March 2009 UBS research focus The financial crisis and its aftermath Public sector debt imbalances to grow more acute Lower trend economic growth, higher risk of inflation Earnings to revert to a more sustainable path Financial markets have priced in a very austere outlook Nominal bonds expensive, stocks and corporates cheap Inflation-linked bonds should top cash as a safe long-term asset Acb Past performance is no indication of future performance. The market prices provided are closing prices on the respective principle exchange. This applies to all perform- ance charts and tables in this publication. This report has been prepared by UBS Financial Services Inc. (‘‘UBSFS’’) and UBS AG Contents Editorial 5 Summary 6 Chapter 1 Reversals of fortune 9 The end of an era 10 The financial crisis: an array of factors 14 Pendulum swings towards the state 18 Chapter 2 The rise of even bigger government 23 The new financial handbook 24 Fiscal policy: money with a mission 25 Monetary policy: beware of excess liquidity 29 Financial industry regulation: a new framework in the making 31 Chapter 3 The long-term economic effects of the crisis 39 Structural debt growth ahead 40 Future economic growth 43 Inflation in the future 49 High and permanent fiscal deficits and inflation 50 Chapter 4 A fundamental reassessment of asset returns 55 A fresh look at the investment horizon 56 Nominal government bonds expensive 59 Equities: value amid structural challenges 63 Real estate: stricter regulation and lower yields 72 Commodities: a partial inflation hedge 72 Conclusion 73 Chapter 5 Investing in trying times 77 Evaluating opportunities and risks 78 Finding the outperformers 79 The portfolio context: putting it all together 80 Conclusion 85 Box: The USD remains an important risk 86 Glossary 87 Bibliography 91 Publication details 94 UBS research focus March 2009 3 Editorial Dear reader, The financial crisis that intensified in 2008 shook the In sum, we expect public sector imbalances to grow global economy to its foundations. It also unleashed a steadily in future as countries grapple with tough choices crisis of confidence among consumers, businesses and over potential spending cuts or higher taxes. investors that threatened to unravel most forms of global commerce. In response, the actions taken by govern- Financial markets, once priced for perfection, now reflect ments – spending measures, tax cuts, reductions in short- a pessimism that is, in fact, far darker than the new eco- term interest rates and purchases of financial assets – nomic realities indicate. Surely, the aftermath of the crisis are essential steps to revive confidence and global eco- will seem austere given its bubbling prelude, but it will nomic activity. also offer investors attractive opportunities. We think this turning point demands a clear-eyed review not only In the aftermath of the crisis, a new economic era is of assets and portfolios, but also of the methods used to taking shape. It is already clear that the state will play a evaluate them. That is what we have attempted to deliver much bigger role in economic affairs, one that it is unlikely in this edition of the UBS research focus. to give up even after the situation stabilizes. And longer- term risks loom. One of them, inflation, is an expedient tool for policymakers to redistribute the burden of high levels of private and public debt. Another, protectionism, is a regrettable knee-jerk reaction during times of eco- nomic upheaval. Falling trade barriers, increased international capital flows, and the spread of private-sector activities produced enormous benefits for the world economy. At the same time, however, these same international trade and capital flows became increasingly unstable, as we discussed in a UBS research focus report entitled, “Currencies: a deli- cate imbalance,” early in 2008. Restoring sustainable economic growth will not be easy, but strong efforts are now underway to reverse the downturn's momentum and offer hope for a recovery. But we should not forget that well before the crisis hit, demographic forces were already pointing to both slower long-term economic growth and greater pressure on gov- ernment finances. The unwinding of household and cor- porate balance sheet leverage, as well as heightened regu- lation, are likely to slow economic activity even further. Andreas Höfert Walter Edelmann Kurt E. Reiman Global Head Wealth Management Research Head Global Investment Strategy Head Thematic Research UBS research focus March 2009 5 Summary Summary The financial crisis and its aftermath A new post-crisis policy paradigm At the same time, central bank purchases of public- and Measured in lost wealth, the financial crisis that erupted in private-sector debt have swelled their balance sheets, and 2007 and intensified throughout 2008 has already hence the money supply. In our view, the question is not achieved historic proportions. Today, we are witnessing whether more central banks will undertake so-called the emergence of a new policy paradigm. After decades “quantitative easing” measures – increasing the money of burgeoning free-market internationalism, governments supply by debt purchases (and the printing press) – but will extend their reach as they struggle to revive their how they will exit this path later on. economies. So far, governments and their central banks have intervened on two fronts: stabilizing and in some Lower trend growth, risk of higher inflation cases nationalizing their crippled financial sectors, and The ongoing aging of the population coupled with both using fiscal and monetary policy tools to counter a deep broad-based deleveraging and increased regulation are global recession. very likely to significantly dampen future growth rates in developed countries. Consequently, governments face In our view, these measures are crucial to turn the tide of ever-increasing deficits and subdued growth with few falling demand, rising unemployment and looming defla- effective options at their disposal. Debt-to-GDP ratios will tion. Had governments not undertaken strong measures likely rise unless there are cuts in discretionary and entitle- during the second half of 2008 to repair dysfunctional ment spending or taxes are increased. And in countries financial markets, most forms of global commerce, which most exposed to the financial crisis, policymakers may pre- were already under severe stress, would have likely ground fer higher inflation as an antidote to ever-increasing debt. to a halt. For many, the inflation of the 1970s is still fresh and it is Public sector debt imbalances to grow more acute often regarded as something bad. Yet inflation would As credit markets seized, households and corporations advance the deleveraging process. It profoundly affects began reducing balance sheet leverage rapidly. This, in wealth redistribution by reducing the real value of out- turn, has accelerated the contraction in overall economic standing debt. The main problem for policymakers once activity in the countries that were hit hardest by the finan- the financial crisis has passed will be to ensure that the cial crisis. But as one set of imbalances begins to fade, massive liquidity injections from governments and central another is set to grow, this time on the balance sheets of banks do not lead to a surge in inflation. We think recent governments. history has shown that the focus on consumer price stabil- ity has its practical limits. It can neither prevent “irrational With central banks having cut short-term interest rates to exuberance,” as the Tech, real estate and credit bubbles historic lows, attention now shifts to government spend- have shown, nor avoid the risk of deflation when the exu- ing plans and nontraditional monetary policy tools. The berance of market participants turns to panic. spending measures mostly target boosting short-term demand, not returning the economy to a sustainable long- Nominal government bonds expensive term growth path. At best, these fiscal measures will suc- Given the cyclically depressed level of bond yields, we find ceed in dampening the impact of the recession while that nominal government bonds offer little value at pres- allowing the private-sector imbalances in the economy to ent. The only supportive scenario for nominal government adjust. Indeed, our analysis suggests that the initial posi- bonds is one of intensifying deflation risk, which, while it tive effects of the spending measures on growth are likely cannot be flatly excluded, is nevertheless unlikely, in our to be reversed in subsequent years. view. On a standalone basis, we find a more compelling risk-return tradeoff in other sectors of the bond market, While the effect of fiscal stimulus on the economy is such as money market instruments, inflation-linked bonds highly uncertain, and a subject of intense academic and corporate bonds. debate, the consequences of big spending packages on government deficits and debt are clear. The large fiscal Earnings growth to return to a more sustainable path packages, the cost of bank bailouts, and the generally The crisis has had a profound effect on the drivers of asset diminished tax revenues have increased public-sector debt returns. In our view, a sharp earnings recovery is unlikely, faster than at any time since World War II. and trend earnings are likely to be structurally weaker. Given the diversity of sectors and companies in overall equity market indexes, the risk to the sustainable earnings trend is much less pronounced than for individual sectors. 6 The financial crisis and its aftermath Summary Overall, we think a trend growth rate of real earnings of Investing in trying times about 2.5% for the US is a reasonable assumption. As individuals reassess their risk appetites in the aftermath Although this is significantly lower than the earnings of the financial crisis, we continue to stress the benefits of growth rate during the two decades preceding the finan- diversification at all risk levels.