Daniel Kalt, economist, UBS AGThomas Berner, CFA, economist, thomas.berner@ubs.com, +1 212 713 4108, UBS FS

Dominic Schnider, analyst, UBS AGConstantin Vayenas, analyst, UBS AG

Wealth Management Research 5 October 2010

Global economy

Moderate global recovery to continue

■ Signs of stabilization are mounting in the US after the growthslowdown in 2Q10, and we expect y/y GDP growth to settle at around2.5-3.0% while the Fed seems ready to counteract any deflationaryrisks with additional quantitative easing measures.

■ In the Eurozone, core and peripheral economic performance continueto diverge, while non-Eurozone peripheral countries show strongmomentum. The ECB is likely to stay on hold and is unlikely to removeextraordinary policy measures before early next year.

■ Asian emerging economies are growing at a solid pace, and thesomewhat softer current economic indicators are more a mid-cycle-downshift than the beginning of a larger growth downtrend. Japan'sstrong currency and lack of sustainable domestic demand growthshould take its toll on economic activity. Growth forecasts for emergingmarkets in Central/Eastern Europe & Latin America have also shown ageneral upward drift, although the overall growth rates for 2011 areexpected to be below the 2010 spikes.

The world economy has recovered from the longest and most severerecession in post-WWII history. In the US, the semi-official NBER BusinessCycle Dating Committee recently declared that the recession that startedin January 2008 had ended in June 2009, reaching a trough from whichthe US economy has since recovered. Indeed, global trade volumes haverebounded steeply from their low point in early 2009, and are now back topre-crisis levels (see Fig. 1). Global industrial production is running at solidpace of some 8% y/y (see Fig. 2). Several months ago, we dubbed this a"sugar rush recovery" primarily driven by huge fiscal and monetary policystimulus measures.

Previous reports

■ 31 August: US economics: Avoiding a USdouble-dip by a hair's length

■ 4 August: Japan economics: Recovery enginesputtering

■ 22 July: Global economy: This recovery crawls,it doesn't leap

■ 9 July: Eurozone economics: The future of theeuro in jeopardy

Fig. 1: World merchandise trade back at pre-crisis levelsWorld trade volume index (1Q2000=100)

60

80

100

120

140

160

180

1998 2000 2002 2004 2006 2008 2010

Merchandise world trade volume(index, 1Q2000=100)

Source: Netherlands Bureau for Economic Policy Analysis

This report has been prepared by UBS AG and UBS Financial Services Inc. (UBS FS).Please see important disclaimers and disclosures that begin on page 13.

We are now at a point where this policy-induced sugar rush is starting tofade and private demand must now kick in to help economic expansionbecome self-sustaining. Over the last couple of weeks, however, some ofthe most widely watched leading indicators have started to come downfrom their healthy levels, signaling a moderation in global growth as weapproach year-end. Since market participants are still not convinced thata sustainable recovery has taken root, this slowdown was already enoughto fuel speculation about an imminent double-dip recession, sending jittersthrough financial markets.

We don't share this gloomy perspective on the world economy. Our basecase is still for a continuation of what we would describe as a choppy, sub-par economic recovery. Job creation in the US and Europe should continue –albeit at a relatively slow pace – and build the basis for consumer spendingto continue expanding moderately. Overall, we expect world GDP to expandat 4.1% this year and 3.7% in 2011.

Of course, there are significant differences across and even within regions,as we highlight in the sections below. Many Asian emerging economieshave recovered very quickly from the global slump and are today producingat substantially higher output levels than at the mid-2008 cyclical peak.Inflationary pressures have emerged, and central banks – most prominentlyin China – have started to tighten monetary policies. On the other hand,Japan is fighting against the deflationary forces stemming from the strongJPY appreciation.

In Europe, the divergence between strong core economies (with Germanyat the forefront) and weak peripheral economies is becoming increasinglyevident. Against this backdrop, central banks in developed economies areunlikely to start hiking rates before the middle of next year. They will likelymake any withdrawal of extraordinary policy measures highly dependent onfurther improvements in macroeconomic developments. Some may evenconsider embarking on a further round of quantitative easing – as signaledby the US Fed in its latest Federal Open Market Committee (FOMC) state-ment – if deflationary forces become entrenched.

US: Signs of stabilization are mountingAfter a significant growth slowdown in 2Q10, signs are mounting thatgrowth stabilized in 3Q10. Housing indicators point to an end of the nega-tive payback after the expiration of the housing tax credit in April. Businessand consumer confidence statistics are still mixed, but at least suggest ahalt to the erosion experienced in the last few months. Initial jobless claimsare retreating after the worrisome surge in August. We continue to expectreal GDP growth of 1.5% q/q annualized in 3Q10 and 2.5% in 4Q10, after1.7% in 2Q10. Such a scenario implies no additional quantitative easing(QE2) by the Fed, but we now expect a Fed rate hike to come in September2011 rather than June 2011.

Growth is stabilizing at a very modest rateThe noticeable growth deceleration to 1.7% q/q annualized in 2Q10, after3.7% in 1Q10 and 5% in 4Q09, seems to have run its course. While themost recent data is still mixed, we think there is sufficient evidence forgrowth stabilization at a very moderate rate.

Fig. 2: Global industrial production running atsolid paceGlobal IP (% y/y, lh scale) and developed marketscomposite leading indicator (rh scale)

-15

-10

-5

0

5

10

2002 2003 2004 2005 2006 2007 2008 2009 2010

-2.5

-2.0

-1.5

-1.0

-0.5

-

0.5

1.0

Global industrial production (% y/y)

DM composite leading indicator (rh scale)

Source: ThomsonReuters EcoWin, UBS WMR

Fig. 3: Moderate but sustainable growthReal GDP y/y growth and its main components

Source: Thomson Datastream, UBS WMR

UBS Wealth Management Research 5 October 2010

Global economy

Global economy - 2

First, one of the most important growth barometers, the ISM Manufactur-ing PMI, is still at a robust level. At 54.4 in September, it is consistent withsolid real GDP growth. While its counterpart, the ISM Non-manufacturingComposite index, fell in August, the non-manufacturing index tends to lagand thus may simply reflect the earlier slide in the ISM Manufacturing PMI.

Furthermore, initial jobless claims, one of the timeliest economic indicators,reversed its sharp August rise in the first three releases in September. Thus,this suggests that private payroll growth can continue at a pace close to100,000 per month. Based on this recent data, we feel confident that realGDP growth is unlikely to deteriorate further. In fact, we think that ourreal GDP growth forecast of 1.5% q/q annualized in 3Q10 might be tooconservative. Looking further ahead, we reiterate our forecast for 2.5%growth in 4Q10 and 2.7% for 2011. The improvement in the growth pacewill likely be driven by some pick-up in private consumption and investment.

Inflation is too low for comfortHeadline and core CPI inflation have fallen to levels clearly below the Fed'slong-term mandate. In its long-term outlook, the Fed has consistently fo-cused on reaching inflation of 1.7-2%. In contrast, core CPI has stabilizedat 0.9% y/y. While we don't expect inflation to slide further, the current lowrate might become a policy driver in its own right. In fact, in its Septem-ber statement, the FOMC explicitly stated low inflation as an economic cir-cumstance that could be addressed by additional quantitative easing. Weforecast core inflation to trend sideways until the end of the year and togradually edge higher in 2011.

Fed on hold, but very close callAlthough our outlook incorporates a slight pick-up in growth after the re-cent growth moderation, the economy is still fragile, and the risks to ourforecast are skewed more prominently to the downside. Our scenario im-plies that the Fed will not have to expand the size of its balance sheet again,but the possibility of renewed liquidity injections by the Fed remains onthe table, which is consistent with more prominent downside than upsiderisk. In its August statement, the FOMC announced that it would keep itsbalance sheet at roughly USD 2.3trn. Since its mortgage backed securities(MBS) are maturing, this directly implies that the Fed will have to buy aboutUSD 20bn in Treasuries per month to keep its balance sheet from shrinking.

Fig. 4: Stable but very low inflationHeadline and core CPI inflation

Source: Thomson Datastream, UBS WMR

The FOMC's 21 September statement reiterated that it would keep its bal-ance sheet from shrinking. It also opened the door for additional quantita-tive easing (QE2) should the economy need it: “The Committee will con-tinue to monitor the economic outlook and financial developments and isprepared to provide additional accommodation if needed to support theeconomic recovery and to return inflation, over time, to levels consistentwith its mandate.” Fed Chairman Ben Bernanke stated a few weeks agothat “further significant weakening” of economic data would be a criterionfor additional quantitative easing. We haven’t seen that so far, and givenour outlook for a growth pick-up in 4Q10, we don’t expect to see it. Thus,we think that QE2 will not materialize. However, as pointed out above, thevery low inflation rate suggests that the Fed will now be even more cautiousthan before about becoming too restrictive too soon. We thus expect thefirst fed funds rate hike to come in September rather than June 2011.

Thomas Berner

UBS Wealth Management Research 5 October 2010

Global economy

Global economy - 3

Europe: Economic fragmentationEurope will increasingly feel the strain of strongly divergent economic de-velopments among its core and more peripheral economies. Back in 2008,the steep slump in global trade and investment spending affected all Euro-pean economies simultaneously, and they initially staged a more or less syn-chronized rebound from the Great Recession's trough starting in mid-2009.Coming out of this initial rebound in economic activity, the aftermath ofthe financial crisis and the ongoing government debt crisis have led to frag-mented economic and political developments.

Gap widens between core and peripheral economiesWithin the Eurozone, the competitive core economies have recently postedvery solid growth numbers. Germany's real GDP expanded an impressive2.2% q/q in 2Q 2010, which translates into 9% annualized growth for thequarter. The Netherlands posted 0.9% q/q growth (3.6% annualized). Atthe same time, Greece's GDP contracted by 1.5% q/q in 2Q 2010, bringingthe y/y rate to -3.5%. Ireland's GDP declined by 1.2% q/q in the secondquarter, and its GDP has fallen 14% since its peak in 2007.

Other economic indicators also point to growing divergences within theEurozone. EMU business sentiment indicators show that a wide gap hasopened up since mid-2009 between the strongest economy (Germany) andthe weakest (Greece), while France and Spain fall somewhere in between(see Fig. 5). A similar picture emerges when looking at consumer confidence(see Fig. 6), where Germans have become much more upbeat as of late,while sentiment among French, Italian and Spanish consumers is laggingbehind.

Overall, we expect German GDP to expand by 3.3% this year and 2.2%next year. The latest figures show that German growth is increasingly driv-en by domestic components, such as investment spending and to a lesserextent private consumption, which bodes well for the sustainability of therecovery. Ireland, Greece and Spain lie at the other end of the spectrum,having already experienced a big contraction in economic output last yearand expecting either flat growth or further contraction this year. We seemoderate growth near long-term averages for Italy and France, the tworemaining big players in the Eurozone.

In sum, we expect Eurozone GDP to grow by 1.7% this year and 1.9%next year. After all, one should not forget that Germany, Italy and Francemake up 65% of Eurozone GDP; Greece contributes only 2.6% of overallEMU GDP, and Ireland and Portugal 1.8% each. While labor markets willalso develop differently depending on each country's growth performance,overall Eurozone unemployment is unlikely to fall very quickly from currentlevels of around 10%.

Fig. 5: Business sentiment: Mind the gapBusiness sentiment indices for various EMU countries

Source: ThomsonReuters EcoWin, UBS WMR

Fig. 6: Consumer sentiment: Germans upbeatConsumer confidence indices for various EMU coun-tries

Source: ThomsonReuters EcoWin, UBS WMR

UBS Wealth Management Research 5 October 2010

Global economy

Global economy - 4

European Central Bank (ECB) on hold for the time beingWe expect inflation to remain well below the ECB's 2% ceiling this year andnext. Against this backdrop, and in light of the continuing fragility of theEuropean banking system, the ECB announced at its September meetingthat full allotment of its repo operations will continue until January 2011,i.e. further steps to exit extraordinary policy measures are unlikely beforeearly next year. If the economic recovery continues as implied by our basecase, we expect a first rate hike in the middle of next year.

UK: Can a weak GBP counterbalance fiscal austerity?The UK economy surprised on the positive side with a strong 2Q10 GDP.Solid growth in Europe should combine with a weak GBP to continue sup-porting British exports. The real effective exchange rate of the GBP – i.e. thetrade-weighted, inflation-adjusted exchange rate versus major trade part-ners – has depreciated some 20% since early 2008, rendering UK exportsmuch more competitive globally. Inflation is expected to remain high in theshort term as a result of the VAT hike and recent commodity price increases.In the medium term, however, we see inflation gradually falling back to theBank of England's target rate.

Against this backdrop, the Bank of England (BoE) will have to strike a bal-ance between fiscal austerity and an economic recovery that may call ul-tra-low policy rates into question. We think the Monetary Policy Committee(MPC) will try to muddle through the middle. We have delayed our rate hikecall from Q1 2011 to Q3 2011, but a hike will depend on a sustained recov-ery in leading indicators such as the PMI. If the economy were to weaken,the MPC would likely implement another round of quantitative easing.

Fig. 7: Weak GBP continues to support exportsUK sterling real effective exchange rate

Source: ThomsonReuters EcoWin, UBS WMR

Nordics and Switzerland: Strong momentumThe Nordic economies of Sweden, Finland and Norway have all weatheredthe financial market crisis relatively unscathed. The same holds for the Swisseconomy, which has delivered an astonishing outperformance comparedwith its neighbors. Government finances in the Nordics and Switzerland arenot deeply in the red, they had no real estate or credit bubbles, and theirbanking systems are in solid shape. Therefore, these economies have re-covered quickly from last year's recession and are showing strong econom-ic momentum. While both the Norwegian and the Swedish central bankshave already started their hiking cycles, the Swiss National Bank has not yetincreased policy rates, as it wanted to prevent the CHF from raising evenmore against the EUR. We think the Norges Bank and the Riksbank willcontinue hiking rates, and that the SNB will also have to raise rates sooneror later, given the Swiss domestic economy's very strong momentum andthe looming risks of a real estate bubble.

Daniel Kalt

Fig. 8: Switzerland is outperformingReal GDP, Index 1Q2005 = 100

Source: ThomsonReuters EcoWin, UBS WMR

UBS Wealth Management Research 5 October 2010

Global economy

Global economy - 5

Asia: Rising gravitySecond attempt at decoupling Asian growthAsia's growth held up remarkably well compared to the weakness wit-nessed in the US. In the second quarter of 2010, most Asian countriesgrew at or above trend. In that sense, Asia's largest economy – China –was lagging behind, growing slightly below trend (8.5-9%) after above-trend growth in the first quarter. Policy tightening aimed at slowing eco-nomic activity has been very effective. Besides this exception, the percep-tion has started to emerge again that the region will be able to decouplefrom macroeconomic trends in the US. We think investors should be carefulwhen making early judgments.

The resilience of Asia's economic growth is based on special factors. US im-ports in 2Q accelerated sharply compared to sub-trend GDP growth. Whilethis is not unusual, the contribution of net exports to GDP activity was ex-ceptionally negative, shaving off considerable US growth. This all coincid-ed with strong investment spending, which was a key driver of US growthin 2Q. Growth from Europe and non-Asian emerging economies was onthe strong side as well. Since we expect some of these parameters to shiftdownwards, we think Asia's GDP growth is set to moderate towards theend of 2010. With stalling Asian export growth to China, growth in Asia exJapan and ex China could drop below 5% in 4Q from growth levels above10% in 1Q.

This could start to change towards the end of the last quarter of 2010,as we expect China's GDP deceleration to stop in 3Q and gain some trac-tion in late 4Q. The latest PMI figures for September and August have sur-prised versus expectations, including a higher ratio of new orders to fin-ished goods inventories. The better-than-expected PMIs have gotten con-firmation from an uptick in electricity production, so we look for China'simport demand to accelerate again at the end of 2010. Economic newsflow from China for 4Q should therefore be rather a stabilizing factor, in ourview, with GDP growth going slightly above 8% in 4Q from levels below8% in 3Q. This should give emerging Asia ex Japan and China a helpinghand in 1H 2011.

Will this be enough to support the view that Asia can decouple from theUS? Doubts will remain in investors' minds, but they will recognize wheregrowth still has room to advance structurally and where not. The combi-nation of low regional leverage, negative real interest rates in most Asiancountries, and functioning banking systems are ideal to generate solid do-mestic demand based on some re-leveraging. Larger and less globally in-tegrated emerging economies like India and Indonesia could stick out. Inthe absence of another US recession, Asia's economic gravity should gatherstrength versus the US and Europe and be resilient enough to master mostexternal shocks. Thus, soft economic activity is more likely to be a mid-cy-cle downshift than the beginning of a larger growth downtrend. Japan'sstrong currency and lack of sustainable domestic demand growth shouldtake its toll on economic activity. We expect the country's economy to growaround 1.5% with swings driven by external demand.

Fig. 9: GDP growth in Asia, Europe and the USValues are seasonally adjusted and annualized versusthe previous period

(1)

1

3

5

7

9

11

13

15

Sing

apor

e *

Indi

a

Phili

ppin

es

Indo

nesi

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an

Mal

aysi

a

Sout

h K

orea

Hon

g K

ong

Euro

pe US

Japa

n

Thai

land

1Q 2010 2Q 2010

Source: Bloomberg, JP Morgan, UBS WMR* In the chart the scale is capped at 15%. Singapore's GDP growth in 1Q 2010was 45.7% and 24% in 2Q

Fig. 10: Chinese PMI and import growth fromAsiaWe expect Chinese imports from Asia to accelerateagain

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45

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65

May-06 May-07 May-08 May-09 May-10

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

PMI China (lhs) China: Import growth from Asia (3mavg 3m/3m, rhs)

Source: Bloomberg, UBS WMR

Fig. 11: Asia's expected growth differential tothe developed world based on IMF forecastsValues in %

0

1

2

3

4

5

6

7

8

9

10

2006 2007 2008 2009 F 2010 F 2011 F 2012 F 2013 F 2014 F 2015 F

Developing Asia Asean 5 Newly industrialized Asian economies

Source: IMF, UBS WMR

UBS Wealth Management Research 5 October 2010

Global economy

Global economy - 6

Looking for Asia's mid-cycle bottom at the end of 2010A downshift in Asian economic growth should not come as a surprise. In-dustrial activity grew at incredible speed in recent quarters, ranging from10% to 60% y/y, which cannot realistically be sustained. Given the natureof economic recoveries, we have seen an almost textbook recovery in Asia.Global capital spending has been leading the way, allowing export-orientedAsia to boom. This tailwind will start turning into a headwind for growthin the coming months.

The big question now relates to the potential bottom of this business cycle.We expect 4Q 2010 to mark the trough for industrial production growth,followed by an acceleration in 1Q 2011. Monetary policy tightening in Asiahas come to a halt, in our view. As in 2008, Asian monetary authorities arelikely to keep their economies well supplied with cheap money to bufferpotential negative spillover effects from the developed world. Recent mon-etary policy tightening in the region barely pushed broad real interest ratesto neutral. Thus, monetary conditions remain very loose – probably tooloose if the developed world does not see a double dip. US Fed ChairmanBernanke recently gave clear indications that more unorthodox monetarypolicy could be used to sustain economic growth. Hence, the probability isincreasing that Asian central banks will find themselves behind the curvein early 2011.

We initially see industrial production growth accelerating again along withsolid consumer demand. Since much of the slack in Asia's economy has dis-appeared, the next acceleration in economic activity could generate moreprice pressure. From a sequence perspective, China should see improve-ments towards the end of the year, followed by the rest of emergingAsia. From a swing perspective, Southeast Asia and highly trade-gearedeconomies should witness the strongest activity amplitudes. Over the en-tire year, however, we expect 2011 GDP growth for Asia to be lower thanin 2010. Solid consumption growth in emerging Asian countries will notchange this. India should be somewhat isolated from these global industrialactivity swings, as it is going its own domestically oriented growth path. Thecountry is expected to grow around trend growth for the coming quarters.

Fig. 12: Real interest rates in AsiaNominal interest rates less CPI y/y

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

Indo

nesi

a

Mal

aysi

a

Phili

ppin

es

Sout

h K

orea

Taiw

an

Chi

na

Thai

land

Sing

apor

e

Hon

g K

ong

Indi

a

Real short-term interest rates

Source: Bloomberg, UBS WMR

Fig. 13: Industrial activity level in Asia todaycompared to the level before the financial crisisValues in %

(15)

(10)

(5)

0

5

10

15

20

25

30

35

40

Chi

na *

Sing

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Sout

h K

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Indi

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Taiw

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Thai

land

Indo

nesi

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Phili

ppin

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Mal

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Japa

n

Industrial production changes from January 2008 to July 2010

Source: CEIC, UBS WMR* Values for China are interpolated

UBS Wealth Management Research 5 October 2010

Global economy

Global economy - 7

Capital flows – a two-way streetWhen investors think about capital flows, they tend to imagine rich coun-tries investing abroad. But the net balance of capital flows consists of muchmore. It is also about Asian investors who invest in the developed world.Detailed and up-to-date data is hard to come by, but we think the incentivefor Asian investors to send their money abroad has diminished sharply inrecent months. The attractiveness of the developed world was in its veryliquid bond market. But Asian investors now find themselves facing a dif-ficult environment: quantitative easing risks lie around the corner for theUS, Europe has to tackle severe structural issues between north and south,and Japan has been a red flag for most investors in recent years. The con-sequence of a poor return outlook for G3 fixed income markets shouldmotivate the repatriation of wealth and current account proceeds. Capitalflows from Asians abroad should thus drop, whereas foreigners' interest inAsia should gather strength. To what degree foreign flows come to Asiadepends on the de-leveraging magnitude and the shift in portfolio alloca-tions.

In many ways, this is exactly what is needed: Asia should consume or investits surpluses regionally, and not use them to finance the notorious overcon-sumption in the developed world (especially in the US). Hence, we remainpositive on Asian ex Japan currencies continuing their appreciation trajec-tory with rather healthy payment surpluses. Mounting price pressure in Asiaduring 2011 is likely to motivate central banks to take a relaxed stance to-wards a firmer currency. Foreign reserve accumulation by emerging Asiancentral banks slowed sharply in 1H 2010. That said, if the USD comes underrenewed pressure and growth in industrial activity decelerates towards theend of 2010, the temptation to stick closer to the USD will again be high.An uptick in foreign reserve accumulation in the coming months shouldnot be viewed as indicative for 2011. The CNY, KRW and MYR offer thebest value in terms of risk-reward, in our view. Risk-seeking investors canreplace the KRW and MYR with INR and PHP.

Dominic Schnider

Fig. 14: Foreign reserve changes of emergingAsia countriesValues until June

(150)

(100)

(50)

0

50

100

150

200

250

300

Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

Billi

on U

SD

80

85

90

95

100

105

EM Asia: Foreign reserves changes over 3 months (lhs) USDAXJ Index (rhs)

Source: Bloomberg, UBS WMRUSDAXJ Index = equally weighted Asian currency basket versus the USD. Alower value means stronger AXJ currencies

Fig. 15: Forecasted Asian currency appreciationversus the USDTotal return = spot return + interest rate carry

-15%

-10%

-5%

0%

5%

10%

15%

KRW PH

P

MY

R

INR

IDR

THB

RUB

SGD

TWD

EUR

CN

Y

JPY

Expected spot move Interest rate carry Expected total return vs the USD

Source: Bloomberg, UBS WMR. see most recent Global Forecasts

UBS Wealth Management Research 5 October 2010

Global economy

Global economy - 8

Central/Eastern Europe & Latin AmericaAs shown in Fig. 16, economic growth in the emerging economies bouncedbacked in the first half of 2010 to levels not far from their pre-crisis peaks.A big part of this recovery is that the banking systems in many of theseemerging countries remained relatively unscathed during this crisis, unlikethe damage done to banks in the US and parts of Europe. To use an analogy:when the average emerging economy opened the lending taps, the creditflowed and people filled their buckets like in the old days. Contrast this withthe US, where even very low interest rates did not have the same impactthis time round. The US faces the additional problem that the outlook forthe most important financial assets that most people own – their homes– is uncertain. In many emerging economies, however, real estate priceshave remained buoyant, which has encouraged mortgage growth. The bigregional exception to this emerging market story has been Central/EasternEurope, where they had the misfortune of being over-reliant on troubledbanks headquartered outside their countries.

Fig. 16: Emerging markets bounce backReal GDP growth, % y/y change

-10%

-8%

-6%

-4%

-2%

1%

3%

5%

7%

9%

11%

04 05 06 07 08 09 10

Africa AsiaCentral and Eastern europe Middle EastLatin America

Source: UBS

A strong rebound in 2010The extent to which the economic outlook in the emerging economies hassteadily improved over the past year can be gleaned from Fig. 17. It showsthe upward revisions to GDP growth across a range of countries. Thus, inOctober 2009, we expected Brazil to grow by around 4% this year, butwe now think that this figure is going to be twice as high. Turkey's GDPnumber also underwent a massive upward revision. A year ago it lookedas though the country might need help from the IMF, but its economy hasmanaged fine and its growth projection for this year has bounced backto over 7%. Many emerging economies are booming. Even a strugglingcountry like Hungary has seen its growth forecast revised up for this yearfrom a contraction to a slightly positive number.

Fig. 17: Forecasts for 2010 real GDP growth% y/y change, published in the following months:

Oct 09 Jan 10 Aug 10 Sep 10

Latam

Brazil 4.0 4.5 8.2 8.2

Mexico 2.5 2.5 5.1 4.8

EMEA

Czech Rep. 1.0 1.5 1.5 1.8

Hungary -0.5 -0.1 0.5 0.5

Poland 2.0 2.4 3.0 3.3

Russia 2.0 5.6 7.5 7.0

South Africa 2.0 2.7 3.3 3.3

Turkey 1.5 2.4 5.5 7.3

Source: UBS

UBS Wealth Management Research 5 October 2010

Global economy

Global economy - 9

What we expect for 2011In light of the strong 2010 bounce, what is in store for 2011? Here, too,we see a general upward drift in growth forecasts for several economies,although overall growth rates are expected to be below the 2010 spikes.At this point, we do not see this loss of momentum falling back into a dou-ble-dip in any of these markets. Of course, those with the lowest growthprojections, like Hungary, have less of a cushion to absorb a sharper globalslowdown if that were to materialize.

Fig. 18: Forecasts for 2011 real GDP Growth% y/y change, published in the following months:

Oct 09 Jan 10 Aug 10 Sep 10

Latam

Brazil 4.5 4.5 5.4 5.4

Mexico 3.2 3.2 3.7 3.7

EMEA

Czech Rep. 3.0 3.0 2.6 2.6

Hungary 2.0 2.0 2.0 2.0

Poland 3.7 3.7 3.9 3.9

Russia 4.2 4.2 6.0 6.0

South Africa 3.9 3.0 3.5 3.5

Turkey 4.3 4.3 4.3 4.7

Source: UBS

No sign of deflation hereFig. 19 shows that consumer price inflation expectations have drifted higherin several countries over the past year. This should come as no surprise:Higher growth is not free – it comes at the price of higher inflation. Thisis also an indication that interest rates in the emerging economies shouldbe higher, and in some cases substantially higher, than those in the UnitedStates, Western Europe and Japan. We expect this interest rate differentialto continue to grow until the developed economies begin to move awayfrom their near zero-interest policies.

Fig. 19: Forecasts for 2010 inflation% y/y CPI change, published in the followingmonths:

Oct 09 Jan 10 Aug 10 Sep 10

Latam

Brazil 4.5 4.5 5.2 5.2

Mexico 3.5 5.0 4.5 4.4

EMEA

Czech Rep. 2.5 1.2 1.2 1.5

Hungary 4.5 4.3 4.9 4.9

Poland 2.5 2.5 2.5 2.5

Russia 10.0 7.8 5.9 6.1

South Africa 6.5 5.6 5.3 4.4

Turkey 6.5 5.7 8.7 8.7

Source: UBS

UBS Wealth Management Research 5 October 2010

Global economy

Global economy - 10

The wrong interest rates for the emerging marketsThese very low global interest rates have two major implications for theemerging markets. First, emerging market residents can borrow dollars, eu-ro, yen and sterling at rates that have never been seen before. This supportscapital inflows into the emerging economies.

The second major implication of low global interest rates is that investors indeveloped countries holding low-yielding cash and bonds in their portfoliosare tempted to look further afield for higher yields. This also benefits theemerging markets because their bonds and money markets typically offerhigher yields.

While these low global rates might be appropriate for developed economiesrecovering from a deep recession, they are almost certainly wrong for mostemerging economies, which did not experience a banking crisis and whereeconomic growth is continuing at healthy levels.

Fig. 20 shows how much cheaper it has become for a selection of emergingeconomies to borrow in US dollars over the past year, in this case Brazil,Indonesia, Russia and Mexico. The idea that the average emerging marketgovernment could borrow US dollars in the international capital marketsfor an interest rate of just 5% would have been unthinkable a few yearsago. Our records show that over the past 210 years, the United States gov-ernment has had to pay an average yield of 5.6% for long-term borrowingin its own currency. Emerging market residents are therefore in the midstof a boom as far as USD borrowing rates are concerned.

The major drawback to these low USD rates are, first, that they could belaying the groundwork for trouble down the road. If money is too cheap,it can result in mispricing and misallocation: Not every new shopping mallor apartment block in Sao Paulo or Shanghai is going to be profitable. Thesecond problem associated with low USD interest rates is that the searchfor yield in the emerging markets is driving up emerging market currencies.This could undermine their competitiveness and weigh on their economicperformance in the medium term.

Constantin Vayenas

Fig. 20: Good news for EM borrowersYields (in %) on USD-denominated EM sovereignbonds

4

5

6

7

8

9

10

11

12

Nov08

Jan09

Mar09

May09

Jul09

Sep09

Nov09

Jan10

Mar10

May10

Jul10

Brazil Indonesia Russia Mexico

Source: UBS

UBS Wealth Management Research 5 October 2010

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UBS forecasts

GDP (real, % yoy) Inflation (in % yoy)

2008 2009 2010 2011 2008 2009 2010 2011

Americas Americas

Brazil 5.1 -0.2 8.2 5.4 Brazil 5.9 4.3 5.2 5.2

Canada 0.5 -2.5 3.1 2.8 Canada 2.4 0.3 1.7 2.3

Mexico 1.5 -6.5 4.8 3.7 Mexico 6.5 3.6 4.4 3.7

USA 0.0 -2.6 2.7 2.7 USA 3.8 -0.3 1.7 1.7

Asia-Pacific Asia-Pacific

Australia 2.2 1.2 3.4 3.8 Australia 4.4 1.8 3.0 3.1

China 9.6 9.1 10.0 8.7 China 5.9 -0.7 3.0 4.0

India 6.7 7.4 9.0 8.0 India 7.8 6.4 8.6 6.0

Japan -1.2 -5.2 3.2 1.7 Japan 1.4 -1.3 -0.9 -0.3

Rest of Asia 2.8 -0.6 5.3 4.3 Rest of Asia 5.7 1.8 2.7 3.2

Europe Europe

Eurozone 0.3 -4.0 1.7 1.9 Eurozone 3.3 0.3 1.6 1.8

Germany 0.7 -4.7 3.3 2.2 Germany 2.8 0.2 1.2 2.0

France 0.1 -2.5 1.7 1.9 France 3.2 0.1 1.8 1.6

Italy -1.3 -5.1 1.1 1.6 Italy 3.5 0.8 1.5 1.9

Spain 0.9 -3.7 0.1 1.0 Spain 2.2 2.7 2.0 1.8

Russia 5.6 -7.8 7.0 6.0 Russia 14.0 11.7 6.1 6.5

Sweden -0.6 -5.1 4.0 2.8 Sweden 3.5 -0.3 1.4 2.3

Switzerland 1.9 -1.9 2.7 2.2 Switzerland 2.4 -0.5 0.7 1.2

UK -0.1 -4.9 1.6 2.3 UK 3.6 2.2 3.1 2.6

World 2.4 -1.1 4.1 3.7 World 5.4 1.3 2.9 3.0

Source: ThomsonReuters EcoWin, UBS WMR

UBS Wealth Management Research 5 October 2010

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Appendix

Global Disclaimer

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UBS Wealth Management Research 5 October 2010

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