investment strategy guide · despite the ongoing challenges from the devastation in japan, unrest...

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Investment Strategy Guide

Resiliency, not complacency

Wealth Management ResearchSecond Quarter 2011

Supply shocks make a comeback Global expansion still on courseStocks more attractive than low-yielding cash and bonds

Investment Strategy Guide Second Quarter 2011 1

Contents

Publication details

Publisher UBS Financial Services Inc.

Wealth Management Research

1285 Avenue of the Americas, 13th Floor

New York, NY 10019

This report has been prepared by UBS

Financial Services Inc. (“UBS FS”) and

UBS AG. Please see important disclaimer

and disclosures at the end of the

document.

This report was published on

30 March 2011.

Editor in ChiefStephen Freedman

EditorMarcy Tolko�

Authors (in alphabetical order)

Thomas Berner

Anne Briglia

Stephen Freedman

Katherine Klingensmith

David Le� owitz

Barry McAlinden

Donald McLauchlan

Kathleen McNamara

Brian Rose

Mike Ryan

Joe Sawe

Dominic Schnider

Michael Tagliaferro

Jeremy Zirin

Project ManagementPaul Leeming

John Bellomo

Zach Graumann

Desktop PublishingGeorge Stilabower

Cognizant Group – Pavan Mekala,

Basavaraj Gudihal and Virender Negi

Video Feature (electronic version only) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Focus: resiliency, not complacency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Progress Report: will, may or won’t? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Our Best Ideas at a Glance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Asset Allocation Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Washington Watch . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Market Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Economic Outlook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Financial Market Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Asset Classes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Foreign Exchange. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

International Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

US Equities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

US Fixed Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

Commodities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

Alternative Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

Detailed Asset Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

Investment Committee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

Portfolio Analytics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

Additional Asset Allocation Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

Tactical Asset Allocation Performance Measurement . . . . . . . . . . . . . . . . . 48

Disclaimers/Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Video feature: To watch Chief Investment Strategist Mike Ryan give a summary of this Investment Strategy Guide, please click here.

http://roundtable.ubs.com/WMROutlook/

2 Investment Strategy Guide Second Quarter 2011

Dear Reader,

The single event that has been seared into our collective consciousness during the � rst quarter of this year is the devastating earthquake—and resulting tsu-nami—in Japan. The � nal human toll from this tragedy may not be known for years, but initial estimates put the loss of life somewhere in the tens of thou-sands. Rebuilding costs meanwhile could reach as much as USD 300 billion be-fore all is said and done. But while graphic visions of the damage and su� ering of victims have been both horri� c and heart-wrenching, the scenes of emergency service workers, soldiers and even ordinary citizens bravely coming to the aid of their countrymen can only be described as deeply inspiring.

The events taking place within the real economy and � nancial markets may seem trivial compared to such a tragedy. However, investors still must focus on both the risks and opportunities they are likely to face in the quarter ahead. It remains our view that the global economy has moved from a fragile and tepid recovery to a somewhat more durable and sustained expansion. We have therefore opted to retain our overweight in risk assets despite headwinds that include not only the impact from the Tohoku earthquake and tensions in the Middle East and North Africa, but also the e� ects from potential policy tightening, government shut-downs and even an economic “so� patch.”

The fact that markets appear to have absorbed recent shocks with only limited fallout has been taken by some to mean investors may have become overly com-placent. We disagree. We instead view the rebound in risk assets as evidence that the extraordinary e� orts of policymakers have largely succeeded and that the expansion is now on � rmer footing. That’s not to say of course that gains within investment portfolios will be easy to come by—or that one can position across asset classes, sectors or individual securities indiscriminately—during the coming quarter. But while investors must remain selective, the overall outlook remains favorable given the resiliency of both the real economy and � nancial markets.

For real-life lessons in resiliency, one need only look to the Japanese people for guidance.

Editorial

Mike Ryan

Mike Ryan, CFAChief Investment StrategistHead, Wealth Management Research – Americas

Stephen Freedman

Stephen Freedman, PhD, CFAHead, Investment StrategyWealth Management Research – Americas


Focus

Resiliency, not complacency

Con� rmationDespite the ongoing challenges from the devastation in Japan, unrest in the Middle East and North Africa (MENA), � scal dif� culties across the Eurozone and in� ation “hot spots” within emerging markets, � nancial markets have come under only modest selling pressure with the S&P 500 currently down just 1% from the February highs (see Fig. 1). Some may consider this a sign that investors have once again grown overly complacent amid excessively accommodative monetary policy conditions. We, however, view this as con� rmation that both the real economy and � nancial markets are on � rmer footing and much better able to absorb exogenous shocks than they were just six months ago. Additional headwinds are apt to emerge as the Fed’s QE2 program winds down, Congress plots a course toward a potential government shutdown, allied military intervention complicates Middle East unrest and rising in� ationary pressures force global policymakers into playing catch-up.

But this decidedly mixed macro backdrop notwithstand-ing, we still elect to retain our preference for risk assets with “overweights” to both equity and credit (see Fig. 2). Stocks remain attractively positioned relative to historical valuation metrics and the return prospects in � xed in-come and cash. Corporate credit spreads, while having narrowed considerably from their post-crisis highs (see Fig. 3), are unlikely to widen materially amid continued improvements in corporate pro� tability, still strong bal-ance sheets and likely further declines in default rates. Despite having underperformed through February, it re-mains our view that emerging market equities will out-perform developed markets as the tightening of policy serves to extend rather than undermine the expansion. Finally, with bond yields having fallen even further amid the events in Japan and MENA, we elect to deepen our underweight in bonds (especially in international mar-kets) and shi� funds to cash.

Fig. 1: Despite a series of exogenous shocks,stocks have proven to be extraordinarily resilient

Source: FactSet and UBS WMR, as of 28 March 2011

S&P 500 Index, since January 2010

1200

1100

1000

1400

1300

Apr-11Jan-11Oct-10Jul-10Apr-10Jan-10

S&P 500

Fig. 2: Tactically overweight equities

Source: UBS Investment Solutions and WMR, as of 30 March 2011.

Benchmark and current allocation: Percentage of portfolio (moderate risk portfolio)

Current allocation

Fixed Income

Equity

Commodities

Cash Alternative Investments

44

37

122 5

49

30

12

45

Benchmark allocation

Both the real economy and � nancial markets have proven to be extraordinarily resilient despite a series of exogenous shocks ranging from the tragedy in Japan to the unrest in the Middle East and North Africa (MENA). It continues to be our view that the global expansion remains on track—albeit with some economic “soft spots” and policy challenges ahead—and that markets have not become overly complacent. We therefore elect to retain our preference for risk assets as we enter the second quarter.

Note: For full explanation of this chart, please see appendix.


Expansion still on trackRecently reported economic data support the notion that the economic recovery process has evolved into a more durable and sustainable expansion—albeit with some likely “so� patches” ahead. Employment growth, which had been by far the most troublesome area of the US economy, has shown signs of improvement lately as evi-denced by the declines in both the weekly claims data and the unemployment rate (see Fig. 4). Better visibility on the economy and policy fronts has prompted an improvement in small business con� dence and created a better environ-ment for hiring (see Fig. 5). This in turn has helped to fuel an increase in personal income that bodes well for con-sumer spending. Keep in mind, however, that the increase in energy prices related to potential disruptions in supply from MENA has already weighed on consumption and has prompted our economics team to pare back our US GDP forecast for 2011 from 3.3% to 3% (please see “US eco-nomic outlook” on pg. 16 for a more detailed discussion).

While the Tohoku earthquake and related tsunami in Japan have had—and will continue to have—a devastat-ing impact on the people of Japan, the e� ect on global growth prospects is actually quite limited. Japan’s share of global GDP is currently somewhere between 6% and 9% (depending on how it is measured). Our economics team initially estimated that the quake would only shave about 0.5% o� growth this year, but that may change given the

ongoing problems at the Daiichi nuclear power facility in Fukushima. But even if growth is reduced by as much as 2% or 3%, as some economists are now forecasting, that would still only reduce global growth by about 0.2% overall. So despite the continued dif� culties in the a� er-math of the earthquake in Japan and the ongoing drag from higher energy costs associated with unrest in MENA, we still look for the world economy to expand at about a 3.8% pace this year.

It’s still a relative gameAs we’ve already noted, we retain our preference for risk assets even though geopolitical, economic and policy headwinds are likely to continue to bu� et � nancial mar-kets in the months ahead. Although most markets have rallied sharply following the spring sell-o� a year ago, there is little to suggest that either stocks or corporate bond spreads have become overly expensive. The US eq-uity market currently trades at a price to forward earnings multiple that is still below its long-term historical average (see Fig. 7) despite nearly doubling from post-crisis lows. What’s more, our own valuation work suggests that global equity markets are also currently trading about 15% below their “fair value” levels. While we’re not look-ing for a material “re-rating” higher for equities in an en-vironment that includes a sluggish growth outlook, a likely in� ection point for in� ation and prospects for a coming shi� in monetary policy, that’s not a necessary

Focus

Fig. 3: US Corporate spreads unlikely to widen materially

Source: Bloomberg, Barclays Capital, UBS WMR, as of 29 March 2011

Credit spreads, in %

4

2

0

8

6

12

6

0

24

18

201120102009200820072006

High Yield (rhs)

Investment Grade (lhs)

Fig. 4: Labor market continues to make steady improvement

Source: Bloomberg and UBS WMR, as of 28 March 2011

US weekly initial jobless claims in thousands and unemployment rate, in %

450

400

350

300

550

500

9.4

9.1

8.8

8.5

10.0

9.7

Apr-11Mar-11Feb-11Jan-11Dec-10Nov-10Oct-10Sep-10Aug-10

US unemployment rate (rhs)

US initial jobless claims (lhs)


condition for stocks to move higher from here. We are looking for S&P pro� ts to come in at about USD 96 for 2011 (+11.5%) and around USD 104 (+8.5%) for next year—which alone should be adequate to drive stocks toward our 1350 target for the S&P 500 this year.

But it’s not just about where equity markets trade versus historical benchmarks—or even where they stack up against proprietary valuation metrics. Rather it is about what returns stocks o� er compared to the other asset choices available to investors. With Treasury yields having declined once again in the wake of the most recent geo-political threats, expected returns on bonds remain near generational lows (see Fig. 8). Cash meanwhile, is still tethered to Fed policy and therefore provides a yield that is only notionally above 0%. Simply put, the return pros-pects for both bonds and cash remain largely uncompeti-tive when compared to those in the equity market where risk premiums appear elevated. This suggests that equity markets are apt to outperform on a relative basis during the current quarter—even if the absolute return prospects appear somewhat modest.

Selectivity is still the key Keep in mind of course that selectivity within the di� erent asset classes remains critical. Growth prospects and policy paths have still not converged and valuation remains un-even across industry sectors and geographic regions. We

therefore recommend that investors position for outper-formance within di� erent asset classes as follows:

• Retain a preference for emerging markets over developed countries: In a replay of 2010, emerging markets underperformed at the beginning of this year amid concerns that in� ationary pressures would prompt an aggressive tightening of policy that would hurt corporate pro� ts. Emerging markets have staged an impressive comeback over the past month and a half, however, as global growth prospects have so� -ened and expectations for a more protracted tighten-ing cycle have eased somewhat. Despite the recent recovery, emerging markets remain attractively posi-tioned relative to developed markets and should out-perform over the balance of the year.

• Seek a more balanced split between cyclical and defensive sectors: As our equity strategy team notes on pg. 28, cyclical sectors have outpaced defensive sectors by a sizable margin since Chairman Bernanke � rst raised the prospects for quantitative easing at the Fed’s Jackson Hole symposium in August. However, with the expansion now entering a more mature phase and policymakers planning to wind down QE2, the sector outlook is far more mixed going forward. We therefore reduce the magnitude of our pro-cyclical sec-tor stance and recommend a more balanced split

Focus

Fig. 5: Small business confidence and activity improving


NFIB Small Business Optimism Index

100

95

90

85

80

110

105

2007 201120031999199519911987198319791975

Average

NFIB Small Business Optimism Index

Fig. 6: Growth and in� ation forecasts

GDP Growth In� ationin % ’10 ’11F ’12F ’10 ’11F ’12FWorld 4.2 3.8 3.9 2.8 3.4 3.1

US 2.8 3.0 2.7 1.6 2.3 1.5

Canada 3.1 2.7 2.6 1.8 2.4 2.2

Japan 4.0 1.0 2.5 -0.7 0.1 0.4

Eurozone 1.7 1.8 2.0 1.6 2.2 2.0

UK 1.3 2.0 2.2 3.3 3.6 1.9

China 10.3 9.3 9.0 3.3 4.8 4.0

India 8.7 7.7 8.6 9.8 7.0 7.5

Russia 4.0 4.8 4.5 6.8 9.6 7.7

Brazil 7.5 4.5 4.5 5.9 5.8 4.8

Asia ex-Jp/Chi/Ind 5.3 4.3 4.3 2.7 3.2 3.2

Note: For full explanation of this table, please see appendix. F: forecast Source: UBS WMR, as of 28 March 2011


between cyclical and defensive sector exposure. Technology, Consumer Staples, and Industrials remain our favored sectors.

• Continue to overweight credit within � xed in-come portfolios: While Treasury rates have fallen in response to a ratcheting up of geopolitical risks, credit spreads are slightly wider than they were back in mid-February when the unrest in the Middle East intensi� ed. However, with balance sheets still in solid shape and corporate default rates likely to edge even lower, corpo-rate and high yield bonds are likely to outperform gov-ernment debt once again during the second quarter.

• A preference for dollar denominated over foreign currency bonds: This re� ects our expectation of a weakening euro and yen, the two largest currencies a� er the dollar. The yen should come under pressure due to the extra liquidity that the Bank of Japan is in-jecting into the economy, reconstruction-driven pres-sures on public � nances and a commitment by G7 of� cials to prevent yen appreciation. The euro, which is expensively valued vs. the dollar, is likely to come under pressure once � nancial stability concerns return to cen-ter-stage. We note that the dollar is likely to continue to remain weak against minor currencies (see pg. 23).

Keep watch for headwindsWhile our overall backdrop remains constructive for growth and risk assets, there are still several headwinds that pose near-term threats to our economic forecast and investment outlook. These challenges range from “melt-downs” and “shoot downs,” to “slowdowns” and “shut-downs.” Consider the following:

• Deepening of the nuclear disaster in Japan: The situation at the Daiichi nuclear facility in Fukushima re-mains both unstable and � uid. High radiation levels have made it dif� cult for workers to conduct repairs and the timing for a “cold shutdown” is still uncertain. The containment vessel of at least one reactor may be leaking. Radioactive contaminants exceeding Japanese safety standards have been found in both food and water supplies in Tokyo. Should the crisis deepen even further, this could weigh heavily upon both consumer and investor con� dence – even if the direct economic impact remains modest.

• Spreading unrest across MENA: Recent violence in Syria suggests that the unrest spreading across the Middle East and North Africa has not yet fully played itself out. With western military forces now actively involved in en-forcing a no-� y zone across Libya, the risks that NATO and its allies may become enmeshed in yet another ex-tended con� ict in the region have risen. This, in turn, could cause additional disruptions in crude supplies, sharp

Fig. 7: Valuations remain supportive for stocks

Source: DataStream and UBS WMR, as of 28 March 2011. P/E = Price-Earnings ratio

S&P 500 P/E based on next 12 months’ consensus earnings estimates

15

10

5

25

20

2009 201220062003200019971994199119881985

Average

S&P 500 12-month forward P/E ratio

Fig. 8: We expect 10-year Treasury yields to rise going forward


US 10-year treasury bond yield, in %

12

10

8

6

4

2

0

16

14

20072002 201219971992198719821977197219671962

Average

US 10-year Treasury yields

Focus


Focus

increases in energy prices and even threaten further radi-calization of Muslim populations. Keep in mind that oil becomes a much bigger threat to growth prospects as prices move above the USD 120 per barrel mark.

• Further shi� s in the monetary policy backdrop: The Fed is committed to winding down its security re-purchase program commonly known as QE2 by the end of this quarter. This is but the � rst phase in what is cer-tain to be a multi-stage process of unwinding accom-modative monetary policy conditions. At the same time, emerging market central bankers continue to battle in� ation “hot spots” and the European Central Bank has signaled its intent to raise base rates in order to nor-malize policy. While the paydown in the Fed balance sheet—coupled with more overt tightening moves by other central banks—represents some risk for global markets, we expect policy “normalization” to be viewed more as con� rmation that the expansion has reached a more sustainable level.

• Potential economic “so� patch”: There is some evi-dence that leading indicators are beginning to top out and that the economy may be headed for a bit of a “so� patch” during the current quarter. Consumer con-� dence fell sharply in March a� er reaching a three-year high the prior month, amid heightened in� ation con-cerns, lingering anxiety over job security and jitters over MENA. While periods of moderating growth are hardly uncommon during an economic expansion, there is un-derstandable concern over the risk of a deeper deceler-ation during the current business cycle. Keep in mind that the recovery itself owes much to the extraordinary steps taken by policymakers. Still, we see this less as a sharp protracted drop in activity and more of a modera-tion within an increasingly durable and sustained expansion.

• Threat of a government shutdown looms: With the continuing resolution required to fund government set to expire on 8 April—and neither party willing to make the types of concessions necessary to break the current stalemate—a government shutdown appears possible this quarter. While some may dismiss this as mere

political theater and argue that the economic impact is minimal, the failure of elected of� cials to address acute � scal problems would likely further undermine support for the dollar and could also precipitate a sell-o� in the Treasury market. Although a weaker dollar would help the US expansion, an abrupt rise in bond yields would clearly be a signi� cant headwind. Keep in mind how-ever that the odds of a shutdown are still fairly low, and that even if it was to happen the duration would likely be short.

ConclusionThe tragedy in Japan and con� ict within the Middle East and North Africa serve as somber reminders of the sort of events that can threaten both life and property. That nei-ther the real economy nor � nancial markets appear to have been materially impacted by these shocks may be seen as a sign of resiliency—but should never be viewed as a reason for complacency. Investors not only must con-tinue to evaluate both growth and return prospects as they make their investment decisions, but must also incor-porate an assessment of the geopolitical, economic and policy headwinds that might threaten that outlook. So while we remain committed to risk assets, we will con-tinue to monitor cyclical and structural changes that might prompt a shi� in this tactical view.

Mike Ryan, CFA, Chief Investment Strategist


Progress report: will, may or won’t?

Will

Equity markets will provide nor-malized returns.

TO DATE: Stocks are up about 4% so far this year (which would translate into annualized returns of about 16%). While above the long-term historical aver-age, this performance is in line with the targets set in our 2011 Outlook report.

�

The sovereign debt crisis will grow more acute.

TO DATE: Portugal is the latest casualty in the debt crisis sweeping through the Eurozone. The EU and IMF have been forced to expand both the funding level and scope of the � nancial stability fund in order to limit further contagion risk. Meanwhile, concerns about Spain appear to have abated somewhat.

�

Corporate cash hoarding will end.

TO DATE: A� er an extended period of vigilantly hoarding cash, corporations have begun to loosen the purse strings a bit. Capital spending is expected to increase by 12%, dividends have risen by 13% in the most recent quarter (ex-cluding � nancials) and share repurchase programs are running at their highest level in 2 years.

�

Geopolitical threats will intensify.

TO DATE: The escalation of tensions in the Middle East and North Africa—including the toppling of several heads of state and open rebellion in other nations—con� rms the ratcheting up of geopolitical risks. With oil-producing states clearly at risk, there is even greater risk of economic fallout from deepening hostilities.

�

Congress will deteriorate into gridlock.

TO DATE: In fewer than three months, the 111th Congress has predictably frac-tured along partisan lines. With a continuing resolution to fund government set to expire on 8 April and neither side willing to make meaningful budget con-cessions, there is increasing risk of a government shutdown this quarter.

�

May

A high pro� le municipality may default.

TO DATE: There have been no high pro� le municipal defaults so far in 2011. However, with several states and municipalities still struggling to close sizable budget de� cits, there is still a chance that a signi� cant player in the muni mar-ket will default before year-end. In fact, Je� erson County, Alabama, home to Birmingham, could default in the absence of assistance from the state legisla-ture to generate additional revenue.

The economy and corporate pro� ts may surprise to the upside.

TO DATE: There is little to suggest that the real economy or corporate pro� ts will surprise meaningfully to the upside. Consumer con� dence readings have so� ened recently amid higher energy costs, while S&P earnings beat estimates for the most recent quarter, but by a smaller margin than the prior four quarters.

�

?

In our 2011 Outlook report, we once again o� ered our forecasts for the � ve things that will, may, or won’t happen in 2011. In the spirit of accountability, we o� er this progress report as to where we stand with one quarter behind us.


Rising protection-ism may trigger a trade war.

TO DATE: Despite ongoing concern over domestic job security and Chinese trade practices, there doesn’t appear to have been any meaningful increase in protectionist sentiments. This may be a function of a surge in export growth and declines in the unemployment rate.

�

Emerging markets may stumble.

TO DATE: Emerging markets underperformed US equities by about 10% from the end of December through mid-February as in� ation “hot spots” prompted a more aggressive tightening of policy. With emerging markets no longer trad-ing at deep discounts to developed market indices, the prospects for slower growth weighed more heavily upon developing nations equities.

�

Bond market volatility may increase.

TO DATE: While bond yields rose sharply through mid-February, rates retraced that move as tensions in MENA escalated. However, with the Fed poised to wind down QE2 toward the end of this quarter, we look for rates to rise further and the bond market to become more volatile.

Won’t

P/E multiples will not exceed long-term averages.

TO DATE: While markets have rallied nearly 30% from their July lows, multiples still remain below long-term averages. Although further increase in multiples is likely, we look for earnings growth to fuel further moves in equity markets.

�

The housing market will not sustain a recovery.

TO DATE: February housing starts fell to the lowest level in nearly two years, while home construction plunged 22.5% to a USD 479k annualized rate and building permits declined 8.2%. The Case-Schiller home price index fell another 3% over the 12-month period through January amid still high inventories and continued increases in delinquency and default rates.

�

There will not be meaningful prog-ress in de� cit reduction.

TO DATE: Congress is deeply divided over potential budget cuts that amount to somewhere between USD 10 and 60bn (i.e., 0.6% to 3.8%) of total spending. None of the budget proposals from either party address the most acute � scal issue: entitlement spending.

�

Commodity prices will not collapse.

TO DATE: While commodity prices have been mixed through the � rst quarter 2011, they have risen overall about 2.5%, as evidenced by the Dow Jones/UBS Commodity Index.

�

In� ation will not be a problem.

TO DATE: Since last December, we have raised our 2011 US in� ation forecast to 2.3% from 1.6% due mainly to the surge in energy and food prices. This is still not a troubling level, and core in� ation, which excludes food and energy, rose by just 1.1% y/y in February. However, in line with our expectations, there have been some trouble spots overseas, especially in emerging markets where food and energy represent a higher share of household spending.

�

?

Progress report: will, may or won’t?


Our Best Ideas at a Glance

Fixed Income

Current allocation: 30.0%

Within US dollar Fixed Income

• High Yield Corporate bonds

• Investment Grade BBB-rated Corporate bonds

• In Emerging Markets, sovereign debt issued by Chile, Mexico and Russia, quasi-sovereign oil and gas conglomerates, and large mining companies

Pages 26, 33

F

ity

Asset ClassesPreference for Equities over Bonds

CurrenciesAvoid Japanese yen. Preference for SEK, NOK, GBP, as well as selected Emerging Market currencies.

The following list represents investment strategy recommendations that we believe will provide attractive oppor-tunities over the next 9-12 months.

Equities


International markets

• Selected Emerging Market equities, especially China, Russia, Taiwan, South Korea, Mexico and South Africa

• UK equities

Within US equities

• Information Technology: hardware and equipment

• Industrials: capital goods

• Consumer Staples: companies with emerging markets exposure, espe-cially household products & cosmetics

• Within Consumer Discretionary: auto suppliers, restaurants, lodging

• Within Energy: oil� eld services

• Within Financials: money center banks & insurers

• Within Healthcare: drug distributors

• Within Materials: chemicals & in-dustrial gas

• Within Telecom: wireless towers & data centers

• Preference for Growth over Value stocks

Pages 24, 28, 31

Alternative InvestmentsCurrent allocation: 12.0%

• Included in portfolio for diversi� cation purposes

Page 39

CommoditiesCurrent allocation: 5.0%

• We see upside potential for gold and selected agricultural commodities.

Page 38

Cash


• Unattractive yields. Cash over-weight to � nance underweight in non-US to o� set � xed income.

For an explanation of current allocation and the underlying benchmark allocation, please see the note on the following page.

OverweightNeutralUnderweight


Asset Allocation Overview Asset Allocation Overview WMR Tactical View Model Portfolio Moderate Risk Pro� le (in %)

Benc

hmar

k A

lloca

tion

Tact

ical

Dev

iati

on

Chan

ge

Curr

ent

Allo

cati

on

EquitiesReasonable valuations and ample liquidity create a supportive environment for equities, especially in view of poor prospects for bonds.

Overweight 44 +5.0 49.0

US EquitiesSolid earnings growth and loose monetary policy are expected to persist a while longer. This currently o� sets valuations, which are less attractive than abroad.

Moderate Overweight

32 +2.5 34.5

US Large Cap ValueValuations and our sector tilts suggest preference for Growth over Value.

Moderate Underweight

11 -0.5 10.5

US Large Cap GrowthValuations and our sector tilts suggest preference for Growth over Value. Large Caps should bene� t from exposure to overseas demand.

Moderate Overweight

11 +4.0 15.0

US Mid CapM&A activity, which bene� ts Mid Cap, should improve modestly in 2011.

Moderate Overweight

5 +0.5 5.5

US Small CapExpensive vs. large caps. Yet, improving � nancing conditions and higher market beta in a rising market should be supportive.

Neutral 3 +0.0 3.0

US Real Estate Investment Trusts (REITs)REITs are still expensive and face headwinds from rising interest rates. Commercial real estate market improving but challenges remain.


2 -1.5 0.5

Non-US Developed EquitiesValuations more attractive than US, especially in Europe. However, lower growth potential and � scal concerns in the Eurozone and Japan suggest more cautious stance.

Neutral 10 +0.0 10.0

Emerging Market (EM) EquitiesStrong valuation, earnings growth and � scal fundamentals are partly o� set by the risk of further food price in� ation and monetary tightening.

Moderate Overweight

2 +2.5 4.5

Fixed IncomeWe expect bond yields to progressively rise from abnormally low levels as central banks normalize monetary policy.

Underweight 37 -7.0 30.0

US Fixed IncomeWe prefer US over non-US � xed income as dollar trades near record-low levels against many major currencies and rebound is possible.


29 -2.5 26.5

Non-US Fixed IncomeExtremely low yields and overvalued yen make Japanese debt unattractive. Euro appears too expensive given ongoing debt crisis and structural issues.

Underweight 8 -4.5 3.5

Cash (USD)Poor prospects for non-US � xed income lead us to shi� into cash.

Moderate Overweight

2 +2.0 � 4.0

CommoditiesWhile we expect commodity prices to rise further this year, negative roll yields (resulting from contango term structure of futures prices) should signi� cantly trim total returns.

Neutral 5 +0.0 5.0

Alternative InvestmentsNo tactical view. Included into portfolio for diversi� cation purposes.

Neutral 12 +0.0 12.0

“WMR tactical deviation” legend: Overweight Underweight Neutral “Change” legend: � Upgrade � DowngradeSource: UBS WMR and Investment Solutions, as of 30 March 2011. For end notes, please see appendix.

�

�

The benchmark allocations underlying this and the previous page are provided for illustrative purposes only by UBS for a hypothetical US investor with a moderate investor risk pro� le and total return objective. See “Sources of benchmark allocations and investor risk pro� les” in the Appendix for a detailed explanation regarding the source of benchmark allocations and their suitability and the source of investor risk pro� les. The current allocation is the sum of the benchmark allocation and the tactical deviation. See “Deviations from benchmark allocation” in the Appendix regarding the interpretation of the suggested tactical deviations from benchmark.


Fiscal issues continue to be the focus in Washington, DC. Katie Klingensmith, Wealth Management Research’s economic and policy analyst, sat down with John Savercool of the US Of� ce of Public Policy to discuss the politics of government spending and other topics currently being debated in DC.

Katie Klingensmith (KK): John, your prediction that � scal issues would dominate Washington has cer-tainly been borne out. What has surprised you most about this session of Congress?

John Savercool (JS): What has surprised me the most about this session is the seriousness with which many members of Congress are engaging in the current debate over the federal budget de� cit and our overall debt. There is a critical mass of members, both Democrats and Republicans, who understand the need to reduce the bud-get de� cit immediately, which is a di� erent dynamic from previous sessions of Congress when there didn’t seem to be any urgency to � x our worsening budget problems. A critical mass doesn’t mean there is consensus behind spe-ci� c proposals to balance the budget, but at least it pro-vides a starting point for compromises to be made.

KK: Has your view on the Tea Party movement changed since the last elections? How do you see the ideas of this movement shaping the current debate in Washington?

JS: The Tea Party movement was obviously in� uential in the 2010 midterm elections and is still a growing and sig-ni� cant force in the Congress and around the country. The Tea Party movement will be viable nationally as long as our government’s budget problems are severe enough to keep these voters outraged. Even voters who do not af� liate with the Tea Party have found themselves en-gaged in the � scal issues that the Tea Party helped bring to light so successfully in the last election, so its impact has been broader than most people think. Tea Party mem-bers attracted national support in � ghting measures to expand government spending; their challenge going for-ward in remaining viable is whether their solutions to these problems can have similar national appeal.

KK: Congress has passed yet another continuing res-olution. Can you explain what this means? Why do they not pass a full funding bill instead?

JS: Congress recently passed a second continuing resolu-tion (CR) to provide government funding through 8 April. A short-term CR was necessary because Democrats and Republicans haven’t yet agreed on a plan for the rest of the � scal year (through September), hence the passage of a temporary CR that gives them additional time to negoti-ate a longer-term measure. Both sides are getting wary of these temporary deals, however, and I suspect that an agreement will be reached prior to 8 April that will cover government funding for the rest of the � scal year. Keep in mind the negotiations and the con� icts that inevitably arise in them are as much ideologically driven as political. One side wants government to do more with a higher price tag, and the other side wants it to do less with a smaller price tag. That constitutes a major philosophical � ght over the role of government that is not easily or quickly resolved.

KK: When and how do you expect Congress to ulti-mately resolve the funding issues for this � scal year and the next?

JS: I believe a funding measure that covers the rest of the � scal year will be approved prior to 8 April. The House will quickly pivot toward consideration of a budget for next year (beginning 1 October 2011) and focus not only on more spending cuts but also on signi� cant entitlement reforms. Addressing major entitlement reforms in the po-litically popular programs of Social Security, Medicare and Medicaid is a major political risk for Republicans, but not addressing these issues is also a major risk. Congress did not pass a budget last year, and there is no guaran-tee that it will pass a budget this year. Many members of Congress are in a quandary—how bold should they be in addressing budget challenges, particularly in the entitlement programs, and what political price will they pay for their boldness or timidity, depending on what route they take?

Washington Watch

Budget crisis still looms


KK: We estimate that the US government will hit the debt ceiling by the end of April, and that the Treasury Department is already scrambling to avoid hitting this limit. Do you think the debt ceiling will be increased soon? What are the political hurdles?

JS: The debt ceiling, as ugly as it is, will have to be in-creased at some point, and I believe Congress will increase it before it is breached. It will have to be accompanied by some structural budget changes that make a majority of Democrats and Republicans con� dent that the de� cit will be dealt with in a meaningful way over the next decade. For instance, a plan to make automatic spending cuts to the government’s budget each year if Congress fails to make the cuts themselves is one option under consider-ation. Budget hawks in Congress will use this debate to gain some in� uence over future government spending lev-els, and it is possible that Congress will have to approve several increases in the debt ceiling prior to the 2012 elec-tions as a way of maintaining pressure to cut the de� cit.

KK: Do you expect that there will be meaningful cuts to government spending in 2011 and 2012?

JS: I believe there will be only modest cuts in spending in 2011 and 2012. The real signi� cance will be in what Congress does to put a foundation in place that will com-mit its members to deal with the de� cit over the next 10 years. To put in motion some form of long-term plan would represent progress, in my view.

KK: Social Security and Medicare are expected to take up a larger and larger part of government spending going forward. Do you see any chance that these pro-grams will be addressed by this Congress? And if so, to what degree and when?

JS: Yes, they will be debated as early as next month once House Republicans unveil their budget plan for Fiscal Year 2012 and beyond. Social Security and Medicare will both be subject to reform proposals, as will Medicaid. Most members know they have to tackle these funding prob-lems if they are serious about reducing the de� cit. There is a lot of work going on quietly now with members on both sides of the aisle to identify meaningful reform options

that involve shared sacri� ces among the various stake-holders, including retirees, current workers, and in partic-ular, younger Americans who have time to consider alternative ways to provide for their future retirement and medical needs. This debate will generate lots of noise in Washington, but I do not think potential solutions will be enacted prior to the 2012 elections.

KK: Unemployment has fallen slightly since the mid-term elections, but is likely still a hot-button issue. Do you think there will be any additional legislation or stimulus to help the unemployed?

JS: No, the political environment is not conducive to fur-ther stimulus. There may be some policy measures on the margins that could a� ect job creation or job preservation and get attention in Congress, such as a transportation/infrastructure spending bill, a corporate tax bill that could be used as an incentive to hire or promotion of free trade measures that could a� ect certain economic sectors, but nothing on the massive scale that we saw with the stimu-lus bill enacted in 2009. Even these smaller measures would face dif� culties in the current Congress.

KK: The administration issued a report with various proposals for how to reform Fannie Mae and Freddie Mac. What changes, if any, do you expect to see in housing policy over the next year?

JS: Very little. Congress and the House in particular, will debate how Fannie and Freddie should be reformed, but there is not enough of a consensus to act on a speci� c

Washington Watch

The debt ceiling, as ugly as it is, will have to be increased at some point, and I believe Congress will increase it before it is breached.

“

“


plan, especially when the housing market is still so� . Major reforms to Fannie and Freddie will wait until 2013 at the earliest. In the meantime, the House will pass a series of “mini-reforms,” including a lowering of the con-forming loan limit, increased guarantee fees and a scaling back of Fannie and Freddie’s investment portfolios. These types of reforms are more widely supported and could pass the Senate as well this year.

KK: On a di� erent note, we have all watched and mourned the situation in Japan. Do you think the tragic events there will change Washington’s views and plans on energy policy?

JS: Yes, Congress will respond to public sentiment, and the public is increasingly anxious about the situation in Japan. We all remember how public support for nuclear power dissipated a� er the Three Mile Island accident, al-though there were no injuries or fatalities associated with that mishap. The same thing could happen here, and all public polls taken so far in the a� ermath of the tsunami reveal reduced support for an expanded use of nuclear power in the US. This is reversible in the future, but in the short term, this sentiment makes passage of a major en-ergy bill, nuclear included, much more dif� cult. We did not envision a major energy reform bill passing this year prior to the catastrophe in Japan, and recent develop-ments only make the likelihood of such legislation even more remote.

KK: And � nally, you shared your perspective last fall that trade was an issue that lacked a clear constitu-ency. It seems the White House is working a bit harder to push through pending free trade agree-ments. Why is this so and what is the likelihood of passage?

JS: The administration has shown more interest in trade over the last few months. Part of that is due to its desire to meet the president’s goal of doubling exports over the next � ve years, and part of it is the business sector’s suc-cessful lobbying for the pending free trade agreements with South Korea, Panama and Colombia. The president has committed his support to the South Korea deal but has demurred on the other two. This is an area where

there could be bipartisan support if the two parties have the will to take advantage of it. Republicans want to con-sider all three trade agreements at once, and the presi-dent wants only the South Korea deal approved at this time. I believe that eventually all of these agreements will be approved, but the timing is uncertain. It could be next year or it could be in 2013.

KK: Shi� ing gears away from economics—but to something that has big price tags—I am interested in your perspective on the attention Washington and the country are paying to events in the Middle East and North Africa. Many Americans seemed surprised by the US’ participation in the enforcement of a no-� y zone in Libya. What is your take on Washington’s attitude about our current involvement in the region?

JS: It seems the administration felt it had to do some-thing, hence the strategy it arrived at with many of our allies. Members of Congress have historically rallied be-hind their commander-in-chief when US troops are sub-ject to combat, but the current friction with Libya is complicated by the fact that the US is already at war in two other countries. The current focus in Congress is not necessarily critical of the administration for its policy—at least not yet. Most members instead want a clari� cation on the policy and how it will be paid for, and are still leery of criticizing the president when troops are in combat. This could change quickly depending on the degree of success and longevity of the no-� y zone action.

Washington Watch


Market ScenariosGlobally, economic indicators showed continued signs of strength. Various factors suggest that the recovery will continue at a moderate pace despite the disaster in Japan and instability in the Middle East and North Africa. However, prospects for a strong recovery have diminished. The main risk to the recovery appears to be a shortage of commodities that would cause prices to spike. A renewed de� ationary downturn appears unlikely at this stage.

High Growth

ModerateRecovery

Low Growth

Negative Growth

Goldilocks Supercycle

Deflation Stagflation

High Negative Inflation

Low Inflation Inflation

70%

High Growth

RenewedDownturn

15%Low Growth

Negative Growth





High Growth

Strongrecovery

10%Low Growth

Negative Growth





High Growth

Stagflation

5%Low Growth

Negative Growth





• The global economy remains on a self-sustaining but unspectacular expansion course.

• Rapid growth in the emerging markets helps to sustain global aggregate demand.

• The recovery in developed countries is more subdued than in prior cycles because of deleveraging pressures on the consumer and � nancial sectors.

• The abundant slack in the US economy keeps in� ation-ary pressures from building up despite easy monetary policy. Food price in� ation abates during the second half of 2011.

• High pro� t margins and low interest rates encourage a surge in investment spending.

• Improvements in the labor market and credit conditions allow for a more dynamic consumer recovery.

• Global GDP growth exceeds 4.5% in 2011.

• Commodity prices rise due to political instability in the Middle East and/or poor food harvests, setting an in� a-tionary process in motion.

• Rising price levels and weak growth prospects pose sig-ni� cant challenges to most � nancial assets.

• The fragile recovery in the developed economies stalls as � scal consolidation and initial interest rate hikes cre-ate additional headwinds.

• Most countries su� er at least one quarter of negative growth as consumers cut back on spending.

• Falling commodity prices and a rise in excess capacities lead to negative consumer price in� ation (de� ation).

60%

20%

15%

5%

(down from 25%)

(up from 10%)

StrongRecovery

Source: UBS WMR


Our commodity team is factoring sustained high oil prices on the back of the political turmoil in the Middle East and North Africa (MENA). Consequently, we lowered our 2011 real GDP growth forecast from 3.3% to 3.0% and raised our 2011 headline CPI fore-cast. As we don’t expect any signi� cant spillover from the surge in energy and food prices into core prices, we leave our core CPI forecast unchanged.

The price of WTI oil has risen from roughly 85 USD/bar-rel to currently about 105 USD/barrel resulting from the political turmoil in MENA. Recently, our commodities team raised its near-term oil price forecast to include an upper bound of 120 USD/barrel, and raised its 12-month target to 105 USD/barrel. This change simply re� ects a higher oil price sooner than we had antici-pated. Our rule of thumb is that for every 10% perma-nent increase in the oil price, US real consumption is curtailed by about 0.4 percentage points over 12 months. Furthermore, despite the January boost to per-sonal income on the back of the late 2010 tax bill, real consumption has been falling short of our expectations for the � rst two months of the running year.

Negative growth impact will likely be front-loadedTo re� ect the recent developments and their impact on the outlook, we are trimming our 1Q11 real GDP growth forecast, but we are keeping our growth forecasts for the remaining quarters of the year unchanged. This lowers

our 2011 real GDP growth forecast from 3.3% to 3.0%, and now the outlook class for a more even growth pat-tern across the quarters. The impact of higher oil prices tends to be front-loaded, thus warranting no change to our outlook beyond 1Q11. Additionally, we don’t expect a permanent increase in oil, even though temporary spikes are still possible. US household balance sheets and savings behavior have adjusted suf� ciently in our view to avoid damaging second-round e� ects on � nal demand.

Positive impact on headline, but not core in� ationNaturally, higher oil prices boost headline in� ation, and we are raising our 2011 calendar average CPI in� ation forecast. However, pass-through of oil price increases to core CPI have been extremely limited since the early 1980s; as the oil intensity of production has fallen, labor unions have less bargaining and businesses less pricing power. We think this decoupling will likely per-sist and don’t expect core CPI in� ation to accelerate beyond what we have already factored in. Speci� cally, we continue to expect a gradual ascent in core CPI in-� ation in 2011 and 2012.

Thomas Berner, CFA, Analyst

US Economic Outlook

Oil price spike is taking its toll

UBSforecasts

Fig. 1: Growth will likely be moderate but steady

Note: For full explanation of this chart, please see appendix.Source: Thomson Datastream, UBS WMR, as of 25 March 2011

US real GDP growth, quarter-over-quarter annualized in %

5

0

–5

–10

10

Q3 2010Q3 2009Q3 2008Q3 2007Q3 2006Q3 2005 Q3 2011

Consumption

Investment in equipment & soware

Investment in nonresidential structures

Residential investment Government

Net exports

Inventories Real GDP(% q/qannualized)

UBSforecasts

Fig. 2: CPI inflation is trending higher

Note: For full explanation of this chart, please see appendix.Source: Thomson Datastream, UBS WMR, as of 25 March 2011

US inflation, year-over-year in %

4

2

0

–2

–4

6

201020082006200420022000 2012

CPI

Core CPI


Despite the political turmoil in MENA and the recent Japanese tragedy, the global economy thus far con-tinues to show robust growth. In fact, the overheat-ing concerns regarding some emerging economies have not faded and the European Central Bank has also signaled its intention to raise rates soon in light of rising in� ation. We continue to expect a sustain-able global expansion, but have lowered our global growth forecast slightly in response to the negative impact of these developments.

Rising interest rates in EuropeThe world’s major developed world economies needed extraordinary stimulus injections to steer economic output back toward pre-� nancial crisis levels. The � rst signs of sustainable, self-driven recovery are apparent in Germany, and are also emerging from the US. One consequence has been indications that the European Central Bank will start to increase interest rates in 2Q11, though at a moderate pace. Prospects for higher interest rates in Europe are mo-tivated by a recent increase in in� ation.

Overheating concerns in emerging economies prevailEmerging economies continue to grow briskly and are led by China, where the question is whether strong growth is leading to overheating and in� ation. Thus, present con-cerns focus on the arguable tardiness of monetary tight-ening and the undervalued Chinese renminbi. Brazil and

other large emerging economies have already seen a round of interest rate hikes and are thus further advanced in the process of cooling the economic engine.

Politics and crisis in MENAThe turmoil in MENA has so far toppled two autocratic governments in Tunisia and Egypt, and is challenging oth-ers as we write, most notably, Libya. The root causes of the “Arab spring” are multiple: demographic pressure from the youth; high unemployment; political corruption and repression; and signi� cant food price increases. The major contagion risk for the global economy stems from the surge in the oil prices. At this stage, developments are unlikely to derail the ongoing global economic expansion, but they strongly suggest that further acceleration in growth is very unlikely.

Signi� cant slow-down in JapanThe scale of the tragic events in Japan and their economic impact is starting to become clearer. It initially appeared that the situation was similar to the 1995 Kobe earth-quake, which ultimately had only a limited e� ect on the economy. However, the economic losses now seem to be far greater this time. Even in Tokyo, which is far from the epicenter, the disruption has been great, and the recovery may be slow. We expect very weak economic data in the months ahead.

Thomas Berner, CFA, Analyst

Global Economic Outlook

Global economy seems resilient

Fig. 3: Manufacturing activity is probably peaking

Source: Bloomberg, UBS WMR, as of 25 March 2011

Global real activity, standardized (mean=0, standard deviation=1)

2

0

–2

–4

4

2010200620021998

USA

Eurozone

UK

Japan

China

Fig. 4: Inflation resurgence a key risk in some countries


Global CPI inflation rates, year-over-year in %

2

0

–2

–4

8

6

4

10

2010200620021998

USA

Eurozone

UK

Japan

China


Fig. 5: Housing recovery likely to be lackluster

2

0

6

4

8

1.0

0.0

3.0

2.0

4.0

Q1 2000Q1 1990Q1 1980Q1 1970Q1 1960Q1 1950 Q1 2010

Residential real estate investment (lhs)

Residential real estate investment (historical average) (lhs)

Homeowner vacancy rate (rhs)

US housing market, le scale in % of GDP, right scale, in %

Source: Thomson Datastream, UBS WMR, as of 25 March 2011

Economic Outlook: Chartbook

Fig. 7: Production recovering, spare capacity remains

Source: Bloomberg, as of 29 March 2011

Manufacturing capacity utilization rates, in %

UKUS Canada

France

85

80

65

70

75

90

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Fig. 9: Federal deficit poised to narrow further

Note: Sum of monthly federal budget balance over the past 12 months divided by current-quarter annualized nominal GDP. Source: Bloomberg, UBS WMR, as of 25 March 2011

US Federal budget balance, in % of GDP

–4

–6

–8

–10

–12

2

0

–2

4

20102004199819921986198019741968

US federal budget balance as a % of GDP

Source: Thomson Datastream, UBS WMR, as of 25 March 2011

US house prices, le scale in %, right scale in year-over-year %

1.0

0.0

3.0

2.0

4.0

–10

–20

10

0

20

Q1 2006Q1 2001Q1 1996Q1 1991Q1 1986Q1 1981Q1 1976 Q1 2011

Homeowner vacancy rate (lhs)

S&P/Case-Shiller house price index (rhs)

FHFA house price index (rhs)

Fig. 6: House prices to fall moderately again in 2011

Fig. 8: Net wealth is recovering, savings rate stabilized

US consumer sentiment (index level) and inflation expectations (in %)

70

50

110

90

130

2.0

1.5

3.0

2.5

3.5

Mar-06Mar-02Mar-98 Mar-10

University of Michigan consumer sentiment index (lhs)

University of Michigan long-term inflation expectations (rhs)

Fig. 10: US consumer sentiment deteriorates


Note: Right scale is invertedSource: Thomson Datastream, UBS WMR, as of 25 March 2011

US household net wealth and savings rate, in % of dispsable income

86420

–2

1210

14

5.0

5.5

6.0

6.5

4.0

4.5

3.5

200019901980197019601950 2010

Savings rate (lhs)

Net wealth to disposable income ratio (rhs)


Financial Market Performance

Fig. 1: Asset classes


Total return in USD and %

US Fixed Income

Non-US Fixed Income

Commodities

Cash (USD)

Non-US Dev. Equities

EM Equities

US Equities

year-to-date

2010

151050–5 20

Fig. 3: International fixed income



UK

Japan

Non-US Fixed Income

EMU

US Fixed Income

year-to-date

2010

151050–5–10 20

Fig. 5: US fixed income

Source: BoAML, UBS WMR, as of 29 March 2011


IG Corporates

PreferredsMortgages

EM SovereignsMunicipal bonds

HY Corporates

TIPSAgencies

Treasuries

year-to-date

2010

12840–4 16

Fig. 2: International equity markets



UK

Japan

Emerging Markets

Non-US Developed

EMU

US Equity

year-to-date

2010

151050–5–10 20

Fig. 4: US equity markets



Mid Cap

REITs

Small Cap

Large Cap Growth

Large Cap

Large Cap Value

year-to-date

2010

2520151050 30

Fig. 6: Currency appreciation vs. USD


Appreciation vs. USD, in %

CAD

AUD

BRL

CHF

GBP

JPY

EUR

year-to-date

2010

1050–5–10 15


Financial markets have absorbed a series of shocks relatively well, including unrest in the Middle East, rising oil prices and the tragedy in Japan. Given a solid economic and earnings backdrop, as well as valuations that still appear fairly attractive, we be-lieve the case for equities remains in place, while bonds look challenged.

Case for equities still compellingAs usual, we evaluate the prospects for various asset classes through our triangular framework consisting of valuation, cyclical factors and timing/market sentiment. In a nutshell, for global equities our scorecard (see Fig. 3) indicates that valuation and cyclical factors are moderately supportive, while sentiment is mixed.

Starting with valuation, WMR’s proprietary dividend dis-count model indicates an upside to fair value of 15% for global equities. On the traditional price-earnings metric, global stocks are trading at 11.7x forward earnings com-pared to a 23-year average of 16.5x. While full conver-gence to this long-term average is unlikely to happen anytime soon, the gap is large enough to suggest the po-tential for some multiples expansion.

On the cyclical side, global economic data has been gener-ally positive, creating a favorable environment for earnings. We expect global growth to remain in expansion mode, as highlighted on pgs. 16 and 17. Under these circumstances,

we would expect upward earnings revisions to continue. Consensus earnings estimates have so far shown little re-action to negative events such as the spike in oil prices and the tragedy in Japan. While estimates continue to be re-vised higher, recent events create downside risk. However, we remain con� dent that earnings will ultimately come in at levels that are consistent with moderate equity market gains. First, we do not expect global supply chains to be heavily impacted by the loss of production in Japan. Second, earnings should still be able to grow at a decent pace given that the streak of positive economic data sur-prises observed during the � rst quarter is unlikely to have been fully re� ected in earnings estimates.

Finally, market sentiment is currently much more mixed than at the beginning of the year, which was character-ized by increasing investor optimism. At the same time market-implied volatility (see Fig. 9) does not exceed long-term averages. The more defensive positioning of many investors, paradoxically, can make the market more resil-ient, as fewer investors are likely to jump ship at the � rst sight of risk.

Bonds in the sour spotWithin our asset allocation, we have downgraded bonds slightly, thereby increasing the underweight (from -5% to -7% in our moderate risk portfolio). We note, however, that this arises not so much based on a view that US bonds are more at risk than a month ago. It rather re� ects

Asset Classes

Equities to trump other asset classes

Fig. 1: Asset class preferences

Note: Black arrows indicate changes as of this report.

Tactical deviations from benchmark

Commodities

Fixed Income

Cash

Equity

+ + ++ + +n–– –– – –

underweight overweight

Fig. 2: Asset class and regional preferences



US Fixed Income

Non-US Fixed Income

Cash (USD)

Commodities

Non-US Developed Eq.

Emerging Market Eq.

US Equity

+ + ++ + +n–– –– – –


Source: UBS WMR, as of 30 March 2011 Source: UBS WMR, as of 30 March 2011


a downgrade of non-US bonds, which we believe are more at risk at this stage due to the prospect of weaken-ing foreign currencies vs. the dollar over the next few quarters (see “International Fixed Income” on pg. 26). The proceeds have been shi� ed into cash.

Nonetheless, we continue to believe that for the broader bond market, including US bonds, medium-term pros-pects are bleak. We believe that bond market valuations are very stretched, that cyclical considerations argue for higher bond yields in the near term, while market senti-ment currently sends mixed signals about the timing of any upward move in yields.

As we’ve described at greater length in our WMR report The Decade Ahead, we expect US in� ation to rise above 3% a� er 2012 and average around 5% for a multi-year period therea� er. Longer-term in� ation expectations are a key parameter when gauging the attractiveness of bond valuations. Currently, market-implied in� ation expecta-tions as indicated by the pricing of Treasuries and TIPS (Treasury In� ation-Protected Securities) are for 2.4% over the next 10 years. Our in� ation scenario therefore implies that the market is underappreciating in� ation risk and that the bond market is signi� cantly overvalued. For his-torical perspective, it is noteworthy that yields on the broad US taxable � xed income market have only been lower than they are today 3% of the time since 1990. With in� ationary pressures making a comeback in

emerging markets and starting to rear their ugly head in parts of the developed world, we believe that bond yields are set to rise, moderately at � rst during the next year and more signi� cantly therea� er.

Commodities supported but upside limitedAs discussed on pg. 38, we remain moderately bullish on commodity prices. However, we believe that price gains will not be enough to o� set the negative roll yield on commodities by a suf� cient margin to consider adding to our commodity exposure.

Since last June, commodity prices have risen by 47% based on the DJ UBS Commodity index. Total returns to investors have been lower at 36% over the same time period. The 11% di� erence is due to the unfavorable term structure of commodity futures. Broad, diversi� ed exposure to com-modity markets is typically achieved through vehicles that rely on investing through commodity futures and rolling them over as they come closer to maturity. The fact that futures prices further out the term structure are higher than spot prices (contango) means that total returns are lower than price returns. Currently, we estimate that the loss due to the shape of the futures curve (negative roll yield) is likely to be -8% over the next year. Therefore, the 10% to 12% price return that we expect for the commodity index will not exceed this hurdle by a clear margin.

Stephen R. Freedman, PhD, CFA, Strategist

Asset Classes

Fig. 3: Asset class scorecardScores range from –3 (very unattractive) to +3 (very attractive)

Valuation Cyclical Timing Overall

Global Equities +1 +1 +0 +1

Commodities –2 +2 –1 +0

Fixed Income –2 –1 +0 –1

Source: UBS WMR, as of 30 March 2011

Fig. 4: Global valuation multiples remain below average

Source: Datastream, IBES, UBS WMR as of 25 March 2011

MSCI World Price-Earnings ratio based on 12-month forward consensus earnings

11

6

21

16

26

2008 20112005200219991996199319901987

Average


Asset Classes: Chartbook

Fig. 5: Bond yields are as low as it gets

Source: Bloomberg, Barclays Capital, UBS WMR, as of 28 March 2011

US taxable fixed income market, yield in %

4

2

0

8

6

10

2008 2010200620042002200019981996199419921990

US taxable fixed income market

Fig. 7: A setback in individual investor sentiment

Source: Bloomberg, American Association of Individual Investors (AAII), UBS WMR, as of 28 March 2011

AAII net bullish sentiment (individual investor survey), in %

3-month averageNet bullish sentiment

Last data pointLong-term average

Individual investors bullish

Individual investors bearish

60

40

20

0

–60

–40

–20

80

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Fig. 9: Low volatility means hedging costs are relatively low


VIX Volatility Index

Average VIX Volatility index

70

60

50

40

30

20

0

10

80

1996 1998 2000 2002 2004 2006 2008 2010

Last point

Fig. 6: Leading index points to continued recovery

Source: UBS WMR, Bloomberg, as of 28 March 2011

UBS WMR Global Leading Index and MSCI All Country (AC) World Index

MSCI AC World (rhs)UBS WMR Global Leading Index (lhs)

130

120

110

100

90

80

140

400

300

200

100

0

500

1995 1997 1999 2001 2003 2005 2007 2009 2011

Fig. 8: Fewer bullish investors than in December

Source: Bloomberg, CFTC, as of 29 March 2011

Net long speculative futures positions in S&P 500 as % of open interest

Net long futures positions

Net short S&P 500 futures positions

10

5

0

–20

–10

–15

–5

15

2004 2005 2006 2007 2008 2009 2010

Fig. 10: Roll yield still a drag on commodities total returns


DJ UBS commodity index, return components, year-over-year, in %

Excess return Spot return Roll yield

40

20

0

–60

–40

–20

60

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011


Expectations of interest rate hikes in the Eurozone have driven up EURUSD; we expect simmering European debt issues to push the pair back down. Our favorite � ve currencies, AUD, CAD, NOK, SEK and CHF, are now expensive; we advise adding on price dips.

The � rst quarter of 2011 saw the euro gain substantially when countries were given international debt support. However, it will take years before debt markets across Europe regain a sense of calm, limiting the upside poten-tial of the euro. Economic performance in the Eurozone varies widely, with some peripheral nations still struggling to grow.

The dollar, on the other hand, has broadly lost value. This is surprising given the risk events around the world, which typically give the dollar a boost. However, growth expec-tations and equity markets remain high, which may mean this relationship is still intact. The dollar is cheapened by its expanding monetary base and concerns over � scal sus-tainability. Overall, however, although we expected the dollar to reach this point, we remind ourselves that cur-rency markets are always relative; while the US has many challenges, so does much of the world. As long as no other large currency can truly compete with the dollar in terms of market liquidity, stability and transparency, the dollar is unlikely to face a crisis. We therefore expect EURUSD to remain in a broad range of 1.30-1.45.

Foreign Exchange

“Favorite Five” stand out

Interest rates to riseThe European Central Bank is likely to be among the � rst of the major economies to raise interest rates in the sec-ond quarter, with the UK soon to follow and the Federal Reserve waiting until the beginning of 2012. Generally, we expect the central banks to act carefully, as growth in many developed economies appears fragile. They will consider that rising food, energy and commodity prices reduce purchasing power for other goods, which typically harms the growth outlook. Markets will tend to favor those currencies with higher interest rates.

“Favorite Five” to stay strongWe do see long-term opportunities in smaller currencies from countries with robust public and private balance sheets. Our “Favorite Five” currencies are from commod-ity-producing countries: the Australian dollar (AUD), the Canadian dollar (CAD), the Norwegian krona (NOK) and the euro diversi� ers, the Swedish krona (SEK) and the Swiss franc (CHF). We expect that these � ve currencies will bene� t from rising demand for commodities in the emerging and advanced world, and in the case of the Swiss franc, gain during times of stress. These favored currencies have become expensive, however, re� ecting the strength of their economies. Our preference for this group is based on long-term fundamentals and we there-fore advise adding positions on dips.

Katherine Klingensmith, Strategist

Fig. 1: Yen and euro look expensive versus US dollar

Note: PPP computed by Bloomberg based on producer price indexesSource: Bloomberg, UBS WMR, as of 29 March 2011

Exchange rates and Purchasing Power Parity (PPP)

USDEUR (rhs)USDJPY (lhs) USDJPY PPP (lhs)

USDEUR PPP (rhs)

80

90

140

110

120

130

100

70

0.8

1.4

1.2

1.0

1.6

1.8

2000 2002 2004 2006 2008 2010

Fig. 2: Favorite five become expensive


Index of CAD, NOK, SEK, AUD and CHP against USD spot prices

0.90

0.85

0.80

1.00

0.95

1.10

1.05

1.15

Jan-11 Mar-11Nov-10Sep-10Jul-10May-10Mar-10Jan-10

Favorite five


International Equities

Risks remain elevated overseas

A glance at recent newspaper headlines reveals a myriad of risks to international equity markets. Amid the turmoil, we maintain a preference for emerging markets and the UK.

International valuations attractive relative to USInternational equities look more attractive than the US on most valuation metrics, while the risks appear more daunting. The UK and Eurozone appear particularly inex-pensive, but ongoing trouble in peripheral Europe make us cautious on Eurozone equities. Emerging markets o� er superior growth prospects while trading at a substantial discount to the US. Japanese equities look less expensive than usual, but the recent tragic events are not yet re-� ected in earnings expectations.

We continue to favor emerging marketsWithin international equity markets we continue to favor emerging markets. A� er a period of underperformance that started last year, emerging markets rebounded in March, rising while the developed markets fell. Emerging markets o� er better long-term growth prospects and trade at a discount to developed markets. In our view, earnings forecasts are more likely to be achieved in the emerging markets. In contrast to developed markets, they rely more on revenue growth and less on a further expan-sion of pro� t margins from already lo� y levels.

The biggest economic threat to the emerging markets is

from further increases in commodity prices. Higher food and energy prices have already pushed up in� ation, trig-gering central bank rate hikes in many countries. However, in most countries real interest rates are still low by historical standards and do not threaten to derail the economy. If commodity prices hold steady in the months ahead, in� ation should peak in most countries by the end of the third quarter. However, if commodities climb fur-ther from current levels, it might trigger more dramatic tightening that could hurt equity markets.

UK o� ers exposure to commodities and growth overseasFor investors unwilling to invest in emerging market equi-ties, we suggest developed market stocks that can bene� t from emerging market growth. In the developed markets, the UK looks relatively attractive, in our view. While the UK economy has been struggling, large-cap companies listed in the UK generate around 70% of their earnings overseas, and include a signi� cant share of commodity producers. Valuations look inexpensive with the market trading below 10 times consensus earnings forecasts and nine out of ten sectors trading at a discount to their US counterparts. The pound is also one of the few currencies that appears to be cheap against the dollar.

Japan: maintain moderate underweightFollowing their dramatic pullback in the wake of the March natural disaster, Japanese equities are trading on

Fig. 3: Equity regions


Tactical deviations from benchmark, including view on currency

Other Developed

Japan

Eurozone

Emerging Markets

US

UK

+ + ++ ++n–– –– – –


Fig. 4: Regional equity valuations and earnings momentum

Source: IBES, UBS WMR, as of 28 March 2011

12-month forward PE; 3-month change in 12-month forward consensus earnings

4

0

–4

8

20

16

12

24

12.6 10.910.0 9.7

11.0 10.6 11.7

0

–3

6

3

15

12

9

18

Emer

ging

Mar

kets

Japa

n

UK

Euro

zone

Non

-US

deve

lope

dUS

Wor

ld

Price/Earnings (PE) ratio (le) Earnings momentum, in % (right)

12.610.9 10.0 9.7 10.6 11.711.0

-4

0

4

8

12

16

US Non-USdeveloped

Eurozone UK Japan EmergingMarkets

World

-3%

0%

3%

6%

9%

12%


just 11 times consensus earnings estimates, which is cheaper than global markets. Downward revisions have yet to appear in consensus earnings forecasts, but even accounting for this the market is cheaper than normal. However, we do not see any particularly strong reason for US investors to put money into the Japanese market and we maintain our moderate underweight recommenda-tion. Reconstruction needs a� er the earthquake and tsu-nami may provide a temporary economic boost, but long-term prospects are poor. The yen also appears to be overvalued, and for dollar-based investors, currency losses could o� set potential gains from the equity market.

Eurozone debt crisis creates downside risksWhile Eurozone equity valuations are also attractive, the ongoing public debt crisis is a risk that is too big to ignore and we maintain a moderate underweight recommenda-tion. The European Central Bank is widely expected to raise rates in April as in� ation has been running above its target. While that is � ne for the stronger economies, such as Germany, it can hardly be expected to help Greece and Ireland, which remain mired in recession. This serves as a reminder that structural problems in the Eurozone will not be easily solved. News of the impending rate hike helped to boost the euro, but we view it as overvalued against the dollar.

Other developed market equities not compellingAustralia and Canada are similar in many respects. Both countries avoided the brunt of the damage from the global � nancial crisis. They enjoy relatively strong eco-nomic conditions and are getting a boost from higher commodity prices. Switzerland has also done reasonably well, avoiding the turmoil in the Eurozone. However, taken as a whole, valuations on these markets are not compelling. Furthermore, the Swiss and Australian curren-cies look overvalued, making their equity markets appear more expensive to dollar investors. Of the three, we would favor Australia, as commodity-related investment spending should kick into high gear later this year.

Brian Rose, PhD, Strategist

International Equities


12-month forward consensus earnings, Dec. 1987 = 100

1,000

800

600

400

200

0

1,400

1,200

1,600

2007 20102004200119981995199219891986

US

Emerging markets

Fig. 5: Long-run earnings growth better in emerging markets

Fig. 6: Rates still low in emerging markets


2

0

–2

6

4

8

2010 201120092008200720062005

Real

Nominal

Average central bank policy rates for emerging markets, in %

Fig. 7: Japan trading at discount to global markets


50

0

100

20102008200620042002200019981996199419921990

Japan

MSCI World

Price-earnings ratio based on 12-month forward consensus earnings


Given our expectation for dollar strengthening vs. the major currencies, we recommend tilting � xed income portfolios away from international and to-ward US bond markets.

Our views on international � xed income are closely linked to the outlook for foreign exchange rates, as the relative performance of US and non-US � xed income investments is o� en dominated by changes in the value of the US dol-lar. Our non-US � xed income benchmark is dominated by euro- and yen-denominated debt. We see these curren-cies as overvalued against the dollar, and we expect the dollar to rebound modestly against them. We have there-fore adopted an underweight position in non-US bonds.

Beware Greeks bearing high yieldsIn our view, measures announced by the European Council on 25 March fall short of a solution to the debt crisis or the structural problems plaguing the Eurozone. We continue to recommend caution on the sovereign debt of peripheral Europe. The European Stability Mechanism (ESM) will replace the current bailout fund a� er June 2013. Debt that matures a� er that date is par-ticularly risky as private bondholders may lose capital when countries seek help from the ESM. While Greek bond yields may appear tempting, we recommend avoid-ing the market as the risk of restructuring is too high. Ireland’s plans to consolidate debt are more credible in our view, but we consider Irish debt too risky for anyone

International Fixed Income

Underweight non-US � xed income

other than aggressive investors. Yields on Portugal’s sov-ereign debt have spiked higher recently, suggesting the market expects it to seek outside help to deal with its debt. For both Ireland and Portugal, we would avoid any debt that matures a� er June 2013.

We favor UK over JapanThe pound is one of the few currencies that appear cheap against the US dollar. Fiscal policy is being tight-ened sharply, which should help to hold down govern-ment debt levels in the medium term. In Japan, government debt levels are extremely high, while bond yields are extremely low and the yen is overvalued. We therefore recommend a moderate overweight in UK bonds and an underweight in Japan.

Emerging markets relatively attractiveIn contrast with the developed economies, most emerg-ing markets feature relatively healthy government � -nances. We also have a generally favorable view of emerging market currencies. In addition, many countries issue debt denominated in US dollars, so it is also possible for dollar-based investors to buy certain emerging market bonds without taking on exchange rate risk. However, investing in emerging market bonds is still risky, and we therefore recommend diversifying across countries and avoiding excessively large positions.

Brian Rose, PhD, Strategist

Fig. 8: Fixed income regions

Note: Arrows indicate changes as of this reportSource: UBS WMR, as of 30 March 2011

Tactical deviations from benchmark, including view on currency

Eurozone

Japan

Other

US

UK

+ + ++ + +n–– –– – –


Fig. 9: Portugal may be next to seek help


10-year bond yield spreads relative to German Bunds, in % pts

2

0

8

6

4

10

Jan-11Sep-10May-10Jan-10

Portugal

Ireland

Greece

Spain


International markets: Chartbook

Fig. 10: Profit margins not yet at prior peaks

Source: Datastream, Worldscope, UBS WMR, as of 28 March 2011

Operating profit margins, in %

12

9

6

3

0

18

15

Q1 2010Q1 2006Q1 2002Q1 1998Q1 1994Q1 1990

Emerging Markets

US

Asia ex Japan

Europe

Fig. 12: EM growth advantage smaller than usual


Average y/y growth rate of industrial production, in %

10

5

0

–5

–10

–15

–20

20

15

2011201020092008200720062005

Emerging markets

Developed markets Difference

Fig. 14: Dollar somewhat undervalued vs. trading partners


USD Real Effective Exchange Rate Index

90

70

50

130

110

20102006200219981994199019861982197819741970

Average +1 standard deviation Average –1 standard deviation

10-year averageUSD Real Broad Effective Exchange Rate

Average +2 standard deviation Average –2 standard deviation

Fig. 11: UBS WMR model points to upward earnings revisions

Note: Prediction shows model-generated forecast of consensus earnings revisionsSource: UBS WMR, IBES, as of 28 March 2011

3-month change in earnings divided by initial price, in basis points

US

UK

World

JP

EM

EMU

Prediction (May 2011)

Actual (March 2011)

35302520151050 40

Fig. 15: Government bond yields at low levels


10-year government bond yields, in %

6

5

4

3

2

1

0

7

201120102009200820072006200520042003200220012000

Japan

US

UK

EMU

Fig. 13: Economic surprises mostly positive

Source: Citigroup, Bloomberg, as of 29 March 2011

Citigroup Economic Surpise Indexes

50

0

–50

–100

–150

–200

150

100

201120102009200820072006

UK Japan

US Eurozone APAC

-100

-50

0

50

100

150

Mar-10 Jun-10 Sep-10 Dec-10 Mar-11

US UK Eurozone Japan APAC

50

70

90

110

130

70 74 78 82 86 90 94 98 02 06 10USD Real Broad Effective Exchange Rate10-year averageAverage +1/-1 standard deviationAverage +2/-2 standard deviations

d d d


US Equities: Sectors

Downshifting our pro-cyclical sector stance

While we remain con� dent in the cyclical economic recovery, we choose to trim but not remove our pro-cyclical sector stance. A maturing business cycle, peaking leading economic indicators and high rela-tive sector valuations between cyclicals and defen-sives suggest a more balanced mix.

Cyclicals have bene� ted from the “risk on” trade…Since Federal Reserve Chairman Ben Bernanke outlined his plan to battle de� ationary pressures head-on through a second round of quantitative easing, known as “QE2,” i.e., government bond purchases by the Fed, in a speech at Jackson Hole, Wyoming, on 27 August 2010, US equi-ties have been on a roll. The S&P 500 has rallied 23% over that seven-month stretch, despite the 23% surge in oil prices brought about by social unrest in the Middle East and North Africa and the devastation caused by the earthquake and tsunami in northern Japan. Over that span, cyclical sectors (which we classify as Materials, Industrials, Technology and Consumer Discretionary) have outperformed defensive sectors (Utilities, Telecommuni-cations Services, Consumer Staples and Health Care) by a large margin (see Fig. 2).

…but the bar has been raised Several factors, however, lead us to believe that sector performance is likely to become more balanced between cyclicals and defensives over the next several months. For

one, cyclicals have bene� ted from a powerful reaccelera-tion of positive economic surprises following last sum-mer’s “so� patch.” In our view, with consensus growth estimates having been ratcheted up over the past few months, further positive economic surprises are becoming less likely and thus less supportive for future cyclical sector outperformance relative to defensives. Along the same lines, leading indicators are at historically high levels and have likely peaked, or are in the process of peaking. The ISM Manufacturing Index (a useful gauge in determining the current stage of the business cycle) surged to 61.4 in February—a level which is above 90% of all observations over the past 60 years. Historically, on average, cyclical sectors tend to lag following a peak in the ISM index. Lastly, valuation considerations no longer favor cyclical sectors relative to defensive sectors.

Tactical shi� s—reducing, but not eliminating cyclical biasOur bottom line is that cyclical sectors should be sup-ported by the ongoing global economic expansion, but sector positioning should become more balanced as the cycle continues to mature. The “risk on / risk o� ” trading pattern of the past three years (essentially since the � nan-cial crisis began) that has been the dominant driver of sector performance, grouping cyclicals versus defensives, has likely run its course, in our view. As the current busi-ness cycle matures into a hopefully less volatile, more

Fig. 1: Trimming pro-cyclical sector bias


US sector strategy allocation, tactical deviations from benchmark

MaterialsFinancials

Health CareEnergy

UtilitiesCons Discretionary

Telecom

IndustrialsConsumer Staples

Tech

+ + ++ + +n–– –– – –


Fig. 2: Cyclicals have benefited from the “risk on” trade

Note: Cyclical sectors (Materials, Industrials, Technology and Consumer Discretionary).Defensive sectors (Utilities, Telecommunications Services, Consumer Staples and Health Care).Cyclicals are outperforming when the line in the chart is rising and underperforming when it isfalling. Source: DataStream and UBS WMR, as of 25 March 2011

Relative performance of cyclicals vs. defensives since 1973, indexed to 100

120

100

80

60

40

160

140

180

200820011994198719801973




sustainable expansionary phase, we look for individual sector fundamentals to matter more than simply adopting a pro-risk or anti-risk sector stance. We continue to � nd the best risk-reward propositions in cheap cyclicals, such as Technology, or bene� ciaries of global growth, such as Industrials and Consumer Staples. We are moving to a tactical underweight in Energy given its strong recent out-performance and stretched relative valuations versus the market. We shi� our preference within Financials to favor Insurance. Within traditional defensive sectors, we adopt a neutral stance for Healthcare, favoring Healthcare Equipment & Services over Pharmaceuticals. We also trim our underweight in Telecommunications Services.

Sector overviewTechnology (overweight): Technology remains our most preferred sector in the S&P 500. For the � rst time since the early 1990s, the sector trades at a valuation discount to the S&P 500. Granted, the low valuation for select mega-cap stocks within the sector may be deserved as legacy platforms are increasingly being challenged by new, innovative technologies. However, business spend-ing on technology products has and should continue to rebound following a multi-year stretch of underinvest-ment. The strong rebound in corporate pro� ts coupled with the more recent evidence of US labor market health should support the ongoing corporate refresh cycle. Consumer demand has been more tepid, with tablets and

smartphones gaining wallet share at the expense of PCs and notebook computers. We anticipate that tech com-panies with either outsized exposure to business (rather than consumer end-markets), or strong product cycles will be relative winners within the sector.

Industrials (moderate overweight): We trim our sector positioning from overweight to moderate overweight by downgrading the transportation group to neutral. While we still like the group’s strong fundamentals—solid pric-ing power and operating leverage to a cyclical recovery—valuations have become quite stretched with the group trading at a 20% premium to the S&P 500. Rising fuel costs are a double-edged sword. In the short-run, higher fuel prices negatively impact earnings. But longer out, lagged fuel surcharges mitigate the earnings hit. From a competitive perspective, rail transportation should gain market share versus the more fuel-intensive truckers. Capital goods manufacturers should post solid earnings growth over the next two years—particularly suppliers of equipment in commodity end-markets.

Consumer Staples (moderate overweight): Consumer Staples have lagged during the cyclical recovery of the past several months due to both their defensive charac-teristics (i.e., low beta) and from rising commodity cost pressures. We continue to believe that fundamentals are superior for Consumer Staples compared to the other

Fig. 3: Cyclical sector valuations becoming more expensive

Note: Cyclical sectors (Materials, Industrials, Technology and Consumer Discretionary) anddefensive sectors (Utilities, Telecommunications Services, Consumer Staples and Health Care).Recessions shaded. Source: DataStream and UBS WMR, as of 25 March 2011

Relative normalized P/E valuation, cyclicals vs. defensives

cyclicals expensive

cyclicalsinexpensive

1.50

0.25

1.00

0.75

0.50

2.25

2.00

1.75

2.50

2010200520001995199019851980

Cyclicals relative to defensives - normalized PE

Average (ex-Tech bubble, 1999–2002)

Fig. 4: Energy stocks - too much optimism?

Source: DataStream and UBS WMR, as of 25 March 2011

Energy sector P/E relative to the S&P 500 P/E, in %

Prior oil price peak–30

–40

0

–10

–20

10

20112009 2010200820072006

Energy sector P/E relative to the S&P 500 P/E

5-year average


traditional defensive sectors. Companies within this sector have a strong track record of producing robust, consistent dividend growth. Many also will bene� t from the rapidly increasing spending power of the emerging market con-sumer. While commodity costs continue to pose a risk, we note that the bigger-cap stocks are likely to mitigate the impact by raising prices, as market conditions allow. Also, it appears unlikely that commodity costs will continue to be as strong a headwind for pro� t margins as year-over-year comparisons likely become more benign.

Financials (neutral): Cheap valuations and rebounding earnings continue to be o� set by increased capital require-ments, intense regulatory scrutiny and higher regulatory costs. We remain neutral on the sector but change our in-dustry views to prefer the insurance group over banks and diversi� ed � nancials (money center banks, brokers, asset managers). Life insurers have compelling valuations (many trading below book value) and bene� t from an environ-ment of rising stock prices and rising interest rates. Property and casualty (P&C) companies have faced numerous natu-ral disasters this year, but cumulative losses are manageable and should start to stabilize pricing going forward.

Healthcare (neutral): The large-cap branded pharma-ceutical companies continue to have very challenging fun-damentals. Generic competition will only intensify over the next year as 2012 marks the peak of the so-called “patent cli� ,” when the largest blockbuster branded drugs go o� patent. We upgrade the Healthcare Equipment and Services group (medical device manufac-turers, drug distributors, managed care) to moderate overweight, o� setting our moderate underweight in pharma, resulting in a neutral sector stance. Similar to pharma stocks, the equipment and services group trades at low valuation multiples, despite having a much better long-term earnings outlook.

Materials (neutral): Despite the rapid price appreciation across the commodity complex, the Materials sector has modestly lagged the broader market. Why? Investors are increasingly skeptical that these higher prices can be sus-tained in the context of a growing global economy. We share this concern and focus on companies within the sec-tor that have comparative cost advantages, such as chemi-

cals, and the more defensive industrial gas companies.

Consumer Discretionary (moderate underweight): While we are underweight at a sector level, we have clear industry preferences within this very heterogeneous sec-tor. Autos have lagged recently given rising commodity costs, but we continue to expect outperformance as auto production and sales rebound from depressed levels. We also like consumer services (restaurants, hotels), which should bene� t from improvements in business spending and labor market conditions. As the cycle matures, we remain cautious on both retailers and consumer durables. These groups are both expensive and are typically early-cycle, not mid-cycle, bene� ciaries.

Energy (moderate underweight): Rising tensions in the Middle East and North Africa have driven oil prices over $105 per barrel. Energy producers have been the big win-ners within the equity markets thus far in 2011 with the Energy sector outperforming the S&P 500 by over 10 per-centage points. Energy sector stocks now appear fully valued to us and quite vulnerable to any setback in the oil prices. We would prefer a better entry point to put new money to work in the sector—and suspect that we will get one over the next few months.

Telecommunication Services (moderate under-weight): Telecom has been our biggest underweight throughout 2011 based on its high relative valuation, challenging industry fundamentals (lack of pricing power, huge maintenance spending requirements) and interest rate sensitivity. We reduce our underweight following the sector’s recent underperformance and the proposed merger between AT&T and T-Mobile which, if approved, would improve the industry pricing environment.

Utilities (moderate underweight): We maintain our moderate underweight allocation. A sustained economic recovery should drive interest rates higher, a negative for the rate-sensitive utilities sector. Utilities should act as a safe haven and likely outperform during periods of mar-ket stress, but valuations are high relative to history and earnings growth is expected to signi� cantly lag the broader market.

Jeremy Zirin, CFA; David Le� owitz, CFA; Joe Sawe, Strategists



Year to date, there has been remarkably little dis-tinction in terms of performance among large-, mid- and small-caps, and between growth and value styles. We remain neutral across size and maintain our preference for growth over value.

Large versus small—cross currents remainThus far in 2011, no clear winner has emerged among large-, mid- and small-cap stock indexes. Fundamental ad-vantages for the smaller-size groups appear to be largely priced into their higher valuations. As a result, we do not believe that size alone will be a major driver of out- or un-derperformance over the next several months. More speci� -cally, an improving M&A cycle, faster earnings growth, greater margin expansion potential and still improving credit conditions are all supportive for small-caps. However, these positive drivers appear to be already re� ected in current valuations; small-cap’s relative forward P/E ratio compared to large-caps is at its most expensive level since the Russell size indexes began in 1979. A decline in leading economic indicators could also be a near-term headwind for small-caps. Given these cross currents, a neutral allocation across company size appears warranted.

Still going for growth over valueAs we have repeatedly stated, the performance of growth versus value is heavily in� uenced by sector performance. Technology stocks have a large weighting in the Russell 1000 Growth index whereas Financials heavily represent

the Russell 1000 Value index. As we described in more detail in our discussion on sectors, we have a favorable outlook for the Tech sector while we are neutral on Financials. In addition, growth tends to outperform value as aggregate S&P 500 earnings growth rates decelerate—an outcome we expect in 2011. In the early stages of a pro� ts recovery, a rising tide li� s all boats and all compa-nies have an easy time generating pro� t growth. As the business cycle matures, growth becomes more scarce. As this occurs, relative pro� t growth between growth and value tends to sharply shi� in the favor of growth stocks. Finally, the relative valuation between the two clearly fa-vors growth (see Fig. 11).

REITs—still too expensive for our tasteWhile fundamentals in the REIT sector are improving, val-uations already re� ect a better outlook. REITs are trading at 18.5x funds from operations, a signi� cant premium to the S&P 500 P/E ratio of 12.5x. To put this premium into context, on average over the past 10 years REIT valuations have been in line with the S&P 500 P/E multiple. Rising interest rates may also be a headwind for REIT shares as capitalization rates rise, thus lowering real estate values. Based on an improving economy and the end of quantita-tive easing, our � xed income team expects 10-year Treasury note yields to rise to 4.25% over the next 12 months. We remain moderately underweight.

Jeremy Zirin, CFA; David Le� owitz, CFA; Joe Sawe, Strategists

US Equities: Size & Style, REITs

No clear winners have emerged

Fig. 5: Favor Growth over Value; still cross currents betweenlarge and small



Small-Cap

Large-Cap Value

REITs

Large-Cap Growth

Mid-Cap

+ + ++ + +n–– –– – –


Fig. 6: Strong prospects for Tech should drive growth

Note: Russell 1000 Growth and Value indices used

Technology relative to Financials and Growth relative to Value

100

80

60

160

140

120

180

200

125

50

425

350

275

500

20132005 2009200119971993

Growth vs. Value (lhs)

Tech vs. Financials (rhs)


US Equities: Chartbook

Fig. 7: Relative valuation for Tech appears very compelling

Source: DataStream, and UBS WMR, as of 25 March 2011

Current relative forward P/E premium/discount to the S&P 500 vs. 5-year average

–10

–20

–30

20

10

0

30

Ener

gy

Indu

stria

ls

Utili

ties

Fina

ncia

ls

Cons

umer

Stap

les

Cons

umer

Disc

retio

nary

Mat

eria

ls

Heal

th C

are

Tech

nolo

gy

Tele

com

%

Fig. 9: Small cap relative valuations are high …

Source: Bloomberg, DataStream and UBS WMR, as of 25 March 2011

Russell 2000 forward P/E relative to Russell 1000 forward P/E, in %

90

80

70

60

120

110

100

130

20101990 2006200219981994198619821978

Russell 2000 P/E relative to Russell 1000 P/E

Average

Fig. 11: Growth stocks remain undervalued

Source: DataStream, Russell Investment Group and UBS WMR, as of 25 March 2011

Valuation premium - growth vs. value, since 1979, in %

40

0

120

80

160

P/E

Forw

ard

(1yr

)

Price

toSa

les

Price

toBo

ok

P/E

Trai

ling

Current Long-Term Average ex-Tech Bubble

Long-Term Average

Fig. 8: Cyclical sectors likely to post stronger earnings growth

2011 and 2012 S&P 500 consensus earnings estimated growth, in %

5

0

–5

20

15

10

25

Cyclicals Defensives

Utili

ties

Heal

th C

are

Cons

umer

Stap

les

Tele

com

Tech

nolo

gy

Cons

umer

Disc

retio

nary

Indu

stria

ls

Mat

eria

ls

2011 2012

Source: DataStream, and UBS WMR, as of 25 March 2011

Fig. 10: …but rising M&A activity boosts small-/mid-cap’s appeal


Announced global M&A volumes (USD billions)

3,000

2,500

2,000

1,500

1,000

500

0

4,000

3,500

4,500

20122006 20102008200420022000

Rolling 12-month global M&A activity

Fig. 12: REIT valuations still stretched

Source: Bloomberg, SNL and UBS WMR, as of 25 March 2011

REIT relative valuations versus S&P 500

REITs expensive

REITs inexpensive

1.2

1.0

0.8

0.6

0.4

0.2

0.0

1.6

1.4

1.8

20112002 20082005199919961993

US REITs price to forward funds from operations relative to S&P 500 P/E


Following the bout of market volatility in March, we recommend staying the course with a preference for credit-sensitive � xed income segments, such as corporate bonds with maturities in the intermediate range.

Fixed income markets felt the impact of an unpredictable global landscape in March, yielding the � rst volatile month thus far in 2011. With instability in the Middle East and North Africa (MENA) region and the destabilizing ef-fects of the earthquake in Japan, Treasuries rallied on the � ight-to-safety bid. The strong demand for lower-risk as-sets temporarily reversed year-to-date trends, with credit spreads widening, and non-credit sectors outperforming credit sectors early in the month. However as the quarter ended, Treasury yields reverted to recent ranges and seem poised to move higher on continued signs of recovery in the US economy.

Maintaining neutral duration positioningDespite our expectation for higher Treasury yields over the next year, we continue to recommend investors maintain a neutral duration stance. The reason for this apparent inconsistency has to do with the historically steep Treasury yield curve and the forgone interest income associated with shorter maturities. This makes very short maturities less attractive than intermediate ones, despite the ex-pected rise in yields.

US Fixed Income

The story stays the same

Total returns consist of an interest component and a price change component. Based on our forecast for a rise in Treasury yields over the next 12 months, we expect the price component to be negative for all maturity buckets. However, for maturities shorter than 8-years, we believe the interest component should more than o� set the ex-pected price decline, leading to positive expected total returns. At the 8-year mark and beyond, the projected price loss is greater than the income component and the expected total return is negative.

Assuming a one-year holding period, the highest ex-pected total return would be around the 5-year maturity point. Consequently, we recommend investors maintain a neutral duration stance, and favor maturities in the 4- to 7-year maturity range for most � xed income segments.

Corporates stay on paceIn our 2011 Outlook, we forecast that credit segments of the taxable � xed income market would outperform non-credit sectors with projected full-year total returns for in-vestment grade (IG) and high-yield (HY) of 3% to 5% and 7% to 9%, respectively. We also noted that the path to tighter spreads would not be a linear one, but rather could be marked by periodic setbacks as macro risk fac-tors have the ability to sharply in� uence market sentiment toward credit risk. Despite an uncertain global stage, as well as a meaningful uptick in shareholder friendly

TreasuriesTIPS

AgenciesMortgages

Inv. Grade CorporatesHigh Yield Corporates

Preferred SecuritiesEmerg. Market

Total TFI non-CreditTotal TFI Credit

+ + + + + + –– –– – – nUnderweight Overweight


Fig. 1: USD � xed income strategy Tactical deviations from benchmark


Fig. 2: US interest rate forecasts, in %

in 3 in 6 in 1228-March months months months

3-month LIBOR 0.31 0.30 0.40 0.60

2-year Treasury 0.77 1.00 1.10 1.30

5-year Treasury 2.21 2.25 2.50 2.70

10-year Treasury 3.48 3.75 4.00 4.25

30-year Treasury 4.53 4.75 5.00 5.00


initiatives and large-scale M&A activity, credit spreads for both IG and HY have tightened year-to-date. From a total return standpoint, this spread compression, combined with only modestly higher Treasury yields, has yielded per-formance that is broadly on pace with our full-year 2011 forecast, with IG returning approximately 0.7% and HY outperforming all other segments, generating roughly 3.7% of total returns.

Our full-year forecast remains unchanged at this time. We expect rising rates will result in low-single digit returns for IG during the remainder of the year— unattractive on an absolute basis, but still outperforming government bonds. As a shorter duration sector, HY is less impacted by rising rates, which is one of the reasons behind our slight rela-tive preference for HY over IG, and our expectation for relative outperformance of HY versus all other � xed in-come segments. We note, however, that during this re-cent period of volatility, HY spreads exhibited higher beta characteristics—a trend we think could repeat itself should macro risks � are up again.

Despite the potential for periodic setbacks to occur in credit, we retain our current overweight posture to both HY and IG. From a fundamental standpoint, companies remain in strong health despite the fact that we are enter-ing the mid to latter stages of this cyclical credit recovery. Overall leverage ratios for non-� nancial companies remain below long-term averages and interest coverage ratios

continue to improve o� their troughs reached in early 2009. Although signs point to an in� ection point in the credit cycle where leverage may begin to tick higher, we remain comfortable with overall fundamentals. Default rates continue to show a declining trend and we expect them to reach 2.1% by year-end. We believe that IG and HY spread levels provide enough compensation against this historically low level of expected defaults.

We maintain our overweight on preferred securitiesSimilar to HY, we believe that the above-average coupon payments that preferreds o� er should help their relative performance. One main di� erence, however, is the higher duration characteristics that preferreds exhibit. It is likely that prices of preferreds as a whole will eventually be pressured by rising rates, but much depends on how rapidly this rise occurs. The scarcity value of preferreds could increase as the large anticipated redemptions of US bank trust preferreds will likely cause the preferred market to shrink going for-ward, unless US banks utilize perpetual preferreds as re-placement capital, which remains a viable option.

Emerging markets shows resiliencyWrapping up credit sectors, we continue to have a posi-tive view on emerging markets (EM) bonds, as we believe that fundamentals remain strong. While increased market choppiness is likely to lie ahead on concerns about rising in� ation and the ongoing situation in the MENA region, economic resilience has been surprising and investor

US Fixed Income

Fig. 3: IG spreads trended gradually tighter for nearly a year

Source: Barclays Capital, UBS WMR, as of 28 March 2011

Investment-grade (IG) corporate bonds spreads, in basis points

600

400

200

0

800

2010 20112009200820072006

All IG Corporates

Industrial

Financials

Fig. 4: Declining default rate signals tighter HY spreads

Source: BAML, Moody’s, UBS WMR, as of 28 March 2011

High yield (HY) credit spreads in basis points and default rates, in %

800

0

1,600

1,200

2,000

3

0

9

6

12

15

200920072005200320011999 2011

Default Rate (2011 projected) in % (rhs)

Credit spreads, in basis points (lhs)

400


US Fixed Income

appetite remains strong. EM spreads have hovered within a 30 basis points range in recent weeks depending on whether US Treasuries rallied or sold o� with very little changes, if any, to dollar-denominated bond prices in times of temporary hikes in risk aversion.

In addition, we see room for potential further credit rating improvements. For instance, on 16 March, S&P upgraded Colombia to the IG category, and Fitch and Moody’s maintain positive outlooks. We believe that it is only a matter of time before the country achieves IG status, making Colombia’s foreign debt eligible for major IG in-dexes and potentially broadening its investor base. Furthermore, we believe that liability management trans-actions may also provide support to bond prices. Overall, we believe that EM � xed income o� ers investors an op-portunity to have exposure to a blend of IG and specula-tive-rated credits. According to major EM benchmark indices, the asset class is 57% IG and 43% HY. For inves-tors looking to have direct exposure to EM debt issuers, we favor sovereign debt issued by Chile, Mexico and Russia, quasi-sovereign oil and gas conglomerates, and large mining companies. A note on TIPSA notable exception to the outperformance of credit sec-tors has been the strong performance of Treasury In� ation-Protected Securities (TIPS). At the index level, TIPS have delivered total returns of 1.8% year-to-date

compared to the slight losses of nominal Treasuries. TIPS performed well due to declines in real yields, especially in the short portion on the TIPS curve. This move was driven by higher oil prices, which caused short-term market-based in� ation expectations to rise. The yield di� erential between matched maturity nominal Treasuries and TIPS is referred to as the breakeven in� ation rate, which re� ects the market’s view of in� ation over the period. Short-term breakevens increased considerably following the sharp rise in oil prices, while the recent rise in longer-term breakevens has been more benign. At this point, we be-lieve that in� ation expectations embedded in TIPS are fairly valued with a one-year horizon in mind. Additionally, we would caution against extrapolating TIPS’ strong per-formance into the future as we look for both real and nominal yields to rise during 2H11, hindering the perfor-mance of both types of government bonds.

Muni supply bears monitoringScarce new issue supply is shaping up to be a main theme for the municipal market. At the same time, the recent � ight-to-quality bid in Treasuries lent some price support to municipal bonds. A thin volume of trading in the sec-ondary market and tapered muni mutual fund out� ows also are signi� cant factors contributing to the � rmer mar-ket tone. Technical support for the market has contrib-uted to positive performance thus far in 2011, despite widespread headlines regarding state and local govern-ment � scal stress.

Fig. 5: Real and nominal Treasury yield curves


Yields in %, by maturity

–2

–3

0

–1

3

2

1

4

Feb-40

5

TIPS real yield curve

Nominal Treasury yield curve

Jan-29Jan-27Jan-21Jul-19Jan-18Jul-16Apr-15Apr-14Apr-13Jan-12

Fig. 6: EM debt offers wider spreads than US IG

Source: Barclays Capital, as of 28 March 2011

Yield spreads over US Treasuries, in basis points

600

400

200

0

1,000

800

1,200

20102008200620042002

All EM

Emerging markets (EM) IG

All US Investment Grade (IG) corporates


US Fixed Income

Most federal stimulus funding comes to an end in June. States relied heavily on this revenue source to balance their budgets over the last two years; stimulus funds com-prised 18% of state budgets in FY 2010 and 14% in FY 2011, according to the National Association of State Budget Of� cers. For the third consecutive year, Moody’s assigned a negative outlook to both the US state and local government sectors and cautioned that downgrades will outpace upgrades amid e� orts to cut spending.

Yield levels attained in the midst of thin market conditions are o� en subject to a sharp turnaround. Over the course of the next few months, we would not be surprised to see bouts of price volatility and upward yield pressures emerge. A combination of new negative news headlines and an eventual uptick in new issue volume will be enough to trigger such a reaction. Also, as the appetite for other risk assets rise in the a� ermath of the Japanese catastrophe, municipal yields are apt to rise when inves-tors’ � ight-to-quality pattern begins to dissipate.

On a relative basis, AAA muni-to-Treasury (M/T) yield ra-tios in the front part of the curve are near recent one-year averages at roughly 80% at the 5-year maturity point and 90% in the 10-year area on suf� cient demand for short-term munis. In contrast, a lack of buyers of long-dated munis is keeping M/T ratios on 30-year securities elevated at 105%. Compared to corporates, a similar pattern ex-ists. Muni-to-corporate (a� er-tax) yield ratios on low

maturities are near fair value, while ratios on long-dated securities are well above average.

We see an immediate opportunity for investors to reposi-tion muni portfolios into higher-grade securities or shorter maturities where strong bids are present, while the mar-ket is relatively calm. It is generally best to restructure or shi� portfolios during periods of stronger performance than in times of risk aversion and its accompanying volatility.

Anne Briglia, CFA, StrategistBarry McAlinden, CFA, StrategistDonald McLauchlan, StrategistKathleen McNamara, CFA, CFP, StrategistMichael Tagliaferro, CFA, Strategist

Fig. 7: Visible supply and yields

Source: MMD, UBS WMR, as of 25 March 2011

Le hand axis (lhs) in yield in %, right hand axis (rhs) in millions

Yiel

d

2,500

12,500

7,500

17,500

22,500

Jan-11Oct-10Jul-10Apr-10Jan-10

AAA GO 10 yr (lhs) 30-Day Visible Supply (rhs)

Treasury 10 yr (lhs)

2

1

3

2.5

3.5

4

1.5


US Fixed Income: Chartbook

Fig. 5: AAA muni-to-Treasury yield ratios

Source: MMD Interactive, UBS WMR as of 22 March 2011

In %

75

50

125

100

150

2011

175

200

AAA GO 30 Year AAA GO 5 Year

AAA GO 10 Year

20102009200820072006200520042003

Fig. 6: Municipal to Corporate (M/C) yield ratio (aer tax)

Source: MMD Interactive, BoAML, UBS WMR, as of 28 March 2011

0.4

0.7

1.0

Dec-10

1.3

1.6

Muni to Corporate (M/C) yield ratio 1–10yr (aer tax) Average 1–10yr

Average 10yr+Muni to Corporate (M/C) yield ratio 10yr + (aer tax)

Dec-08Dec-06Dec-04Dec-02Dec-00Dec-98Dec-96

Fig. 3: Preferred security yields by type


In %

6

5

8

7

9

Apr-11

10

Non-US (QDI) Preferreds US DRD/QDI preferreds

Fully taxable trust preferreds Fully taxable senior notes

Jan-11Oct-10Jul-10Apr-10Jan-10

Fig. 4: Faster growth in EM since 1980

Source: IMF, as of 28 March 2011

Real GDP growth, in %

–3

–6

3

0

6

2010e

9

Advanced economies

Emerging and developing economies

2007200420011998199519921989198619831980

Fig. 1: The yield curve should remain steep


10-year Treasury yield minus 2-year Treasury yield, and WMR forecast, in bps

50

0

–50

150

100

250

200

300

Mar-12Mar-10Mar-08Mar-06Mar-04Mar-02Mar-00

10s/2s Curve

Fig. 2: TIPS breakeven inflation rates have normalized


Breakeven yield (in %)

0

–1

2

1

3

Feb-11

4

5-year breakeven 30-year breakeven

10-year breakeven

Jun-10Oct-09Feb-09Jun-08Oct-07Feb-07Jun-06


Competition for limited resources is likely to gear up in 2Q 2011. This should be supportive of commodity prices. However, recent gains are less likely to be repeated.

Firm economic growth in the developed world, driven by the US, will rival emerging market demand for commodi-ties. Since consumption of most commodities has sur-passed historical highs in late 2010, supply will struggle to keep up with demand. The pressures to expand supply are likely to translate into a double-digit rise in production costs. In areas where supply is unable to adequately meet growing demand, as in the case of crude oil, coal, copper, nickel and platinum, we could see prices rise further. Overall, we expect well diversi� ed commodity indexes to be on track to deliver low double-digit price returns in 2011. Total returns could, however, be reduced by nega-tive roll yields on the order of -8% annually (see pg. 21).

Special factors are likely to continue to a� ect the perfor-mance of the asset class. Social unrest in the Middle East and North Africa has had a strong impact on crude oil. Due to the loss of 1.5 million barrels per day (mbpd) of Libyan crude oil exports and given � rm demand growth, OPEC spare capacity is likely to fall to pre-crisis levels—close to 3.1 mbpd. Given such tightness, any additional blow to the supply and demand balance could easily drive crude oil (West Texas Intermediate) to USD 120 per barrel.

Commodities

Ongoing support for commodities

Another factor that is leaving its mark on commodities is the recent earthquake in Japan and the ongoing nuclear crisis. While the short-term impact on commodities has been rather negative due to a drop in industrial activity, the long-term implications favor higher energy prices and supply-constrained base metals. With around 25% of Japan’s nuclear power capacity shut down for some time, additional fossil fuel demand is likely to favor higher fuel oil and coal prices. However, higher Japanese import de-mand should only favor higher natural gas prices in Europe and Asia. Limited lique� ed natural gas export capabilities in the US should keep the US market oversupplied. In the case of base metals, the reconstruction of Japan should support demand. However, the key driver will remain China’s e� orts to cool economic activity. Thus, investors should be selective when it comes to base metals.

Agricultural commodities, which rallied due to weather-related supply shocks, are likely to trend higher due to low net supply. In particular, we still see attractiveness le� in grains and co� ee. Since in� ation is likely to remain an im-portant topic in emerging markets, demand for gold out of India and China is likely to remain high. Unsolved debt problems in the US and Europe should also secure � rm investment demand. Hence, we stick to our gold forecast of USD 1650/oz over the next 12 months.

Dominic Schnider, Strategist

Fig. 1: Commodity prices continuing to rise

Source: Bloomberg, DJ UBS, UBS WMR, as of 29 March 2011

Spot price returns in USD and %

Energy

Base metals

Precious metals

Grains

Livestock

Sos

Commodities

2010year-to-date

–10 0 10 20 30 7040 50 60

Fig. 2: Electricity mix in Japan

Source: DOE, WNA and UBS WMR, as of 25 March 2011

Total power generation capacity, in %

25

20

15

10

5

0

30

Oi-fired powerGas-fired power Hydro power Coal-fired powerNuclear power

OutagesCapacity


Hedge funds: volatility creates opportunitiesThe hedge fund industry has started 2011 on a mod-erately positive note with most strategies posting returns in the 1–3% range during the � rst quarter. Going forward, we believe that the inclusion of hedge funds in portfolios will continue to provide investment bene� ts.

Hedge funds are currently supported by the following fac-tors. First, the volatile macroeconomic environment that we are facing is likely to persist, thereby o� ering trading opportunities for talented active managers. Second, with valuations in equities and credit closer to fair value than they were last year, the need for active management in se-curity selection has grown, again strengthening the value proposition of various hedge fund strategies.

Below, we highlight recent trends and prospects for the main hedge fund strategy. At the outset, we note that the broadest and therefore most reliable hedge fund perfor-mance indexes are available on a monthly basis, and hence only until the end of February. Given the market volatility that occurred in March, where appropriate, we are also providing some additional perspective based on liquid hedge fund indexes that are available daily but cover a much narrower portion of the industry.

Macro strategies have lagged behind the rest of the in-dustry so far this year. We believe that such strategies

should be able to provide value to investors going for-ward. Macroeconomic factors are expected to remain key market drivers over the next couple of quarters. Moreover, we are starting to see some divergence among the cycles across major regions, partly as a result of di� ering policy choices. This should provide ample trading opportunities to global macro managers.

Managed futures strategies, a� er posting returns in line with other strategies through February, appear to have underperformed in March according to liquid indexes. This behavior has typically been observed following natu-ral disasters such as Hurricane Katarina or the 1995 Kobe earthquake in Japan. The most recent disaster in Japan seems to have led managed futures to come under pres-sure as well. We note however that, if history is any guide, this underperformance has typically been o� set within the following three to six months.

Funds following Equity hedge strategies came under pressure in March due to the stock market sell-o� . We believe these strategies should bene� t from the overall supportive yet choppy equity environment in the follow-ing quarters. Equity-hedged managers with a track record of solid stock-picking have an opportunity before them. Due to their net long exposure, equity hedged strategies o� er upside in a buoyant equities market, but with pro-tection on the downside. During the second half of the year, with downward earnings revisions likely, the ability

Alternative Investments

Hedge funds and private equity

Fig. 1: Performance of selected Hedge Fund strategies

Source: Bloomberg, Hedge Fund Research, DJ Credit Suisse, UBS WMR, as of 28 Feb. 2011

In USD and %

HFRI Fund of Funds CompositeHFRI Macro

Managed Futures (DJ Credit Suisse)HFRI Relative Value

HFRI Merger ArbitrageHFRI Distressed/Restructuring

HFRI Event-Driven

HFRI Equity HedgeHFRI EH: Equity Market Neutral

HFRI Fund Weighted Composite

2010Jan – Feb 2011

0 1242 6 108

Fig. 2: US Private Equity activity in the U.S. Q1 2011

By Stage # DealsTotal Deal

Value (USD Mil)Equity Amount

(USD Mil)

LBO 45 13,622 8,392

Pending Acquisitions 27 7,892 7,908

Secondary Buyout 13 3,260 383

Acquisition 32 621 646

Acquisitions for Expansion 80 366 1,011

Recap or Turnaround 23 321 289

Early Stage 138 0 1,081

Seed 23 0 87

Expansion 127 0 1,514

Later Stage 102 0 1,659

Others 65 0 81

Total 675 26,082 23,051

Source: Thomson ONE, as 16 March 2011


to hedge positions by shorting securities or market in-dexes should o� er capital protection. In the extreme, the equity market neutral sub-strategy is likely to remain a consistent source of returns independent of overall mar-ket movements.

Among Event-driven strategies, merger arbitrage could gain traction based on a likely pick-up in M&A activity against the backdrop of underleveraged corporate bal-ance sheets.

Within Relative value strategies, convertible bond arbi-trage is likely to face headwinds due to higher valuations. The focus there is on new issuance and trading-oriented opportunities. Given the comeback of high-yield and in-vestment grade credit from the depths of 2008, the re-maining opportunity for long-short credit strategy is more trading oriented rather than directional.

Private equity: a muted recovery While valuations have substantially recovered in the broader private equity market, deal activity has been sluggish in the “middle market” segment. Opportunities remain plentiful within distressed in-vesting, while venture capital is still struggling to deliver returns.

Middle market turnaround: With anemic economic growth prospects, we see a protracted and long drawn-out recovery phase in the year ahead. Nonetheless, there are perceptible signs of middle market deal resurgence. In par-ticular, rising purchase price multiples and an increasing number of transactions provide some grounds for optimism. According to S&P’s Leveraged Commentary and Data mid-dle market lending review 4Q 2010, purchase price multi-ples rose from 6.6x in 2009 to 8.3x in 2010, while the number of transactions increased from 56 to 114.

In regard to � nancing, amend and extend tactics that de-ferred loan losses are reaching their limits. With the near freeze in the shadow banking sector and securitization markets still struggling, � nancing continues to remain tight for small � rms leading to re� nancing demand with-out corresponding funding availability in the year ahead. This has created opportunities for private middle market

turnaround � nancing as institutions address � nal resolu-tions of non-performing corporate loans.

Distressed investing: The distressed investing market continues to bring many new opportunities. Bank data suggest that loan loss reserves need to be augmented to bridge the gap with non-performing loans. Moreover, amend and extend deferrals and upcoming maturities will need to be addressed through re� nancing, sale or restruc-turing, especially among non-investment grade issuers. Signi� cant volumes of upcoming loan maturities are ex-pected to create a mismatch between supply of and de-mand for funding in both original and deferred maturities. This will likely drive debt-to-equity conversions and distressed sale opportunities for the preponderance of underperforming loans, and provide scope for private capital to participate. Given the anticipated limited avail-ability of leveraged loans, distressed managers who invest for control will have a rich environment in restructurings, coercive exchange o� ers and recapitalizations for the coming years.

Venture capital: While continued strong growth in Web 2.0 companies continues to make headlines, the overall venture industry continues to struggle to deliver returns. There have been very few IPOs by portfolio companies and the exit markets remain bleak. According to Thomson ONE Analytics, the 10-year internal rate of return for the ven-ture industry is -1.6%. While many recent vintage funds are still in the early stage of their J-curve, top quartile re-turns have not exceeded 5% since the 1998 vintage year. This challenged performance, along with constrained ven-ture capital investor portfolios, are causing signi� cant ven-ture capital fundraising declines from levels of the prior � ve years. Though many venture funds have reduced their new fund target size, many have not hit their reduced tar-gets and/or have delayed fundraising altogether. In 2009 and 2010, the amount raised dropped to USD 16.5 and 9.1 billion, respectively, down from an annual USD 28 to 35 billion between 2005 and 2008. There were 794 active venture capital � rms in the US at the end of 2009, down from 1,023 in 2005, according to the National Venture Capital Association. We expect this trend to continue.

Stephen Freedman, PhD, CFA, Strategist

Alternative Investments


Investorrisk pro� le1

Very conservative Conservative Moderateconservative

Moderate Moderate aggressive

Aggressive Very aggressive

Cash Equities

Bonds NTAs

Cash Equities

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Traditional Assets

Equity 0.0 +0.0 0.0 19.0 +2.5 21.5 32.0 +4.0 36.0 44.0 +5.0 49.0 54.0 +6.0 60.0 62.0 +7.5 69.5 71.0 +2.0 73.0

US Equity 0.0 +0.0 0.0 14.0 +1.5 15.5 23.0 +1.5 24.5 32.0 +2.5 34.5 39.0 +2.5 41.5 44.0 +3.0 47.0 52.0 +1.0 53.0

Large Cap Value 0.0 +0.0 0.0 8.0 -0.5 7.5 8.0 -0.5 7.5 11.0 -0.5 10.5 11.0 -1.0 10.0 11.0 -1.0 10.0 13.0 -2.5 10.5

Large Cap Growth 0.0 +0.0 0.0 5.0 +2.0 7.0 8.0 +3.0 11.0 11.0 +4.0 15.0 11.0 +5.0 16.0 11.0 +5.5 16.5 13.0 +6.0 19.0

Mid Cap 0.0 +0.0 0.0 1.0 +0.0 1.0 4.0 +0.0 4.0 5.0 +0.5 5.5 9.0 +0.0 9.0 11.0 +0.5 11.5 13.0 +0.0 13.0

Small Cap 0.0 +0.0 0.0 0.0 +0.0 0.0 2.0 +0.0 2.0 3.0 +0.0 3.0 5.0 +0.0 5.0 7.0 +0.0 7.0 8.0 +0.0 8.0

REITs 0.0 +0.0 0.0 0.0 +0.0 0.0 1.0 -1.0 0.0 2.0 -1.5 0.5 3.0 -1.5 1.5 4.0 -2.0 2.0 5.0 -2.5 2.5

Non-US Equity 0.0 +0.0 0.0 5.0 +1.0 6.0 9.0 +2.5 11.5 12.0 +2.5 14.5 15.0 +3.5 18.5 18.0 +4.5 22.5 19.0 +1.0 20.0

Developed 0.0 +0.0 0.0 5.0 +1.0 6.0 8.0 +0.5 8.5 10.0 +0.0 10.0 12.0 +0.0 12.0 14.0 +0.5 14.5 14.0 -3.0 11.0

Emerging Markets 0.0 +0.0 0.0 0.0 +0.0 0.0 1.0 +2.0 3.0 2.0 +2.5 4.5 3.0 +3.5 6.5 4.0 +4.0 8.0 5.0 +4.0 9.0

Fixed Income 81.0 -1.0 � 80.0 67.0 -3.5 � 63.5 51.0 -5.5 � 45.5 37.0 -7.0 � 30.0 24.0 -8.5 � 15.5 11.0 -7.5 3.5 0.0 +0.0 0.0

US Fixed Income 74.0 +0.0 74.0 59.0 -1.0 58.0 43.0 -2.0 41.0 29.0 -2.5 26.5 18.0 -3.0 15.0 9.0 -5.5 3.5 0.0 +0.0 0.0

Non-US Fixed Income 7.0 -1.0 � 6.0 8.0 -2.5 � 5.5 8.0 -3.5 � 4.5 8.0 -4.5 � 3.5 6.0 -5.5 � 0.5 2.0 -2.0 0.0 0.0 +0.0 0.0

Cash (USD) 10.0 +1.0 � 11.0 2.0 +1.0 � 3.0 2.0 +1.5 � 3.5 2.0 +2.0 � 4.0 2.0 +2.5 � 4.5 2.0 +0.0 2.0 2.0 -2.0 0.0

Non-traditional Assets 9.0 +0.0 9.0 12.0 +0.0 12.0 15.0 +0.0 15.0 17.0 +0.0 17.0 20.0 +0.0 20.0 25.0 +0.0 25.0 27.0 +0.0 27.0

Commodities 2.0 +0.0 2.0 3.0 +0.0 3.0 4.0 +0.0 4.0 5.0 +0.0 5.0 5.0 +0.0 5.0 6.0 +0.0 6.0 7.0 +0.0 7.0

Alternative Investments5 7.0 +0.0 7.0 9.0 +0.0 9.0 11.0 +0.0 11.0 12.0 +0.0 12.0 15.0 +0.0 15.0 19.0 +0.0 19.0 20.0 +0.0 20.0


Detailed asset allocation, with non-traditional assets (NTAs)


Detailed asset allocation, without non-traditional assets (NTAs)

Investorrisk pro� le1

Very conservative Conservative Moderateconservative

Moderate Moderate aggressive

Aggressive Very aggressive

Cash Equities

Bonds

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Traditional Assets

Equity 0.0 +0.0 0.0 22.0 +2.5 24.5 37.0 +4.0 41.0 52.0 +5.0 57.0 67.0 +6.0 73.0 83.0 +7.5 90.5 98.0 +2.0 100.0

US Equity 0.0 +0.0 0.0 16.0 +1.5 17.5 26.0 +1.5 27.5 37.0 +2.5 39.5 48.0 +2.5 50.5 59.0 +3.0 62.0 72.0 +1.0 73.0

Large Cap Value 0.0 +0.0 0.0 9.0 -0.5 8.5 9.0 -0.5 8.5 13.0 -0.5 12.5 14.0 -1.0 13.0 15.0 -1.0 14.0 18.0 -2.5 15.5

Large Cap Growth 0.0 +0.0 0.0 6.0 +2.0 8.0 9.0 +3.0 12.0 13.0 +4.0 17.0 14.0 +5.0 19.0 15.0 +5.5 20.5 18.0 +6.0 24.0

Mid Cap 0.0 +0.0 0.0 1.0 +0.0 1.0 4.0 +0.0 4.0 6.0 +0.5 6.5 11.0 +0.0 11.0 15.0 +0.5 15.5 18.0 +0.0 18.0

Small Cap 0.0 +0.0 0.0 0.0 +0.0 0.0 3.0 +0.0 3.0 3.0 +0.0 3.0 6.0 +0.0 6.0 9.0 +0.0 9.0 11.0 +0.0 11.0

REITs 0.0 +0.0 0.0 0.0 +0.0 0.0 1.0 -1.0 0.0 2.0 -1.5 0.5 3.0 -1.5 1.5 5.0 -2.0 3.0 7.0 -2.5 4.5

Non–US Equity 0.0 +0.0 0.0 6.0 +1.0 7.0 11.0 +2.5 13.5 15.0 +2.5 17.5 19.0 +3.5 22.5 24.0 +4.5 28.5 26.0 +1.0 27.0

Developed 0.0 +0.0 0.0 6.0 +1.0 7.0 9.0 +0.5 9.5 13.0 +0.0 13.0 15.0 +0.0 15.0 18.0 +0.5 18.5 20.0 -3.0 17.0

Emerging Markets 0.0 +0.0 0.0 0.0 +0.0 0.0 2.0 +2.0 4.0 2.0 +2.5 4.5 4.0 +3.5 7.5 6.0 +4.0 10.0 6.0 +4.0 10.0

Fixed Income 90.0 -1.0 � 89.0 76.0 -3.5 � 72.5 61.0 -5.5 � 55.5 46.0 -7.0 � 39.0 31.0 -8.5 � 22.5 15.0 -7.5 7.5 0.0 +0.0 0.0

US Fixed Income 82.0 +0.0 82.0 67.0 -1.0 66.0 51.0 -2.0 49.0 36.0 -2.5 33.5 23.0 -3.0 20.0 12.0 -4.5 7.5 0.0 +0.0 0.0

Non–US Fixed Income 8.0 -1.0 � 7.0 9.0 -2.5 � 6.5 10.0 -3.5 � 6.5 10.0 -4.5 � 5.5 8.0 -5.5 � 2.5 3.0 -3.0 0.0 0.0 +0.0 0.0

Cash (USD) 10.0 +1.0 � 11.0 2.0 +1.0 � 3.0 2.0 +1.5 � 3.5 2.0 +2.0 � 4.0 2.0 +2.5 � 4.5 2.0 +0.0 2.0 2.0 -2.0 0.0



Wealth Management Americas Investment Committee (WMA IC)

The WMA IC is the primary decision-making body within WM Americas for recommended asset allocations across inves-tor risk pro� les. As explained more fully below, the WMA IC vets the � agship tactical asset allocation recommendations which appear in this publication, the Investment Strategy Guide (ISG). The WMA IC also reviews and approves (i) inputs relating to WM Americas’ strategic asset allocations, and (ii) other tactical asset allocation recommendations which may be developed for ultra high net worth and other speci� c client groups by business areas other than WMRA.

CompositionThe WMA IC currently has seven voting members, and two non-voting members.The voting members include:

Mike Ryan – Head of Wealth Management Research – Americas (WMRA)Stephen Freedman – WMRA Investment Strategy HeadJeremy Zirin – WMRA Equities HeadAnne Briglia – WMRA Taxable Fixed Income HeadTony Roth – Head of Wealth Management Strategies, Wealth Management Solutions (*)Mihir Bhattacharya – Head of Strategic Projects and Services, Wealth Management Solutions (*)Thomas Troy – Head of Market Executions, Wealth Management Solutions (*)(*) Business areas distinct from WMRA

The two non-voting members are employees of UBS Global Asset Management, an af� liate of UBS Financial Services Inc.They are:

John Dugenske – Global Fixed Income, Head of US Fixed IncomeAndreas Koester – Global Investment Solutions, Head of Asset Allocation and Currency

Vetting of WMRA � agship TAA recommendationsAt least monthly, WMRA presents to the WMA IC for its review a � agship TAA proposal and supporting investment case for a moderate-risk pro� le investor. In order to be published in the ISG, the � agship TAA must be accepted by the WMA IC and be supported by a majority of the WMRA members. The � agship TAA recommendations across other risk pro� les published in the ISG are further calculated in accordance with a methodology approved by the WMA IC.

Appendix

Investment Committee


In order to create the analysis shown, the rates of return for each asset class are combined in the same proportion as the asset allocations illustrated (e.g., if the asset alloca-tion indicates 40% equities, then 40% of the results shown for the allocation will be based upon the esti-mated hypothetical return and standard deviation as-sumptions shown below).

You should understand that the analysis shown and as-sumptions used are hypothetical estimates provided for your general information. The results are not guarantees and pertain to the asset allocation and/or asset class in general, not the performance of speci� c securities or in-vestments. Your actual results may vary signi� cantly from the results shown in this report, as can the performance of any individual security or investment.

Appendix

Portfolio Analytics

The portfolio analytics shown for each risk pro� le’s bench-mark allocations are based on estimated forward-looking return and standard deviation assumptions (capital market assumptions), which are based on UBS proprietary re-search. The development process includes a review of a variety of factors, including the return, risk, correlations and historical performance of various asset classes, in� a-tion and risk premium. These capital market assumptions do not assume any particular investment time horizon. The process assumes a situation where the supply and demand for investments is in balance, and in which ex-pected returns of all asset classes are a re� ection of their expected risk and correlations regardless of time frame. Please note that these assumptions are not guarantees and are subject to change. UBS has changed its risk and return assumptions in the past and may do so in the fu-ture. Neither UBS nor your Financial Advisor is required to provide you with an updated analysis based upon changes to these or other underlying assumptions.

RiskPro� le ==>>

Veryconservative Conservative

Moderate conservative Moderate

Moderate aggressive Aggressive

Very aggressive

With non-traditional assets

Estimated Return 4.81% 5.98% 6.89% 7.65% 8.36% 9.00% 9.56%

Estimated Risk 3.21% 4.70% 6.71% 8.69% 10.53% 12.16% 13.81%

Without non-traditional assets

Estimated Return 4.46% 5.67% 6.62% 7.44% 8.33% 9.22% 10.00%

Estimated Risk 3.45% 4.78% 6.93% 9.17% 11.73% 14.46% 16.94%

Asset Class Capital Market AssumptionsEstimated Risk Estimated Return

US Equity

Large Cap Value 16.4% 8.7%

Large Cap Growth 19.0% 9.3%

Mid Cap 18.4% 10.4%

Small Cap 21.4% 10.6%

REITs 23.0% 9.6%

Non-US Equity

Developed Markets Equities 17.7% 10.4%

Emerging Markets Equities 26.6% 12.6%

US Fixed Income 3.7% 4.4%

Non-US Fixed Income 8.8% 6.1%

Cash (USD) 0.5% 4.0%

Commodities 17.1% 7.6%

Alternative Investments 8.5% 8.7%


Appendix

Additional Asset Allocation Models

US Taxable Fixed Income Allocation, in %

Benchmark WMR Tactical deviation2 Current allocation3

allocation1 Previous Current

Treasuries 12.0 -1.0 -1.0 11.0

TIPS (Treasury in� ation-protected securities) 5.0 -1.0 -1.0 4.0

Agencies 22.0 -1.0 -1.0 21.0

Mortgages 20.0 -2.0 -2.0 18.0

Inv. Grade Corporates 22.0 +1.0 +1.0 23.0

High Yield Corporates 10.0 +2.0 +2.0 12.0

Preferred Securities 4.0 +1.0 +1.0 5.0

Emerging Market sovereign bonds in US dollar 5.0 +1.0 +1.0 6.0

TFI non-Credit 59.0 -5.0 -5.0 54.0

TFI Credit 41.0 +5.0 +5.0 +46.0

Non–US Developed Equity Module, in %



Eurozone 27.0 -15.0 -15.0 12.0

UK 19.0 +25.0 +25.0 44.0

Japan 20.0 -15.0 -15.0 5.0

Other 34.0 +5.0 +5.0 39.0

Non–US Fixed Income Module, in %



Eurozone 43.0 +0.0 +1.5 44.5

UK 9.0 +10.0 +16.0 25.0

Japan 32.0 -20.0 -29.0 3.0

Other 16.0 +10.0 +11.5 27.5

Source: UBS WMR and Investment Solutions, as of 30 March 20111 The benchmark allocation refers to a moderate risk pro� le. See “Sources of Benchmark Allocations and Investor Risk Pro� les” in the Appendix for an explanation regarding the source of benchmark

allocations and their suitability.2 See “Deviations from Benchmark Allocations” in the Appendix for an explanation regarding the interpretation of the suggested tactical deviations from benchmark. The “current” column refers to the

tactical deviation that applies as of the date of this publication. The “previous” column refers to the tactical deviation that was in place at the date of the previous edition of the Investment Strategy Guide or the last Investment Strategy Guide Update.

3 The current allocation column is the sum of the benchmark allocation and the WMR tactical deviation columns.


Appendix

Additional Asset Allocation Models Equity Industry Group Allocation, in %

S&P 500 WMR Tactical deviation2 Current Benchmark Numeric Symbol allocation3

allocation1 Previous Current Previous Current

Consumer Discretionary 10.4 -1.0 -1.0 – – 9.4

Auto & Components 0.8 +1.0 +1.0 + + 1.8

Consumer Services 1.7 +1.0 +1.0 + + 2.7

Media 3.3 +0.0 +0.0 n n 3.3

Retailing 3.5 -2.0 -2.0 – – – – 1.5

Consumer, Durables & Apparel 1.0 -1.0 -1.0 – – 0.0

Consumer Staples 10.3 +1.0 +1.0 + + 11.3

Food, Beverage & Tobacco 5.8 +0.0 +0.0 n n 5.8

Food & Staples Retailing 2.2 +0.0 +0.0 n n 2.2

Household & Personal Products 2.2 +1.0 +1.0 + + 3.2

Energy 13.2 +0.0 -1.0 n – 12.2

Financials 15.9 +0.0 +0.0 n n 15.9

Banks 3.0 +0.0 +0.0 n n 3.0

Diversi� ed Financials 7.4 +1.0 +0.0 + n 7.4

Insurance 3.9 +0.0 +1.0 n + 4.9

Real Estate 1.6 -1.0 -1.0 – – 0.6

Health Care 11.0 -1.0 +0.0 – n 11.0

HC Equipment & Services 3.9 +0.0 +1.0 n + 4.9

Pharmaceuticals & Biotechnology 7.0 -1.0 -1.0 – – 6.0

Industrials 11.2 +2.0 +1.0 ++ + 12.2

Capital Goods 8.7 +1.0 +1.0 + + 9.7

Commercial Services & Supplies 0.6 +0.0 +0.0 n n 0.6

Transportation 2.0 +1.0 +0.0 + n 2.0

Information Technology 18.2 +2.5 +2.0 +++ ++ 20.2

So� ware & Services 8.6 +1.0 +0.0 + n 8.6

Technology Hardware & Equipment 7.1 +1.5 +2.0 ++ ++ 9.1

Semiconductors 2.5 +0.0 +0.0 n n 2.5

Materials 3.7 +0.0 +0.0 n n 3.7

Telecom 3.0 -2.5 -1.0 – – – – 2.0

Utilities 3.2 -1.0 -1.0 – – 2.2

Source: S&P, UBS WMR, as of 30 March 2011

The benchmark allocation, as well as the tactical deviations, are intended to be applicable to the US equity portion of a portfolio across investor risk pro� les.1 The benchmark allocation is based on S&P 500 weights.2 See “Deviations from Benchmark Allocations” in the Appendix for an explanation regarding the interpretation of the suggested tactical deviations from benchmark. The “current” column refers to the

tactical deviation that applies as of the date of this publication. The “previous” column refers to the tactical deviation that was in place at the date of the previous edition of the Investment Strategy Guide or the last Investment Strategy Guide Update.

3 The current allocation column is the sum of the S&P 500 benchmark allocation and the WMR tactical deviation columns.

Alternative Investment (AI) Benchmark Allocation (All � gures in % of total portfolio)

Risk pro� le

Very conservative Conservative

Moderate conservative Moderate

Moderate aggressive Aggressive

Very aggressive

Tactical Trading 1.0 1.0 1.0 2.0 2.5 3.5 4.0

Relative Value 1.5 2.0 2.0 2.0 2.0 2.0 2.0

Credit Strategies 1.5 2.0 2.0 2.0 2.5 3.0 3.0

Event Driven 1.5 2.0 2.0 2.0 2.0 2.5 3.0

Equity Hedge 1.5 2.0 2.0 2.0 2.0 3.0 3.0

Private Equity 0.0 0.0 2.0 2.0 2.0 2.0 3.0

Private Real Estate 0.0 0.0 0.0 0.0 2.0 2.0 2.0

Total Alternative Investments 7 9 11 12 15 19 20

See “Sources of Benchmark Allocations and Investor Risk Pro� les” in the Appendix for an explanation regarding the source of the benchmark allocations and their suitability.


Table A re� ects the performance of the tactical asset allo-cation recommendations published in the Investment Strategy Guide during the time period speci� ed. The per-formance is based on the benchmark allocations with nontraditional assets for a moderate risk pro� le investor, and the benchmark allocation with the tactical shi� (see detailed asset allocation tables where benchmark alloca-tion with tactical shi� is referred to as “current alloca-tion”). Performance is calculated utilizing the returns of the indices identi� ed in Table B as applied to the respec-tive allocations in the benchmark and the benchmark with the tactical shi� . For example, if cash were allocated 10% in the benchmark and 12% in the benchmark with the tactical shi� , the cash index respectively contributed to 10% and 12% of the results shown.

The performance attributable to the WMR tactical devia-tions is re� ected in the column labeled “Excess return,” which shows the di� erence between the performance of the benchmark and the performance of the benchmark with the tactical shi� . The Information ratio is a risk-adjusted performance measure, which adjusts the excess returns for the tracking error risk of the tactical devia-tions. Speci� cally the information ratio is calculated as the ratio of the annualized excess return over a given time period and the annualized standard deviation of daily ex-cess returns over the same period. Additional background information regarding the computation of the informa-tion ratio � gures provided below are available upon request.

Table A: Moderate Risk Pro� le Performance Measurement

Benchmarkallocation

Benchmark with tactical shift

Excess return Informationratio

(annualized)

Russell 3000stock index

(total return)

Barclays CapitalUS Aggregate bondindex (total return)

25 Aug. 08 to 31 Dec. 08 -16.59% -15.64% 0.96% +2.0 -29.00% 3.33%

2009 Q1 -5.52% -5.45% 0.07% +0.3 -10.80% 0.12%

2009 Q2 11.18% 11.37% 0.18% +1.0 16.82% 1.78%

2009 Q3 10.44% 11.07% 0.63% +2.1 16.31% 3.74%

2009 Q4 2.99% 3.30% 0.31% +1.2 5.90% 0.20%

2010 Q1 2.74% 2.56% -0.18% -0.9 5.94% 1.78%

2010 Q2 -4.56% -4.87% -0.31% -1.4 -11.32% 3.49%

2010 Q3 8.34% 7.99% -0.35% -2.2 11.53% 2.48%

2010 Q4 5.18% 5.17% -0.01% -0.4 11.59% -1.30%

2011 Q1 until 29 Mar. 2011 2.56% 2.43% -0.12% -0.6 5.64% 0.20%

Since inception 14.21% 15.69% 1.48% +0.5 12.55% 16.85%


Appendix

Tactical Asset Allocation Performance Measurement

Calculations start on 25 August 2008. Prior to 25 August 2008, WMR published tactical asset allocation recommen-dations in the “US Asset Allocation Strategist” using a less comprehensive set of asset classes and sectors, which makes a comparison with the current models dif� cult. In addition, since 25 August 2008, the Investment Strategy Guide has at times published a more detailed set of tacti-cal deviations, whereby the categories “Non-US Developed Equities” and Non-US Fixed Income” were further subdi-vided into regional blocks. Only the cumulative recommen-dations at the level of “Non-US Developed Equities” and “Non-US Fixed Income” were taken into account in calcu-lating the performance shown below.

The calculations assume that the portfolios are rebalanced whenever changes are made to tactical deviations, typi-cally upon publication of the Investment Strategy Guide on a monthly basis. Occasionally, changes in the tactical deviations are made intra-month when warranted by mar-ket conditions and communicated through an Investment Strategy Guide Update. The computations assume portfo-lio rebalancing upon such intra-month changes as well. Performance shown is based on total returns, but does not include transaction costs, such as commissions, fees, mar-gin interest, and interest charges. Actual total returns ad-justed for such transaction costs will be reduced. A complete record of all the recommendations upon which this performance report is based is available from UBS Financial Services Inc. upon written request. Past perfor-mance is not an indication of future results.


Table D: WMR US dollar Taxable Fixed Income Strategy performance measurement

Benchmarkallocation

Benchmarkwith tactical shift

Excessreturn

Information ratio(annualized)

Barclays CapitalUS Aggregate

31 Jan. 2007 to 31 Dec. 2007 4.69% 4.56% -0.12% -1.4 7.01%

2008 -1.17% -2.11% -0.94% -3.2 5.24%

2009 11.67% 12.96% 1.29% 2.8 5.93%

2010 7.97% 8.08% 0.12% 0.7 6.54%

2011 Q1 until 29 Mar. 2011 0.87% 0.94% 0.07% 3.3 0.20%

Since inception 25.82% 26.14% 0.31% 0.2 27.36%


Table B: IS benchmark allocations for moderate risk pro� le investor, and underlying indices (all � gures in %)

25 Aug 2008 to 23 Feb 2009 24 Feb 2009 to present

US Large Cap Value (Russell 1000 Value) 12.5 US Large Cap Value (Russell 1000 Value) 11.0

US Large Cap Growth (Russell 1000 Growth) 12.5 US Large Cap Growth (Russell 1000 Growth) 11.0

US Small Cap Value (Russell 2000 Value) 2.0 US Mid Cap (Russell Midcap) 5.0

US Small Cap Growth (Russell 2000 Growth) 2.0 US Small Cap (Russell 2000) 3.0

US REITs (FTSE NAREIT All REITs) 1.5 US REITs (FTSE NAREIT All REITs) 2.0

Non-US Dev. Eq (MSCI Gross World ex-US) 10.5 Developed Markets (MSCI Gross World ex-US) 10.0

Emerging Markets Eq. (MSCI Gross EM USD) 2.0 Emerging Markets (MSCI Gross EM USD) 2.0

US Fixed Income (BarCap US Aggregate) 30.0 US Fixed Income (BarCap US Aggregate) 29.0

Non-US Fixed Income (BarCap Global Aggregate ex-USD) 8.0 Non-US Fixed Income (BarCap Global Aggregate ex-USD) 8.0

Cash (JP Morgan Cash Index USD 1 month) 2.0 Cash (JP Morgan Cash Index USD 1 month) 2.0

Commodities (DJ UBS total return index) 5.0 Commodities (DJ UBS total return index) 5.0

Alternative Investments (HFRX Equal Weighted Strategies) 12.0 Alternative Investments (HFRX Equal Weighted Strategies) 12.0

Source: UBS WMR and Investment Solutions

Table C: US Equity Sector Strategy performance measurement

S&P 500 Benchmarkallocation

Benchmarkwith tactical shift

Excessreturn

Information ratio(annualized)

29 Oct. 2007 to 31 Dec. 2007 -4.32% -4.02% 0.30% +2.3

2008 -36.97% -36.98% -0.01% -0.2

2009 26.56% 26.28% -0.27% -0.3

2010 15.07% 14.22% -0.85% -1.5

2011 Q1 until 29 Mar. 2011 5.39% 5.51% 0.11% +0.8

Since inception -7.44% -7.95% -0.51% -0.3


Table C similarly indicates the performance of WMR’s US Equity Sector Strategy, which has been published in comparable format since 29 October 2007). The Benchmark allocation is the S&P 500.

Appendix


Finally, table D, provides the performance of the US dollar Taxable Fixed Income Strategy, which has been published by WMR since 31 January 2007. The benchmark allocation and the underlying indices for each segment are available in table E.


Appendix


Table E : Benchmark allocation for US dollar Fixed Income Strategy and underlying indices used to calculate performance shown in Table D (all � gures in %)

31 Jan. 2007 to 30 July 2007

31 July 2007 to 24 Aug 2008

25 Aug 2008 to 30 March 2009

31 March 2009 to present

Treasuries (BoA ML Treasury Master Index) 10.0% 12.0% 12.0% 12.0%

TIPS (BoA ML Treasury In� ation-Linked Index) 5.0% 5.0% 5.0% 5.0%

Agencies (BoA ML Agency Composite Master Index) 20.0% 22.0% 22.0% 22.0%

Inv. Grade Corporates (BoA ML Corporate Master Index) 20.0% 21.0% 18.0% 22.0%

High Yield Corporates (BoA ML High Yield Master II Constrained Index) 10.0% 10.0% 8.0% 10.0%

Preferred Securities (BoA ML Preferred Stock Fixed Index) 10.0% 10.0% 10.0% 4.0%

Mortgages (BoA ML US Mortgage Master Index) 20.0% 20.0% 20.0% 20.0%

Emerg. Markets (BoA ML Emerging Sovereign Plus Index) 0.0% 0.0% 5.0% 5.0%

Cash (BoA ML US T-Bill 3-month Index) 5.0% 0.0% 0.0% 0.0%

Source: UBS WMR and Investment Solutions


Non-Traditional AssetsNontraditional assets include commodities and alternative investments. Alternative

investments, in turn, include hedge funds, private equity, real estate, and managed

futures. Interests of alternative investment funds are sold only to quali� ed inves-

tors, and only by means of o� ering documents that include information about the

risks, performance and expenses of alternative investment funds, and which clients

are urged to read carefully before subscribing and retain. An investment in an

alternative investment fund is speculative and involves signi� cant risks. Alternative

investment funds are not mutual funds and are not subject to the same regulatory

requirements as mutual funds. Alternative investment funds’ performance may be

volatile, and investors may lose all or a substantial amount of their investment in

an alternative investment fund. Alternative investment funds may engage in lever-

aging and other speculative investment practices that may increase the risk of

investment loss. Interests of alternative investment funds typically will be illiquid

and subject to restrictions on transfer. Alternative investment funds may not be

required to provide periodic pricing or valuation information to investors.

Alternative investment fund investment programs generally involve complex tax

strategies and there may be delays in distributing tax information to investors.

Alternative investment funds are subject to high fees, including management fees

and other fees and expenses, all of which will reduce pro� ts. Alternative invest-

ment funds may � uctuate in value. An investment in an alternative investment

fund is long-term, there is generally no secondary market for the interests of a

fund, and none is expected to develop. Interests in alternative investment funds

are not deposits or obligations of, or guaranteed or endorsed by, any bank or other

insured depository institution, and are not federally insured by the Federal Deposit

Insurance Corporation, the Federal Reserve Board, or any other governmental

agency. Prospective investors should understand these risks and have the � nancial

ability and willingness to accept them for an extended period of time before mak-

ing an investment in an alternative investment fund and should consider an alter-

native investment fund as a supplement to an overall investment program.

In addition to the risks that apply to alternative investments generally, the follow-

ing are additional risks related to an investment in these strategies:

• Hedge Fund Risk: There are risks speci� cally associated with investing in hedge

funds, which may include risks associated with investing in short sales, options,

small-cap stocks, “junk bonds,” derivatives, distressed securities, non-US securi-

ties and illiquid investments.

• Hedge Fund of Funds: In addition to the risks associated with hedge funds gener-

ally, an investor should recognize that the overall performance of a fund of funds

is dependent not only on the investment performance of the manager of the

fund, but also on the performance of the underlying managers. The investor will

bear the management fees and expenses of both the fund of funds and the

underlying hedge funds or accounts in which the fund of funds invests, which

could be signi� cant.

• Managed Futures: There are risks speci� cally associated with investing in man-

aged futures programs. For example, not all managers focus on all strategies at

all times, and managed futures strategies may have material directional elements.

• Real Estate: There are risks speci� cally associated with investing in real estate

products and real estate investment trusts. They involve risks associated with

debt, adverse changes in general economic or local market conditions, changes

in governmental, tax, real estate and zoning laws or regulations, risks associated

with capital calls and, for some real estate products, the risks associated with the

ability to qualify for favorable treatment under the federal tax laws.

• Private Equity: There are risks speci� cally associated with investing in private

equity. Capital calls can be made on short notice, and the failure to meet capital

calls can result in signi� cant adverse consequences including, but not limited to,

a total loss of investment.

• Foreign Exchange/Currency Risk: Investors in securities of issuers located outside

of the United States should be aware that even for securities denominated in US

dollars, changes in the exchange rate between the US dollar and the issuer’s

Appendix

End notes for table labeled detailed asset allocations with non-traditional assets (NTAs)1 See “Sources of benchmark allocations and investor risk pro� les”on next page

regarding the source of investor risk pro� les.

2 See “Sources of benchmark allocations and investor risk pro� les” on next page

regarding the source of benchmark allocations and their suitability.

3 See “Deviations from benchmark allocations” in the appendix regarding the

interpretation of the suggested tactical deviations from benchmark.

4 The current allocation row is the sum of the benchmark allocation and the WMR

tactical deviation rows.

5 UBS WMR considers that maintaining the benchmark allocation is appropriate for

alternative investments. The recommended tactical deviation is therefore structur-

ally set at 0. See “Sources of benchmark allocations and investor risk pro� les” on

next page regarding the types of alternative investments and their suitability.

End notes for table labeled detailed asset allocations without non-tradi-tional assets (NTAs)1 See “Sources of benchmark allocations and investor risk pro� les”on next page

regarding the source of investor risk pro� les.

2 See “Sources of benchmark allocations and investor risk pro� les” on next page

regarding the source of benchmark allocations and their suitability.

3 See “Deviations from benchmark allocations” in the Appendix regarding the

interpretation of the suggested tactical deviations from benchmark.

4 The current allocation row is the sum of the benchmark allocation and the WMR

tactical deviation rows.

Emerging Market InvestmentsInvestors should be aware that Emerging Market assets are subject to, amongst

others, potential risks linked to currency volatility, abrupt changes in the cost of

capital and the economic growth outlook, as well as regulatory and socio-political

risk, interest rate risk and higher credit risk. Assets can sometimes be very illiquid

and liquidity conditions can abruptly worsen. WMR generally recommends only

those securities it believes have been registered under Federal US registration rules

(Section 12 of the Securities Exchange Act of 1934) and individual State registra-

tion rules (commonly known as “Blue Sky” laws). Prospective investors should be

aware that to the extent permitted under US law, WMR may from time to time

recommend bonds that are not registered under US or State securities laws. These

bonds may be issued in jurisdictions where the level of required disclosures to be

made by issuers is not as frequent or complete as that required by US laws.

For more background on emerging markets generally, see the WMR Education

Notes “Investing in Emerging Markets (Part 1): Equities,” 30 July 2007, “Emerging

Market Bonds: Understanding Emerging Market Bonds,” 12 August 2009 and

“Emerging Market Bonds: Understanding Sovereign Risk,” 17 December 2009.

Investors interested in holding bonds for a longer period are advised to select the

bonds of those sovereigns with the highest credit ratings (in the investment grade

band). Such an approach should decrease the risk that an investor could end up

holding bonds on which the sovereign has defaulted. Sub-investment grade bonds

are recommended only for clients with a higher risk tolerance and who seek to

hold higher yielding bonds for shorter periods only.


Appendix

“home” currency can have unexpected e� ects on the market value and liquidity

of those securities. Those securities may also be a� ected by other risks (such as

political, economic or regulatory changes) that may not be readily known to a US

investor.

• Options: Options are not suitable for all investors. Please read the Options

Clearing Corporation Publication titled “Characteristics and Risks of Standardized

Options Trading” and consult your tax advisor prior to investing. The Publication

can be obtained from your Financial Services Inc., Financial Advisor, or can be

accessed under the Publications Section of the Option Clearing Corporation’s

website: www.theocc.com.

Description of Certain Alternative Investment Strategies• Equity Hedge: Investment managers who maintain positions both long and short

in primarily equity and equity-derivative securities. A wide variety of investment

processes can be employed to arrive at an investment decision, including both

quantitative and fundamental techniques; strategies can be broadly diversi� ed or

narrowly focused on speci� c sectors and can range broadly in terms of levels of

net exposure, leverage employed, holding period, concentrations of market

capitalizations and valuation ranges of typical portfolios. Equity hedge managers

would typically maintain at least 50% and may, in some cases, be substantially

entirely invested in equities, both long and short.

• Event Driven: Investment managers who maintain positions in companies cur-

rently or prospectively involved in corporate transactions of a wide variety includ-

ing, but not limited to, mergers, restructurings, � nancial distress, tender o� ers,

share-holder buybacks, debt exchanges, security issuance or other capital struc-

ture adjustments. Security types can range from most senior in the capital struc-

ture to most junior or subordinated, and frequently involve additional derivative

securities. Event-driven exposure includes a combination of sensitivities to equity

markets, credit markets and idiosyncratic, company-speci� c developments.

Investment theses are typically predicated on fundamental characteristics (as

opposed to quantitative), with the realization of the thesis predicated on a spe-

ci� c development exogenous to the existing capital structure.

• Credit Arbitrage Strategies: Employ an investment process designed to isolate

attractive opportunities in corporate � xed income securities. These include both

senior and subordinated claims as well as bank debt and other outstanding

obligations, structuring positions with little or no broad credit market exposure.

These may also contain a limited exposure to government, sovereign, equity,

convertible or other obligations, but the focus of the strategy is primarily on � xed

corporate obligations and other securities held as component positions within

these structures. Managers typically employ fundamental credit analysis to evalu-

ate the likelihood of an improvement in the issuer’s creditworthiness. In most

cases, securities trade in liquid markets, and managers are only infrequently or

indirectly involved with company management. Fixed income: corporate strate-

gies di� er from event driven; credit arbitrage in the former more typically involves

more general market hedges, which may vary in the degree to which they limit

� xed income market exposure, while the latter typically involves arbitrage posi-

tions with little or no net credit market exposure, but are predicated on speci� c,

anticipated idiosyncratic developments.

• Macro: Investment managers who trade a broad range of strategies in which the

investment process is predicated on movements in underlying economic variables

and the impact these have on equity, � xed income, hard currency and commodity

markets. Managers employ a variety of techniques, both discretionary and sys-

tematic analysis, combinations of top-down and bottom-up theses, quantitative

and fundamental approaches and long- and short-term holding periods.

Although some strategies employ relative value techniques, macro strategies are

distinct from relative value strategies in that the primary investment thesis is

predicated on predicted or future movements in the underlying instruments,

rather than realization of a valuation discrepancy between securities. In a similar

way, while both macro and equity hedge managers may hold equity securities,

the overriding investment thesis is predicated on the impact movements in under-

lying macroeconomic variables may have on security prices, as opposed to equity

hedge, in which the fundamental characteristics of the company are the most

signi� cant and integral to investment thesis.

• Distressed Restructuring Strategies: Employ an investment process focused on

corporate � xed income instruments, primarily on corporate credit instruments of

companies trading at signi� cant discounts to their value at issuance, or obliged

(par value) at maturity, as a result of either a formal bankruptcy proceeding or

� nancial market perception of near-term proceedings. Managers are typically

actively involved with the management of these companies, frequently involved

on creditors’ committees in negotiating the exchange of securities for alternative

obligations, either swaps of debt, equity or hybrid securities. Managers employ

fundamental credit processes focused on valuation and asset coverage of securi-

ties of distressed � rms. In most cases, portfolio exposures are concentrated in

instruments which are publicly traded, in some cases actively and in others under

reduced liquidity but, in general, for which a reasonable public market exists. In

contrast to special situations, distressed strategies primarily employ debt (greater

than 60%) but also may maintain related equity exposure.

• Relative Value: Investment managers who maintain positions in which the invest-

ment thesis is predicated on realization of a valuation discrepancy in the relation-

ship between multiple securities. Managers employ a variety of fundamental and

quantitative techniques to establish investment theses, and security types range

broadly across equity, � xed income, derivative or other security types. Fixed in-

come strategies are typically quantitatively driven to measure the existing relation-

ship between instruments and, in some cases, identify attractive positions in

which the risk-adjusted spread between these instruments represents an attrac-

tive opportunity for the investment manager. Relative value position may be

involved in corporate transactions also, but as opposed to event-driven exposures,

the investment thesis is predicated on realization of a pricing discrepancy be-

tween related securities, as opposed to the outcome of the corporate transaction.

Chart ExplanationsFigure 2 in FocusSee Sources of benchmark allocations and investor risk pro� les in the Appendix for a detailed explanation regarding benchmarks and their suitability. The current allocation is the sum of the benchmark allocations and tactical deviations. The detailed asset allocation tables in the Appendix also show asset allocations appli-cable to risk pro� les other than the moderate risk pro� le shown here, both with and without nontraditional assets.

Figure 6 in Focus and Figures 1 and 2 in Economic OutlookIn developing the forecasts set forth above, WMR economists worked in collabora-

tion with economists employed by UBS Investment Research (INV). INV is published

by UBS Investment Bank. Forecasts (F) are current only as of the dates of the publi-

cation and may change without notice.


Sources of benchmark allocations and investor risk pro� les• Benchmark allocations represent the longer-term allocation of assets that is

deemed suitable for a particular investor. Except as described below, the bench-

mark allocations expressed in this publication have been developed by UBS

Investment Solutions (IS), a business sector within UBS Wealth Management

Americas that develops research-based traditional investments (e.g., managed

accounts and mutual fund options) and alternative strategies (e.g., hedge funds,

private equity, and real estate) o� ered to UBS clients. The benchmark allocations

are provided for illustrative purposes only and were designed by IS for hypotheti-

cal US investors with a total return objective under seven di� erent Investor Risk

Pro� les ranging from very conservative to very aggressive. In general, benchmark

allocations will di� er among investors according to their individual circumstances,

risk tolerance, return objectives and time horizon. Therefore, the benchmark

allocations in this publication may not be suitable for all investors or investment

goals and should not be used as the sole basis of any investment decision. As

always, please consult your UBS Financial Advisor to see how these weightings

should be applied or modi� ed according to your individual pro� le and investment

goals.

• The process by which UBS Investment Solutions has derived the benchmark

allocations can be described as follows. First, an allocation is made to broad asset

classes based on an investor’s risk tolerance and characteristics (such as prefer-

ence for international investing). This is accomplished using optimization meth-

ods within a mean-variance framework. Based on a proprietary set of capital

market assumptions, including expected returns, risk, and correlation of di� erent

asset classes, combinations of the broad asset classes are computed that provide

the highest level of expected return for each level of expected risk. A qualitative

judgmental overlay is then applied to the output of the optimization process to

arrive at the benchmark allocation. The capital market assumptions used for the

benchmark allocations are developed by UBS Global Asset Management. UBS

Global Asset Management is a subsidiary of UBS AG and an af� liate of UBS

Financial Services Inc.

• In addition to the benchmark allocations IS derived using the aforementioned

process, WMR determined the benchmark allocation by country of Non-US

Developed Equity and Non-US Fixed Income in proportion to each country’s

market capitalization, and determined the benchmark allocation by Sector and

Industry Group of US Equity in proportion to each sector’s market capitalization.

WMR, in consultation with IS, also determined the benchmark allocation for US

dollar taxable � xed income. It was derived from an existing moderate risk taxable

� xed income allocation developed by IS, which includes fewer � xed income

segments than the benchmark allocation presented here. The additional � xed

income segments were taken by WMR from related segments. For example, TIPS

Appendix

Explanations about Asset Classes

were taken from Treasuries and Preferred Securities from Corporate Bonds. A

level of overall risk similar to that of the original IS allocation was retained.

• Alternative investments (AI) include hedge funds, private equity, real estate, and

managed futures. The total benchmark allocation was determined by IS using the

process described above. The Wealth Management Americas Investment

Committee (WMA IC) derived the AI subsector benchmark allocations by adopt-

ing IS’ determination as to the appropriate subsector benchmark allocations with

AI for the following risk pro� les: conservative, moderately conservative, moder-

ate, moderate aggressive and aggressive. The WMA IC then developed subsector

allocations for very conservative and very aggressive risk pro� les by taking the IS

subsector weightings for conservative and aggressive risk pro� le investors and

applying them pro rata to the IS AI total benchmark allocations for very conserva-

tive and very aggressive, respectively. Allocations to AI as illustrated in this report

may not be suitable for all investors. In particular, minimum net worth require-

ments may apply.

• The background for the benchmark allocation attributed to commodities can be

found in the WMR Education Note “A pragmatic approach to commodities,”

2 May 2007.

Deviations from benchmark allocation• The recommended tactical deviations from the benchmark are provided by WMR.

They re� ect our short- to medium-term assessment of market opportunities and

risks in the respective asset classes and market segments. Positive / zero / nega-

tive tactical deviations correspond to an overweight / neutral / underweight

stance for each respective asset class and market segment relative to their bench-

mark allocation. The current allocation is the sum of the benchmark allocation

and the tactical deviation.

• Note that the regional allocations on the International Equities page are provided

on an unhedged basis (i.e., it is assumed that investors carry the underlying

currency risk of such investments). Thus, the deviations from the benchmark

re� ect our views of the underlying equity and bond markets in combination with

our assessment of the associated currencies. The two bar charts (“Equity

Regions” and “Fixed Income Regions”) represent the relative attractiveness of

countries (including the currency outlook) within a pure equity and pure � xed

income portfolio, respectively. In contrast, the detailed asset allocation tables

integrate the country preferences within each asset class with the asset class

preferences stated earlier in the report. As the tactical deviations at the asset class

level are attributed to countries in proportion to the countries’ market capitaliza-

tion, the relative ranking among regions may be altered in the combined view.

Scale for tactical deviation charts

Symbol Description/De� nition Symbol Description/De� nition Symbol Description/De� nition

+ moderate overweight vs. benchmark – moderate underweight vs. benchmark n neutral, i.e., on benchmark

++ overweight vs. benchmark – – underweight vs. benchmark n/a not applicable

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

Source: UBS WMR


Wealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisions of UBS AG (UBS) or an af� liate

thereof. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an o� er, or a solicitation of an o� er, to buy

or sell any investment or other speci� c product. The analysis contained herein is based on numerous assumptions. Di� erent assumptions could result in materially di� erent

results. Certain services and products are subject to legal restrictions and cannot be o� ered worldwide on an unrestricted basis and/or may not be eligible for sale to all

investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty,

express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its af� liates). All information and opinions as well as any prices

indicated are currently only as of the date of this report, and are subject to change without notice. Opinions expressed herein may di� er or be contrary to those expressed by

other business areas or divisions of UBS as a result of using di� erent assumptions and/or criteria. At any time UBS AG and other companies in the UBS group (or employees

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