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Chief Investment Office WM 16 December 2014

European economySpain: Solid recovery but selectiveinvestment choices

• Spain's GDP will likely grow close to 2%, outperforming theEurozone. Upside risks exist if oil remains depressed and/or theEuropean Central Bank embarks on full-fledged quantitative easing.

• The biggest threat to the Spanish outlook lies in politics. Electionsat all levels in 2015 will fragment the landscape.

• Spanish government bonds are trading close to fair value; asustainable fiscal path has not been achieved yet. Financial sectorbonds look more attractive as solvency is restored.

• The Spanish stock market looks attractive, in our view, given theeconomic recovery and the big weight of banks.

Economy: Hefty cyclical bounce masks an incomplete adjustmentWe forecast economic growth of 1.3% in 2014, rising to 2.0% in 2015and 2.2% in 2016 as construction turns the corner. Spain will thus likelyoutperform the Eurozone as a whole, helped by structural reforms thatare bearing fruit and a much better positioned banking sector. Meanwhile,the enormous output gap – particularly in the labor market with anunemployment rate close to 24% – should keep inflation well below trend,only gradually picking up to 0.7% in 2015 and 1.4% in 2016, subject to asizable downside risk if oil prices remain depressed.

Nonetheless, the rebalancing effort has lost momentum in Spain, as shownin the current account struggling to consolidate its surplus or in the spikein government expenditures. Public debt continues to rise, and private andexternal indebtedness remain huge, keeping the recovery vulnerable.

Table 1. Spain country profile

Spain Forecasts �� Real GDP growth (y/y %) -1.6 -1.2 1.3 2.0 2.2Consumption (% growth) -2.8 -2.1 2.2 2.1 2.1Gov. Expenditure (% growth) -4.8 -2.3 1.1 -0.7 -0.3

Construction (% growth) -9.7 -9.5 -4.4 1.6 3.5

Other investments (% growth) -2.5 1.7 5.8 3.7 6.9

Net exports (% contrib. GDP) 2.4 1.5 -0.3 0.0 -0.1

Current Account (% of GDP) -0.4 0.8 0.0 0.7 0.8

Consumer Prices (year end) 2.4 1.5 -0.1 0.7 1.4

Budget Deficit (% of GDP) -10.3 -6.8 -5.8 -4.6 -3.5

Public Debt (% of GDP) 84.4 92.1 98.1 99.9 100.2

Unemployment Rate (average) 24.6 25.9 24.8 23.5 22.3

2013 are actuals. 2014 forward are estimates. Source: INE, European Commission, UBS

Roberto Luis Scholtes Ruiz, economist, UBS [email protected]

With contributions from:Ricardo Garcia-Schildknecht, economist, UBS AGThomas Wacker, CFA, analyst, UBS AGClaudia Sigl, analyst, UBS AGJens Anderson, CFA, FRM, analyst, UBS AGElena Guglielmin, analyst, UBS AGFabio R. J. Trussardi, analyst, UBS AGThomas Veraguth, economist, UBS AG

Related research• European Economic Outlook, 3 November 2014

• Bank stress tests done, Eurozone implications,27 October 2014

• Spain real estate: trough in sight, but recoveryto be slow and uneven, 30 Apr 2014

Fig. 1: A smaller fiscal restraintChange in the cyclically-adjusted primary budgetbalance

-1.5-1.0-0.50.00.51.01.52.02.53.03.5

Fran

ce

Ger

man

y

Irela

nd

Italy

Spai

n

2011 2012 2013 2014 2015 2016

Source: European Commission, UBSFootnote: Based on the "no policy change" rule in 2016. 2013 are actuals.2014 forward are estimates.

Fig. 2: Corporate sentiment points to ongoingrecoveryMarkit PMI index for Spain

283032343638404244464850525456586062

01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

MANUFACTURING PMI

SERVICES PMI

50

Source: Markit, UBS

This report has been prepared by UBS AG. Please see important disclaimers and disclosures that begin on page 14. Past performance is no indication of future performance. Themarket prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication.

The healing labor market and solid consumer confidence sustain con-sumption, while export-related fixed investments keep growing firmly. Thefiscal restraint is decreasing as Spain approaches an intense election yearin 2015 and construction is no longer a drag. Hence, domestic demandis expected to recover almost at a 2% annual rate. Net trade, which hasturned negative again mainly due to imports rising along with the domesticrecovery, should become slightly positive again as the Eurozone and theglobal economy recover and the effects of the weaker euro feed through.This pace of growth is expected to continue as long as the global cycle con-tinues, credit conditions improve and the political situation remains stable.

The external sector remains the brightest spot in the Spanish economy.The ongoing "internal devaluation" process will keep salaries in check,allowing Spain to leverage its improved competitiveness. That said, theglobal activity pothole and the lagged effect of EUR strength have harmedSpanish exports, which were growing just 1.6% y/y in the 12 monthstill September. However, we forecast exports to reaccelerate towards 5%based on stronger global growth, improved competitiveness and the EURdepreciation. But as domestic demand recovers, imports will realign withexports and the improvement in the trade balance should fade in 2016. Infact, net exports decreased from 2.4% in 2012 to 1.5% in 2013 and wouldhave lost an estimated 0.3% in 2014.

Spain currently runs a EUR 41bn (4.0% of GDP) energy trade deficit. If oilprices stayed depressed at around USD 70/barrel, the trade balance couldimprove almost by 1% of GDP after several quarters. This would make netexports positive again, with an upside risk to our GDP forecasts. We expectthe trade surplus to hover above 2.5%. As households and companies holda financing surplus and lower interest rates rein in the income balance,the current account should become positive in 2015. This surplus seemsinsignificant to reduce an external debt (Net International Financial Position)that has expanded to EUR 1.02trn (101% of GDP). This huge external claimon Spain will take many years to come back to a more sustainable level,making Spain very sensitive to interest rates, spreads and foreign investorappetite.

Private sector indebtedness remains very high as well. Despite a materialreduction of outstanding loans (due in part to bankruptcies, write-downsand transfers to the "bad bank"), the combined debt of corporations andhouseholds amounted to a 191% of GDP, albeit down from 222% in 2010.This still represents a big burden when income and earnings are depressedand the value of the real estate collateral has slumped. Therefore, weexpect private deleveraging to continue several more years, hampering con-sumption and investment. But this deleveraging effort is compensated bythe huge accumulation of public debt, and total (ex·banks) gross debt stillhovers around 290% of GDP. Also, the public sector thus exerts a crowding-out effect on credit availability for private sectors.

The labor market is slowly healing as reforms have brought flexibility,reduced dismissal costs and red tape and are helping to rein in salaryincreases. Export and tourism-related activities are leading job creationwhile the public sector will continue destroying jobs due to the lowreplacement rate of retiring employees. A creation of around 200,000annual net payrolls combined with the loss of active population will reducethe unemployment rate by more than a 1% per year, moving from thecurrent 24% to 21.7% at the end of 2016.

Fig. 3: Improved relative competitivenessUnit labor costs for the whole economy (2000=100)

80

85

90

95

100

105

110

115

120

125

130

135

140

95 96 97 98 99 ·00 ·01 ·02 ·03 ·04 ·05 ·06 ·07 ·08 ·09 10 11 12 13 14

Germany

Spain

France

Euro area (17countries)Italy

From 2008 average:Spain -6% France +10%Germany +11% Italy +9%Eurozone +8% OECD +6%

2013 are actuals. 2014 forward are estimates. Source: OECD, ECB, UBS

Fig. 4: Exports should revive but imports haverisen swiftlyReal goods imports, exports and fixed investment

30

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100

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95 96 97 98 99 ·00 ·01 ·02 ·03 ·04 ·05 ·06 ·07 ·08 ·09 10 11 12 13 14 15 16

Goods importsGoods exports

Gross fixed investment

2013 are actuals. 2014 forward are estimates. Source: INE, UBS

Fig. 5: Unemployment slowly declining, helpedby shrinking active populationJobless in thousands and unemployment rate (%)

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

5,500

6,000

6,500

4%

6%

8%

10%

12%

14%

16%

18%

20%

22%

24%

26%

28%

96 97 98 99 ·00 ·01 ·02 ·03 ·04 ·05 ·06 ·07 ·08 ·09 10 11 12 13 14 15 16

Unemployment rate (lhs)Construction employmentUnemployment INE ('000)


European economy

UBS CIO WM 16 December 2014 2

Even so, the number of employees would remain below 18 million by 2016,about three million less than in 2007. Therefore, social security will remainin deficit. This turnaround in employment, the reduction in personal incometax rates and a further decline in the savings rate would allow real con-sumption to grow close to 2% and some pent-up demand to surface.

As the tightening of public expenditures is smaller than agreed in the Sta-bility & Growth Programme 2014-17, the budget deficit reduction relieson the increase in tax revenues, which in turn are pinched by disinflationand the announced Tax Reform. Lower-than-budgeted debt service shouldcause Spain to miss its budget deficit target of 5.5% this year, 4.2% in 2015and 2.8% in 2016 by a few tenths of a percentage point. Nevertheless,Spain won't register a primary fiscal surplus until 2017. Therefore, debt-to-GDP will only likely stabilize by 2016 at close to about 100% and fiscalsustainability has not been achieved yet.

Despite this positive cyclical backdrop, Spain's healing remains fragile andhighly dependent on external economic and financial conditions. Part ofthe cyclical bounce is due to imbalances that haven't been fully correctedand to the vulnerable recovery:

1. Public sector downsizing is proceeding slowly;

2. Households and companies are still highly indebted;

3. The turn in the current account is small and insufficient to significantlyreduce the huge external debt;

4. The recovery could be threatened by rising political instability as local,regional (May) and national (November) elections in 2015 will likelyresult in weaker governments. The Catalonian challenge has to beaddressed.

In conclusion, Spain is consolidating its cyclical recovery ahead of theEurozone average pace. Most factors are aligning to sustain 2% GDPgrowth in the next 2-3 years, providing time to continue correcting theeconomic imbalances. But the high public and private indebtedness keepSpain vulnerable to any material deterioration of the external or internaleconomic, financial or political environment.

With contributions from Ricardo Garcia-Schildknecht

Fig. 8: GDP growth is settling around 2% on domestic demandContribution to annual GDP growth (%)

-9%-8%-7%-6%-5%-4%-3%-2%-1%0%1%2%3%4%5%6%7%8%

96 97 98 99 ·00 ·01 ·02 ·03 ·04 ·05 ·06 ·07 ·08 ·09 ·10 ·11 ·12 ·13 ·14 ·15 ·16

HOUSEHOLD CONSUMPTIONGOVERNMENT CONSUMPTIONNON-CONSTRUCTION INVESTMENTRESIDENTIAL CONSTRUCTIONNON-RESIDENTIAL CONSTRUCTIONNET TRADETOTAL GDP GROWTH

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Fig. 6: Private sector deleveraging is compen-sated by rising public debtGross debt as a % of GDP

0%20%40%60%80%

100%120%140%160%180%200%220%240%260%280%300%

96 97 98 99 ·00·01·02·03·04·05·06·07·08·09·10·11 12 13 14 15 16

Government Debt (% GDP)

Households Debt (% GDP)

Non·Financial Corporate Debt (%GDP)

2013 are actuals. 2014 forward are estimates. Source: Bank of Spain, INE, UBS

Fig. 7: Budget deficit is correcting, still slightlymissing targetsGeneral government balance (EUR bn and % ofGDP)

-3%-2%-1%0%1%2%3%4%5%6%7%8%9%10%11%12%13%

(30)(20)(10)

0102030405060708090

100110120130

95 96 97 98 99 ·00 ·01 ·02 ·03 ·04 ·05 ·06 ·07 ·08 ·09 10 11 12 13 14 15 16

Budget Deficit (bn EUR)

Budget Deficit (% GDP)


European economy


Spanish politics: Prospect of a more fragmented and uncertainpolitical landscapeDespite the better economic and financial outlook in Spain, cautionremains a watchword in politics. As long as the global recovery cycle con-tinues, the biggest threat to the Spanish outlook lies in politics. Local andregional (in 13 out of 17) elections are due next May, and national elec-tions in November 2015. Amid serious corruption scandals and the socialannoyance caused by public expenditure cuts, the Popular Party's supporthas plummeted and a strong left-wing anti-establishment party, Podemos,has arisen from the 15-M (indignados) movement. All polls are pointingto the loss of absolute majorities almost everywhere and to much morefragmented councils and parliaments. Government's ability to pass furtherlaws, reforms or tightening measures will become an issue and the much-needed structural reforms could even be reversed if a left coalition cameto power.

Nevertheless, until the general elections, the PP's ruling government enjoysa solid majority and the 2015 budget and tax reform will be swiftlyapproved by the Parliament. After the general elections, the most plausiblescenario is a grand coalition between the Popular Party and the SocialistParty, in our view, as has occurred in many other European countries. Inthis case, reforms would continue at a slower pace, the sovereign spreadwould keep narrowing and the IBEX would perform in line with or evenoutperform other indices. But many other scenarios could be drawn, theworst of which would be a complete stalemate that would require newelections being called in 1Q16. This would dampen confidence sharply,Spanish assets would suffer, and the recovery would be at risk.

As these scenarios unfold, Spanish bonds and equities are prone tosomewhat higher volatility with possible moderate spikes in sovereignspreads which could lead to episodes of IBEX underperformance. TheSpanish Treasury debt is ceasing to be a one-way bet on narrowing spreadsand, from now on, will probably have a less clear trend. Nonetheless, if theBono-Bund spread was to leap (or the IBEX to underperform) materially, itcould present an opportunity to jump into some assets.

Fig. 9: Voter shift as Podemos appears in the bipartisan systemOfficial quarterly poll on voting intentions

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Box 1. The Catalonian issue

The Catalonian struggle remains unresolved after the 9-N polling. Additional declarations in favor of indepen-dence will be made by the Catalonian government andparliament and a "plebiscite election" on independenceis a distinct possibility in the next months. Nevertheless,a compromise solution cannot be expected until a newnational government is formed in early 2016 (particularlyif it is formed by the grand coalition). Only then coulda deep reform of the regional funding system and somechanges in the Constitution be agreed, fulfilling the desirefor a fairer fiscal system and stronger regional sovereignty.

European economy


Sovereign debt: Limited room for further spread narrowing whilerisks mountGiven the subpar economic recovery and the absence of inflation, the debt-to-GDP ratio will climb to 96% this year and close to 100% in 2016. Onlyfrom 2016 on, when a primary surplus is achieved and nominal GDP growthexceeds 3%, would public indebtedness begin receding. Assuming that apart of the big financial items (Bank Recap-FROB 5.6% of GDP; ElectricityTariff Debt-FADE 2.2%; Fund for Suppliers 3.1% plus participation in thebailout of several Eurozone countries) that enlarged the gross public debtfigure are recovered gradually, the debt-to-GDP ratio could come downtowards 93% at the end of this decade.

But Spain is still far from achieving a long-term sustainable fiscal position.A global recession this decade would find Spain in a still fragile positionthat could even put solvency at risk. Our view is that the solvency of theKingdom of Spain is not at risk in the short and medium term based on theongoing economic recovery and the overall friendly market environmentfor risky assets. Nevertheless, the recent positive news flow from Spainseems to be fully reflected in bond markets, so that temporary setbacksin the fragile recovery could trigger corrections. We think that, in lightof long-term debt concerns, buy-and-hold strategies should be limited toshort-term bonds, while medium-term bonds should only be considered astrading instruments if yields were to rise substantially.

The steep fall in peripheral sovereign spreads, a lower Bund yields curveand the ECB measures are causing the average cost of Spanish debt to fall.This keeps interest on debt from soaring in line with the outstanding debt.The Treasury is taking advantage of this environment by lengthening matu-rities and launching new instruments like inflation-linked bonds and 50-year tenures. Our models point to a fair 10-year spread over German Bundsat around 135bps in 2014, 90bps in 2015 and 70bps in 2016, althoughECB actions could speed up the spread narrowing.

Nevertheless, markets may be discounting a sovereign QE by the ECB toomuch, so disappointments could cause some temporary spikes in sovereignspreads. In addition, it must be taken into account that we expect GermanBund yields to grind higher as the US yield curve moves upwards. So,despite a possible Spanish Bonos spread tightening, nominal yields areexpected to move sideways or even slightly up, meaning that total returnsaren't expected to surpass their starting yield-to-maturity.

With contributions from Thomas Wacker

Regional bonds: Similar credit risk to Spain but on an insufficientilliquidity premiumTotal debt of the autonomous regions has soared from EUR 61bn in 2007to EUR 232bn in 2Q14, moving from 5.8% to 22.0% of the Spanish GDP.There is no legal or constitutional obligation for the Kingdom of Spain tofinancially support its regions, but when they were cut off from capitalmarkets and the Spanish sovereign spread began to escalate, the centralgovernment reacted swiftly to avoid any regional default that could havecreated a domino effect that most probably would have caused the SpanishTreasury to lose market access and Spain to be bailed out. In July 2012the Regional Liquidity Fund (FLA) was created. This scheme enables thecentralization of the public debt issuance for the regions unable to fundthemselves in the market, while ensuring their fiscal sustainability as it islinked to strengthened budgetary conditionality and supervision. In fact, theBudgetary Stability Law has become a transposition of the EU Fiscal StabilityPact rules, including forceful control and sanctioning measures that applyto the regions and municipalities. Therefore, the risk of a serious budgetary

Fig. 10 Public debt has trebled but will onlyrecede graduallyDistribution of the Spanish government debt byissuers (% of GDP)

05

101520253035404550556065707580859095

100105

91 9293 94 95 969798 99·00·01·02·03·04·05·06·07·08·091011 12 13 141516

MUNICIPALITIES (% of GDP)

REGIONS (% of GDP)

CENTRAL ADMINISTRATION (% of GDP)

2013 are actuals. 2014 forward are estimates. Source: Bank of Spain, INE, UBS

Fig. 11 Sovereign spread should tighten as thebudget deficit contractsForecasting model of the 10y Bono-Bund spreadbased on the budget deficit gap and IG corporatespreads

-10

-8

-6

-4

-2

0

2

4

6-100

0

100

200

300

400

500

600

700

98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

Spread IG Bonds (Left; ML)Spread Spain-Germany (Left; 10y)Model Output (left; bp)Budget Deficit Spread SP-GE (Right)

2013 are actuals. 2014 forward are estimates. Source: European Commission,INE, BoA ML, UBS

European economy


slippage has been reduced. All regions must now submit mid-term fiscalconsolidation plans to the central government, similar to the EU ExcessiveDeficit Procedure.

So, in conclusion, the new institutional framework to foster budgetary com-pliance in Spain (enshrined by a constitutional amendment, the forcefulBudgetary Stability Law and the FLA), combined with the unequivocalpolitical will to avoid any default on regional or municipal debt in effectmake the underlying credit risk of the regional bonds the same as for theKingdom of Spain. Therefore, their bonds are due to trade with a (sizable)illiquidity premium over the Spanish government bonds but an idiosyncraticrisk premium to compensate for default would not be justifiable in thecurrent setup.

Rating agencies provide an assessment based on the specific deficit anddebt dynamics, but could not give a good gauge of the real risk of thedebt defaulting or being restructured. The investment horizon becomescritical when buying regional bonds. For true buy-and-hold investments,we would assume that the intrinsic credit risk remains the same as that ofSpain. But the significant illiquidity of most of the regional bonds merit asizable premium, since having to sell them in the secondary market couldbe costly, especially in periods of stress, given the wide bid-ask spreads andthe thin depth of this market segment. Bonds maturing within 3-7 years aretrading around 50-70bps above the Spanish government bonds, probablyan insufficient spread to compensate for the much lower liquidity. Evenmore, according to the Treasury rule, new regional bonds can only be issuedwith a 75bps maximum spread over the government bonds, lowering thepotential yield pick-up in the primary market.

With contributions from Thomas Wacker

Fig.12: Regional bond yields reflect theirrating despite being supported by the SpanishTreasuryAsk yields of bonds maturing in 2020 and averagecredit rating

KINGDOM OFSPAIN

ANDALUCÍA

ARAGÓN

BALEARES

BASQUE

GALICIA

CASTILLA-MANCHA

EXTREMADURA

CASTILLA-LEON

MADRID

MURCIA

CANARIAS

NAVARRA

RIOJA

VALENCIA

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6

2.8

ASK

YIE

LDBO

ND

SM

ATU

RIN

G20

20A A- BBB+ BBB BBB- BB+ BB

CATALUÑA

Source: S&P's, Moody's, Fitch Ratings, Bloomberg, UBS

Table 2. Spanish Sovereign and regional bond issuers

Issuer Rat ing Outlook Rat ing Out look Rat ing Outlook Debt -to-GDP3Q14

RegionalDebt 3Q14

Bondsmaturing af ter

2014

Bonds as %Regional Debt

KINGDOM OF SPAIN BBB Stable Baa2 Positive BBB+ Stable

ANDALUSIA BBB- Stable Ba1 Positive BBB- Stable 19.4% 27,654 4,055 14.7%

ARAGON BBB Stable - - - - 18.1% 5,999 3,274 54.6%

ASTURIAS - - - - BBB Stable 15.5% 3,425 0 0.0%

BALEARIC ISLANDS BBB- Stable - - - - 28.3% 7,597 885 11.6%

CANARIAS BBB Stable - - BBB- Stable 13.8% 5,726 1,230 21.5%

CANTABRIA - - - - BBB Stable 18.8% 2,393 0 0.0%

CASTILLA-LEON - - Baa2 Positive - - 17.2% 9,470 2,544 26.9%

CASTILLA-MANCHA - - Ba2 Positive BBB- Stable 33.7% 12,488 1,455 11.7%

CATALUÑA BB Stable Ba2 Positive BBB- Stable 31.8% 63,075 10,659 16.9%

EXTREMADURA BBB Stable Baa3 Positive - - 17.7% 2,960 606 20.5%

GALICIA BBB Stable Baa2 Positive - - 17.3% 9,816 5,688 57.9%

MADRID BBB Stable Baa2 Positive BBB Stable 13.3% 25,063 13,922 55.5%

MURCIA - - Ba2 Positive BBB- Stable 24.6% 6,673 458 6.9%

NAVARRA A- Stable - - - - 18.4% 3,327 1,998 60.1%

BASQUE COUNTRY A- Stable Baa1 Positive BBB+ Stable 14.1% 9,163 3,724 40.6%

RIOJA - - - - BBB Stable 16.6% 1,329 309 23.3%

VALENCIA BB- Stable Ba2 Positive BBB- Stable 35.8% 35,892 3,861 10.8%

Aggregated regions 22.0% 232,009 54,668 23.6%

S&P's Moody's Fitch

Source: S&P's, Moody's, Fitch Ratings, Bank of Spain, INE, UBS

European economy


Financial sector: Solvency has been restored and bonds remainattractiveThe Spanish banking system has finally restored its solvency and quicklybrought balance sheets towards a more sustainable structure. The clean-up effort has been huge, provisioning or writing-down assets by more thanEUR 270bn while increasing capital (in the market, through burden-sharingexercises or by public injections) by around EUR 100bn, Credit risks seemwell covered. Outstanding bank loans have shrunk by almost EUR 480bn(-25.6% from the end-2008 level or 47% of GDP), swelling capital ratios.

As a result, none of the 15 Spanish banks failed the ECB's comprehensiveassessment. Spanish banks' average Common Equity Tier 1 based on Basel3 transitional rules was 10.9% in the baseline scenario and 9.0% in theadverse scenario, well above the 8.0% and 5.5% respective thresholds. Inaddition, the loan-to-deposits ratio (according to the Bank of Spain clas-sification) which stood at an unsustainable 177% in 2007 has moved to122% nowadays and will keep falling as banks shrink their balance sheets.

With the usual delay, the steep decline in sovereign spreads and banks'wholesale funding costs will be transmitted to credit spreads of new bankloans. Our models point to an average spread on new non-real estate cor-porate loans (now at 3.5%) declining towards 2.5% by 2016. Credit stan-dards are beginning to ease and volumes of new loans are expected to startgrowing in several segments along 2015. This creates a powerful "creditimpulse" which is vital for the economic recovery and that augurs a sus-tained pace of growth in the coming quarters.

Peripheral banks’ funding costs have fallen considerably and Spanish bankshave fully used their EUR 41bn allowance from the first two ECB TLTROwindows, taking advantage of a very attractive four-year 0.15% fundingcost. On the other hand, non-performing loans (NPLs) in Spain have peakedand the cost of risk could be back to a mid-cycle 50-70bps level by 2016.Therefore, we think there are some arguments in favor of investing inSpanish and some other peripheral banks as they are:

1. Improving asset quality with declining NPL and higher provisions;

2. Improving profitability on higher net interest margins (mostly drivenby the fall in the cost of funding) thanks to the ECB’s loose monetarypolicy;

3. Their retail and commercial client-focused franchises will avoid thechallenges coming from higher regulatory capital requirements forwholesale and investment banking activities;

4. These banks don't suffer the drag from volatile Fixed Income, Com-modities and Currencies (FICC) business lines;

5. There is low risk of big fines from litigation.

In conclusion, we believe Spanish banks still have some relative value leftin senior bonds. Absent negative headlines and thanks to fundamentalimprovements in banks’ asset quality and capital levels, we believe thata mixture of low supply, negative ECB deposit rates and abundant liq-uidity will help spreads to narrow further over the next few months. Inthe medium term, we believe that technical as well as fundamental factorspoint to further tightening in financial senior bonds, too.

Among the Spanish lenders, we see quite sizable discrepancies in terms ofasset quality between BBVA and Banco Santander and the smaller, regionalplayers. We feel confident about Spain's two top players due to their fran-chise power both domestically and internationally in the markets in whichthey operate. Both banks have adequate capital levels according to the reg-

Fig. 13: Spanish banks fared well in the ECB'sreviewFully loaded 2016 average Common Equity Tier 1ratio

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Fig. 14: Lower sovereign spread to feed throughbank loansAverage spread on new bank loans to corporations(%)

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

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05 06 07 08 09 10 11 12 13 14 15 16

Monthly change in outstanding loans to private sectors (EURbn; 12m ma)Average Spread on New Loans (bps over 3m Euribor)

5y CDS Spain

Regression Spread

Falling sovereignspread and wholesalefunding w ill quicklyfeed t rough credit

2013 are actuals. 2014 forward are estimates. Source: Bank of Spain, INE,Bloomberg, UBS

Fig. 15: Towards a sustained positive creditimpulseCredit impulse and domestic private demand growth

-15%

-12%

-9%

-6%

-3%

0%

3%

6%

9%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

04 05 06 07 08 09 10 11 12 13 14 15

Priv

ate

Dom

estic

Dem

and

Cre

dit

Impu

lse

Credit Impulse (% YoY; lhs)

Domestic Private Demand (Annual growth %; rhs)

2013 are actuals. 2014 forward are estimates. Source: ECB, INE, UBS

European economy


ulator, having passed the comprehensive assessment, have good liquidityand have managed to partly offset the domestic asset quality weaknesseswith their international operations. Both lenders' ratings do not have anysovereign support notches; hence a potential rating cut following the Res-olution Regime implementation is not envisaged. BBVA's and Santander'scapital ratios are at adequate levels relative to their European peers andhave room to catch up with the fundamentally strong global banks, in ourview. We thus have recently added both BBVA and Banco Santander to ourCore issuers.

With contributions from Jens Anderson, Elena Guglielmin and Fabio R. J.Trussardi

Box 2: Covered bonds fairly valued amid regulatory changesSpanish mortgage covered bonds (cédulas hipotecarias) are backed by the issuer’sentire mortgage book and public sector covered bonds (cédulas territoriales) arebacked by an issuer’s entire public-sector loan book. For now, this provides thehighest over-collateralization in Europe and compensates for weaknesses in Spain’scover bond structures. Nevertheless, the Spanish Treasury is working on a newregime for Spanish mortgage covered bonds that would reduce over-collateral-ization. The new framework should introduce some measures to improve the coverpool credit quality. However, the net combined effect should be slightly credit neg-ative for covered bonds, in our view. It's not clear yet if existing Spanish coveredbonds would be subject to these measures retroactively or if a transition period willbe established. On the other hand, this regulatory change should improve potentialrecoveries for unsecured bank creditors as asset encumbrance will be reduced.

Despite improving fundamentals in Spain, restored solvency and solid domestic andinternational franchises, we consider BBVA and Santander covered bonds are fairlyvalued and we expect them to neither significantly underperform nor significantlyoutperform similarly rated peers.

With contributions from Claudia Sigl

Box 3: Non-financial corporate bonds; IG issuers appear relativelyunattractiveMost of the big, traditional and liquid Spanish non-financial corporate issuers(Telefónica, Repsol, Iberdrola, Gas Natural, Abertis, Enagás, Red Eléctrica, etc) arerated BBB, in line with the Kingdom of Spain. As a result, their yields are very similarto those of the Spanish Treasury, sometimes even below. Despite their solid fun-damentals and their internationally diversified activities in most of the cases, wethink that investors should be asking for a higher liquidity premium for these bonds.Therefore we don't find particular value in the Spanish non-financial investmentgrade corporate universe. We favor core-European corporate hybrid bonds, whichstill compensate well for hybrid-specific risks. This sub-asset class should still benefitfrom the ultra-low yield environment, so we continue to see value versus seniorcorporate bonds.

On the other side of the credit quality spectrum, several mid-sized Spanish com-panies have taken advantage of the search for yield to issue speculative gradebonds, usually under international law. These BB and B rated issues trade at yieldsabove 5% and 6%, albeit on low liquidity. Their attractiveness varies widely fromcase to case, since several defaults and debt restructuring have already taken place.An in-depth analysis is warranted when investing in high yield bonds and a gooddiversification is always advisable.

Fig.16: BBVA and Santander covered bondstrade in line with peers.Covered bonds yields vs. Spain benchmark (%)

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

15 16 17 18 19 20 21 22 23 24 25 26Maturity

BBVA (A)

SANTANDER (AA-)

BNP PARIBAS (AAA)

UNICREDITO (AA)

SPAIN TREASURY (BBB)

Source: Bloomberg, UBS

Fig.17: Most Spanish non-financial IG bondstrade in line with the TreasuryYield-to-maturity (%) and duration of bondsmaturing in 2020-21

TELEFÓNICA

GAS NATURALIBERDROLA

ABERTIS

REE

REPSOL

ENAGÁS

SANTANDER

SPAIN

ICO

FADEMADRID

BBVA

0.6

0.8

1.0

1.2

1.4

1.6

4.2 4.4 4.6 4.8 5 5.2 5.4

��

��


European economy


Real estate market: Trough in sight, but recovery to be slow andunevenResidential marketThe Spanish housing market has suffered a collapse similar to that whichIreland experienced. Building permits have fallen to fewer than 34,000 lastyear from 865,000 in 2006. Housing starts slumped to 37,000 in 2013 from760,000 in 2006: Finished houses, which peaked at 658,000 in 2007, areexpected to trough below 50,000 units in 2015. Almost two million directand indirect jobs have been lost, and the size of the residential constructionsector has shrunk from 12.5% of GDP to just above 4%.

As supply exceeded demand already in the last years of the bubble, anddemand tanked due to the tightening of financial conditions, the economiccrisis and the demographic turnaround, a huge stock for sale has beencreated. We estimate the size of that excess supply still above 500,000units. The key issue is that this excess stock is very unevenly distributed.It represents a high percentage of the total market on the continentalMediterranean coast, the big city outskirts and in the provinces surroundingMadrid. But supply has been absorbed in the center of Madrid, Barcelonaand several other cities and in the Balearic Islands, where prices have startedrising tentatively.

The official national house price index has fallen by 30% from the peakin early 2008. Several private indexes provided by realtors point to a 40%decline. This figure seems to better reflect real market conditions, as theofficial index – based on public records – moves with a lag and is distorteddue to tax reasons. Despite this huge fall, house prices are not cheap inSpain. Affordability measures show that prices would be approaching equi-librium at best. Our main take is that house prices, on a national average,are reaching a trough and just a 1%–3% additional decline could beexpected in the private indexes in the next months (which would translateinto a 5%–8% additional fall in the official index until 2015). But perfor-mance will become increasingly divergent, with prices in prime areas in thecenter of the big cities, the Balearic Islands and prime southeast coastalareas rebounding tentatively as supply is scarcer. Meanwhile, the pendingstock will take a long time to be absorbed in secondary areas, where pricesare prone to decline further, by a sizable amount in some cases.

In the long term, average house prices could remain stuck close to thebottom for several years, in a kind of protracted digestion similar to whathappened in Germany between 1995 and 2009. Certainly the economywill continue to heal, some employment will be created and disposableincome will rise moderately. But on the other hand, the pending stock willtake some time to be absorbed, demand will remain low due to demog-raphy, mortgage rates could rise in the medium term and more impor-tantly, there are millions of square meters of developed land – at prices80%–90% below peak – ready to be built that would bring new supply atprices even below the current secondary market. In conclusion, we don'tsee an investment opportunity in the Spanish residential sectors, exceptfor selected assets at distressed prices in prime locations. The other inter-esting segment is the rental housing market, since average yields havemoved closer to European standards at around 5%, attracting institutionalinvestors to this segment.

Fig. 18: Construction activity has reached atrough but the recovery will be mildConstruction investment index and employment('000)

750

1,000

1,250

1,500

1,750

2,000

2,250

2,500

2,750

3,000

60

75

90

105

120

135

150

165

180

195

95 96 97 98 99 ·00 ·01 ·02 ·03 ·04 ·05 ·06 ·07 ·08 ·09 10 11 12 13 14 15 16

Residential investmentNon-residential construction

Construction payrolls ('000)

2013 are actuals. 2014 forward are estimates. Source: INE, Ministry of PublicWorks, UBS

Fig. 19: House prices have fallen close to 40%from peak but show signs of stabilizationNominal and inflation-adjusted average house price(1995=100)

40%

60%

80%100%

120%140%

160%180%

200%220%

240%

260%280%

300%320%

87 89 91 93 95 97 99 01 03 05 07 09 11 13 15

REAL AVERAGE HOUSE PRICE (Inflation adjusted)

OFFICIAL HOUSE PRICE INDEX (1995=100)

ACTUAL HOUSE PRICE (private agencies data)

��

��

��

��

��

2013 are actuals. 2014 forward are estimates. Source: INE, Ministry of PublicWorks, Bank of Spain, IESE-Fotocasa, Expocasa, UBS

European economy


Commercial real estateThe prime office and retail markets are the most promising due to the com-bination of falling yields, increasing institutional investments and restrainednew supply. Similar to the residential market, the Spanish commercial realestate segments have collapsed since the start of the crisis. Taking theMadrid prime Central Business District (CBD) office market as a reference,both prices and rents have slumped by 40% from 2008. There are scarcedata available but it seems that the adjustment has been even bigger insmaller cities and secondary segments. As vacancy rates begin to decrease(take-up exceeds new supply already), the fall in the Spanish sovereignspreads feeds through mortgage rates and the economic recovery trans-lates into some job creation, prime yields (now around 5.5%) could moveclose to 5% this year to remain around 4.75% in 2015 as improvingdemand conditions would be counterbalanced by rising mortgage rates.While rents are expected to register small increases, the fall in yields wouldend, raising theoretical capital values by 10%-15% during the next coupleof years, which would translate into market prices increasing somewherearound 5% CAGR for several years.

Therefore, we have a constructive view on the prime office market inthe CBD as we forecast a mild recovery in rents and prices with yieldsconverging towards the European average. But this segment is hardlyinvestable directly. Competition is fierce in the best locations of the bigSpanish cities, assets for sale are scarce and the stronger long-term investors(family offices, pension funds or insurers) are accepting low yields for trophyassets.

Spain has, finally, a legal structure (the SOCIMI or Spanish REITs) thatallows investment in the commercial real estate segment in a listed, moder-ately liquid, diversified, transparent and leveraged way. Some SOCIMI havebeen created by property companies by wrapping previously owned assets(subject to independent appraisal), but more interestingly four brand-new"cash boxes" have being launched by renowned real estate managers withEUR 2.6bn of new equity raised and close to EUR 4bn of buying power (on a40%–50% leverage). Their primary focuses are prime offices and shoppingmalls, although the rental housing and the hotel segments are includedin some investment plans. These four SOCIMI trade on average close totheir NAV. From these prices, in our base scenario, net annual returns forinvestors would be in the 7%-10% range in a 3-4 year horizon, a compet-itive return even against the broader Spanish equity market.

With contributions from Thomas Veraguth

Fig. 20: Falling interest rates and vacancy ratespoint to declining office yieldsPrime office yield in Madrid vs our forecasting modelbased on interest rates and availability

-8%

-6%

-4%

-2%

0%

2%

4%

6%

1%

2%

3%

4%

5%

6%

7%

8%

95 97 99 01 03 05 07 09 11 13 15

�'&4� *3( 5&�$( 42('&(

'�/'��&�- '�� $1

*62-/� &- 72*2-*5 '21�

2013 are actuals. 2014 forward are estimates. Source: Cushman & Wakefield,INE, Bank of Spain, UBS

European economy


Equities: Banks expected to support further mild outperformanceThe composition of the Spanish equity market does not represent thestructure of the Spanish economy well.1. First, less than 40% of revenues and earnings come from Iberian activ-

ities, while Latam exposure reaches 25%. Sales and profits from therest of Europe only make up 18% (whereas they still represent over70% of Spanish good exports). Contrary to many other Europeancompanies, the exposure to APAC and Africa barely reaches 10% ofrevenues.

2. Second, there are few examples of the two brightest spots of theeconomy: export-related industries (mostly owned by foreign corpo-rations) and the tourism sector.

3. Besides, despite being almost 80% of the GDP, non-financial servicesare under-represented in the stock market, while financials add up to40% of the IBEX.

All this means that the Spanish index is not a straight way of betting onthe cyclical domestic recovery - apart from the effect on banks' profitabilityand solvency - or on the improved international competitiveness. For this,a much more selective approach is thus needed, looking for either puredomestic cyclical players (i.e. media) or for those multinationals that havea competitive advantage in specific niches.

It's particularly this disproportionate weight of the financial sector that mostdifferentiates the IBEX 35 from the rest of European indices. Nine banksand insurers amount to 40% of the index, while five utilities make another14% and Telefónica accounts for another 12%. In contrast to the DJ EuroStoxx 50, in which pharmaceuticals, industrials (ex-construction) and IT addup to 22%, these three sectors combined don't reach a 6% of the IBEX.This peculiar sector composition has several implications:

1. The performance of the Spanish market is mostly driven by financials(i.e. by sovereign and financial spreads since the crisis erupted) with apoorer sector diversification;

2. Apart from financials, the index has a low cyclical bias, being prone tounderperform when the growth bias leads value sectors;

3. The low weight of high growth/high multiple sectors makes theSpanish equity market deserve – on average through the cycle – slightlylower multiples than other European markets, especially now that abig part of Latam has lost growth potential.

The Spanish equity market is currently trading at a premium versus all thebig European markets except Switzerland, despite its singular composition.This is explained by the expectation of a stronger earnings recovery. If con-sensus is right about its 24% earnings growth in 2015 (mainly based of thenormalization of banks' profits), Spain would trade on the same P/E ratiothan the Eurozone by 2016. Therefore, in terms of valuations on consensusestimates, there is not a strong argument in favor of a continuation of theoutperformance of Spanish equities.

But some short-term dynamics could point eslewhere. Our models find thatthere are three variables that explain most of the relative performance ofthe IBEX against the DAX or Euro Stoxx 50 in the last six years: sovereignspreads (and CDS), the relative strength of the business cycle (measured bythe spread in PMIs) and the spread in forecasted earnings growth. Presentlyall these three factors play in favor of a mild outperformance of the Spanishequity market:

Fig. 21: Big international exposure of theSpanish listed companiesDestination of sales of the IBEX components(weighted average)

IBERIA38%

Rest ofEurope18%

Mexico4%

Brazil9%

Rest ofLatam12%

US10%

Rest of theWorld10%

Source: Santander Investment, CNMV, UBS

Fig.22: High weight of banks and defensivesSector weight of the indices

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

EURO STOXX 50 IBEX 35

Materials

Pharma

Telecom

Technology

Utilities

Transportation

Financials

Consumer & Media

Industry

Construct & Infrastr.

Energy


Table 3. Main equity valuation ratio estimates

% Div.

Spain vs Europe 2014 2015 2014 2015 2016 2014 2015 2014

EUROPE 8.1 8.0 15.8 14.6 13.0 1.4 8.9 3.5

USA 9.4 9.1 17.8 16.6 14.6 6.5 8.1 2.1

Eurozone 7.9 7.5 16.6 14.3 12.7 2.6 16.4 3.3

UK 7.8 8.1 14.0 14.0 12.5 -1.9 -0.1 3.8

Switzerland 11.8 11.0 18.1 16.5 15.2 3.0 9.6 3.3

France 7.7 7.5 17.0 14.5 13.1 -3.5 17.6 3.4

Germany 7.7 7.0 14.8 13.5 12.0 7.0 10.5 3.0

Italy 5.5 5.8 16.4 14.1 11.9 -1.6 15.9 3.9

Emerging Europe 2.6 3.2 5.5 5.7 5.1 -20.1 -2.7 5.2

Spain 8.7 8.1 17.7 14.4 12.5 11.0 23.1 3.7

EV / EBITDA

PER EPS Growth

Source: IBES, UBS, as of 10 December 2014

European economy


1. The sovereign spread should continue to slowly narrow as budgetimbalances are reined in;

2. Spain will grow strongly in this cycle;

3. Earnings are expected to recover more swiftly (or at least more securelyas they rely mostly on an asset quality improvement).

This possibility of some Spanish outperformance would come in line withour preference for the European financial sector. If we are right and banksstart outperforming the broader market as solvency is no longer an issueand margins and profits recover, almost mechanically the IBEX would out-perform other indices given the disproportionate weight of financials.The valuation of the Spanish equity market has been determined in the lastdecade by the multipliers of the European market, the sovereign spread andby earnings expectations. Even assuming a mild multiple compression inEurope as earnings finally pick up, our forecast of further sovereign spreadtightening and the strong growth in Spanish earnings would allow the IBEXto move above 11,500 during 2015.

Banks will be, thus, key for this potential good performance. Similar tothe broader index, Spanish banks trade at a hefty premium above theirEuropean peers on stronger expected earnings. If those come true, valu-ations would converge to the mean by 2016. These aggressive earningsexpectations are based on:

1. Growing net interest margins as deposits and wholesale funding costscheapen and some loans are repriced higher;

2. Declining NPLs and provisions;

3. Lagged effect of cost cutting measures.

While agreeing in these positive dynamics, the biggest caveat to con-sensus forecasts concerns margins. Interest on deposits has come downvery quickly (from 4.8% in 3Q08 to 0.8% in 3Q14), in line with sovereignspreads and wholesale funding costs. As the loan-to-deposits ratio declinesand the ECB grants almost free funding, the "war on deposits" haswaned and its positive effect on margins will surprise positively. The disap-pointment could come from yields for new lending. Banks count on revisingspreads upwards of old credit lines being rolled over and new loans beinggranted at higher spreads than in the back book. But our models (seeFig.14) point to a sizable decrease in the spread over Euribor of new loansto non-financial corporations, so that the increase in the overall loan spreadwould be lower than expected by many. All listed banks are announcingquite aggressive lending campaigns in the SME segment, which will resultin our view in a kind of "war on loans" that will bring spreads below whatis embedded in many analyst and bank expectations. As a result, it must becautioned that upside potential in share prices could be lower than showedin some analysts' reports.

All Spanish banks comfortably passed the comprehensive assessment andcapital ratios look adequate. Non-performing loans are starting to comedown and the gradual economic recovery is expected to allow cost of risk todescend towards a mid-cycle level around 50-70bps in 2016-17. Notwith-standing this, we remain wary about the need of further provisioning ofthose real estate legacy assets that are neither covered by an "asset pro-tection scheme" (granted to those banks that absorbed failed cajas) norhave been transferred to the "bad bank" SAREB. Therefore, we keep ourpreference for the big international banks while being selective on purelydomestic entities.

Fig. 23: Spain trades at a premium, betting on astronger earnings recoveryP/E ratio on 12-month forward consensus earnings(x)

789

101112131415161718192021222324

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

PER 12m Fwd Spain

PER 12m Fwd Europe

2013 are actuals. 2014 forward are estimates. Source: IBES, UBS

Fig. 24: Forward earnings are finally turning thecornerIBEX consensus earnings (index points)

300400500600700800900

10001100120013001400

10 11 12 13 14 15

20102011201220132014

+21.4%

+ 4.5%

2013 are actuals. 2014 forward are estimates. Source: IBES, Bloomberg, UBS

Table 4. Aggregated bank valuation indicatorsCAGR 13-15 EPS

Adj P/ENet Div.

(%)P/GOPS

Adjusted P/Book

RoAE (%)

(%) 14E 15E 16E 15E 15E 15E 15E

Benelux +23.8 11.4x 9.1x 8.3x 3.5 5.4x 0.92 8.5

France +32.5 9.7x 7.9x 6.9x 5.7 4.0x 0.77 0.0

Germany +47.9 26.3x 11.1x 7.6x 1.8 5.2x 0.63 9.5

Italy +31.8 18.0x 11.6x 8.9x 3.7 3.9x 0.78 17.1

Nordic +15.9 11.6x 11.0x 10.3x 5.8 7.7x 1.53 11.1

Spain +43.9 15.9x 10.5x 8.7x 2.8 3.8x 1.16 9.9

Switzerland +37.4 12.8x 10.3x 9.0x 3.8 7.1x 1.21 11.5

United Kingdom +8.7 10.2x 9.5x 8.5x 4.5 5.6x 1.02 9.8

Europe +24.0 12.4x 9.9x 8.5x 4.1 5.0x 0.99 10.1

Europe (ex-UK) +32.7 14.1x 10.2x 8.5x 3.9 4.7x 0.98 0.0

Eurozone +37.7 15.3x 9.9x 8.1x 3.5 4.1x 0.88 4.5

Source: IBES, Bloomberg, UBS as of 12 December

Fig. 25: Spanish banks trade at a premium tooP/E ratio on 12- forward consensus earnings (x)

4

6

8

10

12

14

16

18

20

22

24

26

90 92 94 96 98 00 02 04 06 08 10 12 14

PER BANKS SPAIN

PER EURO BANKS

Source: IBES, UBS

European economy


In conclusion, we have a constructive view on the Spanish stock marketas the economy recovers, companies reestablish their solvency and prof-itability and valuations seem fair. Its potential outperformance could comefrom its financial sector, a heavyweight in the index which is expected toquickly normalize earnings. Those looking for the more dynamic, cyclicaland competitive parts of the economy would have to select among the few(often mid-cap) multinationals that have achieved a leading role in someniche business. An area of interest lies in some former construction com-panies that have transformed themselves into global concession managers.

With contributions from Jens Anderson and Fabio R. J. Trussardi

Table 5. Spanish equities overview: valuation multiples of IBEX 35 components

Company SectorMarketCap (inEURmn)

P/E 2014e P/E 2015e P/Book2014e RoE 2014e

DividendYield

2014e (%)

Net Debt /Equity2014e (x)

2014 totalreturn (%

Ytd)

Weight inIBEX 35

ABENGOA-B Industrials 1,768 14.0 9.0 n/a 9.0% 5.3 4.2 -1.3% 0.3%

ABERTIS Industrials 14,377 20.6 18.3 4.1 19.1% 4.0 2.0 8.3% 2.4%

ACCIONA Utilities 3,203 43.2 27.5 1.0 2.9% 0.0 1.9 33.9% 0.5%

ACS Industrials 8,540 12.0 11.3 2.6 20.0% 4.2 0.9 12.7% 1.8%

AMADEUS Technology 14,217 20.8 19.2 6.4 31.0% 2.0 0.6 4.3% 3.0%

ARCELORMITTAL Materials 14,785 12.5 10.7 n/a 1.4% 1.6 0.3 -30.5% 0.6%

BBVA Financials 49,346 17.3 11.9 1.0 6.1% 5.1 2.7 -7.3% 10.4%

BANCO DE SABADELL Financials 8,608 28.1 15.0 0.8 3.0% 0.5 4.0 14.3% 1.8%

BANCO POPULAR Financials 8,890 34.1 16.5 0.7 2.3% 0.3 4.1 -2.3% 1.9%

BANCO SANTANDER Financials 86,254 14.0 11.6 1.1 7.4% 8.8 2.2 14.8% 18.4%

BANKIA Financials 14,834 15.7 11.9 1.2 8.1% 0.0 8.1 4.4% 1.9%

BANKINTER Financials 6,097 20.6 15.7 1.7 8.3% 1.2 5.3 38.4% 1.3%

BME Financials 2,648 16.3 15.4 6.2 40.8% 5.2 -0.7 18.3% 0.6%

CAIXABANK Financials 24,632 32.5 15.3 1.0 3.0% 4.6 3.2 20.2% 3.0%

DIA Consumer Staples 3,412 13.7 13.3 11.4 76.7% 3.1 4.3 -17.4% 0.7%

ENAGAS Utilities 6,159 15.5 15.2 2.7 18.0% 5.0 1.8 40.5% 1.3%

FERROVIAL Industrials 11,795 32.8 29.7 1.8 6.1% 4.8 0.6 17.0% 2.5%

FCC Industrials 2,998 n/a 27.4 4.7 -94.7% 0.0 25.4 -2.9% 0.5%

GAMESA Industrials 2,223 22.7 15.2 1.6 8.6% 0.0 0.3 5.0% 0.5%

GAS NATURAL SDG SA Utilities 20,764 14.6 13.8 1.4 10.5% 4.3 0.9 15.9% 2.7%

GRIFOLS Health Care 9,997 18.0 16.8 4.2 22.0% 0.8 1.0 -9.7% 1.4%

IBERDROLA Utilities 34,753 15.7 14.9 1.0 6.4% 2.8 0.8 28.1% 7.4%

INDITEX Cons. Discretionary 71,044 28.4 24.9 8.1 25.4% 1.7 -0.4 -2.7% 9.1%

INDRA SISTEMAS Technology 1,283 11.0 9.8 1.1 10.1% 4.3 0.3 -33.9% 0.3%

AIG Industrials 11,812 14.6 9.9 n/a 18.3% 0.0 0.4 19.7% 2.5%

JAZZTEL Telecom. 3,214 41.3 30.3 6.8 16.7% 0.0 0.5 61.0% 0.7%

MAPFRE Financials 8,614 9.5 8.9 1.0 10.4% 5.0 0.1 -5.7% 1.1%

MEDIASET ESPAÑA Cons. Discretionary 4,117 41.6 21.6 3.6 6.2% 0.0 -0.1 20.6% 0.7%

OHL Industrials 1,813 6.3 6.1 0.8 11.2% 3.7 1.7 -36.9% 0.3%

RED ELECTRICA Utilities 9,496 16.8 15.8 4.0 23.9% 3.6 2.4 51.1% 2.0%

REPSOL Energy 22,192 12.7 12.8 0.8 6.5% 6.1 0.4 -3.3% 4.7%

SACYR Industrials 1,520 13.1 10.7 1.3 10.9% 0.0 6.8 -19.6% 0.3%

TECNICAS REUNIDAS Energy 1,943 14.0 12.6 4.2 29.0% 4.0 -1.4 -9.0% 0.4%

TELEFONICA Telecom. 58,471 14.5 14.1 2.3 16.6% 5.9 1.8 12.7% 12.5%

VISCOFAN Consumer Staples 2,033 20.3 18.4 3.8 17.8% 2.6 0.2 7.3% 0.4%

18.5 15.2 2.4 12.3% 4.5 1.8 7.5%Source: IBES, Bloomberg, UBS, as of 15 Deecember 2014

European economy


AppendixIf you require information on UBS Chief Investment Office WM and its research products, please contact the mailbox [email protected] (please note that e-mail communication is unsecured) or contact your client advisor for assistance.

Disclosures (16 December 2014)Abertis 10, 12; Banco Santander Brasil 2, 4, 10, Enagas 4, Gas Natural Fenosa 4, Iberdrola 4, 10, 11, Repsol 4, 10, 11, Santander2, 4, 5, 6, 7, 8, 9, 10, 11, Telefonica 1, 3, 4, 7, 10, 11,

1. UBS Limited is acting as advisor to Telefonica SA on the acquisition of 11.1% stake in Mediaset Premium2. This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and investment banking servicesare being, or have been, provided.3. UBS Limited is acting as advisor to Telefonica SA on the acquisition of 56% of the share capital of Distribuidora de TelevisionDigital S.A from Promotora de Informaciones S.A. and a further 22% in Distribuidora de Television Digital S.A from MediasetEspana S.A.4. UBS AG, its affiliates or subsidiaries expect to receive or intend to seek compensation for investment banking services from thiscompany/entity within the next three months.5. This company/entity is, or within the past 12 months has been, a client of UBS Financial Services Inc, and non-investment bankingsecurities-related services are being, or have been, provided.6. Within the past 12 months, UBS Financial Services Inc has received compensation for products and services other than investmentbanking services from this company.7. UBS Securities LLC makes a market in the securities and/or ADRs of this company.8. UBS Ltd is advising Santander Asset Management regarding talks with UniCredit Group in relation to a possible combinationwith its asset management business.9. An employee of UBS AG is an officer, director, or advisory board member of this company.10. Within the past 12 months, UBS AG, its affiliates or subsidiaries has received compensation for investment banking servicesfrom this company/entity.11. UBS AG, its affiliates or subsidiaries has acted as manager/co-manager in the underwriting or placement of securities of thiscompany/entity or one of its affiliates within the past 12 months.12. UBS AG, its affiliates or subsidiaries held other significant financial interests in this company/entity as of last month's end (orthe prior month's end if this report is dated less than 10 working days after the most recent month's end).

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UBS Chief Investment Office WM's investment views are prepared and published by Wealth Management and Retail & Corporate and Wealth Management Americas,Business Divisions of UBS AG (UBS, regulated by FINMA in Switzerland) or an affiliate thereof. In certain countries UBS AG is referred to as UBS SA. This material is foryour information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. Certain services and productsare subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinionsexpressed in this material were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to itsaccuracy or completeness (other than disclosures relating to UBS, its subsidiaries and affiliates). All information and opinions as well as any prices indicated are currentas of the date of this report, and are subject to change without notice. The analysis contained herein is based on numerous assumptions. Different assumptions couldresult in materially different results. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS, its subsidiariesand affiliates, as a result of using different assumptions and/or criteria. At any time UBS and other companies in the UBS group (or its employees) may have a long orshort position, or deal as principal or agent, in relevant securities or provide advisory or other services to the issuer of relevant securities or to a company connectedwith an issuer. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying therisk to which you are exposed may be difficult to quantify. 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UBS will not be liable for any claims or lawsuits from anythird parties arising from the use or distribution of this material. This report is for distribution only under such circumstances as may be permitted by applicable law.In developing the Chief Investment Office (CIO) economic forecasts, CIO economists worked in collaboration with economists employed by UBS Investment Research.Forecasts and estimates are current only as of the date of this publication and may change without notice.. For information on the ways in which UBS CIO WealthManagement manages conflicts and maintains independence of its investment views and publication offering, and research and rating methodologies, please visitwww.ubs.com/research. 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Prior to making anyinvestment decision, a recipient should obtain personal financial product advice from an independent adviser and consider any relevant offer documents (including anyproduct disclosure statement) where the acquisition of financial products is being considered. 2) Clients of UBS AG: This notice is issued by UBS AG ABN 47 088 129613 (Holder of Australian Financial Services Licence No 231087): This Document is issued and distributed by UBS AG. This is the case despite anything to the contraryin the Document. The Document is intended for use only by “Wholesale Clients” as defined in section 761G (“Wholesale Clients”) of the Corporations Act 2001 (Cth)(“Corporations Act”). In no circumstances may the Document be made available by UBS AG to a “Retail Client” as defined in section 761G of the Corporations Act.UBS AG’s research services are only available to Wholesale Clients. The Document is general information only and does not take into account any person’s investmentobjectives, financial and taxation situation or particular needs. Austria: This publication is not intended to constitute a public offer or a comparable solicitation underAustrian law and will only be used under circumstances which will not be equivalent to a public offering of securities in Austria. The document may only be used bythe direct recipient of this information and may under no circumstances be passed on to any other investor. Bahamas: This publication is distributed to private clientsof UBS (Bahamas) Ltd and is not intended for distribution to persons designated as a Bahamian citizen or resident under the Bahamas Exchange Control Regulations.Bahrain: UBS AG is a Swiss bank not licensed, supervised or regulated in Bahrain by the Central Bank of Bahrain and does not undertake banking or investment business

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activities in Bahrain. Therefore, Clients have no protection under local banking and investment services laws and regulations. Belgium: This publication is not intendedto constitute a public offering or a comparable solicitation under Belgian law, but might be made available for information purposes to clients of UBS Belgium, branch ofUBS (Luxembourg) SA, registered with the National Bank of Belgian and authorized by the “Financial Services and Markets Authority", to which this publication has notbeen submitted for approval. Brazil: Prepared by UBS Brasil Administradora de Valores Mobiliários Ltda, entity regulated by Comissão de Valores Mobiliários ("CVM").The views and opinions expressed in this report accurately reflect analyst's personal views about the subject securities and issuers. This report is only intended for Brazilianresidents if such residents are directly purchasing or selling securities in the Brazil capital market through a local authorized institution. For investors residing in Brazil,Eligible Investors are considered to be: (i) financial institutions, (ii) insurance firms and investment capital companies, (iii) supplementary pension entities, (iv) entities thathold financial investments higher than R$ 300.000 and that confirm the status of qualified investors in written, (v) investment funds, (vi) securities portfolio managersand securities consultants duly authorized by CVM, regarding their own investments, and (vii) social security systems created by the Federal Government, States, andMunicipalities. Canada: The information contained herein is not, and under no circumstances is to be construed as, a prospectus, an advertisement, a public offering, anoffer to sell securities described herein, solicitation of an offer to buy securities described herein, in Canada or any province or territory thereof. Any offer or sale of thesecurities described herein in Canada will be made only under an exemption from the requirements to file a prospectus with the relevant Canadian securities regulatorsand only by a dealer properly registered under applicable securities laws or, alternatively, pursuant to an exemption from the dealer registration requirement in therelevant province or territory of Canada in which such offer or sale is made. Under no circumstances is the information contained herein to be construed as investmentadvice in any province or territory of Canada and is not tailored to the needs of the recipient. To the extent that the information contained herein references securitiesof an issuer incorporated, formed or created under the laws of Canada or a province or territory of Canada, any trades in such securities must be conducted through adealer registered in Canada or, alternatively, pursuant to a dealer registration exemption. No securities commission or similar regulatory authority in Canada has reviewedor in any way passed upon these materials, the information contained herein or the merits of the securities described herein and any representation to the contrary isan offence. Tax treatment depends on the individual circumstances and may be subject to change in the future. UBS does not provide legal or tax advice and makesno representations as to the tax treatment of assets or the investment returns thereon both in general or with reference to specific Client's circumstances and needs.Clients should obtain independent tax advice on the suitability of products, assets or instruments before investing and as they may consider appropriate. In Canada, thispublication is distributed to clients of UBS Wealth Management Canada by UBS Investment Management Canada Inc. China: This research report is neither intended tobe distributed to PRC investors nor to provide securities investment consultancy services within the territory of PRC. Dubai: Research is issued by UBS AG Dubai Branchwithin the DIFC, is intended for professional clients only and is not for onward distribution within the United Arab Emirates. France: This publication is distributed byUBS (France) S.A., French "société anonyme" with share capital of € 125.726.944, 69, boulevard Haussmann F-75008 Paris, R.C.S. Paris B 421 255 670, to its clientsand prospects. UBS (France) S.A. is a provider of investment services duly authorized according to the terms of the "Code Monétaire et Financier", regulated by Frenchbanking and financial authorities as the "Autorité de Contrôle Prudentiel et de Résolution." Egypt: Securities or other investment products are not being offered or soldby UBS to the public in Egypt and they have not been and will not be registered with the Egyptian Financial Supervisory Authority (EFSA). Germany: The issuer underGerman Law is UBS Deutschland AG, Bockenheimer Landstrasse 2-4, 60306 Frankfurt am Main. UBS Deutschland AG is authorized and regulated by the "Bundesanstaltfür Finanzdienstleistungsaufsicht". Hong Kong: This publication is distributed to clients of UBS AG Hong Kong Branch by UBS AG Hong Kong Branch, a licensed bankunder the Hong Kong Banking Ordinance and a registered institution under the Securities and Futures Ordinance. India: Distributed by UBS Securities India Private Ltd.2/F, 2 North Avenue, Maker Maxity, Bandra Kurla Complex, Bandra (East), Mumbai (India) 400051. Phone: +912261556000. SEBI Registration Numbers: NSE (CapitalMarket Segment): INB230951431 , NSE (F&O Segment) INF230951431, BSE (Capital Market Segment) INB010951437. Indonesia: This research or publication is notintended and not prepared for purposes of public offering of securities under the Indonesian Capital Market Law and its implementing regulations. Securities mentionedin this material have not been, and will not be, registered under the Indonesian Capital Market Law and regulations. Israel: UBS AG is registered as a Foreign Dealer incooperation with UBS Wealth Management Israel Ltd, a wholly owned UBS subsidiary. UBS Wealth Management Israel Ltd is a licensed Portfolio Manager which engagesalso in Investment Marketing and is regulated by the Israel Securities Authority. This publication shall not replace any investment advice and/or investment marketingprovided by a relevant licensee which is adjusted to your personal needs. This document may not be reproduced or used for any other purpose, nor be furnished to anyother person other than those to whom copies have been sent. Anyone who purchases the product[s] subject of this publication shall do so for its own benefit and forits own account and not with the aim or intention of distributing or offering the aforementioned product [s] to other parties. Anyone who purchases the product[s] shalldo so in accordance with its own understanding and discretion and after it has received any relevant financial, legal, business, tax or other advice or opinion requiredby it in connection with such purchases. Italy: This publication is distributed to the clients of UBS (Italia) S.p.A., via del vecchio politecnico 3, Milano, an Italian bankduly authorized by Bank of Italy to the provision of financial services and supervised by "Consob" and Bank of Italy.UBS Italia has not participated in the production ofthe publication and of the research on investments and financial analysis herein contained. Jersey: UBS AG, Jersey Branch, is regulated and authorized by the JerseyFinancial Services Commission for the conduct of banking, funds and investment business. Luxembourg: This publication is not intended to constitute a public offerunder Luxembourg law, but might be made available for information purposes to clients of UBS (Luxembourg) S.A., a regulated bank under the supervision of the"Commission de Surveillance du Secteur Financier" (CSSF), to which this publication has not been submitted for approval. Mexico: This document has been distributedby UBS Asesores México, S.A. de C.V., a company which is not subject to supervision by the National Banking and Securities Commission of Mexico and is not part of UBSGrupo Financiero, S.A. de C.V. or of any other Mexican financial group and whose obligations are not guaranteed by any third party. UBS Asesores México, S.A. de C.V.does not guarantee any yield whatsoever.Netherlands: This publication is not intended to constitute a public offering or a comparable solicitation under Dutch law, butmight be made available for information purposes to clients of UBS Bank (Netherlands) B.V., a regulated bank under the supervision of “De Nederlansche Bank" (DNB)and "Autoriteit Financiële Markten" (AFM), to which this publication has not been submitted for approval. New Zealand: This notice is distributed to clients of UBSWealth Management Australia Limited ABN 50 005 311 937 (Holder of Australian Financial Services Licence No. 231127), Chifley Tower, 2 Chifley Square, Sydney, NewSouth Wales, NSW 2000, by UBS Wealth Management Australia Ltd. You are being provided with this UBS publication or material because you have indicated to UBSthat you are a client certified as a wholesale investor and/or an eligible investor ("Certified Client") located in New Zealand. This publication or material is not intendedfor clients who are not Certified Clients ("Non-Certified Clients"), and if you are a Non-Certified Client you must not rely on this publication or material. If despitethis warning you nevertheless rely on this publication or material, you hereby (i) acknowledge that you may not rely on the content of this publication or material andthat any recommendations or opinions in this publication or material are not made or provided to you, and (ii) to the maximum extent permitted by law (a) indemnifyUBS and its associates or related entities (and their respective directors, officers, agents and advisers (each a "Relevant Person") for any loss, damage, liability or claimany of them may incur or suffer as a result of, or in connection with, your unauthorised reliance on this publication or material and (b) waive any rights or remediesyou may have against any Relevant Person for (or in respect of) any loss, damage, liability or claim you may incur or suffer as a result of, or in connection with, yourunauthorised reliance on this publication or material. Singapore: Please contact UBS AG Singapore branch, an exempt financial adviser under the Singapore FinancialAdvisers Act (Cap. 110) and a wholesale bank licensed under the Singapore Banking Act (Cap. 19) regulated by the Monetary Authority of Singapore, in respect of anymatters arising from, or in connection with, the analysis or report. Spain: This publication is distributed to clients of UBS Bank, S.A. by UBS Bank, S.A., a bank registeredwith the Bank of Spain. Taiwan: This material is provided in accordance with ROC laws, in agreement with or at the request of clients. Thailand: At your specificrequest, this material has been provided to you. This document has not been approved by the Thai SEC, which has not verified the correctness or completeness of thisdocument either on the issuing date of this document or later. This document has not passed any consideration by the Thai SEC. Investment in these securities involvesrisks investors should exercise due care and discretion in considering investment risk. The Investors should carefully study the investment risk and ensure that they havea good understanding of such risk. This is not an offer or sale to any person within Thailand. Turkey: No information in this document is provided for the purpose ofoffering, marketing and sale by any means of any capital market instruments and services in the Republic of Turkey. Therefore, this document may not be consideredas an offer made or to be made to residents of the Republic of Turkey in the Republic of Turkey. UBS AG is not licensed by the Turkish Capital Market Board (the CMB)under the provisions of the Capital Market Law (Law No. 2499). Accordingly neither this document nor any other offering material related to the instruments/servicesmay be utilized in connection with providing any capital market services to persons within the Republic of Turkey without the prior approval of the CMB. However,according to article 15 (d) (ii) of the Decree No. 32 there is no restriction on the purchase or sale of the instruments by residents of the Republic of Turkey. UAE: Thisresearch report is not intended to constitute an offer, sale or delivery of shares or other securities under the laws of the United Arab Emirates (UAE). The contentsof this report have not been and will not be approved by any authority in the United Arab Emirates including the UAE Central Bank or Dubai Financial Authorities,the Emirates Securities and Commodities Authority, the Dubai Financial Market, the Abu Dhabi Securities market or any other UAE exchange. UK: Approved by UBSAG, authorised and regulated by the Financial Market Supervisory Authority in Switzerland. In the United Kingdom, UBS AG is authorised by the Prudential RegulationAuthority and subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. Details about the extent of ourregulation by the Prudential Regulation Authority are available from us on request. A member of the London Stock Exchange. This publication is distributed to privateclients of UBS London in the UK. Where products or services are provided from outside the UK, they will not be covered by the UK regulatory regime or the FinancialServices Compensation Scheme. USA: This document is not intended for distribution into the US and / or to US persons. UBS Securities LLC is a subsidiary of UBS AGand an affiliate of UBS Financial Services Inc., UBS Financial Services Inc. is a subsidiary of UBS AG.Version 11/2014.© UBS 2014. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

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