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Global Investment Strategy Global

UBS Investment Research Global Investment Strategy

Strategy Asset Allocation

Ten surprises for 2012 „ Our year end tradition At the end of each year, in our final strategy note, the global asset allocation and global equity strategy teams join up to consider possible surprises for investors in the year ahead. Inside, we briefly describe ten such outcomes, and also provide a review of how last year’s surprise candidates fared. „ Market surprises Fittingly, a number of our surprise candidates are about market outcomes—for example unexpected euro strength, sharp oil price declines, the outperformance of financials, or significantly higher US Treasury yields. „ Other surprises But ‘the political economy’ could also be the source of surprises, including unexpected electoral resilience of incumbents, sovereign default outside the Eurozone, an Italian sovereign debt rating upgrade, or a fraying of European political integration. Keeping with tradition, we also offer a sports surprise—the thrill of victory or the agony of defeat for ‘Team Great Britain’ in next summer’s London Olympics. „ Season’s greetings This is our final note for 2011. We’d like to take this opportunity to wish our readers our very best wishes for the holiday season and the New Year.

16 December 2011 www.ubs.com/investmentresearch

Larry Hatheway Economist [email protected] +44-20-7568 4053

Sunil Kapadia Economist [email protected] +44-20-7567 4090

Jeffrey Palma Strategist [email protected] +1-203-719 1135

Christopher Ferrarone Strategist [email protected] +852-3712 4951

Ramin Nakisa Strategist [email protected] +44-20-7567 6861

Jerry McGuire Associate Strategist [email protected] +1-203-719 3600 "Surprise"

UBS "Base case"

The consensus of bottom-up earnings estimates is right

It is wrong

Financials outperform

Financials underperform

The euro rallies

The euro depreciates

Oil prices fall below $70/barrel

Oil prices stabilize around $95/barrel

Sovereign default outside the Eurozone

Sovereign default inside the Eurozone

Rising Treasury yields

Stable Treasury yields

An Italian sovereign upgrade

No upgrade

EU or EMU disintegration

Europe manages to keep it together

Fewer than five governments switch hands

N/A

Britain does Great at next summer’s Olympics

Depends on who you ask

Source: UBS

This report has been prepared by UBS Securities LLC ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 12. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Global Investment Strategy 16 December 2011

Ten for 2012 At the end of each year, in our final strategy note, the global asset allocation and global equity strategy teams join up to consider possible surprises for investors in the year ahead. In what follows, we briefly describe ten such outcomes, and also provide a review of how last year’s surprise candidates fared.

Our year end tradition

Our aim is not to second-guess our or our colleagues’ baseline scenarios. Rather, we are all too aware of what can happen to forecasts, particularly when shocks arrive or when consensus-like positioning evaporates. Of course, in these turbulent economic times, with elevated levels of sovereign stress and market volatility, the bar for qualifying as a genuine surprise keeps moving higher.

Ten surprises for 2012 Caveats aside, here are our ten surprise candidates for 2012:

1. The consensus is right (for once) Let’s face it: Bottom-up consensus earnings forecasts have a miserable track record. The traditional bias is well known. And even when analysts, as a group, rein in their enthusiasm, they are typically the last ones to anticipate swings in margins.

Hold on to your seats, the analysts are right

So it qualifies as surprise in any year if the bottom-up consensus is close. Maybe 2012 will be the year they get it right. Unsurprisingly, the collective wisdom of analysts anticipates another robust year of earnings growth in 2012, with global earnings expected to be up 11.7%. While this figure has moved lower in recent months, expectations remain overly optimistic. After all, global economic activity is slowing. Our economists forecast global GDP growth of just 2.7% in 2012. That figure is only slightly above levels normally associated with global recession and implies earnings growth in the low-to-mid single digits, at best. Furthermore, the current bottom-up earnings estimate is generated on forecast revenue growth of just 4.2%, which implies significant margin expansion in the coming year to arrive at a double-digit earnings forecast. The assumption of margin expansion appears heroic. Margins have flattened or shrunk in the last two quarters. It is unusual to see a further widening of profit margins at this stage of the cycle, particularly from current levels. So what needs to happen for the consensus of analysts to get it right? For one, global GDP growth would have to re-accelerate to drive up revenue estimates. Operating leverage remains high across the corporate sector generally, so any increase in final demand above current forecasts could be magnified to the bottom-line. That would particularly be the case if companies remain cautious about hiring and capital expenditures. In that case, higher turnover would lift productivity and capacity utilization, factors which typically push profit margins higher. Still, the conclusion is inescapable: Consensus estimates will only be right if everything goes right.

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Global Investment Strategy 16 December 2011

Chart 1: Progression of annual earnings growth rates for MSCI AC World 50% 40% 30% 20% 10% 0% -10% -20% 08

09 2009

10 2010

11 2011

2012

Source: Thomson Datastream, UBS

2. Financials outperform Perhaps, after five years of underperformance, financials will outperform in 2012. Readers will be forgiven if that sounds both a bit far-fetched and selfserving. After all, most of the conditions that have caused the sector to sharply underperform are still in place: Mounting regulatory hurdles (many of which are yet-to-be implemented), insufficient capitalization, deteriorating credit and funding conditions in Europe, fears of hard landings and property bubbles in China, weak turnover in capital markets, moribund primary businesses, a stagnant US housing market, etc.

Return of the living dead

And then there are the new challenges: Shrinking balance sheets and sovereign stress in Europe coupled with woeful policy responses. Looming ahead are possible further regulatory changes, reflecting popular discontent with banks, as manifest for example in the ‘occupy’ movements. Maybe, therefore, we should just move on to surprise #3… The hope, however, is that much of the bad news about banks is known and discounted. According to our global banks team, for example, expectations for the sector are low and costs are being slashed. As a result, any unexpected revenue pick up could lead to nice bottom-line surprises.

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Global Investment Strategy 16 December 2011

Chart 2: Financials vs. overall market Index Jan 07 = 100

140 120 100 80 60 40 20 0 07

08

09 MSCI AC World

10 11 MSCI AC World Financials

Source: Bloomberg, UBS

Furthermore, if some elements of the Dodd-Frank bill and Volcker rule could be eased, that would provide a further positive catalyst for the sector. Most important would be an early recapitalization of European banks, coupled with more decisive action to stabilize the Eurozone sovereign credit crisis.

The sector needs a lift from better policy in Europe. Oh well.

Of course, if sector performance depends on European policy makers getting it right, then arguably this surprise is the longest shot of them all.

3. The euro rallies The resilience of the euro in 2011 was one of the bigger surprises given the immense pressures seen in European equity and bond markets. After starting the year around 1.33, the currency rallied above 1.48 in April and only recently has started to fall more sharply. Yet it remains within a whisper of its 2011 starting value at the time of writing. In classic British understatement, all is not well in Europe. Europe’s policy makers have shockingly mis-diagnosed the patient, administering pro-cyclical fiscal austerity just as a full-blown credit crunch and deep recession get underway. Meanwhile, the ECB had the temerity to hike rates earlier this year. It has belatedly undone its error, but still remains incapable of providing the monetary stimulus the Eurozone now clearly needs to offset fiscal austerity and tighter credit conditions. The ECB is more worried about moral than economic hazard.

More worried about moral than economic hazard

Predictably, the Euro area economy is forecasted to contract -0.7% next year (with the annualized pace of decline around -1.7% in the first half of 2012). In short, Germany and the ECB are conducting a majestic string quartet while Rome, Athens, Madrid, Lisbon and Dublin burn. And the sparks are beginning to fly in Paris as well. In less prosaic terms, the euro is sliding in the currency markets. So it would be a big surprise if, contrary to all evidence and reason, the euro were to rally in 2012.

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Global Investment Strategy 16 December 2011

So why might it happen? Part of the answer is ‘the pain trade’. As our currency strategy team points out, the consensus is already short of the euro. In addition, strategists are falling over themselves to see who can forecast euro/dollar parity soonest. Hence, short-covering euro rallies are surely possible in 2012. What else could help the single currency? Fundamentally, renewed US economic weakness and another round of Fed quantitative easing might do the trick. Even if unlikely, that scenario can’t be ruled out, particularly if financial contagion from Europe spreads across the Atlantic. A second source of (temporary) euro support could come from aggressive asset repatriation by European financial institutions striving to shore up their domestic liquidity buffers and capital positions in the event the Eurozone crisis intensifies.

Bad policy, strong currency: It could happen

Come to think of it, euro strength might not be all that far-fetched.

4. Oil prices drop below $70/barrel Brent crude oil prices began this year at $95/bbl and proceeded to rally in almost uninterrupted fashion up to $123/bbl by the end of April, as ‘Arab spring’ unfolded. Since then Brent prices have trended gently lower but have remained well supported above $100/bbl, apart from a dip in early October.

Europe may drive oil prices as well

The resilience of oil prices has been notable, particularly given the US ‘soft patch’ this summer, the advent of Eurozone recession in late 2011, and slowing growth across the emerging complex, including in China. Demand is likely to soften further and oil production may get a lift from some resumption of output in Libya. Accordingly, our oil team forecasts that the price of Brent crude will fall to $95/bbl by the end of 2012. But the idea of oil prices falling even further from current levels (say 25%-30% or more) is difficult to envision given still-present tensions in the Middle East. While a repeat of the protests and rebellion seen this year may be unlikely, uncertainty is likely to remain high, particularly as now regards Iran. So an unexpected sharper fall in oil prices would require some reduction in regional tensions. The other way oil prices could drop more than we expect is via global recession. We are sceptical that could originate in China (we don’t fancy the hard landing scenario there) or from the US. Yet again, it seems all trails lead to Europe.

5. Sovereign default…outside the Eurozone We doubt anyone would be surprised by a Eurozone sovereign default in 2012. Greece, after all, is almost certain to default—only the form and precise timing remain in question. What would be a surprise is if an emerging economy defaulted first.

Could an emerging country default first?

As we have noted elsewhere, sovereign balance sheets and fiscal sustainability metrics look pretty robust across the emerging complex. But a few risk cases stand out. The following chart shows credit default swap pricing for selected emerging countries. The highest probability of default, according to investors, exists in Pakistan, the Ukraine, Hungary and Croatia.

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Global Investment Strategy 16 December 2011

Chart 3: Sovereign CDS 1200 Latest 5y CDS 1000 800 600 400 200

USA Sweden United Kingdom Germany Chile Qatar Abu Dhabi Japan Malaysia China Colombia Mexico Brazil Korea Peru Czech Estonia Austria Thailand Philippines South Africa Israel France Indonesia Russia Kazakhstan Poland Turkey Latvia SBI Lithuania Bulgaria Spain Romania Croatia Italy Hungary Ireland Ukraine Pakistan Portugal Greece

0

Source: UBS, Bloomberg

Among emerging countries, our strategy teams have highlighted that Hungary looks particularly worrisome, given its high sovereign debt-to-GDP ratio and weak growth prospects. Hungary also has the highest external public debt ratio in the emerging world. With significant foreign currency funding exposure Hungary is vulnerable to ‘sudden stops and reversals’ of capital flows, without the backstop of its central bank (which can only act as lender of last resort for local-currency bank financing). That situation is reminiscent of peripheral Eurozone countries. Any unexpected sovereign default would boost risk premiums across equity and debt markets, probably leading to an underperformance of emerging versus developed markets. Safe-haven assets such as US Treasuries, German Bunds, the Swiss franc, and Japanese yen would perform best.

6. US 10-year Treasury yields break out Despite large deficits, mounting debt levels and a downgrade, US Treasuries remain amongst the safest of all asset classes. Coupled with strong support from the Fed (in terms of quantitative easing), this has led to a period of dampened volatility for Treasury yields. Most investors expect more of the same in 2012.

A different sort of bond market shock

What could prove them wrong? The case for higher yields would be presented by a sustained improvement in US economic and financial conditions. That scenario would most likely be accompanied by a recovery in risk appetite and, ultimately, in shifting expectations for Fed policy normalisation. All of those factors would lead to a rise in yields. The other path to higher yields would be a significant worsening in US sovereign credit quality. To be sure, investors continue to assign a very low default probability to US government debt. Alternatively, the appeal of US Treasuries could be eroded by common bond issuance in the Eurozone, creating the potential for a larger homogenous market for European government debt that UBS 6

Global Investment Strategy 16 December 2011

could rival US government debt hegemony. That, however, seems a remote possibility. In market terms, rising bond yields would obviously erode the value of Treasuries. A rise in US ten-year yields to, say, 4.5% next year would imply a negative -16% total return. Stocks would clearly outperform if the reason was stronger growth. A US sovereign crisis, on the other hand, would produce just the opposite result—a risk asset sell-off.

7. An Italian sovereign upgrade Yes, you read that right—an Italian sovereign upgrade.

Not quite as crazy as it sounds

Here goes. The austerity package proposed by the Monti government has not yet persuaded the rating agencies’ to lift their outlook on Italian sovereign debt from ‘negative watch’. An Italian rating upgrade within a year appears highly unlikely—clearly it would be a big surprise to markets. But it isn’t impossible. There have been two examples in the recent past where investment grade sovereign debt ratings have been upgraded within two years of the initiation of a negative outlook. The first comes from the Baltic region, namely Estonia and Latvia. They were among the most severely hit economies during the financial crisis, which resulted in Fitch announcing a negative outlook in April 2009. But both Estonia (July 2010) and Latvia (March 2011) were upgraded (to A and BBB, respectively) within two years of being put on negative watch. The second example is Turkey. In March 2003 Turkish sovereign debt was put on negative outlook, but the Turkish government responded by slashing the budget deficit from about 15% of GDP in 2002 to below 5% three years later. Fiscal tightening resulted in Fitch upgrading the debt first to B in September 2003 and again to B+ in February 2004, all within a one-year time frame. So, back to Italy—can it make the grade? As our European economists have noted, the reform package in Italy is credible. We suspect that the criteria for an upgrade are three: 1) Final political approval of the austerity package (our economists expect this to happen before year-end); 2) Efficient implementation of the austerity package; and finally 3) Restoration of ‘normal’ liquidity conditions in Italian sovereign debt markets. The second and third factors arguably pose the biggest challenge to an upgrade. They are also interrelated. For liquidity to return to the Italian bond market investors need to be convinced about implementation of austerity. Investors would also have to be re-assured that Italy can avoid a severe and/or prolonged recession. For that, Italy needs help from Germany or the ECB.

Made in Germany

So it seems Italy’s sovereign rating, like so much else these days, will be made in Germany.

8. An E(M)U exit Over the past year, we’ve written extensively about the prospects for, and consequences of, Eurozone exit. The bottom line is that exit would be a dreadful mistake for the departing country, as well as for those remaining in the Euro area. UBS 7

Global Investment Strategy 16 December 2011

That doesn’t mean it couldn’t happen. One clear lesson from history is that when populism and nationalism are in ascendency, rationality is usually in decline. And frustration with the mis-diagnosis of the Eurozone crisis—and hence the application of the wrong policy prescription (fiscal tightening without any offset)—could lead to a populist backlash and calls for exit.

Outcomes aren’t always dictated by rationality

But, equally, the imperative for a closer fiscal union (with proper transfers and common debt issuance) implies the need for a closer political union. That’s where matters also get tricky. Fiscal subordination and other forms of sovereignty transfer are unpopular in many parts of Europe. Look no further than to Cameron’s veto of the proposed changes to the EU treaty last week for evidence of ambivalence to ‘an ever closer European union’. Nor is the UK as isolated as some might think. Within Germany there is open hostility to the idea of a ‘fiscal transfer union’. Nationalist and populist forms of discontent are already evident in Finland, the Netherlands and France. Moreover, any discussion of ‘disintegration’ in the old world is not limited to the EU—it is also evident within countries. The rise of Scottish nationalism or the linguistic and cultural splits in Belgium offer examples of fault lines within nations. To be sure, the political, legal and practical challenges of exit—whether from the Eurozone, the EU, or from national association are daunting. As a result, the probability of disintegration in Europe in the next twelve months remains very low. But it has happened—Czechoslovakia and the former Yugoslavia provide the most recent examples of disintegration in Europe. And if Europe’s long history tells us anything, it is that political structures have a tendency not to last.

It has happened before

So watch this space. Even a rising probability of disintegration—particularly within the Eurozone—is likely to greatly unnerve investors and send them scurrying for the safest assets they can find.

9. Fewer than five governments switch hands In 2012 a number of countries go to the polls. Incumbents are nervous, and rightly so as public opinion polls register mounting voter discontent. Already in 2011 turnover at the top has been in evidence, among others in Greece, Italy, Portugal, Belgium and Spain (not to mention in the Arab world, albeit under different circumstances).

Will ‘change’ be again the winning slogan in 2012?

So it would not come as surprise to see many fresh faces in office at the end of 2012. Given the number of elections (and other ways political change could happen), the surprise would be if fewer than five heads of state are shown the door in 2012. Political change is already determined by process or law in China, Mexico and Russia—so we won’t count those in our baseline of five. Otherwise, elections are scheduled next year in Taiwan, Finland, France, South Korea, Switzerland, India, The Ukraine, the US, and Venezuela. In addition, coalition governments are feeling strains in countries where elections are not otherwise scheduled for 2012—among them, Germany and the UK. UBS 8

Global Investment Strategy 16 December 2011

10. Britain does Great The summer Olympic Games will be held in London next year and provide a bevy of opportunities for surprise. Rather than think about individual events and the historical dominance of certain nations in certain disciplines, we choose to focus on the home nation’s prospects. The following chart shows that until the last Olympics in 2008, Great Britain consistently achieved a number six rank in the summer Olympics. In 2008, ‘Team GB’ leapfrogged to fourth place, narrowly missing out on a top-three result.

The host advantage

Chart 4: Gold medal count 60

Gold Medal Count

50 40 30 20 10 0 1992

1996

2000

2004

2008

USA

CHINA

Russia

Great Britain

Germany

Australia

Source: Wikipedia, UBS

Next year, a ‘team bronze’ is within reach. Discouraged by Eurozone political ineptitude, we have recently turned our research focus to the academic literature of sports and have built a model to forecast the country medal count next summer. One well-known tenet of ‘Olympic modeling’ is accounting for host nation advantage. Host nations usually manage to boost their medal haul relative to previous Olympics (and also suffer ‘hangover’ in subsequent games). Whether the host advantage resides in ‘home cooking’ or more favorable treatment by judges, officials and referees we can’t tell, but the tendency for the hosts to do well is clear. So what do our models suggest? The table below is our prediction of the medal results at the London Olympics, ranked by number of gold medals (rather than total medals). In short, we wouldn’t be surprised by a top-three result for Great Britain. The real surprise would be for the Brits to finish ahead of either the Americans or the Chinese. Or to finish below the Australians—heaven forbid!

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Table 1: 2012 estimated medal wins vs. 2008 result 2012

2008

Gold

Total

Gold

Total

China

44

69

51

100

USA

35

104

36

110

Great Britain

25

62

19

47

Russia

23

91

23

73

Australia

18

55

14

46

Germany

7

29

16

41

Source: UBS

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Recapping last year’s surprises Below, we reprint our list of ‘surprises’ from last year, and compare our conjectures to actual outcomes. Most of our surprises remained just that, although there were a couple of close calls and a few did happen. Q

Gold prices plunge below $1,000 per ounce: With interest rates making new lows over the year and given the intensification of the Eurozone sovereign crisis, gold prices continued to climb for much of 2011, peaking just above US$ 1900/oz in early September. More recently, some of the gloss has come off gold, with prices dipping below US$ 1600/oz. Still, gold prices remained supported in an environment of political, sovereign and monetary uncertainty.

Did it happen? No.

Q

Ten-year Treasury yields rise above 4.5%: Ten-year Treasury yields hit an all-time low around 1.8% in September, and have failed to recover meaningfully since then. Lower global growth expectations, higher market volatility and elevated safe-haven flows fuelled the demand for Treasuries during 2011. Despite the US sovereign rating downgrade, Treasuries have once again proved their worth as the ultimate safe-haven asset.

Did it happen? No

Q

Oil prices reach $125 per barrel: The price of Brent crude oil reached a high of $126/barrel in April this year as ‘Arab spring’ lifted energy risk premiums. WTI oil prices also rose to a high of $115/barrel in April, but then fell to lows around $80/barrel before recovering to their current levels just under $100/barrel.

Did it happen? Yes

Q

European sovereign debt restructured: Despite ostensible PSI agreements, Eurozone sovereign bond holders have not yet suffered a restructuring related loss in 2011. Mark-to-market losses are an altogether different matter. But as yet, no coercive (with CDS trigger) or voluntary (no CDS trigger) restructuring has occurred. To be sure, private sector holders of Greek sovereign debt are currently in negotiations to determine the contribution that they will ultimately make to the Greek rescue package. Before long, a Greek restructuring will take place—whether it triggers CDS is harder to determine.

Did it happen? Not quite

Q

Implied equity volatility drops to the low teens: Falling volatility is often associated with rising equity markets. US equity markets have broadly remained range bound this year, but with wide swings and elevated levels of volatility. The VIX index hovered around 15 during early 2011 but with uncertainty increasing particularly in the second half of the year implied volatility (VIX-basis) has traded in a 25 -45 range in the past six months.

Did it happen? No.

Q

US government debt downgraded: S&P downgraded the US AAA to AA+ on August 5th. Although a downgrade might have been expected to erode investor confidence in US debt, it did not—Treasury yields have fallen by about 100 basis points since the downgrade.

Did it happen? Yes.

Q

Financials outperform. Financials outperformed in the first quarter of 2011, but since then they have again underperformed. Regulatory risk, sovereign stress, and fears of dilution have all depressed shares of financials in 2011.

Did it happen? No.

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Global Investment Strategy 16 December 2011 Q

China experiences a ‘hard landing’. China has not experienced a hard landing yet (defined as growth below 7%). For 2011 as a whole, GDP growth will be around 9%, albeit lower than the 10.4% rate recorded in 2010. For the coming year we expect modest policy stimulus to stabilize growth around 8%.

Did it happen? No.

Q

US economy double dips. Although growth slowed to a ‘soft patch’ pace around mid-year, the US economy avoided recession in 2011. Strong corporate profits, moderate employment growth, higher capital expenditures, and a resilient consumer all helped to sustain the US recovery in 2011.

Did it happen? No.

Q

Fed hikes rates in H1 2011. If anything, just the opposite happened with the Fed committing to a low policy rate for the foreseeable future (mid-2013) and introducing ‘operation twist’ in the late summer.

Did it happen? No.

Q

The ‘other’ Manchester wins the Premiership. Manchester City did not win the UK Premiership last season. So far this season is a different story— ‘City’ leads their Manchester rivals by five points as the half-way mark of the season approaches, bolstered by a formidable goal difference above 30.

Did it happen? No.

Q

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