UBS global outlook Fourth quarter 2009swissbiz.ca/attachments/q4_ubs_global_outlook.pdf · 2019-05-13 · UBS global outlook – Fourth quarter 2009 5 consumer demand. The unemployment

UBS global outlookFourth quarter 2009

October 2009

Signs of stabilization andimprovement in the economicoutlook are likely to underpinrisky assets during the fourthquarter.

Wealth Management Research

The tough climb continues

Economic upturn to continue, despite structural risks

Government bond yields to move higher

Corporate bonds attractive despite impressive run

Economic and earnings recovery to underpin equities

Commodity prices have room to rise

Carry trades and fundamentals weigh on US dollar

This report has been prepared by UBS AGPast performance is not an indication of future returns. The market prices provided are closing prices on the respectiveprincipal stock exchange.

Key investment views 3

Investment outlook 4

Fixed income 9

Equities 10

Nontraditional asset classes 12

Currencies 14

Financial market performance 15

Publication details 16

Hedge funds

Commodities

Listed real estate

Emerging market

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2004 - 2008 (annualized)

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3UBS global outlook – Fourth quarter 2009

Economic upturn to continue, despite structural risksWe think that the second half of 2009 and the earlypart of 2010 will be marked by a rebound in eco-nomic activity. Developed economies could experi-ence a renewed bout of weakness heading into themiddle of 2010, since many government stimulusprograms are poised to end. That said, a reneweddecline into a full-fledged recession is not part of ourbase case scenario. With the many risks to the long-term economic outlook, we should not forget thatthe near-term cyclical recovery, coupled with favor-able liquidity conditions, remain generally supportiveof financial markets and especially investments incorporate assets.

Government bond yields to move higherFurther improvement in the economic outlook islikely to reduce private demand for bond invest-ments. The recovery phase will also stimulate discus-sions about so-called exit strategies for central banks,namely how they will reverse their currently very sup-portive near-zero interest rates or quantitative easingpolicies. We expect yields of the highest qualitybonds to rise moderately over the next year in devel-oped markets. As a consequence, we favor govern-ment bond investments with short- and medium-term maturities.

Corporate bonds attractive despite impressive runWe expect corporate bonds to outperform govern-ment bonds for the next 12 months, althoughreturns will not be as spectacular as they have beenyear-to-date, as tighter spreads are likely to be coun-terbalanced by rising government bond yields. Again,we would stress corporate bonds with short- tomedium-term maturities.

Key investment views

Economic and earnings recovery to underpin equitiesAfter the sharp rally in global equities, up by about50% from the mid-March lows, we judge that equitymarket valuations do not look stretched. We findEurozone equities particularly attractive at present.We also continue to like emerging markets from alonger-term perspective. Among the sectors, we pre-fer Energy and remain cautious on Healthcare.

Commodity prices have room to riseOur scenario for a sustained economic recovery inemerging markets and a moderate recovery in the USand the Eurozone has materialized in the third quar-ter and is surprising even optimistic forecasters. Inparticular, emerging markets, which generate mostof the marginal demand for many important com-modities are leading the recovery. We expect this tocreate upward price pressure for commodities, especially where little spare production capacity isavailable.

Carry trades and fundamentals weigh on US dollarEconomic recovery supports carry trades and there-fore hurts the USD. This was the case in 2005–08,and conditions are similar today. Even positive USeconomic data hurts the greenback. Nevertheless,volatility may emerge in the fourth quarter, asinvestors take profits from their current carry posi-tions before yearend. We recommend that investorstake measures to protect their portfolios from strongcurrency swings.

Performance of main asset classes

Note: Information through 22 September 2009. Returns over five years are annualized.Source: Bloomberg, GPR, HFR, JP Morgan, Merrill Lynch, Thomson Financial, UBS WMR

Total return, in %

4 UBS global outlook – Fourth quarter 2009

The tough climb continues

Signs of a revival in economic activity continued toemerge throughout the third quarter, providing acatalyst for further gains in financial markets. A sharpsnapback in leading economic indicators and new-found resiliency in manufacturing orders point to anupturn in industrial production, which will likelygather momentum over the next several months.

Although the durability and strength of the recoveryare very much in doubt – especially as the massivemonetary and fiscal stimulus measures are eventuallywithdrawn – signs of stabilization and improvementin the economic outlook are likely to underpin riskyassets during the fourth quarter. Despite the impres-sive performance within financial markets since earlyMarch, valuations of most risky assets have not yetrun ahead of economic fundamentals – even if weassume a rather shallow and anemic recovery.

Therefore, we think that equities and corporatebonds, as well as certain other nontraditional assets,such as commodities, can continue to climb higher.The ascent will become increasingly more challengingas financial markets revert to normal cyclical patterns.While the benefits of owning higher-risk assets are notlikely to be as robust as the past six months, the earlystages of an economic recovery are generally favor-able for equities, corporate bonds, and commodities,whereas fixed-rate government bonds tend to lag.

A year since the credit crunchIn the year since the Lehman Brothers bankruptcy –an event that nearly pushed the world economy intoa full-blown depression – there has been a normal-ization in business activity and financial market con-ditions.

Investment outlook

Having seen the second-quarter economic growthfigures, as well as leading and concurring businesscycle indicators for the third quarter, there is nowample evidence showing that most major economicregions and countries started to recover from anexceptionally deep recession (see Fig. 1). Therefore,we think it is safe to assume that the second half of2009 and the early part of 2010 will be marked by arebound in economic activity. Nevertheless, there aremany reasons to remain cautious beyond the nextcouple of quarters.

Not only will the recovery likely pale in comparison toprevious downturns, it will likely take several years tofully restore the level of lost output, to say nothing ofsurpassing the previous highs. And when looking outbeyond the next two to three quarters, concernsabout the durability of the recovery are still warranted.

Temporary supportsThe recovery within developed economies has beenbuilt on two main pillars. On the one hand, there is aneed for restocking of depleted inventories after anexceptionally large drawdown during the recession(see Fig. 2). On the other hand, governments aroundthe world continue their pledge to stimulate theirdomestic economies with infrastructure spending,accommodative monetary policy measures, subsidiesfor car scrapping schemes and tax rebates. Unfortu-nately, consumer and business demand in the US,Europe and Japan has not picked up yet, and indica-tions of such an upturn are still largely missing (seeFig. 3 for our forecasts for economic growth, interestrates and exchange rates).

The employment situation, which is in particularlypoor shape and is once again lagging the businesscycle, is primarily responsible for this malaise in final

Fig. 1: Manufacturing upturn follows China’s lead

Source: Thomson Financial, UBS WMR

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Fig. 2: Order-to-inventory ratio signals recovery

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consumer demand. The unemployment rate, which ispoised to top 10% in the US, will likely continue toincrease through the end of 2009,. As a conse-quence, there is a high risk that consumer confi-dence and spending will remain subdued (see Fig. 4).

Private investment activity is also under considerablestrain, thanks to the fact that record-low capacity uti-lization rates are overwhelming the potential positiveeffect of low interest rates.

Final demand constrainedOverall, the outlook for private final demand, a termthat refers primarily to corporate and householdspending, is rather sobering. Since many governmentstimulus programs are poised to end in the not-too-distant future, developed economies could experi-ence a renewed bout of weakness heading into themiddle of 2010. That said, a renewed decline into afull-fledged recession (also known as a double-dip or W-shaped recession) is not part of our base casescenario.

We continue to expect the trend rate of economicgrowth will likely be slower than during the lastquarter century. We outlined our reasoning for this inthe March 2009 edition of the UBS research focusentitled, “The financial crisis and its aftermath.” Theexpected sluggishness arises from three main

sources: ongoing household and financial sectordeleveraging, a reduction in investor risk appetites,and the still-to-be-decided new rules and regulationsgoverning the financial system. And although wethink trade tensions are manageable, the latestbrouhaha between the US and China over tireimports illustrates the risk that protectionism couldharm the budding recovery.

Monetary policy dilemmasMeanwhile, the debate over the exit strategies ofcentral banks and governments is just beginning toheat up. Timing the exit will be critical: some coun-tries might remove policy stimulus too early, raisingthe risk of falling back into slow growth and defla-tion, while others might wait too long and then findthemselves managing a stagflation environment.How this final act in the financial crisis plays out isdifficult to know.

Private sector deleveraging, low capacity utilizationrates and high unemployment would augur fordeflation. However, the surge in base money createdby central banks, as well as ballooning governmentdeficits and debt and the tendency to monetizelarge amounts of this debt, are the necessary ingredients for a rise in inflation. This highly binaryset of extreme potential outcomes will likelyremain in place for a long time. Therefore, inflation

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* purchasing power parity Source: UBS WMR

Interest rates 3-month LIBOR 10-year govt bond10-Mar Oct-10 10-Mar Oct-10

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Fig. 3: WMR economic forecasts

Real GDP growth in % Inflation in %2008 2009 2010 2008 2009 2010

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Brazil

Asia/Pacific Japan

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expectations will likely rise and fall according to theprevailing sentiment over the path that seems mostlikely. This should imply higher interest rate volatilityin the coming months and quarters.

Regional differences in the policy response willremain important for assessing relative asset priceperformance across regions and countries. In thisregard, some emerging market countries havealready started raising interest rates, which wouldsuggest that these economies have found more sta-ble footing and that many of the systemic risksrelated to the financial crisis have abated.

Putting the rally into perspectiveA stabilization in earnings, continued firming incredit markets and indications that the economy isfinally turning the corner bolstered financial marketsduring the third quarter. After the strong rally sincethe March 2009 lows, investors are rightly question-ing how much further there is to go. The question isespecially relevant given the still unsettled outlookfor the global economy.

The massive decline in global risk premiums and cor-responding increase in the price of higher risk assetswas clearly justified by the stabilization in the econ-omy, but the rally also needs to be put into perspec-tive. Although global equities have risen 50% sincethe March 2009 lows, prices are still well below thelevels that prevailed just before the Lehman bank-ruptcy (see Fig. 5). Speculative-grade (or high yield)bonds have performed as impressively as global equi-ties even though credit spreads are still wide by his-torical standards. Therefore, the repricing of equitiesand corporate bonds is consistent with the recentstabilization and recovery in the global economy. But

financial market valuations also reflect the likelihoodthat large structural factors – such as deleveraging,greater regulation, and massive fiscal and monetarystimulus measures – will prevent the global economyfrom simply returning to business as usual.

More normal price dynamicsThe performance of most risky assets during the pastsix months far exceeds the required returns thatinvestors normally demand for accepting the riskembedded in these assets. Even commodity indexeshave more than doubled off the March lows. Year-to-date performance looks less out of the ordinary, sincethis period includes a wave of extreme market pes-simism. In early March, fears that bank balance sheetproblems would again paralyze credit marketsspawned a new round of panic. Still, even on a year-to-date basis, performance numbers have nowmoved into double-digit territory, with global equitiesup 22%, high yield bonds gaining 50%, and invest-ment grade bonds delivering a return of 14%.

The rapid gains in financial markets are most likelybehind us, and investors should now expect morenormal, cyclical performance patterns to emerge.This means that asset-specific fundamentals, ratherthan simply the big macro picture, will become therelevant drivers. For equities, the focus will shift toearnings and the potential for further increases overthe coming months. In the case of corporate bonds,trends in underlying credit fundamentals, such asbalance sheet strength and ratings trends, will bedecisive in timing market direction. And within com-modities, supply considerations are coming back intoview. Importantly, normalization along a recoverypath would also likely improve the diversificationpotential between asset classes.

Fig. 4: US consumer recovery remains challenged


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The price of US equities is roughly 15.5 times earn-ings, based on 12-month forward consensus earn-ings expectations (see Fig. 6). For the Eurozone andthe UK the respective price-to-earnings (P/E) ratiosare roughly 13. These multiples do not appear at allexpensive, in our view, especially if the earningsexpectations prove correct and the macroeconomicenvironment continues to stabilize.

Investors should be wary of using P/E ratios as agauge for valuation when earnings become struc-turally impaired. However, earnings have alreadycontracted sharply and are far below trend. Animprovement from cyclically depressed levels wouldlikely prove supportive of equities. Even a shalloweconomic recovery should support an improvementin earnings, which would imply that current P/E levelsare at least fair, if not attractive, from a valuationstandpoint.

Bond markets: at a crossroadsLow inflation and accommodative monetary policymeasures have managed to forestall a selloff in gov-ernment bonds. However, while inflation pressuresshould remain at bay over the near term, there arerisks of building price pressures as the recoverymatures.

Meanwhile, the still-elevated spread differentialbetween corporate and government bond yieldspoints to continued positive absolute returns in corporate bonds (see Fig. 7). Should the economicrecovery force government bond yields higher, wethink such a move will be accompanied by furtherreductions in credit risk premiums. This spread com-pression is likely to outweigh the negative dragfrom rising bond yields, especially in the case of

A return to more cyclical patterns also means thatinvestors will need more time for risky assets to gen-erate significant excess returns. In addition, investorswill also need to be prepared to withstand temporarysetbacks. In this regard, investors should considerlengthening their investment horizon to take advan-tage of longer-term opportunities. As long as pricesof risky assets have not run ahead of fundamentalsand are not yet overvalued, investors should expectto reap sufficient excess returns from long-terminvestments. According to our calculations, globalequities as well as corporate bonds still offer value,even in a rather shallow economic recovery scenario.

Equities: earnings back in focusWith the many risks to the long-term economic out-look, we should not forget that the near-term cyclicalrecovery, coupled with favorable liquidity conditions,remain generally supportive of financial markets. His-torically, the early stages of an economic recovery tendto support investments in corporate assets. In ourview, the expected pick-up in global economic activityduring the fourth quarter should continue to underpinrecent price increases in global equities. However, mar-ket participants will also expect to see a recovery incompany earnings for further gains to materialize.

The timing of such a recovery in earnings, as well asits strength, remains highly uncertain. Second-quar-ter results yielded some early signs that corporationshave finally arrested the decline in profitabilitythrough intense cost reduction measures. US compa-nies even reported the first sequential increase inearnings since the onset of the crisis. Interestingly,earnings in emerging markets held up much betterduring the crisis and seem to have bottomed outalongside an improvement in sales volumes.

Fig. 6: P/E ratio for major equity markets

Sources: Thomson Financial, UBS WMR

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Fig. 7: Global credit spreads have contracted

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speculative-grade bonds where default risks are themore dominant driver for overall performance. How-ever, for more risk-averse investors, investment gradebonds still offer an attractive tradeoff betweenexpected return and risk.

Regional differentiationLooking at the regions and countries one can see notonly a decoupling between emerging markets anddeveloped economies but also a different type ofgrowth.

China was the first large economy to escape thegrips of the global recession. This was achieved inlarge part because of fiscal stimulus measures, whichwere among the largest of all countries relative tothe size of its economy. In contrast to the US andother developed countries, China‘s fiscal stimulusspurred final domestic demand, making the recoveryone of the soundest from a business cycle perspec-tive. China‘s growth also enabled other smallerexport-oriented Southeast Asian countries to leavethe recession behind in the second quarter of 2009.

The US and the UK, as well as Germany and France,posted surprisingly strong second-quarter economicgrowth figures. However, many developed economiesmay experience setbacks during 2010 as policy stimu-lus is removed. The European Central Bank could beamong the first developed country central banks tohike interest rates, whereas the Federal Reserve willlikely wait until the US labor market stabilizes orimproves before it makes a first move. Such divergentpolicy actions between the two major central bankswill likely put pressure on the US dollar to weaken.

The return of the “carry trade” – borrowing in a low-yielding currency to fund investments in high-yieldingcurrencies – will also work against the US dollar.Since carry trades move in synch with the overall riskappetite in financial markets, we expect this strategyto play out favorably during the next couple ofmonths. We therefore favor high-yielding currencieslike the Australian dollar over the low-yielding ones,like the Japanese yen.

Walter Edelmann

Head Investment Strategy

Andreas Höfert

Global Head Wealth Management Research


We expect further declines in corporate creditspreads ahead but also look for an increase inthe underlying risk-free rates. As a conse-quence, corporates’ performance should bemore muted in the coming months. Neverthe-less, corporate bonds remain more attractivethan government bonds, in our view.

Government bonds unmovedGovernment bond yields have remained rather stableover the past couple of months even though eco-nomic indicators and equity markets have improvedsignificantly. It seems that skepticism regarding a full-fledged economic recovery and high demand forbond market investments from private investors aswell as from central banks have so far kept yieldsfrom rising more significantly.

Normalization imminentLooking ahead, we expect the bond market environ-ment to turn less favorable. We think the economicoutlook is likely to improve further, which shouldreduce private demand for bond investments. Thiswill also stimulate discussions about so-called exitstrategies for central banks, namely how they willreverse their currently very supportive near-zero inter-est rates or quantitative easing policies. Also, wenote that headline inflation has already changeddirection in most countries, moving back towardspositive territory.

Given our expectation for only a subdued recovery,we think central banks are likely to increase interestrates slowly, starting probably only in the second halfof 2010. Given this environment, we expect yields ofthe highest quality bonds to rise moderately, bybetween 30 and 100 basis points over the next year

Fixed income

in developed markets. As a consequence, we favorgovernment bond investments with short- andmedium-term maturities.

Attractive corporate bonds While government bonds performed with littlesparkle during the third quarter, corporate bondscontinued to rally (see Fig. 8). Over the past severalmonths, companies have implemented substantialcost-cutting programs and reduced capital spending.These measures led to better earnings margins and,as a consequence, corporations are well positionedto benefit from the economic recovery that liesahead. In addition, companies have pursued prudentfinancing by extending debt maturities or increasingtheir liquidity.

We continue to expect corporate bonds to outper-form government bonds for the next 12 months,although returns will not be as spectacular as theyhave been year-to-date, as tighter spreads are likelyto be counterbalanced by rising government bondyields (see Fig. 9). Again, we would stress corporatebonds with short- to medium-term maturities.

Fig. 8: High yield bonds outperformed

Source: JP Morgan, Merrill Lynch, Bloomberg, UBS WMR

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Fig. 9: Credit spreads narrow further

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Even after the sharp rally in global equities, upby about 50% from the mid-March lows, wejudge that equity market valuations do not lookstretched. We find Eurozone equities particu-larly attractive at present. We also continue tolike emerging markets from a longer-term per-spective. Among the sectors, we prefer Energyand remain cautious on Healthcare.

Continued strong gainsAfter taking a breather in early summer, equity mar-kets resumed their upward surge, advancing byabout 20% in the third quarter. While the rally wasagain led by cyclical sectors, we saw some changes inleadership among countries. European marketsstepped up their pace while emerging marketsmoved more in line with global markets. All in all, thereturn differential between countries as well as sec-tors has started to narrow compared to the first halfof the year.

Eurozone equities attractiveBy absolute valuation measures, we find that equitymarkets are still attractive. Nevertheless, we observedifferences among the various markets.

At the end of the second quarter, we stressed theappealing valuation of Eurozone equities. They cur-rently trade at a price-to-earnings ratio of only 13.5,which is clearly below the level of global equities. Inaddition, they offer a dividend yield of about 4%,which is very attractive in the current low-interest-rate environment, even exceeding the coupon rateon 10-year EMU government bonds.

There are also good medium-term reasons to holdEurozone equities in a portfolio, in our view. In thepast, Eurozone equities tended to outperform when

Equities

business sentiment improved and economic activityrevived (see Fig. 10). As they are particularly exposedto exports, Eurozone equities suffered from the col-lapse in global trade. Thus, they are now likely tobenefit from the improving global activity that is cur-rently underway.

In addition, the sharp cost-cutting measures under-taken by companies have helped to turn the earningsmomentum. Rather than cutting earnings forecasts,analysts have lately grown slightly more optimisticand even raised some projections. Finally, prospectsfor Financials, which represent a quarter of the Euro-zone market capitalization, have improved in recentmonths. Some banks even surprised positively withtheir earnings reports in the second quarter. Centralbanks around the globe continue to run a very easymonetary policy. Although the sector is not yet outof the woods, it is no longer a drag on the overallmarket.

We continue to like emerging marketsAs emerging markets in general and the major Asiancountries in particular continue to see higher eco-nomic growth, we retain our positive view on thisinvestment area (see Fig. 11). Surely, there are stillemerging markets with high country-specific risks,but overall we find their long-term growth trendsoffer attractive opportunities. China remains ourfavorite emerging market. We see the risks togrowth disappointments there as lower than in otheremerging markets and valuations are also still rela-tively attractive in China. We also retain our positiveviews on Poland and South Africa.

Turning cautious on Japanese equitiesWe have recently changed our view on Japaneseequities and have become more cautious. The rea-

Fig. 10: Rising sentiment supports Eurozone equities


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sons are manifold. First, valuation relative to othermarkets looks rather stretched. The price-to-earningsratio is twice that of Europe, for example. Second,we expect Japan‘s economic growth dynamics to lagbehind other developed countries. The government’sfiscal stimulus had its major impact in the secondquarter, and we think any effects are likely to fade inthe coming quarters. And finally, the earnings out-look for Japanese companies remains difficult (seeFig. 12). The yen is still strong and domestic demandweak. Sharp cost-cutting measures are likely to haveonly a temporary impact, in our view.

Keeping neutral on US equitiesWe retain our neutral stance on the US equity mar-ket. Valuation is fair in our view and the improvingearnings momentum supports the market. But theeconomic recovery is already fairly advanced, withless potential for positive surprises, in our view.

Sector leadership less clearThe global market recovery since March has beencharacterized by large differences between sectorreturns. Typical cyclical sectors like Financialsincreased by about 85%, and Materials by roughly65% from their low points. On the other hand, sec-tors like Telecom and Healthcare rose only by 20% to25%. These differences are typical for periods whenmacroeconomic indicators suggest the end of arecession and the risk appetite of investors normal-izes. Therefore, we think these return spreads are notlikely to last over the long run. Rather, we expect sec-tor return disparities to narrow over the next fewquarters, as the valuation differences between cycli-cal and defensive sectors are now much more bal-anced than they were in March (see Fig. 13). Never-theless, we think the overall valuation level remainsvery attractive.

Sector choice depends on risk profileThe current investment environment leads us toemphasize that the appropriate sector selection forinvestments depends on an individual’s appetite forrisk. For those who have higher return expectationsand are willing to take more risk, cyclical sectors suchas Chemicals, Mining, Steel and Transportation stilloffer upside potential, which mainly stems from theexpected earnings growth in 2010 and beyond.Given the generally low level of capacity utilizationand the improving new orders inflow, we forecastearnings in general to recover from a low basis anddeliver about 15% growth in 2010. Investors with acautious stance should look at non-cyclical sectorslike Energy and Telecoms, which offer dividend yieldsof 6%–7%, attractive enough in a low-interest-rateenvironment. In addition, should the market take abreather, we expect these sectors to be less affected.Besides swine flu, we see no particular trigger for theHealthcare sector in the short term and thereforeremain cautious about it at present.

Fig. 12: Japanese earnings have been hard hit


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Hedge fundsAfter last year’s financial market turmoil, thethird quarter brought renewed confidence inhedge funds. In the fourth quarter, we expecthedge fund returns to remain above their his-toric average.

Hedge funds have benefitted from the favorablefinancial market conditions in place since the equitymarket rally began in March. Last year’s extraordinarylosses have at least partially been offset by this year’sparticularly propitious market conditions for hedgefunds. A decline in credit spreads, as well as aresilient equity rally complete with clear sector andregional trends, have allowed hedge funds to imple-ment specific strategies. Commodities – in particular,oil, gold and base metals – have also followed thetrend of recovery in industrial production during thesecond and third quarters.

We expect hedge funds to continue producingreturns above their long term average in the fourthquarter. For 2010, it is prudent to expect a modera-tion of hedge fund returns towards their long termaverages. The considerable reduction of marketvolatility to pre-crisis levels also supports this view.

The same market conditions that have contributed tothe outperformance of certain strategies, such asconvertible arbitrage, fixed income arbitrage areunlikely to remain in place (see Fig. 14). Given theexpected changes to macroeconomic fundamentalsin 2010, we expect macro strategies to be well posi-tioned. Yet, we prefer a diversified approach acrossmany hedge fund strategies and remain optimisticabout the asset class.

Listed real estateThe shockwaves of the financial crisis still res-onate in the UK and US commercial real estatemarkets, while Asia and the Eurozone havealready begun to revive.

Listed real estate has recovered in parallel with theequity market rally (see Fig. 15). In Asia, the recoveryhas been particularly vigorous due to ample liquidityprovision by monetary authorities and a rapid eco-nomic recovery. Stability in Asian banking presentsfew obstacles to the refinancing activities of local realestate firms.

The situation is very different in the UK and the US.While the low interest rate environment is support-ive, higher risk premiums and the reluctance of crisis-ridden banks to lend to real estate firms with weakfundamentals are clouding the outlook. Withvacancy rates rising and rental incomes falling, largertransactions that enable REITs to sell properties togenerate liquidity and deleverage are rare. Mean-while, securitization channels to support refinancingremain closed. Therefore, the refinancing stream forcommercial mortgages will have to be fully absorbedby UK and US bank balance sheets. For the UK andthe US, we expect a full recovery to take severalyears, with listed real estate underperforming equi-ties in the coming quarters.

In this market, investors should focus on sound fun-damentals. For Asia and the Eurozone, we expect theasset class to perform more in line with the respec-tive equity indices.

Nontraditional asset classes

Fig. 14: Return of principal hedge fund indices

Note: Updated as of 15 September 2009Source: Hedge Fund Research, Inc.

Fig. 15: Listed real estate continues to recover

Source: GPR, MSCI, UBS WMR

0

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2005 2006 2007 2008 2009 2010

GPR 250 Hong Kong GPR 250 UK GPR 250 US MSCI World

Total return, in % Index (January 2005 = 100)


CommoditiesAn expected acceleration of economic activitysupports our forecast for higher commodityprices in the coming quarter.

Commodities have experienced a synchronous recov-ery alongside equities after lagging equities as thefinancial crisis unfolded (see Fig. 16). Our scenario fora sustained economic recovery in emerging marketsand a moderate recovery in the US and the Eurozonehas materialized in the third quarter and is surprisingeven optimistic forecasters. In particular, emergingmarkets, which generate most of the marginaldemand for many important commodities are lead-ing the recovery. We expect this to create price pres-sure for commodities, especially where little spareproduction capacity is available. This is the case foroil where we expect its price to average USD 85 perbarrel in 2010 with peaks around USD 90 per barrel.

Precious metals, in particular gold, will likely be sup-ported by expectations of higher inflation and USdollar weakness. Over the next few quarters, weexpect gold to reach USD 1100 per ounce. Price pres-sures will be more modest in the near term for com-modities with ample spare capacities, such as alu-minum and nickel.

Longer term, the need for central banks to exit themonetary easing strategies could have negativerepercussions for commodity prices (see Fig. 17).However, these considerations are not likely to signif-icantly affect the price development during the bal-ance of 2009.

Private equity Private equity is likely to produce attractivereturns for investors prepared to adopt therequired longer term investment horizon, partic-ularly in the secondary and distressed markets.

In addition to the traditional arenas of buyout andventure investments, the current post-crisis environ-ment is characterized by attractive secondary and dis-tressed private equity markets. The private equityindustry has ample liquidity available to invest in situ-ations where others face profitability and liquidityconstraints. Distressed investment funds acquireinterests in companies that have defaulted or are in apotentially precarious situation. Since the credit cycleis moving into a phase with higher defaults, such sit-uations will abound. Control of distressed firms by aprivate equity manager can produce an operationalturnaround or a balance sheet restructuring. The spe-cialized knowledge about the intricacies of the bank-ruptcy process is decisive to produce value forinvestors.

In the secondary private equity market, new investorsare offered the opportunity to purchase interestsfrom forced sellers that are trying to recover liquidityfrom past private equity investments. This is anopportunity for new investors to accelerate their dis-tribution schedule that normally requires three to fiveyears before producing the first distribution.

Post-recession vintages have recorded the best per-formance, which suggests that the current environ-ment bodes well for the asset class.

Fig. 16: Commodities and equities moving in sync


Commodities: DJ-UBS Composite Total Return MSCI World

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2003 2004 2005 2006 2007 2008 2009 2010

Fig. 17: Soaring money growth reflects improved demand


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1982 1986 1990 1994 1998 2002 2006 2010-10

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CRB commodity index, lhs US M1 growth, rhs

Change in CRB index, in % y/y Money growth, in % y/yIndex


Forex markets were characterized by risk-takingbehavior during the third quarter, and weexpect this trend to continue.

Ride the carryRisk-taking in currency markets is manifested in carrytrades, which attempt to profit from yield differencesacross currency areas. Carry trades are hurting the USdollar (USD), Japanese yen (JPY) and the Britishpound (GBP). The biggest winners are emerging mar-ket currencies, plus the Australian dollar (AUD), NewZealand dollar (NZD) and Norwegian krone (NOK), aswell as some other, not explicitly high-yielding cur-rencies, such as the euro (EUR), the Canadian dollar(CAD), the Swiss franc (CHF) and the Swedish krona(SEK).

A glance at purchasing power parities (PPP) showsthat the GBP and the JPY are in equilibrium with theUSD. The AUD, EUR, SEK, and CHF are now signifi-cantly overvalued versus the USD, but are more orless in line with each other (see Fig. 18).

One could argue that post-crisis carry trades are ananomaly because interest rates and interest-rate dif-ferentials are too low to make this strategy attractive.Today’s circumstances surely differ from 2005-08,when yield differentials were far higher. Australianmoney market rates, for example, are now about 5%lower than in 2008, while JPY money market ratesfell by only 1% since 2008. Still, higher-yielding cur-rencies are appreciating at the expense of lower-yielding ones.

Currencies

Carry should continue to workToday’s incentives for carry trades are more funda-mental than those of 2008. The currencies that havetended towards overvaluation this year are from theeconomies that were the least challenged by thefinancial crisis. Governments in Japan, the UK andthe US will each accumulate debt of 25% to 30% ofGDP between 2008 and 2010, according to theOECD (see Fig. 19). Australia and Canada will seelimited erosion in their debt ratios, and even Europeis set to accumulate debt of less than 15% of GDP.The long-term consequences of high debt accumula-tion include a heightened risk of inflation and fallingproductivity, both at a time when governments needto increase taxes. For this reason we recommendsticking with currencies that have stable finances.

Don’t get carried awayEconomic recovery supports carry trades and there-fore hurts the USD. This was the case in 2005-08,and conditions are similar today. Even positive USeconomic data hurts the greenback. Nevertheless,volatility may emerge in the fourth quarter, asinvestors take profits from their current carry posi-tions before yearend. We recommend that investorstake measures to protect their portfolios from strongcurrency swings.

Fig. 18: Some large overvaluations versus USD


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Fig. 19: Change in debt position varies widely

Source: OECD, UBS WMR

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Deviation of PPP from spot rate, in % Change in debt-to-GDP ratios from 2008–10, in percentage points

Equities

Total return, in local currency and % Total return, in USD and %Markets YTD 3-mo 1-yr 5-yr YTD 3-mo 1-yr 5-yr

Global 22.2 19.0 –7.8 3.0 27.2 22.4 –6.7 4.4US 21.5 20.7 –8.8 1.6 21.5 20.7 –8.8 1.6Japan 11.1 2.4 –19.4 –1.4 10.5 7.8 –5.5 2.5Canada 32.7 18.4 –3.9 9.9 53.1 27.7 –6.9 14.0Eurozone 25.5 23.9 –6.8 4.8 33.5 32.1 –5.8 8.9UK 20.6 22.6 3.1 6.0 37.4 22.5 –8.4 4.1Sweden 45.9 23.2 13.9 9.0 69.3 44.8 9.1 10.9Switzerland 19.3 19.8 –5.6 5.0 24.0 27.0 0.3 9.5Australia 30.4 21.0 –1.6 10.6 63.4 33.4 1.8 15.5Emerging markets 53.6 20.9 13.9 16.4 66.3 26.2 11.0 18.0

Asia 61.7 20.8 22.0 15.8 64.9 23.4 18.9 16.2Eastern Europe, Middle East & Africa 53.9 24.8 –5.8 9.5 64.1 32.3 –10.4 11.4Latin America 47.9 20.8 14.1 22.7 79.2 29.6 8.1 28.6

SectorsConsumer discretionary 31.0 19.1 –5.9 –0.3 34.4 22.6 –3.0 1.5Consumer staples 10.4 12.4 –2.5 7.6 14.9 14.7 –1.9 8.8Energy 16.9 16.4 –9.9 9.7 23.3 18.8 –11.7 10.6Financials 30.3 27.4 –16.2 –2.9 37.8 32.2 –15.2 –1.3Healthcare 9.5 13.3 –2.2 2.4 12.2 15.3 –1.4 3.4Industrials 22.5 22.7 –11.7 3.0 26.4 26.7 –9.1 4.8IT 41.6 19.1 0.9 2.8 43.0 20.8 3.2 3.9Materials 38.6 22.2 –10.4 10.4 50.2 27.8 –9.0 12.6Telecom 5.9 14.5 1.4 3.9 11.4 18.5 1.1 5.2Utilities 1.9 10.2 –8.1 8.8 5.4 13.7 –7.2 10.6

Fixed income

Total return, in local currency and % Historic 3-month LIBOR rates, in %Money market YTD 3-mo 1-yr 5-yr Current 3-mo 1-yr 5-yr

US 1.3 0.3 2.7 4.1 0.3 0.6 3.2 1.9Japan 0.7 0.2 1.0 0.6 0.3 0.5 0.9 0.1Eurozone 2.0 0.5 3.8 3.6 0.7 1.2 5.0 2.1UK 2.0 0.5 4.3 5.2 0.6 1.2 6.0 4.9Switzerland 0.6 0.2 1.8 1.9 0.3 0.4 2.8 0.7

Government bonds Historic 10-year govt. yields, in %US –3.3 2.2 6.0 5.0 3.4 3.7 3.8 4.0Japan 0.2 1.2 3.2 1.7 1.4 1.5 1.5 1.5Germany 0.8 1.6 10.6 4.5 3.4 3.5 4.3 4.0UK –0.3 2.2 11.7 5.8 3.8 3.7 4.7 4.8Switzerland 1.8 1.8 8.1 3.6 2.1 2.3 2.8 2.6

Global inflation linked bonds 11.7 6.1 2.0 5.8 – – – –

Total return, in local currency and % Option adjusted spread, in bpsInvestment grade corporate bonds YTD 3-mo 1-yr 5-yr Current 3-mo 1-yr 5-yr

USD denominated 17.5 8.5 15.9 4.2 230 332 409 90EUR denominated 12.3 5.9 12.2 3.1 191 283 269 45

High yield corporate bondsUSD denominated 47.5 14.8 14.4 5.9 793 1093 921 386EUR denominated 64.9 20.6 18.2 5.5 926 1502 988 313

EM USD sovereign bondsGlobal 23.6 12.0 14.0 8.9 328 458 374 405Asia 24.8 10.4 17.0 9.3 253 352 310 281Eastern Europe 30.1 10.4 15.0 8.2 314 421 357 395Latin America 23.0 13.4 12.5 8.3 362 513 401 484

Nontraditional asset classes

Total return, in local currency and % Total return, in USD and %YTD 3-mo 1-yr 5-yr YTD 3-mo 1-yr 5-yr

Listed real estate 25.8 30.4 –17.8 2.7 30.9 34.2 –16.2 4.5Commodities 8.8 5.3 –29.7 –0.3 – – – –

Currencies

Change versus the USD, in % Exchange rateYTD 3-mo 1-yr 5-yr Current Current

EUR 5.9 6.5 0.3 3.8 EURUSD 1.48 USDCNY 6.83GBP 12.0 0.0 –11.8 –1.8 GBPUSD 1.64 NZDUSD 0.72JPY –0.4 5.2 16.6 3.9 USDJPY 91 EURCHF 1.51CAD 13.9 7.9 –3.2 3.7 USDCAD 1.07 EURGBP 0.90CHF 4.3 6.0 4.9 4.2 USDCHF 1.02 EURJPY 135SEK 15.3 17.2 –4.6 1.7 USDSEK 6.81 EURSEK 10.07AUD 24.3 11.2 3.5 4.3 AUDUSD 0.87 EURNOK 8.63


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Financial market performance

Note: Information through 22 September 2009. Returns over five years are annualized. Past performance is not an indication of future returns. The market prices provided are closing prices on the respective principal stockexchange. This applies to all performance charts and tables in this publication.Source: Bloomberg, GPR, HFR, JP Morgan, Merrill Lynch, MSCI, Thomson Financial, UBS WMR

20 400–20–40–60 60

12840–4–8–12–16 16

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40200–20–40–60 60

YTD3-month

YTD3-month


Publication details

Publisher: UBS AG, Wealth Management Research, P.O. Box, CH-8098 ZurichEditor in chief: Kurt E.ReimanEditor: Roy Greenspan Lead authors:– Key investment views: Kurt E. Reiman, strategist, UBS AG– Investment outlook: Andreas Hoefert, chief economist, UBS AG; Walter Edelmann, strategist, UBS AG– Fixed income: Bernhard Obenhuber, strategist, UBS AG; Achim Peijan, strategist, UBS AG– Equities: Markus Irngartinger, strategist, UBS AG– Nontraditional asset classes: Sandro Merino, strategist, UBS AG– Currencies: Thomas Flury, strategist, UBS AGEditorial deadline: 23 Septmeber 2009Project management: Valérie IserlandDesktop: Srinivas Addugula, Basavaraj Gudihal, Pavan Mekala, Virender Negi, Margrit Oppliger Translation: 24 Translate, St Gallen, Switzerland; CLS Communication, Basel, SwitzerlandTranslation coordinator: Sita ChavaliCover picture: www.masterfile.comPrinter: UD Print AG, Lucerne, SwitzerlandLanguages: Published in English, German, Italian, French, Spanish, Portuguese, Chinese (traditional and simplified), Japanese and RussianContact: [email protected]

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