ab CIO WM September 2012

UBS CIO Monthly Letter

This report has been prepared by UBS AG. Please see important disclaimers and disclosures at the end of the document. Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication.

Dutch cyclist Marianne Vos recently won Olympic gold in the 140 km road race, just months after fracturing her collarbone in a collision with a motorcycle. Vos claimed gold by taking a risk: she cycled away from the peloton considerably earlier than orthodox strategy would suggest. In investing too, sometimes it can make sense to push your-self into taking measured risks, even when the temptation is to stay with the pack.

Today, the investment world’s “peloton” remains firmly underweight Eurozone equi-ties, yet recently the negative economic and political news has been moderating. Euro-pean Central Bank (ECB) President Draghi’s recent statements pledging assistance to countries that enter fiscal adjustment pro-grams are another incremental positive development in the Eurozone crisis, and alle-viate some of the tail risk. The crisis is far from solved, and many key events are ahead this fall. However, any deviation from bench-mark, whether an over- or underweight, is an active risk position. And with the poten-tial for further negative outcomes in Europe reduced, we have lower conviction in our long held underweight position in Eurozone equities vs. global equities. We have there-fore moved this position to neutral. We would suggest clients look to the CIO pre-ferred theme High Quality Dividend Yields to implement part of this portfolio adjustment.

With Chinese equities back to levels last seen in 2009, investors continue to be down-beat on the region. While recent economic data has continued to disappoint, we expect looser policy to have a lagged positive impact on Chinese growth in the second half, and

have chosen to overweight emerging mar-ket equities broadly and Chinese equities in particular.

In the US, the consensus is more favorable; here we have benefited by staying with the peloton this year. US equities have outper-formed European equities by around 6% YTD and US high yield is up 10% YTD, as many investors have shared our positive view on these asset classes. Now, after a brief summer blip, US economic momentum is improving and we believe it makes sense to continue to cycle with the peloton: our biggest overweight position remains in US high yield credit, we are overweight the US dollar, and the US is still one of our two pre-ferred equity regions. US High Yield and US Housing are also CIO preferred themes.

If we look back on markets to this time last year, it looked like more than Miss Vos’s col-larbone was fractured. The US faced a sover-eign credit rating downgrade, the Eurozone debt crisis was growing more acute, and China faced an inflationary threat. Examin-ing how the market fared over the past year helps frame the investment picture today.

Europe – economy worse, but policy betterSince last summer, when Italian 10-year bond yields rose above 6% for the first time in the euro era, the Eurozone has repeatedly been pushed to the brink before being pulled back by piecemeal fixes by politicians. The volatility has made it difficult to make an investment case for the Eurozone, but this does not mean that positive policy devel-opments should be dismissed.

Alexander S. FriedmanCIO UBS WM

Winning the investment Olympics takes measured risks

UBS CIO Monthly Letter

UBSChiefInvestmentOffice September 2012 2

Over the past year we have seen some tentative steps toward fiscal integration. Also, the central bank is taking a more active role in supporting the banking system, and is considering supplementing official support programs for Spain and Italy by buying short-term bonds in the sec-ondary market. These piecemeal developments have now created a framework for aid – distressed countries can enter a Memorandum of Understanding for fiscal adjustment in exchange for primary market assistance from the European Stability Mechanism (ESM) and sec-ondary market support from the ECB. A reduced “break-up risk” in the Eurozone has helped push yields down sharply on shorter-term sovereign peripheral debt (see Figure 1), and sparked a rally in equities.

The economic outlook is admittedly darker than it was last year. Recent data showed that Eurozone GDP con-tracted in the second quarter (–0.2%) as a year of finan-cial stress, weakening confidence, and fiscal austerity have taken their toll. And political risks remain – notably surrounding Greek negotiations with the Troika (the European Commission, the International Monetary Fund and the European Central Bank) and Dutch elections in September. The ECB Governing Council will convene and then report on 6 September; and the German Constitu-tional Court will pronounce its decision regarding the European Stability Mechanism and the related fiscal pact on September 12.

While September is full of political events that could delay a European solution, “risk” is not a one-way street. Assuming an investor’s strategic asset allocation is con-structed to best match their longer-term goals and risk profile, any deviation from this allocation, either positive or negative, represents an active “bet.” The bottom line is that volatility is likely to stay with us in the region, but a continued political willingness to solve the euro crisis could provide another leg up to this rally, given that the region has underperformed global equities this year.

The US – policy stalemate, economy better“You can always count on Americans to do the right thing – after they’ve tried everything else,” Winston Churchill once said. Last summer, the US did indeed eventually increase its debt ceiling, but only following a political battle. The messy policy debate resulted in a sov-ereign credit rating downgrade and sparked a more than 6% sell-off in the S&P 500 equity index. This was cou-pled with an economy that appeared to be stalling – non-farm payroll growth was less than 100,000 jobs for four consecutive months between May and August 2011.

Earlier this year, it seemed as though the US economy might be on course to repeat last summer’s economic slump. Job growth was weak and negative economic surprises were increasing. Yet now economic momen-tum appears to be turning. Non farm payroll growth jumped to +163,000 in July, from +64,000 in June (see Figure 2), and retail sales rose +0.8% m/m in July relative to –0.7% m/m in June. The retail sales data is particularly important, since a slowdown in real consumption was the primary cause of weakening US GDP growth from the first to the second quarter. Overall, we continue to believe the US economy remains on a moderate growth path, with modest improvement in the job market and, notably, continued signs of a gradual recovery in housing.

This is not to say that risks do not remain. The US presi-dential election season moves into full swing in Septem-ber, and debate is likely to heat up on the fiscal cliff that looms in January 2013 – particularly given Republican presidential candidate Mitt Romney’s choice of running mate, Paul Ryan, a noted fiscal conservative. Without an agreement between Democrats and Republicans, USD 607bn (3.7% of GDP) of spending cuts and tax increases will be automatically triggered. Cooperation is unlikely ahead of the November election, but we believe, as

Figure 2: US economic data improved in July

Source: Bloomberg, as of 31 July 2012

Non farm payrolls – ‘000s Consumer confidence

80

60

40

20

0

100

120

140

160

180

66

64

62

60

58

68

70

72

Non farm payrollsConsumer confidence

Mar-12 Apr-12 May-12 Jun-12 Jul-12

Figure 1: Pledges of ECB support have led to declining Spanish yields

Source: Bloomberg, as of 21 August 2012

09-A

ug

16-A

ug

02-A

ug

26-J

ul

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an

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6.5

7.0

Spanish 2-year bond yield

ECB President Draghi promisesto do “whatever it takes” tosave the euro

UBS CIO Monthly Letter

UBSChiefInvestmentOffice September 2012 3

Churchill suggested, that the US will ultimately do what it takes to avert a disaster. The most likely outcome is a “fiscal pothole” rather than a fiscal cliff, which would consist of either modest fiscal tightening (of perhaps 0.7% of GDP) or some temporary tightening that gets retroactively reversed in early 2013. While these scenar-ios would modestly slow the economy, we believe they would not be enough to tip the US into recession.

On balance, we continue to hold a broad preference for US assets within our tactical asset allocation. We are overweight US high yield credit, US equities, the USD, and US investment grade credit. We also believe that Agency Mortgage Backed Securities (Agency MBS) rep-resent an attractive investment opportunity. Agency MBS offer higher yields than government bonds, but have minimal volatility and a favorable supply and demand balance. And while recent indicators have generally shown signs of stabilization and overall improvement in the US housing market, the recovery is likely to remain gradual, limiting the prospect that homeowners will pre-pay their mortgages. For more information see our CIO Preferred theme US Housing. MBS would also likely ben-efit from any future quantitative easing (QE) in the US. We believe the US could engage in further QE if eco-nomic momentum, or the Eurozone situation, deterio-rates, and the Fed could detail its thinking at the annual Jackson Hole summit on August 30–31.

China – policy to make economy betterA year ago, with the US and Europe facing idiosyncratic difficulties, some investors might have turned to the emerging world for comfort. Unfortunately, China was facing its own issues. Consumer price inflation (CPI) was running at about 6%, and investors and policymakers alike feared it could rise further.

In response, China kept policy tight in an attempt to cool the economy. We are continuing to see the effects of these moves, and China’s economy has slowed in 2012.

Crucially, inflation has fallen as intended (see Figure 3). With year-on-year CPI growth below 2%, China has room to ease monetary conditions further if necessary, and infrastructure investment is likely to pick up in the second half, supporting a gradual, investment-led recov-ery. We continue to believe that fears of a “hard land-ing” are misplaced.

China is one of CIO WM Research’s preferred emerging equity markets, due to its positive economic outlook and reasonable valuations. We expect pro-cyclical measures to drive better performance from the Financials, Energy, and Materials sectors. An alternative method of benefit-ing from China’s economic growth is through the CIO Preferred theme Western Winners from Emerging Mar-ket growth.

Asset allocation changesOverall, we have seen a number of positive develop-ments this month, with improved US economic data and encouraging policy developments in the Eurozone. These factors have helped push implied equity market volatility close to five-year lows (see Figure 4) suggesting that mar-kets may be getting complacent, despite potential risks ahead. We continue to believe that the best course of action is a “middle ground” strategy.

Within our fixed income allocation, this strategy focuses on earning yield in corporate credit, particularly US high yield, global investment grade, and emerging market USD-denominated bonds. We maintain overweights in these three credit segments.

Despite strong performance year-to-date, US high yield bonds remain the largest overweight in our tactical asset allocation. We continue to believe that the asset class will be fundamentally supported by positive, if sub-trend, US growth and solid corporate balance sheets. The current spread of around 5.9% still compensates investors comfortably for expected future default risk,

Figure 3: Low inflation provides scope for China policy easing

Source: Bloomberg, as of 29 June 2012

Chinese CPI – yoy % Chinese Industrial Production growth – yoy %

1

0

2

3

4

5

7

6

20

468

10

161412

China CPI – yoyChina IP – yoy

Mar

-12

Dec-

11

Sep-

11

Jun-

11

Mar

-11

Dec-

10

Jun-

12

Figure 4: Implied equity market volatility at a 5-year low

Source: Bloomberg, as of 21 August 2012

2011

2010

2009

2008

2007

2006

2012

20

10

0

30

40

50

70

60

90

80

VIX implied volatility index

UBS CIO Monthly Letter

UBSChiefInvestmentOffice September 2012 4

and is well above both the long-run average of 5.4% and our six-month target of 5.3%. Companies have also taken advantage of record-low absolute yields to refi-nance their debt cheaply. Year-to-date, there has been USD 208bn of new issuance, above the USD 200bn issued over the same period last year. With only modest amounts of debt left to mature in 2012 and 2013, default rates should remain low, further supporting the asset class.

Within equities, we remain overweight US equities, but reduce the size of the position after outperformance year-to-date. As we outlined earlier, we have moved to a neutral posture on Eurozone equities. We have also moved to a neutral stance on UK equities, which, although attractively valued on a relative basis, do not offer an obvious trigger to unlock this valuation potential over the coming six months. In currencies, we have reduced our underweight in the euro due to the more balanced Eurozone risks described above. We have also initiated a short recommendation in the Japanese yen. The yen is expensive in trade-weighted terms and Japan’s economic momentum appears to be weakening as the growth boost from earthquake recon-struction fades out. In addition, political pressure on the Bank of Japan (BoJ) to play a more active role could increase, given that the central bank is falling behind its inflation goal. We expect the BoJ to ramp up its asset purchase program in the second half of 2012, purchas-ing an additional JPY 10tn (around USD 126bn) in assets.

Within commodities, we continue to see further price weakness ahead, and keep a small underweight in energy. The oil price has rallied in the past month on geopolitical concerns, yet fundamentally we believe it is overvalued based on weak demand relative to supply.

I can conclude with another lesson from Marianne Vos’s Olympic win, which is that you can’t win if you don’t stay in the race. The turbulence of summer and fall 2011 was a good example of this. Thinking the markets were bro-ken, many investors gave up, and sold all of their risk assets. Yet as the past 12 months have shown, in difficult times, measured risks can pay off.

To communicate our views on a more frequent basis, we have decided to issue a CIO Weekly publication. It pro-vides a concise review of the “need to know” news from the prior week, a closer look at a topical investment issue relevant to the UBS House View, and a market-specific investment viewpoint from your Regional CIO.

Kind regards,

Alexander S. FriedmanGlobal Chief Investment OfficerWealth Management23 August 2012

UBSChiefInvestmentOffice September 2012 5

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UBS CIO MonthlySeptember 2012

CIO WM Global Investment Office

CIO monthly videowww.ubs.com/cio-video

For smartphone users: scan the code with an app like "scan"

Published 23 August 2012

This report has been prepared by UBS AG. Please see important disclaimers and disclosures at the end of the document. Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts

and tables

in this publication.

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Summary

Economy While global growth momentum remained weak in August, several indicators stabilized or even

improved. Central banks confirmed their commitment to provide additional support if needed. In the US, labor market and retail sales data beat expectations but

the option of further QE remains

on the table. The rise of short-term Spanish and Italian bond yields was reversed by the European Central Bank's (ECB) announcement of possible further bond buying, although such action is still conditional on a request for an aid program. Emerging market growth should be supported by policy easing in the months ahead. We expect a gradual improvement in global growth in H2.

Equities With the potential for further negative outcomes in Europe reduced, we have lower conviction in

our long-held underweight position in Eurozone equities. Although UK equities are attractively valued on a relative basis, they do not offer an obvious trigger

to unlock this valuation potential

and hence we close our overweight. Our most preferred regions remain the US and the emerging markets (EM) as earnings are relatively resilient, valuations are still attractive, and the growth outlook speaks in favor of the two regions.

Fixed Income Despite the recent tightening in corporate bond spreads we keep our overweight positions in

investment grade corporate bonds, EM bonds, and US high yield bonds. Credit continues to benefit from low default rates, the outlook for modest positive global growth, and investors' appetite for yielding assets. We reiterate our underweight in government bonds.

Commodities It is not the right time to invest into commodities as global demand is still weak and only gradual improvement is expected in H2. We expect the (Brent) oil price to trend below USD 100 again on relatively weak global demand and strong supply. Hence we keep our underweight on energy.

Foreign Exchange We reduce the underweight on the EUR and, by extension, the CHF due to lower Eurozone tail

risks. Both currencies remain underweight though as the relative economic weakness and a likely

further rate cut by the ECB still favor the USD. We initiate an underweight on the JPY as the Japanese economy has deteriorated further and the Bank of Japan will likely step up quantitative easing efforts. GBP and CAD remain preferred currencies to diversify out of the EUR.

"Uncertainty remains high despite clearer guidance by central banks. Credit should still be preferred over equities."

Please see important disclaimer and disclosures at the end of the document.

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Commodities2%Real Estate

5%Hedge Funds / Private Equity

10%

Equities USA10%

Equities Europe

23%EmMa Equities

6%

Equities Other6%

Emerging Markets Bonds

6%

High Yield Bonds

6%

Inv Grade Corporates

Bonds9%

High Grade Bonds

7%

Liquidity10%

Cross-asset preferences

•

USD•

CAD •

GBP

•

EUR•

CHF

•

JPY ()

•

Developed market government bonds

•

US high yield•

Global investment grade credit•

EM corporate bonds•

Event-driven and relative value hedge funds

•

US Housing

Most preferred Least preferred

•

US •

Western winners from EM growth

•

High quality dividend yields•

Event-driven and relative value hedge funds

•

Natural gas growth gainers

•

Canada•

Australia

Recent upgrades Recent downgrades

Equities

Fixed income

Foreign exchange

Commodities

Note: Portfolio weights are for an advisory client with a "EUR moderate" profile. For portfolio weights related to other risk profiles please contact your client advisor.

Portfolio weights

Please see important disclaimer and disclosures at the end of the document.

•

Energy

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Reference portfolio

Please see important disclaimer and disclosures at the end of the document.

Source: UBS CIO – as of 23.08.2012

Tactical asset allocation deviations from benchmark* Currency allocation

* Please note that the bar charts show total portfolio preferences and thus can be interpreted as the recommended deviation from the relevant portfolio benchmark for any given asset class and sub asset class.

The UBS Investment House view is largely reflected in the majority of UBS Discretionary Mandates and forms the basis of UBS Advisory Mandates. Note that the implementation in Discretionary or Advisory Mandates might slightly deviate from the "unconstrained" asset allocation shown above, depending on benchmarks, currency positions and for other implementation considerations.

USD

EUR

GBP

JPY

CHF

SEK

NOK

CAD

NZD

AUD

new old

neutralunderweight overweight

Cash

Equities total

US

Eurozone

UK

Japan

Switzerland

EM

Other

Bonds total

Government bonds

Corporate bonds (IG)

High yield bonds

EM bonds (USD)

Commodities total

Precious metals

Energy

Base metals

Agricultural

Listed Real Estate

Equ

itie

sB

on

ds

Co

mm

od

itie

s

new old

neutralunderweight overweight

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Preferred themes

Government bond alternatives (sourced from government bonds – CIO UW)

Developed world government bonds offer a comparatively small cushion against future interest rate hikes and many face increasing credit risk. We expect selected bonds of supranational or national agencies, sub-national governments, multinational corporates, and covered bonds to outperform government bonds. We recommend switching out of government bonds into these alternatives.

US high yield corporate bonds (sourced from government bonds – CIO UW)

Positive economic growth, robust corporate earnings and healthy balance sheets

provide support to US high yield

corporate bonds. Current yield

spreads of 585 basis points still price in a more dire economic outcome than we expect. Historically, US high yield bonds have delivered

similar

returns as US equities with lower volatility. We continue to believe that US high yield corporate bonds represent a more favorable risk/return potential than equities and expect mid single digit returns over

the next 6

months.

US Housing (sourced from government bonds – CIO UW)

There are a range of investment opportunities related to US housing, but their relative performance will vary depending on where we are in the cycle. While recent indicators have generally shown signs of stabilization and overall improvement in the US housing market, the recovery is likely to remain gradual. In this environment, we believe that Agency Mortgage Backed Securities (Agency MBS), and related US Agency Mortgage REITS, are amongst the best investment opportunities. Agency MBS offer a positive spread to government bonds with minimal volatility, have a favorable supply and demand balance, and would likely benefit from any future quantitative easing in the US. US Agency Mortgage REITS are leveraged exposures to the same type of underlying bonds.

The place to be in Hedge Funds Growth

in most developed markets remains muted. In this environment,

less directional hedge fund strategies, such as relative value and event driven, should offer above average returns.

High quality dividend yields (sourced from existing European

and UK equities) High quality companies with geographically diversified business models that pay sustainable dividends offer an attractive income stream

in a

low yield world. Historically, dividends have made a substantial contribution to total returns, and we expect this to remain the case in

the current environment.

Western winners from emerging market growth (sourced from existing equity holdings)

Emerging economies continue to grow faster than developed economies. With little need to deleverage and repair balance sheets, Asian economies are also well positioned to continue to outpace their Western peers in the years ahead. We have identified companies from a variety of sectors in Europe, the US and Japan which have significant exposure to the rapidly growing emerging regions. We believe a diversified portfolio of these companies will reward investors seeking to profit from the robust demand growth in emerging economies.

Natural gas growth gainers Natural gas is a relatively clean source of energy, and we think

it will

benefit from continued substitution for other energy sources over the long term. We have examined the dynamics of the global market and the various components of the gas value chain, and identified the areas we see as the most significant beneficiaries currently. These include producers in Europe and Asia, suppliers of infrastructure, services and related machinery, and Master Limited Partnerships (MLPs) in the US, that offer both attractive yields and growth.

EM corporates: a growing asset class (sourced from global government bonds –

CIO UW)

Given our relatively constructive current view on risk, we regard EM corporate debt as more attractive than EM sovereign debt due to its higher overall yield. Over a 6-month horizon, we expect EM corporate bonds to outperform US Treasuries and deliver total returns of close to 7% p.a.

Please see important disclaimer and disclosures at the end of the document.

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Real GDP growth in % Inflation in %2011 2012F 2013F 2011 2012F 2013F

Americas US 1.8 2.1 2.3 3.1 2.0 1.9Canada 2.4 2.1 2.4 2.9 2.1 2.3Brazil 2.7 2.0 4.8 6.5 5.0 6.5

Asia/Pacific Japan -0.7 2.5 2.2 -0.3 0.2 0.3Australia 2.1 3.7 3.5 3.4 1.7 2.6China 9.2 8.0 8.3 5.4 2.8 3.8India 6.5 6.0 7.0 7.8 6.9 7.0

Europe Eurozone 1.5 -0.4 0.4 2.7 2.4 1.8 Germany 3.1 1.0 1.1 2.5 1.7 1.5 France 1.7 0.3 0.4 2.1 2.0 1.5 Italy 0.5 -1.8 0.2 2.9 3.4 2.2 Spain 0.7 -1.6 -1.3 3.1 2.3 2.3UK 0.8 -0.5 0.8 4.5 2.7 2.3Switzerland 2.1 1.3 1.7 0.2 -0.4 1.4Russia 4.3 3.8 3.7 8.5 4.9 6.4

World 3.2 2.7 3.2 3.9 2.9 3.0

30

35

40

45

50

55

60

2008 2009 2010 2011 2012

ManufacturingServicesNo-change line

Key dates6 Sep

Eurozone: ECB press conference

7 Sep

US: Nonfarm payrolls and unemployment rate for August12 Sep

Eurozone: German constitutional court ESM ruling; Dutch parliamentary elections

11–15 Sep

China: New bank lending, M2 (August)

Key questions• What are the prospects for the global economy in the second half

of 2012?

• When is the European economy likely to return to sustainable economic expansion?

• What are the risks that the US economic recovery will falter in the near term?

• Are agricultural price increases preventing emerging market policy makers from monetary easing?

CIO View (Probability: 65%*) Sluggish expansion

• Global growth momentum as indicated by the latest July PMI surveys continued to worsen in

manufacturing activity, while services experienced a slight uptick. Stronger disposable income growth should lend some support in 2H 2012. We further think that central bank action is likely, which would support our expectation of a mildly accelerating global economy in the second half of the year.•

We forecast the economies of the UK and the Eurozone to improve

from their current state of

contraction, moving to growth by year-end. We expect the ECB to act decisively in the coming months: finalizing new bond-buying program modalities in August, cutting its main policy rate from 0.75% to 0.5%, deciding on the new collateral framework in September, and announcing an LTRO by year-end. •

The US economic recovery remains moderate. Surveys and labor market data are still weak, with the

European debt crisis and uncertainty regarding the fiscal outlook in particular weighing on sentiment. The Federal Reserve has extended Operation Twist to lower longer-term yields. We see a 50% chance that the Fed will take more action to support the economy at its September meeting.•

While PMI surveys still show weak growth momentum in EM, business cycle indicators point towards a

recovery in 2H 2012. However, there is significant divergence: Asia looks stronger, whereas EMEA is lagging and Latin America lies in between. Despite higher food prices, further policy rate cuts are still likely.

6

Global economic outlook – SummaryGlobal growth expected to be under 3% in 2012

Source: Bloomberg, UBS CIO, as of 6 August 2012Note: Past performance is not an indication of future returns. *Scenario probabilities are based on qualitative assessment.

For further information please contact CIO economist Dirk Faltin, dirk.faltin@ubs.com and CIO economist Ricardo Garcia, ricardo-za.garcia@ubs.com

Please see important disclaimer and disclosures at the end of the document.

Services and manufacturing diverging(Global PMIs, 3-month moving averages)

Positive scenario

(Probability: 10%*)

Return to long-term trend

• The Eurozone crisis abates. Financial market conditions recover, mitigating the drag from fiscal austerity.•

Growth in Western Europe turns decisively positive by year-end and the US economy grows moderately

above trend. Negative scenario

(Probability: 25%*)

Recession

• There are three key downside risks to the global economy: 1) a significant escalation of the Eurozone

debt crisis; 2) a sharp fiscal contraction in the US, and 3) a sharp deceleration of the Chinese economy. Each of these risks could precipitate a significant downturn of the global economy.

Source: UBS CIO, as of 14 August 2012In developing the CIO economic forecasts, CIO economists worked in collaboration with economists employed by UBS Investment Research. Forecasts and estimates are current

only as of the date of this publication and may change

without notice.

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7

Key financial market driver 1 – Eurozone crisis

CIO View (Probability: 60%*) Austerity and weak growth•

The latest indicators suggest ongoing economic contraction at the beginning of the third quarter, posing

some downside risks to the UBS forecast of 0.0% GDP growth for the third quarter. The ECB's recent announcement that it would revise its collateral framework and use its firepower to address stressed bond markets (subject to conditions) is expected to support the improvement of the economy towards marginally positive economic growth in the fourth quarter. We continue to expect a further rate cut in September, which is likely to weaken the Euro further, and now expect a new

LTRO by year-end.

• While the Spanish bank recapitalization is still pending, there

is pressure on Spain to officially ask for

support (secondary bond buying by the ECB and some direct support from the EFSF/ESM/IMF). Spain may wait for more market pressure by September before doing so, leading to a short-term risk of disappointment.•

With the ECB buying to concentrate on the short end, long yields should stay high as bondholders remain

highly concerned about de-facto subordination to ECB holdings and official loans, which we think cannot

be mitigated by a legal pari passu status. If Spain joins a program, any further slippage on consolidation targets like earlier this year may lead to pressure for more reforms or put support at risk. We believe Italy requires the same type of support as Spain, despite Monti's attempt to get support without conditionality.•

We do not think Greece will exit the euro in 2012, but the risk

has increased. We expect a memorandum

with a few adjustments to be signed by September. Greece's likely failure on targets will lead to high exit and default risk by 2013. Portugal and Ireland should receive favorable amendments to their bailout packages, Cyprus will most likely get a new package and Slovenia

is likely to ask for help soon.

Key dates6 Sep

ECB press conference

12 Sep

German constitutional court ESM ruling; Dutch parliamentary elections15 Sep

Eurogroup meeting

20 Sep

Estimate for September Eurozone composite purchasing managers index

For further information please contact CIO analyst Thomas Wacker, thomas.wacker@ubs.com andCIO economist Ricardo Garcia, ricardo-za.garcia@ubs.com

Please see important disclaimer and disclosures at the end of the document.

Key questions• What is the state of the economy and what will the ECB do to support the fight against the crisis?

• Can Spain and Italy continue to tap the primary market if they ask for a support program?

• How much more support will Greece receive and will it be able to

stay in the Eurozone?

Positive scenario

(Probability: 15%*) Return to macro stability

• Bond yields decline as peripheral countries' budgets stay on track and economic activity recovers faster

than expected. Greece complies with the new austerity plans and market confidence is restored. Negative scenario

(Probability: 25%*)

Major shock

• Major shocks include Spain and Italy being fully cut off from bond markets, i.e. requiring all funding

through EFSF/ESM/IMF loans, with European rescue funds only able to cover them until the end of 2013;

resistance from core countries against further support; a significant delay of ESM implementation; a Portuguese default; a Greek euro exit by the end of 2012; or a major external growth shock.

Composite purchasing managers index stabilizing at low levels

Source: Bloomberg, UBS CIO, as of July 2012

Yield of Spanish and Italian 10-year bonds over German Bunds (in bps)

Source: UBS CIO, Bloomberg, as of 17 August 2012Note: Past performance is not an indication of future returns.* Scenario probabilities are based on qualitative assessment.

253035404550556065

07 08 09 10 11 12Manufacturing Services

Composite No-change line

0

100

200

300

400

500

600

700

01/2011 04/2011 07/2011 10/2011 01/2012 04/2012 07/2012

Italy Spain

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CIO View (Probability: 65%*) Sluggish expansion

• The economy stays on a moderate growth path but the unemployment rate comes down only very

gradually with a year-end 2012 forecast of 8.0%. Core personal consumption expenditures (PCE) inflation stays close to the Fed's target of 2%. UBS forecasts real GDP growth of 1.5% in 3Q 2012 and 1.8% in 4Q 2012 (consensus for both 3Q and 4Q: 2.2%). The Fed extended Operation Twist until the end of the year. On top of that, we see a 50% chance of more near-term monetary easing, with a slightly higher probability of QE3 (USD 500–750bn) than a discount window-based lending program. Should the Fed decide to embark on QE3, it would likely focus more on agency MBS instead of US Treasury purchases in order to support the housing market. UBS expects a first rate hike in early 2014.•

In the elections, Republicans will likely lose seats in the House on a net basis but retain a majority; we

expect them to be even with Democrats in the seat count in the Senate. Obama will likely retain the White House. Such an electoral outcome would prolong the existing gridlock between Republicans and Democrats.• Against the backdrop of ongoing political gridlock, we expect only moderate fiscal tightening of about

0.7% of GDP in 2013. The government will likely let unemployment benefits and the payroll tax cuts expire,

but postpone income tax hikes and "sequestration" spending cuts.

8

Key questions• Will the economic outlook deteriorate? Will additional Fed stimulus become necessary?

• How will the election result change fiscal policy deliberations?

• Can politicians find an agreement to avoid a sharp fiscal contraction in early 2013 (i.e. the "fiscal cliff")?

Key dates4 Sep

ISM manufacturing purchasing managers index for August

7 Sep

Nonfarm payrolls and unemployment rate for August6 Nov

US presidential and Congressional elections

Moderate US growth to continue

Source: Thomson Datastream, UBS CIO, as of 6 August 2012Note: For 2013 growth is spread evenly over all quarters to be consistent with a full-year growth rate forecast of 2.3%.

For further information please contact US economist Thomas Berner, thomas.berner@ubs.com

Please see important disclaimer and disclosures at the end of the document.

US fiscal cliff at year-end 2012

Key financial market driver 2 – US economic outlook

US real GDP and its components, quarter-over-quarter annualized in %

Source: CBO, UBS CIO, as of May 2012* Scenario probabilities are based on qualitative assessment.Note: Past performance is not an indication of future returns.

Fiscal budget balance effects of change in provisions under current law, in USD billion

Positive scenario

(Probability: 10%*) Strong expansion

• Propelled by expansive monetary policy and a fading Eurozone crisis, growth accelerates persistently

above 3.0%. This leads to higher inflation and the Fed responds by raising rates sooner than early 2014.•

The better economic outlook raises the odds of an Obama reelection and makes it harder for Republicans

to gain seats in Congress. Faster-rising tax collection and a Democratic stronghold leads to some tax hikes and limited spending cuts. Fiscal policy tightens by about 1.2% of GDP in 2013. Negative scenario

(Probability: 25%*) Growth recession

• US fiscal deleveraging and an escalating Eurozone crisis weigh on the cyclical recovery, thus growth

deteriorates. The Fed eases further, most likely massively purchasing agency MBS and Treasuries. •

The debt limit is reached earlier and the Treasury runs out of money before year-end. Political gridlock

becomes dysfunctional, thus sending the country over the "fiscal cliff," with fiscal policy tightening by

USD 607 billion (3.7% of UBS estimate of 2013 GDP) in 2013. The US credit rating is downgraded.

FY2013

Expiration of certain income tax and estate and gift tax provisions and of indexing the AMT for inflation 221Expiration of the reduction in the employee's portion of the payroll tax 95Other expiring provisions 65Taxes included in the Affordable Care Act 18Effects of the automatic enforcement procedures specified in the Budget Control Act 65Expiration of eligibility to start receiving emergency unemployment benefits 26

Reduction in Medicare's payment rates for physicians 11Other changes in revenues and spending 105

Total effect without economic feedback effect 607Effects of economic feedback -47

Total effect 560

-12%

-10%-8%

-6%-4%

-2%

0%2%

4%6%

8%

Q12006

Q12007

Q12008

Q12009

Q12010

Q12011

Q12012

Consumption Commercial real estate investmentCapital expenditures Residential investmentInventories Net ExportsGovernment Real GDP (q/q annualized)

UBS CIO forecastsq/q annualized

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9

Key financial market driver 3 – China growth outlook

CIO View (Probability: 70%*)

Gradual investment-led recovery in 2H12

• We continue to expect a gradual economic recovery in H2. There could be some downside risk though to

our higher-than-consensus 3Q12 GDP growth forecast of 8% y/y given recent data disappointments.

• In the coming months, we look for monthly new loans to reach CNY 600bn or above in 3Q12 and possibly

slightly below that in 4Q12. The proportion of medium- and long-term loans should increase gradually to

50% or above of total loans. •

However, destocking will become less of a drag on growth. The official PMI was down 0.1 points to 50.1

in July, but the decline was more benign than in the past when the July figures were on average 1.1 points lower than those in June. While production and new orders weakened slightly, finished goods inventory plunged a visible 4.3ppt to 48, indicating the pressure for corporate destocking may alleviate going forward.•

More pro-growth policies have been introduced by central and local governments recently, e.g. raising

2012 railway spending twice to around CNY 500bn (railway investment growth rebounded sharply in July), expanding structural tax cuts through a VAT reform to 8 more provinces/cities, enacting various "stimulus" packages from local governments focusing on infrastructure investment, etc. Although we do not expect new major stimuli this year, we believe these measures will help

stabilize growth momentum.

• All in all, with the impact from destocking fading as inflation

bottoms in 3Q12 and the ongoing recovery

in infrastructure investment, we continue to expect a gradual investment-led recovery in 2H12. The weakness in new construction starts is, however, likely limiting

the upside.

For further information please contact CIO analyst Gary Tsang, gary.tsang@ubs.com, Glenda Yu, glenda.yu@ubs.com, Patrick Ho, patrick-ww.ho@ubs.com

Please see important disclaimer and disclosures at the end of the document.

Key questions• What is the current state of the economy?

• What are the important indicators to watch for growth recovery?

• What can we expect from the government to support the economy ahead?

Key dates 1 Sep Manufacturing purchasing managers index (August)9 Sep

Fixed asset investment, industrial production, consumer price index (August)

11–15 Sep New bank lending, M2 (August)22–25 Sep

HSBC flash manufacturing purchasing managers index (September)

Look for further pick-up in infrastructure investment

Source: Bloomberg, UBS CIO, as of 17 August 2012Note: Past performance is not an indication of future returns.* Scenario probabilities are based on qualitative assessment.

Both amount and structure of loans matter

Source: Bloomberg, UBS CIO, as of 17 August 2012

Positive scenario (Probability: 20%*)

Higher-than-expected growth

• Chinese GDP grows above 8% in 2012. We lowered it from 8.5% to reflect the growth slowdown. This

would probably require stronger-than-expected fiscal and monetary policy support from the government. A speedy improvement in the Eurozone debt crisis could also lead

to this positive scenario.

Negative scenario (Probability: 10%*)

Hard landing

• Chinese GDP growth below 6%, i.e. a hard landing of the economy. This could be triggered by a global

financial crisis/recession, causing a slump in Chinese exports. Other risks include a sharp decline in Chinese residential property prices (which would slow investment growth), a large-scale default of local government debt, or a surge in inflation that forces the PBoC

to significantly tighten monetary policy.

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Contact list

UBS WM Global Chief Investment OfficerAlexander Friedmanalexander.friedman@ubs.com

Head of InvestmentMark Haefelemark.haefele@ubs.com

Global Investment Office

Themes / UHNWSimon Smilessimon.smiles@ubs.com

Kiran Ganeshkiran.ganesh@ubs.com

James Purcelljames.purcell@ubs.com

Christopher Wrightchristopher-zb.wright@ubs.com

Asset Allocation AdvisoryMark Andersenmark.andersen@ubs.com

Karsten Baggerkarsten.bagger@ubs.com

Achim Peijanachim.peijan@ubs.com

Philipp Schöttlerphilipp.schoettler@ubs.com

Asset Allocation DiscretionaryMads Pedersenmads.pedersen@ubs.com

Walter Edelmannwalter.edelmann@ubs.com

Markus Irngartinger, CFAmarkus.irngartinger@ubs.com

Oliver Malitiusoliver.malitius@ubs.com

Matthias Uhlmatthias-w.uhl@ubs.com

Regional CIO SwitzerlandDaniel Kaltdaniel.kalt@ubs.com

Regional CIO South Asia-PacificKelvin Taykelvin.tay@ubs.com

Regional CIO North Asia-PacificYonghao Puyonghao.pu@ubs.com

Regional CIO Emerging MarketsJorge Mariscaljorge.mariscal@ubs.com

Regional Chief Investment Officers

Regional CIO EuropeAndreas Höfertandreas.hoefert@ubs.com

Alternative InvestmentsAndrew Leeandrew.lee@ubs.com

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