ubs global outlook - swiss canadian chamber of commerce · 2019-05-13 · ubs global...

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UBS global outlookDecember 2009

2010 Be alert and agile

Economy Recovery on track but outlook uncertain

Emerging markets Strong economic growth should yield solid returns

Fixed income Government bonds at risk, corporates still favored

Equities Earnings stability lends support to prices

Currencies Focus on emerging markets and commodity producers

Commodities Broad firming in prices with emphasis on energy

This report has been prepared by UBS Financial Services Inc. (“UBS FS”) and UBS AG.Please see important disclaimer at the end of the document.Past performance is no indication of future performance. The market prices provided are closing prices on the respectiveprincipal exchange. This applies to all performance charts and tables in this publication.

3UBS global outlook 2010

Contents

Editorial 4

Key investment views 5

Investment strategy 6

Backing away from the abyss

Economy 8

An uneven recovery

Currencies 11

Trends nearing a limit

Equities 14

Removal of policy support takes center stage

Fixed income 17

Government bonds at risk

Nontraditional asset classes

– Listed real estate 20Time to focus on quality

– Commodities 21A positive but more selective outlook

– Hedge funds 22In the slipstream of equity markets

– Private equity 23

Opportunities emerge after the global recession

Financial market performance 24

Publication details 25

4 UBS global outlook 2010

Editorial

Andreas Höfert Walter Edelmann

Global Head Wealth Management Research Head Global Investment Strategy

Walter Edelmann

Andreas Höfert

Dear reader,

As we reflect on the shifting fortunes of 2009 and consider the year ahead, wefind the steadily unfolding global economic recovery reassuring but incomplete.There are still weak spots. Unemployment continues to mount, and, after yearsof debt-financed excess, consumer spending in many countries remains feeble.But the incredible efforts of policymakers the world over – flooding the systemwith liquidity, slashing interest rates and taxes, subsidizing consumption andsimply spending money – appear to have stopped the hemorrhaging, at leastfor now.

Compared to the bleak mood of March 2009, when global equities had lostroughly half of their value from the 2007 peak, confidence has grudginglyrevived, which, in turn, has helped restore order to financial markets. Weexpect the economic momentum heading into 2010 to further underpin theprices of corporate assets, but we note that the removal of policy supportcould temper performance and even trigger bouts of weakness. Emerging market economies should continue to outpace the rest of the world, whichreinforces the profit potential of companies exposed to their dynamism, as wellas implying strong global demand for commodities and structural support foremerging market currencies and sovereign debt.

But while the recovery may have soothed tormented financial markets, trou-bles could eventually resurface. We highlight the massive stockpiling of foreignexchange reserves and the stubbornly high US current account deficit as signif-icant structural risks to the economic and financial market outlook, as well asthe alarming buildup of public deficits and debt in the US and many otherdeveloped countries. After the spending binge and liquidity surge, policymak-ers must now be alert to the sustainability of the recovery and they must beagile enough to reverse their accommodative stances without triggering infla-tion, a sharp spike in bond yields or instability in foreign exchange markets.

Our baseline forecast for the global economy assumes further recovery amidlow inflation; however, we do not ignore the potential for setbacks in thecourse of next year. We enter 2010 with a cautiously optimistic stance. Wethink diversification's benefits for portfolios have been revalidated and maywell play an important role during 2010, as could well-timed tactical shiftsamong various asset classes and sectors.


Key investment views

Key investment views

Economic recovery on track but outlook uncertainWe expect the global economy to continue to recover during 2010, but wealso see a world that is still starkly out of balance. Risk perceptions will likelynormalize further during 2010, but that does not mean a calm ride lies ahead.A well-diversified portfolio should help smooth performance, and we expectopportunities to emerge for tactical moves throughout the year.

Strong emerging market growth translates into solid returnsMost major emerging market economies will likely continue to outpace eco-nomic growth in the developed world. We expect this to translate into fasterearnings growth and ultimately higher equity market returns. Although valua-tions of emerging market bonds are less attractive than at the beginning of theyear, we do not regard current prices as expensive given the improved eco-nomic fundamentals.

Government bonds at risk, corporate bonds still favoredSeveral factors point to the continued solid performance of corporate bondsduring 2010, especially when compared to the dismal outlook for governmentbonds. We think cautious investors should shift some of their governmentbond exposure to investment-grade corporate bonds with medium-term dura-tions, whereas investors with greater risk tolerance should still consider highyield corporate bonds.

Earnings stability lends support to equity pricesGiven our outlook for a recovery in economic activity and business sentiment,we think corporate profits will continue to improve during the early part of2010. We enter the year with a cyclical stance, a preference for Eurozone andemerging market equities, and a positive outlook on the Energy, Materials andInformation Technology sectors. However, removal of policy support is a risk toequities and will dictate the preference for cyclical or defensive tilts during theyear.

Focus on emerging market and commodity-producer currenciesThe clear trends that have dominated currency markets in 2009 – US dollarweakness and the search for higher-yielding currencies – are unlikely to exert asmuch influence during 2010. However, we do expect the US dollar to remainweak, and we look for emerging market and commodity-producer currenciesto stabilize at even stronger levels than in 2009.

Broad firming in commodity prices with emphasis on energyThe revival in global economic activity is broadening, with industrial productionin the developed world finally expanding robustly, leading us to expect com-modity prices to trend higher on average in 2010. However, the fundamentalsupply and demand backdrop differs strongly among commodity sectors andalso within sectors. In the first half of 2010, we expect crude oil prices to movehigher amid continued strong demand.


Investment strategy

Past performance is not an indication of future returns. The market prices provided are closing prices on the respective principal stock exchange.

Backing away from the abyss

We expect risk perceptions to normalize further during 2010. Thus, we stillfind value in corporate assets and would also stress new growth opportuni-ties. Government bonds appear expensive.

350

200

300

250

150

100

502004 2005 20072006 2008 2009 2010

Fig. 2: Risky assets recovered in 2009

Source: GPR, J.P. Morgan, Merrill Lynch, MSCI, UBS WMR

Total return index (January 2004 = 100)

Government bondsDeveloped market equitiesEmerging market equities

Listed real estateCommodities

–10 0 10 20 4030 6050 70

Fig. 1: Performance of main asset classes

Source: Bloomberg, GPR, HFR, J.P. Morgan, Merrill Lynch, MSCI, Thomson Reuters, UBS WMR

Total return, in %

CashFixedincome

Equities

Non-traditionalasset classes

CashGlobal inflation-linked

GovernmentInvestment grade

High yieldEmerging market

ConvertibleDeveloped marketEmerging marketListed real estate

CommoditiesHedge funds

Jan – Nov 2009 2004–2008 (annualized)

Convinced of recoveryAfter teetering on the edge of a full-blown depres-sion, 2009 will be remembered as the year when theglobal economy got back on its feet. Hit by arenewed bout of market panic during the first fewmonths of the year, risk-bearing assets becameexceptionally cheap. Our analysis then suggestedthat investors should re-engage in equities, and espe-cially in corporate bonds, as alternatives to the safetyof cash and government bonds. As more evidenceemerged to confirm the economic recovery, a majorrelief rally unfolded. This uptrend persisted into thefourth quarter, although at a more subdued pace(see Fig. 1 and Fig. 2).

Towards normalizationNormalization tends to follow periods of extremefinancial market upheaval. Almost by definition,extreme events happen rarely and are normally theresult of accumulated stresses in the system. In thecase of the global financial crisis, it was the rottenstate of bank balance sheets that caused a dominoeffect when the underlying asset values – mostimportantly US real estate – deteriorated. Thoughbalance sheet repair is ongoing, most larger bankshave been able to recapitalize, and house prices inthe US have corrected to more reasonable levels.

Normalization implies that investor perception ofextreme market risk declines as events fade from

view. This should continue to prove beneficial forrisky assets. However, it also implies that more nor-mal price behavior will re-emerge, including the riskof setbacks amid all the economic uncertainties thatlie ahead.

Corporate assets still offer good valueThe rally in risky assets since March quickly erasedthe extreme valuation upside potential that equitiesenjoyed at the height of the financial crisis. However,our calculations suggest that financial markets havenot yet overshot, with global equities as well as cor-porate bonds still offering good value. In particular,Eurozone and UK equities appear to offer the bestvalue among developed equity markets. By contrast,longer-term government bonds look expensive froma valuation standpoint and also face downward pricepressure from an improving economy. Thus, we rec-ommend that investors direct some of their govern-ment bond exposure to corporate bonds.

Prepare for road bumpsFurther normalization in risk does not mean that acalm ride lies ahead. A well-diversified portfolioshould help to smooth performance in 2010 (see thebox on page 7 for a more detailed discussion), andopportunities will emerge for tactical moves through-out the year. The timing of central bank rate hikeswill be critical. For government bonds, the first rateincreases should be negative, but a tightening of


Investment strategy

Past performance is not an indication of future returns.

Balancing opportunities and risks

Given the ongoing economic recovery, we see furtherupside in equities, corporate bonds, and broad commodityindexes (see Fig. 3). While the economic outlook entailsconsiderable risk, favorable valuations suggest thatinvestors should remain exposed to corporate securitiesduring the early part of 2010. To maintain this stance, itwill be important to determine whether the earnings cyclehas truly embarked on an upswing.

Government bonds are likely to post poor returns during2010. We favor reducing overall exposure to them andadvise against long-dated maturities. However, govern-ment bonds can still play an important role for investors,shielding them against extreme event risks, such as a sud-den negative shock to the global economy. In general, thepotential diversification benefits of mixing equities andlong-term, high-quality bonds should be carefully consid-ered. Those benefits need to be assessed in the context ofour main scenario for 2010, which calls for higher bondyields and, thus, disappointing returns.

With the inflation outlook uncertain, we think it is pru-dent to invest part of a portfolio in assets that eventuallyadjust for inflation, other than just equities. In particular,we expect commodities to yield important diversificationbenefits during 2010. Gold could weaken in the rather

unlikely event that the risks surrounding high governmentbudget deficits were to fade. However, other commodi-ties, such as crude oil, are likely to do well in an environ-ment of steady economic recovery and benign inflation.

–40 –30 –20 –10 0 20 3010 40

Government bonds

Corporate bonds

High yield bonds

Emerging market bonds

Developed market equities

Emerging market equities

Listed real estate

Commodities

Fig. 3: Expected 2010 returns and historical return ranges

UBS WMR expected return range

Past 10-year average return

UBS WMR expected 2010 return

Note: Return range shows +/– one annualized standard deviation from the expected 2010 return, based on the past 10 years of monthly returns. Historical average return is the compounded average annual return over the past 10 years.

Source: J.P. Morgan, Merrill Lynch, MSCI, GPR, Bloomberg, Thomson Reuters, UBS WMR

In %

monetary policy might also trigger a general setbackin financial markets. Still, we expect equities andcommodities to generate a decent positive returnduring 2010. Within listed real estate we see higherrisk, as prices have also moved sharply higher despitea supply overhang.

An agile tactical approach should prove valuable inthe event of a major market setback. Monetary pol-icy statements and economic developments need tobe closely monitored to establish the best position-ing. Somewhat ironically, we note that sustainedweakness in final demand might actually helpsmooth the performance of financial markets in2010 as it would impose some constraints on centralbank rate hikes. Higher-than-expected inflationwould be a major risk to both bonds and equities, asit would increase rate hike concerns.

2010: emerging growth opportunitiesEmerging markets should continue to produce stronggrowth opportunities. Although their performancemay be uneven due to the underdeveloped state oftheir financial markets, we expect well-targetedinvestments in emerging markets to generate attrac-tive returns. In addition, investing in new technolo-gies offers exposure to above-average growth poten-tial. Along these lines, we think 2010 will prove to bea good year for assets that help to meet the world’simportant environmental challenges, such as globalwarming and the limited supplies of food and cleanwater.


Economy

An uneven recovery

We expect the economic recovery process to continue well into 2010. In anycase, the foundations of the global economy are still not yet stable enough to warrant an all-clear signal.

Economies out of balanceThe financial crisis has shown even skeptics that gov-ernment action can revive economic activity aftertraumatic events threaten to shut it down. In late2008 and early 2009, most advanced economieswere heading into the worst recession in more thanfifty years. By volume, international trade shrank by athird and unemployment surged. But by the middleof 2009, most countries had returned to growth,albeit modest, and some were even expecting stronggrowth in early 2010.

This remarkable outcome would have been impossi-ble without the massive monetary and fiscal stimulusmeasures that governments implemented. However,self-sustaining economic growth is still beyond thereach of many countries, which leads us to believethat policies will remain highly accommodative forseveral quarters. Although this is necessary to sustainthe recovery’s momentum, this approach bears thelonger-term risks of soaring government budgetdeficits and significantly higher inflation pressures.

Considering the economic outlook for 2010, we seea world that is still starkly out of balance. We woulddivide the global economy into three distinct groups:the sluggish deleveragers, the re-energized devel-oped exporters, and the highly dynamic emergingmarkets and commodity producers. (Detailed macro-economic forecasts for many countries and regionscan be found on page 10.)

The sluggish deleveragersDespite its massive household debt burden, the USmanaged to post strong economic growth towardsthe end of 2009, although it is much less impressiveafter government-subsidized consumption gains arestripped away. Investment activity and unsubsidizedconsumer demand, two GDP components that arecritical to the strength of the US economy, remainsubdued. Already high unemployment will likely con-tinue to rise into early 2010 and, even after the situa-tion eventually improves, will probably stabilize at anuncomfortably high level. Households continue toreduce debt and increase savings. Therefore, we donot expect private consumption to become a drivingforce of the US economy anytime soon.

Nor do we expect a sharp increase in US interestrates, with the Federal Reserve likely to remain onhold until the middle of 2010, when the US labormarket may start to improve. Meanwhile, record-lowcapacity utilization rates should keep companiesfrom significantly increasing their investment activi-ties. Thus, once fiscal stimulus measures fade and theinventory cycle turns down – most likely towards theend of the first half of 2010 – we see a serious riskthat the US economy could weaken again. A similarrelapse appears plausible for other deleveragingcountries, such as the UK, Spain and Ireland, whichare also affected by a drastic surge in unemploymentand heavily indebted households.

The re-energized developed exportersThe financial crisis yielded two positive surprises. Thefirst was the resilience of emerging markets, whichwe will discuss in more detail later. The second wasthe much more muted increase in the unemploymentrate throughout Europe, despite its recession beingat least as deep as it was in the deleveraging coun-tries, if not deeper. Both subsidized part-time workand costly labor-market frictions can explain thisapparent anomaly. Moreover, Europe as a whole didnot experience a crash in the construction sector; noris its financial sector anywhere near as important tothe overall economy as it is in the UK and the US.

There is no guarantee that the relative resilience ofthese countries will continue. Some part-time laborsubsidies, as well as other fiscal stimulus measures,will end in the first half of 2010. Moreover, the Euro-pean Central Bank (ECB), which pursued a ratheraccommodative monetary policy in 2009, might startto tighten much earlier than the Federal Reserve,pushing the euro to even higher levels against the USdollar.

Meanwhile, we expect positive economic growth forJapan in the quarters ahead, but a full recovery thereis likely a long way off. The Japanese labor marketremains extremely weak, and wages are fallingsharply as businesses cut costs in response to lowerrevenues. Deflationary pressures remain intense asconsumers try to stretch their shrinking paychecks.And while fiscal stimulus measures have been critical


Economy

to supporting the economy, the boost from govern-ment spending may have already peaked.

While we forecast lower economic growth for theEurozone and Japan than for the US during 2010,we think growth in Europe and Japan is likely to bemore broadly distributed throughout their econo -mies, particularly in terms of both private consump-tion and corporate investment activity. Exports shouldalso be quite solid in sectors exposed to emergingmarkets. However, European export-oriented compa-nies will need to exhibit some degree of pricingpower to withstand further appreciation of the euro.

Dynamic emerging markets and commodityproducersChina‘s strong economic growth in the first quarterof 2009 was astonishing given the intensity of thefinancial crisis. It was soon followed by rebounds inSouth Korea and the commodity producers, Australiaand Norway. Both the Asia-Pacific region and com-modity producers are clearly profiting from the Chi-nese boom.

At first glance, the Chinese rebound appears to bethe result of a government spending package thatwas even larger as a share of GDP than that of theUS. However, the big difference between China anddeveloped countries can be found in the quality of itsgrowth. Regarding demand prospects, the cyclicaloutlooks in China and other large emerging marketsare much more broad-based than they are in delever-aging Western countries.

But China and Southeast Asia are still too small totake the weight of the entire global economy upontheir shoulders like the US consumer did during thepast few years (see box below for a more detaileddiscussion). Moreover, the growth in emerging mar-ket countries is highly commodity-intensive, whichmight put upward pressure on energy prices andweigh on final consumer demand in advancedeconomies.

The inflation versus deflation debateWe think inflation will remain well contained in mostdeveloped countries during 2010, given low capacityutilization rates and increasing unemployment. This

Can Asia carry the world on its shoulders?

Asia weathered the credit crisis and the ensuing globalrecession surprisingly well. The downturn in Asia took itstoll on export sectors but left the broader economiesintact. Thus, all eyes have turned to Asia, hoping theregion’s demand will drive global economic growth nowthat the deleveraging countries, especially the US, are suf-fering under the weight of heavy debt burdens.

While Asia is home to 60% of the world’s population, itsshare of economic output is much smaller (see Fig. 4).Measured in terms of market exchange rates, Asia con-tributes only 22% to global GDP. Exclude Japan and thisshare shrinks to only 14%. Measured in purchasing powerterms (consider that the US dollar buys considerably moregoods and services in Beijing than in New York), Asia’sshare of global GDP jumps to nearly 30% – a third ofwhich comes from China and only a fifth from Japan.

We believe that Asian consumer demand will continue toincrease in the years ahead, yielding many benefits tocompanies exposed to the region. However, Asia‘s con-sumer base is small and will take years to approximate theweight of the US and Europe. Since savings rates aremuch higher in Asia than in developed economies – con-sider that every second renminbi earned in China is saved– only every ninth dollar spent on consumption globally isbeing spent in Asia ex-Japan. Thus, to offset a 1% drop inUS consumption, which makes up nearly 30% of globalconsumption, Asian consumer demand would need togrow 3% in excess of its usual growth rate.

Although Asia‘s consumption is still modest compared todeveloped countries‘, it has become vitally important insome areas. Asia now plays a critical role in the globaldemand for commodities. And the region also contributesdisproportionately to global growth, given its very sizeablegrowth differential to developed countries. While Asia‘sconsumption is still too small to compensate for slowerdemand growth in advanced economies, its ascent hasbeen steep and its impact will soon rival that of the USand European economies.

0 20 40 60 80 100

Fig. 4: Asia still has room to grow

Source: AsianBondsOnline, BIS, Bloomberg, CIA World Factbook, ECB, IMF, Thomson Reuters, UN, US Treasury Department, worldatlas.com, UBS WMR

PopulationLand mass

PPP-adjusted GDPEquity market capitalization

Sovereign bond issuanceNominal GDPConsumption

Equity market cap Currency transactions (local)

Corporate bond issuance

Asia’s share of selected demographic, economic and financial measures, in %

Asia ex-Japan Japan Rest of the world

0.4 –2.4 2.6 3.0 3.8 –0.4 1.3 1.5

0.4 –2.3 2.9 3.4 2.4 0.4 1.9 1.6

1.3 –7.0 2.5 3.2 6.5 4.8 3.8 3.7

5.1 0.0 4.5 4.5 5.9 4.5 4.5 4.8

–0.7 –5.2 2.1 1.3 1.4 –1.3 –1.3 –0.4

2.4 0.8 3.3 4.0 4.4 1.6 2.0 2.5

9.0 8.4 9.0 8.7 5.9 –0.5 3.0 4.0

6.7 6.0 9.0 8.5 9.1 2.2 5.0 7.0

2.8 –0.7 5.2 4.2 5.7 1.8 2.6 3.2

0.6 –3.6 2.4 2.2 3.3 0.2 1.2 1.5

1.0 –4.7 2.1 1.7 2.8 0.2 1.7 2.2

0.3 –1.9 2.6 2.5 3.2 0.2 1.7 2.0

–1.0 –4.6 2.1 2.2 3.5 1.0 1.9 1.9

0.9 –3.9 0.7 1.7 4.1 0.3 2.1 1.7

0.6 –4.5 1.8 2.3 3.6 2.0 1.5 1.3

–0.4 –4.5 2.8 3.2 3.5 –0.5 1.2 1.7

1.8 –1.4 1.7 2.1 2.4 –0.5 0.7 1.1

5.6 –6.5 5.5 4.2 14.0 11.9 7.5 7.5

2.6 –1.0 3.6 3.7 5.0 1.6 2.4 2.6


Economy

should enable central banks to maintain expansivemonetary policy conditions at least until the middleof 2010. However, the long-term consequences ofabundant liquidity and ballooning government debtwill remain a challenge for monetary policymakers.

The so-called “exit strategies“ of central banks (thatis, the mopping up of excess liquidity created in theaftermath of the financial crisis) should be neithertoo hasty nor too slow – a difficult challenge indeed.

If removed too quickly, there is a strong risk that theeconomy will weaken. Left in place too long, infla-tion risks will likely surge. We doubt that every cen-tral bank will successfully manage this delicate bal-ancing act, and the final outcome will depend on theskills, preferences and objectives of the various cen-tral banks. The ECB is more likely to react too early inorder to maintain its inflation-fighting credentials,whereas the Fed could move too late over concernsabout high household and government debt levels.

Interest rates, in % 3-month LIBOR 10-year govt. bondJun-10 Dec-10 Jun-10 Dec-10

US

Eurozone

Japan

UK

Switzerland

Australia

Canada

Sweden

China1

Exchange ratesJun-10 Dec-10 equilibrium3

EURUSD

USDJPY

GBPUSD

USDCHF

USDCAD

AUDUSD

NZDUSD

USDSEK

USDNOK

USDCNY2

UBS macroeconomic forecasts

Real GDP growth in % Inflation in %2008 2009 2010 2011 2008 2009 2010 2011

Americas US

Canada

Mexico

Brazil

Asia/Pacific Japan

Australia

China

India

Rest of Asia

Europe Eurozone

Germany

France

Italy

Spain

UK

Sweden

Switzerland

Russia

World

0.50 1.00 4.00 4.25

1.00 1.80 3.80 4.00

0.30 0.30 1.60 1.70

0.80 1.30 4.30 4.50

0.30 0.90 2.50 2.80

4.50 4.80 5.80 6.00

0.80 1.50 3.80 4.00

0.50 1.20 3.80 4.00

2.30 2.80 4.00 4.50

1.57 1.57 1.27

100 105 95

1.70 1.70 1.73

0.97 0.99 1.19

1.03 1.00 1.11

0.98 0.95 0.68

0.78 0.76 0.58

6.21 6.11 7.53

5.10 5.03 6.75

6.75 6.65 n.a.1 7-day Interbank rate instead of 3-month LIBOR; 2 Chinese yuan; 3 purchasing power paritySource: UBS



Currencies

Trends nearing a limit

We expect emerging market and commodity-producer currencies to stabilizeat even stronger levels than in 2009. The US dollar is likely to remain weak.

–20 –10 0 10 20 4030 50

Fig. 6: Currency valuation shift

Source: Thomson Reuters, UBS WMR

Deviation from purchasing power parity (PPP) versus US dollar, in %

Nov 2009Nov 2008

undervalued

overvalued

Australian dollar

New Zealand dollar

Euro

Norwegian krone

Swiss franc

Swedish krona

Japanese yen

Canadian dollar

British pound–10–20 100 20 30 40 50

Fig. 5: Currency performance

Source: Bloomberg, UBS WMR

Change versus US dollar, in %

Australian dollar

New Zealand dollar

Norwegian krone

Canadian dollar

British pound

Swedish krona

Euro

Swiss franc

Japanese yen

Jan – Nov 092004 – 2008 (annualized)


Currency markets lack clear directionThe factors that dominated currency markets in2009 – US dollar weakness and the search forhigher-yielding currencies – are unlikely to exert asmuch influence during 2010. These trends are likelyto fade as currencies already deviate sharply fromtheir fair value levels (see Fig. 5). The euro, the cur-rencies of commodity producers, such as the Aus-tralian dollar, the Canadian dollar, the Norwegiankrone, and the New Zealand dollar, as well as free-floating emerging market currencies, all appreciatedstrongly versus the US dollar (see Fig. 6). Meanwhile,the Japanese yen and the British pound appreciatedversus the greenback, but remained weak versusmost other currencies.

A new carry trade in 2009A new carry trade emerged in 2009, one that seeksto exploit not only lower yield differentials than the2005-08 carry trade era, but also important differ-ences in economic stability. Currency regions thatwere less affected by the financial crisis benefitedfrom expectations that their respective central bankswould be quicker to raise rates in 2010 and wouldact more aggressively than those in the US, the UKand Japan. Investors who established carry tradepositions relatively early in 2009 made remarkableprofits, which are unlikely to be repeated in 2010.Nevertheless, we think carry trades will continue to

perform well early in the new year. In our view, theUS dollar has more room to depreciate beforeinvestors will need to evaluate risk exposure andunwind carry trade positions.

New comfort zones to emergeOur principal macroeconomic scenario for the nexttwo years involves a stabilization of global GDPgrowth, very moderate inflation, and a tightening ofmonetary policy. Emerging market economies arelikely to post the strongest growth rates, whichshould support global export volumes and commod-ity producers. The appreciation of emerging marketand commodity-producer currencies in 2009 alreadyanticipated such a favorable environment.

Once expectations are confirmed by economic reality,exchange rates are likely to establish new comfortzones. The new comfort zones for the EURUSD andAUDUSD are slightly above 2009 year-end values(detailed exchange rate forecasts for many countriesand regions can be found on page 10). The Cana-dian dollar is likely to strengthen slightly, and theBritish pound will probably stay close to fair valueversus the US dollar. Broadly, we expect the US dollarto remain weak when global growth normalizessince it will take many years for households todeleverage before market participants are preparedto accumulate new long-term US dollar-denominatedinvestments.


Currencies

To complicate matters, one of our risk scenariosincludes a dip in US GDP growth when the stimulusmeasures fade and inventory restocking is complete.In this case, risk aversion, repatriation and safe havenflows could temporarily lift the dollar. But as noted inour UBS research focus entitled, “The future of theUS dollar,” such a move would likely prove short-lived given the many structural weaknesses con-fronting the US dollar.

Euro: the only liquid alternative to the USDThe Eurozone differs markedly from the US and othercountries, implying a different long-term path for theeuro. Europe has built up its exports to countriesother than the US over the past decade, and we alsosee relatively strong domestic demand conditions inContinental European countries that were lessaffected by the financial crisis than the US, UK orJapan. Debt levels as a share of GDP did not rise asquickly in the Eurozone, and the ECB was able tomaintain higher interest rates than other major cen-tral banks. Moreover, Continental Europe as a wholedid not experience a real estate market crash, unlikethe UK and the US. We expect the ECB to maintainits prudent course and even allow the euro to appre-ciate a bit more before taking countermeasures.

Switzerland and Japan no longer in stepWhile the Swiss franc and the Japanese yen wereboth used as funding currencies in the 2005-08 carrytrade, the fate of the Swiss franc changed quickly.Sound economic fundamentals helped the francremain strong; however, the Swiss National Bank pre-vented the currency from appreciating too strongly.We expect the SNB to continue intervening to limitthe franc’s strength, but we also look for a moderatedepreciation of the franc versus the euro as soon asthe ECB hikes rates and the yield differential widens.

The yen and the franc have historically moved in tan-dem. However, this pattern is fading as Japan‘s fun-damentals deteriorate. During the financial crisis,Japan‘s government debt soared to 200% of GDP,leaving it very exposed to the risk of rising interestrates. Debt servicing would become very difficultwith higher yields, and we think authorities will dotheir best to prevent this from happening. That said,we think it will be a long time before Japan is anattractive investment destination for foreigninvestors. Therefore, we expect the yen to weaken todeeply undervalued territory in the years ahead.

Cautious on the poundFears that the UK might slip into a deflation trapwere strong in early 2009. The situation has sincestabilized somewhat thanks to generous liquidityinjections by the Bank of England. The UK‘s debt-to-GDP ratio, which was among the lowest in Europe,has since risen quickly to the EU average and willsoon move even higher. Therefore, we remain cau-tious on the pound despite its weak valuation versusthe euro. We only suggest entering a cautious over-weight in the pound when UK growth surprisesstrongly to the upside.

Australia profits from Chinese commodity imports,and the Reserve Bank of Australia has already startedto lift interest rates, which we expect to continue,supporting the Australian dollar. Any setbacks,should they occur, will likely be limited. Rising com-modity prices should also support the Canadian dol-lar and Norwegian krone. However, the case for thekrone appreciating is stronger than for the Canadiandollar, since Canada‘s economy is challenged by itsclose trade relationship with the US.

It takes a lot to become a dollar bullWe recommend strategic allocations to the curren-cies of commodity producers and emerging markets(see box on page 13 for a more detailed discussion).Among the most liquid currencies, we have a clearlong-term preference for the euro. The yen will likelylose its current appeal as soon as the policy rates ofother major central banks drift higher again. Mean-while, the possibility of temporary spikes in the USdollar from a renewed wave of risk aversion or anunwinding of carry trade positions should not beignored. However, it will take many years before theUS has stabilized its finances enough to make usbullish on the dollar.


Currencies

Stronger emerging market currencies

45403515 30–5 0 5 10 20 25

Fig. 7: Emerging market currencies post strong results


Total return versus the US dollar during 2009, in %

Forex return versus US dollarLocal interest return

Brazilian realSouth African rand

Chilean pesoIndonesian rupiah

Colombian pesoRussian ruble

Hungarian forintMexican pesoCzech koruna

Turkish liraPolish zloty

Indian rupeePhilippine peso

Chinese yuan

Fundamentals favor emerging market currenciesEmerging market currencies have withstood the storms ofthe past year and a half. After the traumas of 2008, abrightening outlook for the global economy, recoveringinflows of foreign capital and improving access to interna-tional capital markets have led several emerging marketcurrencies to appreciate noticeably against the US dollar(see Fig. 7). In other words, a reversal of the factors thatcaused the sharp depreciation at the beginning of thefinancial crisis has supported emerging market currenciesduring the recent upswing.

Two other forces driving currency values are worth high-lighting. First, much of the recent strengthening of mostemerging market currencies is due to weakness in the USdollar. By early November 2009, only a few emerging mar-ket currencies had not appreciated against the US dollarduring the previous twelve months. Against the euro, thepicture is reversed; only a few currencies are now worthmore in euro terms than twelve months earlier. We expectthe dollar to remain weak in the quarters ahead. Thismeans that investors for whom the greenback is their ref-erence currency may gain extra returns from emergingmarket currency investments than those who are euro- orSwiss franc-based. That said, risks of a weakening inemerging market currencies would increase if globalgrowth prospects were to significantly deteriorate duringthe course of 2010.

The other notable development is that many emergingmarket economies have learned from previous crises thatcash really is “king.“ On the whole, emerging market cen-tral banks now hold more foreign currency reserves, theirbanks are better capitalized, and their economies are lessdependent on foreign capital. Also, many of these coun-tries now have independent central banks with explicitinflation targets. In sum, their improved standards of gov-ernance and more stable economic fundamentals confirmthat emerging market economies are well advanced onthe path to converge with developed economies. Emerg-ing markets are a safer investment destination than theywere just a decade ago, which improves the long-termattractiveness of their currencies.

Regional distinctionsCurrency performance will continue to differ acrossregions and countries. The export-driven economies inAsia tend to have current account surpluses which lowertheir dependence on foreign capital. We think several ofthese currencies will continue to appreciate versus the USdollar over the coming quarters. Given an environment ofpersistent US dollar weakness, we expect the Chineseyuan to resume its gradual appreciation. This entails a ris-ing trade-weighted yuan index, consistent with the robust

growth outlook for the Chinese economy. We expect thePeople’s Bank of China to adopt this stance in the first halfof 2010, when it is convinced the recovery in exports issustainable.

In Central and Eastern Europe, prospects for furtherappreciation also appear intact, especially for those coun-tries targeting Eurozone membership. Poland‘s zloty hasthe strongest appreciation potential versus the euro, inour view, while we expect the Czech koruna and Hungar-ian forint to stay flat versus the euro and to appreciateversus the US dollar.

We think the South African rand will trend slightly weakeragainst the dollar during the course of 2010, while weexpect the Turkish lira to continue its gradual appreciationtrend against the dollar.

We think Argentina, Ecuador and Venezuela face a chal-lenging 2010, and the appreciation potential of their cur-rencies is limited, in our view. With improved monetaryand fiscal policy frameworks in Brazil, Chile, Colombia,Mexico, and Peru, these countries look decidedly morepromising. However, countries in the region haveannounced a variety of measures to stem the appreciationof their currencies versus the US dollar. While this mighthave a short-term impact on exchange rates, we do notthink such measures will have a lasting effect on a cur-rency’s long-term appreciation potential.

Summing up, we think 2010 will be a more challengingyear for emerging market currencies than 2009. However,structural factors supporting emerging market currenciesremain intact and should continue to yield interestinglong-term opportunities.


Equities

Removal of policy support takes center stage

Removal of policy support is a risk to equities and will dictate the preferencefor cyclical or defensive tilts. We expect emerging market equities to generatestrong long-term returns.

1300

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Fig. 8: First rate hikes a burden for equities


In % Index

US fed funds target rate (lhs)S&P 500 index (rhs)

2.5

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Jan 03 Jul 03 Jan 04 Jul 04 Jan 05

0–10 10 20 30 40 50 60 70

Fig. 9: Performance of equity markets


SingaporeHong Kong

Emerging marketsSweden

SpainAustraliaCanada

Netherlands US UK

FranceSwitzerland

ItalyGermany

Japan

Total return, in % and in local currency

Jan – Nov 2009 2004–2008(annualized)


Equities rebounded sharplyEquity markets pulled off an impressive rebound dur-ing 2009 as risk aversion declined and the shock ofthe financial crisis faded from view. A critical elementof this turnaround was the massive fiscal stimulusmeasures and ultra-loose monetary policy through-out the world. The main question for 2010 is howthe removal of these policy measures will affectequity markets and sectors.

Shifting cyclical tilt during 2010We expect economic activity, business sentiment andcorporate profits to continue to improve during theearly part of 2010 (see box on page 16 for a moredetailed discussion). Such an environment typicallyfavors a cyclical stance. Therefore, we enter the yearwith a preference for Eurozone and emerging marketequities, as well as the Energy, Materials and Infor-mation Technology (IT) sectors.

Speculation about central bank rate hikes and theremoval of accommodative monetary and fiscal pol-icy will likely trigger heightened equity market volatil-ity. The massive stimulus is unprecedented, whichlimits the relevance of historical comparisons abouthow equity markets perform during periods whencentral banks raise rates. Still, equities tend to comeunder pressure in the months leading up to the Fed-eral Reserve’s first rate hike and then retreat after-wards (see Fig. 8). Our economists expect the first

rate hike in the US to occur during the summer.Therefore, a more defensive stance might becomeappropriate in the middle of the year. We alreadyhave a preference for the UK because of its attractivevaluation. However, its defensive characteristicsmight lead us to increase exposure over the course ofthe year.

Having said this, historical experience shows thatequity markets eventually recover, since the rateincreases tend to be a sign that the economic recov-ery is self-sustaining. By autumn, market participantsmight already turn more confident about achievingsuch a growth path, which would support a shiftback to a more cyclical stance towards the end of theyear.

Emerging markets to leadEmerging market equities have benefited dispropor-tionately from the sharp fall in risk aversion, leadingto strong outperformance during 2009 (see Fig. 9).We believe that strong economic growth and a fur-ther decline in risk aversion will continue to supportemerging market equities (see Fig. 10). Major emerg-ing market countries, especially in Asia and LatinAmerica, have so far been relatively unscathed by thefinancial crisis and will likely continue to outpaceeconomic growth in the developed world. We expectthis to translate into faster earnings growth and ulti-mately higher equity market returns.


Equities

25

20

5

10

15

0

Fig. 11: Valuation comparison of equity markets


Selected price-to-earnings ratios based on expected earnings

World US Eurozone Japan Switzerland Emergingmarkets

Note: Data as of the end of November 2009.


Thus, we clearly favor emerging market equities overthe long term. Although country-specific risks are stillconsiderably higher than in developed equity mar-kets, a diversified investment approach can minimizethis risk exposure. That said, portfolios can still betilted towards certain regions and countries in orderto take advantage of their specific opportunities. Forthis reason, we enter the year with a preference forEmerging Europe, Middle East & Africa (EMEA) andAsia over Latin America. In the near term, we arebiased towards EMEA, since we believe it is the mostattractively valued region even after factoring in therelatively weak economic fundamentals. Meanwhile,Asia‘s superior growth rates make it an attractiveregion over a longer time horizon. And Latin Americamay become more appealing during the latter half ofthe year if developed countries exhibit more subduedeconomic growth.

US and Japan take cues from currency swingsUS equities are fairly valued in our view but notoverly compelling at approximately 15 timesexpected earnings for 2010 (see Fig. 11). Positivecorporate profit momentum late in 2009 should lastinto early 2010. But the US dollar may also play alarge role in determining performance results. In arecent edition of the UBS research focus, we outlinedour view that the US dollar is likely to stay weak overthe next several years. In the event of a sustained USdollar depreciation, export competitiveness of UScompanies would increase. Moreover, profitabilitywould also improve since one-quarter of US profits isgenerated abroad. In addition, the more balancedsector composition could prove an advantage ifequity markets were to trend sideways.

The strong Japanese yen, especially relative to the USdollar, hurts the profitability of Japanese exporters.Taken together with the structural economic weak-

ness, we remain cautious on Japanese equities. How-ever, a sharply weaker yen might temporarily prompta less negative stance at some point during 2010.

A thematic approach to sectorsHeading into 2010, we prefer sectors that are mostsensitive to further improvement in global economicactivity. As more central banks begin to raise interestrates, sector leadership will become increasingly moreopaque. Nevertheless, we favor the Energy sectorsince it typically performs well in relative terms aroundthe time when the Fed first tightens. Moreover, webelieve the sector is attractively valued and offers ahigh dividend yield. As we do not expect oil prices todeviate substantially from current levels, Energy sectorearnings are likely to remain well supported.

The IT sector appears to be a potential beneficiary ofpent-up corporate demand and investment. A broadstabilization in corporate profits should underpin theability of companies to upgrade their IT infrastruc-ture. Several new productivity-enhancing productcycles should foster a meaningful IT upgrade cycle.

We also highlight our Strategic Call on “Rising Asianconsumer demand“ as an attractive investmenttheme for 2010 and beyond. We have identified aselection of companies poised to profit from theemergence of Asian consumption. In addition toinvesting directly in emerging markets, one mightalso consider companies with high exposure toemerging markets, such as certain global brands inthe Consumer Staples sector.

Another compelling investment theme is the increasein infrastructure spending. In our UBS research focusfrom September 2009, we outline several trends fos-tering new spending on infrastructure as well as thefactors that support investments in listed equitiesexposed to this theme.

1993 1997 19991995 2001 2003 2005 2007–2

0

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–40

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40

Fig. 10: Higher growth associated with higher returns

Source: MSCI, Thomson Reuters, UBS WMR

In %

Difference between emerging market and global equity returns (lhs)Difference between emerging market and G7 real GDP growth (rhs)

In %


Equities

Cyclical earnings recovery in 2010

Forecasting only a moderate recovery in the global econ-omy during 2010, we think corporate earnings growthwill not come easily. However, margin expansion can alsolead to a solid earnings rebound. As operating expenseswere already scaled back sharply during 2009, some mar-gin improvement appears likely. In sum, we expect earn-ings to grow by more than 20% in the US and the Euro-zone during 2010 from highly depressed levels.

Margin expansion drives earnings growthMargins for nonfinancial companies collapsed during2009 as revenues fell faster than costs. For example, thenet income margin in the US stands slightly above 3%,compared to an average of 5.5% since 1980. The sameholds true for US operating margins, which are based onearnings before interest and tax (EBIT) payments arededucted. This figure sank to the lowest level in 30 years,35% below its long-term average (see Fig. 12). Given such

depressed levels and the unfolding economic recovery,improvement in profit margins in 2010 appears likely. Still,we would caution against over optimism. Following previ-ous recessions, it took a recovery in capacity utilizationbefore margins started to materially expand.

Assuming net income margins increase to 3.5% in the USand company sales increase in line with expected nominalUS GDP growth of 4%, companies outside the Financialsector would likely achieve roughly 15% earnings growth.In Europe, margins have not fallen as steeply as they havein the US. With similar growth assumptions, but based ona more cautious margin expansion, we conclude that non-financial earnings in the Eurozone can grow 10–15%.Adding in Financial sector earnings growth leads to anoverall profit recovery of more than 20% in the US andthe Eurozone.

Low hurdles for Financials, Energy and MaterialsA growth rate of this magnitude may seem impressive,but, given the year’s low starting points, it is not so sur-prising. Financial sector earnings were deeply depressed inthe first half of 2009. The same holds true for commodity-related sectors, such as the Energy and Materials sectors,which had to grapple with low raw materials prices. Fromthese cyclically weak levels, we expect to see sharprebounds in US earnings during 2010 in these three sec-tors. Although tighter regulation looms as a significantrisk to Financial sector profit growth, we expect earningsto advance more than 70% in 2010. Meanwhile, profits inthe US Energy sector are likely to grow by more than60%. At the other end of the earnings spectrum aredefensive sectors like Consumer Staples, Healthcare andUtilities, which saw very little earnings contraction duringthe recession. For these sectors, we forecast a more mod-erate 5–10% rate of earnings growth in the US.

85

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651981 1985 1989 1993 1997 2001 2005 2009

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12

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Fig. 12: Margins follow capacity utilization


In %

EBIT margin for nonfinancial US companies (lhs)Capacity utilization (rhs)

In %


Fixed income

Government bonds at risk

Corporate bond spreads have already declined substantially. In contrast, government bonds hardly reflect the economic recovery and we expect their prices to fall in 2010.

–4 –2 0 2 6 84 10

Fig. 13: Performance of bond markets

Total return, in % and in local currency terms

Source: Bloomberg, JP Morgan, UBS WMR


Swiss franc

Euro

British pound

Japanese yen

Canadian dollar

Swedish krona

US dollar

Australian dollar

7

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020012000 2002 2003 2004 2006 20082005 2007 2009 2010

Fig. 14: Historical development of bond yields

Source: Bloomberg, J.P. Morgan, UBS WMR

10-year government bond yields, in %

Swiss francEuro

Japanese yenUS dollar


Range-bound yield environmentIn 2009, government bonds were generally indiffer-ent to the changing economic environment, but per-formance still deviated significantly across regions (seeFig. 13). Yields on two-year government bondsdenominated in Swiss francs, euros and US dollarsremained within a range of +/– 10 basis points formost of the year. The yield range for longer-termmaturities was only slightly wider (see Fig. 14). Mean-while, the consensus economic outlook moved fromdeep concern about the potential for depression inthe first few months of 2009 to hope of a strong eco-nomic recovery as the year headed toward a close.

From our point of view, monetary policy provides thekey to understanding the seemingly odd behavior inthe bond market. Central banks reacted resolutely tothe crisis, cutting interest rates close to zero andcommitting themselves to keeping rates low for anextended period of time. This put a straitjacket onshort-term bonds. Additional measures, known asquantitative easing, were put in place to keep inter-est rates low further out along the yield curve. Cen-tral banks increased liquidity and in some casesinvested large amounts in bond markets. Subduedvolatility in long-term interest rates can be seen as asign that central banks were successful in stabilizingnominal growth expectations, which are the maindriver of long-term bond yields.

Central banks expected to shift their focusWith the global economy on a more solid footing,central banks will likely shift their focus from avoid-ing an economic meltdown to the risks of remainingtoo loose for too long. While we expect centralbanks to loosen their grip on the bond market in2010, their influence will still be felt. Typically, bondsare most at risk when central banks stop fightingrecession risks and start to normalize interest rates.When we look at how interest rates moved at theend of past recessions, we find that long-term bondyields increased sharply during the six months pre-ceding the first central bank hike. During such peri-ods, bond yields increased an average of 80 basispoints. By comparison, long-term yields only rose byan average of 20 basis points in the six months fol-lowing the first rate hike.

Assuming that the global economic recovery contin-ues, we expect leading central banks to begin raisingrates in the third quarter of 2010, and we look forlong rates to rise from current low levels. Supply anddemand will also turn less favorable for governmentbonds. Central banks and private investors are likelyto reduce the amount of new investments theymake, while private bond issuance typically increasesduring an economic recovery. Fiscal deficits inadvanced economies will remain stubbornly high in2010, according to the IMF, at around 8% of GDP.


Fixed income

0–10 2010 30 40 7050 60 80

Fig. 15: Performance of bond market segments

Total return, in %

Source: Bloomberg, J.P. Morgan, Merrill Lynch, UBS WMR

Money marketWorld Bond Index


High yieldEmerging markets


High yieldEmerging markets

US dollar

Euro


24

20

12

8

4

16

0

Fig. 16: Credit spread above government bonds

Investment grade and high yield bond spreads, in percentage points

Source: Bloomberg, Merrill Lynch, UBS WMR

EuroUS dollarUS dollarEuroInvestment grade High yield

2000 2002 2004 2008 20102006


Having said this, the reversal in bond yields may belimited given the still shaky state of the global econ-omy. Overall, we recommend bonds with short- andmedium-term maturities that are likely to preservecapital, whereas we think longer-dated bonds are atrisk of generating losses.

Corporate credit remains attractiveIn 2009, the performance of US dollar-denominatedhigh yield corporate bonds was outstanding (seeFig. 15). Credit spreads – the difference between theyields on high yield bonds and risk-free governmentbonds – declined from roughly 18 percentage pointsat the beginning of the year to 7.5 percentage pointsin November, which is still only slightly below the lev-els reached in previous recessions (see Fig. 16). Sinceperformance was driven by this singular decline incredit spreads, such stellar performance cannot berepeated in 2010. Nevertheless, there are several fac-tors in place that speak for continued solid perform-ance, especially when compared to the dismal out-look for government bonds.

Companies repairing balance sheetsCompanies introduced measures to protect andimprove their balance sheets in 2009. Together withaggressive cost-cutting programs and measures toshift the profile of their debt to long-term financing,the first signs of measureable improvement began toemerge toward the end of 2009. We think this trendshould continue in 2010 as companies retain theirfocus on costs and benefit from some recovery inrevenues. As a consequence, we expect a substantialdecline in corporate default rates. For example, webelieve the default rate on US high yield companieswill likely fall to around 6–8%, which, although ele-vated, is significantly below the 13% pace reachedduring 2009.

Return to normalityA lack of access to short- and long-term financingthrough bank credit and capital market channelsposed a major risk to the overall economy in early2009. A prolonged credit crunch along with a sharpincrease in corporate failures would have been likelyhad governments not successfully initiated variousprograms to revive lending. Consequently, bondissuance surged across sectors and rating segmentsas companies took advantage of low underlying gov-ernment bond yields, strong investor demand forincome-generating investments, and the shift frombank lending to capital market financing.

While banks will probably continue to be rather cau-tious in allocating credit, we do not think they will beas restrictive as they were during 2009. Bank lendingsurveys conducted in late 2009 in the US and Europehave already shown that fewer banks have tightenedlending standards. And the willingness to lend tocompanies and individuals should also increase afterthe peak in loan-loss provisioning, which we expectto occur during the first half of 2010.

Another favorable year for creditAs we have outlined above, we expect governmentbond yields to rise over the next twelve months. Con-sidered in isolation, this would tend to pressure bondsof all types. But for corporate bonds, the expecteddecline in credit spreads is likely to offset the rise ingovernment bond yields. For high yield bonds, thedecline in the credit risk premium could more thancompensate for higher government bond yields.Therefore, we think cautious investors should shiftsome of their government bond exposure to invest-ment-grade corporate bonds with medium-termdurations, while investors with greater tolerance forrisk should consider high yield corporate bonds.


Fixed income

Further strength in emerging market bonds and money markets

Back in 1993, less than 2% of emerging market sover-eigns issuing foreign currency bonds were classified asinvestment grade. Essentially, this meant that 98% wereclassified as “junk.” Back then, emerging markets seemedto lurch from one crisis to the next. But something hap-pened – several things, actually – to enable emerging mar-kets to withstand the biggest financial panic since the1930s better than the developed economies lately.

An important development is the ongoing ratings upgradetrend in the emerging market foreign currency debt uni-verse. In 2009, almost 60% of the bonds in that universefulfilled the higher economic, financial and governancestandards associated with an investment-grade rating.Confirming this trend, 2009 – not an easy year by anystandard – saw positive ratings developments for severalemerging market countries. The implication for emergingmarket bonds is that they have become a safer investmentclass on average, and we expect this upgrade trend tocontinue in 2010, notwithstanding the potential for somenear-term setbacks.

Attractive sovereign bonds…Although valuations of emerging market bonds were lessattractive toward the end of 2009 than at the beginningof the year, we do not regard current prices as expensive,taking the improved economic fundamentals into account.We believe the yield differential between EMBI global, awidely used benchmark index for emerging market for-eign currency debt, and US Treasury bonds should narrowfrom above 3% towards 2.5% during the course of 2010.

Despite this benign outlook for the asset class, we notethat differences across countries remain pronounced. First

of all, we think that not all of the weaker emerging mar-ket sovereigns are out of the woods yet. Looking at funda-mentals, the bonds issued by Argentina, Pakistan, theUkraine and Venezuela, for example, look vulnerable.

We expect risks in Central and Eastern Europe to declinefurther in 2010. Although the region is a laggard in termsof economic recovery, the medium-term prospects of eco-nomic convergence appear intact, and we think bonds ofseveral CEE sovereigns offer interesting opportunities atcurrent levels.

Economic recovery in 2009 has clearly been strongest inAsia and we think the region should remain an outper-former in terms of economic growth, also benefiting fromthe ongoing global economic recovery in 2010. Given theimproved fundamentals, the benign growth outlook andthe solid credit ratings prevalent in the region, severalAsian sovereign bonds offer interesting longer-term invest-ment opportunities, in our view.

…and local-currency money market instrumentsWe also see opportunities in local-currency money marketinstruments. But after a strong recovery in 2009, mostemerging market currencies appear close to their fair val-ues. Hence, we believe that the upside potential againstthe US dollar in 2010 is more limited. However, as weexpect the interest rate differential between emerging anddeveloped markets to remain favorable for carry tradesduring the course of 2010, exchange rates could well tem-porarily overshoot (see also the currency section on page11). But this increases the risk of exchange-rate correc-tions later in the cycle. When investing in local-currencydebt, diversification is crucial.



Listed real estate

Time to focus on quality

Strong performance from substantial capital increases has masked quality differences among listed companies. We focus on the high quality segment.

2004 2005 2006 20082007 2009 2010

350

300

150

250

200

100

50

0

Fig. 17: Listed real estate continues to recover

Source: GPR, MSCI, UBS WMR

Local-currency index (January 2004 = 100)

UKHong Kong

Global equitiesUS

Fig. 18: Listed real estate has linked to equities

Daily correlation between US listed real estate and US equities

Source: Bloomberg, MSCI, Standard & Poor's, UBS WMR

Note: MSCI US listed real estate total return index and S&P 500 total return index used in calculation.

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New capital to the rescueSo far during 2009, listed property companies haveshown signs of renewed health. This follows anextremely difficult 2008 that featured dysfunctionalcapital markets and saw listed property companieslose much of their equity market value (see Fig. 17).Globally, real estate investment trusts (REITs) haveraised more than USD 40 billion in capital, allowingthem to delever and extend debt maturities. This, inturn, has led to a strong global performance forlisted property companies. One particularly strikingaspect of this resurgence has been the dramatic out-performance of the lower-quality REITs. This “betatrade“ has been driven by a removal of the “surviv-ability question“ among investors coupled with fiercebouts of short covering.

Time to separate the wheat from the chaffWe believe the indiscriminate outperformance of thelower-quality REITs has many of them trading at valu-ations that are not, in our opinion, in line with therisks inherent in both the economy and the commer-cial real estate (CRE) market. In our opinion,2010–2012 will reflect the substantial uncertaintiesin the CRE market stemming from the significantdebt maturities and the current dearth of refinancingcapacity. We prefer to be exposed to those compa-nies that have more defensive portfolios and prop-

erty types, stronger balance sheets, better inherentleasing economics and the best positioning to capi-talize on distressed acquisition opportunities.

Underwriting, underwriting, underwritingOne of the prime contributors to stress in the globalcommercial and residential property markets was theloss of underwriting discipline between 2005 andearly 2008. In 2009 it appears that lenders, operatorsand investors have refocused on essential discipline.We would strongly advise property investors to paystrict attention to underwriting fundamentals in theirfuture investments, be they direct or via an invest-ment vehicle.

A word about correlation and volatilityCRE has historically been an uncorrelated, low-volatility asset class. However, the equitization of CREvia the REIT structure, combined with the increasingvolatility of the financial sector stocks after the BearStearns and Lehman collapses, has significantlyaltered the trading profile of REITs. Using US-basedREITs as a proxy, it should be evident to investors thatpurchasing CRE through a REIT structure adds signifi-cant equity market correlation and volatility to theequation (see Fig. 18).



Commodities

A positive but more selective outlook

The revival in global economic activity is broadening, with industrial produc-tion in the developed world finally expanding robustly, leading us to expectcommodity prices to trend higher on average in 2010.

2004 20062005 2007 20092008 2010

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Fig. 19: Freight and commodity prices move together

Source: Bloomberg, DJ UBS, UBS WMR

Commodity index

DJ UBS Spot Commodity Index (lhs)Baltic Dry Freight Index (rhs)

Freight index

1992 1998 20011995 2004 2007 2010

Fig. 20: Correlations have fallen below trend


Correlation based on a six-month rolling performance window

Rolling three-year average trendAverage correlation between commodities on a sector level

0.7

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Developed country demand criticalSoaring new-order-to-inventory ratios in developedeconomies are a good precondition for higher com-modity demand in 2010. Until now, the price recov-ery in commodities was driven by emerging marketcountries, primarily China. Fiscal and monetary stim-ulus measures in China have swiftly revived commod-ity demand and freight rates (see Fig. 19). Arbitrageconsiderations and higher prices in China comparedto the US and Europe propelled Chinese importseven higher. Since these arbitrage opportunities havealmost vanished and company restocking has largelybeen completed, developed country demand or fur-ther US dollar weakness is necessary to achieve fur-ther price strength.

Investors should remain selectiveThe price performance among commodities has beendiverse in 2009, and we think this should continue in2010. The fundamental supply and demand back-drop differs strongly among different commodity sec-tors and also within sectors, suggesting that correla-tions will continue to decline (see Fig. 20).

Oil has the best outlook, coal is catching upIn the first half of 2010, we expect crude oil prices tomove higher, as global demand will likely increase byalmost 2%. This should allow inventories to normal-

ize further, restoring the focus on structural supplyissues. Our bullish crude oil forecast does not contra-dict our natural gas view. Ample supply, inventoriesat storage limits, and high investment costs makenatural gas unattractive, in our view. However, coalprices, which also underperformed crude oil, shouldcatch up. Strong coal demand, especially from Indiaand China, has improved the fundamental backdrop.

We favor platinum over goldWe caution investors not to have too high returnexpectations for precious metals after their solid per-formance in 2009. We favor platinum over gold andadvise avoiding silver, as mine supply is set toincrease. Platinum‘s lower exposure to financialdemand and higher gearing to industrial activity arepositives for it versus gold.

Copper stands out, as does cornOn the base metals side, copper has the best funda-mental outlook on constrained mine supply and highemerging market exposure. Overall, we expect basemetals prices to increase gradually, as higher demandshould induce additional mining activity. Corn alsoenjoys solid fundamental support, in our view. Weexpect inventories to drop, while demand should bestrong in 2010.



Hedge funds

In the slipstream of equity markets

Hedge funds have recovered and regained investors’ confidence. We expectthe environment to stay supportive.

110120130

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2007 2008 2009 2010

Fig. 21: Hedge fund performance versus other asset classes

Cumulative total return index in US dollars (January 2007 = 100)

Source: Hedge Fund Research, J.P. Morgan, MSCI, UBS WMR

US equitiesWorld equities ex US

US government bondsUS hedge funds liquid (HFRX)US hedge funds broad (HFRI) –40 –30 –20 –10 0 10 20 30 40

Jan – Nov 20092008

Relative value arbitrage

Event driven

Equity hedge

Global hedge fund

Equal weighted strategies

Macro

Fig. 22: Performance of selected hedge fund style indices

Total return in %, and in US dollars

Source: Hedge Fund Research, UBS WMR


A partial recoveryIn 2009, hedge funds recovered roughly half of thelosses from the previous year (see Fig. 21). Accordingto our analysis, about half of this return is linked tothe development of underlying financial markets,namely rising equities, corporate bonds and aweaker US dollar. We attribute the other half of theperformance to the value that was added by hedgefund managers‘ active investment decisions. Thisrelationship has been relatively stable over the pastcouple of years.

Mirror image of 2008In 2009, the performance of the individual hedgefund styles differed substantially but generallyreversed the patterns of 2008 (see Fig. 22). Relative-value arbitrage funds showed the largest swings.Simply put, these funds try to exploit pricing discrep-ancies between related securities by taking short andlong positions. However, during the crisis, the mar-kets exhibited very different risk characteristics andthe expected close correlation broke down betweenthe instruments with lower liquidity and credit qual-ity, which the funds bought, and those with higherliquidity and credit quality, which they sold. However,during the course of 2009, liquidity returned tofinancial markets and the funds‘ assets recovered,allowing arbitrage fund performance to catch up

with that of other styles. As a consequence, styleperformance looks surprisingly homogeneous ifviewed over the past two years.

Investors regain confidenceThe crisis left other marks on the industry. Increasedliquidity needs and reduced willingness to lend in thebanking sector made financing for hedge funds moredifficult. As a consequence, funds operate with lowerleverage now. But the ultimate impact on the funds‘performance in 2009 has been limited. This isbecause the large movements of financial marketshave provided more opportunities to funds. Anotherchange in the industry is the increased proportion ofseparately managed account platforms. Even thoughthe money outflow has stopped, investors appear tobe demanding more transparency and influence.

For 2010, we expect the environment to remain sup-portive. Volatility is unlikely to decline to pre-crisislevels, as uncertainty about the macroeconomic envi-ronment should persist. We also have a cautiouslyoptimistic view on equities and corporate bonds.And with fewer assets under management, we thinkcompetition for investment opportunities will remainlower than before the crisis.



Private equity

Opportunities emerge after the global recession

While investors understandably seek quality in the wake of the financial crisis,we argue that attractive opportunities in distressed and secondary marketsshould not be ignored.

3600

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6

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9

3

Fig. 23: Resurgence of private equity IPOs

Source: ECM Analytics, UBS WMR

IPO deal value, in millions of US dollars Number of deals

Deal value (lhs)Number of deals (rhs)

Jan 08 Apr 08 Jul 08 Jan 09 Apr 09 Jul 09Oct 08 Oct 09


The worst is overAfter sharply declining during the financial crisis, pri-vate equity-related initial public offerings are return-ing to more normal levels (see Fig. 23). This is in linewith our overall assessment that the worst is nowbehind the private equity industry, and its outlook for2010 is favorable. In fact, post-recession privateequity vintages have historically recorded the bestperformance. We think opportunities in distressedand secondary markets can reward private equityinvestors who have multi-year investment horizons.

Distressed marketsThe private equity industry has ample liquidity toinvest in situations that others might avoid owing toprofitability and liquidity constraints. Distressedinvestment funds acquire stakes in companies orassets that have defaulted or are in danger of doingso. Since we expect a higher-than-normal number ofdefaults in 2010, such situations will abound. A pri-vate equity manager can often produce an opera-tional turnaround or a balance sheet restructuring ina distressed firm. And the private equity manager‘sspecialized knowledge about the intricacies of thebankruptcy process can also produce value forinvestors. While many investors are seeking highquality assets in the wake of the financial crisis, we

think that a contrarian approach that identifiesopportunities in distressed situations can yield posi-tive returns over the coming years.

The secondary marketThe secondary private equity market offers investorsthe opportunity to purchase interests in companiesor assets from forced sellers seeking to recover liquid-ity from pre-crisis private equity investments. This isan opportunity for new investors to receive an accel-erated distribution; for primary investments, it nor-mally requires three to five years before the first dis-tribution is made. During 2009, the secondarymarket has not yet fully cleared. Disparities in priceexpectations between institutional sellers and newentrants hunting for bargains were considerable inthe secondary market. The recovery of equity mar-kets and the stabilization in real estate markets alsohelped lessen the pressure on potential sellers toreduce their secondary-market private equity hold-ings. Nevertheless, we expect the secondary marketto continue to offer attractive opportunities in 2010since the imbalances created by the financial crisisstill need to be cleared.


Equities

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

Global 21.6 2.9 22.9 2.0 27.9 5.2 32.1 2.9US 24.1 6.6 25.7 0.9 24.1 6.6 25.7 0.9Japan 0.3 –12.2 3.3 –3.3 5.6 –4.8 14.2 0.1Canada 30.4 4.0 26.1 8.5 52.5 6.8 48.3 11.1Eurozone 21.7 0.4 22.0 3.2 31.4 4.9 44.3 5.8UK 22.4 6.4 26.9 5.7 39.7 7.1 35.7 2.5Sweden 47.9 2.0 53.1 8.0 67.4 3.0 77.5 7.2Switzerland 17.5 0.7 11.9 5.1 24.6 5.8 35.4 7.8Australia 32.4 6.1 31.5 9.2 73.8 14.9 84.8 12.9Emerging markets 56.2 8.0 63.4 15.4 72.2 12.3 85.7 16.1

Asia 60.8 6.8 70.6 14.7 66.6 10.2 85.3 14.3Emerging Europe, Middle East & Africa 59.2 7.9 56.9 9.2 70.9 11.9 69.3 10.2Latin America 59.5 14.0 67.9 22.1 100.1 21.1 106.5 27.9

SectorsConsumer discretionary 29.6 1.8 33.7 –1.4 34.9 4.6 43.0 –0.1Consumer staples 15.5 7.8 16.2 7.5 21.3 9.8 24.0 8.3Energy 18.2 7.4 14.3 8.9 25.5 8.8 21.3 9.0Financials 24.3 –2.7 23.0 –4.6 33.2 0.0 35.7 –3.5Healthcare 13.6 5.8 19.2 3.8 17.2 7.6 25.9 4.3Industrials 19.5 2.9 22.3 1.3 25.2 5.8 31.6 2.8IT 42.2 4.3 44.4 1.3 44.7 5.7 48.9 2.1Materials 43.1 8.4 46.7 9.4 57.9 12.2 66.8 10.8Telecom 7.1 4.1 10.0 2.8 13.8 6.8 20.1 3.3Utilities –0.4 –1.0 0.9 7.0 4.4 1.7 9.1 8.2

Fixed income

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

US 1.4 0.1 1.9 4.0 0.3 0.3 2.2 2.4Japan 0.8 0.2 0.9 0.7 0.3 0.4 0.9 0.1Eurozone 2.2 0.3 2.8 3.5 0.7 0.8 3.9 2.2UK 2.1 0.2 2.8 5.0 0.6 0.7 3.9 4.9Switzerland 0.7 0.2 1.0 1.9 0.3 0.3 1.3 0.7

Government bonds Historic 10-year govt. yields, in %US –1.1 2.5 2.4 5.8 3.2 3.4 2.9 4.3Japan 0.8 0.7 2.7 1.7 1.3 1.3 1.4 1.5Germany 2.8 1.6 4.7 4.5 3.2 3.3 3.3 3.8UK 1.7 0.8 7.3 5.7 3.5 3.6 3.8 4.6Switzerland 3.9 1.6 4.8 3.3 1.8 2.0 2.3 2.3

Global inflation linked bonds 17.2 6.2 25.8 5.5 – – – –

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

USD denominated 21.0 4.5 27.7 5.0 221 252 642 85EUR denominated 15.0 3.3 15.8 3.2 173 210 418 45

High yield corporate bondsUSD denominated 52.7 9.0 64.3 6.0 765 904 1978 318EUR denominated 70.8 9.8 71.1 5.5 813 1075 2186 292

EM USD sovereign bondsGlobal 25.7 6.3 36.4 8.9 342 387 748 363Asia 26.5 4.5 38.6 9.6 278 298 642 276Eastern Europe 34.3 7.6 43.7 8.5 332 368 702 357Latin America 24.1 5.9 34.0 8.1 383 423 765 433


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

Listed real estate 18.7 –1.0 27.9 –0.1 26.2 1.9 39.3 1.4Commodities 16.6 6.8 11.4 0.5 – – – –

Currencies

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

Euro 7.3 4.5 17.9 2.4 EURUSD 1.50 USDCNY 6.83British pound 12.3 0.6 6.7 –3.0 GBPUSD 1.64 NZDUSD 0.71Japanese yen 5.2 8.4 10.7 3.6 USDJPY 86 EURCHF 1.51Canadian dollar 15.3 3.2 17.3 2.4 USDCAD 1.06 EURGBP 0.91Swiss franc 6.2 5.2 20.6 2.5 USDCHF 1.01 EURJPY 129Swedish krona 11.9 1.1 15.8 –0.8 USDSEK 7.02 EURSEK 10.51Australian dollar 29.8 8.5 39.2 3.4 AUDUSD 0.91 EURNOK 8.55

–40 –20–30 –10 0 20 3010 40

YTD3-month

–40 –30 –10 10 30–20 0 20 40

YTD3-month

Financial market performance

Note: Information through 30 November 2009. Returns over five years are annualized. Past performance is not an indication of future returns. The market prices provided are closing prices on the respective principal stockexchange. This applies to all performance charts and tables in this publication.Source: Bloomberg, GPR, HFR, J.P. Morgan, Merrill Lynch, MSCI, Thomson Reuters, UBS WMR

20 400–20–40–80 –60 8060

15105–0–5–10–15–20 20

YTD3-month

40200–20–40–60–80 8060

YTD3-month

YTD3-month


Publication details

Publisher: UBS AG, Wealth Management Research, P.O. Box, CH-8098 Zurich

Editor in chief: Kurt E. Reiman

Editor: Roy Greenspan

Authors:

– Investment strategy: Mark Andersen, analyst, UBS AG; Walter Edelmann, analyst, UBS AG

– Economy: Andreas Höfert, Chief economist, UBS AG; Thomas Kägi, economist, UBS AG

– Currencies: Michael Bolliger, strategist, UBS AG; Thomas Flury, strategist, UBS AG

– Equities: Yves Bogni, strategist, UBS AG; Markus Irngartinger, strategist, UBS AG;

Jeremy Zirin, analyst, UBS Financial Services Inc.

– Fixed income: Bernhard Obenhuber, strategist, UBS AG; Achim Peijan, strategist, UBS AG;

Costa Vayenas, strategist, UBS AG

– Listed real estate: Jonathan Woloshin, analyst, UBS Financial Services Inc.

– Commodities: Dominic Schnider, strategist, UBS AG

– Hedge funds: Achim Peijan, strategist, UBS AG

– Private equity: Sandro Merino, strategist, UBS AG

Editorial deadline: 1 December 2009

Project management: Valérie Iserland

Desktop: Werner Kuonen, Virender Negi, Margrit Oppliger

Translation: CLS Communication AG; Basel, Switzerland, 24translate, St Gallen, Switzerland

Cover picture: Skybridge Langkawi Island, Malaysia, www.prisma-dia.ch

Printer: Druckerei Flawil AG, Flawil, Switzerland

Languages: Published in English, German, French, Italian, Spanish, Portuguese,

Chinese traditional and Chinese simplified.

Contact: [email protected]

© UBS AG 2009

SAP No. 82251E-1001

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