseholds. We, however, view it as a signalthat the Fed is preparing to raise its fed fundstarget and confirm our call for a first ratehike in June. Thomas Berner, CFA

US Economist, UBS Financial Services Inc.

[email protected]

Real GDP recovered in 3Q09 and the pace ofthe recovery accelerated in 4Q09. Meanwhile,M2, the broadest available money aggregate,remains bloated. While this does not imply animmediate inflation threat, the Fed will haveto mop up liquidity in order to rein in inflationfurther down the road.


Spotlight · Economy


Economy · Spotlight

From firing to (cyclical) hiring

Surge in permanently laid off workers

The labor market report differentiatesbetween temporary and permanently laid offworkers. The former tend to get reemployedquickly, as they get called back to their for-mer jobs. The latter tend to stay unemployedfor longer periods, as they have to find newjobs, most likely in other industries.

nsa = not seasonally adjusted

8

4

2

5

7

6

3

1

0

Source: Thomson Reuters, UBS WMR

1967 19871977 1997 2007

% of labor force, nsa

On temporary layoffNot on temporary layoffJob losers

Several developments visible in the eco-nomic landscape make us optimisticthat employment growth will soon turnpositive. The turn in the inventorycycle has boosted production and thesurge in productivity growth suggeststhat businesses are utilizing their exis -ting workforces to an extreme. How-ever, the labor recovery will likely belackluster as the deep recession hasfilled the ranks of the structurallyunemployed.

A key missing signpost of a sustainable USrecovery is businesses once again hiring work-ers. The recovery in real GDP thus far has beendriven by a moderation in inventory depletionby businesses in order to better align them-selves with rebounding sales. However, con-sumer spending will not continue to expandunless labor income growth stabilizes, whichrequires positive employment growth. A returnto hiring would break the downward trend in

wage growth, which emerged as employmentgrowth started to falter in early 2007. Two keydevelopments suggest that a return to hiring isaround the corner.

Positive feedback loop from the inventory cycleFirst, as sales rebounded in 3Q09, in largepart due to the monetary and fiscal stimulus,businesses were able to slow down inventorydepletion rates, which meant boosting pro-duction. This is the spark that typically ignitesa sustainable recovery. Economic outputimproves from rising production related tothe turn of the inventory cycle. Such a boostto real GDP generates income, which in turnspurs consumption. However, the inventorysnapback can only substantially lift the econ-omy for a few quarters, historically for a max-imum of three quarters. However, it sets inmotion a positive feedback loop betweenrising economic output and hiring. As busi-nesses expand, they tend to need moreworkers to run their operations. This, in turn,raises aggregate labor income, which conse-quently supports consumption.

Soaring productivity growth bodes wellfor future employmentSecond, the surge in productivity in 2H09bodes well for renewed hiring. The growthrate was visibly higher than the average pro-ductivity growth of about 3.5% during thepeak productivity growth years of the techboom in the late 1990s. With trend produc-tivity growth likely lower today than overthat period, we expect the surge in produc-tivity to falter going forward. Economically,businesses have been firing workers and cut-ting working hours, which raised productiv-ity, as less total man-hours produced moreoutput in 2H09 than in 1H09. However, assales continue to grow it will be hard forbusinesses to expand their operations tomeet rising sales without increasing theirtotal man-hours. They cannot raise the pro-ductivity of their existing workforces any fur-ther. The workweek in the monthly labormarket report has already tentativelyrebounded from a cyclical low. The next log-ical development to expect is a return to hir-ing by companies.

Increase in structural unemploymentDespite our optimism about a swift return tonet hiring, we do not expect employmentgrowth to be strong in this recovery. One ofthe key consequences of deep recessionscharacterized by marked sector restructuringis a sharp increase in structural unemploy-ment. This refers to workers that are perma-nently laid off and have to find a new job,most likely in another industry. Conse-quently, they tend to stay unemployed forlonger and typically suffer paycheck cutsonce reemployed – both fates that speak forlackluster employment and consumptiongrowth for some time.

For additional information, see US econ-nomics: How severe is structural unemploy-ment? 25 Jan. 2010.Thomas Berner, CFA

US Economist, UBS Financial Services Inc.

[email protected]

Normalization versus exit strategy

The Fed announced last Thursday that it would increase its discount rate from 1/2 per-cent to 3/4 percent and lowered the maximum maturity for discount loans from 28 daysto overnight.

We view this move as a further step towards normalizing monetary policy and a hintthat the Fed is preparing to raise its more important Fed funds rate target. However,the move itself did not tighten monetary policy as the discount rate does not affect bor-rowing rates for businesses or households. The discount window is merely a liquiditybackstop facility for commercial banks that need funding but cannot find it in the inter-bank market.

We continue to expect a first Fed funds rate hike in June, but that forecast is based onour expectation for a return to positive payrolls in 2Q10 as well as continued overallgrowth and stable financial conditions.


US market · EquitiesEconomy · Regions

UK

Eurozone

Asia–Pacific

Japan

Technology

Energy

Materials

Consumer staples

Industrials

Financials

Health care

Consumer discretionary

Utilities

Telecom

US equity sector strategy

Sector Performance (local currency/USD, in %)underweight neutral overweight mtd ytd 2009

5.0 –3.8 61.7

4.5 –0.2 13.8

7.0 –2.2 48.6

3.5 2.3 14.9

5.1 3.8 20.9

2.0 0.6 17.2

0.6 1.1 19.7

4.5 1.5 41.3

1.0 –4.0 11.9

–0.2 –8.3 8.9Total return indices in USD: S&P 500 sector indices as of 22 February 2010 Source: UBS WMR, as of 25 February 2010

For more information, please read the most recent US Investment Strategy Guide. See Scale for Investment Strategy in the Appendix for an explanation of thestrategy.

UK Retail sales fell in January and unemploymentis on the rise. After nearly flat growth (0.1%) inthe fourth quarter of 2009, the UK now seemsunlikely to post a strong result for the first quar-ter of 2010. At the same time, inflation has beenrising strongly over the last two months. TheBank of England has made it very clear that itsees the increase in inflation as temporary and is

more concerned about the recovery remainingfragile. Thus, the window for further quantitativeeasing remains wide open. A policy rate hike any-time soon is very unlikely, in our view. As a result,there is a good chance for inflation to remainhigh for longer. This, together with very weakeconomic growth, makes for an uncomfortablescenario.

Fourth-quarter GDPs in the eurozone have beendisappointing, as have recent “soft data” releaseslike PMI and consumer confidence. The recoverythat so far has mainly been driven by strongexports and an upswing in inventories is still ontrack. But as long as consumer spending does notpick up, it will remain modest. The need for fiscal

consolidation in many eurozone countries poses afurther risk to future economic growth. The dark-ening outlook has led us to lower our growthforecast for 2010 to 1.5%. The European CentralBank has started to pare down some of itsextraordinary measures, but interest rates arelikely to remain unchanged until late 2010.

All remaining Asian economies have reported fourth-quarter GDP figures, which were very strong andmuch better than expected. The numbers were nodoubt greatly helped by base effects as economicactivity is compared with the utterly depressed situ-ation of a year ago. According to our estimates, Asiaex-Japan as a whole grew slightly above 8% year-

on-year, the fastest pace since early 2008. The samebase effects will almost surely help push growth rateshigher in the first half of the year. With economicactivity back to pre-crisis levels and a further increasein Asian export volumes, we believe policymakers inAsia, led by the People’s Bank of China, will allowmore currency appreciation than seen so far.

– – – – – – n + ++ +++

GBP** �

EUR** �

AXJ** �

JPY** �

Earnings season wrapping up

Exports have been gaining strength in recentmonths, growing 41% y/y in January. This is pro-viding a base of support for the economy, reduc-ing the risk of a double-dip recession. However,domestic demand remains weak overall as com-

panies try to cut costs in the face of the strongeryen. With help from the government, employmentappears to be stabilizing, although wages remainunder downward pressure. Prices and rents arecontinuing to trend lower.

**Arrows indicate whether the currency is expected to strengthen, weaken or trend sideways aginst the US dollar.

With 96% of the S&P 500 (by market capi-talization) having reported 4Q09 earnings, itis clear that the season was strong in severalrespects. The quarter was the first showingpositive earnings growth for the S&P 500 inover two years, with results more thantripling the depressed number from last year(USD 17.53 vs. USD 5.62), with 7% sequen-tial im provement as well. Sales rose a solid5% after posting low teen double-digitdeclines throughout 2009. Another positiveis that 74% of S&P 500 companies beat theirrespective consensus earnings estimate byan average of 11%. Importantly, sales havealso played an increasing role in the strongbeats this quarter. An impressive 68% ofcompanies beat the market’s estimate forsales, in contrast to the previous three quar-ters when cost cutting was the principalearnings driver. Strength was seen across themarket. The largest sector (and currently our

preferred sector within US sector allocation),Technology, proved to be the standout.Eighty-five percent of technology companiesbeat consensus estimates, followed by thestrongest positive earnings revisions for thecoming year. Lastly, companies themselvesproved optimistic by raising their future earn-ings outlook as well. Company estimates for2010 have risen by 2% while 2011 estimateshave gone up 1% during 4Q09 earnings sea-son. We conclude that a sustained earningsrecovery is occuring, driven by the combina-tion of strong cost cutting over the past yearand rebounding revenue growth. We lookfor earnings growth of 29% in 2010 and15% in 2011.Joseph Anthony Sawe


[email protected]


Equities · Market outlook Market outlook · Equities

Commercial real estate (CRE): “Exorcising the shoe”

Large–cap Growth

Large–cap Value

Mid–Cap

REITs

Small–Cap

US equity size and style

Sector Strategy Performance (local currency/USD, in %)underweight neutral overweight mtd ytd 2009

4.0 –0.5 37.2

3.4 0.5 19.7

5.1 1.6 40.5

4.5 –0.9 28.0

5.0 1.1 27.2Total return indices in USD: Russell as of 22 February 2010 Source: UBS WMR, as of 25 February 2010


– – – – – – n + ++ +++

Given the relatively small size of the US com-mercial real estate debt market, potentiallosses will not likely create systemic risks forthe financial markets.

US residential market is far bigger than the CRE debt market

Source: US Federal Reserve, UBS WMR as of 11 Feb. 2010

Home 75.3%

Commercial 17.5%

Farm 0.9%

Multifamily residential 6.3%

We conclude that while CRE-relatedcredit losses are likely to remain elevated at regional and communitybanks, it is highly unlikely that these losses will lead to a repeat ofthe 2008/09 severe credit crunch.

We discuss nine reasons why we believe thatCRE is not the “next shoe to drop”.

1. The CRE market is much smaller thanresidential real estate. As chart below illus-trates, the residential mortgage market isover three times the size of the commercialand multi-family residential (condos, co-ops)markets combined. The sheer size of themarket means that losses are unlikely tomaterially impact bank capital.

2. The banking system has a stronger cap-ital position now than before the residentialmortgage meltdown. Even in a scenariowhere losses are at the high end of the Fed’sstress test assumptions, the banking systemwould generate about USD 150bn of losses.This is manageable versus total bank capitalof about USD 1,000bn.

3. Underwriting standards are higher forCRE. This is not to imply that standards didnot weaken for both categories of mort-gages during the prior economic expansion,but generally, commercial mortgage loan-to-value (LTV) ratios are between 55% and70%, while LTVs for residential mortgagestypically begin at 80%.

4. What bubble? The CRE market did notexperience nearly the same increase incapacity over the past 20 years compared tothe residential real estate market.

5. Loan modification programs ridiculedas “extend and pretend” or “delay andpray” often are a net positive. A key differ-ence between residential and commercialmortgages is that many commercial prop-erties are income-producing and oftenhave a diversified tenant base that buffersthe losses incurred from individual defaults.Loan workouts for delinquent commercialproperties that still generate cash flow,albeit at reduced levels, are common in theindustry and can make economic sense forboth the lender and the borrower.

6. Interest rates are at historically low lev-

els. Not only does a low interest rate supportthe valuation of real estate, but it also low-ers the interest burden on borrowers, allow-ing more time for economic conditions toimprove to avoid a payment default or prop-erty foreclosure.

7. The economy is improving! US real GDPhas been positive for two consecutive quar-ters and labor market trends – a key driver ofvacancy rates and commercial property pric-ing – appear to be stabilizing. The recentuptick in the National Association of Realtor(NAR) Commercial Leading Indicator alsosupports our view that the CRE market is sta-bilizing.

8. Unlike residential mortgages and secu-ritized assets that are mostly held by largerfinancial institutions, commercial mortgagesare disproportionately held at smaller,regional banks. By definition, these smallerbanks are not systemically important. Also,there is a well-defined, FDIC-managedprocess to wind down smaller commercialbanks, which should avoid a Lehman Broth-ers-like disorderly collapse that led to a sub-stantial increase in risk aversion.

9. Significant CMBS (commercial mort-

gage-backed securities) losses have alreadybeen incurred. About 20% of commercialmortgages outstanding, or roughly $700 bil-lion, are in the form of CMBS. Current mar-ket pricing already reflects high default rateson the underlying mortgages and significantCMBS writedowns have already been takenby CMBS holders.

In summary, while we recognize that CREloan losses will likely remain at elevated lev-els over the next two years, losses areunlikely to trigger another credit crisis.

For more information, see Risk Watch:Commercial Real Estate - Exorcising the shoe,11 Feb. 2010.Jeremy Zirin, CFA

[email protected]

David Lefkowitz, CFA

[email protected]

Strategists, UBS Financial Services Inc.


US and Global · Equities


Equities · US and Global

Best opportunities lie within emerging marketsName Ticker Sector Price Date of P/E 2010 EPS y/y Total Return

addition Jan. Sinceaddition

Abbott Laboratories* ABT Health Care $54.42 1-Feb-2010 12.7 14% – –

Ameriprise AMP Financials $40.48 30-Sept-2009 10.7 23% –1% 4%

Apache APA Energy $104.02 1-Sept-2008 10.0 77% –4% –6%

Apple AAPL Technology $200.42 20-Nov-2009 16.7 29% –9% –7%

Avon Products AVP Consumer Staples $30.40 6-Nov-2009 14.5 19% –4% –10%

Bank of America BAC Financials $16.21 30-Oct-2009 14.7 N/A 1% 4%

Cisco Systems CSCO Technology $24.30 20-Nov-2009 14.9 14% –6% –6%

Coca-Cola KO Consumer Staples $55.37 31-Mar-2008 16.1 11% –5% –7%

Colgate-Palmolive CL Consumer Staples $82.12 1-Jun-2007 16.6 11% –2% 27%

Cooper Industries CBE Industrials $45.36 30-Oct-2009 15.1 17% 1% 12%

CSX CSX Industrials $46.81 29-May-2009 14.3 11% –12% 28%

Disney DIS Consumer Discretionary $31.12 30-Jun-2009 15.0 9% –8% 27%

FedEx Corp.* FDX Industrials $82.42 1-Feb-2010 18.3 33% – –

Freeport McMoran FCX Materials $76.24 31-Jul-2009 9.7 32% –17% 3%

Gilead Sciences* GILD Health Care $47.88 1-Feb-2010 13.4 15% – –

Google GOOG Technology $542.80 16-Jun-2008 19.4 18% –15% –7%

Hess HES Energy $60.11 30-Jun-2009 13.6 82% –4% 9%

Hewlett-Packard HPQ Technology $50.56 31-Aug-2009 11.2 15% –9% 8%

Microsoft MSFT Technology $28.73 30-Jun-2009 13.5 17% –8% 18%

Monsanto MON Materials $76.79 23-Apr-2009 20.2 –25% –7% –6%

PMC Sierra PMCS Technology $8.60 30-Sept-2009 12.6 33% –8% –13%

Teva Pharmaceuticals+ TEVA (ADR) Health Care $59.87 31-Jul-2008 12.8 35% 1% 25%

Travelers TRV Financials $52.99 10-Jan-2007 9.0 –6% 2% 7%

Weatherford Internat.* WFT Energy $16.78 1-Feb-2010 19.8 50% – –

YUM! Brands YUM Consumer Discretionary $33.68 22-Jul-2009 13.9 11% –2% 3%

No longer recommended

AstraZeneca+ Health Care

HSBC+ Financials

Thermo Fisher Scientific+ Health Care

Total+ EnergyP/E = price to earnings on consensus forward 12 months estimates, EPS = earnings per share, 2010 estimates are consensus.

Source: Bloomberg and UBS WMR, return data as of 29 Jan. 2010. Price, P/E, EPS data as of 22 Feb. 2010. For more information, please see most recent U.S. Top25 Stock List.Stocks which are only covered by UBS Investment Research are annotated as such with a “+” sign. These stocks have a 12-month rated Buy or Neutral recommen-dation. UBS Investment Research is part of UBS Investment Bank (the UBS business group that includes, among others, UBS Securities LLC). * These stocks have been added as of the last UBS investor’s guide publication.

U.S. Top 25 Stock List

ADR Top List

Company Ticker Sector Price (22 Feb)

Honda Motor HMC Consumer Discret. $34.35

British American Tobacco BTI Consumer Staples $69.01

Nestle NSRGY Consumer Staples $48.63

BP BP Energy $54.30

Total TOT Energy $58.25

Yanzhou Coal Mining YZC Energy $20.71

Bank of Nova Scotia BNS Financials $45.94

Chine Life Insurance LFC Financials $66.42

HSBC HBC Financials $53.28

ING ING Financials $9.34

Lloyds Banking LYG Financials $3.16

Company Ticker Sector Price(22 Feb)

AstraZeneca AZN Health Care $43.65

Mindray Medical MR Health Care $37.39

Teva Pharmaceutical TEVA Health Care $58.74

ABB ABB Industrials $19.78

ArcelorMittal MT Materials $39.38

BHP Billiton BHP Materials $74.94

Rio Tinto RTP Materials $213.30

ASML ASML Technology $31.80

SAP SAP Technology $44.50

China Unicom CHU Telecomm. $11.04

Telefonica TEF Telecomm. $70.94

For more information please see most recent ADR Top List. Source: Bloomberg and UBS WMR, as of 22 Feb. 2010.

Stocks are covered by UBS Investment Research. These stocks have a 12-month rated Buy or Neutral recommendation. UBS Investment Research is part of UBS Investment Bank.

The WMR American Depositary Receipt(ADR) Top List represents our best interna-tional stock ideas. We combine top-downanalysis from our WMR equity strategy teamand bottom-up company analysis from UBSInvestment Research. In our view, there arepowerful forces that will drive emergingmarket economic growth in the years aheadand the list is heavily tilted towards captur-ing that growth. Favorable structural earn-ings growth prospects are coupled with stillfair valuations, which should benefit emerg-ing market equities relative to global equi-ties. Unlike their developed market counter-parts, emerging market consumers have verylow levels of debt and a high savings rate,suggesting there is significant scope forincreased levels of consumption. Consumerspending on discretionary goods and servicestends to increase only when a certain level of

income is reached. Although per capitaincomes in emerging Asian countries are stillwell below those in developed countries,personal consumption growth rates aremuch higher. Emerging market governmentsare also promoting domestic consumption tobecome less dependent on world trade, andwe expect that pent-up consumer demandwill begin to be unleashed. On the ADR TopList, there are several companies well posi-tioned to benefit from rising emerging mar-ket consumption, including Honda Motor,BAT, Nestle, AstraZeneca, Mindray Medical,Teva, China Unicom and Telefonica.

For additional information, see EducationNote: Understanding ADRs, 29 Nov. 2007.Joseph Anthony Sawe


[email protected]


Equities · Europe

European equities


Asia–Pacific · Equities

Global risks in local context

We prefer China, Hong Kong, and Singa-pore. We expect Malaysia, Korea and Thai-land to underperform over the next 12months relative to the overall Asia ex-Japanequity market.

Market performance Asia ex-Japan

0 20 40 60 80 100

Malaysia

Taiwan

Singapore

Philippines

Korea

Hong Kong

MSCI ASIA EX-JAPAN

China

India

Thailand

Indonesia

Source: Thomson Reuters

12-month rolling average5 years annualized

in %

US

Japan

Other developed

UK

Eurozone

Emerging markets

Regional equity strategy


3.8 0.1 28.3

–2.8 –1.0 6.4

–0.4 –5.1 34.4

–0.2 –5.0 43.4

–2.5 –10.0 32.8

0.1 –5.5 79.0Total return indices in USD: Russell 3000, MSCI for non–US, as of 22 February 2010 Source: UBS WMR, as of 25 February 2010

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 + ++ +++

Eurozone equities: Down and upEurozone equities suffered a setback in theearly part of February as Greek sovereignissues took a stab at inves tor sentiment. Itwas the first time since the March 2009 lowsthat the equity market suffered a 10% pluspeak-to-trough decline. The medium-termstructure of the market remains positive.

We remain positive for the next fewmonths as earnings and revenues remainsupportive. Not only have we seen, on bal-ance, more positive surprises for the fourthquarter. It also marked the turning point onthe revenue side. This is supportive for theequity markets in the coming months. Forinvestors who seek to add to equities, wewould recommend applying a staggeredapproach as sovereign debt issues and pol-icy tightening could still provide some nega-tive headwinds.Tim Gorlé

Analyst, UBS AG

UK equities: The return to qualityThe economic recovery is underway. Manyequity markets remain attractively valued, asa strong corporate earnings season is con-cluding. However, the macro-economic con-cerns of late (e.g. sovereign debt issues;China's lower lending growth; increased reg-ulation), caused a recent correction in themarkets. This brings into focus some of thestill significant challenges to the recovery.Further news around monetary policy nor-malization, "exit strategies" by central banksfrom their stimulus programs and risinginterest rates may create continued volatilityin the equity markets.

The strong performers in last year's equityrally were the lower quality companies, manyof which had been priced for failure in thedepths of the recession. In light of contin-ued macro-economic uncertainties as thisyear progresses, we expect higher qualitystocks to outperform. Many of these stocksare trading at attractive valuations, withmore stable earnings and favorable dividendyields.Caroline Winckles

Analyst, UBS AG

Asian markets were not spared when globalequity markets corrected earlier this month.The market jitters have been driven by acombination of concerns about the exitingstrategies of central banks, stricter bankingregulation, and worries about sovereigndebt. Looking at the individual factors, webelieve that when assessing the prospects oftighter banking regulation or issues to repaysovereign debt, Asia's position is lookingdecidedly brighter than those of the G3economies. Asian banking systems haveweathered the global financial crisis relativelywell compared with their western peers and,as a result, Asian banks remain generally wellcapitalized. Of course, local regulators inAsia are also revisiting their policies andglobal trends will likely influence their assess-ments, but the potential impact on the Asianfinancial sectors seems to be very much lim-ited. Also, when considering sovereign debt,Asia appears well-positioned as its debt-to-GDP ratios have declined considerably sincethe Asian crisis, and remain generally at lowlevels, and in most countries they are below

50%. Of course, budget deficits have alsoincreased in Asia as a result of declining rev-enues and fiscal stimulus programs. How-ever, in our view, the budgets deficits seemmanageable especially when compared withthe budget deficits we see in many G10countries.

Central bank exit strategies, however, arelikely to have a more profound impact as theincrease in China's reserve requirement hasshown. However, as discussed in lastmonth's Investor's Guide, while material, theimpact on markets tends to be short-lived aslong as the economy continues to recover –which is precisely what we expect. And in asituation in which concerns about growthand debt drive financial markets, the invest-ment case for Asia, which enjoys strong eco-nomic fundamentals and superior growth,remains very much valid, in our opinion.Yves Bogni

Strategist, UBS AG


Technical Analysis

S&P 500: Where we see things


Technical Analysis

S&P 500 daily chart – A head-and-shoulders top?

A head-and-shoulders top is a technical chartpattern that warns of distribution forces atwork. However, confirmation via a necklinebreakdown validates this reversal pattern. TheOct/Nov/Dec 2009 lows near 1020 – 1044constitute the neckline. A violation here con-firms a distribution top and renders a down-side target of 915 – 944.

Technical levels

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

Support 1070 – 1080 10000 – 10100 2150 – 2200 3.50 – 3.55

1020 – 1030 9650 – 9850 2000 – 2100 3.05 – 3.10

Resistance 1105 – 1120 10500 – 10550 2320 – 2330 3.90 – 4.10

1150.41 10700 – 10750 2450 – 2500 4.30 – 4.44Source: UBS WMR UBS WMR as of 22 February 2010 Source: Reuters and UBS WMR (prices as of 23 Feb 2010)

The 72.5% rally since the March 2009bottom has resulted in an overboughttechnical condition. Other flashing war -ning signals point toward a matu ringcyclical bull rally. Mid-term election andnew-decade cycles point to a volatileyear, and the potential for a head-and-shoulders top suggests traders andinvestors should adhere to strict riskmanagement techniques.

Although we are not yet calling for a majorcyclical peak in the stock market, we arebeginning to see some chinks in the armor.For example, the March/July 2009 uptrendshave been broken; the 30/50-day movingaverages are beginning to show signs of flat-tening/rolling over; momentum indicators(MACD) are putting in lower highs and lowerlows; early leadership areas (financials, tech-nology, emerging markets and China) havebeen losing some relative strength in recentmonths; and the January 2009 negative out-

pattern was subsequently negated as themarkets quickly rallied higher.

That said, the rally seems to be a bit moremature this time around as it has gained72.5% since its March low. As a result, webelieve the SPX is trading in an intermediate-term overbought status and in need of someform of consolidation in order to alleviatethis condition. Two ways to do this would bethrough either a price correction or a periodof sideways trading (duration). The questionnow becomes which one, if any, we are nowencountering. At this point, we believe thebest approach to investing new money is towait and see what the market tape has tosay, since the tape does not lie.

So what are the charts telling us to keepan eye on? Given the recent sharp declineof 9.21%, a technical oversold rally hasensued and has tested the top of the supplyzone near 1,085–1,115, or possibly over-reaching toward 1,130. A convincing movehigher negates the head-and-shoulders topand sets a continuation of the rally intomotion. To the downside, several failedattempts to clear this supply could result ina more developed right shoulder. A violationof neckline support of 1,020–1,044 validatesthe head-and-shoulders top and renders adownside target to 915–944.

side month – all are signs of distribution anda maturing rally.

Studies such as mid-term election anddecennial-year (start of a new decade) cyclesalso suggest that equity markets could be infor a volatile year. In fact, during thesecycles, the SPX has averaged an intra-yearcorrection of about 20%. Also, as the so-called January Barometer says, as Januarygoes, so goes the rest of the year. The SPXwas down 3.7% this year; does that mean2010 will be down for the year? Not neces-sarily. In fact, even though this study tendsto be directionally biased, the last 24 downJanuary periods resulted in 13 down yearsand 10 up years. This is hardly an over-whelming statistic, but a well-known studynonetheless. Lastly, a head-and-shoulderstop has been forming for the last fivemonths. In theory, this is a reversal chartpattern with bearish implications. However,this topping pattern first needs to be con-firmed before calling for a more significantcorrection. Looking back over the last yearor so, we saw two similar patterns developbut fail to form the right shoulders, and the

The bottom line is that we continue to expectpockets of volatility in the equity marketsthroughout the year as decennial and mid-term election cycle studies average intra-yearcorrections of 20%–22%. An overboughtstatus on the SPX also warns of some formof consolidation. As stated above, whetherthis consolidation is one of price or durationis yet to be seen. The silver lining in all of thisis that the July/August 2009 breakout of ahead-and-shoulders bottom still renders anupside target to 1,221 and to 1,350 in thelonger term. We therefore believe there isunfinished business to the upside, and aprice correction coinciding with mid-termelection cycle lows could prove an attractivebuying opportunity.Peter Lee, Chief Technical Strategist

[email protected]

Jonathan Beck, Investment Strategist

[email protected]

UBS Financial Services, Inc.


US equity sectors

US Equity Sectors US Equity Sectors

Below are excerpts from our US Equity Sector monthly reports which, along withupdates, are located in the Equity section of the Online Services Research website.

Information TechnologyStocks down; IT budgets are going upThe IT sector is down 2.5% year to date, andwe attribute the sell-off to several reasons,including: worries about China’s crackdownon lending, the increasing likelihood of tight-ening federal policy in the US and the inten-sifying fears of a potential sub-prime-like con-tagion from Southern European sovereigndebt (i.e., Portugal, Greece). PresidentObama’s attack on banks and insurance com-panies, an important customer segment fortechnology vendors, did not help sentimenteither. Looking on a more micro level, techcompanies posted solid fourth-quarter resultscourtesy of a robust year-end IT budget flushfrom enterprises and the telecoms. A strongpush from retailers of consumer electronicsand solid PC sales helped as well. We likelarge-cap software names. We encourageinvestors to remain overweight the IT sectorand to take advantage of the recent pull-back to incrementally add to positions.Cesare Valeggia

Analyst, UBS Financial Services Inc.

[email protected]

Consumer StaplesPositive view of Consumer StaplesWe continue to view the US Consumer Sta-ples sector’s relative valuation as attractive andthe fundamental outlook as favorable. Werecommend investors moderately overweightthe group in their portfolios. Our top picksreflect our bias toward consumer packagedgoods companies with emerging marketsexposure and our view that leading brands are

Asset managers are typically the classic playon rebounding financial markets and shouldcontinue to enjoy asset appreciation andinflows if the equity market continues tomove higher. Regulatory changes could pro-vide challenges and opportunities (mostlythe former in 2010) for the exchanges.Following several months of sector under-perfomance, we are becoming more con-structive on REIT equities. That said, westrongly reiterate our "quality focus" thesiswith a clear bias toward well-capitalizedREITs with defensible, high-quality assets andstrong management teams. We continue tobelieve that 2010 and 2011 will representthe inflection point for CRE stress given thematurity schedule for CRE and CMBS loans. Within the bank and diversified financial sec-tors, we continue to favor the universalbanks that are more consumer-oriented,have less commercial real estate exposureand a more diverse earnings stream. It is ourview that consumer credit quality willimprove before commercial real estate. Incontrast, we have been more cautious on thecredit-impaired regional banks because oftheir greater exposure to commercial realestate (including construction). In addition,the credit-impaired regional banks all con-tinue to have TARP and will likely need toraise additional common equity at somepoint to repay it. Despite these concerns, weare becoming selectively more positive onthe regional banks as overall credit trendsappear to be moderating.Michael Dion, CFA

[email protected]

Dean Ungar, CFA

[email protected]

Jonathan Woloshin, CFA

[email protected]

Analysts, UBS Financial Services Inc.

best poised to grow in developed and emerg-ing markets. We look for companies with suc-cessful productivity or cost savings initiativesthat can fund investments to drive futuregrowth. Taken together, these attributesshould contribute to a company’s ability topost upside to earnings expectations. Otherimportant considerations include manage-ment quality, financial flexibility, solid dividendyields, and attractive valuation. Among con-sumer packaged goods companies, we seethe most appealing opportunities in house-hold products/cosmetics and beverage stocks,reflecting their generally higher weighting ininternational markets. Within food and drugretail, we prefer the drug stores, where favor-able demographics and new generic drugsshould drive sales and profit growth. For now,we are on the sidelines in food retailing,awaiting improved visibility around fooddeflation and competitive pricing dynamics.Sally Dessloch, Analyst, UBS Financial Services Inc.

[email protected]

FinancialsRecovery starting to take holdOur insurance sector view is predicated uponlimited near-term downside due to low histor-ical valuations, solid balance sheets and ade-quate/excess capital positions, an improvingeconomy, and effective cost control initiatives.Our favorites in the space (mostly life insurers)are benefiting from many of these factors.The companies we would avoid include thosethat have typically grown more than peers,but now face challenging headwinds that arenot fully reflected in their valuations.

Consumer DiscretionaryConsumer keeps stepping closer to the plateYear to date, the S&P Consumer Discre-tionary index has risen 0.66% and outper-formed the S&P 500 by 250 basis points(bps). Generally, recent trends in the groupinclude modest improvements in consumerspending and profit margin growth fromcost savings/sales leverage. A significant per-centage of consumer discretionary compa-nies reported earnings (88% have reportedto date) and 89% of the index beat consen-sus estimates.

We maintain our moderate underweighton the Consumer Discretionary Sector. Ourfundamental concerns, coupled with thesector’s strong performance in 2009, makethe Consumer Discretionary sector less com-pelling in 2010, in our view.

Within the sector, we prefer the Mediaindustry group (moderate overweight). Theother allocations include a neutral weight onthe Auto & Components industry group anda moderate underweight for the ConsumerServices, Retailing and Consumer Durables &Apparel industry groups.

Over the past month, multiple changeswere made to our company-specific ratings.Please see our latest US Equity ConsumerDiscretionary Sector Monthly (Consumerkeeps stepping closer to the plate, 12 Feb.2010) and Sector Update (Several changes inthe homebuilder ratings, 18 Feb. 2010) forfurther details.George Lambertson

[email protected]

Alexandra Mahoney

[email protected]

Jonathan Woloshin, CFA

[email protected]



US Equity Sectors


US Equity Sectors

HealthcareReading fourth quarter tea leavesFourth-quarter reports were mostly in line orbetter than expected. The 20% that disap-pointed were from a mixed bag of health-care subsectors, all related to company-spe-cific fundamentals. A few important subsec-tor trends appear to be emerging.

For managed care organizations(MCOs), commercial insurance pricingappears to be moderately positive and,while commercial volumes continue towane, Medicare volume continues to grownicely; a mixed blessing for managed care.

In medical technology, some historicalgrowth markets appear to be slowing, mostimportantly implantable defibrillators andstents and possibly orthopedics implants(hip and knee), though it may be too soonto judge the latter because many proce-dures were electively delayed until this year.

In pharmaceuticals, investors wereclearly not enamored with Pfizer’s decisionto spend some of its synergies (via theWyeth acquisition) in R&D and marketing,negatively affecting the valuations of thegroup, despite Merck’s intentions to stilldeliver synergies to the bottom line (fromthe Schering-Plough acquisition).

In all, healthcare stocks are still tradingat relatively low multiples but we believethey are unlikely to see major P/E expansionas the economy recovers and with the darkcloud of healthcare reform once again onthe horizon. We remain neutral on thehealthcare sector.Jerome Brimeyer


[email protected]

UtilitiesThe doldrumsThe S&P 500 is essentially flat year to datebut the utility sector is down over 4.5%.We believe continued weak power marketfundamentals are the culprit. Power pricesgenerally track natural gas prices. Weaknatural gas prices have dragged downpower prices and, as a result, power gener-ator earnings estimates continue to driftlower.

The silver lining is that forward naturalgas prices are now generally lower than ourestimate of the long-run “normal” price, ofroughly USD 6.50. This suggests that gasprices will ultimately reverse their slide. Wewould become more encouraged if we sawa slowdown in natural gas drilling activity,suggesting that supply and demand is get-ting into better balance.

Power prices have also been hurt bythe recession-induced decline in powerdemand. We are seeing the beginnings ofthe supply reductions needed to get themarket back into balance. Auctions will beheld in May that will give us a better senseof the supply/demand balance for 2013/14.This could be an important data point, butfor now there is nothing to suggest thatestimate revision trends will improve. Inconjunction with our generally pro-cyclicaloutlook, we believe other sectors of themarket are poised for better performance.We retain our Underweight rating.David Lefkowitz


[email protected]

Industrials

Will 4Q09 earnings season comments revealsales growth for 2010?Third-quarter US Industrial sector earningsresults benefited from cost-savings meas-ures, namely restructuring and lower taxrates. With large amounts of capacity andboth fixed and variable costs removed fromthe balance sheets and income statementsof Industrial sector companies, a modest liftin sales driven by an economic recovery maylead the sector to benefit from increasedoperating leverage and expanding profitmargins—supportive of Industrial equitiesand their earnings multiples.

While sales seem to be the most recentfocus of investor concerns, a commontheme running across many companieswithin the Industrial sector was theimprovement in short-cycle trends and con-tinued weakness in long-cycle businesses.We continue to believe companies withhigh conversion ratios of free cash flow tonet income will be advantaged on severalfronts in the upturn of the business cycle.The most important advantage, in our view,may be the ability of Industrial companiesto harness their free cash flow to makeacquisitions, drive superior sales and earn-ings growth and gain market share at theexpense of competitors. With trough earn-ings likely reached during the past twelve-month period, we expect merger and acqui-sition activity to accelerate thanks in largepart to the availability of low-interest ratefinancing. On the flip side, we expect com-panies to also continue to divest non-coreassets.Andrew Sutphin


[email protected]

EnergyAn upcycle in oil services is approaching We continue to favor oil-oriented names inthe energy sector, and our estimate for oilprices to average USD 85/bbl in 2010 isunchanged. The companies on ourOutperform list are best-positioned to ben-efit from stronger oil prices, in our opinion.Contrarily, we believe performance by natu-ral gas-oriented producers and serviceproviders may be hampered by an oversup-plied North America natural gas market andweaker gas prices. We forecast NorthAmerica natural gas prices to average USD5.10/mcf in 2010.

Of the energy sub-sectors, we believethe oil services companies and drillers offerthe best risk/reward at this time. Increasedoil and gas exploration and developmentactivity by the producers should boost rev-enues and margins. We expect an 11%increase in worldwide exploration anddevelopment spending this year.

For the services companies and drillers,we see the next upcycle becoming most evi-dent in 2H 2010. For producers — E&P’sand Integrated Oils — a tightening of theglobal oil and gas supply/demand balancewill be the next catalyst for sustained higheroil prices, in our view. In refining, we see aprolonged downcycle primarily due to theextraordinary amount of excess refiningcapacity that resulted from the prolongedupcycle of 2004–2008. Nicole Decker


[email protected]


US Market · Bonds


US Equity Sectors

This chart shows the growth in US Treasurymarketable debt outstanding, which excludesan additional 4.5tn in intragovernmentalholdings. As debt levels have risen, non-USinvestors have become a proportionally largersource of demand.

Foreign investors are a major source of demand8

5

3

6

7

4

1

2

60

40

20

50

30

10

Mar 02 Mar 04 Mar 07 Mar 08 Mar 09 Mar 10Mar 00 Mar 01 Mar 03 Mar 05 Mar 06

Source: Bloomberg, US Treasury, UBS WMR

in trillions USD %

Marketable Debt Outstanding (lhs)% Held by Foreigners (rhs)

Higher yields shape our outlook In the short run, we believe Treasuries couldbenefit on flight-to-quality flows into dollar-denominated assets stemming from sover-eign debt fears in Europe. Longer term,though, the US faces formidable challengesthat are likely to push yields in the oppositedirection. The budget deficit jumped fromUSD 454 billion in fiscal year 2008 to USD1.4 trillion in fiscal year 2009, as a result ofincreased spending and falling tax receiptsdue to the recession. Furthermore, while UBSeconomists expect the deficit to fall this year,the US could be facing trillion dollar deficitsfor the foreseeable future. Deficits of thismagnitude put the US on a path that isincompatible with a AAA credit rating. Whilethe credit rating agencies have indicated thata downgrade is unlikely in the near term,they have clearly stated their concerns in themedium term.

Against this unfavorable fiscal backdrop,we believe Treasury yields will be biasedhigher. To finance the on-going budgetdeficits, Treasury supply is expected to beheavy again this year. On the demand side,we are concerned about the willingness of

foreign investors, who own approximatelyhalf of the outstanding Treasury supply, topurchase large amounts of Treasury securi-ties. Putting it all together, we expect Treas-ury yields to rise over the course of 2010.

This outlook influences our bond marketrecommendations in two main ways. First,we recommend investors maintain a shortduration (1 year below benchmark). Second,we continue to favor credit related segmentsof the market (Investment Grade Bonds,High-yield Bonds, and preferred securities)over government related segments (Trea-suries, Agencies, Mortgages, and TreasuryInflation-Protected Securities). Althoughcredit spreads have recovered at a rapidpace, further modest improvement couldhelp to partially absorb the price impact fromrising rates.Barry McAlinden, CFA


[email protected]

TelecommunicationsTower stocks can outperformWe have an Underweight on the telecom-munications sector. Our economists’ fore-cast of a growing economic recovery in2010 supports our Underweight view onthe sector. While we believe valuations arenot demanding and that the largest tele-com service companies have sound businessmodels and sustainable dividends, weexpect companies more exposed to cyclicalor secular growth to outperform in the cur-rent environment. We believe sectors moreexposed to a growing economy (e.g.,Materials) will outperform those that areless exposed and more defensive (e.g.,Telecom).

Within the telecom sector we preferthe wireless tower subsector. This reflectstower operators’ favorable exposure tomass adoption of smartphones, notebooks,and e-readers; surging data usage; the needfor increasing network capacity; and conse-quent increasing tower lease revenues.Barriers to entry for these companies arevery high because municipalities do notwant new towers in their communities.Revenue visibility for the tower companies ishigh because a substantial majority of rev-enues is tied to 5-to 10-year contracts, andcontracts have 3–5% rent escalators.George Lambertson


[email protected]

MaterialsOn the path to further outperformanceBetter-than-expected 3Q09 earnings resultscontinued to positively impact the Materialssector during the last months of 2009 asinvestors look for further improvement dur-ing the 4Q09 earnings season. While thedebate continues on whether all the sub-sectors are past the worst in terms of theirrespective sales and earnings, we believe asequential improvement in quarterly resultsin 2010 will become increasingly evident asthe year progresses. Several leading eco-nomic indicators are already pointingtoward expanding activity.

To cope with the economic mayhemthat unraveled in late 2008 and ran throughmost of 2009, companies responded withinitiatives aimed at reducing their fixed andvariable costs in an effort to align their assetbases with rapidly declining demand. In ourview, companies in the Materials sector arenow more agile, leaner and well positionedto take advantage of the potential improve-ment in demand in the near- to medium-term. We believe further increases in bothrevenues and margins will drive the sector’sperformance in the coming quarters.

The emerging markets have re -bounded strongly and North America hasalso begun to expand. We expect Europe tobe the last to recover as the signs of stabi-lization and a modest expansion have onlyrecently appeared.Andrew Sutphin


[email protected]

32 UBS investor’s guide 26 February 2010 UBS investor’s guide 26 February 2010 33

Market outlook · BondsBonds · Market outlook

It is not just the sheer amount that counts


–2.6 –4.8 10.4

–5.4 –4.8 16.0

–0.5 1.0 5.9

–1.5 1.1 –1.5Total return indices in USD: Barclays Capital, as of 22 February 2010 Source: UBS WMR, as of 25 February 2010


Regional bond strategy

– – – – – – n + ++ +++Other

Eurozone

UK

US

Japan

In many markets yields have spread tightlybetween 4% and 5%, while governmentdebt has varied widely between 45% and120%. Also, the yields in Japan and Australiaare hardly justified by the debt levels. The textexplains what other factors need to be con-sidered.

Gross debt and long-term interest rates (average last 5 years)7

5

3

1

6

4

2

Source: OECD

0 20 6040 80 100 120 140 160 180

Long term interest rates in %

Government debt (gross) in % of GDP

New Zealand

Australia UK

USA Italy

Switzerland

Japan

Finland

Rising government debt is a threat forbond investors. However, yields inindividual countries also depend on thegovernment’s financing alternativesand the reliability of financing sources

Investors are increasingly worrying about thecreditworthiness of government bonds asdebt levels rise sharply. However, the level ofgross debt is an imperfect indicator ofdefault and inflation risk. To start with, gov-ernments may have different financing alter-natives available to them.

Financing alternativesGovernments may own tangible assets thatcould be sold to bridge a short-term financ-ing gap. Norway is in the most comfortablesituation here. While gross debt is indicatedby the Organization for Economic Coopera-tion and Development (OECD) to be about60%, the country actually owns net assetsworth about 140% of GDP if one takes intoconsideration the government pension fund

that manages wealth produced by the petro-leum industry. In Japan the differencebetween gross and net debt is about 100%,largely a reflection of its huge currencyreserves.

In addition, governments may have theoption to raise taxes. For example, the USand UK collect taxes worth about 30% ofGDP; this compares to 40% in continentalEurope. So it seems that the scope for addi-tional tax financing could be larger in the for-mer countries than in Continental Europe,assuming the risk of political conflict is aboutthe same. Central banks, where not inde-pendent, can be another source of financingif they buy government bonds. However, asa consequence, money supply and inflationare likely to increase in the medium term.

Reliability of financing sourcesFinally, the source of financing is importantfor the yield level. If foreigners are needed tobridge the financing gap, yields generallytend to be higher. This applies not only to thenominal yields shown in the chart, but also

to real yields, i.e., the return investors receiveafter subtracting inflation. The most promi-nent cases in this respect are Australia andNew Zealand (represented by the two dotsin the upper left corner of the chart). Bothmarkets have relatively high yields, whiledebt is very low. However, as their currentaccount balances are deeply negative, bothmarkets need to offer a premium to attractsufficient foreign investors. Japan is at theother extreme: while debt is expected toapproach 200% of GDP next year, the cur-rent account is (similar to Switzerland) in sur-plus, indicating that Japan can easily financeits public deficit. As a consequence, yieldshave remained very low in nominal termsand about average in real terms compared toother countries.

Conclusion for the marketsWe expect increasing pressure in the eurozone to consolidate fiscal policy and thinkthat the ECB will allow less inflation than itsUK and US counterparts. There the focuswill be more on growth, even if it comeswith somewhat higher inflation. Thereforewe expect yields in the British pound and the

US dollar to increase more over the nextcouple of years. Also (real) yields are still rel-atively lower than in the euro zone. The Aus-tralian dollar, on the other hand, offersattractive investment opportunities, fromour point of view.Achim Peijan

Strategist, UBS AG


US Pharmaceuticals/Healthcare Sector · Bonds


Bonds · US Banks and Brokers Sector

The long, slow road to recovery

US fixed income strategy


–0.6 0.9 –3.7

–1.4 0.1 10.0

–0.3 0.8 0.9

–0.3 1.1 5.8

–1.0 1.0 19.8

–0.4 1.1 58.1

1.8 2.8 20.1

0.2 0.6 27.2

Total return indices in USD: BAS/Merrill Lynch as of 22 February 2010 Source: UBS WMR, as of 25 February 2010

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 + ++ +++Treasuries

TIPS

Agencies

Mortgages

Inv. Grade Corporates

High Yield Corporates

Preferred Securities

Emerging Market

Politics and cliffsfront, banks generally showed higher levelsof securities portfolios as many anticipatethat minimum liquidity requirements may bepart of the new global banking require-ments. Capital levels remain adequate whenmeasured from both a Tier 1 and Tier 1 com-mon level, providing bond and preferredholders comfort that there is enough of acapital cushion to absorb further loan lossesand avoid a systemic relapse.

Despite regulatory uncertainties, we thinkthat current spread levels are factoring in thepotential for lower credit ratings. We con-tinue to see value within certain bank andbroker bonds based on current valuations.From a credit perspective, we are also com-fortable moving down the capital structureinto their trust and perpetual preferred secu-rities in certain cases. Barry McAlinden, CFA

[email protected]

Michael Tagliaferro, CFA

[email protected]


The Obama administration wants torevive the healthcare debate, andmanaged care providers could sufferthe most. Patent cliff is a major issuefor big pharma.

Despite the Democratic Party’s massive set-back in Massachusetts, the issue of health-care reform has not gone away. As evi-denced by recent correspondence betweenWellPoint and the US Department of Healthand Human Services on certain individual-market rate hikes in California, the Obamaadministration has taken the initiative, and islooking to revive the debate. On 22 Febru-ary, the White House released a proposal thatis expected to serve as a basis for discussionsat the 25 February summit between Democ-rats and Republicans. How much progresswill both parties be able to achieve remainsuncertain, although we still expect somekind of legislation. Whether it deserves to belabeled reform or not is a different matter. Atthis stage, the Senate’s version seems theworst case scenario.

Managed care providers appear as thesub-group most likely to be affected via theprobable provisions, which may result inhigher medical-related costs, caps on price orrate hikes, and restrictions on rejecting cov-erage due to pre-existing conditions. Besidesa likely new framework, managed careproviders will also have to deal with risingCOBRA-related costs due to high unemploy-ment.

Drug producers will have to deal withtheir own set of issues. Big pharma in partic-ular, will be confronted with material patentexpirations, a.k.a. patent cliff, by 2013. This

issue potentially compromises a substantialportion of revenues, although the magni-tude depends on the degree of productdiversification for each specific drug maker.It remains to be seen if the strategy of recentyears to boost product pipeline via megamergers and acquisitions will yield thedesired results or not.

Despite limited visibility in pharma/health-care, in our view, major sector companies stillboast some of the strongest fundamentalsand highest credit ratings within the assetclass.Donald McLauchlan


[email protected]

The bank and broker sector comprisesroughly 24% of the investment grade bondmarket and 50% of the USD preferred secu-rities market. For the companies in this sec-tor, the operating environment remains chal-lenging. Although the economy is slowlyimproving, unemployment remains high andloan losses continue to be a drag on per-formance. Banks and brokers recentlyannounced 4Q09 earnings, and these head-winds remain evident. High levels of creditprovisioning continue to pressure earnings,particularly for certain regional banks withless diversified revenue exposure.

Despite the credit challenges that pose adrag to profitability, two of the most impor-tant metrics for credit investors – liquidityand capital – showed adequate levels during4Q09 earnings releases. On the liquidity

Credit Sector reports and our Corporate Bond/PreferredSecurity Valuation Reports are located in the Credit sec-tion of the Online Services Research website.


Spotlight · CurrenciesCurrencies · Spotlight

Better medium- than short-term outlook on Euro

We shift our forecasts for the majorcurrencies as global risk aversion andin particular worries about Greecehave hit markets in a way that we didnot expect.

While the signals of global economic recov-ery are as strong as we had expected whenwe changed our major forecasts on 31 Octo-ber, we were unable to foresee the increasein worries about European finances. Thelong-term USD weakness certainly remains acentral part of our view, but, for the timebeing, we recommend closing USD shortpositions and wait to re-enter them as soonas the current momentum loses strength.We have set the three-month forecast forEURUSD close to the current spot at 1.35,since we expect a stabilization of the Euro-pean situation over the next three months.We would, however, warn that until then themarket could prove quite unstable. At pres-ent, we see a possibility that risk aversioncould even lead to tests of the 2009 lows of1.24 in EURUSD. Later, we expect EURUSD

to recover again towards 1.42 in six monthsand 1.53 in 12 months.

Currency implication of GreeceOne key reason for the relative strength ofthe euro in the last years has been thegreater trust in European institutions toenforce fiscal prudence and low-inflationpolicies. Clearly, if Greece‘s problems aredealt with in a way that does not compro-mise trust in the euro, the single currency willeventually resume its strength. However, ifthe handling of the debt problem in Greeceinflicts damage on the credibility of the EUinstitutions or undermines the independenceof the ECB, this would call for a weaker euroin the future.

We do not expect that Greece willundergo any kind of debt restructuring oreven default further out in the future. How-ever, if that should happen, it would ofcourse hurt the currency, at least initially, asmarkets have become concerned about theintegrity of the currency area. If the Eurozoneremains intact without Greece or other“weak” members, this would likely be seenas positive for the currency in the long term.

Our strategy now is to unwind euro exposureas much as reasonable during the period ofGreece‘s upcoming bond issuance, i.e., overthe next few months. We are looking to re-enter euro positions as soon as the refinanc-ing is over, because we think overcomingthis hurdle will support the currency.

Fiscal positions and the currency valueThe OECD calculates forecasts for the fiscaldeficits of its member countries. Accordingto these calculations, the US deficit relativeto GDP will, for this year and the followingtwo years, be 3–4% higher than the Euro-pean deficits. This deficit difference is mean-ingful, in our view. A long-term comparisonbetween the US and the EU’s relative debtpositions shows that the long-termexchange rate is quite sensitive to deficittrends. In the late 1990s, the US posted sur-pluses for a couple of years and the fiscalposition was quite strong in relation to theEurozone. During this time the USD was rel-atively strong. Since then, the fiscal positionand the USD have deteriorated. We had justone brief period in which the USD strength-ened slightly, but this was during the recentfinancial crisis, as repatriation flows sup-ported the greenback.

Taking the above as an example, we seetwo situations lending the USD a moremeaningful support. One is in the case ofanother global crisis, leading to renewed riskaversion and repatriation. The other wouldbe in reaction to consolidation of the US fis-cal position, which would reduce the financ-ing needs of the US. However, this seemsunlikely for the coming years, and for thisreason we keep our longer-term bearish casefor the USD.Thomas Flury

Analyst, UBS AG

A long-term comparison between the US’sand the EU’s relative debt positions showsthat the exchange rate reacts rather sensi-tively to long-term deficit trends.

US and European deficits drive EURUSD6

2

–2

4

0

–4

1.7

1.2

1.0

1.3

1.4

1.5

1.6

1.1

0.9

1998 2002 2008 2010 20121990 1992 1994 1996 2000 2004 2006

Source: OECD, Thomson Reuters, UBS WMR

US deficit higher than EMU deficit

EMU deficit higher than US deficit

US-Eurozone budged deficit to GDP (lhs)EURUSD (rhs)

Spot 3 M1 6 M1 12 M1 PPP2

USD

EURUSD 1.3644 1.35 1.42 1.53 1.25

GBPUSD 1.5462 1.58 1.62 1.70 1.68

USDJPY 90.97 92 97 105 89

USDCAD 1.0417 1.05 1.03 1.00 1.051 UBS WMR Forecast 2 Purchasing Power Parity Sources: Thomson Reuters, UBS WMR

Exchange rate forecasts


Readers’ Questions


Currencies · Outlook

Euro per US dollar (EURUSD)

US dollar per Japanese yen (USDJPY)

Can inflation really eat up debt?

What’s on your mind?Ask the expert at: ask–[email protected]


Forward

Forecast

Volatility Range

Volatility Range

1.60

1.50

1.40

1.30

1.20

Jun 10 Oct 10 Feb 11 Jun 11 Jun 09Feb 09 Oct 09 Feb 10


Forward

ForecastVolatility Range

Volatility Range

110

85

90

95

100

105

80

75



Forward

Forecast

Volatility Range

Volatility Range

2.0

1.8

1.6

1.4


British pound per US dollar (GBPUSD)


Forward

Forecast

Volatility Range

Volatility Range1.10

1.00

0.90

0.80

0.70

0.60


Australian dollar per US dollar (AUDUSD)The pair temporarily dipped below 0.86, the low-est in four months, on strong risk reduction dueto European fiscal worries. It has since recoveredin line with improving risk appetite. The near-term jitters will remain, in our view, making cur-rent levels attractive for establishing longAUD positions.

The next couple of months will not be easy forthe euro. Bond issuance by Greece, Spain and coreEurope will potentially weigh on the common cur-rency. However, the longer-term outlook remainsnegative for the USD, as foreign central bankshave accumulated increasing quantities overrecent weeks.

Japan‘s 4Q09 GDP confirmed a firm recovery inthe manufacturing and external sectors. Thedomestic economy continues to waver and defla-tion has only worsened. The Bank of Japan vowedto keep its loose policy for longer, which shouldcap any strength from risk aversion in the shortterm.

Dear Andreas, Many pundits say that one way toreduce public debt, and overall debtgenerally, is by creating inflation. Isthis really possible? Won’t interestrates just increase by the amount ofthe inflation rate, increasing the costof servicing the debt too?

A client from Solothurn, Switzerland

To analyze the impact of inflation on debt,one needs to differentiate between twotypes of inflation: expected and unexpected.If inflation is expected, then you are right:market participants will ask for higher inter-est rates, which will take into account infla-tion expectations. With higher interest rates,the debt service cost will increase by at leastthe amount needed to compensate for theloss of purchasing power on the principal.However, this will only occur on newly raiseddebt. Investors who held debt before infla-tion expectations adapted to the new infla-tion environment will be locked in to lowinterest rates which do not compensate forthe inflation increase. If they sell those lowyielding bonds, then they will lose money onthe principal. This actually leads to unex-pected inflation, which will always hurt cred-itors while helping debtors.

The fact that inflation can redistributepurchasing power from creditors to debtorsis a strong incentive for an indebted govern-ment to inflate itself out of debt or monetizethe debt, i.e., to pay back the debt withfreshly printed money. This is why, in manycountries around the globe, monetary

authority is today in the hands of an “inde-pendent” central bank, with a clear mandateto keep inflation under control.

That said, US economists Thomas Sargentand Neil Wallace showed in 1981 in a widelycited paper entitled “Some unpleasant mon-etarist arithmetic” that even an independentcentral bank does not guarantee an infla-tion-free environment and that governmentdebt can still cause inflation. In a recent mon-umental study, “This time it’s different”, USeconomists Carmen Reinhart and KennethRogoff empirically investigated the relation-ship between government debt and infla-tion. Their conclusion was ambiguous. Theycould only find a statistically significant pos-itive correlation between inflation and gov-ernment debt in emerging markets, not indeveloped countries.

In fact, if a government would like tocompletely reduce its debt through inflation,it would need to achieve very high inflationrates or even hyperinflation (double-digitmonthly inflation rates), which in turn woulddislocate the economic environment. Thus,the remedy to get rid of debt could be ulti-mately worse for the government than thedebt itself.Andreas Hoefert


We expect GBPUSD to be shaky in the short termdue to the downside risk of further quantitativeeasing by the Bank of England (BoE). The risk of ahung Parliament (with no overall majority party) atthe May election and the continued fiscal instabil-ity could also weigh on the pound. In the longterm, we expect the USD to weaken from US struc-tural problems.


Investors' newfound love of precious metals will be tested

Commodities · Spotlight Outlook · Commodities

Crude Oil

Gold

Silver

Coffee

24.02.2010 Forecast Forecast

USD/bbl 71.4 3 months 9–12 months� �


USD/oz 1066 3 months 9–12 months� �


USD/oz 15.17 3 months 9–12 months��


USD/lb 128.8 3 months 9–12 months ��Coffee has been off the radar for mostinvestors. The performance in 2009 laggedbehind most other commodities. Further-more, in recent years coffee returns havebeen disappointing when roll costs are con-sidered. However, coffee prices and invento-ries have now reached a point where we

could see a 30% price spike over the coming12 months. If Brazil’s crop runs short of mar-ket expectations, we expect the market willfocus on very low producer inventories andfalling inventories at exchange warehouses.

The recent strength in crude oil prices has asolid base and is likely to continue, in ourview. We see emerging markets as thesource of incremental demand in the future.The story is not new, but the latest figuresfrom China underpin this outlook. China’s oil

production should peak at around 4 mbpd,which favors higher crude oil imports. SaudiArabia’s exports to China already surpass thevolume shipped to the US. China aloneshould account for almost 40% of globalincremental demand (+0.65 mbpd) in 2010.

From a technical perspective, the gold pic-ture has improved substantially. The priceconsolidation since early December 2009 hascome to a halt. Despite this positive back-drop, the price increase is likely to be grad-ual. The IMF gold sales could weigh on prices

in the short run, though it should not reversethe expected uptrend in prices. We stillbelieve the market runs the risk of undersup-ply in the coming two years. Our nine- to 12-month forecast stands at USD 1,250/oz.

We expect the gold/silver ratio to reach 80.At present the ratio stands at 68.7. Despiteimproved macroeconomic conditions in 1H2010, silver supply should remain ample andkeep the fabrication balance oversupplied.This surplus is unlikely to be snapped up by

final demand, which limits the appreciationpotential for silver. Silver should thereforelag in performance compared to gold. Thatsaid, price dips below USD 15/oz – towardUSD 14/oz – can be used to build up longpositions, in our view.

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

Precious metals enjoyed a stronginvestment demand in 2009. This year,we expect these inflows to slow asinvestors keep close track of the per-formance of their existing metalinvestments to see if they will live upto their return expectations.

Economic uncertainty, financial market wor-ries, ballooning central bank balance sheets,soaring government debt levels and a slidingUSD produced a tidal wave of inflows intoprecious metals. Investment demand forgold reached almost 1,300 tons in 2010, upby almost 100% from 2007. Silver, platinumand palladium also enjoyed heightened mar-ket interest. Financial investors increasedtheir commitment in silver also by around100% from 2007, and in platinum and pal-ladium by at least 150%. Though investorsbought precious metals for all kinds of rea-sons, return expectations rose across theboard. Thus, some investors could be disap-pointed as the stories and risks differstrongly.

Central banks to become net buyers ofgold againA solid economic outlook for emergingeconomies plays a vital role for gold. Sub-dued growth in Asia would keep jewelrydemand in the doldrums. But specific to goldis our view that central banks could becomenet buyers of the metal after years of beingnet sellers. We therefore feel comfortablethat gold will move above USD 1,250/oz in

2010. Though gold for us remains a keyanchor for prices of all other precious met-als, silver should fall behind, and we thinkthe gold-to-silver price ratio could reach 80.Higher mining activity forming secondarysupply should keep the silver market wellsupplied in 2010. With its stronger gearingtoward industrial activity, we think silver'srisk-return characteristics remain inferior togold's. Over the last three years, silverinvestors enjoyed only volatility but no mean-ingful uptrend in the price.

The ties of platinum and palladium to indus-trial demand are even higher. Though invest-ment demand has become a vital driver inrecent quarters, investors should not befooled about the sustainability of theseinflows. Investment and jewelry demand inplatinum and palladium picked up becauseof their relative attractiveness to gold. Withthe platinum-to-gold ratio reaching parity atthe end of 2008, investors associated plat-inum with gold, including a free call optionon economic growth. At a ratio of 1.4 to 1.5currently, the call option comes at a priceagain. Though the structural price outlookremains positive for platinum, its strong2009 performance is unlikely to be repeatedin 2010. We expect the average price forplatinum to be around USD 1,650/oz thisyear. Palladium, on the other hand, shouldwitness flat to negative returns. Even in thecase of a positive performance, investors’compensation for the risks taken is likely tobe poor, in our view.Dominic Schnider

Analyst, UBS AG


Three reasons why we like emerging market bonds

Emerging Markets · Spotlight Outlook · Emerging Markets

Investors should be aware that Emerging Market assets are subject to, amongst others, potential risks linked to currency volatility, abrupt changesin the cost of capital and the economic growth outlook, as well as regulatory and socio–political risk, interest rate risk and higher credit risk. Assetscan sometimes be very illiquid and liquidity conditions can abruptly worsen. WMR generally recommends only those securities it believes have beenregistered under Federal U.S. registration rules (Section 12 of the Securities Exchange Act of 1934) and individual State registration rules (commonlyknown as “Blue Sky” laws). Prospective investors should be aware that to the extent permitted under US law, WMR may from time to time recom-mend bonds that are not registered under US or State securities laws. These bonds may be issued in jurisdictions where the level of required disclo-sures 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 anactively 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 theinvestment–grade band). Such an approach should minimize the risk that an investor could end up holding bonds on which the sovereign hasdefaulted. Sub–investment grade bonds are recommended only for clients that have a higher risk profile and who seek to hold higher yielding bondsfor only shorter periods.

Brazil

Russia

India

China

The Reserve Bank of India (RBI) joined its Chinesecounterpart in January and started to signal tightermonetary conditions. The RBI increased banks’cash reserve ratio by 75bp while also raising itsgrowth and inflation forecasts. Indeed, inflationhas increased further, reaching 8.6% in January,while food prices are up even more, causing social

discomfort. We expect inflation to peak some timein the third quarter. While a tightening throughhigher interest rates would have been more effec-tive in our view, we believe political forces preventthis move. We expect the RBI to raise rates in thecoming months, probably before its next regularmeeting in April.

As China enters the year of the tiger, data flowcontinues to be strong. Unsurprisingly, bank lend-ing soared to RMB 1.4tn in January, suggestingthat credit remains very supportive of economicactivity. This triggered a second hike within weeksin banks’ reserve requirements. January inflation,however, was tamer than expected, temporarily

easing fears of overheating in China. We believeauthorities will have to tighten monetary condi-tions more significantly in the weeks and monthsahead. This could happen not only through a fur-ther increase in reserve requirements but also afirst interest rate hike in the second quarter.

Brazil’s economic recovery is well on track, as thelatest data show, and we believe the country con-tinues to lead the economic recovery in the region.This is partly due to Brazil’s supportive fiscal policyin the run-up to the presidential elections in Octo-ber. With the economy rebounding strongly andfood and energy prices causing headline inflation

to rise over the coming months, we also expectBrazil to be the first country in the region to hikerates, possibly as early as March 2010.

Russia looks forward to a recovery story in 2010after a sharp economic contraction in its real GDPlast year. Receding inflationary pressures give thecentral bank room for additional rate cuts, therebystimulating the recovery. The economic reboundshould be underpinned by a number of additionalfactors, such as rising commodity prices, the

delayed impact of the government’s large fiscalstimulus package, and much lower public debtthan in most other countries.

Concerns about the dire fiscal situationin Greece and other European econo -mies have led to a correction in emer -ging market asset prices. Despite in -creased risk aversion, we think variousfactors speak in favor of holding a diver-sified basket of emerging market bonds.

Healthier fiscal balance sheetsA sovereign’s fiscal sustainability is a keydriver of bond spreads, i.e., the difference inyields over US Treasury bonds. Within theemerging market universe, indebtedness andfiscal deficits tend to be highest in central andeastern Europe. It is therefore not surprisingthat bonds issued by countries from theseregions were generally hit the hardest duringthe recent market correction. However,expected debt-to-GDP ratios and deficits for2010 in these countries are considerablylower than in Greece, Ireland, Italy or Portu-gal.

Supported by higher growthThe International Monetary Fund expectsthat, over the next five years, central andeastern Europe and Latin America will on

average grow more than one percentagepoint faster than the developed world. Foremerging Asia, growth is expected to bemore than six percentage points higher. Thisimproves the credit profiles of these coun-tries as it will generally widen governmenttax bases.

Higher saving ratesDomestic saving rates tend to be higher inemerging markets than in developed ones.This is crucial for a country’s medium-termability to absorb higher fiscal deficits.Greece‘s savings rate is roughly 10% of GDP.With an expected fiscal deficit of 10%, theentire 2010 savings will be soaked up. Thisleads to higher interest rates, which weighson the country’s growth prospects.

Favor diversification, tolerate volatilitySumming up, we think that in the currentenvironment bouts of weakness in emergingmarket asset prices represent buying oppor-tunities for investors looking to build updiversified exposure to emerging markets.However, emerging market bonds are likelyto stay more volatile in the coming months,not least until a solution for Greece is found.Michael Bolliger, Analyst, UBS AG


Market Scenarios Appendix

Analysts provide a relative rating, which is based on the stock’s total return potential against the total estimated return of theappropriate 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 flagged as “Under review” by theanalyst. Suspended: If data is not valid anymore, the stock rating may be flagged as “Suspended” by the analyst.Restricted: Issuing of research on a company by WMR can be restricted due to legal, regulatory, contractual or bestbusiness–practice obligations which are normally caused by UBS Investment Bank's involvement in an investment banking trans-action in regard to the concerned company.

Stock Recommendation System

Analyst CertificationEach research analyst primarily responsible for the content of this research report, in whole or in part, certifies that withrespect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his orher personal views about those securities or issuers; and (2) no part of his or her compensation was, is, or will be, directly orindirectly, related to the specific 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 requestto UBS Wealth Management Research Business Management, 1285 Avenue of the Americas, 13th Floor, New York, NY10019.

Required disclosures

Statement of riskStock and bond market returns are difficult to forecast because of fluctuations in the economy, investors psychology, geopoliticalconditions and other important variables.

Scale for Investment Strategy charts

Symbol Description/ Symbol Description/Definition Definition

+ moderate – moderateoverweight vs. underweight vs.

benchmark benchmark

++ overweight vs. – – underweight vs.benchmark benchmark

+++ strong – – – strongoverweight vs. underweight vs.

benchmark benchmark

n neutral, i.e.,on benchmark

Source: UBS WMR

The overweight and underweight recommendations represent tactical deviations that can be applied to any appropriate benchmarkportfolio allocation. They reflect WMR’s short– to medium–term assessment of market opportunities and risks in the respective assetclasses and market segments. The benchmark allocation is not specified here. It should be chosen in line with the risk profile of theinvestor. Note that the Regional Equity and Bond Strategy is provided on an unhedged basis (i.e., it is assumed that investors carry the underly-ing currency risk of such investments). Thus, the deviations from the benchmark reflect our views of the underlying equity and bondmarkets in combination with our assessment of the associated currencies. The two bar charts (“Regional equity strategy” and “Regionalbond strategy”) represent the relative attractiveness of countries (including the currency outlook) within a pure equity and pure fixedincome portfolio, respectively.For more information, please read the most recent US Investment Strategy Guide.

Sector bellwethers, or stocks that are of high importanceor relevance to the sector, that are not placed on eitherthe outperform or underperform list (i.e., are notexpected to either outperform or underperform the sec-tor benchmark) will be classified as marketperform.Additionally, when stocks that are not deemed to be ofhigh importance or relevance to the sector are notexpected to outperform or underperform the sectorbenchmark, they will simply be removed from the listsand will not be assigned a WMR rating.

In the table below, we discuss four potential market scenarios for the 12–monthhorizon and assign a probability to each.

Base Case Scenario

ModerateRecovery

60%

• Policy measures merely provide a temporaryboost to demand but their effect then fadesaway before the self-healing forces in the econ-omy take hold.

• Tighter credit conditions and deflationary forcestake the upper hand, leading consumer andinvestment demand to plummet once again.

• Falling commodity prices and a rise in excesscapacities lead to deflation expectations, exacer-bating the decline in aggregate demand.

• Rising commodity prices set an inflationaryprocess in motion and contribute to chokingthe emerging recovery.

• The combination of rising price levels and weakgrowth prospects pose significant challenges tomost financial assets.

• Higher inflation expectations become en -trenched.

• The strong policy impulse continues to filterthrough the economic and financial system.

• The economy snaps back to its longer growthaverage surprisingly quickly, driven by a surgein investment spending, inventory build-up anda recovering consumer.

• Commodity prices rise moderately withoutderailing the recovery.

• The global economy remains on expansioncourse.

• The recovery is slow and protracted because ofdeleveraging pressures on the consumer andthe financial sector.

• However, government expenditures and a pick -up in business spending provide sufficient sup-port to allow growth to become self-sustaining.

• The abundant slack in the economy keeps infla-tionary pressures from building up.

Alternative Scenario 1

V–Shaped Recovery

20%


Stagflation

5%


Deflation /Double-DipRecession

15%

Goldilocks Supercycle

Deflation Stagflation

HighGrowth

LowGrowth

NegativeGrowth

NegativeInflation

LowInflation

HighInflation



HighGrowth

LowGrowth

NegativeGrowth

NegativeInflation

LowInflation

HighInflation



HighGrowth

LowGrowth

NegativeGrowth

NegativeInflation

LowInflation

HighInflation



HighGrowth

LowGrowth

NegativeGrowth

NegativeInflation

LowInflation

HighInflation

Source: UBS WMR Stephen Freedman, CFA


Appendix Appendix

Other Important DisclosuresIn certain countries UBS AG is referred to as UBS SA. This publication is for our clients’ information only and is not intended as an offer, or a solici-tation of an offer, to buy or sell any investment or other specific product. It does not constitute a personal recommendation or take into accountthe particular investment objectives, financial situation and needs of any specific recipient. We recommend that recipients take financial and/or taxadvice as to the implications of investing in any of the products mentioned herein. We do not provide tax advice. The analysis contained herein isbased on numerous assumptions. Different assumptions could result in materially different results. Other than disclosures relating to UBS AG, its sub-sidiaries and affiliates, all information expressed in this document were obtained from sources believed to be reliable and in good faith, but no rep-resentation or warranty, express or implied, is made as to its accuracy or completeness. All information and opinions are current only as of the dateof this report, and are subject to change without notice. This publication is not intended to be a complete statement or summary of the securities,markets or developments referred to in the report.

Opinions may differ or be contrary to those expressed by other business areas or groups of UBS AG, its subsidiaries and affiliates. UBS WealthManagement Research (UBS WMR) is written by Wealth Management & Swiss Bank and Wealth Management Americas. UBS InvestmentResearch is written by UBS Investment Bank. The research process of UBS WMR is independent of UBS Investment Research. As a consequenceresearch methodologies applied and assumptions made by UBS WMR and UBS Investment Research may differ, for example, in terms of invest-ment horizon, model assumptions, and valuation methods. Therefore investment recommendations independently provided by the two UBS researchorganizations can be different.

The analyst(s) responsible for the preparation of this report may interact with trading desk personnel, sales personnel and other constituencies forthe purpose of gathering, synthesizing and interpreting market information. The compensation of the analyst(s) who prepared this report is deter-mined exclusively by research management and senior management (not including investment banking). Analyst compensation is not based oninvestment banking revenues, however, compensation may relate to the revenues of UBS as a whole, of which investment banking, sales and trad-ing are a part.

At any time UBS AG, its subsidiaries and affiliates (or employees thereof) may make investment decisions that are inconsistent with the opinionsexpressed in this publication, may have a long or short positions in or act as principal or agent in, the securities (or derivatives thereof) of an issueridentified in this publication, or provide advisory or other services to the issuer or to a company connected with an issuer. Some investments maynot be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you areexposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas withinUBS, into other areas, units, groups or affiliates of UBS. Some investments may be subject to sudden and large falls in value and on realization youmay receive back less than you invested or may be required to pay more. Changes in foreign currency exchange rates may have an adverse effecton the price, value or income of an investment. Past performance of an investment is not a guide to its future performance. Additional informationwill be made available upon request.

All Rights Reserved. This document may not be reproduced or copies circulated without prior written authority of UBS or a subsidiary of UBS. UBSexpressly prohibits the distribution and transfer of this document to third parties for any reason. UBS will not be liable for any claims or lawsuits fromany third parties arising from the use or distribution of this document. This report is for distribution only under such circumstances as may be per-mitted by applicable law. The securities described herein may not be eligible for sale in all jurisdictions or to all categories of investors.

Australia: Distributed by UBS Wealth Management Australia Ltd (Holder of Australian Financial Services Licence No. 231127), Chifley Tower, 2Chifley Square, Sydney, New South Wales, NSW 2000. Bahamas: This publication is distributed to private clients of UBS (Bahamas) Ltd and is notintended for distribution to persons designated as a Bahamian citizen or resident under the Bahamas Exchange Control Regulations. Canada: InCanada, this publication is distributed to clients of UBS Wealth Management Canada by UBS Investment Management Canada Inc.. Dubai: Researchis issued by UBS AG Dubai Branch within the DIFC, is intended for professional clients only and is not for onward distribution within the United ArabEmirates. France: This publication is distributed by UBS (France) S.A., French «société anonyme» with share capital of € 125.726.944, 69, boulevardHaussmann F–75008 Paris, R.C.S. Paris B 421 255 670, to its clients and prospects. UBS (France) S.A. is a provider of investment services duly author-ized according to the terms of the «Code Monétaire et Financier», regulated by French banking and financial authorities as the «Banque de France»and the «Autorité des Marchés Financiers». Germany: The issuer under German Law is UBS Deutschland AG, Stephanstrasse 14–16, 60313Frankfurt am Main. UBS Deutschland AG is authorized and regulated by the «Bundesanstalt für Finanzdienstleistungsaufsicht». Hong Kong: Thispublication is distributed to clients of UBS AG Hong Kong Branch by UBS AG Hong Kong Branch, a licensed bank under the Hong Kong BankingOrdinance and a registered institution under the Securities and Futures Ordinance. Indonesia: This research or publication is not intended and notprepared for purposes of public offering of securities under the Indonesian Capital Market Law and its implementing regulations. Securities men-tioned in this material have not been, and will not be, registered under the Indonesian Capital Market Law and regulations. Italy: This publicationis distributed to the clients of UBS (Italia) S.p.A., via del vecchio politecnico 3 – Milano, an Italian bank duly authorized by Bank of Italy to the pro-vision of financial services and supervised by «Consob» and Bank of Italy. Jersey: UBS AG, Jersey Branch is regulated by the Jersey Financial ServicesCommission to carry on investment business and trust company business under the Financial Services (Jersey) Law 1998 (as amended) and to carryon banking business under the Banking Business (Jersey) Law 1991 (as amended). Luxembourg/Austria: This publication is not intended to con-stitute a public offer under Luxembourg/Austrian law, but might be made available for information purposes to clients of UBS (Luxembourg) S.A./UBS(Luxembourg) S.A. Niederlassung Österreich, a regulated bank under the supervision of the «Commission de Surveillance du Secteur Financier»(CSSF), to which this publication has not been submitted for approval. Singapore: Please contact UBS AG Singapore branch, an exempt financialadviser under the Singapore Financial Advisers Act (Cap. 110) and a wholesale bank licensed under the Singapore Banking Act (Cap. 19) regulatedby the Monetary Authority of Singapore, in respect of any matters arising from, or in connection with, the analysis or report. Spain: This publica-tion is distributed to clients of UBS Bank, S.A. by UBS Bank, S.A., a bank registered with the Bank of Spain. UAE: This research report is not intendedto constitute an offer, sale or delivery of shares or other securities under the laws of the United Arab Emirates (UAE). The contents of this reporthave not been and will not be approved by any authority in the United Arab Emirates including the UAE Central Bank or Dubai Financial Authorities,the Emirates Securities and Commodities Authority, the Dubai Financial Market, the Abu Dhabi Securities market or any other UAE exchange. UK:Approved by UBS AG, authorised and regulated in the UK by the Financial Services Authority. A member of the London Stock Exchange. This pub-lication is distributed to private clients of UBS London in the UK. Where products or services are provided from outside the UK they will not be cov-ered by the UK regulatory regime or the Financial Services Compensation Scheme. USA: Distributed to US persons by UBS Financial Services Inc., asubsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and an affiliate of UBS Financial Services Inc. UBS Financial Services Inc. acceptsresponsibility for the content of a report prepared by a non–US affiliate when it distributes reports to US persons. All transactions by a US person inthe securities mentioned in this report should be effected through a US–registered broker dealer affiliated with UBS, and not through a non–US affil-iate.

Version as per October 2009.

© 2010. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

UBS Financial Services Inc. Technical Research Dept.: Definitions and Distribution

UBS Financial Definition and Criteria CorrespondingServices Rating Rating

CategoryBullish Well–defined, reliable up–trend, an increase in the rate Buy

of change (or strong momentum) and confirming technical indicators

Mod. Bullish Positive overall trend, momentum and confirming Buytechnical indicators

Neutral Trading range trend, a flat rate of change and Neutral/Holdconfirming technical indicators

Mod. Bearish Weakened trend, momentum and confirming Selltechnical indicators

Bearish Negative trend, momentum and confirming Selltechnical indicators

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

For information on the ways in which UBS manages conflicts and maintains independence of its research product; historicalperformance information; and certain additional disclosures concerning UBS research recommendations, please visitwww.ubs.com/disclosures.

Global Equity Rating AllocationsUBS 12–Month Rating Rating Category Coverage1 IB Services2

Buy Buy 48% 40%Neutral Hold/Neutral 40% 35%Sell Sell 13% 26%1Percentage of companies under coverage globally within the 12–month rating category.2Percentage of companies within the 12–month rating category for which investment banking (IB) services were provided within the past 12 months.Source: UBS. Rating allocations as of 31 December 2009.

Global Equity Rating DefinitionsUBS 12–Month Rating DefinitionBuy 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 defined as expected percentage price appreciation plus gross dividend yield over the next 12 months. Market Return Assumption (MRA) is defined 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 flagged as UR by the analyst, indicating that the stock’s price target and/or rating are subject topossible change in the near term, usually in response to an event that may affect 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 Committee(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 exceptionsapply, they will be identified in the Companies Mentioned or Company Disclosure table in the relevant research piece.

UBS Investment Research

UBS Closed–End Funds Ratings: Definitions and Allocations

UBS Financial Definition and Criteria % of companies % for which IBServices Rating under coverage services have

with this rating been providedBuy Higher stability of principal and higher stability of dividends 40.0 17.0Hold Potential loss of principal, lower degree of dividend stability 46.0 35.0Sell High potential for loss of principal and dividend risk 14.0 71.0Source: UBS WMR, as of 31 December 2009

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