CIO Year AheadCIO Wealth ManagementWealth Management

2014

A journey to your fi nancial goals.

CONTENTS

12 Economic outlook A world shaped by

deleveraging and convergence

Global growth shi ing up a gear in 2014

20 Monetary policy outlook The hard way forward from

easy money

08 Editorial 2014: Time to re-orient

Observe

CIO Year Ahead 2014This report has been prepared by UBS AG and UBS Financial Services Inc. (“UBS FS”).

This report was published on 11 December 2013.

Editor in ChiefMark Andersen

Project ManagementPaul LeemingNikki AckermanBrian AldenCorrine FedierRéda MouhidSita L. Chavali

EditorsThomas GundyAndrew DeBooCLS Communication

DesignLinda Sutter

LayoutCIO Digital & Print Publishing, UBS AG

24 Investment principles Look before you leap

Succeeding with timeless investment principles

28 Strategic asset allocation Asset allocation in 2013,

a retrospective

Orient Decide

34 Asset allocation Positioning portfolios for

2014 and beyond

35 Bonds Limited value

37 Corporate and emerging market bonds

Count on credit

41 Agency debt & mortgage backed securities

2014: the death of the carry trade

42 Municipal bonds Managing credit risk

43 Preferred securities Look back to look forward

44 Investment theme Tiptoeing out the yield curve

45 Equities Stay stocked up on stocks

This report has been prepared by UBS AG and UBS Financial Services Inc. (“UBS FS”).

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

48 US equity sector strategy Further fuel for cyclicals

49 Investment themes Water: thirst for investments

Energy independence: forward march

Dividend investing: don’t overpay for yield

52 Currencies A major rebound

54 Commodities Little in return

56 Hedge funds Attractive risk-adjusted returns

expected

57 Private markets Complement traditional

portfolios

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2014:Time to re-orient

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EDITORIAL

Alexander S. Friedman Global Chief Investment OfficerWealth Management

S ince 2008, the main secular trends driving the markets have been deleveraging and declin-ing core government bond yields. As we end 2013 and move into 2014, these trends are changing in important ways. US Federal Reserve Chairman Ben Bernanke’s speech last May to the US Congress, suggesting that the central bank was considering “recalibrating” its

pace of asset purchases, sparked a retreat in government bond prices and ended their three-decade long secular bull market. The era of falling government bond yields and perpetual stimulus appears to be ending.

This adjustment caused a sharp sell-off in many emerging markets, particularly those with dual fi scal and current account defi cits. Combined with China’s diffi culties in containing credit growth while maintaining its economic expansion, this situation laid bare the need for structural reforms in many of the larger emerging markets. Implementing such reforms will mean these economies will likely grow at a slower pace than investors have become used to over much of the past decade.

In the developed markets, we have moved further down the long road of deleveraging that began in 2008. In the US, the private sector deleveraging process appears close to complete, with house prices having risen markedly. Public sector debt remains high, but as long as the US dollar remains the world’s reserve currency, the US faces little external pressure to reform its fi scal profi le. In the Eurozone, bank deleveraging still has a way to go, but government austerity is easing and is no lon-ger acting as a major drag on economic growth and political confi dence. And in Japan, the govern-ment enacted its most aggressive attempt yet to end its roughly two-decade-long economic malaise, combining aggressive monetary and fi scal stimulus with structural reforms.

So, as what may come to be viewed as a game changing year winds down and we look to the future, it makes sense for investors to take stock of some of the structural shi s underway and re-orient their portfolio holdings.

It is therefore important to remember that even in the unusual world we have lived in since 2008, the basic principles of investment management have not changed.

First, at the core is the idea that investors should not take unnecessary risks. This means that inves-tors should diversify across, and within, asset classes. A concentrated portfolio of individual stocks contains much greater idiosyncratic risk while off ering no greater expected return than a widely diversifi ed basket.

Mike Ryan Chief Investment StrategistWealth Management Americas

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Second, it can be easy for investors to underestimate risks close to home, due to familiarity. Home bias, however, can lead to excess risk for no commensurate return. Investors should avoid home bias by diversifying globally.

And third, when diversifying, investors should consider hedging their currency exposure. Currencies tend to add little more than noise to investment performance. Hedging enables an investor to reduce risk without sacrifi cing returns.

Beyond these core tenets, there is also now a need for investors to consider making shi s in their portfolio construction to account for the structural changes we mentioned earlier.

First, diversifi cation across asset classes remains critical, so investors should still generally hold bonds as well as equities in their portfolios. But the beginning of the end of quantitative easing will bring about rising bond yields, undoubtedly aff ecting the returns available in bonds. The best solution to this problem could prove to be credit, which off ers not only some of the diversifi cation benefi t of government bonds but also a higher return. As a result, we believe credit should play a more inte-gral role in investors’ allocations than may have been assumed in recent years.

Second, the end of the era of falling bond yields will not come without its risks. We witnessed in May and June how worries about a withdrawal of central bank stimulus can temporarily lead to all asset classes falling in tandem. Investors will need to increasingly consider alternative investments as sources of less correlated returns.

Finally, a er annualized returns of more than 15% from global equities and around 20% from high yield credit over the past fi ve years, investors will have to revise down their return expectations. Economic and earnings growth have simply not kept pace. We expect annual equity returns to be more in the range of 7%–8% over the coming fi ve to seven years. Therefore, fi nding extra return will require not only increased allocations to alternatives, but also the agility to adjust to changes in short-term market conditions. Entering 2014, our highest tactical conviction is to be overweight “risk” assets, including equities and US high yield credit.

That said, a number of dangers do potentially lurk in the year ahead. We face the threats of contin-ued US government dysfunction, a Chinese credit crunch, a reappearance of the Eurozone crisis, and the possibility of infl ation in Japan without economic growth, producing pressure on its government bonds. Cutting across these risks is the biggest risk of all – policy error. We still rely on policymakers to make the right choices at the right times.

Overall, however, the environment for risk-seeking investors appears positive. We expect 2014 will produce 3% growth in the crucial US economy, close to the highest growth rate in the developed world. Meanwhile, the Eurozone should fi nally experience modest expansion. And we anticipate that the overall global economy will grow by 3.4% over the next 12 months, the fastest pace of growth since 2010.

All the best for the year ahead.

Alexander S. Friedman Mike RyanGlobal Chief Investment Offi cer Chief Investment StrategistWealth Management Wealth Management Americas

Observe:Before you start your journey, you need to observe the environment that shapes the investment landscape.

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A mong the largest developed countries, the US economy is best positioned and boasts the stron-gest growth outlook (see Fig. 1). We foresee the US expanding on average by 2%–3% per year,

as opposed to the Eurozone’s 1%–2% over the next fi ve to seven years. China should continue to lead the emerg-ing world and outpace most developed nations growth-wise, but its expansion has decelerated from the 10% it posted since remaking its economy in the early 1980s to a level of 7%–8%. In the process of converging toward the developed world, emerging markets (EM) are seeing their growth rates naturally decline, though due to their larger economies, they have more impact on the rest of the world than ever before.

As for infl ation, we expect prices to rise only mod-erately despite the ultra-expansionary monetary policies major central banks are still pursuing. Slower GDP growth means that it will take years to close the existing output gap in the developed nations – the diff erence between a coun-try’s actual GDP (or output) and its potential GDP – and to reduce unemployment rates to pre-fi nancial crisis levels. Consequently, companies will fi nd it diffi cult to raise prices for their goods and services, and workers will have little bar-gaining power to secure higher wages. We see infl ation in developed markets reaching 1.5%–2.5%, and running 2%–3% higher in emerging economies as prices there grad-ually converge toward those of the G7 nations.

A world shaped by deleveraging and convergenceThe global economic growth seen in recent decades will not be repeated in the fi ve to seven years ahead, as developed market deleveraging and emerging market convergence continue to shape the world.Andreas Hoefert, Chief Economist, Regional CIO Europe

The forces behind growthLong-term economic growth in a country or region is deter-mined by the workings of three diff erent forces – labor, capi-tal, and productivity. We thus need to look at current trends in each of these input factors to grasp the direction the global economy is heading over the next fi ve to seven years.

Labor will not be the crucial constraint. The growth of a country’s workforce depends on how fast its popula-tion rises. However, while crucial to their long-term growth outlook, workforce size will not constrain most developed nations for some time to come. Their unemployment rates remain high and their labor market participation rates con-tinue to fall as discouraged workers stop looking for jobs. The US and the Eurozone face the problem of too little demand for labor rather than too little supply of it, a situation unlikely to change in the next two or three years, and one that will keep policymakers busy trying to fi nd ways to reinvigorate pri-vate demand.

Demographic change also plays a vital role in capital accumulation. Typically, people save money during their work-ing lives, which increases the capital stock. A er they retire they live on their savings and reduce that store of capital. Based on this framework, capital in the US can be expected to grow relatively strongly in the years ahead from its current low level as the baby boomers reach their “high saving years” right before retirement age. Japan will likely experience much lower capital growth as retirees spend their savings.

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Why bother with economics?

Understanding how diff erent regions and countries will evolve

over the next fi ve to seven years from both a growth and an

infl ation standpoint is crucial to determining one’s longer-

term Strategic Asset Allocation (SAA). This might be viewed

as a daunting task given the less-than-stellar track record of

economic forecasts over a typical one- or two-year time

frame. However, because the factors aff ecting long-term

growth and infl ation rates – those that prevail in a country or

region beyond short-term business cycle fl uctuations – are

well-established, we can assess them relatively well.

In general, demographic developments continue to support stronger economic growth in emerging than in devel-oped nations. The UN estimates that population growth in the former will surpass that in the latter by a full percentage point in each of the next 10 years. Greater population growth off ers advantages not only in terms of total “labor input” but also in maintaining the ratio of working to retired people. This so-called support ratio has been eroding steadily in devel-oped economies. It has dropped in the US from 7.8 in 1950 to 5.1 today, and is expected to fall below four by the end of the decade. The situation is even bleaker in Western Europe, where the ratio will plunge to three, and Japan, where each retiree, once able to rely on 12 workers in 1950, will have to make do with just 2.1 in 2020. In contrast, emerging coun-tries´ higher birth rates will keep that ratio between six and 10 for the foreseeable future.

Deleveraging and convergenceTwo factors stand out in terms of aff ecting the growth rate of capital: deleveraging and convergence.

In the wake of the fi nancial crisis, the private, and even sometimes the public, sector of many developed econo-mies has been deleveraging, reducing debt and fi xing bal-ance sheets. Hence, fi rms have been unwilling to borrow for the purpose of investing. That said, even if they did wish to borrow, they would face fi nancial intermediaries, i.e. banks, reluctant to lend to them because they themselves are in the

US3.0 %

UK2.3 %

Eurozone1.1 % Japan

1.5 %

Switzerland2.0 %

Mexico3.4 %

Brazil3.0 %

Russia2.5 %Poland

2.8 %

South Africa2.7 %

Turkey3.8 % China

7.8 %

India5.7 %

Australia3.3 %

Canada2.6 %

Fig. 1: Expected real GDP growth in 2014 (adjusted for infl ation), in %

Source: UBS, as of 26 November 2013

The size of the bubbles represents the countries’ current share of global GDP.

process of repairing their balance sheets. Such a “balance sheet recession” can last much longer than a normal business cycle and has been weighing on many developed economies in recent years.

Japan, Switzerland and several Nordic countries expe-rienced an extended period of stagnation in the 1990s a er their housing bubbles burst. The US, UK and many periph-eral Eurozone nations are – or have been – in the midst of a

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similar situation. The US and UK appear relatively far along in their deleveraging eff orts and in cleaning up the balance sheets of their fi nancial sectors. While credit activity has been rising for more than a year in the US, it was still falling as of the end of 2013 in the Eurozone (compared with the pre-vious year), and is expected to remain tepid. This illustrates a decoupling in the deleveraging process between the two regions and is a critical reason why we see the US maintain-ing its stronger position in the years ahead.

Emerging markets are undergoing the phenomenon of convergence, which means that, everything else being equal, investment activity will be more pronounced where capi-tal remains scarce because higher returns on capital can be expected. This leads to a greater growth rate of capital and, more generally, stronger economic expansion in emerging than in developed nations (see Fig. 2). However, convergence does not aff ect all emerging markets equally. A country can experience it to a greater or lesser degree depending on its institutional framework (whether the rule of law and clearly defi ned property rights prevail within it) and educational sys-tem (how good it is).

Productivity: Putting it all togetherThe productivity of an economy ultimately determines how effi ciently the input factors of labor and capital can be trans-formed into output. Technological progress is an important determinant of how quickly productivity increases. Over time, the rate of progress tends to even out within developed econ-omies but can vary over a single business cycle. It also plays a part in the convergence story of emerging markets: as the Chinas and Indias of the world approach the level of develop-ment that characterizes fully industrialized nations, they see their rate of technological progress gently decline toward that of the leading industrial countries.

Infl ation expected to remain in checkSince the Lehman Brothers bankruptcy in September of 2008, the balance sheets of the central banks in the G7 countries have increased threefold. The US Federal Reserve’s current monetary base is four times as large as it was before the fi nancial crisis, while the European Central Bank’s is “only” twice as large. The Bank of Japan announced at the begin-ning of 2013 that it would double its monetary base by 2015. While such central bank balance sheet expansion was argu-ably necessary to break the downward economic spiral during the fi nancial crisis, it le many fearing an eventual rapid rise in the price of goods and services as a consequence.

Remembering the famous Milton Friedman mantra that “infl ation is always and everywhere a monetary phenome-non,” one can only marvel that infl ation hasn’t reared its ugly head so far and that infl ation expectations remain “well-anchored” in the jargon of central bank offi cials, despite the tremendous amount of money that has been created.

There are several explanations for infl ation’s no-show. The most common is that many developed economies are operating at far less than capacity. The International Monetary

Source: IMF, UBS, as of 26 November 2013

Fig. 2: Emerging economies outpacing their developed peersDevelopment of GDP per capita in USD (index 1980 = 1; incl. IMF forecasts)

30

35

10

5

15

25

20

01980 1985 1990 1995 2000 2005 2010 2015 2020

KoreaBrazil

ChinaIndia

US

Estimates

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DemographicsOver a long time frame, population growth plays a prominent

role in infl uencing growth. From UN projections we can infer

that the US, in the next 20 years, will add another 57 million

people to its current population of 312 million and has better

economic growth prospects than the Eurozone, whose 331

million inhabitants will be joined by just another eight million

in that same time period. The US benefi ts in this regard from

its open immigration policy and birth rate of almost 2.1 per

woman: even absent immigration, the US population can sus-

tain itself, in contrast to the EU (with its 1.6 birth rate), Japan

(1.4) and even China (1.6). In addition, the US excels at

attracting young skilled immigrants. From 2000 to 2010, its

net immigration amounted to 5.1% of its total population,

well ahead of such competitors as the UK (3.1%), Germany

(1.6%) and Japan (0.3%).

Fund estimates that the US economy in 2013 is still running roughly 5% below its potential output. Closing this output gap will take the better part of this decade. Unemployment rates remain markedly higher than they were pre-crisis and are only slowly retreating. In some peripheral European coun-tries, they exceed 20%. Cost-push infl ation can gain little traction where wage costs stay fl at or decline due to high unemployment.

The infl ation prospects for the emerging markets as a whole are easier to describe. Indeed, as mentioned above, many emerging economies have begun decisively converg-ing with their developed counterparts. As they do, their real exchange rates tend to appreciate, i.e. either their currency itself appreciates or, more commonly, infl ation powers the rise. Therefore, even when governed by a conservative cen-tral bank, emerging markets will tend to experience higher infl ation than their developed counterparts do. The GDP-per-capita convergence of emerging markets means, ultimately, that their price levels draw closer and closer to those of the developed economies as their non-tradable goods, i.e. ser-vices, rise in price as a consequence of their increasing wealth and the greater purchasing power of their inhabitants. •

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Global growth shifting up a gear in 2014

T he environment in 2014 will be characterized by faster global economic growth. We expect world GDP to expand by 3.4%, the fastest pace of growth since 2010, as the eff ects of fi scal auster-

ity fade in both the US and the Eurozone. This should also help support emerging markets, where we expect growth of 5.0%, a er 4.5% in 2013. There is still suffi cient slack in labor markets to keep infl ation in check, and so major central banks will be able to maintain loose monetary pol-icy. The US Federal Reserve is likely to phase out its bond purchase program through 2014, but is highly unlikely to raise interest rates.

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US:

Transitioning to a self-sustaining recoveryThomas Berner, Economist

Among the developed countries of the world, the US is likely furthest along in the process of deleveraging. We expect pri-vate sector balance sheets to stop shrinking in 2014, which would support increased consumer and business spending and thus economic growth.

US fi scal policy, however, can still trigger major sur-prises, especially since decisions about the debt ceiling and the budget have simply been delayed. Even assuming they have no severe economic consequences, they pose signifi cant event risk for markets in the short term. But if we look past such temporary uncertainty, the picture will actually brighten in 2014. The fi scal drag will likely abate further, from an esti-mated 1% of GDP in 2013 to around 0.3% in 2014. While an additional USD 45bn in sequester spending cuts (about 0.3% of GDP) are legally due in 2014, we sense little to no appetite in Congress for raising personal taxes further, and don’t expect a dramatic shi in fi scal policy a er the next round of budget negotiations in early 2014.

All eyes will thus be on the private sector in 2014, as we expect US household spending to accelerate and spur on a more robust, self-sustaining recovery. Factors infl uenc-ing consumption have turned positive and should serve to boost it. The almost two-year-old rebound in house prices has underpinned the rise in household wealth. Households are more willing to take on new debt, while banks have turned sympathetic to lending more freely. Real labor income growth remains mediocre, but we expect easier credit conditions to raise overall economic activity and, with it, growth in payrolls and real wages. Households also face fewer hindrances to spending. The savings rate has already increased to a more sustainable level of around 4.5%, higher personal taxes have been absorbed, interest rates have retreated somewhat again, and infl ation has stayed low. We expect real consump-tion to climb from its average rate of close to 2% since the recovery began to close to 3% as 2014 progresses.

The pickup in household spending should persuade businesses to invest at a faster pace, especially since the other key drivers of capital expenditure (capex) are all conducive

to increasing it. The cost of capital remains low. The average age of the capital stock outstanding is at a 50-year high. The capex share of GDP is still below its long-term average, and aggregate stock prices have risen to all-time highs. If we com-bine the spending of the private and government sectors, we see real GDP growth expanding from just above 2% in 2013 to slightly above 3% in 2014 (on a 4Q-to-4Q basis).

The speedier growth will help take up labor market slack more rapidly: we envision unemployment falling well below 7% by year end. A jobless rate approaching 5.5% is consistent with full employment in the long run, so we don’t anticipate infl ation galloping away, only slowly rising higher toward the Federal Reserve’s goal of 2%.

A stronger private sector recovery and fading fi scal drag in an environment of moderate infl ation will enable the Fed to scale back its bond purchases in early 2014 and stabi-lize the size of its balance sheet toward the end of the year.

“ The US is likely furthest along in the process of deleveraging.”

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Europe:

More stability, more growthRicardo Garcia, EconomistBill O’Neill, StrategistCaesar Lack, Economist

The economic recovery in the Eurozone is expected to gain ground in 2014, though it’s doubtful that growth will reach even half the rate we expect for the US (see Fig. 3). The Eurozone private sector is still digging itself out of debt, and the deleveraging, along with the forthcoming bank stress tests and new capital requirements that could still crimp banks’ ability to lend, is likely to limit the continent’s eco-nomic expansion.

Still, even modest growth beats the contraction of last year. A er peaking in 2012, austerity remains on the retreat and the fi scal drag is decreasing. We anticipate fi scal

tightening of only half a percentage point on average for 2014 – down from almost a full point in 2013 – which should fi nally permit the economy to breathe a bit easier. Consumer confi dence, benefi ting from greater economic and political stability and a stabilizing unemployment rate, is expected to settle in at more normal levels. The better fi nancial condi-tions and increased external demand should enable fi rms to invest more than in recent years. A rise in exports, however, should also be accompanied by recovering imports as pent-up demand materializes, which would cap the large gains in net trade observed in recent years. Consumer price infl ation is expected to fall well short of the European Central Bank (ECB) target of just under 2%. Faced with low infl ation and mediocre growth, the ECB, in our view, will retain its eas-ing bias to boost the recovery and provide enough liquid-ity when banks fi ll their capital shortfalls stemming from the stress tests.

Meanwhile, some downside risks persist: economic dis-appointments could bring a country, such as Cyprus, close to default and reignite exit fears. However, we believe the ECB and its mechanisms will continue to serve as a credible back-stop against any return to crisis. While political developments could disrupt the recovery, we expect the current relative calm to persist. For instance, early elections are likely to be held in Italy in the fi rst half of the year, but chances are good that the outcome will be a stable majority as opposed to the current “hung parliament.”

Elsewhere on the continent, the Swiss economy is expected to experience robust growth. While exports stag-nate, the domestic economy booms on the back of strong private consumption, easy monetary policy and greater immi-gration. As long as the euro-Swiss franc exchange rate fl oor of 1.20 stays in place, and we see no near-term end to it, Switzerland in eff ect continues to follow the ECB’s accom-modative monetary policy, which will go on fueling consump-tion and driving housing prices higher. We expect the Swiss economy to grow by 2% in 2014.

The UK is expected to outpace even Switzerland at 2.3% real GDP growth, as its housing support measures, easier access to credit and declining household savings rate kickstart its economy. We anticipate the Bank of England will maintain its loose monetary stance through 2014, despite a decline in the unemployment rate.

4

65

789

–5

–3–4

3210

–1–2

1992 1996 19981994 2000 2002 2008 201220102004 2006 2014

Estimates

Emerging markets

US

Eurozone

Source: IMF, UBS, as of 26 November 2013

Fig. 3: Growth shi ing up a gearReal GDP growth and forecasts for 2014 in %(adjusted for infl ation)

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Emerging markets:

Moderately faster expansionCosta Vayenas, Analyst

A er tracing a fl atter trajectory for three straight years, eco-nomic growth in the emerging markets (EM) should rise mod-erately again in 2014, reaching 5% from around 4.5% in both 2013 and 2012. A 5% real GDP growth rate on almost USD 30trn would enlarge the EM share of the global econ-omy to nearly 40%. The larger emerging countries – Brazil, Russia, India, China – are facing the need for structural changes as they converge toward the more developed econ-omies. This process will require some of them, like China, to adapt to lower annual rates of growth than what they have become accustomed to.

The highest risk for those emerging economies that rely on foreign capital inflows to finance growth stems from higher global interest rates. The “fragile fi ve” (India, Indonesia, Brazil, Turkey, South Africa) are particularly vulner-able, though some of them, such as Indonesia, have made structural improvements recently. Additionally, an earlier-than-expected tightening of the US Federal Reserve’s mon-etary policy could cause renewed capital outfl ows and weigh on currencies such as the Indian rupee. Overall, however, as exports pick up we expect net capital fl ows into EM to trend higher into 2014 from the outfl ows seen last year. Any weak-ening in US and/or European growth would curtail exports in China and curb growth across EM, but our outlook for higher growth in the developed world bodes well for EM.

Asia fuels the growth engineWe expect Asia to continue to grow fastest, at more than 6% in 2014 from 5.5% in 2013. Much will depend, of course, on the performance of China. Its trend growth has begun declining from its almost 10% pace of recent decades, and for 2014 we expect its GDP to expand by 7.8%. Rapidly rising Chinese residential property prices and/or broad infl ation would force the central bank to tighten policy, which would hurt growth. But we think the govern-ment’s policy fi ne-tuning will keep a lid on new credit and infl ation. The second-largest emerging market, India, should accelerate from the near 5% it notched in 2013 to closer to 5.7% in the year ahead.

Latin America stays below potentialLatin America, in our estimation, will rev up moderately to 4% from 2013’s 3.5%. We expect Mexico to recover strongly and expand at 3.4% – more than double its growth rate in 2013 – thanks in large measure to its close trade links with the US. Structural reforms should also boost its longer-term potential and attract foreign direct investment. Our outlook for Brazil is less sanguine. We think the Brazilian economy will be hampered by persistent high infl ation and structural defi cits, which are likely to limit GDP expansion to 3% in the year ahead.

Fundamentals challenging in EMEAIn emerging Europe, Middle East and Africa (EMEA), we should see a growth speed-up to 3.5% from below 3% in 2013. Russia limped along at an average rate below 2% in 2013, but increasing domestic consumption should raise growth to 2.5%, though economic conditions will remain challenging as its commodity-based growth model of the last decade proves unsustainable. In Turkey we foresee growth approaching 4%. Trade links to Western Europe are a plus for the country, but its large current account defi cit clouds the longer-term picture. The outlook for South Africa is similar. The rand’s relatively cheap valuation and the country’s exposure to better European economic dynamics should revive growth, but dependence on external fi nancing poses a key risk to the economy, which we expect to expand by 2.5%–3%. •

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The hard way forward from easy moneyIn the years after World War I, US President Warren Harding called for “a return to normalcy.” Today, central banks around the world are seeking something similar after an extended period of unprecedented monetary policy.Thomas Berner, Economist Achim Peijan, Strategist

I nterest rates still sit at or close to zero in most developed countries, while monetary stimulus policies enacted at the onset of the fi nancial crisis persist in the form of various kinds of quantitative easing. Getting to normal-

ized rates and self-sustaining economies is the daunting task central bankers face.

The obstacles to tighteningGrowth today remains fragile. One of the key questions econ-omists and policymakers confront is when the global econ-omy will be healthy enough to withstand a shi to tighter monetary policy. The nervous manner in which fi nancial mar-kets reacted when US bond yields rose rapidly in mid-2013 a er the US Federal Reserve indicated it could reduce mon-etary stimulus over time illustrates their vulnerability.

This sensitivity to higher interest rates originates in the large debt levels accumulated by most developed countries and the inverse relationship between sustainable debt and interest rates. The lower interest rates are, the higher is the sustainable debt level. If interest rates increase sharply with-out any accompanying economic improvement, the risk that the deleveraging process will intensify, i.e. that debtors will step up eff orts to reduce their borrowings without creditors off setting the declining demand for goods and services, rises.

The solution, however unpleasant, is for central banks to tighten monetary policy in the not-too-distant future. The longer central bank rates remain at or close to zero (and real rates negative), the more problematic it becomes to raise them later. Low interest rates currently may prop up investments that might turn unprofi table should borrow-ing become more expensive. People may go back to buy-ing houses they can ill aff ord. Likewise, companies based on shaky business models that survive in today’s benign environ-ment might very well struggle if rates were to rise too rapidly.

Normalizing monetary policy conditions looms as a delicate balancing act that central bankers face in the years ahead.

The long way back to normalWith growth expected to remain restrained due to ongoing deleveraging and new banking rules, we see little infl ation-ary pressure arising in the near term. As has been the case

Current motives for supportive monetary policy:

To off set deleveraging forces originating from high debt

levels in the private and public sectors and stabilize aggre-

gate demand, as in the case of the US, UK, Europe and

Japan

To increase domestic demand and keep a currency rela-

tively weak to off set sluggish international trade and a

loss of competitiveness, as in the case of Japan and China

To prevent currency appreciation, as in the case of

Switzerland and Scandinavia

To provide liquidity to the banking sector to mitigate the

deleveraging of bank balance sheets and declining asset

prices that could jeopardize the solvency of borrowers, as

in the case of Europe

To stimulate demand from private investors for less liquid

assets, as in the case of the US, with its purchase of USD

1.3trn of mortgage-backed securities in recent years

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since the fi nancial crisis commenced, central bank money cre-ation alone appears to be insuffi cient to provoke the infl ation beast. Both infl ation and infl ation expectations look very sta-ble. Therefore we do not expect the major developed market central banks to raise interest rates during 2014. We expect the Fed to apply the brakes to its bond-buying program (QE3), with its balance sheet peaking sometime in late 2014.

In 2015, we expect the Fed to start raising interest rates. However, the pace of the hikes will be slower than in the past, when the Fed raised rates by roughly two per-centage points per year on average. We currently assume an increase of about 1% annually. Toward the end of 2017 we anticipate that the Fed funds and the US dollar short-term

Transmission channels obstructed Andreas Hoefert, Chief Economist, Regional CIO Europe

One important explanation for the lack of infl ation is the fact that

the so-called transmission channels of monetary policy, the two

main avenues by which central bank money fl ows into the real

economy, are clogged. The money multipliers, through which the

credit activity of the fi nancial intermediaries transforms and mul-

tiplies central bank money into the actual money used in an econ-

omy, make up the fi rst channel. The second consists of the velocity

of money, how o en money changes hands within a specifi c peri-

od of time. Both have deteriorated signifi cantly in the past fi ve

years.

In the US, for example, the money multiplier transforming the

monetary base into “actual” money stood at 9x in the fourth

quarter of 2007, but was only 3.3x in the third quarter of 2013.

Each freshly “printed” Fed dollar that created nine dollars of

“actual” money in 2007 results in barely a third of that today. The

velocity of money has dropped too, if not as dramatically. Given

the damage both channels have suff ered, infl ation is unlikely to

surge in the next fi ve to seven years.

At present central banks worldwide remain knee-deep in

eff orts to unclog the channels and improve the eff ectiveness of

their policies in stimulating growth. The Fed is furthest along in

this mission, as US banks’ greater willingness to lend indicates, but

the European Central Bank and the Bank of Japan have further

stepped up their attempts.

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2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Central bank policy rate 10-year Treasury yield

Estimates

Source: Thomson Reuters, UBS, as of 26 November 2013

Fig. 4: Rates will only increase graduallyUS central bank policy rate and 10-year Treasury yield (with forecasts), in %

money markets rates will approach 2.5%–3.0% (see Fig. 4). A er 2017 we expect the Fed funds rate to climb to its “ter-minal” value of about 3%–4%.

We think real interest rates in other markets will also start to normalize. This process, along with our views on infl a-tion, determines our forecasts for the nominal central bank rates in these countries. We foresee a level between 2% and 2.5% for the Eurozone, 1.25% and 1.75% for Switzerland and 2.5% and 3% for the UK in 2017, with each therea er rising somewhat higher. •

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Orient:To choose the right path, you need to orient yourself toward your fi nancial goal and consider the challenges you might face on the way.

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T he journey toward any goal becomes easier with preparation. Where are you starting from? How much risk will you take along your path? Do you believe in your plan enough to stick with it when

the going is diffi cult?

Orient yourself:

Where are you?Understanding your fi nancial situation and personality – your investor profi le – helps you to determine the level of risk you are prepared to take, and thus, which destinations are within your reach.

Where do you want to go?Select a realistic destination and the best route for you. Some investors value preserving their wealth fi rst and foremost, while others favor capital appreciation strate-gies with more risk.

Look before you leapWhether you are embarking on a journey or investing your assets, preparation is vital. A clear goal and a well-planned route are critical to success.Mark Haefele, Global Head of InvestmentMark Andersen and Mads Pedersen, co-Heads of Asset Allocation

What should you take on your journey?A strategic asset allocation (SAA) forms the basis for deciding the best mix of investments to help you reach your goals. The SAA represents the asset classes and regions that you invest in over the longer term. Because the SAA determines about 80% of your portfolio’s return and risk over time, it is crucial to select the SAA that best matches your personal situation.

How will you adjust to the unforeseen?The Tactical Asset Allocation (TAA) represents the shorter-term allocation away from the longer-term SAA. Its six-month time frame is attuned to business cycle developments and momentum trends. The TAA should not jeopardize your long-term investment goals, and therefore needs to be imple-mented with all due attention to managing risk.

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Which is your route?

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Succeeding with timeless investment principlesMark Haefele, Global Head of InvestmentMark Andersen and Mads Pedersen, co-Heads of Asset AllocationChristophe de Montrichard, Strategist

I t’s great to watch the price of a stock you own dou-ble in a year. But over the long term, the lion’s share of your portfolio performance is determined by the alloca-tion among diff erent asset classes.

Frankly, much of what passes for successful investing in fi nan-cial newspapers stems from lucky timing and is o en short-lived. In our view, investors benefi t far more from focusing on their long-term strategy.

While we are passionate about the individual stocks and bonds we select, these timeless principles determine how we invest:

Top down – Allocate assets fi rst, then select instrumentsNumerous investors build their portfolios by selecting indi-vidual attractive investment opportunities as they arise, o en in the form of single securities. The overall proportions they hold in the various asset classes ( equities, bonds, etc.), however, are o en less carefully considered, yet they still determine the portfolio’s overall risk and return characteris-tics. Therefore, we believe in starting at the top, fi rst setting the asset allocation and then selecting the right instruments to fi t it.

Diversify among asset classes – and within themCombining asset classes, some of which will perform bet-ter in certain economic conditions while others shine under a diff erent scenario, can increase return while reducing risk, thereby ensuring a smoother path of portfolio returns. While two separate asset classes might both produce positive returns over the long term, they will not necessarily move in sync. For example, US equities and US government bonds have delivered 7.5% and 5.2% per annum respectively for the past 10 years. In 2008 during the fi nancial crisis, how-ever, US equities lost 37% of their value while US govern-ment bonds returned 8%. Portfolio diversifi cation is achieved by properly combining such asset classes to reduce overall swings (day-to-day and during a crisis) while maintaining long-term performance potential. Ultimately, a good port-folio is one that, relative to others, provides the best risk-return trade-off .

Diversifi cation within each asset class is also important. Investing in just a few US companies will expose you to spe-cifi c company and related managerial risks that may or may not work in your favor. A broader exposure to US equities provides a greater likelihood that you will benefi t from their expected long-term rise.

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Only assume risk for an expected returnInvestors should only take on risk when they think they will be well compensated for it. Each asset class must be ana-lyzed, and the value it brings to your portfolio needs to be clear. Foreign currencies require careful consideration: if you expect no gains from converting into them, remove the risk of loss through hedging.

Limit your biasesMany investors prefer to invest in companies and opportuni-ties “close to home.” While owning such assets can give you peace of mind, doing so in extreme proportions prevents you from diversifying worldwide. Therefore, we try to limit the home market bias in our recommended portfolios.

Set realistic expectations – and invest for the long termNo one enjoys their portfolio declining in value, whether on a daily, weekly, monthly or yearly basis. However, because most cash rates are close to zero currently, and many gov-ernment bonds yield less than 2%–3%, anyone who wants to achieve a better return has to assume additional risk. Achieving gains in the short term – time periods of less than a year – is no sure thing. Over a longer time frame (fi ve to seven years), however, we believe that asset prices tend to revert to a fair, calculable value, which makes portfolio returns more predictable. •

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Asset allocation in 2013, a retrospectiveAs we had forecast in our 2013 Year Ahead publication, returns in 2013 turned out to be more dispersed and lower overall than in prior years. So while diversifi cation worked in 2013, portfolio returns have trailed the stellar performance we saw in 2012.Michael Crook, StrategistStephen Freedman, Strategist

2013 asset class performance reviewAsset class performance has been highly dispersed within and between major markets. Developed market equities and high yield bonds are clear outperformers, but otherwise the invest-ment environment has been more challenging. Ten months into the year, the 2013 “effi cient frontier” is neither effi cient nor a frontier (see Fig. 5). Although we do not expect asset classes to always perform in a predictable or well-behaved way relative to each other in any given calendar year, the nature of dispersion this year has been somewhat unique.

Most fi xed income asset classes are fl at to slightly neg-ative. Based on index data, US government bonds declined 1.6%, municipals and investment grade credit are down about 2%, and emerging market bonds have lost 3%–4% year to date. Such setbacks in the bond market are not overly surprising considering that interest rates have risen about 100 bps over the course of the year. The one exception is the high yield corporate bond segment which is up over 6% this year.

Global equity market dispersion has been a bit unusual

in 2013 as well. Developed market equities have returned 20% or more, depending on the region and sector. Emerging market equities, on the other hand, are actually down about 2%. Assuming this holds through December, it will be the fi rst calendar year since 1998 in which emerging mar-ket equities have declined while developed market equities appreciated.

Despite slightly negative returns in many fi xed income assets, all of the major asset classes we track appear on course for a “normal” year, defi ned as being within one stan-dard deviation of our long-term return estimates2 (see Fig. 7). Better-than-expected performance has been concentrated in developed market assets, and US assets specifi cally. Yet, given the volatile nature of equity markets, returns in the order of 20% in US equities like we’ve seen this year are not unusual even if they are not expected to occur with regularity.

Diversifi cation worked in 2013Correlations between asset classes, which spiked during the

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2008-09 fi nancial crisis, have been relatively low this year. Additionally, none of the major policy risk events, including the government shutdown, resulted in spiking correlations among risk assets.

However, some unique correlations between asset classes manifested themselves this year, particularly within fi xed income. We typically expect US government bonds and US Investment grade (IG) credit to be moderately correlated with each other. They both exhibit interest rate risk, but the credit risk component of investment grade credit generally provides some disconnect between the two bond sectors. This year, however, the correlation has been 0.96 – meaning that they have been nearly perfectly correlated.

In contrast to the high correlation between IG and government bonds, the correlation between high yield cor-porates and government bonds has been virtually zero. Of course, we normally expect lower-grade credit to be more correlated to equities than to other types of fi xed income. This year has not been an exception in that regard, with cor-relations between high yield and equities coming in at 0.5 or greater. Investors who are tempted to shi the bulk of their portfolio toward high yield bonds and developed mar-ket equities on the basis of their strong 2013 performance should nonetheless refrain from excessively concentrating

their wealth in these two asset classes. Their high correlation means that in the case of an economic downturn or market shock, such a portfolio would off er very little diversifi cation to control volatility and protect assets.

Portfolio performanceRoughly speaking, portfolio returns have been in line with long-term return estimates in 2013. Globally diversifi ed mod-erate portfolios, not including fees or manager outperfor-mance (something increasingly common this year), will have returned about 7%–8% this year. In infl ation-adjusted terms that’s a real return of 5.5%–6%. Our long-term estimate is between 5.5% and 6% nominally (3%–3.5% real), so we’re above target thus far.

Fig. 6 provides return numbers into November for our moderate fl agship portfolio, a naïve 60/40 US equity/US fi xed income portfolio, and a global market cap portfolio.3 The rea-son why the naïve US-centric portfolio has outperformed the other two is that US assets have outperformed their interna-tional counterparts this year. Throughout 2013, we have cap-italized on this development by tilting our portfolios toward high yield and US equities which has benefi tted performance on the margin. That being said, even with these tilts, our portfolios contain international exposure and it’s clear that

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EM Equities

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Source: FactSet, UBS, as of 7 November 2013

Fig. 5: Asset class performance, 2013Performance year-to-date through 7 Nov

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Barclays AggUBS Moderate

PortfolioGlobal MarketCap Portfolio

Source: FactSet, UBS, as of 7 November 2013

Fig. 6: 2013 year-to-date returns have favored US assetsPortfolio performance year to date

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portfolios concentrated in US risk assets, including equities and high yield, have performed better. However, we believe that the more globally diversifi ed portfolios should provide better outcomes over multi-year periods.

Considerations for 2014 and beyondIt’s also important to keep in mind that strategic (long-term) asset allocations are not designed to be responsive to or try to capture the short-term market fl uctuations described ear-lier (that’s what tactical asset allocation is for). Instead, they represent well-diversifi ed starting points designed to limit exposure to specifi c risks as much as possible while meeting specifi c return targets over the course of a market cycle. That being said, there are dynamic aspects to strategic asset allo-cation as well.

For instance, strategic asset allocations (SAA) can be made to refl ect long-term fi nancial views beyond pure diver-sifi cation considerations. We did this in early 2013 when launching a new set of SAAs for UBS Wealth Management Americas. Based on reports published in 20114 and 20125, which made a case for a structural preference for emerg-ing market debt and emerging market equities, we adopted a long-term bias toward those assets that exceeds what an investor would normally hold absent any views.

In full disclosure, the impact of these emerging-mar-ket-tilted portfolios in 2013 has been uniformly negative. We currently remain confi dent6 that the long-term case favoring emerging markets remains in place and advise investors to

retain these exposures in their portfolios. However, were that view to change, our strategic asset allocation recommenda-tions would also change in kind.

Additionally, structural risk and correlation changes should be accounted for in strategic asset allocation deci-sions. For instance, we hold relatively large positions in high yield fi xed income across our portfolios. The 0.96 correla-tion between IG and government bonds this year is impor-tant in that regard because if we believed that such a high correlation would persist structurally (i.e. zero diversifi cation benefi t), it would justify modifying the makeup of the bond allocation.

However, at this time we feel very comfortable in main-taining our overall asset allocation recommendations. We believe 2014 has a good chance of being a year that is actu-ally “more normal” than the last two. Although we continue to prefer US equities and high yield bonds on a tactical basis, we acknowledge that we’re unlikely to see the same outper-formance in those positions in 2014 as 2013 has off ered so far.

While more-normal will likely mean more-modest returns, at least for US equities, we do expect to see contin-ued diff erentiation between sectors and regional equity mar-kets. Within fi xed income, the only real diff erentiation in 2013 has been between high yield and everything else. It’s reason-able that in 2014 investors should expect greater dispersion and better performance in that market as well. Unlike cash, a well-constructed bond portfolio has a good chance of provid-ing positive real returns in 2014. •

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EmergingMarketsEquity

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+1 Standard Deviation–1 Standard Deviation

ActualMedian (estimated)

Source: FactSet, UBS, as of 7 November 2013

Fig. 7: Returns have been within normal rangePerformance relative to 1-year estimates

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Decide: Along the journey, you need to make sound investment decisions. Insight into each asset class is vital.

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Positioning portfolios for 2014 and beyondHigher economic growth and accommodative central banks promote investments in equities and credit, over liquidity and government bonds.Mark Andersen and Mads Pedersen, co-Heads of Asset Allocation

W e expect stronger economic growth and accom-modative central banks to continuously favor equities and credit during the year ahead. We recommend refl ecting this in your portfolio by

being tactically overweight equities and credit at the expense of government bonds and liquidity.

Why we favor equities and credit Recent years have been kind to corporate credit and equities, among our overweight positions in 2013. Deleveraging in the developed world has led to only moderate growth of its economies, enough to hold down default rates and improve credit conditions but not enough to boost corporate earn-ings on a broad scale. With loose central bank monetary policy spilling over into 2014, companies will benefi t from low debt-servicing costs, as well as the expected speed-up in the global recovery. The resul ting increase in consumer and investor confi dence should further reduce the risk premium demanded for equities. The result: an environment that rewards equities and corporate bonds more than liquidity and government-backed bonds. Our tactical preference has been US equities recently but we are increasingly attracted to European equities.

Credit the better fi xed income optionUnprecedented central bank policies drove bond yields in many developed countries to record lows in recent years. This situation has created a dilemma for investors: the traditionally safe strategy of holding liquidity and government bonds has become “risky” by exposing investors to losses, as portfolio yields could fail to keep up with infl ation.

We advise investors to shi from traditional govern-ment bonds into corporate credit. We recommend corpo-rate bonds of medium and shorter duration as well as high yield credit. The easy financial conditions and improved growth outlook are expected to result in rising interest rates and lower returns for government bonds that barely exceed the infl ation rate in the years ahead. A move into corporate credit would help off set the eff ects of these trends by off er-ing a better return outlook. If the economy has improved enough for central banks to start hiking rates, it has probably improved enough for the yield spreads on corporate bonds to tighten and boost the bonds’ value.

These dynamics also hold true for emerging market (EM) sovereign and corporate bonds, which off er better return prospects than developed market bonds. As a re sult, we recommend a small strategic position in EM bonds for most portfolios. •

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GOVERNMENT BONDS

Limited valueGovernment bonds, and other bonds with strong credit ratings, will off er only limited returns in the years ahead. Nonetheless, they continue to provide safety and diversifi cation, and still have a role to play as part of a diversifi ed portfolio.Thomas Berner, Strategist Achim Peijan, StrategistDaniela Steinbrink Mattei, Strategist

M ajor developed economies have an interest in keeping government bond yields low to support their defi cit reduction eff orts and economic recov-eries. We think that most developed market sov-

ereigns cannot aff ord a large climb in interest rates because it would cause their budgets to teeter further out of balance and endanger debt sustainability. As a result, we expect cen-tral bank rates to remain low (see page 20, “The hard way forward from easy money”).

How quickly bond yields normalize will diff er from region to region depending on the speed at which each is recovering. As these diff erences in the pace of recovery become more evident, we anticipate the market distinguish-ing between regions and refl ecting local fundamentals in its pricing of future rates. Since we see the US furthest along in its economic recovery, we expect US rates and bond yields to lead the European markets, with Japanese bond yields lag-ging on the way to normalization.

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GOVERNMENT BONDS

Lower expected returns

We expect bonds to perform sluggishly over the next couple

of years. While short-term bonds suff er from very low cou-

pons, longer-term bonds will experience declining prices as a

consequence of rising yields. We expect yields over the next

fi ve to seven years to increase by about one or two percent-

age points from their current levels, depending on market and

maturity. Returns under this assumption will be positive but

unlikely to exceed the infl ation rate in some markets, meaning

that investors could lose in real terms (see Fig. 8).

While bonds of diff erent maturities are expected to pro-

vide comparably low returns, the degree of price variation

(volatility) among longer bonds will exceed that of shorter

ones. Therefore, very conservative portfolios should contain

more short-term bonds. Combining longer-term bonds with

equities remains worthwhile, since longer-term bonds provide

greater diversifi cation benefi ts.

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2009 2010 2011 2012 2013 2014 2015

Estimates

EUR USD CHF

Source: Barclays, UBS, as of 20 November 2013

Fig. 8: The end of the bond bull marketTotal return indexes of medium-term (5–7 yrs) government bonds (2009 = 100; incl. forecasts)

Government bonds retain value in a portfolioDespite the subdued outlook for government bonds, they retain their importance in a diversifi ed portfolio. Bond prices generally rise during periods with an uncertain economic out-look, which is not the case with equities. The degree of cor-relation between the two asset classes determines how well bonds can reduce the risk of a portfolio: if the correlation is negative, the overall risk of a global portfolio that consists primarily of equities and bonds – the two largest and most important asset classes – drops markedly. In the current envi-ronment, bonds diversify portfolios and are worth holding even though their expected return is low.

Since the fi nancial crisis, the correlation between equity and bond performance has been mostly negative: when equity markets have risen, bond performance has declined as yields increased. This situation is common in periods of stable infl ation expectations, as has been the case in recent years. It contrasts with times when infl ation volatility dominated, as occurred between 1970 and 1990, for instance. Then the correlation between equities and bonds was positive, as infl a-tion uncertainties pushed the valuations of both down. Stable infl ation, which we foresee, is therefore key to our expecta-tions of a mix of bonds and equities providing good portfolio diversifi cation. •

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O ne can easily form the impression from fi nancial newspapers that sequences of sensational events determine the movements of asset classes. But we believe that a meaningful analy sis of credit invest-

ments has to focus on underlying economic trends and the broader credit cycle. To us, what really matters for credit returns over the medium and long term is how the business cycle is progressing. We view the returns as primarily gov-erned by the prevailing yield level and default losses – both of which change meaningfully through the credit cycle.

US: Re-leveraging from a strong baseAs we laid out in our economic outlook for the years ahead, the US economy is further along in the process of deleverag-ing than most of its developed market peers, and its corpo-rate credit fundamentals are strong. The interest coverage ratio (earnings generation relative to debt payment) is high and funding at low yields is likely to continue. US companies have used the favorable funding environment to refi nance a large portion of their outstanding bonds at lower rates. Furthermore, the fundamental trend of US fi nancials remains positive due to post-crisis regulations that require banks to hold greater capital levels and liquidity reserves.

US banks started to ease their lending standards for corporate borrowers in early 2010 and have since (with a brief exception in 2012) made funding available at easier conditions (see Fig. 9). Credit ratings among US bond issuers remained stable through 2013, and we expect this trend to continue in the coming year.

Count on creditWe believe credit should play a more important role in asset allocation than in the past. Developed market corporate and emerging market bonds will outperform government bonds in the years ahead, in our view.Barry McAlinden, StrategistDonald McLauchlan, StrategistPhilipp Schöttler, StrategistBernhard Obenhuber, Strategist

CORPORATE AND EMERGING MARKET BONDS

In addition, the US Federal Reserve is playing an impor-tant role. By keeping interest rates low it has in essence encouraged investors to seek out higher-yielding assets. Bond issuers, in particular those with a high yield rating, ben-efi t from open primary markets. As long as ample funding is available, default rates are unlikely to climb. We expect the default rate on US high yield bonds to stay below 2% through 2014 and foresee total returns of 4%–6% for the year. Investment grade corporate bonds (with an average maturity of fi ve years) will feel the drag from rising bench-mark rates, but their expected total return of 1%–2% in 2014 compares favorably with that of government bonds of close to zero.

In terms of the credit cycle, the US corporate sec-tor entered the “re-leveraging” stage in 2013 (see Fig. 10). Aggregate credit metrics for non-fi nancial issuers have peaked and are in the so ening phase. Over the past year the aver-age debt level on the balance sheets of US non-fi nancials rose by almost 10% while earnings climbed by roughly 7%. Furthermore, more “aggressive” issuance practices, such as loans with limited covenants (covenant lite), and shareholder-friendly activities, such as debt-fi nanced dividend payouts, have revived since early 2013. But they have done so from a very low level and remain far below the excesses seen in 2006 and 2007.

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This fi gure illustrates the credit cycle in a stylized manner, using US high yield bonds as an example.

The credit cycle in four stagesStage 1: DownturnThe fi nancial crisis of 2008–09 pushed major economies into

recession, which led to soaring default rates on corporate bonds.

As company earnings fell, more borrowers struggled to service

their debt. At the same time, companies found it increasingly dif-

fi cult to obtain funding for new debt or existing bonds without the

help of government support programs. Credit spreads skyrocketed

and total credit returns turned deeply negative.

Stage 2: Balance sheet repairThe US came out of recession in 2009, and company earnings

began increasing again. The weakest companies had defaulted on

their bonds, and the remaining ones had a much healthier credit

profi le than before the recession due to cost cutting and delever-

aging. Credit spreads tightened rapidly when central banks were

still cutting interest rates, so total credit returns rose. The riskier

parts of the spectrum, such as high yield and parts of emerging

markets, outperformed equities.

Stage 3: Re-leveragingAs the business cycle has advanced, borrowers and lenders have

regained confi dence. In this third stage of the credit cycle the

focus usually shi s from repairing balance sheets and improving

credit quality to looking for investment and growth opportunities

again. Consequently, leverage increases. Company earnings in

this phase continue to grow robustly. The good funding environ-

ment means that defaults remain rare and total returns are usually

comfortably positive. But as benchmark interest rates start rising

in the improving economic landscape, they take their toll on

longer-duration credit. The US, according to our analysis, entered

this “re-leveraging” stage of the credit cycle in 2013.

Stage 4: OverheatingIn the fi nal stage of the cycle, interest rates reach prohibitively

high levels, making it diffi cult for certain companies to generate

earnings. While leverage may continue to rise, economic growth

and earnings start to tip over, signaling the next recession. Credit

spreads start rising ahead of an increase in defaults and credit

returns turn negative. And so the cycle starts new.

Source: BoAML, UBS, as of 26 November 2013

Fig. 10: A stylized credit cycleAdditional yield of US high yield over government bonds (spread) in percentage points and stylized credit cycle phases

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(IV) (I) (II) (III) (IV) (I) (II) (III)

CORPORATE AND EMERGING MARKET BONDS

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Eurozone: Balance sheet repairThe Eurozone only le recession behind in the second quarter of 2013. Unlike in the US, non-fi nancial companies there are still reducing their average debt levels, which fell by roughly 1% over the last year. At the same time, earnings are only now showing tentative signs of stabilizing, and should grow again in 2014.

As such, the Eurozone is still in stage two of the credit cycle – repairing balance sheets – though we expect it to enter the third stage in 2014. The fi nancial sector is playing an important role here. Fig. 9 illustrates how Eurozone banks have tightened their lending standards since 2007 due to their need to reduce debt. Recent survey data suggests that this trend will end in 2014, and Eurozone banks will make loans more readily to the corpo rate sector again.

Based on the strengthening economic outlook and improving access to loan fi nancing, we expect the default rate for EUR-denominated high yield bonds to decline in 2014 from its current level of around 3%. Again, central bankers are playing a major part here. Since the recovery remains fragile and infl ation low, the European Central Bank is expected to retain its easing bias through 2014, which will support credit investments.

Though the Eurozone is seemingly in a more favorable stage of the credit cycle than the US, its credit fundamentals improving instead of moderately deteriorating, we fi nd that a lot of the positive news in the Eurozone has been priced in already. Credit spreads mirror US ones and total yields are lower.

Total returns on EUR investment grade corporate bonds (with an average maturity of fi ve years), expected to be around 1% in the coming year, are depressed by the relatively low yield level and the expected rise in benchmark rates. But they will still outperform government bonds. EUR high yield bonds should by and large perform in line with their US coun-terparts at 4%–6% expected returns.

Emerging markets: convergence makes them attractive…The gradual macro-economic convergence by emerging mar-ket (EM) toward developed market (DM) nations in recent decades has narrowed the diff erence in credit quality of EM and DM companies. In 2000, US corporates on average rated four notches higher than their EM counterparts. A modest deterioration of the US corporate rating average and a strong improvement of EM ratings have closed the gap between them (see Fig. 11). EM sovereign bond ratings have similarly improved while the rating of several developed European countries has deteriorated. Today, the ratings of Brazil, Russia and India are very similar to Italy’s, Spain’s and Ireland’s, and

better than Portugal’s. However, the bulk of rating conver-gence occurred before 2007. Since then, EM ratings have only marginally improved, and we expect them to stabilize at the current level.

EM structural improvements over the last 15 years that led to the rating convergence include: more fl exible exchange rates; prudent fi scal and monetary policies; and a better insti-tutional and regulatory framework. The greater economic and political stability in EM led to more sophisticated domes-tic capital markets, which, along with fewer capital account restrictions, enabled EM corporates to issue bonds more reg-ularly on the global market. In 2000, the EM corporate bond market totaled around USD 72bn. It is now 15 times as large and amounts to more than USD 1trn. The US corporate bond market, by comparison, is at roughly USD 5trn. EM corpo-rate bonds, in short, have become a sizable market for global bond investors.

… but be aware of weaker issuing countriesEmerging countries have only recently reached the trough in the economic cycle. In 2014, they should experience gradu-ally improved growth, aided by the stronger global economy, but still face several headwinds. First and foremost, coun-tries with current account defi cits such as India, Indonesia, Brazil, South Africa and Turkey need to cut imports. To do so, they must tighten their fi scal and monetary policies. However, these “fragile fi ve” all have elections scheduled in 2014, mak-ing it diffi cult for governments to advocate austerity. The EM bank lending survey suggests that banks have become more

Source: Thomson Reuters, Bloomberg, UBS, as of 26 November 2013

Fig. 9: Easier lending for US corporatesBank lending condition indicators

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

easing standards

tightening standards

US Eurozone Emerging markets

CORPORATE AND EMERGING MARKET BONDS

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restrictive with their loans, which should weigh on credit and, by extension, economic growth. Domestic demand will not fuel it. While the major EM economies are expected to revive, the credit conditions of the weakest EM sovereigns, such as Ukraine, Argentina and Venezuela, continue to deteriorate.

This means, as it relates to the EM corporate bond seg-ment, that the credit cycle is somewhat more challeng ing. Tighter bank lending standards (see Fig. 9), ongoing re-lever-aging of corporate balance sheets and weak EM corporate earnings portend a rising number of corporate defaults in 2014, in contrast to the developed markets.

Despite the mixed fundamental outlook, and credit spreads close to fair, we still expect EM bonds to outperform developed market government bonds. But they will be more vulnerable when the Fed begins scaling back quantitative eas-ing due to their dependence on capital from foreign inves-tors, especially if domestic growth is shaky. For 2014, US and Eurozone corporate bonds thus have a more favorable out-look, in our view. •

The credit rating scale goes from AAA (highest rating,

i.e. lowest default risk) to D (defaulted)

Source: BoAML, UBS, as of 1 November 2013

Fig. 11: Credit ratings have convergedAverage credit ratings

A

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1999 2001 2003 2005 2007 2009 2011 2013

Emerging market sovereignsEmerging market corporates

US corporates

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CIO YEAR AHEAD 2014

AGENCY DEBT & MORTGAGE BACKED SECURITIES

W e continue to recommend deemphasizing agency debt within the taxable fi xed income (TFI) com-ponent of the UBS CIO recommended portfolio. We expect a relatively healthy economic recovery

in 2014 will motivate the Fed to taper back QE in 1Q2014, the result of which should be a rising rate environment. Specifi cally, we expect this environment to manifest itself as a so-called bearish steepening, where longer maturity rates rise more than shorter maturity rates. Likewise, we expect inter-est rate volatility to evolve in the same manner, i.e., an over-all rise led by longer-term tenors vis-à-vis shorter-term tenors. This environment generally augurs poorly for the expected total return for the asset class on both an absolute and rela-tive basis.

While we don’t expect anything approaching what a reasonable person would call substantive regulatory reform of the government-sponsored enterprises (GSEs) next year, we do expect more related headlines. For example, 1) Fannie and Freddie continue to make signifi cant payments to Treasury as part of the Senior Preferred Stock Purchase Agreement, and 2) the midterm electioneering season kicks into full gear. The combination of higher rates and elevated headline risk histor-ically has been associated with wider spreads and increased spread volatility, neither of which would bode well for the so-called carry trade (i.e., the strategy of buying and holding fi xed income securities to “clip the coupon” and “roll down the yield curve”). Thus, we expect some unwinding of the spread compression that we’ve seen in high quality, liquid alternatives to Treasury notes (e.g., agency callable and non-callable notes, mortgage-backed securities) as the combina-tion of programmatic central bank buying and the “reach for yield” trade presumably recedes.

We continue to believe that mortgage-backed securities (MBS) will perform broadly in line with the rest of the taxable fi xed income segment. In other words, we prefer mortgages to agency debt. This is because the additional spread off ers relative total return outperformance potential over a one-year horizon, assuming our interest rate forecasts are real-ized. Note that this analysis is purely based on changes in interest rates, i.e., it does not impute any spread widening in

2014: The death of the carry trade?

either agency debt or MBS. One major concern we have for MBS spreads going forward is that if and when the Fed tapers back its support for the product, it’s not apparent to us which buyers would replace that demand at current spread valua-tions, i.e., spreads may widen.

Within the mortgage universe, we still like the “up in coupon” trade (i.e., a preference for higher coupon pass-throughs versus lower coupons). This is for two key reasons: 1) higher coupons off er relatively better protection against duration extension than lower coupons; and 2) the Fed’s QE-related buying has been disproportionately concen-trated in lower coupon securities, so their valuations should be expected to weaken disproportionately if and when that support eventually slackens. •

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Source: Bloomberg, Yield Book, UBSNote: Spreads to 10yr Treasury for 10yr agency bullet, 10yr non-call 3mo agency callable and 30yr current coupon mortgage pass-through

Fig. 12: Compressed spread pickups avail-able in agencies and mortgages Agency debt and MBS spreads

Greater headline risk and Fed tapering bode poorly.Jim Rhodes, Strategist

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I ndividual investors constitute the single most impor-tant source of capital for state and local governments. Alone, they hold approximately half of all tax-exempt bonds outstanding. When combined with open-end

mutual funds, through which many individuals purchase munis, the “retail” investor holds roughly three-quarters of the market’s nominal value.

Individuals favor muni bonds for their tax advantages and o en pursue a buy-and-hold strategy but fi nancial dis-closure practices are inconsistent and pale in comparison with the corporate bond market. The regulatory regime is dis-jointed and spread across the 50 states and territories, all of which tends to weaken price transparency and contributes to periodic bouts of volatility. The municipal market responds by lurching between extended periods of tranquility and abrupt interludes of instability.

The most recent bout of price volatility began in May 2013 on the heels of Chairman Bernanke’s inference that the Fed would begin tapering its large-scale asset purchases. The prospect of higher rates was enough to convince many investors to focus on duration risk in their portfolios and redeem mutual fund shares at a record pace, a trend rein-forced as net asset values declined. Previous periods of mar-ket instability have been short-lived aff airs. Indeed, market sentiment improved in late September as more state govern-ments reported better fi nancial results. However, while the fourth quarter of 2013 off ered a brief respite, the year ahead is shaping up to be a volatile one for four reasons.

Pension liabilities garner attentionInsufficient contributions, optimistic investment return assumptions, and poorly negotiated collective bargain-ing agreements have contributed to an escalating pension burden that is unsustainable in the long run. Detroit, San Bernardino and Stockton all opted for bankruptcy in the wake of an economic recession that robbed them of their ability to make scheduled retirement and post-employment benefi t payments.

Detroit’s decision to fi le for bankruptcy protection will have far-reaching implications for the municipal bond market. By treating general obligation (GO) bondholders and pen-sioners as a single class of unsecured creditors, the city has

managed to upend traditional notions regarding the safety of GO debt. We expect that litigation surrounding the Motor City bankruptcy will extend beyond 2014, and initial bank-ruptcy court decisions will add to investor uneasiness.

Puerto Rico credit challengesThe Garcia Administration has taken a series of responsible steps to close the structural budget defi cit but the island’s economy remains mired in recession. The Commonwealth of Puerto Rico’s bond ratings are likely to decline further, placing the GO bonds into a speculative grade category. Although the willingness of the current administration to repay its debt in a timely manner is clear, rating revisions will make it more diffi cult to access the capital markets. Puerto Rico’s bonds are widely held and rating revisions would lead to further selling pressure.

The specter of tax reformLegislative initiatives to curtail or eliminate municipal bond tax exemption resurface periodically on Capitol Hill and most die a quiet death in committee. However, Congress did come peril-ously close to limiting the benefi ts of tax exemption for higher income households in late 2012 and political support for a restriction on federal tax exemption is evident in Washington. While we believe that passage of comprehensive tax reform legislation is unlikely, investors should be prepared for the inevitable municipal bond price volatility that accompanies any debate over limiting the tax advantages of municipals.

Rating agencies divergeThe municipal market, more than most, is highly reliant on bond ratings. Unfortunately, the three principal rating agen-cies o en appear to be working at cross-purposes. While Fitch registered more rating downgrades than upgrades in the third quarter of 2013, S&P raised its assessment of local government debt more o en. Meanwhile, Moody’s has elected to apply a lower discount rate to local govern-ment pension liabilities. Rating revisions will surely follow. All three rating agencies remain under regulatory scrutiny and are likely to pull the trigger on rating changes more quickly than in the past. •

Managing credit riskMunicipals should outperform treasuries but investors should be prepared for some volatility. Tom McLoughlin, Strategist

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PREFERRED SECURITIES

Look back to look forward

P referred investors can take a page out of 2013 to help them navigate the year ahead as the uncomfort-able prospect of Fed tapering will surely be a focal point toward the beginning of the year. So, just as we

ushered in 2013 with a cautious view on securities with long duration, we again expect interest rates to be the primary driver of market valuations next year. Demand from individ-ual investors is likely to remain tempered by the expectation of rising rates, although the outlook for robust new issuance of fi xed-to-fl oat structures is sure to spark investor interest.

With credit spreads currently range-bound at levels approximately 110bps wider than the historical average of 190bps, we expect material spread widening to be a less likely scenario in the year ahead. The worst of the Eurozone debt crisis is seemingly behind us. Furthermore, systemically important US fi nancial institutions have been bolstering their capital and liquidity ratios at an encouraging pace. The con-centration of bank issuers in the preferred market makes the reduced systemic concerns particularly relevant. We are gen-erally comfortable with the improved issuer fundamentals and continue to look for preferred credit spreads to cushion some of the interest rate movements as the 10-year Treasury heads toward the 3.3% mark forecasted by CIO in the next 12 months.

In 2014, we foresee possible risks stemming from a few areas that are mostly demand-based in nature. First, average coupon rates have been dropping steadily since the begin-ning of 2012, to 6.6% on average, as issuers took advantage of strong demand and lower interest rates to refi nance debt at historically low fi xed rates. The now deeply discounted prices of where these preferreds currently trade and the fore-cast for a continued rise in rates should keep investors cau-tious. Second, outfl ows from the preferred securities asset class have been signifi cant since the second half of 2013. Unless these outfl ows subside, they could further weigh on performance in 2014. Third, supply tends to follow demand and the second half of 2013 saw a diminishing supply of new issues, which is typically a sign of a jittery market.

On balance, we look to the year ahead with cautious optimism. With the largest US banks estimated to raise addi-tional regulatory capital to the tune of USD 50bn–60bn in the next two years, investors should expect new issues to off er higher coupons to conform to a higher rate environ-ment and spur investor demand. Inevitably, we believe most preferreds with fi xed low coupons that trade to their perpet-ual/long maturity dates will be subjected to further price pres-sure. This phenomenon is already unfolding with recent new issuance being repriced with higher yield levels, in the 7% range. These new securities may serve to be the new bench-mark toward which preferred yields will eventually converge, with some adjustments in spread premium according to the individual security’s credit quality. •

Investors should set their rearview mirrors on the recent past. Henry Wong, Strategist

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9830-Oct-1315-Oct-1330-Sep-1315-Sep-1331-Aug-13 14-Nov-13

Capital securities

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Fixed rate preferred (retail)

Fig. 19: Preferreds not created equal Cumulative total return, index 31 (August 2013 = 100)

Source: BofAML, UBS, as of 15 November 2013

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INVESTMENT THEME

U nlike during prior cyclical economic recoveries in the US, rates on the short end of the curve are unlikely to rise sustainably in the near term. With cash rates likely to remain anchored until

2015, we recommend that investors redeploy excess cash into short-term credit instruments.

Long end of the curve aff ected by multiple variables As the post-crisis economic recovery slowly gains trac-tion, investors have been preparing portfolios for the rising rate environment that is typically associated with the tightening phase of the monetary cycle. Longer-term Treasury rates have historically increased during Fed tight-ening cycles, and we expect this time to be no diff erent. As we’ve witnessed recently, however, near-term swings in long rates can be quite erratic. The long end of the curve is infl uenced by multiple and o en complex vari-ables including infl ation and term premiums, and even possibly a sovereign risk premium. In other words, when forecasting the level of long rates, the cone of predictabil-ity can be wide.

Curve to remain steep at the short endThe short end of the curve, on the other hand, tends to be a bit more straightforward as its direction is directly tied to the Fed funds target rate. One of the most unprec-edented aspects of the current economic recovery is that we remain in a unique monetary policy environment where the Fed is committed to keeping short rates low for an extended period, even a er its large-scale asset purchases are complete. This means that the short end of the Treasury curve should remain fairly well anchored at current levels and the shape of the curve will remain steep, even as it shi s upward.

Tiptoeing out the yield curve will outperform cashRates on cash-like investments will remain near zero for the foreseeable future and then rise only very gradually. This comes at a time when many investors are holding an unusually high amount of cash on hand as a means to boost confi dence. Some of the safety or low volatility that cash provides can still be obtained by venturing incre-mentally further out the maturity spectrum into shorter maturity fi xed income instruments of up to four years in maturity.

We recommend laddering short-term bondsWith rates on cash instruments expected to remain near zero, holding individual bonds or bullet exchange-traded funds (ETFs) that have specifi c short maturities can be an eff ective strategy. The advantages of utilizing individ-ual bonds include more certainty in the ladder’s coupon cash fl ows and principal redemption value. By using ETFs, investors can more broadly diversify their credit issuer exposure. Laddering bond maturities is o en considered to be a buy-and-hold strategy since investors will take the principal proceeds of each maturity and redeploy at the new prevailing market rate, which increases in a rising rate environment. •

Tiptoeing out the yield curveBarry McAlinden, StrategistMichael Crook, StrategistAndrea Fisher, Strategist

BONDS

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Fed funds rate 2-year Treasury

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Fig. 13: The Fed funds rate infl uences short-term yields Yield, in %

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CIO YEAR AHEAD 2014

EQUITIES

T he robust rebound in global equities that character-ized 2013 should continue in the coming year due to increased global economic growth and corporate earnings. In our view, the asset class still off ers the

requisite upside to justify a solid longer-term portfolio alloca-tion, though we caution investors who may be spoiled by the gains of recent years to temper their expectations.

Despite the rather tepid increase in overall corpo-rate earnings in 2013, global equities went right on rising, paced by the developed market indices and buoyed by the removal of several political roadblocks. US policymakers’ fail-ure to resolve the US budget and debt ceiling issues resulted in the Federal Reserve delaying its decision to scale back its quantitative easing (QE) program, which kept its ultra-loose monetary bias in place and eliminated a key market concern. Worries that governments in Europe, mainly that of Italy, might fail proved unfounded, bolstering market sentiment. Developed markets also benefi ted from additional evidence that the US fi nancial system had largely healed from its crisis-time wounds, and that deleveraging in Europe was proceed-ing apace.

The unfortunate consequence of the climbing equity prices in the face of unimpressive earnings is that price-to-earnings (P/E) ratios have risen and earnings yields fallen (see Fig. 14). The earnings yield is a measure of a company’s ability

to deliver returns to investors, whether by issuing dividends, buying its shares back or investing in growth. The current cyclically adjusted reading of greater than 5% still compares favorably with the low real yield of less than 1% on 10-year US Treasuries, even if it is below last year’s mark. Thus, the near-term return potential occasioned by a re-rating of equi-ties – the falling equity risk premium driving the earnings yield further down – is also more limited. This applies to all regions that have shown strong stock market performance.

US remains a portfolio linchpinWe prefer the US and the Eurozone market. With the global cycle strengthening and the Eurozone making progress on multiple fronts, equities become increasingly interesting. With regard to Japan, we need to see clearer signs from the government, as we near the April tax hike, that it will apply strong fi scal and monetary measures to alleviate the tax increase.

The Eurozone, for its part, must forge ahead with dele-veraging and establish a unifi ed banking system while repair-ing still-broken credit channels in the peripheral countries. Emerging markets need to demonstrate that they can deal with political and structural impediments: countries with current account defi cits in particular will have to adjust to less global liquidity, and China must plow ahead with such

Stay stocked up on stocksGlobal equities delivered annual returns of more than 15% over the past fi ve years and some equity indices reached new all-time highs in 2013. While investors might start to question the future potential of the asset class, we still see good value in equities.Jeremy Zirin, Strategist Walter Edelmann, StrategistMarkus Irngartinger, Strategist

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reforms as liberalizing its interest rates and opening up its state-dominated service sector while curtailing the risks asso-ciated with its fi ve-year credit boom.

Central banks to remain market focal pointsIn addition to earnings strength, political factors will strongly aff ect equity returns in 2014. The timing and magnitude of the Fed’s QE tapering decisions will dominate the market’s attention. By contrast, we think US fi scal policy risks will play a less dominant role, though they could cause further bouts of volatility as deadlines for raising the spending authority approach.

We expect the Fed to start scaling back QE amid strengthening growth but continued low infl ation. This posi-tive backdrop should enable US equity markets to endure the move to tighter money, despite the potential for higher bond yields to temporarily raise growth concerns. Such setbacks might create attractive entry points for investors who want (more) exposure to the US.

In Europe, the European Central Bank (ECB) will remain the center of attention as it probes the health of the Eurozone fi nancial system and urges on its deleveraging eff orts. We consider the system up to the challenge, although some smaller and mid-sized banks on the periphery might encoun-ter problems. Overall, the ECB’s fi rst steps into its new role as

Listed real estate alluring

Thomas Veraguth, EconomistKarsten Bagger, Strategist

Global listed real estate remains attractive in the current envi-

ronment. Better global growth, good access to fi nancing, low

supply overall and low rates sustain fair valuations. We expect

investors to move further away from low-yielding bonds and

focus increasingly on real estate as net asset values and earn-

ings rise by high single-digit percentage rates. Dividend yield

should stay around 4% as payout ratios are at historical lows.

Compared to 2013, listed real estate companies face slightly

slower earnings growth, but the main impediment to their

performance would be a real interest rate shock. The compa-

nies, however, are less sensitive to rising rates today.

Conservative management has led to greater duration on

loans. Their real estate portfolios are healthy, and the compa-

nies are working to strengthen their rental income and

improve their refi nancing strategies.

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EQUITIES

Fig. 14: US earnings yield suggests upside for equitiesCyclically adjusted earnings yield; in %

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1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

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Source: Thomson Reuters, UBS, as of 26 November 2013

a single banking supervisor should help rebuild investor con-fi dence and li equities. We expect the ECB to maintain easy liquidity conditions, which will limit the impact of any Fed tightening on the European economy.

The gradual Eurozone economic recovery should trans-late into rising earnings and enable Eurozone equi ties to outperform markets like the UK and Switzerland, with their greater share of defensive sectors such as healthcare and con-sumer staples. Monitoring the progress of the recovery is cru-cial as ongoing economic malaise in weak countries could bring back euro exit fears.

Japan will face a test of “Abenomics,” the fi scal policies named a er Prime Minister Shinzo Abe, as April approaches and indirect taxes rise from 5% to 8%. We expect a sharp but temporary economic contraction, with part of the tax hike blow being counteracted by supplementary fi scal mea-sures. A er the boost the Bank of Japan (BoJ) measures gave equities last year by drastically weakening the yen and con-tributing to a broad earnings rebound, further gains will hinge on additional, diffi cult-to-time policy moves, includ-ing the BoJ buying equities. On the government’s willingness to enact true reform by fi ring the so-called “third arrow” of Abenomics from its quiver, we are skeptical.

EM with improving earnings, but country-specifi c challengesEmerging market (EM) countries display highly diff erentiated economic, political and monetary conditions. With exports expected to boost growth moderately, we expect EM com-pany earnings to rise by about 10% in 2014, which should help broadly diversifi ed EM equity indices to make gains. Investor concern about structural and liquidity issues that sur-faced in 2013 will not simply vanish, though. Countries with current account defi cits like India, Indonesia and Turkey could face renewed currency pressure from capital outfl ows when Fed tapering re-enters the discussion.

Although our base case calls for China to avoid a hard landing, we see its fi nancial companies being forced to recog-nize some of their bad loans, and a few of its basic resources fi rms having to face the fact that they are operating in a sec-tor with vast excess capacity. •

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US EQUITY SECTOR STRATEGY

S ectors of the US equity market that are most sensi-tive to changes in economic growth, i.e., cyclical sec-tors, outperformed defensive sectors in 2013 and we expect further outperformance in 2014. The strong

relative performance of cyclicals over defensives may seem surprising considering the fact that US real GDP growth decelerated from 2.8% in 2012 to just 1.7% (UBS forecasts) in 2013.

So, why did cyclicals outperform in an environment of slowing US GDP growth? We identify three main drivers:

1. Valuation. At the beginning of 2013, cyclical sectors traded at an 11% discount relative to defensives com-pared to their long-term 8% average premium valuation.

2. Rising interest rates. Defensive sectors carry higher divi-dend yields. Rising interest rates are not only a signal that economic growth is improving (boosting earnings prospects for cyclical sectors), but also reduce the rela-tive attractiveness of the defensive, high dividend yield-ing sectors.

3. GDP is not the only measurement of economic growth. Other indicators, such as purchasing managers surveys, housing starts, auto sales, and the unemployment rate, all experienced meaningful improvement during the year. Additionally, GDP growth was largely constrained by reduced government spending. Private sector GDP remained resilient in 2013.

From this perspective, 2014 should be another solid year for cyclicals as the drag from higher taxes and lower government spending fades, and as the US expansion broad-ens and shows increasing signs of becoming self-sustaining. Our economists expect US real GDP growth to accelerate to 3% in 2014. Furthermore, as economic growth prospects improve, interest rates are likely to head higher. Our fi xed income team forecasts 10-year Treasury yields to rise to 3% in six months and to 3.3% in 12 months – a further headwind for the higher-yielding defensive sectors. And while cyclical sector valuations are no longer at extremely low levels (as was the case one year ago), cyclicals remain inexpensive com-pared to defensive sectors.

So in a nutshell, cyclical sectors remain undervalued relative to defensives and should deliver stronger earnings growth over the next 12 months. Mix in the prospect of rising

interest rates and we expect 2014 to be another year of cycli-cal sector outperformance.

But which of the cyclical sectors – Consumer Discretion-ary, Technology, Industrials, and Materials – appear best posi-tioned? During the past year, Consumer Discretionary has delivered the strongest performance of the ten S&P 500 sectors. This sector typically performs best during the early stages of an economic expansion as low interest rates spur recoveries in two of the sector’s most important end-markets – housing and autos.

As the economic expansion broadens to also include stronger manufacturing activity and an increase in business spending on capital equipment, we believe investors should focus on the benefi ciaries of an upturn in capital spending. In our view, the Industrials and Technology sectors – the sellers of capital equipment – as well as Financials, are poised to be the market leaders of 2014. •

Further fuel for cyclicals

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10-year US Treasury yield (right), in %

Fig. 15: Rising rates, driven by stronger growth, is a positive for cyclicalsPerformance of cyclicals vs. defensives and 10-year Treasury yield

Source: Bloomberg, Thomson Datastream, UBS, as of 2 December 2013

Cyclicals should outperform defensives in 2014. Jeremy Zirin, Strategist

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INVESTMENT THEME

T he world’s population exceeds 7 billion, and the UN estimates that this number will rise to 9.3 bil-lion by 2050. This growth will increase demand for food, energy and consumer products, all of

which require substantial amounts of water to produce. Over the next 12 months, we expect companies tied to water infrastructure, treatment, etc. to outperform the global equity market.

Long-term trends favor companies exposed to water themesWater forms the basis for a sustainable business model since it entails a growing demand little aff ected by eco-nomic conditions. We estimate the global water market to be USD 450-500bn, and to have an annual growth rate of roughly 6%. Long-term trends such as population growth, higher living standards, urbanization, industrial-ization in emerging markets, lack of infrastructure and climate change all aff ect the availability and quality of water. In addition, we have identifi ed three additional factors that should add earning power to companies exposed to them – ship ballast water treatment, US shale development and desalination.

Major infrastructure investments neededCurrently, a little more than half of the global population lives in urban areas. The UN expects this share to grow to 60% by 2030. Growing urban areas require substantial investments in water infrastructure, which is o en already strained. For example, the US Environmental Protection Agency estimates that 60% of all US water main pipes will be classifi ed as substandard by 2020.

Water treatment off ers opportunitiesAnother threat to freshwater supply is industrialization in emerging markets, which has o en been associated with a disregard for the environmental impact of waste water

and presents opportunities for companies specializing in improving water quality.

We also expect shale gas/oil development, which is booming in the US, to raise water-treatment expendi-tures. Between 7.5 million and 19 million liters of water per well, depending on the shale play, are used in the fracking process and need to be treated.

Stronger earnings growth key to outperformanceThe US and, in particular, Europe continue to face a low-growth economic environment in the wake of the 2008-09 global recession. This situation may persist for several more years due to the high indebtedness of both regions. Finding companies that can increase their earnings in such a landscape and benefi t from strong investment in emerging markets is important. We think water-exposed companies can do so and expect strong earnings growth from them over the next 12 months. •

Water:thirst for investmentsAlexander Stiehler, AnalystSebastian Vogel, Analyst

EQUITIES

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Fig. 16: S&P Global Water vs. MSCI World Jan 2003 - Sep 2013

Source: Bloomberg, UBS, as of 27 September 2013

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INVESTMENT THEME

T he potential for North American energy indepen-dence by the end of the decade, made possible by new shale drilling and extraction techniques, has become widely recognized and accepted.

Supported by a structurally high price of crude oil, US oil production is rising at a rapid pace. Abundant and cheap natural gas is creating a competitive advantage for the US by bolstering energy-intensive industrial operations. As the world looks on, we expect growth in US oil and gas supplies to continue to impress in 2014, providing addi-tional economic benefi ts for the US, and opportunities for investors.

Ongoing technical advances may help fuel high US production growth in 2014 In each of the past two years, US oil production has risen by 1 million barrels per day, to 8 million barrels per day. This has exceeded expectations, and we believe a high rate of growth may continue in 2014. Operators in the major shale plays are testing higher density drilling, enhanced well design, and other technical and effi ciency improve-ments; and early results show potential for meaningful productivity gains. These gains will become more evident as use of these processes becomes more widespread, in our view. Meanwhile, persistently high oil prices, as well as policy initiatives have led US consumers to use fuel more effi ciently. Domestic consumption of refi ned products such as gasoline is below historical peak levels, and we expect US oil consumption to continue to decline.

Positive outlook for US-based natural gas producers and consumers Abundant supplies of low-cost natural gas support our outlook for greater demand from the industrial and mate-rials sectors. As manufacturing activity increases, the US’s share of the global market for energy-intensive industrial products will likely rise. Natural gas has also gained share from coal as a cheaper and cleaner fuel for US power generation. Over time we believe more natural gas will be used as a transportation fuel, helping to diversify the

transportation fuel base. In addition, by 2016, we project the US to be a natural gas exporter. This should help sup-port natural gas prices, which have hovered at cash break-even levels. However, the US will retain its relative energy cost advantage versus the rest of the world due to its abil-ity to meet its natural gas needs with domestic resources.

Infrastructure continues to lag Rapid oil and natural gas production growth in the US and western Canada has created bottlenecks in trans-port and processing capacity. More pipeline and rail capac-ity is needed to effi ciently move product away from the wellhead. Meanwhile, bottlenecks have created regional supply gluts. US refi ners are benefi ting from the lower-cost crude supplies. They have also benefi ted from rising refi ned product demand in Latin America, where growth in refi ning capacity has been limited. The US has turned from a top importer into a large exporter of refi ned product.

Benefi ciaries beyond energyContinued progress toward North American energy inde-pendence will be a driver of growth within many indus-try sectors. Benefi ciaries within the energy industry will include select producers, services companies, refi ners and pipeline operators. Beyond energy, we see opportunities for companies in sectors such as chemicals, industrials and utilities, as well as engineering and construction, rail, and auto parts. •

Energy independence: forward marchNicole Decker, Analyst

EQUITIES

7,400

8,000

Thou

sand

B/D

5,600

5,000

4,400

6,800

6,200

3,800SepJunMarDec Dec

2008

2009

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2011

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2013

Fig. 17: US crude oil production Accelerated growth over the past two years

Source: Energy Information Administration, as of 2 December 2013

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INVESTMENT THEME

R elative to high dividend yielding stocks, high divi-dend growth stocks trade at very attractive valu-ations. We expect high and consistent dividend growers to outperform the highest dividend

yielding stocks over the next 12 months (and beyond).Stocks with strong income-generating properties,

i.e., dividend paying stocks, are more attractive to inves-tors when interest rates are low. So it should come as no surprise that dividend-based investment styles have gained enormously in popularity. But investors should note that not all dividend-paying companies have the same investment characteristics. While 84% of S&P 500 companies pay shareholders some form of recurring divi-dend payment, the level of the dividend relative to the company’s share price (dividend yield) and earnings (divi-dend payout ratio) strongly varies across industries and companies, as does the growth rate of the dividends per share paid by companies.

Stocks with the highest current dividend yield are trading at high relative valuations compared with history. At a sector level, this becomes quite clear when looking at the current relative sector P/E (price-to-earnings ratio) of some of the highest yielding sectors of the market. Utilities, for instance, has a dividend yield of 3.9% and is currently trading at a 2% P/E premium to the S&P 500 compared to its long-run average of a 14% discount.

Alternatively, S&P 500 stocks with more moderate current dividend yields but high dividend growth rates appear much more attractively valued compared to the aforementioned expensive high dividend yielding stocks. In fact, the top decile of “dividend growers” – S&P 500 stocks that have delivered the strongest dividend growth rates over the past 10 years – currently trade at a par valuation with the S&P 500. Historically, high dividend growth stocks have traded at a premium to the market. So for investors looking for “cheaper yield,” high divi-dend growth stocks are trading at very attractive valua-tions relative to the highest dividend yielding stocks.

How to implement this investment ideaIn October 2003, we launched a report series called the UBS Dividend Ruler Stocks List, a list of consistent divi-dend growth stocks that grew their dividends “as straight as a ruler.” This list is our recommended implementation for the theme discussed in this report. The CIO Dividend Ruler Stocks List is comprised of stocks with the following characteristics: attractive yield, solid fundamentals/valua-tion, strong historical dividend growth, and high dividend consistency. •

Dividendinvesting: don’t overpay for yieldJeremy Zirin, StrategistDavid Lefkowitz, StrategistMatthew Baredes, Strategist

EQUITIES

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0.9

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1.2

1.1

1.0

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1.4

0.81995 1997 1999 201120092007200520032001 2013

Relative P/E of high dividend growth versus high dividend yieldAverage

Fig. 18: Dividend growth still cheap rela-tive to high dividend yield Relative P/Es

Source: FactSet, UBS, as of 4 December 2013

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CURRENCIES

A major rebound The world’s major currencies have weakened in recent years due to loose monetary policy. But with less accommodative conditions on the horizon, currencies like the US dollar and the British pound could benefi t.Katie Klingensmith, StrategistThomas Flury, Strategist

W e expect 2014 to be the year when major currencies recover some of the losses they experienced due to the ultra-accommodative monetary policies in place in recent years. We

expect the majors – especially the US dollar, euro and British pound – to outpace the weaker emerging market curren-cies and even those of some of the commodity producers. Foreign exchange (FX) markets will likely become anxious about potential monetary policy tightening, which in our view will boost major currencies. For strategic investors, we recommend hedging broad international FX exposure.

The end of ultra-expansive monetary policy leads to a shi in demandDemand for the major currencies should increase steadily and start to weaken the higher-yielding currencies like the Australian dollar and the New Zealand dollar, the Scandies (Swedish krona and Norwegian krone) and emerging mar-ket (EM) currencies of countries with a prominent fi scal and/or current account defi cit – i.e. the “fragile fi ve”: the South African rand, Turkish lira, Brazilian real, Indian rupee and Indonesian rupiah. They all profi ted in 2011–2012 from dol-lar weakness triggered by the US Federal Reserve’s unlim-ited third program of quantitative easing (QE) and ultra-low interest rates in developed markets. The easing bias and the forward guidance introduced by the European Central Bank and the newly appointed Bank of England Governor Mark Carney in the summer of 2013 reinforced the search for higher-yielding, albeit riskier currencies. With the global econ-omy expected to strengthen and yields set to rise in major currencies, we see appreciation among the latter coming at the cost of expensive commodity-producer currencies like the Australian dollar.

A currency war that never happened endsAccusations of a currency war have haunted fi nancial mar-kets since March 2009, when the Fed started its fi rst QE pro-gram. The currencies of commodity producers and the more liquid emerging markets such as Mexico and Brazil benefi ted vis-à-vis the dollar. The rapid appreciation of the Brazilian real caused the country’s minister of fi nance to accuse the US of pursuing a currency war. The accusations were as hot as the consequences were limited.

In practice, the ample central bank liquidity reduced foreign exchange volatility. With interest rates barely above zero and defl ation threatening, central banks have tried to prevent excessive currency appreciation. The consequence has been FX trading within very tight ranges for major cur-rency pairings over the last couple of years.

In 2014 this paradoxical situation is likely to ease, as growth trends are normalizing and markets are preparing for the end of QE. Greater growth in the US, Europe and the UK also allows for more fl exibility with respect to central bank policy and FX moves. We therefore forecast rising FX volatility and a stronger need to use options and forward contracts to protect against potential moves.

USD to appreciate in coming yearsFed offi cials are at pains to emphasize that scaling back QE3 should not be confused with tightening. Nevertheless, the tapering should strengthen the dollar, as it involves rising lon-ger-term interest rates, which could trigger another sell-off of EM currencies. An actual hike in short-term interest rates is something we forecast for 2015. Once the Fed confi rms the end of the fi nancial crisis by guiding overnight interest rates above infl ation rates, a clear case can be made for a strong rebound of the greenback (USD). Markets anxious about tapering and tightening will have a bias to buy US dollars. For this reason we see only a limited risk of extended deprecia-tion and a good chance for appreciation in the next few years.

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Euro benefi ts from strong fundamentals despite weak politicsThe euro is the anti-dollar. Asset managers need to diver-sify their holdings into an alternative to the dollar, and the second-largest fi nancial market is in the euro. In addition, Europe as a currency area diff ers markedly from the US, and has areas of clear strength relative to it. Its infl ation is lower and its current account has been balanced for many years, so it does not rely on foreign investment infl ows. Finally, it hosts many highly innovative export industries accustomed to coping with real exchange rate appreciation. However, incomplete political and banking integration and internal fi ghts about government debt limit the euro’s attractiveness. Europe also acts less than the US does as a hegemonic power. This last point is important for the US dollar and its role as the international reserve currency.

Pound delivers a rebound with momentumThe British pound rebounded nicely in 2013 amid an improved macroeconomic environment. For 2014 we expect a sustained appreciation underpinned by higher infl ation in the UK. Infl ation in the US and the Eurozone ended 2013 very low, while prices in the UK were rising at close to 2%. On top of this, GDP growth was strong, so the Bank of England may seek to tighten rather than loosen monetary policy. As long as this is the case, we think the pound will remain well supported.

Swiss franc (CHF) fl oor here to stay – for nowIt will take another two to three years, in our view, before the Swiss National Bank (SNB) gives up the fl oor of 1.20 on the EURCHF exchange rate. European price data has been so ,

and the damage from the European debt crisis persists, such that the European Central Bank (ECB) has little leeway to hike rates over the next two years. Such a hike, which would sig-nal the end of the European debt crisis, is in our view the minimum requirement for the SNB to abandon the fl oor. We therefore see EURCHF continuing to trade in a 1.20–1.25 range over the next year.

Japanese yen (JPY) to fallWe see USDJPY shi ing from a range of 95–100 toward 100–110 as the Bank of Japan (BoJ) adopts a more expansionary monetary policy, which will be needed to so en the negative growth impact of a VAT rate hike. The BoJ is likely to wait until the spring to become more accommodative because of import price infl ation, which rose strongly in 2013 as the yen depreciated. Consumers felt the rise of food and energy prices strongly. In the spring of 2014 these negative eff ects should have grown out of the year-over-year infl ation exclud-ing the impact from the VAT hike. Therefore the BoJ will have room to push yen depreciation forward. •

CURRENCIES

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A s real and tangible assets, commodities provide attractive opportunities to benefi t from specifi c eco-nomic trends. Gold, for example, defi nitely has its merits as long-term “insurance” against extreme

risks such as hyperinfl ation. But a er the mid-to-high sin-gle-digit percentage decline in broadly diversifi ed commod-ity indices over the last year, investors should not expect the asset class to catch up with other risky assets like equities in the year ahead. But that does not mean we dismiss commod-ities as an asset class. We recommend instead taking tactical exposure whenever short-term opportunities arise.

Global economic growth should improve through-out 2014, but only mildly in emerging markets, which have become the biggest consumers of many commodities. China will need to balance its economy by curbing investment growth. And the entire Asian region is poised to expand more slowly as it converges toward the developed world, a er having re-leveraged in recent years, so incremental com-modity demand should be so in the market. Keep in mind that China alone consumes more than 40% of global copper production and 50% of global coal. Therefore, most com-modity markets will experience excess supply, and any tem-porary market tightness is likely to be short-lived. The year’s economic growth should occur primarily in the fi rst several months, and potential price advances are then expected to reverse and in some cases trigger even lower prices by the end of the year. Thus, investors are well advised to use higher prices in the fi rst half to exit positions.

Oil and gold the weak candidatesCommodities that were supported in 2013 due to supply challenges, like crude oil, may no longer enjoy stable prices. Unplanned production outages, which reached record highs last year, are expected to moderate. At the same time non-OPEC supply is anticipated to outpace demand growth in 2014. As a consequence, the crude oil market should be well supplied and force OPEC to cut output (see Fig. 20). We

Little in returnCommodities have a distinct appeal for certain investors. However, we expect negative returns in 2014 with demand still muted and supply ample.Dominic Schnider, AnalystGiovanni Staunovo, Strategist

COMMODITIES

expect an average price around USD 100/bbl in 2014, but temporary dips below that mark are likely.

Gold is another candidate for lower prices. Outfl ows from gold ETFs as a result of a lack of infl ation in the devel-oped world and the US Federal Reserve likely starting to taper in the fi rst half of 2014 could pressure the yellow metal. Although its price fell substantially in 2013, an additional 300–500 tons (i.e. 7%–11% of yearly demand) of outfl ows from ETFs and futures/option positions in 2014 are forecast to hit the market. They are unlikely to be absorbed even at lower current prices due to prohibi tively high import duties in India and fewer central bank purchases. Only a fall in the price of

3.53.02.52.01.51.00.5

0–0.5–1.0–1.5

Estimates

2001 2003 2005 2007 2009 2011 2013 2015

Global oil demand growthGlobal oil supply growth

Source: EIA, IEA, UBS, as of 26 November 2013

Fig. 20: Oil supply likely to outpace demand growth also in the coming yearsAnnual global oil supply and demand growth (incl. demand forecast) in million barrels per day

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CIO YEAR AHEAD 2014

gold to marginal production costs of USD 1,050/oz–1,150/oz (cash cost basis) would balance supply and demand, in our view. Nega tive spillovers from a lower gold price should be visible in silver, which faces a meaningful fabrication surplus. We advise investors seeking exposure to precious metals to hold the industrially oriented platinum and palladium: both metals are expected to be undersupplied.

A more balanced story in base metals and agricultureThe profi tability of companies producing industrial metals has dropped in tandem with prices, which should keep them from increasing production meaningfully. Thus, limited sup-ply should prevent prices from falling further, and metals such as zinc and lead even off er modest upside. For both markets we have penciled in a marginal supply defi cit in 2014. Aging mines and the lack of any incen tive to increase production provide the necessary price support. This cannot be said for copper and iron ore. We expect production growth of 6% for the former in 2014 a er strong mine output in 2013, which is likely to weigh on its price throughout the year.

A er more than two years of declines, the prices of agricultural commodities may fi nally form a bottom in 2014. Rising inventories in key crops, due to a strong production year in South America and the US, have by now been priced in, and are unlikely to further weigh on prices in 2014. On the other hand, it is probably too early to get optimistic. Estimates for the coming year – given normal weather condi-tions – point to a solid supply, which can match higher grains demand from emerging markets. •

COMMODITIES

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H edge funds invest opportunistically across asset classes, using techniques like short-selling and leverage and instruments such as derivatives to pur-sue compelling returns while limiting downside risk.

Managers seek to capitalize on certain market ineffi ciencies not available to classic long-only fund managers. Although hedge funds do not have the same liquidity as traditional assets, they should nonetheless be important strategic com-ponents of well-balanced portfolios for investors willing to accept this trade-off , in our view.

Our recommended allocations to hedge funds presume diversifi ed exposure across diff erent hedge fund strategies; we would advise disproportionate weightings only to target individual preferences. Over the long term, we expect hedge funds to enhance portfolio characteristics due to their lower volatility, their focus on downside protection, and their poten-tial for achieving incremental outperformance due to man-ager skill.

In the year ahead we expect the market environment to remain positive for equity long/short strategies, with low intra-stock correlations and high equity return dispersion sup-porting the ability of stockpickers to deliver attractive risk-adjusted returns. This should create opportunities to generate alpha, the excess return of an investment over its benchmark on a risk-adjusted basis. Rising levels of corporate actions such as mergers & acquisitions should create opportunities for certain event-driven strategies. Macro/trading strate-gies typically serve a diversifying role in portfolios, producing returns less correlated to other hedge fund strategies and tra-ditional assets. Although discretionary macro managers may be able to reverse lackluster recent performance, with cross-asset opportunities unfolding in Japan, Europe and emerg-ing markets, we view systematic strategies less favorably due to the continuing lack of persistent trends. Finally, we

are becoming more cautious on relative-value strategies that depend on high leverage and low-rate volatility.

We emphasize the importance of diversifying among hedge fund managers who refl ect diverse investment styles. Bottom-up manager selection remains critical, particularly in equity long/short, as performance dispersion remains high. Also, we view emerging and midsize managers as better posi-tioned than larger managers to be opportunistic and respon-sive to macro and market developments. •

Attractive risk-adjusted returns expectedHedge funds should form an important part of a well-balanced portfolio. By diversifying return sources, hedge funds can improve risk-adjusted returns for investors who can tolerate moderate illiquidity.Andrew Lee, Head of Alternative InvestmentsCesare Valeggia, Strategist

A positive outlook

Over the next fi ve years, we expect investments in diversifi ed

hedge funds to deliver annual returns of 4%–6%, depending

on the liquidity of the instruments, with volatility of about

5%–7%. This compares favorably to expectations for tradi-

tional asset classes. Investors who can tolerate moderate illi-

quidity should therefore replace some bond and equity

exposure with hedge funds.

HEDGE FUNDS

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T he umbrella term “private markets” encompasses all illiquid strategies that target long-term equity and debt investments in assets not listed on classic stock and bond markets. Although people have histori-

cally associated illiquid investments with private equity for the most part, the range of such strategies has expanded to include private debt and real asset strategies.

Private market investments off er numerous compelling advantages over traditional investments. Examples include investing in unlisted fi rms, in companies under going turn-arounds and in direct corporate lending. Private market man-agers can also exploit temporary asset mispricing that results either when public markets or private owners value assets dif-ferently from their intrinsic or potential value or from short-term uncertainties. Finally, managers can eff ect operational and strategic change in the underlying assets and companies to enhance value and generate returns.

Allocations to private markets require a long-term per-spective, as managers need time to make strategic and oper-ational changes, reposition underlying investments, and exit the investments.

Private market strategies are particularly well positioned to capitalize on the following opportunities, in our view:

European bank deleveraging. Banks in Europe will con-tinue to deleverage. Private market strategies can take advan-tage of this situation by lending privately as banks reduce their loan activity and by selectively purchasing assets divested by banks.

Contrarian plays. Long-term-oriented private market funds can benefi t from short-term negative sentiment. For instance, they can purchase peripheral European assets being sold, as

well as investments in emerging markets that target long-term structural shi s in sectors less well served by public markets.

Energy value chain opportunities. New gas resources, shi s toward certain types of renewable energy, and aging infrastructure are creating long-term opportunities that enable investors to tailor energy exposure to their return and risk objectives while potentially mitigating underlying com-modity price volatility. •

Complement traditional portfoliosPrivate markets encompass a range of investment strategies including private equity, private debt, and real assets. Investors willing to commit capital for multi-year periods can access opportunities in private markets that are unavailable in traditional asset classes.Andrew Lee, Head of Alternative InvestmentsStefan Braegger, Strategist

PRIVATE MARKETS

Compelling long-term returns

Over the past two decades, private markets have generated

annual returns of 11%–15% with 12%–15% volatility. We

have similar expectations for a diversifi ed private market port-

folio in the years ahead. Between 2% and 4% of this return

represents the estimated illiquidity premium that compensates

investors for their multi-year commitment. In a portfolio con-

text, investors at ease with illiquidity should replace some of

their bond and equity exposure with a diversifi ed allocation to

private market investments.

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DISCLAIMER

Chief Investment Offi ce (CIO) Wealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisions of UBS AG (UBS) or an affi liate thereof. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an off er, or a solicitation of an off er, to buy or sell any investment or other specifi c product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, fi nancial situation and needs of any specifi c recipient. It is based on numerous assumptions. Diff erent assumptions could result in materially diff erent results. We recommend that you obtain fi nancial and/or tax advice as to the implications (including tax) of investing in the manner described or in any of the products mentioned herein. Certain services and products are subject to legal restrictions and cannot be off ered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affi liates). All information and opinions as well as any prices indicated are current only as of the date of this report, and are subject to change without notice. Opinions expressed herein may diff er or be contrary to those expressed by other business areas or divisions of UBS as a result of using diff erent assumptions and/or criteria. At any time, investment decisions (including whether to buy or hold securities) made by UBS AG, its subsidiaries and employees thereof, may diff er from or be contrary to the opinions expressed in UBS research publications. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be diffi cult to quantify. UBS relies on information barriers to control the

fl ow of information contained in one or more areas within UBS, into other areas, units, divisions or affi liates of UBS. Futures and options trading is considered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in FX rates may have an adverse eff ect on the price, value or income of an investment. This report is for distribution only under such circumstances as may be permitted by applicable law.

Distributed to US persons by UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and an affi liate of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US affi liate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be eff ected through a US-registered broker dealer affi liated with UBS, and not through a non-US affi liate. The contents of this report have not been and will not be approved by any securities or investment authority in the United States or elsewhere.

UBS specifi cally prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect.

Version as per September 2013.

© UBS 2013. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

Disclaimer

“Asset allocation in 2013, a retrospective,” pg. 28

1 Crook, Michael and Brian Nick. “Portfolio Positioning: Not a time for complacency.” CIO WMR Year Ahead 2013.

2 UBS WMA’s Capital Markets Model: Explained, January 2013.

3 Doeswijk, Ronald et al., “Strategic Asset Allocation: The Global Multi-asset Market Portfolio 1959-2011” SSRN Working Paper.

4 WMRA Decade Ahead, 2011.

5 WMRA Decade Ahead, 2012.

6 Mariscal, Jorge. “The case for emerging markets, revisited.” August 28, 2013.

Footnotes

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64 LOREM IPSUM

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