Monthly Investment Guide Portfolio Advisory Group (PAG) November 2011 Published 11/07/11 Private Wealth Management Contributors Members of the Portfolio & Wealth Advisory Group Anthony Roth Head of Wealth Management Strategies Portfolio Advisory Group Wealth Advisory Group Michael Crook, CAIA® Richard Hollmann, CFA® Executive Director Executive Director Brian Nick, CAIA® Christopher Bryan, CIMA® Director Director Diana Chen Christian Capasso Director Associate Director Andrea Fisher Sujata Hingorani Associate Director Analyst Kaitlyn Fischer Carly Sharon Analyst Analyst UBS Wealth Management Americas Investment Committee Mihir Bhattacharya Michael Ryan, CFA® Head, Strategic Projects and Services Chief Investment Strategist and Head of WMR Anne Briglia, CFA® Thomas Troy Fixed Income Strategist, WMR-A Head, Market Executions Stephen Freedman, CFA® Jeremy Zirin, CFA® Head of WMR Investment Strategy Head, Equities, WMR-A Anthony Roth Head of Wealth Management Strategies Introduction The Portfolio Advisory Group (PAG) is pleased to provide our valued clients the November 2011 Monthly Investment Guide. The Guide sets out key economic and market data from the past month and offers forward-looking UBS views over a wide range of market and investment areas. Unless otherwise noted, all opinions, projections and forecasts found within this Guide are taken from research conducted and published by UBS Wealth Management Research- Americas and/or UBS Investment Research. Unless otherwise noted, all information in the Monthly Investment Guide, including allocations, is as of November 7, 2011. The investment ideas presented in this Guide are for informational purposes only. In the context of making actual investment decisions, clients should work with their Private Wealth Advisors to customize their portfolios to meet their unique financial and life circumstances, taking into account age, risk tolerance, financial commitments and short-term liquidity needs. In addition, each UBS program, product or service is subject to specific eligibility and suitability requirements, each of which must be met in order for a client to invest. Please see the following pages for a general discussion of risk disclosures and other important information. CFA® is a trademark owned by the CFA Institute. ® CIMA is a registered certification mark of the Investment Management Consultants Association. 1 CAIA® is a professional designation offered by the CAIA Association. Table of Contents & Editorial Economic and 3 Tragedies Only End One Way – Tragically Market Outlook The human oddity of any tragedy – Greek or otherwise – is the maintenance of suspense in the face of the inevitable. By definition, we know the basic outcome, but withhold belief or Monthly Spotlight: 5 acceptance until the final act. With the fate of Greece – and indeed Europe itself – hanging in Greece & the the balance, financial markets spasm with the revelation of each new hope or misery, only to reverse course again with the next twist or turn. But in the end, the outcome for Greece can Eurozone only be misery, and that for Europe further protraction of its own sufferings. Strategic and 7 The basic tragic form involves the commencement of fate upon an inevitable course of ruin by Tactical Asset an initial act of folly, and the modern epic at hand follows the form. In joining the European Allocation Models monetary unit, Greece imagined for itself a level of wealth and prosperity that was simply undeserved given the underlying absence of any degree of efficiency, productivity or entrepreneurship in its economy. Now, Greece must choose between two profoundly Asset Class 11 unattractive outcomes: either remain in the EMU and endure years of economic contraction, Outlook Summary declining levels of real income and social malaise; or, still worse, withdraw from the EMU and suffer more acute levels of economic failure, widespread private and public bankruptcy, Investment Ideas 13 international isolation and pervasive social upheaval. While we believe overwhelmingly that Greece will choose the former course and avoid the Economic 15 certain chaos of the latter, it is virtually impossible to say which would better serve the country Snapshot over the long term. But more germane for financial markets now, neither outcome will bring with it an immediate abatement of the broader economic instability within Europe. In our Important 16 view, it will take years for the structural imbalances afflicting Europe to resolve themselves. In Information and the end, and in fits and starts, Europe is very likely to move towards a more integrated Glossary political, fiscal and economic union, one that should enjoy greater economic uniformity and stability. In the meantime, investors must acclimate themselves to the enormous volatility of today’s financial markets – we do not expect it to subside any time soon. Indeed, we view the recently announced bailout package as a short-term fix. The combination of a 50% haircut on Greek bonds, a 9% core Tier 1 capital ratio requirement for banks, and an expansion of the European Financial Stability Facility should provide some breathing room, but the measures appear to treat the symptoms rather than the illness. What’s more, economic expansion in the Eurozone – a necessary ingredient in any long-term fix – currently looks tenuous at best, as noted by UBS economists who forecast that the region will fall into recession in the first half of 2012. In any case, we do view as a positive that the plan appears to ring-fence Eurozone banks, which would theoretically curtail the systemic contagion risk to the global financial sector. In light of the economic instability emanating from Europe and the recent acute equity market rally, we continue to recommend an underweight to risk assets, which we view as overbought. Further, we advise clients to consider rebalancing portfolios that may now reflect an above- benchmark position in these assets after last month's run-up. We also retain an overweight cash allocation to deploy should market conditions improve. Last, we now favor high yield fixed income, whose spreads appear attractive given the relatively low expected default rates for the market. Anthony Roth Christian Capasso Head, Wealth Management Strategies Wealth Advisory Specialist UBS Wealth Management Americas UBS Wealth Management Americas 2 Portfolio Advisory Group Economic & Market Outlook Monthly Investment Guide In October, global equity markets experienced one of their largest Brian Nick monthly gains in decades. At the start of November, many investors Senior Portfolio Strategist are asking whether it is finally safe to start adding more exposure to 212-713-6146 risk assets. Global risks still loom, particularly in the Eurozone, but [email protected] the outlook for the U.S. economy appears a bit brighter after a period of mostly positive economic releases. Andrea Fisher As long as Greek politicians seem determined to provide higher 212-713-6241 market volatility for the remainder of the year, we believe that [email protected] market swings will continue to produce dislocations, and thus opportunities, in select risk assets. Investors who are significantly underweight U.S. equities should consider adding selective exposure at this time to bring their portfolio weight to neutral. In addition, we recommend adding an overweight in U.S. high yield credit, Figure 1: Consumer sentiment troughs can which remains partially dislocated after a sharp sell-off this summer. signal a buying opportunity for stocks A Tale of Two Economies 170 120 160 110 Over the past few weeks, two major factors have changed the investment landscape. Most notably, the agreement on a crisis fix in 150 100 the euro area healed some of the damage inflicted on the markets 140 90 during the past few months. However, as discussed in the Spotlight, this temporary tailwind has already partially reversed course, as 130 80 closer analysis highlights the challenges in implementing the 120 70 proposed fixes. In addition, UBS economists now expect a euro area 110 60 recession in the first half of next year, further complicating policymakers' tasks in the region. 100 50 On this side of the pond, the 2.5% rate of U.S. GDP in Q3 implies 90 40 that the recession risk in the U.S. is receding. U.S. consumers and 78 81 84 87 90 93 96 99 02 05 08 11 companies have proven resilient to political turmoil and higher S&P 500 (LHS Log Scale) U. of Michigan Consumer Sentiment (RHS) commodity prices. The majority of corporate profits beat Q3 expectations and personal consumption levels are healthy despite Source: Bloomberg, as of Oct. 31, 2011. dismal but improving sentiment. Indeed, Figure 1 shows that consumer sentiment bottoms have historically been good entry Figure 2: Disappointing U.S. economic points for stock owners. While the recovery in the U.S. remains recovery frustratingly subpar (Figure 2), it is still vastly preferable to a recession. We expect U.S. growth to strengthen modestly over the 15.0 $ trillions next few years. 14.5 Potential GDP Strong Preference for U.S. Stocks over Europe 14.0 Real GDP 13.5 As Figure 3 shows, U.S. equity markets have been closely tracking economic data surprises. We expect that as the recovery continues, 13.0 continued positive economic indicators will boost investor sentiment 12.5 and provide support to equity markets. While GDP alone is not a 12.0 good predictor of equity returns, the wide gap between our forecasted growth rates for the U.S. and euro area in 2012 (2.3% 11.5 vs. 0.2%) warrants investors' attention. Overall, we have a strong 11.0 preference for U.S. equities over non-U.S. developed market 10.5 equities, and our underweight is concentrated in the Eurozone, where positive economic surprises should be harder to come by. This 10.0 tactical stance makes the overall equity portfolio more defensive, 2000 2002 2004 2006 2008 2010 particularly when factoring in the currency risk for U.S.