UBS House View 17 June 2021 Monthly Letter Chief Investment Office GWM Investment Research

Reopening momentum Pressure drop Event horizon Asset allocation In the second half, Asia will We expect inflation to fall from More persistent inflation, We maintain a positive outlook gain momentum as vaccinations current elevated levels as base slower growth, geopolitical for global equities. We think drive reopening. effects and pandemic-related tensions, and new COVID-19 the best opportunities to bene- supply issues dissipate, keeping variants all pose potential fit from the reopening trade the pressure off central banks. risks to the equity rally. are in Asia. We see further upside in energy, financials, and US small- and mid-caps.

Predator or prey?

You’ve probably noticed that some animals, like chickens, sheep, and zebras, have eyes on the sides of their heads, while others, like wolves, tigers, and owls, have eyes facing front. The first group, whose primary aim is not to be eaten, values awareness of what’s around and behind. For the second group, more focused on the catch, the ability to perceive depth is critical to successfully navigating the world and securing their prey.

For investing, seeing what lies ahead is paramount. Our perception of future economic trends helped us increase our risk asset exposure when virus fears were high last year. It also helped us tilt exposure toward reopening and reflation beneficiaries in September, even before vaccines had been broadly rolled out. Mark Haefele Chief Investment Officer Today, if we just look around and behind us, we see economies reopening, inflation Global Wealth Management rising, and equity volatility sitting at its lowest level since before the pandemic. But if we look forward, we see something different. Follow me on LinkedIn linkedin.com/in/markhaefele First, while we expect economies in the US and Europe to reopen successfully, we Follow me on Twitter think the best opportunities are shifting toward Asia, as vaccinations in the region pos- twitter.com/UBS_CIO itively impact local markets. We like Japanese stocks, which languished in the first half, as Japan is now vaccinating more than 1% of its population each day. We also see vaccinations and lower infection rates lifting India’s markets. Meanwhile, we expect Chinese equities to benefit from the strong earnings growth we anticipate next year.

Second, we expect inflation to fall from today’s elevated levels as base effects and pandemic-related supply issues dissipate. This will keep the pressure off central banks to take drastic action, and we expect yields to remain negative in real terms. As such, investors will need to look for opportunities to maintain purchasing power and generate returns. For income, we like US senior loans, select dividend-paying stocks, as well as “alternative yield” strategies. We see limited near-term catalysts for tech mega-caps in the US and Asia. However, we see opportunity in small and midsize firms exposed to trends like 5G, fintech, greentech, and healthtech; and in digital subscription businesses. Looking further ahead, the inflation outlook remains uncertain and the Federal Reserve has acknowledged the potential for more persistent inflation. For long-term inflation protection we like stocks with strong pricing power, private market infrastructure opportunities, and commodities. Finally, experience tells us that volatility will return at some point in the future.

This report has been prepared by UBS AG. Please see important disclaimers and disclosures at the end of the document. Predator or prey?

Investors can use periods of low volatility to prepare. Strategies include utilizing options and structures to reduce downside exposure, taking profits on certain stocks that have notably appreciated, and diversifying into hedge funds.

For more on these ideas and our views on investing into the second half of 2021, please see our 17 June report “Our outlook for 3Q: Ideas for growth, income, and protection.”

Navigating falling inflation and the Fed’s reaction

US consumer price inflation rose at a 5% year-over-year rate in May, the highest increase since 2008. In the Eurozone, CPI rose 2%, the highest since October 2018. In Asia, factory gate prices have been rising at the fastest pace in over a decade.

We expect US inflation to fall Looking ahead, we expect inflation to fall. The low bases of comparison with last from the 5% year-over-year rate year’s energy prices will start to drop out of inflation calculations, and by the end of reached in May. the year we expect the direct influence of oil prices on US consumer price inflation to almost halve. Outside of energy, only a small number of items have pushed inflation higher. For Americans who did not buy a used car in May, their actual inflation experience was closer to 4% than 5%, and those who do not drive experienced consumer price inflation of around 1.5%.

Figure 1 Ination concerns have intensi ed Google trends, interest for “inflation”, in the US US CPI and core PCE, year-over-year, in %

100 6 90 5 80 4 70 60 3 50 2 40 1 30 20 0 2004 2008 2012 2016 2020 2019 2020 2021 CPI YoY Core PCE YoY

Source: Google trends, UBS, as of June 2021 Source: Bloomberg, UBS, as of June 2021

Falling inflation means Falling inflation means that we don’t foresee the Federal Reserve being pressured the Fed won’t be pressured into tapering its asset purchases or raising rates. The Fed’s latest “dot plot” of into tightening policy. FOMC members’ interest rate projections implies rates may now rise in 2023, but markets have already priced in a rate rise in 1Q 2023. Fed chair Jerome Powell has said that a plan for tapering its asset purchases could be announced at an “upcoming meeting.” We expect the Fed to announce a plan to taper by the end of the year, but this would only occur if jobs data and overall economic growth are consistent with the Fed’s own definition of “substantial progress.” After payroll growth for March was initially estimated at 916,000, Powell said, “We want to see a string of months like that so we can really begin to show progress toward our goals.” This is important for investors because tighter policy historically has not been negative for stocks provided it is accompanied by growth.

June 2021 – UBS House View Monthly Letter 2 Predator or prey?

Another overlay to consider, supporting our view that the Fed will remain accommodative for longer, is the political dimension. Powell’s term as Fed chief is due to expire early next year, and announcements about his future could come as soon as late summer or early fall this year. At the margin, political dynamics tilt the Fed’s focus more toward jobs growth and running the economy hot in the near term. We note that the Fed has already added “broad-based and inclusive” employment to its policy objectives in recent months.

We won’t know if inflation There are of course risks to this inflation view. Inflation has been more concen- is contained until the fall at trated in goods prices so far, but could transmit into services as consumption the earliest, so expect periodic switches, particularly if supply challenges in the service sector persist. Over the inflation “scares.” longer term, there is also a risk that the cumulative policy decisions around easy fiscal and monetary stimulus may reverse well-anchored, low inflation expectations. Perhaps the biggest risk is that 10-year US Treasury yields have fallen back from recent highs, indicating that a contained inflation view has become a bigger part of the consensus thinking. Since we won’t know if inflation is contained until the fall at the earliest, periodic inflation “scares” should be on the radar for the remainder of the year.

Looking for reopening opportunities

Our view of inflation, virus, Vaccination programs continue to progress in developed countries. The US has and policy dynamics leads us vaccinated 65% of its adult population with at least one dose. Retail and recreation to seek reopening and recovery mobility indicators are now running at just 6% below pre-pandemic levels, with opportunities. variation across states, and retail sales are now 20% above pre-pandemic levels.

In major European Union economies, the level of first-dose vaccinations is running at around 45–50%, and the number of hospitalizations is also declining. Restric- tions are starting to be lifted, and in Germany and France retail and recreation mobility data is tracking at 13–14% below pre-pandemic levels, with retail sales already above pre-pandemic figures. In the UK, a renewed increase in cases linked to the delta variant has prompted the government to delay the final stage of reopening by four weeks. This is likely to have only a minimal economic impact, given the efficacy of existing vaccines against the strain, and we do not expect additional restrictions to be imposed.

Our base-case view of inflation, virus, and policy dynamics leads us to seek opportunities to benefit from reopening and recovery in the equity market. With stocks in the US and Europe up 13–15% year-to-date, much of the reopening trade has been priced in these regions. That said, we continue to see investors underestimat- ing the strength of the rebound in parts of the market:

We think there is more upside Energy. Although energy stocks have have risen nearly 50% year-to-date, the to go in energy, financials, and sector has only rallied back to pre-pandemic levels, compared with the S&P 500, US small- and mid-caps. which is 25% above the February 2020 peak. In our view, US energy stocks are still only pricing in a Brent crude oil price of USD 55–60/bbl, versus our forecasts for USD 78/bbl in September and USD 75/bbl at year end.

Financials. The S&P 500 financials sector has rallied 9% since the end of March, despite a yield curve that makes it harder for banks to generate interest income. We still expect 10-year yields to finish the year higher; our forecast is 2% as the labor market continues to recover and the economy fully reopens. The potentially earlier start to Fed rate hikes in 2023 implied by the June FOMC meeting also sup- ports our view that yields are likely to rise. Higher yields, a steeper yield curve, and reduced loan-loss provisions should support financials in the second half.

June 2021 – UBS House View Monthly Letter 3 Predator or prey?

Figure 2 Upside for Japanese equities as virus cases decline Equities’ relative performance Japan/US (lhs, in %), normalized 7-day average new cases (Japan-US), inversed (rhs)

110 –3

–2 105 –1

100 0

95 1 2 90 3

85 4 Jun-20 Sep-20 Dec-20 Mar-21Jun-21 Japan vs US – relative performance Normalized 7-day average new cases Japan-US (inv, rhs)

Source: Re nitiv, UBS, as of June 2021

US small- and mid-caps. We also see potential for continued outperformance for US small-caps and mid-caps over large-caps. On a price-to-earnings basis, US small- and mid-cap valuations are near 20-year lows relative to large-caps, despite the likelihood that earnings growth for smaller companies will outpace large-cap earnings through at least 2022.

We see the biggest potential It is, however, in Asia where we see the biggest potential upside from the reopening upside from the reopening trade trade in the second half. A number of Asian economies have suffered renewed in Asia. waves of COVID-19 infections in the second quarter, most notably India where new cases were in excess of 400,000 a day in mid-May. Restrictions were also tightened in several Asian economies, including India, Singapore, and Taiwan. Japan, hampered by a slow vaccine rollout, extended its state of emergency restrictions (covering 70% of nationwide GDP and population) until 20 June.

This more challenging backdrop has also been reflected in stock price performance. The MSCI Asia ex-Japan and MSCI Japan indexes are trading at similar levels to mid- January, while the MSCI All Country World index has rallied by 9.8% and the S&P 500 by 12.7%.

But the situation is improving. Daily new cases in India have fallen below 65,000 per day, and 15% of the population have now received at least one vaccine dose, up from roughly 10% in mid-May. In Japan, the pace of vaccination rollout has accelerated to more than 1% of the population per day.

Figure 3 MSCI China earnings to see robust growth Consensus earnings growth forecasts rebased to 100

150

140

130

120

110

100 2019 2020 2021 2022

Source: UBS, as of June 2021

June 2021 – UBS House View Monthly Letter 4 Predator or prey?

We expect stronger stock market performance in Asia in the second half, powered by its two largest markets: China and Japan.

Both tactically and strategically China. After a 20% gain in MSCI China from the start of the year to mid-February, we see the setback in Chinese higher US yields, less accommodative domestic monetary policy, rotation out of equities as an opportunity to tech, and antitrust measures against Chinese tech companies all contributed to a gain exposure at better levels. reversal of the rally. The index fell into bear-market territory in May.

Both tactically and strategically we see the setback in Chinese equities as an opportunity to gain exposure at better levels. We expect mid-teens earnings growth in 2022, versus 8% globally, and we note that Chinese equities’ price-to-earnings to growth (PEG) ratio looks attractive at below 1x. A strengthening yuan should also provide additional support for stocks.

Given strong earnings growth Japan. The TOPIX index is currently trading at 15.7x 12-month forward earnings, and attractive valuations, we versus 17.8x in January, but on higher consensus earnings estimates, which are expect Japan to outperform. up 13% since the start of the year. Japanese earnings are geared to the global recovery, with 40% of MSCI Japan revenues coming from abroad, and we expect 40% growth in earnings per share for MSCI Japan in 2021, similar to our global forecast.

Preparing for risks on the horizon

For much of the second quarter, equity markets traded in relatively narrow ranges close to record highs. This is leading some investors to question whether most of the good news is priced in, and to focus on potential downside risks:

Whether inflation proves Persistent, broader inflation. A key issue for investors is whether inflation proves transitory is a key risk for transitory, as we expect in our base case. Should above-target inflation persist, markets. the Fed’s willingness to keep policy on hold might be tested. The prospect of higher rates could push 10-year benchmark yields above 2%, weighing on valuations and equity prices overall. However, in an environment of higher inflation and rates, our preferred sectors of energy and financials should still outperform.

Peak growth. Consensus forecasts expect a peak in US growth around the middle of the second quarter, as pandemic restrictions are lifted. The peak matters because, historically, equity returns are higher when growth is accelerating than when it is decelerating. However, passing the arithmetic peak in GDP growth may be less negative for markets than feared because: 1) the peak in jobs growth may still be ahead; 2) financial conditions are still looser than ever; 3) inflation should start to fall; and 4) growth and vaccination rates are still on the upswing globally.

US-China tensions escalate. As US foreign policy under President Joe Biden starts to take shape, underlying tensions between the US and China remain. At this month’s G7 summit, the US led plans to launch a “green belt and road” initiative to counter China’s influence, provide developing countries with a “democratic alternative” to loans from China, and condemn forced labor in Xinjiang province. The final summit communique called on China to respect human rights and agreed to the principle of a green infrastructure plan, while stopping short of the US’s more forceful language toward China. But the trajectory of US policy is toward a tougher stance, and a Chinese spokesperson said the summit “exposed the sinister intentions of a few countries including the US.” We are currently tactically cautious on gold, and the potential for an earlier start to Fed tightening reinforces our view that real rates are likely to rise, weighing on gold prices. But in the event of geo political risks increasing, it could begin to regain investor interest.

June 2021 – UBS House View Monthly Letter 5 Predator or prey?

Key scenarios and asset class impact

Upside Central Downside Investment ideas Top ideas 1. Position for reopening 1. Protect against 1. Protect against and recovery inflation downside risks 2. Seek opportunities in Asia 3. Position for structural growth 4. Hunt for yield 5. Go sustainable 6. Diversify into private markets Scenarios Inflation / Inflation increases on the US Inflation stays at elevated Inflation rises more persis- Central banks back of positive economic levels until end-2021 before tently while growth disap- growth (“good inflation”). gradually falling toward 2% points (“bad inflation”) and Central banks stay accom- by mid-2022. Central banks the Fed announces tapering modative but start reducing stay accommodative. The of asset purchases to start asset purchases by end-2021 Fed discusses tapering, but by end-2021. as the recovery beats expec- only to commence in 2022. tations.

Growth Growth momentum acceler- Growth momentum remains Growth momentum fades ates. Developed countries’ strong. Developed countries’ soon. Developed countries’ GDP returns to pre-pan- GDP returns to pre-pan- GDP returns to pre-pandemic demic levels by 3Q21. demic levels by 4Q21. levels in 2022.

Fiscal Discretionary fiscal impulse Fiscal impulse fades as Diminishing fiscal impulse continues to support the governments account for is unable to compensate for economy. economic recovery. economic weakness.

COVID-19 Vaccination programs gener- Restrictions do not return Immunity against COVID is ate lasting immunity across forcefully as current vaccines less durable than anticipated developed markets, and offer sufficient protection or more resistant mutations most adults in key emerging against severe disease, and emerge, leading to height- economies are vaccinated by public fear remains low. ened public fear and recur- end-2021. Boosters against variants rent strict restrictions on may be necessary. business activity.

Geopolitics A partial rollback of existing The US takes a more multi- Growth is hurt by renewed trade tariffs raises global lateral and predictable US-China tensions over trade growth. approach to trade policy. and/or regional geopolitics.

Asset class Spot* impact S&P 500 4,255 4,600 4,400 3,500 (targets for December Euro Stoxx 50 4,132 4,700 4,350 3,400 2021) MSCI EM 1,383 1,650 1,500 1,100 SMI 11,853 12,500 12,000 10,000 TOPIX 1,960 2,200 2,100 1,600 USD IG spread** 62 45bps / –1.0% 70bps / –1.0% 150bps / –2.0% USD HY spread** 321 270bps / +1.0% 300 bps / +1.0% 550bps / –13.0% EMBIG spread** 330 300bps / –2.0% 340bps / –1.0% 550bps / –12.0% EUR USD 1.21 1.30 1.25 1.12 Gold 1,866 USD 1,300 –1,400/oz USD 1,600/oz USD 1,800 –1,900/oz

* Spot prices as of 14 June 2021 ** During periods of market stress, credit bid-offer spreads tend to widen and result in larger ranges. Percentage changes refer to expected total return (t.r.) for the indicated spread levels Note: Asset class targets above refer to the respective macro scenarios. Individual asset prices can be influenced by factors not reflected in the macro scenarios Source: UBS, as of June 2021

June 2021 – UBS House View Monthly Letter 6 Predator or prey?

While vaccines work against COVID-19 resurgence. The UK’s experience with a renewed surge in cases based existing variants, the threat on the delta variant highlights the risk posed by mutations of the virus spreading of renewed lockdowns because from countries with less access to vaccines. Developed countries are starting to pro- of new variants can’t be ruled out. vide support for lower-income countries to reduce the risk, with the G7 nations pledging to deliver at least 1 billion extra doses of vaccines over the next year. While vaccines work against existing variants, the threat of renewed lockdowns because of new variants can’t be ruled out. If there were renewed widespread lockdowns, equity markets would likely be broadly negatively impacted. However, parts of the technology sector could be relative outperformers as they would benefit from a likely decline in government bond yields. Expected demand for stay-at-home products could also receive a fresh boost.

Figure 4 Still an upside story to be told Select indexes, returns since January 2021 and 2022/2019 CIO EPS growth forecasts (%)

–10 S&P 500 Euro Stoxx 50 MSCI EM TOPIXMSCI AC Swiss Market FTSE 100 Composite USD Asia ex-JP USD (SMI)

Returns since January 2020 (%) 2022/2019 CIO EPS growth forecasts (%)

Source: Re nitiv, UBS, as of 15 June 2021

Investment ideas In our base case, we expect the global economy to continue to reopen in the second half amid the ongoing vaccine rollout. We expect inflation to fall from current levels as base effects and pandemic-related supply issues dissipate, allowing major central banks to keep monetary accommodation in place. A continued risk-on stance in equities is warranted, in our view, and we favor sectors and regions that have the most to gain from the reopening trade.

Reopening opportunities

As vaccine programs accelerate Asia. As discussed above, we see opportunity for reopening trades in Asia, where and infections are brought under rising COVID-19 infections and lagging vaccination programs have been reflected in control, we expect Asian equities stock index underperformance. As vaccine programs accelerate and infections are to catch up. brought under control, we expect economies to reopen and Asian equities to catch up. We prefer Japan, where we expect 40% earnings growth this year, and China, where we believe the recent sell-off has created an attractive entry point.

Energy, financials, US small- and mid-caps. We expect energy stocks to benefit from a further rise in oil prices in the second half, while we also forecast 10-year Treasury yields to reach 2%, which should support financials. Small-caps’ cyclical exposure and cheap valuations should drive outperformance.

June 2021 – UBS House View Monthly Letter 7 Predator or prey?

Growth opportunities

Digital subscriptions. We’ve now entered the subscriptions era, and the pandemic is accelerating its takeover. Within digital subscriptions we focus on four unique traits: first-mover advantage, recurring revenues, margin and cash flow upside, and an emphasis on mid-caps.

The Next Big Thing. In our Year Ahead outlook, we said that we expected “The Next Big Thing” to materialize within the fintech, healthtech, or greentech spaces, or be enabled and accelerated by the global rollout of 5G technology. Since then, these sectors have continued to benefit from the pandemic-driven acceleration of longer-term trends such as digitalization. Despite rotation away from growth stocks toward reopening beneficiaries, in 2Q the theme’s performance has been in line with global equities.

Income opportunities

Senior loans. We prefer US senior loans, which we believe will be supported by the healthy US growth and earnings outlook, the ongoing search for yield, and accommodative monetary and fiscal policy. Their floating-rate structure provides greater insulation against potential interest rate rises.

Inflation-busting dividend stocks. In 2020, growth companies, which typically pay low or no dividends, performed very well, while more cyclical sectors, such as financials, which usually pay higher yields, underperformed. The situation has flipped this year, and stocks with higher-than-average dividends have outperformed. We think this trend will continue. Within the higher yielding segment of the equity market we suggest focusing on companies with attractive dividend growth or cheaper stocks with a potential catalyst.

“Alternative yield.” In a low-yield environment, investors can also consider strategies beyond traditional asset classes to enhance portfolio income, including employ- ing more active approaches in fixed income, investing in private credit, engaging in prudent borrowing, or selling volatility.

Inflation protection

Pricing Power Standouts: In our view the environment remains positive for companies with pricing power. We view companies with pricing power as having high and stable gross margins, relatively high market share, and strong branding. Companies with these characteristics look better positioned to pass on rising input costs to the consumer relative to peers. For investors looking to maintain or add equity exposure, pricing power standouts offer a way to do so while keeping inflation concerns in mind.

Private market infrastructure. Infrastructure investments can be a good hedge against inflation because revenue streams are often tied to consumer price indexes. For example, utilities, transport, and telecom assets, as well as other regulated industries, often use inflation-linked pricing. Buying infrastructure assets directly is next to impossible for most investors, but private market funds provide them with the opportunity to participate.

Commodities. Commodity prices are positively correlated with inflation, and energy has historically outperformed when US headline CPI is above 2% and rising (i.e., the environment we are in now). The current economic environment is conducive for higher commodity prices, in our view, and we expect broadly diversified commodity indexes to deliver total returns of about 10% over the next six months.

June 2021 – UBS House View Monthly Letter 8 Predator or prey?

Figure 5 Oil prices highly correlated to ination expectations Crude oil prices in USD/bbl (lhs) and 5y5y ination expectations in % (rhs)

130 3.4

110 3.1

90 2.8

70 2.5

50 2.2

30 1.9

10 1.6 2009 2012 2015 20182021 Brent, USD/ bbl WTI, USD/bbl USD 5Y5Y ination expectations, % (rhs)

Source: Bloomberg, UBS, as of 15 June 2021

Downside protection

The current market Hedge funds typically exhibit a lower beta to global markets and include a focus on environment favors long and risk management and downside mitigation. In addition, in an environment when short hedge fund strategies. some sectors are benefiting while others are struggling—i.e., when dispersion of stock returns is high—hedge funds tend to do well given their ability to hold both long and short positions.

Options and structures are another way investors can reduce downside exposure. The recent decline in the VIX index of equity volatility, from a recent peak of 29 to 17 at the time of writing, reflects a reduced cost of buying outright downside protection through put options.

For more on these ideas and our views on investing into the second half of 2021, please see our 17 June report “Our outlook for 3Q: Ideas for growth, income, and protection.”

Mark Haefele Chief Investment Officer Global Wealth Management

June 2021 – UBS House View Monthly Letter 9 Predator or prey?

Follow Mark Haefele UBS Investor Forum Insights

on Linkedin At this month’s Investor Forum, participants discussed the outlook for and Twitter inflation and central bank policy as the economic recovery broadens. – Participants considered the rise in US consumer price inflation to 5% year-over-year in May. While most believed this was likely to mark the high point in the cycle, views diverged on whether inflation will prove transitory or more sustained. Even those participants who regarded Follow me on LinkedIn inflation as transitory noted that it might be prudent to consider hold- linkedin.com/in/markhaefele ing some inflation hedges in portfolios. Participants also cited a rapid Follow me on Twitter increase in yields as a risk to monitor. twitter.com/UBS_CIO – Most participants shared the view that the Fed is likely to retain an accommodative stance and look for signs of a sustained recovery in the labor market. – The broadening global economic recovery should create a supportive environment for risk assets, participants believed. Several saw opportunities in more cyclical areas of the equity market such as financials, and in regions with catch-up potential, particularly Europe and Japan.

June 2021 – UBS House View Monthly Letter 10 UBS Chief Investment Office’s (“CIO”) investment views are prepared and published by the Global Wealth Management business of UBS Switzerland AG (regulated by FINMA in Switzerland) or its affiliates (“UBS”). The investment views have been prepared in accordance with legal requirements designed to promote the independence of investment research.

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June 2021 – UBS House View Monthly Letter 12