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CIO Year Ahead

CIO Wealth Management


A journey to your nancial goals.


CIO Year Ahead 2014 This report has been prepared by UBS AG and UBS Financial Services Inc. (UBS FS). This report was published on 11 December 2013. Editor in Chief Mark Andersen Project Management Paul Leeming Nikki Ackerman Brian Alden Corrine Fedier Rda Mouhid Sita L. Chavali Editors Thomas Gundy Andrew DeBoo CLS Communication Design Linda Sutter Layout CIO Digital & Print Publishing, UBS AG


08 Editorial
2014: Time to re-orient


Economic outlook
A world shaped by deleveraging and convergence Global growth shiing up a gear in 2014

20 Monetary policy outlook

The hard way forward from easy money



24 Investment principles
Look before you leap Succeeding with timeless investment principles

34 Asset allocation
Positioning portfolios for 2014 and beyond

48 US equity sector strategy

Further fuel for cyclicals

49 Investment themes
Water: thirst for investments Energy independence: forward march Dividend investing: dont overpay for yield

35 Bonds
Limited value

28 Strategic asset allocation

Asset allocation in 2013, a retrospective


Corporate and emerging market bonds

Count on credit


Agency debt & mortgage backed securities

2014: the death of the carry trade

52 Currencies
A major rebound

54 Commodities
Little in return

42 Municipal bonds
Managing credit risk

56 Hedge funds
Attractive risk-adjusted returns expected

43 Preferred securities
Look back to look forward


Private markets
Complement traditional portfolios

44 Investment theme
Tiptoeing out the yield curve

45 Equities
Stay stocked up on stocks
This report has been prepared by UBS AG and UBS Financial Services Inc. (UBS FS). Please see the important disclaimer at the end of the document.


2014: Time to re-orient



Alexander S. Friedman Global Chief Investment Officer Wealth Management

Mike Ryan Chief Investment Strategist Wealth Management Americas

ince 2008, the main secular trends driving the markets have been deleveraging and declining core government bond yields. As we end 2013 and move into 2014, these trends are changing in important ways. US Federal Reserve Chairman Ben Bernankes speech last May to the US Congress, suggesting that the central bank was considering recalibrating its pace of asset purchases, sparked a retreat in government bond prices and ended their three-decade long secular bull market. The era of falling government bond yields and perpetual stimulus appears to be ending. This adjustment caused a sharp sell-o in many emerging markets, particularly those with dual scal and current account decits. Combined with Chinas difculties in containing credit growth while maintaining its economic expansion, this situation laid bare the need for structural reforms in many of the larger emerging markets. Implementing such reforms will mean these economies will likely grow at a slower pace than investors have become used to over much of the past decade. In the developed markets, we have moved further down the long road of deleveraging that began in 2008. In the US, the private sector deleveraging process appears close to complete, with house prices having risen markedly. Public sector debt remains high, but as long as the US dollar remains the worlds reserve currency, the US faces little external pressure to reform its scal prole. In the Eurozone, bank deleveraging still has a way to go, but government austerity is easing and is no longer acting as a major drag on economic growth and political condence. And in Japan, the government enacted its most aggressive attempt yet to end its roughly two-decade-long economic malaise, combining aggressive monetary and scal stimulus with structural reforms. So, as what may come to be viewed as a game changing year winds down and we look to the future, it makes sense for investors to take stock of some of the structural shis underway and reorient their portfolio holdings. It is therefore important to remember that even in the unusual world we have lived in since 2008, the basic principles of investment management have not changed. First, at the core is the idea that investors should not take unnecessary risks. This means that investors should diversify across, and within, asset classes. A concentrated portfolio of individual stocks contains much greater idiosyncratic risk while oering no greater expected return than a widely diversied basket.


Second, it can be easy for investors to underestimate risks close to home, due to familiarity. Home bias, however, can lead to excess risk for no commensurate return. Investors should avoid home bias by diversifying globally. And third, when diversifying, investors should consider hedging their currency exposure. Currencies tend to add little more than noise to investment performance. Hedging enables an investor to reduce risk without sacricing returns. Beyond these core tenets, there is also now a need for investors to consider making shis in their portfolio construction to account for the structural changes we mentioned earlier. First, diversication across asset classes remains critical, so investors should still generally hold bonds as well as equities in their portfolios. But the beginning of the end of quantitative easing will bring about rising bond yields, undoubtedly aecting the returns available in bonds. The best solution to this problem could prove to be credit, which oers not only some of the diversication benet of government bonds but also a higher return. As a result, we believe credit should play a more integral role in investors allocations than may have been assumed in recent years. Second, the end of the era of falling bond yields will not come without its risks. We witnessed in May and June how worries about a withdrawal of central bank stimulus can temporarily lead to all asset classes falling in tandem. Investors will need to increasingly consider alternative investments as sources of less correlated returns. Finally, aer annualized returns of more than 15% from global equities and around 20% from high yield credit over the past ve years, investors will have to revise down their return expectations. Economic and earnings growth have simply not kept pace. We expect annual equity returns to be more in the range of 7%8% over the coming ve to seven years. Therefore, nding extra return will require not only increased allocations to alternatives, but also the agility to adjust to changes in short-term market conditions. Entering 2014, our highest tactical conviction is to be overweight risk assets, including equities and US high yield credit. That said, a number of dangers do potentially lurk in the year ahead. We face the threats of continued US government dysfunction, a Chinese credit crunch, a reappearance of the Eurozone crisis, and the possibility of ination in Japan without economic growth, producing pressure on its government bonds. Cutting across these risks is the biggest risk of all policy error. We still rely on policymakers to make the right choices at the right times. Overall, however, the environment for risk-seeking investors appears positive. We expect 2014 will produce 3% growth in the crucial US economy, close to the highest growth rate in the developed world. Meanwhile, the Eurozone should nally experience modest expansion. And we anticipate that the overall global economy will grow by 3.4% over the next 12 months, the fastest pace of growth since 2010. All the best for the year ahead.

Alexander S. Friedman Global Chief Investment Ofcer Wealth Management

Mike Ryan Chief Investment Strategist Wealth Management Americas



Before you start your journey, you need to observe the environment that shapes the investment landscape.




A world shaped by deleveraging and convergence

The global economic growth seen in recent decades will not be repeated in the ve to seven years ahead, as developed market deleveraging and emerging market convergence continue to shape the world.
Andreas Hoefert, Chief Economist, Regional CIO Europe



mong the largest developed countries, the US economy is best positioned and boasts the strongest growth outlook (see Fig. 1). We foresee the US expanding on average by 2%3% per year, as opposed to the Eurozones 1%2% over the next ve to seven years. China should continue to lead the emerging world and outpace most developed nations growthwise, but its expansion has decelerated from the 10% it posted since remaking its economy in the early 1980s to a level of 7%8%. In the process of converging toward the developed world, emerging markets (EM) are seeing their growth rates naturally decline, though due to their larger economies, they have more impact on the rest of the world than ever before. As for ination, we expect prices to rise only moderately despite the ultra-expansionary monetary policies major central banks are still pursuing. Slower GDP growth means that it will take years to close the existing output gap in the developed nations the dierence between a countrys actual GDP (or output) and its potential GDP and to reduce unemployment rates to pre-nancial crisis levels. Consequently, companies will nd it difcult to raise prices for their goods and services, and workers will have little bargaining power to secure higher wages. We see ination in developed markets reaching 1.5%2.5%, and running 2%3% higher in emerging economies as prices there gradually converge toward those of the G7 nations.

The forces behind growth

Long-term economic growth in a country or region is determined by the workings of three dierent forces labor, capital, and productivity. We thus need to look at current trends in each of these input factors to grasp the direction the global economy is heading over the next ve to seven years. Labor will not be the crucial constraint. The growth of a countrys workforce depends on how fast its population rises. However, while crucial to their long-term growth outlook, workforce size will not constrain most developed nations for some time to come. Their unemployment rates remain high and their labor market participation rates continue to fall as discouraged workers stop looking for jobs. The US and the Eurozone face the problem of too little demand for labor rather than too little supply of it, a situation unlikely to change in the next two or three years, and one that will keep policymakers busy trying to nd ways to reinvigorate private demand. Demographic change also plays a vital role in capital accumulation. Typically, people save money during their working lives, which increases the capital stock. Aer they retire they live on their savings and reduce that store of capital. Based on this framework, capital in the US can be expected to grow relatively strongly in the years ahead from its current low level as the baby boomers reach their high saving years right before retirement age. Japan will likely experience much lower capital growth as retirees spend their savings.


Fig. 1: Expected real GDP growth in 2014 (adjusted for ination), in %

Canada 2.6 % US 3.0 % Mexico 3.4 % Switzerland 2.0 %

UK 2.3 % Poland 2.8 % Eurozone 1.1 % Turkey 3.8 %

Russia 2.5 %

China 7.8 % India 5.7 %

Japan 1.5 %

Brazil 3.0 % South Africa 2.7 % Australia 3.3 %

The size of the bubbles represents the countries current share of global GDP.
Source: UBS, as of 26 November 2013

In general, demographic developments continue to support stronger economic growth in emerging than in developed nations. The UN estimates that population growth in the former will surpass that in the latter by a full percentage point in each of the next 10 years. Greater population growth oers advantages not only in terms of total labor input but also in maintaining the ratio of working to retired people. This so-called support ratio has been eroding steadily in developed economies. It has dropped in the US from 7.8 in 1950 to 5.1 today, and is expected to fall below four by the end of the decade. The situation is even bleaker in Western Europe, where the ratio will plunge to three, and Japan, where each retiree, once able to rely on 12 workers in 1950, will have to make do with just 2.1 in 2020. In contrast, emerging countries higher birth rates will keep that ratio between six and 10 for the foreseeable future.

process of repairing their balance sheets. Such a balance sheet recession can last much longer than a normal business cycle and has been weighing on many developed economies in recent years. Japan, Switzerland and several Nordic countries experienced an extended period of stagnation in the 1990s aer their housing bubbles burst. The US, UK and many peripheral Eurozone nations are or have been in the midst of a

Why bother with economics?

Understanding how dierent regions and countries will evolve over the next ve to seven years from both a growth and an ination standpoint is crucial to determining ones longerterm Strategic Asset Allocation (SAA). This might be viewed as a daunting task given the less-than-stellar track record of economic forecasts over a typical one- or two-year time frame. However, because the factors aecting long-term growth and ination rates those that prevail in a country or region beyond short-term business cycle uctuations are well-established, we can assess them relatively well.

Deleveraging and convergence

Two factors stand out in terms of aecting the growth rate of capital: deleveraging and convergence. In the wake of the nancial crisis, the private, and even sometimes the public, sector of many developed economies has been deleveraging, reducing debt and xing balance sheets. Hence, rms have been unwilling to borrow for the purpose of investing. That said, even if they did wish to borrow, they would face nancial intermediaries, i.e. banks, reluctant to lend to them because they themselves are in the



similar situation. The US and UK appear relatively far along in their deleveraging eorts and in cleaning up the balance sheets of their nancial sectors. While credit activity has been rising for more than a year in the US, it was still falling as of the end of 2013 in the Eurozone (compared with the previous year), and is expected to remain tepid. This illustrates a decoupling in the deleveraging process between the two regions and is a critical reason why we see the US maintaining its stronger position in the years ahead. Emerging markets are undergoing the phenomenon of convergence, which means that, everything else being equal, investment activity will be more pronounced where capital remains scarce because higher returns on capital can be expected. This leads to a greater growth rate of capital and, more generally, stronger economic expansion in emerging than in developed nations (see Fig. 2). However, convergence does not aect all emerging markets equally. A country can experience it to a greater or lesser degree depending on its institutional framework (whether the rule of law and clearly dened property rights prevail within it) and educational system (how good it is).




Productivity: Putting it all together

The productivity of an economy ultimately determines how efciently the input factors of labor and capital can be transformed into output. Technological progress is an important determinant of how quickly productivity increases. Over time, the rate of progress tends to even out within developed economies but can vary over a single business cycle. It also plays a part in the convergence story of emerging markets: as the Chinas and Indias of the world approach the level of development that characterizes fully industrialized nations, they see their rate of technological progress gently decline toward that of the leading industrial countries.

Ination expected to remain in check

Since the Lehman Brothers bankruptcy in September of 2008, the balance sheets of the central banks in the G7 countries have increased threefold. The US Federal Reserves current monetary base is four times as large as it was before the nancial crisis, while the European Central Banks is only twice as large. The Bank of Japan announced at the beginning of 2013 that it would double its monetary base by 2015. While such central bank balance sheet expansion was arguably necessary to break the downward economic spiral during the nancial crisis, it le many fearing an eventual rapid rise in the price of goods and services as a consequence. Remembering the famous Milton Friedman mantra that ination is always and everywhere a monetary phenomenon, one can only marvel that ination hasnt reared its ugly head so far and that ination expectations remain wellanchored in the jargon of central bank ofcials, despite the tremendous amount of money that has been created. There are several explanations for inations no-show. The most common is that many developed economies are operating at far less than capacity. The International Monetary

Fig. 2: Emerging economies outpacing their developed peers Development of GDP per capita in USD (index 1980 = 1; incl. IMF forecasts)
35 30 25 20 15 10 5 0 1980 1985 1990 1995 2000 2005 2010 2015 2020 Korea Brazil China India US Estimates

Source: IMF, UBS, as of 26 November 2013



Fund estimates that the US economy in 2013 is still running roughly 5% below its potential output. Closing this output gap will take the better part of this decade. Unemployment rates remain markedly higher than they were pre-crisis and are only slowly retreating. In some peripheral European countries, they exceed 20%. Cost-push ination can gain little traction where wage costs stay at or decline due to high unemployment. The ination prospects for the emerging markets as a whole are easier to describe. Indeed, as mentioned above, many emerging economies have begun decisively converging with their developed counterparts. As they do, their real exchange rates tend to appreciate, i.e. either their currency itself appreciates or, more commonly, ination powers the rise. Therefore, even when governed by a conservative central bank, emerging markets will tend to experience higher ination than their developed counterparts do. The GDP-percapita convergence of emerging markets means, ultimately, that their price levels draw closer and closer to those of the developed economies as their non-tradable goods, i.e. services, rise in price as a consequence of their increasing wealth and the greater purchasing power of their inhabitants.

Over a long time frame, population growth plays a prominent role in inuencing growth. From UN projections we can infer that the US, in the next 20 years, will add another 57 million people to its current population of 312 million and has better economic growth prospects than the Eurozone, whose 331 million inhabitants will be joined by just another eight million in that same time period. The US benets in this regard from its open immigration policy and birth rate of almost 2.1 per woman: even absent immigration, the US population can sustain itself, in contrast to the EU (with its 1.6 birth rate), Japan (1.4) and even China (1.6). In addition, the US excels at attracting young skilled immigrants. From 2000 to 2010, its net immigration amounted to 5.1% of its total population, well ahead of such competitors as the UK (3.1%), Germany (1.6%) and Japan (0.3%).





Global growth shifting up a gear in 2014

he environment in 2014 will be characterized by faster global economic growth. We expect world GDP to expand by 3.4%, the fastest pace of growth since 2010, as the eects of scal austerity fade in both the US and the Eurozone. This should also help support emerging markets, where we expect growth of 5.0%, aer 4.5% in 2013. There is still sufcient slack in labor markets to keep ination in check, and so major central banks will be able to maintain loose monetary policy. The US Federal Reserve is likely to phase out its bond purchase program through 2014, but is highly unlikely to raise interest rates.






Transitioning to a self-sustaining recovery

Thomas Berner, Economist

Among the developed countries of the world, the US is likely furthest along in the process of deleveraging. We expect private sector balance sheets to stop shrinking in 2014, which would support increased consumer and business spending and thus economic growth. US scal policy, however, can still trigger major surprises, especially since decisions about the debt ceiling and the budget have simply been delayed. Even assuming they have no severe economic consequences, they pose signicant event risk for markets in the short term. But if we look past such temporary uncertainty, the picture will actually brighten in 2014. The scal drag will likely abate further, from an estimated 1% of GDP in 2013 to around 0.3% in 2014. While an additional USD 45bn in sequester spending cuts (about 0.3% of GDP) are legally due in 2014, we sense little to no appetite in Congress for raising personal taxes further, and dont expect a dramatic shi in scal policy aer the next round of budget negotiations in early 2014. All eyes will thus be on the private sector in 2014, as we expect US household spending to accelerate and spur on a more robust, self-sustaining recovery. Factors inuencing consumption have turned positive and should serve to boost it. The almost two-year-old rebound in house prices has underpinned the rise in household wealth. Households are more willing to take on new debt, while banks have turned sympathetic to lending more freely. Real labor income growth remains mediocre, but we expect easier credit conditions to raise overall economic activity and, with it, growth in payrolls and real wages. Households also face fewer hindrances to spending. The savings rate has already increased to a more sustainable level of around 4.5%, higher personal taxes have been absorbed, interest rates have retreated somewhat again, and ination has stayed low. We expect real consumption to climb from its average rate of close to 2% since the recovery began to close to 3% as 2014 progresses. The pickup in household spending should persuade businesses to invest at a faster pace, especially since the other key drivers of capital expenditure (capex) are all conducive

to increasing it. The cost of capital remains low. The average age of the capital stock outstanding is at a 50-year high. The capex share of GDP is still below its long-term average, and aggregate stock prices have risen to all-time highs. If we combine the spending of the private and government sectors, we see real GDP growth expanding from just above 2% in 2013 to slightly above 3% in 2014 (on a 4Q-to-4Q basis).

US is likely furthest along in The the process of deleveraging.

The speedier growth will help take up labor market slack more rapidly: we envision unemployment falling well below 7% by year end. A jobless rate approaching 5.5% is consistent with full employment in the long run, so we dont anticipate ination galloping away, only slowly rising higher toward the Federal Reserves goal of 2%. A stronger private sector recovery and fading scal drag in an environment of moderate ination will enable the Fed to scale back its bond purchases in early 2014 and stabilize the size of its balance sheet toward the end of the year.





More stability, more growth

Ricardo Garcia, Economist Bill ONeill, Strategist Caesar Lack, Economist

The economic recovery in the Eurozone is expected to gain ground in 2014, though its doubtful that growth will reach even half the rate we expect for the US (see Fig. 3). The Eurozone private sector is still digging itself out of debt, and the deleveraging, along with the forthcoming bank stress tests and new capital requirements that could still crimp banks ability to lend, is likely to limit the continents economic expansion. Still, even modest growth beats the contraction of last year. Aer peaking in 2012, austerity remains on the retreat and the scal drag is decreasing. We anticipate scal

Fig. 3: Growth shiing up a gear Real GDP growth and forecasts for 2014 in % (adjusted for ination)
9 8 7 6 5 4 3 2 1 0 1 2 3 4 5 Estimates

tightening of only half a percentage point on average for 2014 down from almost a full point in 2013 which should nally permit the economy to breathe a bit easier. Consumer condence, beneting from greater economic and political stability and a stabilizing unemployment rate, is expected to settle in at more normal levels. The better nancial conditions and increased external demand should enable rms to invest more than in recent years. A rise in exports, however, should also be accompanied by recovering imports as pentup demand materializes, which would cap the large gains in net trade observed in recent years. Consumer price ination is expected to fall well short of the European Central Bank (ECB) target of just under 2%. Faced with low ination and mediocre growth, the ECB, in our view, will retain its easing bias to boost the recovery and provide enough liquidity when banks ll their capital shortfalls stemming from the stress tests. Meanwhile, some downside risks persist: economic disappointments could bring a country, such as Cyprus, close to default and reignite exit fears. However, we believe the ECB and its mechanisms will continue to serve as a credible backstop against any return to crisis. While political developments could disrupt the recovery, we expect the current relative calm to persist. For instance, early elections are likely to be held in Italy in the rst half of the year, but chances are good that the outcome will be a stable majority as opposed to the current hung parliament. Elsewhere on the continent, the Swiss economy is expected to experience robust growth. While exports stagnate, the domestic economy booms on the back of strong private consumption, easy monetary policy and greater immigration. As long as the euro-Swiss franc exchange rate oor of 1.20 stays in place, and we see no near-term end to it, Switzerland in eect continues to follow the ECBs accommodative monetary policy, which will go on fueling consumption and driving housing prices higher. We expect the Swiss economy to grow by 2% in 2014. The UK is expected to outpace even Switzerland at 2.3% real GDP growth, as its housing support measures, easier access to credit and declining household savings rate kickstart its economy. We anticipate the Bank of England will maintain its loose monetary stance through 2014, despite a decline in the unemployment rate.



1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Emerging markets US Eurozone

Source: IMF, UBS, as of 26 November 2013



Emerging markets:

Moderately faster expansion

Costa Vayenas, Analyst

Aer tracing a atter trajectory for three straight years, economic growth in the emerging markets (EM) should rise moderately again in 2014, reaching 5% from around 4.5% in both 2013 and 2012. A 5% real GDP growth rate on almost USD 30trn would enlarge the EM share of the global economy to nearly 40%. The larger emerging countries Brazil, Russia, India, China are facing the need for structural changes as they converge toward the more developed economies. This process will require some of them, like China, to adapt to lower annual rates of growth than what they have become accustomed to. The highest risk for those emerging economies that rely on foreign capital inflows to finance growth stems from higher global interest rates. The fragile ve (India, Indonesia, Brazil, Turkey, South Africa) are particularly vulnerable, though some of them, such as Indonesia, have made structural improvements recently. Additionally, an earlierthan-expected tightening of the US Federal Reserves monetary policy could cause renewed capital outows and weigh on currencies such as the Indian rupee. Overall, however, as exports pick up we expect net capital ows into EM to trend higher into 2014 from the outows seen last year. Any weakening in US and/or European growth would curtail exports in China and curb growth across EM, but our outlook for higher growth in the developed world bodes well for EM.

Latin America stays below potential

Latin America, in our estimation, will rev up moderately to 4% from 2013s 3.5%. We expect Mexico to recover strongly and expand at 3.4% more than double its growth rate in 2013 thanks in large measure to its close trade links with the US. Structural reforms should also boost its longer-term potential and attract foreign direct investment. Our outlook for Brazil is less sanguine. We think the Brazilian economy will be hampered by persistent high ination and structural decits, which are likely to limit GDP expansion to 3% in the year ahead.

Fundamentals challenging in EMEA

In emerging Europe, Middle East and Africa (EMEA), we should see a growth speed-up to 3.5% from below 3% in 2013. Russia limped along at an average rate below 2% in 2013, but increasing domestic consumption should raise growth to 2.5%, though economic conditions will remain challenging as its commodity-based growth model of the last decade proves unsustainable. In Turkey we foresee growth approaching 4%. Trade links to Western Europe are a plus for the country, but its large current account decit clouds the longer-term picture. The outlook for South Africa is similar. The rands relatively cheap valuation and the countrys exposure to better European economic dynamics should revive growth, but dependence on external nancing poses a key risk to the economy, which we expect to expand by 2.5%3%.

Asia fuels the growth engine

We expect Asia to continue to grow fastest, at more than 6% in 2014 from 5.5% in 2013. Much will depend, of course, on the performance of China. Its trend growth has begun declining from its almost 10% pace of recent decades, and for 2014 we expect its GDP to expand by 7.8%. Rapidly rising Chinese residential property prices and/ or broad ination would force the central bank to tighten policy, which would hurt growth. But we think the governments policy ne-tuning will keep a lid on new credit and ination. The second-largest emerging market, India, should accelerate from the near 5% it notched in 2013 to closer to 5.7% in the year ahead.




The hard way forward from easy money

In the years after World War I, US President Warren Harding called for a return to normalcy. Today, central banks around the world are seeking something similar after an extended period of unprecedented monetary policy.
Thomas Berner, Economist Achim Peijan, Strategist




nterest rates still sit at or close to zero in most developed countries, while monetary stimulus policies enacted at the onset of the nancial crisis persist in the form of various kinds of quantitative easing. Getting to normalized rates and self-sustaining economies is the daunting task central bankers face.

Normalizing monetary policy conditions looms as a delicate balancing act that central bankers face in the years ahead.

The long way back to normal

With growth expected to remain restrained due to ongoing deleveraging and new banking rules, we see little inationary pressure arising in the near term. As has been the case

The obstacles to tightening

Growth today remains fragile. One of the key questions economists and policymakers confront is when the global economy will be healthy enough to withstand a shi to tighter monetary policy. The nervous manner in which nancial markets reacted when US bond yields rose rapidly in mid-2013 aer the US Federal Reserve indicated it could reduce monetary stimulus over time illustrates their vulnerability. This sensitivity to higher interest rates originates in the large debt levels accumulated by most developed countries and the inverse relationship between sustainable debt and interest rates. The lower interest rates are, the higher is the sustainable debt level. If interest rates increase sharply without any accompanying economic improvement, the risk that the deleveraging process will intensify, i.e. that debtors will step up eorts to reduce their borrowings without creditors osetting the declining demand for goods and services, rises. The solution, however unpleasant, is for central banks to tighten monetary policy in the not-too-distant future. The longer central bank rates remain at or close to zero (and real rates negative), the more problematic it becomes to raise them later. Low interest rates currently may prop up investments that might turn unprotable should borrowing become more expensive. People may go back to buying houses they can ill aord. Likewise, companies based on shaky business models that survive in todays benign environment might very well struggle if rates were to rise too rapidly.

Current motives for supportive monetary policy:

To oset deleveraging forces originating from high debt levels in the private and public sectors and stabilize aggregate demand, as in the case of the US, UK, Europe and Japan To increase domestic demand and keep a currency relatively weak to oset sluggish international trade and a loss of competitiveness, as in the case of Japan and China To prevent currency appreciation, as in the case of Switzerland and Scandinavia To provide liquidity to the banking sector to mitigate the deleveraging of bank balance sheets and declining asset prices that could jeopardize the solvency of borrowers, as in the case of Europe To stimulate demand from private investors for less liquid assets, as in the case of the US, with its purchase of USD 1.3trn of mortgage-backed securities in recent years



since the nancial crisis commenced, central bank money creation alone appears to be insufcient to provoke the ination beast. Both ination and ination expectations look very stable. Therefore we do not expect the major developed market central banks to raise interest rates during 2014. We expect the Fed to apply the brakes to its bond-buying program (QE3), with its balance sheet peaking sometime in late 2014. In 2015, we expect the Fed to start raising interest rates. However, the pace of the hikes will be slower than in the past, when the Fed raised rates by roughly two percentage points per year on average. We currently assume an increase of about 1% annually. Toward the end of 2017 we anticipate that the Fed funds and the US dollar short-term

money markets rates will approach 2.5%3.0% (see Fig. 4). Aer 2017 we expect the Fed funds rate to climb to its terminal value of about 3%4%. We think real interest rates in other markets will also start to normalize. This process, along with our views on ination, determines our forecasts for the nominal central bank rates in these countries. We foresee a level between 2% and 2.5% for the Eurozone, 1.25% and 1.75% for Switzerland and 2.5% and 3% for the UK in 2017, with each thereaer rising somewhat higher.

Transmission channels obstructed

Andreas Hoefert, Chief Economist, Regional CIO Europe
One important explanation for the lack of ination is the fact that the so-called transmission channels of monetary policy, the two main avenues by which central bank money ows into the real economy, are clogged. The money multipliers, through which the credit activity of the nancial intermediaries transforms and multiplies central bank money into the actual money used in an economy, make up the rst channel. The second consists of the velocity of money, how oen money changes hands within a specic period of time. Both have deteriorated signicantly in the past ve years. In the US, for example, the money multiplier transforming the monetary base into actual money stood at 9x in the fourth quarter of 2007, but was only 3.3x in the third quarter of 2013. Each freshly printed Fed dollar that created nine dollars of actual money in 2007 results in barely a third of that today. The velocity of money has dropped too, if not as dramatically. Given the damage both channels have suered, ination is unlikely to surge in the next ve to seven years. At present central banks worldwide remain knee-deep in eorts to unclog the channels and improve the eectiveness of their policies in stimulating growth. The Fed is furthest along in this mission, as US banks greater willingness to lend indicates, but the European Central Bank and the Bank of Japan have further stepped up their attempts.

Fig. 4: Rates will only increase gradually US central bank policy rate and 10-year Treasury yield (with forecasts), in %
6.0 5.0 4.0 3.0 2.0 1.0 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Estimates

Central bank policy rate

Source: Thomson Reuters, UBS, as of 26 November 2013

10-year Treasury yield





To choose the right path, you need to orient yourself toward your nancial goal and consider the challenges you might face on the way.





Look before you leap

Whether you are embarking on a journey or investing your assets, preparation is vital. A clear goal and a well-planned route are critical to success.
Mark Haefele, Global Head of Investment Mark Andersen and Mads Pedersen, co-Heads of Asset Allocation


he journey toward any goal becomes easier with preparation. Where are you starting from? How much risk will you take along your path? Do you believe in your plan enough to stick with it when the going is difcult?

What should you take on your journey?

A strategic asset allocation (SAA) forms the basis for deciding the best mix of investments to help you reach your goals. The SAA represents the asset classes and regions that you invest in over the longer term. Because the SAA determines about 80% of your portfolios return and risk over time, it is crucial to select the SAA that best matches your personal situation.

Orient yourself:

Where are you?

Understanding your nancial situation and personality your investor prole helps you to determine the level of risk you are prepared to take, and thus, which destinations are within your reach.

How will you adjust to the unforeseen?

The Tactical Asset Allocation (TAA) represents the shorterterm allocation away from the longer-term SAA. Its sixmonth time frame is attuned to business cycle developments and momentum trends. The TAA should not jeopardize your long-term investment goals, and therefore needs to be implemented with all due attention to managing risk.

Where do you want to go?

Select a realistic destination and the best route for you. Some investors value preserving their wealth rst and foremost, while others favor capital appreciation strategies with more risk.



Which is your route?





Succeeding with timeless investment principles

Mark Haefele, Global Head of Investment Mark Andersen and Mads Pedersen, co-Heads of Asset Allocation Christophe de Montrichard, Strategist



ts great to watch the price of a stock you own double in a year. But over the long term, the lions share of your portfolio performance is determined by the allocation among dierent asset classes. Frankly, much of what passes for successful investing in nancial newspapers stems from lucky timing and is oen shortlived. In our view, investors benet far more from focusing on their long-term strategy. While we are passionate about the individual stocks and bonds we select, these timeless principles determine how we invest:

Diversify among asset classes and within them

Combining asset classes, some of which will perform better in certain economic conditions while others shine under a dierent scenario, can increase return while reducing risk, thereby ensuring a smoother path of portfolio returns. While two separate asset classes might both produce positive returns over the long term, they will not necessarily move in sync. For example, US equities and US government bonds have delivered 7.5% and 5.2% per annum respectively for the past 10 years. In 2008 during the nancial crisis, however, US equities lost 37% of their value while US government bonds returned 8%. Portfolio diversication is achieved by properly combining such asset classes to reduce overall swings (day-to-day and during a crisis) while maintaining long-term performance potential. Ultimately, a good portfolio is one that, relative to others, provides the best riskreturn trade-o. Diversication within each asset class is also important. Investing in just a few US companies will expose you to specic company and related managerial risks that may or may not work in your favor. A broader exposure to US equities provides a greater likelihood that you will benet from their expected long-term rise.

Top down Allocate assets rst, then select instruments

Numerous investors build their portfolios by selecting individual attractive investment opportunities as they arise, oen in the form of single securities. The overall proportions they hold in the various asset classes (equities, bonds, etc.), however, are oen less carefully considered, yet they still determine the portfolios overall risk and return characteristics. Therefore, we believe in starting at the top, rst setting the asset allocation and then selecting the right instruments to t it.


Only assume risk for an expected return

Investors should only take on risk when they think they will be well compensated for it. Each asset class must be analyzed, and the value it brings to your portfolio needs to be clear. Foreign currencies require careful consideration: if you expect no gains from converting into them, remove the risk of loss through hedging.

Set realistic expectations and invest for the long term

No one enjoys their portfolio declining in value, whether on a daily, weekly, monthly or yearly basis. However, because most cash rates are close to zero currently, and many government bonds yield less than 2%3%, anyone who wants to achieve a better return has to assume additional risk. Achieving gains in the short term time periods of less than a year is no sure thing. Over a longer time frame (ve to seven years), however, we believe that asset prices tend to revert to a fair, calculable value, which makes portfolio returns more predictable.

Limit your biases

Many investors prefer to invest in companies and opportunities close to home. While owning such assets can give you peace of mind, doing so in extreme proportions prevents you from diversifying worldwide. Therefore, we try to limit the home market bias in our recommended portfolios.





Asset allocation in 2013, a retrospective

As we had forecast in our 2013 Year Ahead publication, returns in 2013 turned out to be more dispersed and lower overall than in prior years. So while diversication worked in 2013, portfolio returns have trailed the stellar performance we saw in 2012.
Michael Crook, Strategist Stephen Freedman, Strategist



2013 asset class performance review

Asset class performance has been highly dispersed within and between major markets. Developed market equities and high yield bonds are clear outperformers, but otherwise the investment environment has been more challenging. Ten months into the year, the 2013 efcient frontier is neither efcient nor a frontier (see Fig. 5). Although we do not expect asset classes to always perform in a predictable or well-behaved way relative to each other in any given calendar year, the nature of dispersion this year has been somewhat unique. Most xed income asset classes are at to slightly negative. Based on index data, US government bonds declined 1.6%, municipals and investment grade credit are down about 2%, and emerging market bonds have lost 3%4% year to date. Such setbacks in the bond market are not overly surprising considering that interest rates have risen about 100 bps over the course of the year. The one exception is the high yield corporate bond segment which is up over 6% this year. Global equity market dispersion has been a bit unusual

in 2013 as well. Developed market equities have returned 20% or more, depending on the region and sector. Emerging market equities, on the other hand, are actually down about 2%. Assuming this holds through December, it will be the rst calendar year since 1998 in which emerging market equities have declined while developed market equities appreciated. Despite slightly negative returns in many xed income assets, all of the major asset classes we track appear on course for a normal year, dened as being within one standard deviation of our long-term return estimates2 (see Fig. 7). Better-than-expected performance has been concentrated in developed market assets, and US assets specically. Yet, given the volatile nature of equity markets, returns in the order of 20% in US equities like weve seen this year are not unusual even if they are not expected to occur with regularity.

Diversication worked in 2013

Correlations between asset classes, which spiked during the


2008-09 nancial crisis, have been relatively low this year. Additionally, none of the major policy risk events, including the government shutdown, resulted in spiking correlations among risk assets. However, some unique correlations between asset classes manifested themselves this year, particularly within xed income. We typically expect US government bonds and US Investment grade (IG) credit to be moderately correlated with each other. They both exhibit interest rate risk, but the credit risk component of investment grade credit generally provides some disconnect between the two bond sectors. This year, however, the correlation has been 0.96 meaning that they have been nearly perfectly correlated. In contrast to the high correlation between IG and government bonds, the correlation between high yield corporates and government bonds has been virtually zero. Of course, we normally expect lower-grade credit to be more correlated to equities than to other types of xed income. This year has not been an exception in that regard, with correlations between high yield and equities coming in at 0.5 or greater. Investors who are tempted to shi the bulk of their portfolio toward high yield bonds and developed market equities on the basis of their strong 2013 performance should nonetheless refrain from excessively concentrating

their wealth in these two asset classes. Their high correlation means that in the case of an economic downturn or market shock, such a portfolio would oer very little diversication to control volatility and protect assets.

Portfolio performance
Roughly speaking, portfolio returns have been in line with long-term return estimates in 2013. Globally diversied moderate portfolios, not including fees or manager outperformance (something increasingly common this year), will have returned about 7%8% this year. In ination-adjusted terms thats a real return of 5.5%6%. Our long-term estimate is between 5.5% and 6% nominally (3%3.5% real), so were above target thus far. Fig. 6 provides return numbers into November for our moderate agship portfolio, a nave 60/40 US equity/US xed income portfolio, and a global market cap portfolio.3 The reason why the nave US-centric portfolio has outperformed the other two is that US assets have outperformed their international counterparts this year. Throughout 2013, we have capitalized on this development by tilting our portfolios toward high yield and US equities which has benetted performance on the margin. That being said, even with these tilts, our portfolios contain international exposure and its clear that

Fig. 5: Asset class performance, 2013 Performance year-to-date through 7 Nov

30 25 20 15 Return 10 5 0 5 10 15 0 2 4 6 8 10 Volatility
Source: FactSet, UBS, as of 7 November 2013

Fig. 6: 2013 year-to-date returns have favored US assets Portfolio performance year to date
16 14

US Equities

Intl Developed Equities Cash High Yield

12 10 8

EM Equities Govt/ IG/ EM bonds Commodities 12 14 16

6 4 2 0 60/40 S&P/ Barclays Agg UBS Moderate Portfolio Global Market Cap Portfolio

Source: FactSet, UBS, as of 7 November 2013





portfolios concentrated in US risk assets, including equities and high yield, have performed better. However, we believe that the more globally diversied portfolios should provide better outcomes over multi-year periods.


Considerations for 2014 and beyond

Its also important to keep in mind that strategic (long-term) asset allocations are not designed to be responsive to or try to capture the short-term market uctuations described earlier (thats what tactical asset allocation is for). Instead, they represent well-diversied starting points designed to limit exposure to specic risks as much as possible while meeting specic return targets over the course of a market cycle. That being said, there are dynamic aspects to strategic asset allocation as well. For instance, strategic asset allocations (SAA) can be made to reect long-term nancial views beyond pure diversication considerations. We did this in early 2013 when launching a new set of SAAs for UBS Wealth Management Americas. Based on reports published in 20114 and 20125, which made a case for a structural preference for emerging market debt and emerging market equities, we adopted a long-term bias toward those assets that exceeds what an investor would normally hold absent any views. In full disclosure, the impact of these emerging-market-tilted portfolios in 2013 has been uniformly negative. We currently remain condent6 that the long-term case favoring emerging markets remains in place and advise investors to

retain these exposures in their portfolios. However, were that view to change, our strategic asset allocation recommendations would also change in kind. Additionally, structural risk and correlation changes should be accounted for in strategic asset allocation decisions. For instance, we hold relatively large positions in high yield xed income across our portfolios. The 0.96 correlation between IG and government bonds this year is important in that regard because if we believed that such a high correlation would persist structurally (i.e. zero diversication benet), it would justify modifying the makeup of the bond allocation. However, at this time we feel very comfortable in maintaining our overall asset allocation recommendations. We believe 2014 has a good chance of being a year that is actually more normal than the last two. Although we continue to prefer US equities and high yield bonds on a tactical basis, we acknowledge that were unlikely to see the same outperformance in those positions in 2014 as 2013 has oered so far. While more-normal will likely mean more-modest returns, at least for US equities, we do expect to see continued dierentiation between sectors and regional equity markets. Within xed income, the only real dierentiation in 2013 has been between high yield and everything else. Its reasonable that in 2014 investors should expect greater dispersion and better performance in that market as well. Unlike cash, a well-constructed bond portfolio has a good chance of providing positive real returns in 2014.


Fig. 7: Returns have been within normal range Performance relative to 1-year estimates
40 30 20 10 0 10 20 US Government FI US Munici- US Investment pal FI Grade FI US High Yield FI Intl Developed EM Fixed Mkt FI Income US Equity International Emerging Developed Markets Markets Equity Equity Commodities

+1 Standard Deviation 1 Standard Deviation

Source: FactSet, UBS, as of 7 November 2013

Actual Median (estimated)




Along the journey, you need to make sound investment decisions. Insight into each asset class is vital.



Positioning portfolios for 2014 and beyond

Higher economic growth and accommodative central banks promote investments in equities and credit, over liquidity and government bonds.
Mark Andersen and Mads Pedersen, co-Heads of Asset Allocation




e expect stronger economic growth and accommodative central banks to continuously favor equities and credit during the year ahead. We recommend reecting this in your portfolio by being tactically overweight equities and credit at the expense of government bonds and liquidity.

Why we favor equities and credit

Recent years have been kind to corporate credit and equities, among our overweight positions in 2013. Deleveraging in the developed world has led to only moderate growth of its economies, enough to hold down default rates and improve credit conditions but not enough to boost corporate earnings on a broad scale. With loose central bank monetary policy spilling over into 2014, companies will benet from low debt-servicing costs, as well as the expected speed-up in the global recovery. The resulting increase in consumer and investor condence should further reduce the risk premium demanded for equities. The result: an environment that rewards equities and corporate bonds more than liquidity and government-backed bonds. Our tactical preference has been US equities recently but we are increasingly attracted to European equities.

We advise investors to shi from traditional government bonds into corporate credit. We recommend corporate bonds of medium and shorter duration as well as high yield credit. The easy financial conditions and improved growth outlook are expected to result in rising interest rates and lower returns for government bonds that barely exceed the ination rate in the years ahead. A move into corporate credit would help oset the eects of these trends by oering a better return outlook. If the economy has improved enough for central banks to start hiking rates, it has probably improved enough for the yield spreads on corporate bonds to tighten and boost the bonds value. These dynamics also hold true for emerging market (EM) sovereign and corporate bonds, which oer better return prospects than developed market bonds. As a result, we recommend a small strategic position in EM bonds for most portfolios.

Credit the better xed income option

Unprecedented central bank policies drove bond yields in many developed countries to record lows in recent years. This situation has created a dilemma for investors: the traditionally safe strategy of holding liquidity and government bonds has become risky by exposing investors to losses, as portfolio yields could fail to keep up with ination.




Limited value
Government bonds, and other bonds with strong credit ratings, will oer only limited returns in the years ahead. Nonetheless, they continue to provide safety and diversication, and still have a role to play as part of a diversied portfolio.
Thomas Berner, Strategist Achim Peijan, Strategist Daniela Steinbrink Mattei, Strategist

ajor developed economies have an interest in keeping government bond yields low to support their decit reduction eorts and economic recoveries. We think that most developed market sovereigns cannot aord a large climb in interest rates because it would cause their budgets to teeter further out of balance and endanger debt sustainability. As a result, we expect central bank rates to remain low (see page 20, The hard way forward from easy money).

How quickly bond yields normalize will dier from region to region depending on the speed at which each is recovering. As these dierences in the pace of recovery become more evident, we anticipate the market distinguishing between regions and reecting local fundamentals in its pricing of future rates. Since we see the US furthest along in its economic recovery, we expect US rates and bond yields to lead the European markets, with Japanese bond yields lagging on the way to normalization.




Government bonds retain value in a portfolio

Despite the subdued outlook for government bonds, they retain their importance in a diversied portfolio. Bond prices generally rise during periods with an uncertain economic outlook, which is not the case with equities. The degree of correlation between the two asset classes determines how well bonds can reduce the risk of a portfolio: if the correlation is negative, the overall risk of a global portfolio that consists primarily of equities and bonds the two largest and most important asset classes drops markedly. In the current environment, bonds diversify portfolios and are worth holding even though their expected return is low. Since the nancial crisis, the correlation between equity and bond performance has been mostly negative: when equity markets have risen, bond performance has declined as yields increased. This situation is common in periods of stable ination expectations, as has been the case in recent years. It contrasts with times when ination volatility dominated, as occurred between 1970 and 1990, for instance. Then the correlation between equities and bonds was positive, as ination uncertainties pushed the valuations of both down. Stable ination, which we foresee, is therefore key to our expectations of a mix of bonds and equities providing good portfolio diversication.

Lower expected returns

We expect bonds to perform sluggishly over the next couple of years. While short-term bonds suer from very low coupons, longer-term bonds will experience declining prices as a consequence of rising yields. We expect yields over the next ve to seven years to increase by about one or two percentage points from their current levels, depending on market and maturity. Returns under this assumption will be positive but unlikely to exceed the ination rate in some markets, meaning that investors could lose in real terms (see Fig. 8). While bonds of dierent maturities are expected to provide comparably low returns, the degree of price variation (volatility) among longer bonds will exceed that of shorter ones. Therefore, very conservative portfolios should contain more short-term bonds. Combining longer-term bonds with equities remains worthwhile, since longer-term bonds provide greater diversication benets.



Fig. 8: The end of the bond bull market Total return indexes of medium-term (57 yrs) government bonds (2009 = 100; incl. forecasts)
135 130 125 120 115 110 105 100 95 90 2009 EUR 2010 2011 USD 2012 2013 CHF 2014 2015 Estimates

Source: Barclays, UBS, as of 20 November 2013




Count on credit
We believe credit should play a more important role in asset allocation than in the past. Developed market corporate and emerging market bonds will outperform government bonds in the years ahead, in our view.
Barry McAlinden, Strategist Donald McLauchlan, Strategist Philipp Schttler, Strategist Bernhard Obenhuber, Strategist

ne can easily form the impression from nancial newspapers that sequences of sensational events determine the movements of asset classes. But we believe that a meaningful analysis of credit investments has to focus on underlying economic trends and the broader credit cycle. To us, what really matters for credit returns over the medium and long term is how the business cycle is progressing. We view the returns as primarily governed by the prevailing yield level and default losses both of which change meaningfully through the credit cycle.

US: Re-leveraging from a strong base

As we laid out in our economic outlook for the years ahead, the US economy is further along in the process of deleveraging than most of its developed market peers, and its corporate credit fundamentals are strong. The interest coverage ratio (earnings generation relative to debt payment) is high and funding at low yields is likely to continue. US companies have used the favorable funding environment to renance a large portion of their outstanding bonds at lower rates. Furthermore, the fundamental trend of US nancials remains positive due to post-crisis regulations that require banks to hold greater capital levels and liquidity reserves. US banks started to ease their lending standards for corporate borrowers in early 2010 and have since (with a brief exception in 2012) made funding available at easier conditions (see Fig. 9). Credit ratings among US bond issuers remained stable through 2013, and we expect this trend to continue in the coming year.

In addition, the US Federal Reserve is playing an important role. By keeping interest rates low it has in essence encouraged investors to seek out higher-yielding assets. Bond issuers, in particular those with a high yield rating, benet from open primary markets. As long as ample funding is available, default rates are unlikely to climb. We expect the default rate on US high yield bonds to stay below 2% through 2014 and foresee total returns of 4%6% for the year. Investment grade corporate bonds (with an average maturity of ve years) will feel the drag from rising benchmark rates, but their expected total return of 1%2% in 2014 compares favorably with that of government bonds of close to zero. In terms of the credit cycle, the US corporate sector entered the re-leveraging stage in 2013 (see Fig. 10). Aggregate credit metrics for non-nancial issuers have peaked and are in the soening phase. Over the past year the average debt level on the balance sheets of US non-nancials rose by almost 10% while earnings climbed by roughly 7%. Furthermore, more aggressive issuance practices, such as loans with limited covenants (covenant lite), and shareholderfriendly activities, such as debt-nanced dividend payouts, have revived since early 2013. But they have done so from a very low level and remain far below the excesses seen in 2006 and 2007.





The credit cycle in four stages

Stage 1: Downturn The nancial crisis of 200809 pushed major economies into recession, which led to soaring default rates on corporate bonds. As company earnings fell, more borrowers struggled to service their debt. At the same time, companies found it increasingly difcult to obtain funding for new debt or existing bonds without the help of government support programs. Credit spreads skyrocketed and total credit returns turned deeply negative. Stage 2: Balance sheet repair The US came out of recession in 2009, and company earnings began increasing again. The weakest companies had defaulted on their bonds, and the remaining ones had a much healthier credit prole than before the recession due to cost cutting and deleveraging. Credit spreads tightened rapidly when central banks were still cutting interest rates, so total credit returns rose. The riskier parts of the spectrum, such as high yield and parts of emerging markets, outperformed equities. Stage 3: Re-leveraging As the business cycle has advanced, borrowers and lenders have regained condence. In this third stage of the credit cycle the focus usually shis from repairing balance sheets and improving credit quality to looking for investment and growth opportunities again. Consequently, leverage increases. Company earnings in this phase continue to grow robustly. The good funding environment means that defaults remain rare and total returns are usually comfortably positive. But as benchmark interest rates start rising in the improving economic landscape, they take their toll on longer-duration credit. The US, according to our analysis, entered this re-leveraging stage of the credit cycle in 2013. Stage 4: Overheating In the nal stage of the cycle, interest rates reach prohibitively high levels, making it difcult for certain companies to generate earnings. While leverage may continue to rise, economic growth and earnings start to tip over, signaling the next recession. Credit spreads start rising ahead of an increase in defaults and credit returns turn negative. And so the cycle starts new.


Fig. 10: A stylized credit cycle Additional yield of US high yield over government bonds (spread) in percentage points and stylized credit cycle phases
20 18 16 14 12 10 8 6 4 2 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 Overheating 2008 2009 2010 2011 2012 2013 (IV) (I) (II) (III) (IV) (I) (II) (III)


Balance sheet repair


US high yield spread

This gure illustrates the credit cycle in a stylized manner, using US high yield bonds as an example.
Source: BoAML, UBS, as of 26 November 2013




Eurozone: Balance sheet repair

The Eurozone only le recession behind in the second quarter of 2013. Unlike in the US, non-nancial companies there are still reducing their average debt levels, which fell by roughly 1% over the last year. At the same time, earnings are only now showing tentative signs of stabilizing, and should grow again in 2014. As such, the Eurozone is still in stage two of the credit cycle repairing balance sheets though we expect it to enter the third stage in 2014. The nancial sector is playing an important role here. Fig. 9 illustrates how Eurozone banks have tightened their lending standards since 2007 due to their need to reduce debt. Recent survey data suggests that this trend will end in 2014, and Eurozone banks will make loans more readily to the corporate sector again. Based on the strengthening economic outlook and improving access to loan nancing, we expect the default rate for EUR-denominated high yield bonds to decline in 2014 from its current level of around 3%. Again, central bankers are playing a major part here. Since the recovery remains fragile and ination low, the European Central Bank is expected to retain its easing bias through 2014, which will support credit investments. Though the Eurozone is seemingly in a more favorable stage of the credit cycle than the US, its credit fundamentals improving instead of moderately deteriorating, we nd that a lot of the positive news in the Eurozone has been priced in already. Credit spreads mirror US ones and total yields are lower. Total returns on EUR investment grade corporate bonds (with an average maturity of ve years), expected to be around 1% in the coming year, are depressed by the relatively low yield level and the expected rise in benchmark rates. But they will still outperform government bonds. EUR high yield bonds should by and large perform in line with their US counterparts at 4%6% expected returns.

Fig. 9: Easier lending for US corporates Bank lending condition indicators

easing standards

tightening standards 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 US Eurozone Emerging markets

Source: Thomson Reuters, Bloomberg, UBS, as of 26 November 2013

Emerging markets: convergence makes them attractive

The gradual macro-economic convergence by emerging market (EM) toward developed market (DM) nations in recent decades has narrowed the dierence in credit quality of EM and DM companies. In 2000, US corporates on average rated four notches higher than their EM counterparts. A modest deterioration of the US corporate rating average and a strong improvement of EM ratings have closed the gap between them (see Fig. 11). EM sovereign bond ratings have similarly improved while the rating of several developed European countries has deteriorated. Today, the ratings of Brazil, Russia and India are very similar to Italys, Spains and Irelands, and

better than Portugals. However, the bulk of rating convergence occurred before 2007. Since then, EM ratings have only marginally improved, and we expect them to stabilize at the current level. EM structural improvements over the last 15 years that led to the rating convergence include: more exible exchange rates; prudent scal and monetary policies; and a better institutional and regulatory framework. The greater economic and political stability in EM led to more sophisticated domestic capital markets, which, along with fewer capital account restrictions, enabled EM corporates to issue bonds more regularly on the global market. In 2000, the EM corporate bond market totaled around USD 72bn. It is now 15 times as large and amounts to more than USD 1trn. The US corporate bond market, by comparison, is at roughly USD 5trn. EM corporate bonds, in short, have become a sizable market for global bond investors.

but be aware of weaker issuing countries

Emerging countries have only recently reached the trough in the economic cycle. In 2014, they should experience gradually improved growth, aided by the stronger global economy, but still face several headwinds. First and foremost, countries with current account decits such as India, Indonesia, Brazil, South Africa and Turkey need to cut imports. To do so, they must tighten their scal and monetary policies. However, these fragile ve all have elections scheduled in 2014, making it difcult for governments to advocate austerity. The EM bank lending survey suggests that banks have become more





restrictive with their loans, which should weigh on credit and, by extension, economic growth. Domestic demand will not fuel it. While the major EM economies are expected to revive, the credit conditions of the weakest EM sovereigns, such as Ukraine, Argentina and Venezuela, continue to deteriorate. This means, as it relates to the EM corporate bond segment, that the credit cycle is somewhat more challenging. Tighter bank lending standards (see Fig. 9), ongoing re-leveraging of corporate balance sheets and weak EM corporate earnings portend a rising number of corporate defaults in 2014, in contrast to the developed markets. Despite the mixed fundamental outlook, and credit spreads close to fair, we still expect EM bonds to outperform developed market government bonds. But they will be more vulnerable when the Fed begins scaling back quantitative easing due to their dependence on capital from foreign investors, especially if domestic growth is shaky. For 2014, US and Eurozone corporate bonds thus have a more favorable outlook, in our view.


Fig. 11: Credit ratings have converged Average credit ratings

A A BBB+ BBB BBB BB+ BB BB B+ 1999 2001 2003 2005 2007 2009 2011 2013 Emerging market sovereigns Emerging market corporates US corporates

The credit rating scale goes from AAA (highest rating, i.e. lowest default risk) to D (defaulted)
Source: BoAML, UBS, as of 1 November 2013




2014: The death of the carry trade?

Greater headline risk and Fed tapering bode poorly.
Jim Rhodes, Strategist

e continue to recommend deemphasizing agency debt within the taxable xed income (TFI) component of the UBS CIO recommended portfolio. We expect a relatively healthy economic recovery in 2014 will motivate the Fed to taper back QE in 1Q2014, the result of which should be a rising rate environment. Specically, we expect this environment to manifest itself as a so-called bearish steepening, where longer maturity rates rise more than shorter maturity rates. Likewise, we expect interest rate volatility to evolve in the same manner, i.e., an overall rise led by longer-term tenors vis--vis shorter-term tenors. This environment generally augurs poorly for the expected total return for the asset class on both an absolute and relative basis. While we dont expect anything approaching what a reasonable person would call substantive regulatory reform of the government-sponsored enterprises (GSEs) next year, we do expect more related headlines. For example, 1) Fannie and Freddie continue to make signicant payments to Treasury as part of the Senior Preferred Stock Purchase Agreement, and 2) the midterm electioneering season kicks into full gear. The combination of higher rates and elevated headline risk historically has been associated with wider spreads and increased spread volatility, neither of which would bode well for the so-called carry trade (i.e., the strategy of buying and holding xed income securities to clip the coupon and roll down the yield curve). Thus, we expect some unwinding of the spread compression that weve seen in high quality, liquid alternatives to Treasury notes (e.g., agency callable and noncallable notes, mortgage-backed securities) as the combination of programmatic central bank buying and the reach for yield trade presumably recedes. We continue to believe that mortgage-backed securities (MBS) will perform broadly in line with the rest of the taxable xed income segment. In other words, we prefer mortgages to agency debt. This is because the additional spread oers relative total return outperformance potential over a oneyear horizon, assuming our interest rate forecasts are realized. Note that this analysis is purely based on changes in interest rates, i.e., it does not impute any spread widening in

either agency debt or MBS. One major concern we have for MBS spreads going forward is that if and when the Fed tapers back its support for the product, its not apparent to us which buyers would replace that demand at current spread valuations, i.e., spreads may widen. Within the mortgage universe, we still like the up in coupon trade (i.e., a preference for higher coupon passthroughs versus lower coupons). This is for two key reasons: 1) higher coupons oer relatively better protection against duration extension than lower coupons; and 2) the Feds QE-related buying has been disproportionately concentrated in lower coupon securities, so their valuations should be expected to weaken disproportionately if and when that support eventually slackens.

Fig. 12: Compressed spread pickups available in agencies and mortgages Agency debt and MBS spreads
100 90 80 70 60 50 40 30 20 10 0 10
31-Dec 31-Jan 28-Feb 31-Mar 30-Apr 31-May 30-Jun 31-Jul 31-Aug 30-Sep 31-Oct

Agency bullet Agency callable


Source: Bloomberg, Yield Book, UBS Note: Spreads to 10yr Treasury for 10yr agency bullet, 10yr non-call 3mo agency callable and 30yr current coupon mortgage pass-through




Managing credit risk

Municipals should outperform treasuries but investors should be prepared for some volatility.
Tom McLoughlin, Strategist



ndividual investors constitute the single most important source of capital for state and local governments. Alone, they hold approximately half of all tax-exempt bonds outstanding. When combined with open-end mutual funds, through which many individuals purchase munis, the retail investor holds roughly three-quarters of the markets nominal value. Individuals favor muni bonds for their tax advantages and oen pursue a buy-and-hold strategy but nancial disclosure practices are inconsistent and pale in comparison with the corporate bond market. The regulatory regime is disjointed and spread across the 50 states and territories, all of which tends to weaken price transparency and contributes to periodic bouts of volatility. The municipal market responds by lurching between extended periods of tranquility and abrupt interludes of instability. The most recent bout of price volatility began in May 2013 on the heels of Chairman Bernankes inference that the Fed would begin tapering its large-scale asset purchases. The prospect of higher rates was enough to convince many investors to focus on duration risk in their portfolios and redeem mutual fund shares at a record pace, a trend reinforced as net asset values declined. Previous periods of market instability have been short-lived aairs. Indeed, market sentiment improved in late September as more state governments reported better nancial results. However, while the fourth quarter of 2013 oered a brief respite, the year ahead is shaping up to be a volatile one for four reasons.

managed to upend traditional notions regarding the safety of GO debt. We expect that litigation surrounding the Motor City bankruptcy will extend beyond 2014, and initial bankruptcy court decisions will add to investor uneasiness.

Puerto Rico credit challenges

The Garcia Administration has taken a series of responsible steps to close the structural budget decit but the islands economy remains mired in recession. The Commonwealth of Puerto Ricos bond ratings are likely to decline further, placing the GO bonds into a speculative grade category. Although the willingness of the current administration to repay its debt in a timely manner is clear, rating revisions will make it more difcult to access the capital markets. Puerto Ricos bonds are widely held and rating revisions would lead to further selling pressure.

The specter of tax reform

Legislative initiatives to curtail or eliminate municipal bond tax exemption resurface periodically on Capitol Hill and most die a quiet death in committee. However, Congress did come perilously close to limiting the benets of tax exemption for higher income households in late 2012 and political support for a restriction on federal tax exemption is evident in Washington. While we believe that passage of comprehensive tax reform legislation is unlikely, investors should be prepared for the inevitable municipal bond price volatility that accompanies any debate over limiting the tax advantages of municipals.

Pension liabilities garner attention

Insufficient contributions, optimistic investment return assumptions, and poorly negotiated collective bargaining agreements have contributed to an escalating pension burden that is unsustainable in the long run. Detroit, San Bernardino and Stockton all opted for bankruptcy in the wake of an economic recession that robbed them of their ability to make scheduled retirement and post-employment benet payments. Detroits decision to le for bankruptcy protection will have far-reaching implications for the municipal bond market. By treating general obligation (GO) bondholders and pensioners as a single class of unsecured creditors, the city has

Rating agencies diverge

The municipal market, more than most, is highly reliant on bond ratings. Unfortunately, the three principal rating agencies oen appear to be working at cross-purposes. While Fitch registered more rating downgrades than upgrades in the third quarter of 2013, S&P raised its assessment of local government debt more oen. Meanwhile, Moodys has elected to apply a lower discount rate to local government pension liabilities. Rating revisions will surely follow. All three rating agencies remain under regulatory scrutiny and are likely to pull the trigger on rating changes more quickly than in the past.




Look back to look forward

Investors should set their rearview mirrors on the recent past.
Henry Wong, Strategist

referred investors can take a page out of 2013 to help them navigate the year ahead as the uncomfortable prospect of Fed tapering will surely be a focal point toward the beginning of the year. So, just as we ushered in 2013 with a cautious view on securities with long duration, we again expect interest rates to be the primary driver of market valuations next year. Demand from individual investors is likely to remain tempered by the expectation of rising rates, although the outlook for robust new issuance of xed-to-oat structures is sure to spark investor interest. With credit spreads currently range-bound at levels approximately 110bps wider than the historical average of 190bps, we expect material spread widening to be a less likely scenario in the year ahead. The worst of the Eurozone debt crisis is seemingly behind us. Furthermore, systemically important US nancial institutions have been bolstering their capital and liquidity ratios at an encouraging pace. The concentration of bank issuers in the preferred market makes the reduced systemic concerns particularly relevant. We are generally comfortable with the improved issuer fundamentals and continue to look for preferred credit spreads to cushion some of the interest rate movements as the 10-year Treasury heads toward the 3.3% mark forecasted by CIO in the next 12 months. In 2014, we foresee possible risks stemming from a few areas that are mostly demand-based in nature. First, average coupon rates have been dropping steadily since the beginning of 2012, to 6.6% on average, as issuers took advantage of strong demand and lower interest rates to renance debt at historically low xed rates. The now deeply discounted prices of where these preferreds currently trade and the forecast for a continued rise in rates should keep investors cautious. Second, outows from the preferred securities asset class have been signicant since the second half of 2013. Unless these outows subside, they could further weigh on performance in 2014. Third, supply tends to follow demand and the second half of 2013 saw a diminishing supply of new issues, which is typically a sign of a jittery market.

On balance, we look to the year ahead with cautious optimism. With the largest US banks estimated to raise additional regulatory capital to the tune of USD 50bn60bn in the next two years, investors should expect new issues to oer higher coupons to conform to a higher rate environment and spur investor demand. Inevitably, we believe most preferreds with xed low coupons that trade to their perpetual/long maturity dates will be subjected to further price pressure. This phenomenon is already unfolding with recent new issuance being repriced with higher yield levels, in the 7% range. These new securities may serve to be the new benchmark toward which preferred yields will eventually converge, with some adjustments in spread premium according to the individual securitys credit quality.

Fig. 19: Preferreds not created equal Cumulative total return, index 31 (August 2013 = 100)
105 104 103 102 101 100 99 98
31-Aug-13 15-Sep-13 30-Sep-13 15-Oct-13 30-Oct-13 14-Nov-13
Capital securities Euro Tier 2
Source: BofAML, UBS, as of 15 November 2013

Euro Tier 1 Fixed rate preferred (retail)






Tiptoeing out the yield curve

Barry McAlinden, Strategist Michael Crook, Strategist Andrea Fisher, Strategist

Tiptoeing out the yield curve will outperform cash

Rates on cash-like investments will remain near zero for the foreseeable future and then rise only very gradually. This comes at a time when many investors are holding an unusually high amount of cash on hand as a means to boost condence. Some of the safety or low volatility that cash provides can still be obtained by venturing incrementally further out the maturity spectrum into shorter maturity xed income instruments of up to four years in maturity.


nlike during prior cyclical economic recoveries in the US, rates on the short end of the curve are unlikely to rise sustainably in the near term. With cash rates likely to remain anchored until 2015, we recommend that investors redeploy excess cash into short-term credit instruments.

We recommend laddering short-term bonds

With rates on cash instruments expected to remain near zero, holding individual bonds or bullet exchange-traded funds (ETFs) that have specic short maturities can be an eective strategy. The advantages of utilizing individual bonds include more certainty in the ladders coupon cash ows and principal redemption value. By using ETFs, investors can more broadly diversify their credit issuer exposure. Laddering bond maturities is oen considered to be a buy-and-hold strategy since investors will take the principal proceeds of each maturity and redeploy at the new prevailing market rate, which increases in a rising rate environment.

Long end of the curve aected by multiple variables

As the post-crisis economic recovery slowly gains traction, investors have been preparing portfolios for the rising rate environment that is typically associated with the tightening phase of the monetary cycle. Longer-term Treasury rates have historically increased during Fed tightening cycles, and we expect this time to be no dierent. As weve witnessed recently, however, near-term swings in long rates can be quite erratic. The long end of the curve is inuenced by multiple and oen complex variables including ination and term premiums, and even possibly a sovereign risk premium. In other words, when forecasting the level of long rates, the cone of predictability can be wide.

Fig. 13: The Fed funds rate inuences short-term yields Yield, in %
8 7 6 5 4 3 2 1 0 1 92 94 96 98 00 02 04 06 08 10 12 14

Curve to remain steep at the short end

The short end of the curve, on the other hand, tends to be a bit more straightforward as its direction is directly tied to the Fed funds target rate. One of the most unprecedented aspects of the current economic recovery is that we remain in a unique monetary policy environment where the Fed is committed to keeping short rates low for an extended period, even aer its large-scale asset purchases are complete. This means that the short end of the Treasury curve should remain fairly well anchored at current levels and the shape of the curve will remain steep, even as it shis upward.

Fed funds rate 2-year Treasury

3-month Treasury bill

Source: Bloomberg, UBS, as of 18 November 2013




Stay stocked up on stocks

Global equities delivered annual returns of more than 15% over the past ve years and some equity indices reached new all-time highs in 2013. While investors might start to question the future potential of the asset class, we still see good value in equities.
Jeremy Zirin, Strategist Walter Edelmann, Strategist Markus Irngartinger, Strategist

he robust rebound in global equities that characterized 2013 should continue in the coming year due to increased global economic growth and corporate earnings. In our view, the asset class still oers the requisite upside to justify a solid longer-term portfolio allocation, though we caution investors who may be spoiled by the gains of recent years to temper their expectations. Despite the rather tepid increase in overall corporate earnings in 2013, global equities went right on rising, paced by the developed market indices and buoyed by the removal of several political roadblocks. US policymakers failure to resolve the US budget and debt ceiling issues resulted in the Federal Reserve delaying its decision to scale back its quantitative easing (QE) program, which kept its ultra-loose monetary bias in place and eliminated a key market concern. Worries that governments in Europe, mainly that of Italy, might fail proved unfounded, bolstering market sentiment. Developed markets also beneted from additional evidence that the US nancial system had largely healed from its crisistime wounds, and that deleveraging in Europe was proceeding apace. The unfortunate consequence of the climbing equity prices in the face of unimpressive earnings is that price-toearnings (P/E) ratios have risen and earnings yields fallen (see Fig. 14). The earnings yield is a measure of a companys ability

to deliver returns to investors, whether by issuing dividends, buying its shares back or investing in growth. The current cyclically adjusted reading of greater than 5% still compares favorably with the low real yield of less than 1% on 10-year US Treasuries, even if it is below last years mark. Thus, the near-term return potential occasioned by a re-rating of equities the falling equity risk premium driving the earnings yield further down is also more limited. This applies to all regions that have shown strong stock market performance.

US remains a portfolio linchpin

We prefer the US and the Eurozone market. With the global cycle strengthening and the Eurozone making progress on multiple fronts, equities become increasingly interesting. With regard to Japan, we need to see clearer signs from the government, as we near the April tax hike, that it will apply strong scal and monetary measures to alleviate the tax increase. The Eurozone, for its part, must forge ahead with deleveraging and establish a unied banking system while repairing still-broken credit channels in the peripheral countries. Emerging markets need to demonstrate that they can deal with political and structural impediments: countries with current account decits in particular will have to adjust to less global liquidity, and China must plow ahead with such






reforms as liberalizing its interest rates and opening up its state-dominated service sector while curtailing the risks associated with its ve-year credit boom.

Central banks to remain market focal points

In addition to earnings strength, political factors will strongly aect equity returns in 2014. The timing and magnitude of the Feds QE tapering decisions will dominate the markets attention. By contrast, we think US scal policy risks will play a less dominant role, though they could cause further bouts of volatility as deadlines for raising the spending authority approach. We expect the Fed to start scaling back QE amid strengthening growth but continued low ination. This positive backdrop should enable US equity markets to endure the move to tighter money, despite the potential for higher bond yields to temporarily raise growth concerns. Such setbacks might create attractive entry points for investors who want (more) exposure to the US. In Europe, the European Central Bank (ECB) will remain the center of attention as it probes the health of the Eurozone nancial system and urges on its deleveraging eorts. We consider the system up to the challenge, although some smaller and mid-sized banks on the periphery might encounter problems. Overall, the ECBs rst steps into its new role as

Listed real estate alluring

Thomas Veraguth, Economist Karsten Bagger, Strategist
Global listed real estate remains attractive in the current environment. Better global growth, good access to nancing, low supply overall and low rates sustain fair valuations. We expect investors to move further away from low-yielding bonds and focus increasingly on real estate as net asset values and earnings rise by high single-digit percentage rates. Dividend yield should stay around 4% as payout ratios are at historical lows. Compared to 2013, listed real estate companies face slightly slower earnings growth, but the main impediment to their performance would be a real interest rate shock. The companies, however, are less sensitive to rising rates today. Conservative management has led to greater duration on loans. Their real estate portfolios are healthy, and the companies are working to strengthen their rental income and improve their renancing strategies.




a single banking supervisor should help rebuild investor condence and li equities. We expect the ECB to maintain easy liquidity conditions, which will limit the impact of any Fed tightening on the European economy. The gradual Eurozone economic recovery should translate into rising earnings and enable Eurozone equities to outperform markets like the UK and Switzerland, with their greater share of defensive sectors such as healthcare and consumer staples. Monitoring the progress of the recovery is crucial as ongoing economic malaise in weak countries could bring back euro exit fears. Japan will face a test of Abenomics, the scal policies named aer Prime Minister Shinzo Abe, as April approaches and indirect taxes rise from 5% to 8%. We expect a sharp but temporary economic contraction, with part of the tax hike blow being counteracted by supplementary scal measures. Aer the boost the Bank of Japan (BoJ) measures gave equities last year by drastically weakening the yen and contributing to a broad earnings rebound, further gains will hinge on additional, difcult-to-time policy moves, including the BoJ buying equities. On the governments willingness to enact true reform by ring the so-called third arrow of Abenomics from its quiver, we are skeptical.

Fig. 14: US earnings yield suggests upside for equities Cyclically adjusted earnings yield; in %
12 10 8 6 4 2 0 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 Cyclically adjusted earnings yield
Source: Thomson Reuters, UBS, as of 26 November 2013

EM with improving earnings, but countryspecic challenges

Emerging market (EM) countries display highly dierentiated economic, political and monetary conditions. With exports expected to boost growth moderately, we expect EM company earnings to rise by about 10% in 2014, which should help broadly diversied EM equity indices to make gains. Investor concern about structural and liquidity issues that surfaced in 2013 will not simply vanish, though. Countries with current account decits like India, Indonesia and Turkey could face renewed currency pressure from capital outows when Fed tapering re-enters the discussion. Although our base case calls for China to avoid a hard landing, we see its nancial companies being forced to recognize some of their bad loans, and a few of its basic resources rms having to face the fact that they are operating in a sector with vast excess capacity.





Further fuel for cyclicals

Cyclicals should outperform defensives in 2014.
Jeremy Zirin, Strategist



ectors of the US equity market that are most sensitive to changes in economic growth, i.e., cyclical sectors, outperformed defensive sectors in 2013 and we expect further outperformance in 2014. The strong relative performance of cyclicals over defensives may seem surprising considering the fact that US real GDP growth decelerated from 2.8% in 2012 to just 1.7% (UBS forecasts) in 2013. So, why did cyclicals outperform in an environment of slowing US GDP growth? We identify three main drivers: 1. Valuation. At the beginning of 2013, cyclical sectors traded at an 11% discount relative to defensives compared to their long-term 8% average premium valuation. 2. Rising interest rates. Defensive sectors carry higher dividend yields. Rising interest rates are not only a signal that economic growth is improving (boosting earnings prospects for cyclical sectors), but also reduce the relative attractiveness of the defensive, high dividend yielding sectors. 3. GDP is not the only measurement of economic growth. Other indicators, such as purchasing managers surveys, housing starts, auto sales, and the unemployment rate, all experienced meaningful improvement during the year. Additionally, GDP growth was largely constrained by reduced government spending. Private sector GDP remained resilient in 2013. From this perspective, 2014 should be another solid year for cyclicals as the drag from higher taxes and lower government spending fades, and as the US expansion broadens and shows increasing signs of becoming self-sustaining. Our economists expect US real GDP growth to accelerate to 3% in 2014. Furthermore, as economic growth prospects improve, interest rates are likely to head higher. Our xed income team forecasts 10-year Treasury yields to rise to 3% in six months and to 3.3% in 12 months a further headwind for the higher-yielding defensive sectors. And while cyclical sector valuations are no longer at extremely low levels (as was the case one year ago), cyclicals remain inexpensive compared to defensive sectors. So in a nutshell, cyclical sectors remain undervalued relative to defensives and should deliver stronger earnings growth over the next 12 months. Mix in the prospect of rising

interest rates and we expect 2014 to be another year of cyclical sector outperformance. But which of the cyclical sectors Consumer Discretionary, Technology, Industrials, and Materials appear best positioned? During the past year, Consumer Discretionary has delivered the strongest performance of the ten S&P 500 sectors. This sector typically performs best during the early stages of an economic expansion as low interest rates spur recoveries in two of the sectors most important end-markets housing and autos. As the economic expansion broadens to also include stronger manufacturing activity and an increase in business spending on capital equipment, we believe investors should focus on the beneciaries of an upturn in capital spending. In our view, the Industrials and Technology sectors the sellers of capital equipment as well as Financials, are poised to be the market leaders of 2014.

Fig. 15: Rising rates, driven by stronger growth, is a positive for cyclicals Performance of cyclicals vs. defensives and 10-year Treasury yield
106 104 102 100 98 2.2 96 94 92 90 88 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 2.0 1.8 1.6 1.4 3.0 2.8 2.6 2.4

Cyclicals vs. Defensives (le) 10-year US Treasury yield (right), in %

Source: Bloomberg, Thomson Datastream, UBS, as of 2 December 2013





Water: thirst for investments

Alexander Stiehler, Analyst Sebastian Vogel, Analyst

and presents opportunities for companies specializing in improving water quality. We also expect shale gas/oil development, which is booming in the US, to raise water-treatment expenditures. Between 7.5 million and 19 million liters of water per well, depending on the shale play, are used in the fracking process and need to be treated.

Stronger earnings growth key to outperformance

The US and, in particular, Europe continue to face a lowgrowth economic environment in the wake of the 200809 global recession. This situation may persist for several more years due to the high indebtedness of both regions. Finding companies that can increase their earnings in such a landscape and benet from strong investment in emerging markets is important. We think water-exposed companies can do so and expect strong earnings growth from them over the next 12 months.

he worlds population exceeds 7 billion, and the UN estimates that this number will rise to 9.3 billion by 2050. This growth will increase demand for food, energy and consumer products, all of which require substantial amounts of water to produce. Over the next 12 months, we expect companies tied to water infrastructure, treatment, etc. to outperform the global equity market.

Long-term trends favor companies exposed to water themes

Water forms the basis for a sustainable business model since it entails a growing demand little aected by economic conditions. We estimate the global water market to be USD 450-500bn, and to have an annual growth rate of roughly 6%. Long-term trends such as population growth, higher living standards, urbanization, industrialization in emerging markets, lack of infrastructure and climate change all aect the availability and quality of water. In addition, we have identied three additional factors that should add earning power to companies exposed to them ship ballast water treatment, US shale development and desalination.

Fig. 16: S&P Global Water vs. MSCI World Jan 2003 - Sep 2013
250 200 150 100 50 0 50 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13

Major infrastructure investments needed

Currently, a little more than half of the global population lives in urban areas. The UN expects this share to grow to 60% by 2030. Growing urban areas require substantial investments in water infrastructure, which is oen already strained. For example, the US Environmental Protection Agency estimates that 60% of all US water main pipes will be classied as substandard by 2020.

Water treatment oers opportunities

Another threat to freshwater supply is industrialization in emerging markets, which has oen been associated with a disregard for the environmental impact of waste water

S&P Water MSCI World TR

Source: Bloomberg, UBS, as of 27 September 2013





Energy independence: forward march

Nicole Decker, Analyst


transportation fuel base. In addition, by 2016, we project the US to be a natural gas exporter. This should help support natural gas prices, which have hovered at cash breakeven levels. However, the US will retain its relative energy cost advantage versus the rest of the world due to its ability to meet its natural gas needs with domestic resources.

Infrastructure continues to lag

Rapid oil and natural gas production growth in the US and western Canada has created bottlenecks in transport and processing capacity. More pipeline and rail capacity is needed to efciently move product away from the wellhead. Meanwhile, bottlenecks have created regional supply gluts. US reners are beneting from the lowercost crude supplies. They have also beneted from rising rened product demand in Latin America, where growth in rening capacity has been limited. The US has turned from a top importer into a large exporter of rened product.


he potential for North American energy independence by the end of the decade, made possible by new shale drilling and extraction techniques, has become widely recognized and accepted. Supported by a structurally high price of crude oil, US oil production is rising at a rapid pace. Abundant and cheap natural gas is creating a competitive advantage for the US by bolstering energy-intensive industrial operations. As the world looks on, we expect growth in US oil and gas supplies to continue to impress in 2014, providing additional economic benets for the US, and opportunities for investors.

Beneciaries beyond energy

Continued progress toward North American energy independence will be a driver of growth within many industry sectors. Beneciaries within the energy industry will include select producers, services companies, reners and pipeline operators. Beyond energy, we see opportunities for companies in sectors such as chemicals, industrials and utilities, as well as engineering and construction, rail, and auto parts.

Ongoing technical advances may help fuel high US production growth in 2014
In each of the past two years, US oil production has risen by 1 million barrels per day, to 8 million barrels per day. This has exceeded expectations, and we believe a high rate of growth may continue in 2014. Operators in the major shale plays are testing higher density drilling, enhanced well design, and other technical and efciency improvements; and early results show potential for meaningful productivity gains. These gains will become more evident as use of these processes becomes more widespread, in our view. Meanwhile, persistently high oil prices, as well as policy initiatives have led US consumers to use fuel more efciently. Domestic consumption of rened products such as gasoline is below historical peak levels, and we expect US oil consumption to continue to decline.

Fig. 17: US crude oil production Accelerated growth over the past two years
8,000 7,400 6,800 6,200 5,600 5,000 4,400 3,800
2008 2009

Positive outlook for US-based natural gas producers and consumers

Abundant supplies of low-cost natural gas support our outlook for greater demand from the industrial and materials sectors. As manufacturing activity increases, the USs share of the global market for energy-intensive industrial products will likely rise. Natural gas has also gained share from coal as a cheaper and cleaner fuel for US power generation. Over time we believe more natural gas will be used as a transportation fuel, helping to diversify the

Thousand B/D

2010 2011

2012 2013



Source: Energy Information Administration, as of 2 December 2013





Dividend investing: dont overpay for yield

Jeremy Zirin, Strategist David Lefkowitz, Strategist Matthew Baredes, Strategist

elative to high dividend yielding stocks, high dividend growth stocks trade at very attractive valuations. We expect high and consistent dividend growers to outperform the highest dividend yielding stocks over the next 12 months (and beyond). Stocks with strong income-generating properties, i.e., dividend paying stocks, are more attractive to investors when interest rates are low. So it should come as no surprise that dividend-based investment styles have gained enormously in popularity. But investors should note that not all dividend-paying companies have the same investment characteristics. While 84% of S&P 500 companies pay shareholders some form of recurring dividend payment, the level of the dividend relative to the companys share price (dividend yield) and earnings (dividend payout ratio) strongly varies across industries and companies, as does the growth rate of the dividends per share paid by companies. Stocks with the highest current dividend yield are trading at high relative valuations compared with history. At a sector level, this becomes quite clear when looking at the current relative sector P/E (price-to-earnings ratio) of some of the highest yielding sectors of the market. Utilities, for instance, has a dividend yield of 3.9% and is currently trading at a 2% P/E premium to the S&P 500 compared to its long-run average of a 14% discount. Alternatively, S&P 500 stocks with more moderate current dividend yields but high dividend growth rates appear much more attractively valued compared to the aforementioned expensive high dividend yielding stocks. In fact, the top decile of dividend growers S&P 500 stocks that have delivered the strongest dividend growth rates over the past 10 years currently trade at a par valuation with the S&P 500. Historically, high dividend growth stocks have traded at a premium to the market. So for investors looking for cheaper yield, high dividend growth stocks are trading at very attractive valuations relative to the highest dividend yielding stocks.

How to implement this investment idea

In October 2003, we launched a report series called the UBS Dividend Ruler Stocks List, a list of consistent dividend growth stocks that grew their dividends as straight as a ruler. This list is our recommended implementation for the theme discussed in this report. The CIO Dividend Ruler Stocks List is comprised of stocks with the following characteristics: attractive yield, solid fundamentals/valuation, strong historical dividend growth, and high dividend consistency.

Fig. 18: Dividend growth still cheap relative to high dividend yield Relative P/Es
1.6 1.5 1.4 1.3 1.2 1.1 1.0 0.9 0.8 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 Relative P/E of high dividend growth versus high dividend yield Average
Source: FactSet, UBS, as of 4 December 2013





A major rebound
The worlds major currencies have weakened in recent years due to loose monetary policy. But with less accommodative conditions on the horizon, currencies like the US dollar and the British pound could benet.
Katie Klingensmith, Strategist Thomas Flury, Strategist



e expect 2014 to be the year when major currencies recover some of the losses they experienced due to the ultra-accommodative monetary policies in place in recent years. We expect the majors especially the US dollar, euro and British pound to outpace the weaker emerging market currencies and even those of some of the commodity producers. Foreign exchange (FX) markets will likely become anxious about potential monetary policy tightening, which in our view will boost major currencies. For strategic investors, we recommend hedging broad international FX exposure.

A currency war that never happened ends

Accusations of a currency war have haunted nancial markets since March 2009, when the Fed started its rst QE program. The currencies of commodity producers and the more liquid emerging markets such as Mexico and Brazil beneted vis--vis the dollar. The rapid appreciation of the Brazilian real caused the countrys minister of nance to accuse the US of pursuing a currency war. The accusations were as hot as the consequences were limited. In practice, the ample central bank liquidity reduced foreign exchange volatility. With interest rates barely above zero and deation threatening, central banks have tried to prevent excessive currency appreciation. The consequence has been FX trading within very tight ranges for major currency pairings over the last couple of years. In 2014 this paradoxical situation is likely to ease, as growth trends are normalizing and markets are preparing for the end of QE. Greater growth in the US, Europe and the UK also allows for more exibility with respect to central bank policy and FX moves. We therefore forecast rising FX volatility and a stronger need to use options and forward contracts to protect against potential moves.

The end of ultra-expansive monetary policy leads to a shi in demand

Demand for the major currencies should increase steadily and start to weaken the higher-yielding currencies like the Australian dollar and the New Zealand dollar, the Scandies (Swedish krona and Norwegian krone) and emerging market (EM) currencies of countries with a prominent scal and/ or current account decit i.e. the fragile ve: the South African rand, Turkish lira, Brazilian real, Indian rupee and Indonesian rupiah. They all proted in 20112012 from dollar weakness triggered by the US Federal Reserves unlimited third program of quantitative easing (QE) and ultra-low interest rates in developed markets. The easing bias and the forward guidance introduced by the European Central Bank and the newly appointed Bank of England Governor Mark Carney in the summer of 2013 reinforced the search for higher-yielding, albeit riskier currencies. With the global economy expected to strengthen and yields set to rise in major currencies, we see appreciation among the latter coming at the cost of expensive commodity-producer currencies like the Australian dollar.

USD to appreciate in coming years

Fed ofcials are at pains to emphasize that scaling back QE3 should not be confused with tightening. Nevertheless, the tapering should strengthen the dollar, as it involves rising longer-term interest rates, which could trigger another sell-o of EM currencies. An actual hike in short-term interest rates is something we forecast for 2015. Once the Fed conrms the end of the nancial crisis by guiding overnight interest rates above ination rates, a clear case can be made for a strong rebound of the greenback (USD). Markets anxious about tapering and tightening will have a bias to buy US dollars. For this reason we see only a limited risk of extended depreciation and a good chance for appreciation in the next few years.



Euro benets from strong fundamentals despite weak politics

The euro is the anti-dollar. Asset managers need to diversify their holdings into an alternative to the dollar, and the second-largest nancial market is in the euro. In addition, Europe as a currency area diers markedly from the US, and has areas of clear strength relative to it. Its ination is lower and its current account has been balanced for many years, so it does not rely on foreign investment inows. Finally, it hosts many highly innovative export industries accustomed to coping with real exchange rate appreciation. However, incomplete political and banking integration and internal ghts about government debt limit the euros attractiveness. Europe also acts less than the US does as a hegemonic power. This last point is important for the US dollar and its role as the international reserve currency.

and the damage from the European debt crisis persists, such that the European Central Bank (ECB) has little leeway to hike rates over the next two years. Such a hike, which would signal the end of the European debt crisis, is in our view the minimum requirement for the SNB to abandon the oor. We therefore see EURCHF continuing to trade in a 1.201.25 range over the next year.

Japanese yen (JPY) to fall

We see USDJPY shiing from a range of 95100 toward 100 110 as the Bank of Japan (BoJ) adopts a more expansionary monetary policy, which will be needed to soen the negative growth impact of a VAT rate hike. The BoJ is likely to wait until the spring to become more accommodative because of import price ination, which rose strongly in 2013 as the yen depreciated. Consumers felt the rise of food and energy prices strongly. In the spring of 2014 these negative eects should have grown out of the year-over-year ination excluding the impact from the VAT hike. Therefore the BoJ will have room to push yen depreciation forward.

Pound delivers a rebound with momentum

The British pound rebounded nicely in 2013 amid an improved macroeconomic environment. For 2014 we expect a sustained appreciation underpinned by higher ination in the UK. Ination in the US and the Eurozone ended 2013 very low, while prices in the UK were rising at close to 2%. On top of this, GDP growth was strong, so the Bank of England may seek to tighten rather than loosen monetary policy. As long as this is the case, we think the pound will remain well supported.

Swiss franc (CHF) oor here to stay for now

It will take another two to three years, in our view, before the Swiss National Bank (SNB) gives up the oor of 1.20 on the EURCHF exchange rate. European price data has been so,





Little in return
Commodities have a distinct appeal for certain investors. However, we expect negative returns in 2014 with demand still muted and supply ample.
Dominic Schnider, Analyst Giovanni Staunovo, Strategist



s real and tangible assets, commodities provide attractive opportunities to benet from specic economic trends. Gold, for example, denitely has its merits as long-term insurance against extreme risks such as hyperination. But aer the mid-to-high single-digit percentage decline in broadly diversied commodity indices over the last year, investors should not expect the asset class to catch up with other risky assets like equities in the year ahead. But that does not mean we dismiss commodities as an asset class. We recommend instead taking tactical exposure whenever short-term opportunities arise. Global economic growth should improve throughout 2014, but only mildly in emerging markets, which have become the biggest consumers of many commodities. China will need to balance its economy by curbing investment growth. And the entire Asian region is poised to expand more slowly as it converges toward the developed world, aer having re-leveraged in recent years, so incremental commodity demand should be so in the market. Keep in mind that China alone consumes more than 40% of global copper production and 50% of global coal. Therefore, most commodity markets will experience excess supply, and any temporary market tightness is likely to be short-lived. The years economic growth should occur primarily in the rst several months, and potential price advances are then expected to reverse and in some cases trigger even lower prices by the end of the year. Thus, investors are well advised to use higher prices in the rst half to exit positions.

expect an average price around USD 100/bbl in 2014, but temporary dips below that mark are likely. Gold is another candidate for lower prices. Outows from gold ETFs as a result of a lack of ination in the developed world and the US Federal Reserve likely starting to taper in the rst half of 2014 could pressure the yellow metal. Although its price fell substantially in 2013, an additional 300500 tons (i.e. 7%11% of yearly demand) of outows from ETFs and futures/option positions in 2014 are forecast to hit the market. They are unlikely to be absorbed even at lower current prices due to prohibitively high import duties in India and fewer central bank purchases. Only a fall in the price of

Fig. 20: Oil supply likely to outpace demand growth also in the coming years Annual global oil supply and demand growth (incl. demand forecast) in million barrels per day
3.5 3.0 2.5 2.0 1.5 1.0 0.5 0 0.5 1.0 1.5 2001 2003 2005 2007 2009 2011 Global oil demand growth Global oil supply growth
Source: EIA, IEA, UBS, as of 26 November 2013


Oil and gold the weak candidates

Commodities that were supported in 2013 due to supply challenges, like crude oil, may no longer enjoy stable prices. Unplanned production outages, which reached record highs last year, are expected to moderate. At the same time nonOPEC supply is anticipated to outpace demand growth in 2014. As a consequence, the crude oil market should be well supplied and force OPEC to cut output (see Fig. 20). We






gold to marginal production costs of USD 1,050/oz1,150/oz (cash cost basis) would balance supply and demand, in our view. Negative spillovers from a lower gold price should be visible in silver, which faces a meaningful fabrication surplus. We advise investors seeking exposure to precious metals to hold the industrially oriented platinum and palladium: both metals are expected to be undersupplied.

A more balanced story in base metals and agriculture

The protability of companies producing industrial metals has dropped in tandem with prices, which should keep them from increasing production meaningfully. Thus, limited supply should prevent prices from falling further, and metals such as zinc and lead even oer modest upside. For both markets we have penciled in a marginal supply decit in 2014. Aging mines and the lack of any incentive to increase production provide the necessary price support. This cannot be said for copper and iron ore. We expect production growth of 6% for the former in 2014 aer strong mine output in 2013, which is likely to weigh on its price throughout the year. Aer more than two years of declines, the prices of agricultural commodities may nally form a bottom in 2014. Rising inventories in key crops, due to a strong production year in South America and the US, have by now been priced in, and are unlikely to further weigh on prices in 2014. On the other hand, it is probably too early to get optimistic. Estimates for the coming year given normal weather conditions point to a solid supply, which can match higher grains demand from emerging markets.




Attractive risk-adjusted returns expected

Hedge funds should form an important part of a well-balanced portfolio. By diversifying return sources, hedge funds can improve risk-adjusted returns for investors who can tolerate moderate illiquidity.
Andrew Lee, Head of Alternative Investments Cesare Valeggia, Strategist




edge funds invest opportunistically across asset classes, using techniques like short-selling and leverage and instruments such as derivatives to pursue compelling returns while limiting downside risk. Managers seek to capitalize on certain market inefciencies not available to classic long-only fund managers. Although hedge funds do not have the same liquidity as traditional assets, they should nonetheless be important strategic components of well-balanced portfolios for investors willing to accept this trade-o, in our view. Our recommended allocations to hedge funds presume diversied exposure across dierent hedge fund strategies; we would advise disproportionate weightings only to target individual preferences. Over the long term, we expect hedge funds to enhance portfolio characteristics due to their lower volatility, their focus on downside protection, and their potential for achieving incremental outperformance due to manager skill. In the year ahead we expect the market environment to remain positive for equity long/short strategies, with low intra-stock correlations and high equity return dispersion supporting the ability of stockpickers to deliver attractive riskadjusted returns. This should create opportunities to generate alpha, the excess return of an investment over its benchmark on a risk-adjusted basis. Rising levels of corporate actions such as mergers & acquisitions should create opportunities for certain event-driven strategies. Macro/trading strategies typically serve a diversifying role in portfolios, producing returns less correlated to other hedge fund strategies and traditional assets. Although discretionary macro managers may be able to reverse lackluster recent performance, with crossasset opportunities unfolding in Japan, Europe and emerging markets, we view systematic strategies less favorably due to the continuing lack of persistent trends. Finally, we

are becoming more cautious on relative-value strategies that depend on high leverage and low-rate volatility. We emphasize the importance of diversifying among hedge fund managers who reect diverse investment styles. Bottom-up manager selection remains critical, particularly in equity long/short, as performance dispersion remains high. Also, we view emerging and midsize managers as better positioned than larger managers to be opportunistic and responsive to macro and market developments.

A positive outlook
Over the next ve years, we expect investments in diversied hedge funds to deliver annual returns of 4%6%, depending on the liquidity of the instruments, with volatility of about 5%7%. This compares favorably to expectations for traditional asset classes. Investors who can tolerate moderate illiquidity should therefore replace some bond and equity exposure with hedge funds.




Complement traditional portfolios

Private markets encompass a range of investment strategies including private equity, private debt, and real assets. Investors willing to commit capital for multi-year periods can access opportunities in private markets that are unavailable in traditional asset classes.
Andrew Lee, Head of Alternative Investments Stefan Braegger, Strategist

he umbrella term private markets encompasses all illiquid strategies that target long-term equity and debt investments in assets not listed on classic stock and bond markets. Although people have historically associated illiquid investments with private equity for the most part, the range of such strategies has expanded to include private debt and real asset strategies. Private market investments oer numerous compelling advantages over traditional investments. Examples include investing in unlisted rms, in companies undergoing turnarounds and in direct corporate lending. Private market managers can also exploit temporary asset mispricing that results either when public markets or private owners value assets differently from their intrinsic or potential value or from shortterm uncertainties. Finally, managers can eect operational and strategic change in the underlying assets and companies to enhance value and generate returns. Allocations to private markets require a long-term perspective, as managers need time to make strategic and operational changes, reposition underlying investments, and exit the investments. Private market strategies are particularly well positioned to capitalize on the following opportunities, in our view: European bank deleveraging. Banks in Europe will continue to deleverage. Private market strategies can take advantage of this situation by lending privately as banks reduce their loan activity and by selectively purchasing assets divested by banks. Contrarian plays. Long-term-oriented private market funds can benet from short-term negative sentiment. For instance, they can purchase peripheral European assets being sold, as

well as investments in emerging markets that target longterm structural shis in sectors less well served by public markets. Energy value chain opportunities. New gas resources, shis toward certain types of renewable energy, and aging infrastructure are creating long-term opportunities that enable investors to tailor energy exposure to their return and risk objectives while potentially mitigating underlying commodity price volatility.

Compelling long-term returns

Over the past two decades, private markets have generated annual returns of 11%15% with 12%15% volatility. We have similar expectations for a diversied private market portfolio in the years ahead. Between 2% and 4% of this return represents the estimated illiquidity premium that compensates investors for their multi-year commitment. In a portfolio context, investors at ease with illiquidity should replace some of their bond and equity exposure with a diversied allocation to private market investments.




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Asset allocation in 2013, a retrospective, pg. 28

Crook, Michael and Brian Nick. Portfolio Positioning: Not a time for complacency. CIO WMR Year Ahead 2013. UBS WMAs Capital Markets Model: Explained, January 2013. Doeswijk, Ronald et al., Strategic Asset Allocation: The Global Multi-asset Market Portfolio 1959-2011 SSRN Working Paper. WMRA Decade Ahead, 2011. WMRA Decade Ahead, 2012. Mariscal, Jorge. The case for emerging markets, revisited. August 28, 2013.

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