UBS HouseView Digest US Edition CIO Wealth Management Research November 2014 Half full or half empty? Half full of half empty? Is a half-filled glass of water “half full” or “half empty?” People tend to see this one way or the other. Yet, markets can frequently and quickly flip from optimism to pessimism—and back again. Global equity markets have suffered the largest sell-off in more than two years, despite economic and corporate fundamental data not deteriorating materially. Mark Haefele Global Chief Investment Officer Wealth Management While we did not reduce our portfolio’s allocation to risk assets before the market turn, our strategy does not expect, nor pretend to be able to consistently and precisely time changes in the market’s mood. In our view, trying to do this might be successful on occasion, but is likely to prove a costly and losing strategy over the business cycle. A solid investment strategy involves good diversification, suitable risk limits, regular rebalancing, and tactical positioning that can benefit when the markets are feeling “half full,” but also be relatively protected when markets are feeling “half empty.” We keep a positive view on risky assets and add to our overweight position in US equities, after adding to US high yield last week. Our overweight positions are now concentrated in the US where growth is solid, consumers will benefit from declining oil prices, and the central bank has flexibility. At the same time, we reduce exposure to emerging market equities. Overall, the region has a weaker growth impulse, faces some threats from declining commodity prices, and does not have much policy flexibility outside of China. We believe this position will dampen the effects on portfolios of a renewed period of market volatility, and expect it to perform well even in a more normal market environment, given the cyclical and structural challenges facing many emerging markets. Mark Haefele Global Chief Investment Officer Wealth Management This Digest contains excerpted material. To read the full version, please see the UBS House View Investment Strategy Guide. This report has been prepared by UBS Financial Services Inc. (“UBS FS”) and UBS AG. Please see important disclaimers and disclosures beginning on page 5. november 2014 UBS house view: Digest 1 Tactical preferences The US economic recovery remains relatively strong, making US assets our preferred choice. We are holding overweights in US equities, US high yield corporate bonds, and the dollar. d xe Fi me o c in Int’l Developed Emerg Markets i Mark ng ets Tot al Com mo dit ies US Mid cap EUR US Large cap Value GBP Asset Classes Tactical asset allocation al Tot sh Ca tal To ities u q E US CHF cap Large th w Gro JPY Oth er this month 1) Equities Within US equities, we increase our overweight on small caps and downgrade EM to underweight. 2) Fixed income We maintain our preference for high yield corporate bonds over Treasuries and EM. 3) Foreign exchange We favor the US dollar and British pound over the euro and Swiss franc. Legend Overweight: Tactical recommendation to hold more of the asset class than specified in the moderate risk strategic asset allocation Underweight: Tactical recommendation to hold less of the asset class than specified in the moderate risk strategic asset allocation Neutral: Tactical recommendation to hold the asset class in line with its weight in the moderate risk strategic asset allocation *Investment grade corporates are overweight in non-taxable portfolios but underweight in most taxable portfolios. Note: Tactical time horizon is approximately six months 2 ubs house view: digest november 2014 hange ign exc Fore USD US Small cap l ta To Int’ Dev l Ma elope rke d ts Em Ma ergi rke ng ts US HY Corp nal itio rad nt No tal To v’t Go US US IG Corp* i un US M Preferred investment views A s of 23 October 2014 Asset Class Most preferred Least preferred Equities • US small and mid caps () • US technology • US capex • North American energy independence • Cancer therapeutics • e-Commerce () • Benefit from reform in Mexico •UK • Emerging markets () Bonds • US high yield • Mortgage IOs () • US senior loans • Commercial mortgage-backed securities • Government bonds • Emerging market corporate bonds () Foreign exchange •USD • GBP •EUR •CHF Alternative investments • Credit alternatives to diversify bond portfolios Cash  Recent upgrades  Recent downgrades november 2014 UBS house view: Digest 3 Asset class overview Economy Some moderation in global economic growth, worsening risk sentiment, and technical factors have been key drivers of the latest financial market weakness. The Eurozone is struggling to maintain even very modest positive growth rates, while the European Central Bank (ECB) is trying to prevent deflation. Meanwhile, the US economy remains on track to grow by around 3% in the quarters ahead, leading global growth, as it remains supported by the labor market’s continued recovery. The Chinese government is focused on structural reforms, which – despite some targeted easing measures to offset them – will likely continue to weigh on economic growth in the quarters ahead. Equities Against a backdrop of solid US growth but growth concerns outside of North America, US equities remain well-positioned to post further gains, and we hold an overweight in the region. US companies continue to show strong quarterly earnings growth of 8–10% year-on-year, including the current 3Q earnings season. The latest fall in oil prices will place more downward pressure on emerging market equities, where commodity price weakness adds to earnings pressure. We therefore underweight the EM region against US equities, as we don’t foresee a turn-around in profitability of EM companies over the next six months. We are underweight UK equities which face a further earnings burden from the drop in commodity prices. Fixed income Bond yields, both in the US adn Europe, took another dive over the past month as inflation fell and growth concerns emerged. The US 10-year Treasury yield at 2.2% is trading at the same level as in June 2013 in the midst of the “taper tantrum,” and German 10-year Bund yields at 0.85% are close to all-time lows. Better investment opportunities can be found in developed market corporate bonds. In particular, the lower-rated high yield segment offers a favorable outlook following the recent market setback and we increased our overweight position on 15 October. Emerging market (EM) bonds will likely suffer more from weakening fundamentals. Following the recent underperformance of EM sovereign bonds, shift the underweight call from EM sovereigns to EM corporates. Foreign exchange Major foreign exchange rates continue to be driven by monetary policy divergences which reflect diverging economic growth and inflation prospects across regions. Disinflationary worries in the Eurozone and the ECB’s tendency to do more to fight them, combined with a gradual move by the Federal Reserve toward monetary tightening in mid-2015, will keep EURUSD under pressure. The Bank of England is in a similar situation as the Fed, which should keep demand for the pound high. We therefore expect the GBP to resume its uptrend against the Swiss franc. 4 ubs house view: digest november 2014 Disclaimer Chief Investment Office (CIO) Wealth Management (WM) Research is published by UBS Wealth Management and UBS Wealth Management Americas, Business Divisions of UBS AG (UBS) or an affiliate thereof. 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Sources of strategic asset allocations and investor risk profiles Strategic asset allocations represent the longer-term allocation of assets that is deemed suitable for a particular investor. The strategic asset allocation models discussed in this publication, and the capital market assumptions used for the strategic asset allocations, were developed and approved by the WMA AAC. The strategic asset allocations are provided for illustrative purposes only and were designed by the WMA AAC for hypothetical US investors with a total return objective under five different Investor Risk Profiles ranging from conservative to aggressive. In general, strategic asset allocations will differ among investors according to their individual circumstances, risk tolerance, return objectives and time horizon. Therefore, the strategic asset allocations in this publication may not be suitable for all investors or investment goals and should not be used as the sole basis of any investment decision. Minimum net worth requirements may apply to allocations to non-traditional assets. As always, please consult your UBS Financial Advisor to see how these weightings should be applied or modified according to your individual profile and investment goals. The process by which the strategic asset allocations were derived is described in detail in the publication entitled “UBS WMA’s Capital Markets Model: Explained, Part II: Methodology,” published on 22 January 2013. Your Financial Advisor can provide you with a copy. Deviations from strategic asset allocation or benchmark allocation The recommended tactical deviations from the strategic asset allocation or benchmark allocation are provided by the Global Investment Committee and the Investment Strategy Group within Wealth Management Research Americas. They reflect the short- to medium-term assessment of market opportunities and risks in the respective asset classes and market segments. Positive / zero / negative tactical deviations correspond to an overweight / neutral / underweight stance for each respective asset class and market segment relative to their strategic allocation. The current allocation is the sum of the strategic asset allocation and the tactical deviation. november 2014 UBS house view: digest 5