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CIO WM Research 18 September 2012

US economy Election Watch 2012 - Implications

In this report, we sort through the likely outcome of the US election,the potential impact on the economy and the implications forinvestors.

While the policy paths may not diverge as radically as some suggest,there are still important distinctions that could create selectiveinvestment opportunities and risks.

It is also important particularly with an election so difficult to call to consider investments that are likely to perform well regardlessof the victor.

With the elections less than two months away, the outcome is still verymuch in question. However, based upon current polls and the electoralcalculus, it would appear that President Obama will win a closely contestedreelection, the Republicans will retain a comfortable majority in the Houseand the Democrats will hang on to the Senate by the very narrowest ofmargins.

The policy issues

While the candidates present vastly different ideologies about the roleand size of government, many of the policy outcomes ironically wouldbe quite similar.

We think some sort of grand bargain that would cut deficits by$4 trillion over the next 10 years is likely, regardless of who wins inNovember. Taxes would be part of such a deal, but under Republicanleadership, broad-based tax code reform would be more likely.

Policy differences are much sharper regarding specific elements of taxand fiscal reform as well as financial sector and healthcare policies.

Election outcomes

A close contest, likely shaded more blue than redWith the conventions now behind us and November 6 rapidly approaching,the 2012 election race has continued to tighten. The UBS US Office of PublicPolicys current base case scenario is that President Barack Obama will servea second term in the White House, Republicans will retain control of theHouse with a comfortable majority and the Senate will remain Democraticby the narrowest of margins.

Katherine Klingensmith , strategist, UBS [email protected]

Jrg de Spindler , PhD, economist, UBS AG [email protected]

This report was originally published in the US on 12September 2012. This report has been customized for outside the US distribution.

Related reports 17 April 2012: Elections 2012: the risks beyond 7 Feb: US elections: basic scenarios

Economic and market implications Both Romney and Obama would have to address

a slowgrowth economy and the ongoing painof austerity measures. However, we think that aRepublican administration could produce fewer andclearer regulations and more spending and taxreform, which could enhance growth prospects in thelong run.

A Romney presidency could also bring greateruncertainty in the near term amid a more substantive

realignment of the political balance, which could inturn lead to slower growth in 2013.

A moderately better intermediate-term growthoutlook, fewer regulatory threats and higher chancesof long-term tax reform therefore paint a slightlymore positive equity outlook under Romney.

Republican leadership would likely eliminate orsoften certain elements of reform for the Healthcareand Financial sectors.

While some may wish to speculate about winnersand losers based on the outcome of the election,we choose to focus on equity sectors, such asTechnology and Consumer Staples, whose fortunesare less outcome-dependent.

Interest rates are unlikely to be dramatically affectedby the elections, though somewhat higher long-termgrowth could imply a sharper rise in bond yields.A credible commitment to deficit reduction targetsof $4 trillion is probably sufficient to avoid anotherdowngrade to the US governments credit rating.

Municipal bonds could be impacted by a potentialincrease in marginal tax rates as well as wholesalereform that subjects interest on state and local bondsto federal taxation. While the former would likelyenhance the value of municipal bonds in general, the

latter would create a two-tiered municipal marketwith a premium placed on grandfathered bonds.

This report has been prepared by UBS Financial Services Inc. (UBS FS) and UBS AG. Please see important disclaimers and disclosures that begin on page 16. Past performance isno indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables inthis publication.


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Election Snapshot

29% 15% 15% 15% 26%The US Elect orate

172 49 126 57 134The Electoral CollegeCurrent 2012 projection270 votes needed to win

Democratic Leaning Democratic Independent / undecided Leaning Republican Republican

VT

3

NH

4

MA11

CT

7

NJ

14

RI

4

DE

3

MD

10

DC

3

HI

4

AK

3

AZ

11

NM

5

TX

38

OK

7

CO

9

NV

6

IA

6

MO

10

IN

11

WI

10

OH18

VA

13

NC

15

PA

20

FL

29

NY

29

ME4

GA

16

SC

9AL

9

MS

6LA

8

AR

6

TN 11

KY 8

WV

5

KS

6

MN

10

IL20

MI

16NE

5

SD

3

ND

3

MT

3

WY

3

UT

6

ID

4

WA

12

OR

7

CA

55

Follow the money

Source: Datafromthe New York Times, as of31 July 2012

The Nati onState-by-state breakdown of 2012 Electoral College projection

Source: Data from RealClearPolitics, as of 11 September 2012

Source: Gallup poll, 12 August 2012

Source: Data from RealClearPolitics,as of 11 September 2012

DemocraticLeaning DemocraticToss upLeaning RepublicanRepublican

221 Obama 126 Toss Up Romney 191

President Barack ObamaApproval on Issues (Gallup poll, 12 August 2012)Do you approve or disapprove of the way Barack Obama is handling _____?

DisapproveNot sure

Approve

58%

Terrorism Education Immigration

35% 49%43%38%

54%

37%

Creating jobs The economy The federal budget de

58%

36%

60%

30%

64%

270 Electoral votes needed to win

RepublicanIndependent / undecidedDemocrat

587.7502.8

131.2

524.2

395.1

197.1

Note: Figures are in millions of US dollars. Totals

include money raised and spent through July by thepresidential candidates, the national parties, and theprimary ACs(for Romney).

Raised Spent Cashon hand

Obama

Romney

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Standard approval ratings may also turn out to be less reliable than in thepast given instant access to information, the increased polarization of thetwo parties and an everlarger portion of the voting public that identifies

itself as independent. Given how the electoral map shakes out, this elec-tion will likely be decided by the swing voters in just 10 states (Colorado,Florida, Iowa, Michigan, Nevada, New Hampshire, Ohio, Pennsylvania, Vir-ginia and Wisconsin). President Obama currently leads Governor Romneyin six of those states, is tied in three of them and trails in only one. So whileeconomic data and approval polls would seem to favor the challenger, theymay not fully reflect the critical factors that will ultimately determine theoutcome of this election. It is therefore our view that President Obama willbe reelected President albeit by a narrow margin.

Election issuesThe legislative agendas under Democrats or Republicans

The Democratic and Republican parties are advancing decidedly differentvisions for the future role of the government; however, we think that manyof the policies would actually only be different at the margin under either anObama or Romney administration. Keep in mind that even with a Repub-lican sweep, the large minority of Democrats in the Senate would makebipartisan support necessary for any major policy changes. Although opin-ions vary, our own discussions with economists and policy analysts suggesta bipartisan fiscal deal that includes reductions in deficit spending and somechanges to the tax code is likely under either candidate. A Romney adminis-tration is more apt to achieve fundamental tax reform and potentially somelong-term reforms to entitlement programs, such as Medicare. However,energy policies would likely be similar under either candidate, with bothlooking to promote natural gas production. Recent healthcare and financial

regulations would admittedly be vulnerable under a Republican sweep, butprobably not as much as the campaigns would have voters believe.

The fiscal cliff and the debt ceilingThe most immediate challenges facing the president and Congress afterthe election will be addressing the fiscal cliff and raising the debt ceiling.January 2013 will see four major fiscal initiatives expire and soon thereafteryet another potential showdown on the debt ceiling (see Fig. 3). If Congressfails to renew or replace these measures, taxes will rise and US governmentspending will contract sharply (see our June 26, 2012 publication, No US fiscal cliff , but beware the pothole). Our view remains that a crisis likely willbe avoided. However, if Republicans do take both the White House and theSenate, sitting Republicans may simply refuse to make a deal during the

lame duck session. While we expect the Bush tax cuts to be temporarilyextended, automatic spending cuts to be avoided and the debt ceiling tobe raised under either electoral scenario, the payroll tax holiday will likelyexpire and emergency unemployment benefits will likely be phased out.

A grand bargain?Following an increasingly familiar high-stakes game involving threats ofsequestration and/or a government default, reductions in deficit spend-ing could materialize under Democratic or Republican leadership. PresidentObamas second term could well resemble President Clintons, with a shifttoward the center. We think a deal under Obama could result in up to $4trillion in deficit reduction over the next 10 years, comprising a spendingcuts/revenue increases ratio of potentially 3 to 1. This would likely include

deficit reduction measures that would replace the discretionary spendingcaps and the across-the-board spending cuts currently on the books (i.e.,sequestration). While Democrats have insisted and will continue to insistupon increases in tax revenue, expenditure reductions are still likely to bethe bulk of any major fiscal deal.

"Virtually everyone in Washington wants to see some sort of change to personal taxes, especially giv-en that the Bush tax cuts are set to expire in 2013.

Fig. 3: US debt poised to hit limit soonUS statutory debt limit and public debt level, in tril-lions of US dollars

Source: Bloomberg, UBS, as of 5 September 2012

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Under a Republican sweep, the size of the package would be roughly sim-ilar, but spending cuts could exceed revenue increases by a ratio of 4 to1. Such reforms would likely be inspired by Representative Ryans propos-

als, including some long-term changes to large social safety net programs.The reforms would be limited, in part, because of the Republicans narrowmajority in the Senate as well as the political challenge of cutting suchpopular programs. A Republican Congress would likely be forced to usethe reconciliation process to achieve such spending cuts, since this processwould require only a majority vote in the Senate and thus avoid the threatof filibuster. Reconciliation can generally be used for legislation that has animpact on government spending or revenues with some limits.

Personal tax reform comes into focusVirtually everyone in Washington wants to see some sort of change to per-sonal taxes, especially given that the Bush tax cuts are set to expire in 2013.A Democratic White House is unlikely to pursue major reforms, but rather

would work to extend the Bush tax cuts for all but the highest earners. Thiswould likely affect households earning over $1 million dollars annually, butthe threshold could be set even lower, depending on revenue needs andprojected spending cuts (see Fig. 4).

Tax reform likely would be an early focus under Republican leadership,although implementation would prove difficult. Romney would likely seekto reduce personal income tax by 20% for all brackets relative to the pre-Bush levels; however, identifying the deductions required to offset the lossin revenue would be challenging. The UBS US Office of Public Policy has ahigh conviction that the final outcome would be at least as progressive asthe current tax code, since most deductions are currently disproportionatelyenjoyed by the wealthy. However, major tax reform is politically challenging

and takes careful study and analysis given the potential impact on certaincritical sectors of the US economy as well as the almost certain oppositionby entrenched special interests. It is only likely to be achieved if Congressinitiates a serious process to remedy these challenges in a comprehensivemanner, since a last-minute deal and/or piecemeal approach cannot addressthe complexity of the tax code.

Deductions: very few sacred cowsAll deductions are vulnerable under either partys leadership, especiallyin the event of comprehensive tax code reform. Among the most like-ly changes are both the elimination of second-home mortgage interestdeductions as well as the reduction in the size of a primary mortgage fromwhich interest can be deducted. Municipal bond tax exemption is another

likely target. However, it is still unlikely to be completely eliminated andinterest on existing bonds would be grandfathered in under the existing taxrules, in our view. The most sacrosanct and therefore the least vulnerabledeductions are the defined contributions to qualified retirement plans.

Only modest changes to capital gains and dividendsUnder either political alignment, but especially under Republican leader-ship, capital gains and dividends are unlikely to be taxed as ordinary income.However, the rate could rise from the current 15% to as high as 25% in asecond Obama administration once the additional 3.8% tax on unearnedincome for high earners mandated by the Affordable Care Act (ACA) isincluded. Romney, on the other hand, would seek to maintain both divi-dend and capital gains rates at the current 15% level.

Fig. 4: Marginal income tax rates at historic lowsTop marginal federal income tax rate, in %

Source: Internal Revenue Service, UBS, as of 30 August 2012

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Corporate tax reform likely in either scenarioCorporate tax reform appears to be a goal, of both parties albeit a chal-lenging one. US statutory rates are high relative to the rest of the world

(see Fig.5). However, US corporations dont pay higher effective rates, norhave these effective rates gone up over time, as many take advantage ofloopholes and companies have increasingly taken advantage of lower taxrates outside the US. Reform is challenging precisely because so many firmshave been structured around these loopholes. Corporate taxes are likelyto be reduced under either partys leadership, with a goal of a 25% rate,although something closer to 30% is probably more feasible. Democratswould look for some revenue enhancement and would be more willing toclose many loopholes. On the other hand, Republicans would seek a rev-enue-neutral proposal. Pass through entities such as S corporations, MLPsand REITs with more than $50 million in revenue could be at some risk offacing corporate income tax, especially under an Obama administration. Aone-time reduction in the tax rate on the repatriation of overseas corporate

cash is likely but only as part of a broader tax deal.

Healthcare reform in jeopardyWhile it should come as no surprise that the ACA would remain large-ly untouched under a second Obama administration, we believe signifi-cant components of the law could be modified by a Romney administra-tion and Republican Congress. Republicans would try to use the congres-sional reconciliation process to repeal the individual mandate and blockthe expansion of Medicaid. Additionally, a Romney administration may bemuch more inclined to grant waivers exempting states from establishinginsurance exchanges. Given the breadth and complexity of the law, it isunlikely that it would be entirely repealed and there may be substantialuncertainty for some time. In addition, Medicare reimbursement cuts would

be likely under any budget deficit reduction initiative. However, compre-hensive entitlement reform is more challenging, in light of the need to reach60 votes in the Senate.

Cheap natural gas, not politicians, driving energyCampaign rhetoric suggests a bigger difference in policy than is actual-ly likely to materialize in the Energy sector. Under either Obama or Rom-ney, natural gas extraction through hydraulic fracturing (fracking) is like-ly to expand and the Keystone Pipeline is likely to be approved. Obamacould push for regulations that encourage alternatives to carbon-inten-sive fossil fuels, promoting green and renewable energy, but would likelyonly achieve policies with small price tags. Alternatively, Republicans couldreduce or simplify some environmental regulations and facilitate on and

offshore drilling. Wind power subsidies could continue despite the electionoutcome given that GOP-leaning states are major wind power producers.Coal usage could face incremental pressure under an Obama reelection,but a Romney EPA will likely not roll back the coal regulations that havebeen put in place over the last four years. We see the nuclear industry asbeing largely unaffected by the election.

Financial regulation could lightenIf Obama returns to the White House, Dodd-Frank likely will be fully imple-mented. But even under a Romney administration, Dodd-Frank would alsoremain largely intact although certain measures could be revised in the allimportant rule-making process. If Romney wins, regulations that have notbeen finalized before the election may be subject to a more industry-friend-

ly interpretation. Of note, the Volcker rule, which limits proprietary tradingat large banks, will not likely be finalized before the election and a Rom-ney administration could pursue a more industry-friendly interpretation ofthis rule. The Basel capital accords which regulate bank capital levels couldpotentially also be applied more leniently.

Fig. 5: US corporations face higher statutoryrates than peersTotal corporate tax rate, including provincial and cen-

tral government, in %

Source: Organization for Economic Co- operation and Development (OECD) Tax

Database, UBS, as of 1 April 2012

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Economic implicationsLarge fiscal drag regardless of election outcome

While the political messaging on the campaign trail suggests fundamentallydifferent economic policies, we expect the differences between a secondObama administration and a Republican sweep are likely to be much moresubtle. The four areas that we focus on are 1) the size of the deficit reduc-tion package; 2) the composition of that package; 3) the level of policyuncertainty; and 4) the degree of regulation. Both candidates would haveto contend with the same high de cits, entrenched entitlements and overallslow-growth environment. We expect that a deficit reduction plan emerg-ing from either political scenario would come at substantial cost to GDPgrowth either now or in the future. But foregoing deficit reduction risksan even bigger crisis down the road. However, we conclude that a Romneyvictory may lead to slightly lower growth in 2013 but higher growth in theyears thereafter, relative to an Obama victory.

Deficit reduction similar size under either partyWe envision deficit savings of up to $4 trillion over the next 10 years undereither partys leadership. This assumes an additional $3 trillion in deficitreduction beyond the nearly $1 trillion of savings in the form of spendingcaps agreed upon during the debt ceiling negotiations of 2011, but in lieuof sequestration, triggered by the Budget Control Act, or BCA. While $4trillion may sound like a large number, the deficit projections would still notbring the US budget into balance anytime in the foreseeable future (seeFig. 6). However, this level of savings would at least begin to stabilize debt-to-GDP levels over the next decade.

The Congressional Budget Office (CBO) shows that under a continuation

of current policy, deficits would improve from an estimated 7.7% of GDPin 2012 to about 5% by 2018, and then begin to deteriorate again there-after. Savings of $4 trillion, 1 spread evenly across 10 years, would lowerthe deficit to about 3.5% by 2018, with a subsequent deterioration there-after. These cuts would therefore significantly improve debt sustainabilityrelative to current policy, largely stabilizing the debt-to-GDP ratio close tocurrent levels over the next decade (see Fig. 7). However, without significantreform, the rising cost of Medicare will drive an increase in debt-to-GDPlevels beginning in the latter part of the decade. While Republican leader-ship may be more likely to implement some entitlement reforms, deepercuts would subsequently be necessary to bring the programs into balance.Importantly, this level of deficit reduction would likely be enough to avertanother US credit rating downgrade in the near term, while a smaller pack-

age of deficit cuts, or one that only promises to make cuts in the future,could prompt further credit rating downgrades.

Small difference in composition of deficit reductionBased on their respective political preferences, we expect that the com-position of a fiscal package would differ moderately under Democratic orRepublican leadership. In the status quo scenario, we expect the ratio ofspending cuts to revenue increases to amount to 3 to 1, compared to a 4to 1 ratio under a Republican victory. These distinctions are likely too smallto imply a materially different economic growth outlook. The InternationalMonetary Fund (IMF) estimates that spending cuts have a larger drag on theeconomy than revenue hikes. Assuming for simplicity and illustration pur-poses that fiscal restraint starts in 2012 and is spread evenly over 10 years,

we estimate that a 3 to 1 spending-to-revenue ratio would reduce real GDPby 2.1%, and 1.5% in the first and second year, respectively. Under a 4 to 1

1USD 3 trillion in addition to the assumptions embedded in the CBO sce-nario.

Polarization and gridlock in Congress have added tothe sense of uneasiness among businesses and con-

sumers that has discouraged hiring, investing and

spending.

Fig. 6: Grand bargain doesnt drastically change pro- jectionsFederal budget projections under different scenarios,in % of GDP

Note: The "grand bargain" is approximately 4 trillion US dollars in deficit sav-ings. The CBO projection is from its extended alternative scenario, which isbased on current policy and includes th e savings from the discretionary spend-ing caps from the Budget Control Act of 2011. Source: CBO, UBS, as of 29

August 2012

Fig. 7: Debt-to-GDP would stabilize with a grand bar- gainFederal debt held by the public under different sce-narios, in % of GDP

Note: The "grand bargain" is approximately 4 trillion US dollars in deficit sav-ings. The CBO projection is from its extended alternative scenario, which isbased on current policy and includes th e savings from the discretionary spend-ing caps from the Budget Control Act of 2011. Source: CBO, UBS, as of 29

August 2012

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ratio, these figures would be insignificantly higher at -2.3% and -1.6% (seeFig. 8). In practice, political realities and the business cycle would probablymake these cuts more back-end loaded but the relative impact under both

scenarios should be similar.

The key takeaways are that:1. The fiscal restraint necessary to stabilize public debt ratios implies a

significant drag on the economy in the coming years unless the deficitcuts are weighted toward the end of the decade.

2. A greater focus on spending cuts will have a stronger adverse impacton growth, but not significantly so.

Policy uncertaintyEconomic policy uncertainty has been abnormally high since the financialcrisis first broke. Polarization and gridlock in Congress have added to thesense of uneasiness among businesses and consumers that has discouragedhiring, investi ng and spending. In our rece nt Exchange publication focusedon the upcoming election, industry experts discussed how this heighteneduncertainty about everything from the tax code to the ability of the US topay its debt has been detrimental to confidence and a drag on growth. Thiscan be illustrated with the US Economic Policy Uncertainty Index 2 (see Fig.9), which has remained elevated since 2008. It is our view that a Repub-lican sweep would allow for a greater political mandate that would ulti-mately reduce policy uncertainty. However, the first year of a Republicanadministration may actually see a spike in uncertainty, as the GOP is like-ly to attempt to overturn or revise previous legislation and embark on itsown reform agenda. After this period of more heightened uncertainty, weexpect the policy environment would become less volatile and uncertainthan it has been in the past few years.

Considering only this difference in uncertainty and relying on our estimatesof the impact of uncertainty on GDP growth, 3 we believe economic growthunder a Romney administration would be 0.3% lower in 2013 but then0.6% faster in 2014 vs. the Obama reelection scenario.

These differences while not extreme do suggest that the election resultswill have some impact on both current and longer-term growth prospects.

Regulatory burdenThe last aspect that is likely to distinguish between political scenarios isthe amount of government regulation. We assume that under a Romneyadministration a lighter approach to regulation would ultimately prevail.

We estimate that in 2014, the level of regulation might revert halfway topre-crisis level. This may amount to a 0.2% boost to GDP growth in thatyear. 4

2 The index was created by Baker, Bloom and Davis. Seewww.policyuncertainty.com for more info.3 We estimate that a sustained one standard deviation increase in the USEPUI curtails US real GDP growth by 0.6% after four quarters, as businessesand households pare back on their spending if they feel less certain aboutthe economic and policy outlook. We assume that a Republican-dominatedadministration would lower the US EPUI halfway back to pre-crisis levels inyear 2014 (a one standard deviation decline), while increasing uncertain-ty by half that amount in year 2013 (half a standard deviation increase),whereas under an Obama administration, uncertainty would be largelyunchanged.4 See UBS research focus, The financial crisis and its aftermath, March2009, for estimates of the impact of regulation on economic growth. Weassume that the Fraser Institute Economic Freedom Indexs regulation sub-component corrects halfway back to its pre-crisis level under a Republicansweep scenario, but stays constant under an Obama victory.

Fig. 8: GDP suffers under austerity regardless ofpartyFirst and second year impact of Grand Bargain on

real GDP growth

Note: Ratios computed assuming that fiscal restraint starts in 2012 and isspread evenly over 10 years. Source: IMF Fiscal Monitor April 2012, UBS as of7 September 2012.

Fig. 9: Policy uncertainty remains elevated post-LehmanUS economic policy uncertainty index, standardized

Note: The indexes are standardized and have a mean of zero and a stan-dard deviation of one. Source: EconomicPolicyUncertainty.com, UBS, as of 29August 2012.

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Market implicationsElections dont radically alter market outlook

The market ramifications of policy decisions made over the next severalyears will be widespread and, in some cases, very important. However, wedo not think that whoever controls the White House will radically alter thecourse of financial markets in general. Asset allocation implications at thebroad asset class level will therefore likely be limited. However, equities arepoised to perform somewhat better under a Republican administration,while bonds may come under greater pressure especially after the firstyear. If there is indeed a major fiscal deal, US Treasuries will retain theircurrent ratings. Municipal bonds run a not insignificant risk of losing theirtax-exempt status, regardless of who is in power. Implications for municipalbond holdings will depend on how broad the application of such a changewould be, and whether existing bonds would retain their tax-free status.

Equity marketsFundamentals matter more than party controlAverage annual US equity market returns have been higher under Demo-cratic presidents since 1928. But we also found that Democrats tend to takeoffice when stock market valuations are lower, which we believe is the pri-mary factor that explains the moderate outperformance (see Fig. 10). Withless than two months remaining before the election, numerous historicalfacts (most lacking statistical relevance) will be bandied about regardingthe relationship between elections and the stock market. The most welldocumented thesis is that stocks perform best in the second half of presi-dential terms as incumbent administrations promote pro-growth policies inorder to improve their chances of remaining in power. Keep in mind that

while on average stocks have historically performed better in the two-year period that includes the presidential election, the sample size that goesback 84 years is still relatively small (21 data points per year of electioncycle), and the premise has not been validated by the past two presidentialcycles (See Fig. 11).

While this type of analysis makes for fun cocktail party conversation, ittends to grossly oversimplify the investing landscape. We believe a betterapproach is to determine the outlook for corporate earnings and marketvaluations, i.e., core equity market fundamentals. As we describe above,the economic outlook under either election outcome is fairly similar andtherefore earnings growth rates should not differ greatly under Romney orObama. But there could be differences in equity market valuation multiples

as we describe below.

Obama victory limited impactAn Obama victory would more or less be a continuation of the status quoand therefore not likely alter our current stance on US equities, which webelieve are close to fair value. Over the last four years, P/E multiples haveaveraged about 13x forward estimates, lower than the long-term aver-age of 14.5x. We believe this valuation discount is a reflection of uncer-tainty about the longterm sustainability of US government debt dynam-ics, greater-than-normal threat of regulatory changes, consumer deleverag-ing, demographics and other factors that constrain economic growth andincrease uncertainty. In an Obama second term, most of the factors thatare weighing on equity market valuations will continue to linger. However,

there could be some progress on budget sustainability although long-termentitlement reform is challenging.

Romney victory a modestly higher P/EA Romney victory could be mildly supportive for US equity markets. Policyuncertainty could increase in the near term; however, once the fiscal cliff

The economic outlook under either election out-come is fairly similar and therefore earnings growthrates should not differ greatly under Romney or Oba-

ma. But there could be differences in equity market valuation multiples.

Fig. 10: Low valuation behind outperformanceunder Democrats

Note: Historical analysis begins in 1928.

Source: FactSet, Office of the Clerk of the U.S. Ho use of Representatives, RobertShiller, UBS , as of 6 September 2012

Fig. 11: Stock market election cycle has notworked recentlyS&P 500 returns by year of presidential term

Source: Bloomberg, Ibbotson, UBS as of 10 September 2012

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is behind us and Republicans have left their mark on tax, financial andhealthcare reforms, uncertainty should decline. Looking ahead a bit fur-ther, we believe a Romney administration may be able to achieve some

long-term and marginal entitlement reform, likely more than under a sec-ond Obama term. However, a Romney administration would still have toaddress many of the same secular challenges, such as consumer deleverag-ing, demographics and the pain of fiscal austerity. But given our view thata Romney administration will be able to achieve some long-term fixes topersonal and corporate income taxes and greater regulatory clarity, evenwith a rocky transition and potentially some growth slowdown in 2013,we believe equity market valuation multiples have a greater potential toimprove in this scenario.

Separating rhetoric from realityWhile economic policy may not be that different under an Obama vs. aRomney administration, there are still a number of areas where specific

policies would vary. The policy agendas presented in the campaign mayindeed be curtailed by a near evenly divided Senate, but whichever partycontrols the White House will be able to pursue and implement at leastsome changes.

Dividend and capital gains taxesUnder an Obama reelection scenario, we expect only a modest increase individend tax rates to 20-25%. A Romney victory could result in no changeto current dividend tax rates (15% for qualified dividend income). Histori-cally high valuations of the highest-yielding sectors of the market (Telecomand Utilities) would be vulnerable if dividend income tax rates were to rise.However, an increase in dividend tax rates under an Obama White Housewill likely be accompanied by an increase in ordinary income rates for the

highest earners as well, which means that dividend yields may not lose theirtax advantage relative to fixed income investments. Capital gains tax ratesare scheduled to rise to 20% next year (from 15%), a level that is likelyunder an Obama victory. As a result, there could be some year-end profittaking in stocks that have performed well. A Romney administration wouldlikely be able to achieve an extension of the 15% capital gains tax rate,mitigating this risk.

Corporate tax reform: lots of moving piecesAny corporate tax reform will likely have to be at least revenue-neutral,which means that a lower tax burden for some industries has to be offsetby higher taxes for others, creating winners and losers (see Fig. 12). Onebig ticket item that lawmakers would likely include as part of a larger tax

reform, especially under a Romney win, is a one-time reduced tax rate onthe repatriation of overseas income. While this would be modestly positivefor Technology, Industrials, Pharmaceuticals and select Consumer Staplescompanies, there will be intense scrutiny around how companies deploythis cash, and management teams will have to be careful about distributingtoo much of this to shareholders. In addition, the quid pro quo for this one-time tax holiday will likely be restrictions on transferring intellectual prop-erty to overseas subsidiaries in locations with lower tax rates, which may bea modest negative for many Technology and Pharmaceutical companies.

Finding opportunities regardless of the election outcomeNot surprisingly, industries would likely face more change under a Romneyadministration rather than a second Obama term, as a new president tries

to roll back some of the reforms put in place over the last four years andimplement his own policy agenda. Therefore, in the run-up to the election,investors in Healthcare and, to some extent, Financials, will once again con-tend with some policy uncertainty. As the election is still a very close call,we recommend investors focus on sectors that are well-positioned regard-

Fig. 12: Corporate tax burden in line with his-

torical averageCorporate tax receipts as a share of GDP, in %

Source: Office of Management and Budget, UBS , as of 6 September 2012

Fig. 13: Current US sector strategyTactical deviations from benchmark

Source: UBS, as of 6 September 2012

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less of the election outcome. Within cyclicals we highlight the Technologysector (low valuations, product cycle visibility, and strong balance sheets).Consumer Staples (dividend growth, emerging market consumer exposure)

is our preferred defensive (see Fig. 13). In Fig. 14, we summarize the poten-tial impact on all sectors of an Obama or Romney victory.

Fig. 14: Sector implications of potential election outcomes

Impact Obama victory Romney victory

Financials Medium/ High

Small risk that quasi pass-through entities, such asREITs, will incur corporate tax, depressing earningsand valuations

Reduced risk of regulation/threats of legal action,more industry-friendly interpretation of nancial reg-ulations and potential scale back of rules to limit pro-prietary trading could li the current low valuationsof large banks and brokers

Utilities Medium Some risk of lower industry valuations due tohigher dividend tax rates

Wind power generators bene t from extension ofsubsidies beyond 2012

Coal- red generators face further potentialrestrictions

Threat of additional regulation removed for coal- redgenerators

Potential bene t from extension of low dividendincome tax rates

Healthcare Medium Pharma bene ts from repatriation tax holiday buttax reform may limit ability to book pro ts in non-US, low tax jurisdictions going forward

Overall slightly negative for the sector Healthcare product companies such as pharma, bio-

tech, medical equipment hurt by lower volumes (lessinsurance coverage) and government reimbursementcuts

Managed care companies bene t from less regulationand move toward privatization of Medicare/Medicaidalthough possible government reimbursement cutscould hurt

Pharma bene ts from repatriation tax holiday but taxreform may limit ability to book pro ts in non-US,low tax jurisdictions going forward

Energy Low Small risk that quasi pass-through entities, such asMLPs will incur corporate income tax, depressingearnings and valuation

Streamlining of drilling permits could bene t E&P andoil eld services companies

Coal mining companies bene t from lower threat ofadditional regulation on coal usage

ConsumerDiscretionary

Low Homebuilders could bene t from possibly moreaid to underwater homeowners

Cable companies could bene t if allowed to prioritizeinternet traf c (scale back internet or net neutrality)at the expense of content owners

ConsumerStaples

Low Modest possible bene t from repatriation taxholiday

Modest possible bene t from repatriation tax holiday

Industrials Low Defense contractors hurt by continued defensespending reductions

Modest possible bene t from repatriation taxholiday

Somewhat smaller defense spending reductions Rails could bene t from less pressure on coal and

threat of regulation Modest possible bene t from repatriation tax holiday

Materials Low No signi cant changes likely Possible reduction to ethanol mandates could lead toreduced corn and fertilizer demand

Technology Low Could bene t from repatriation tax holiday but taxreform may limit ability to book pro ts in non-US,low tax jurisdictions going forward

Cuts in government spending could hamper Techdemand

Could bene t from repatriation tax holiday but taxreform may limit ability to book pro ts in non-US,low tax jurisdictions going forward

Telecom Low Some risk of lower industry valuations due tohigher dividend tax rates

Could bene t from government green light on wire-less industry consolidation

Pricing may improve if allowed to prioritize internet

traf c (scale back net neutrality) Potential bene t from extension of low dividendincome tax rates

Source: UBS, as of 11 September 2012

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FinancialsMost of the changes we expect under a Romney administration, as laid outin Election issues section, would have only a modest impact on Financial

sector earnings, but there could be notable valuation expansion, especiallyfor the large banks and brokers which are trading at historically very lowvaluations (see Fig. 15), based on an improvement in the regulatory envi-ronment. These companies represent nearly 40% of the sector. Insurancecompanies (25% of the sector) would be largely unaffected, but there couldbe a halo effect that also boosts valuations for this industry. With thestatus quo largely maintained under an Obama victory, the sector wouldlikely be unaffected if Obama wins reelection.

HealthcareContrary to consensus thinking, we believe a Romney victory would beslightly negative for the sector. The product companies (pharmaceuticals,biotech and medical devices), which comprise 80% of the market cap of

the sector, would suffer from fewer Americans with medical insurance cov-erage and possibly lower government reimbursements (see Fig. 16). Thiswould be somewhat offset by a higher valuation multiple due to less gov-ernment regulation and a tax holiday on the repatriation of overseas cash.Furthermore, there is a small chance of Medicare eligibility changes thatwould reduce benefits in the long term. On the flip side, a Romney victorywould be positive for the managed care industry, which represents about10% of the sector. These companies would likely benefit from incentivesfor individuals to move to privately managed Medicare and Medicaid plans.Repeal of the individual mandate would translate into less growth for thecommercial insurers, but we believe the market is skeptical of the profitabil-ity of this incremental business anyway. An Obama reelection would nothave much impact on the sector as the status quo is maintained.

Energy and powerDespite the rhetoric, the divide between the two candidates on energy pol-icy is actually quite narrow. Rather than policy, the sector is being reshapedby cheap natural gas, which we expect to continue under either candidate.On the margin, a Romney victory could boost sector valuations due to theperception that a new administration would be more supportive of theindustry and could pave the way for slightly faster domestic drilling overtime. Coal miners would probably also get a boost as the threat of fur-ther regulation diminishes. An Obama victory would not likely have a majorimpact on the sector, although coal mining shares could come under somepressure over fears of further restrictions on coal usage, and wind powergenerators could benefit from expansion of renewable power mandates.

MLPs and REITs will face more scrutinyWhile not our base case, we believe there is some risk that MLP and REITincome (and other quasi pass-through entities) could become subject tocorporate income tax as the government looks to raise revenue while reduc-ing corporate tax rates. As a result, these securities could come under sub-stantial selling pressure. This scenario has up to a 20% probability under anObama victory with slightly lower odds under a Romney win. Once again,this is not our baseline view. However, given its potential significant impacton investors, we will be monitoring this issue very closely.

Fig. 15: Increased regulation has weighed onFinancials valuationRelative price-to-book ratio of Financials vs. the mar-

ket

Source: Thomson Datastream, UBS, as of 1 September 2012

Fig. 16: 80% of sector negatively impacted byACA repealShare of Healthcare sector, as % of market cap

Source: FactSet, UBS, as of 6 September 2012

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Fixed incomeTreasuries: not election-dependent in the near term

Election results, while important over the long run, are less likely to driveyields in one direction or another. We expect economic fundamentals in theUS and developments in Europe to determine the general direction of Trea-sury yields in the near- to medium-term. The fiscal cliff poses the most sig-nificant risk to this forecast as a failure to negotiate a political compromisemay yet trigger another economic recession. The second main event riskis the extension of the debt ceiling, which could lead to technical defaultif the statutory borrowing limit is not increased. (see Fig. 3). However, weexpect a satisfactory deficit reduction package and an increase in the debtceiling regardless of the outcome of the election. Any signs of economicnormalization could lead to an eventual tightening of Federal Reserve pol-icy, consistent with our expectation for marginally higher yields over a 6- to12- month horizon. To the extent GDP growth may be lower under Romney

in 2013 but higher in 2014, a Romney victory may keep downward pres-sure on yields at first but then lead to a somewhat sharper rise thereafter.

Longer term, however, the size of the federal budget deficit and elevatedlevels of debt-to-GDP should exert a powerful influence on yields partic-ularly as the cost of funding increases when growth picks up, as we expect.In the absence of credible longer-term fiscal reform, an additional credit riskpremium has the potential to be built into Treasury yields, in light of the riskof future credit rating downgrades. This could contribute to Treasury yieldlevels that are considerably higher than current levels in the years ahead.However, a lack of viable safe haven alternatives would still serve to limitthe magnitude of any repricing on credit concerns alone. And if a crediblefiscal plan is indeed put into place, it would also prevent any such sizable

uptick in yields.

Rating agencies taking a wait and see approachS&Ps much publicized US sovereign credit rating downgrade in August2011 initially triggered substantial consternation among market partici-pants. Since then, Moodys, S&P and Fitch have maintained a negative out-look on their Aaa/AA+/AAA ratings, respectively. A negative outlook repre-sents the possible ratings path over the intermediate term, whereas a creditwatch or review reflects prospects in the near term. We expect the agencieswould first move from a negative outlook to a negative credit watch beforechanging the rating. While it is difficult to precisely identify when any ofthe rating agencies will act, all three have intimated that they would be ina position to alter their outlooks in mid-2013 to early 2014. As it relates to

fiscal reform, the rating agencies are taking a wait-and-see approach over ahorizon that spans the presidential election and subsequent lame duck ses-sion of Congress (see Fig. 17). All three agencies agree that some form ofdeficit reduction package in excess of last years Budget Control Act (BCA)is likely and have largely built this into their base case fiscal outlooks. Webelieve that a $4 trillion deficit reduction package is likely to placate the rat-ing agencies for now, but still result in warnings about the long-term out-look and the commitment to control deficits. Political brinkmanship couldyet threaten current credit ratings in the near term, especially as it relatesto a potential showdown in raising the debt ceiling in early 2013. Over thelonger term, US sovereign ratings could be at risk if debt/GDP ratios arenot deemed to be within acceptable limits, which would likely necessitatemore significant entitlement reforms.

GSE reform not likelyGovernment-sponsored enterprises (GSEs) Fannie Mae and Freddie Machave been in government conservatorship since September 2008 andhave received $188 billion in cash from the US Treasury in order to keep

Longer term, the size of the federal budget deficit and elevated levels of debt to GDP should exert a

powerful influence on yields particularly as the cost

of funding increases when growth picks up, as weexpect.

Fig. 17: US sovereign rating agency outlooks

Source: Moodys, S&P, Fitch, UBS as of 6 September 2012

Fig. 18: Market assigning little value to tax-exemptionTreasury, municipal, and corporate yield curves, in %

Note: GO stands for general obligations.

Source: Municipal Market Data, Bloomberg, UBS as of 4 September 2012

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the sale of new tax-exempt bonds may be limited to just a few public pur-poses. Alternatively, tax-exempt interest on newly issued bonds may betaxed but at a lower marginal rate than earned income. A third option,

the provision of direct federal subsidies toward the payment of debt ser-vice, was successfully tested by the Build America Bonds program. To theextent any of these options plays out, we would expect pre-existing munic-ipal bonds to outperform other fixed income asset classes on the basis ofscarcity value alone.

The outcome could go one of two ways. Grandfathering outstanding bondsin conjunction with the imposition of new limitations should produce arally as long as these bonds retain a relative tax advantage to other assetclasses. Retroactivity, which we believe is far less likely, is more of a mixedbag. Provided the tax imposed on municipal bonds is relatively low, the taxadvantage of municipals is preserved but the benefit is reduced. We donot recommend repositioning municipal bond portfolios now since there is

little clarity as to the path either administration would likely take, but closermonitoring is warranted.

ConclusionOn the campaign trail, President Obama and Governor Romney advocatevastly different visions for the future role of the federal government. How-ever, in practice, the two may not be able to exercise as much discretion asthey promise and neither individual is likely to be able to radically alter therole and size of government. Both candidates would be faced with a slow-growth economy and the pain of implementing fiscal austerity, and bothwould have to reckon with a closely divided Senate which would inhibitthem from implementing or repealing ambitious reforms.

In spite of the political and economic challenges facing the next president,we expect more progress on fiscal issues than over the past several years.While this may be the result of a more collaborative political environment,its more likely that the fiscal cliff especially the unpleasant indiscriminate-ness of sequestration and the looming debt ceiling will force such a deal.We believe a bipartisan deficit reduction package would look broadly simi-lar under either administration, likely placating the rating agencies for now.A mildly more optimistic intermediate-term GDP growth expectation, cou-pled with incrementally greater policy clarity under Romney, may be morefriendly for equity markets.

While the big policy outcomes may not be vastly different under a Rom-

ney or Obama White House, there are still many specific areas that coulddiffer, with important implications for financial markets. However, someimportant policy changes may transpire regardless of who wins in Novem-ber. Elections do matter and the two candidates would pursue very differ-ent visions, but the difference between what each of them could actuallyachieve in office may not be quite as dramatic as current rhetoric wouldsuggest.

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Appendix

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