deflation ubs june 2010

8/8/2019 Deflation Ubs June 2010

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Philippe G. Mller, CIIA, analyst, [email protected], UBS AG

Dirk Effenberger, strategist, [email protected], UBS AG

Wealth Management Research 11 June 2010

Deflation-inflation knife-edge

Past performance is no indication of future performance. The market prices provided are closing prices on the respective principle

stock exchange. This applies to all performance charts and tables in this publication.

Updating our investment strategies for deflation

s Although not our base case scenario, we examine the potential impact

of a prolonged period of deflation on various asset classes. We also

suggest investment strategies suitable for those who expect such anextended period of falling prices.

s For equity investors, we think shares of companies with proven pricing

power, solid balance sheets and good regional diversification may be

attractive.

s Extending the average portfolio duration and a careful selection of

bonds can also help preserve purchasing power. The fine print relating

to embedded deflation floors should also be well understood by

investors in inflation-linked bonds.

s While cash seems to be king and liabilities are less welcome, investors

are well advised to understand the FX landscape since deflation

promises to trigger some bouts of high volatility on this market.

s Other asset classes, such as hedge funds or commodities, are also

examined in this note and we highlight how important selectivity

becomes in a persistent deflationary environment.

Selected related publications

s Deflation-inflation knife-edge: Corporate

bonds facing inflation, 10 February 2010

s Deflation-inflation knife-edge: Strategies to

meet a surge in inflation, 15 September 2009

Table of contents

Economics 2Liabilities 3Fixed Income Investments 4Currencies 6Equities 8Hedge Funds and Private Equity 9

Real Estate 10Commodities 11

On the cusp

Economic opinion is divided, and this makes life difficult for some investors.

In the aftermath of the financial crisis, do we face an era of inflation or

deflation? Investors need to know how best to position themselves in either

case. In this paper, we now take a close look at the investment implications

of a deflationary scenario after having shed some light on the consequences

of inflation in an earlier publication.

Although we think it is less likely to unfold than an inflationary environment(Fig. 1), we cannot dismiss the emergence of deflation altogether. For

investors who think deflation is inevitable in the coming years, we outline

some strategies for preserving wealth in what would prove to be a

challenging environment.

Fig. 1: WMR inflation expectationsIn percentage points

Source: UBS WMR, Reuters Ecowin, as of 07. June 2010

This report has been prepared by UBS AG.Please see important disclaimers and disclosures that begin on page 13.


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Economics Defining deflation

Inflation is commonly understood as a persistent rise in the general level

of prices, while deflation is a sustained drop in prices as measured by the

consumer price index, for example. The emphasis here is on the words

"sustained" and "general." Clearly, prices falling for a few months would

not constitute much of a problem. Likewise, at any given time, prices of

some goods and services will fall, reflecting changes in demand and supply.

Painful as this may be for the sectors and industries that have to cut prices

in response to weakening demand, this is not what we mean by deflation.

In fact deflation has two faces: There is "good" deflation that results

from more efficient and thus cheaper means of production (think: flat

screen TVs). This type of deflation prevailed for much of the 19th

century, accompanying strong economic growth. But there is also "bad"

deflation, which is associated with a deep, dark economic recession. In this

form, overall economic conditions are such that declining prices reinforce

expectations that prices will fall even further in future. This prompts

consumers and businesses to postpone purchases, only aggravating the

drop in total demand that has caused prices to weaken in the first place.

The cause of pernicious deflation is said to be a collapse of aggregate

demand, a drop in spending so severe that producers across all sectors

must cut prices on a sustained basis in order to find buyers for their

products. Following the great recession of 2009, demand has been

successfully propped up by the massive fiscal and monetary stimulus

programs implemented by governments worldwide.

Today, there are concerns that the world's economy may slip back into

recession the W-shaped "double dip," as it is called as soon as

government support is reversed. It is a fact that a looming sovereign debt

crisis has already prompted many governments, especially in Europe, to

announce tough fiscal austerity programs. On the other hand, we think

that monetary policy may remain loose for longer than currently anticipated

in order to counterbalance the burden of tighter fiscal policy.

We contend that, in the longer-term, inflationary pressure may be the

bigger problem. However, deflation risks cannot be dismissed out of hand

and investors are well advised to contemplate its consequences. Before

looking at the implications of deflation for different asset classes, we

highlight one specific and profound economic consequence: Deflationactually increases the real value of debt.

Consider a loan of USD 1000: If prices drop 3% per year for 10 years, the

nominal repayment sum at the end of that period would be worth more

than USD 1,340. In contrast, 3% inflation would have lowered the value of

the loan to only USD 737. Thus, deflation is bad for borrowers. On the other

hand, it is good for savers. Their thrift is rewarded well beyond any nominal

interest gains they may receive. In short, deflation discourages borrowing

and encourages saving. This single effect of deflation has consequences for

virtually all asset classes, which we will consider in detail in the following

sections

Dirk Faltin, Economist, UBS AG

UBS Wealth Management Research 11 June 2010


Deflation-inflation knife-edge - 2


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Managing assets and liabilities indeflationary times

We have outlined the consequences of inflation on an investors asset

and liability management in a previous paper. We concluded that higher

inflation is generally positive for debt holders, all the more if they have been

able to finance their debt with long-term fixed-rate loans when inflation

(and therefore interest rates) was still low. But in the case of a prolonged

period of deflation, this dynamic is reversed.

Deflation is good for savers (or holders of cash) and bad for debtors, as we

have seen. The various forms of deflation will affect the balance sheet of a

private household or a company in different ways. Deflation in the form of

falling consumer prices will increase the real value of debt, as noted above.

If deflation is protracted, not only will consumer prices fall, but typically also

wages. Thus, the "real" (inflation-adjusted) burden of a private household's

debt increases as its ability to pay for interest fees and amortization shrinks

with its falling wage income.

Usually, in a deflationary environment it is not only consumer goods and

services prices which fall, but also asset prices such as equities or real estate.

Falling real estate prices diminish the home equity position of a private

household and one can even end up in a situation where home equity is

negative, i.e. outstanding mortgage debt is higher than the value of the

home.

Implications for investors are straightforward: If deflation is anticipated with

high conviction, a rational approach would be to start paying down debt,either by selling assets that are likely to fall in value anyway in a deflationary

environment or through retained income. If debt cannot be completely paid

down, it should be financed with short-dated loans since central banks

usually cut interest rates all the way down to zero in a prolonged period of

deflation, driving short-term loan rates below those for longer-term loans.

Daniel Kalt, Economist, UBS AG

Fig. 2: Energy-driven swing in headline inflationCore inflation more stable (% y/y rates)

Source: ThomsonReuters EcoWin, UBS WMR, as of 06. June 2010





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Fixed income investments and deflation

The underlying trend of consumer price inflation is critical for any bond

investment. Market prices and yield trends for government bonds are

closely linked to changes in inflation expectations. If consumer price

inflation is expected to decline, yields tend to decline and prices for

nominal government bonds tend to rise. It is important to note that

expected and not actual inflation is the driver here. However, the latter can

impact the former as inflation expectations tend to be adaptive. Thus, the

developments of yields is not only correlated to inflation expectations, but

also to actual inflation (Figure 3). Therefore, nominal government bonds

would be one of the main beneficiaries of a prolonged period of falling

prices, that is, deflation.

Nominal government bonds preferred

The market's inflation expectations can be broadly inferred from thedifference between yields on nominal government bonds and those on

real or inflation-linked bonds (ILBs) of a similar maturity. Chart 4 shows

that the market shifted from a deflation towards an inflation scenario in

2009. However, since early this year markets have revised their inflation

expectations sharply downward and now project inflation to remain below

its long-term average over coming years in major countries. For example,

the market thinks consumer price inflation in Germany will remain below

the ECB inflation ceiling of 2% over the next five years.

What if there were in fact a lengthy period of unexpected deflation,

with consumer prices falling significantly? Experience suggests that if

consumer price inflation were to be lower than breakeven inflation over

a given period, nominal government bonds would be more attractive

than inflation-linked government bonds. Similarly, if an investor expects

deflation, nominal government bonds should be preferred over inflation-

linked bonds.

Considering corporate credit

We think it useful to differentiate within nominal bonds. Credit quality

becomes an important factor in times when risk aversion is likely to revive,

driving credit risk premiums higher. Companies with considerable amounts

of (fixed) debt on their balance sheets are likely to have difficulties paying

it down quickly if business volumes and cash flows fade. Hence, many

bond issuers with lower credit ratings see their credit metrics detriorate in a

period of prolonged deflation, and the prices of their bonds may well suffermore than they could benefit from falling government bond yields. As a

consequence, we would avoid the high-yield bond segment. Instead, we

would move up the rating scale as credit default rates might not drop to

levels seen in previous credit cycles.

Therefore, credit issuers that benefit from guarantees (supranationals,

government-guaranteed agencies, some local governments, etc.) should

do well, in our opinion. And since deflation is not likely to be a global

phenomenon, regionaly well diversified issuers of corporate credit who

enjoy pricing power the ability to maintain their prices at higher levels

and who have good cost control should perform better given their more

stable cash flows. Industries with inelastic demand include health care, food

and to some degree utilities. We woud prefer higher-rated credits of thesesegments to cyclical sectors and capital goods since delayed investment

activity is likely to hurt such companies.

Fig. 3: Deflation vs. bond yields in the USIn percentage points

(4)

(2)

0

2

4

6

8

10

12

14

16

1977 198 1985 1989 1993 1997 2001 2005 2009

0

2

4

6

8

10

12

14

16

18

US CPI (lhs) 10-year treasury yields (rhs)

Source: UBS WMR, Reuters EcoWin as of 07 June 2010

Fig. 4: Markets inflation expectationsIn %, calculated as the difference between yields on5-year nominal and 5-year real inflation-linked bonds






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The potentialy lower liquidty of corporate bonds is also an important aspect

to consider in a prolonged deflationary period. In an environment of lower

growth with incentives for corporations to pay down debt rather than

refinance debt, new issuance could decline and net activity could be flat tonegative. Investors should therfore be prepared to hold bonds to maturity

in some segments.

Inflation-linked bonds can still shine during deflation

Under certain circumstances, inflation-linked bonds (ILBs) can perform well

in a deflationary environment. The "deflation floor" of some ILBs can

work in their favor, for example. This floor determines that the redepmtion

amount at maturity cannot be lower than the nominal value at the time

of issue, even if consumer prices have declined over the period. The floor

acts as nominal capital protection (not issuer protection!) at maturity. If

consumer prices were to fall over the entire term of a newly issued ILB, at

maturity the investor would not receive the inflation-adjusted value, but

rather the bond's nominal value at issue. Accordingly, the real yield is higher

than the real coupon on the bond as set at the time of issue.

Mind the gaps in the deflation floor

ILB's are not without pitfalls. For one thing, not all issuers have bonds with

deflation floors (see Table). Secondly, this deflation protection only kicks in

at maturity. This means that during the term of the bond, its nominal value

may drop below its level at issue and, during this period, can be sold only

at a loss on the invested capital.

In any case, we note, protection against deflation comes at the price of a

lower real yield to maturity. Finally, the protection depends on the timing of

the issue. If a bond were issued years ago and, due to inflation, its inflation-adjusted nominal value is now well above that nominal value at issue, then

the deflation floor may not be effective. It will only kick in if, during the

residual term to maturity, prices fall by more than the cumulative inflation

to date. Investors with a strong deflationary view should therefore focus on

recently issued bonds with a deflation floor.

In sum, investors expecting an extended period of falling prices can

generate a positive return by investing in nominal government bonds and

thus hope to increase purchasing power. With respect to inflation-linked

bonds, investors should prefer recently issued ILBs with an embedded

deflation floor. Similarly, with other variable (nominal) rate bonds such

as floating rate notes investors worried about deflation should prefer

products with an embedded interest rate floor.

Dirk Effenberger, Analyst, UBS AG

Philippe G. Mller, Analyst, UBS AG

Inverse floating rate notes and curve positioning

Generally, an economic environment associated with deflation leads to

lower interest rates. In an ordinary interest-rate cycle, long-term interest

rates first fall in anticipation of lower inflation as investors accept lower

compensation. To limit deflationary pressures and ensure gradual price

increases over the medium to long term, central banks try to counter

falling inflation by lowering interest rates, thus stimulating consumption via

cheaper credit. Normally, lower interest rates have positive consequences

for fixed-income investments: already issued ordinary bonds with fixed

coupons rise in value, since only lower interest rates are available in the

market compared a pre-existing bond's fixed coupon.

ILBs in different regions

ILBs offer a real coupon that is constant over

the life of the bond. In addition, the principal is

adjusted for increases in the reference price index.

Thus, coupon payments compensate for inflation,

which helps an investor maintain overall purchasing

power. For more details, see our Education Note:

Understanding Bonds, Part 8 Inflation-linkedbonds.

Market Reference IndexDeflation

Floor*Coupon

US TIIPS All Items consumer

Price Index for all

Urban Consumers

(CPI-U)

Yes Semi-annual

UK Treasury Gilt I/L Retail Price Index (RPI) No Semi-annual

French OATie Euro-area Consumer

Price Index, excl.

tobacco (HICPx)

Yes Annual

Germany I /L Euro-area Consum-er

Price Index, excl.

tobacco (HICPx)

Yes Annual

Inflation-linked bonds (ILBs) and products like

inflation swaps and inflation-linked structured notes

are the most direct types of investment to protect

against an increase in consumer prices. In contrast

to nominal bonds, ILBs pay a fixed real coupon plus

compensate for rising consumer prices by adjusting

the bonds nominal value for inflation.Source: UBS WMR

Fig. 5: Steepness of the US interest rate curveDifference between 2- and 10-year rates

-1

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

1986 1989 1992 1995 1998 2001 2004 2007 2010

US 10 year - US 2 year






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An inverse floating rate note (FRN) is even better protected against falling

yields and deflation, as its coupon is adjusted to the new interest rate

environment at each coupon date and rises if the Libor rates decrease.

It is crucial to distinguish between theory and practice when investing.

Generally, inverse floating rate notes profit from lower Libor. Today's

historically low central bank rates do not offer much potential for lower

rates. This is especially the case for the US, UK and Switzerland. The Federal

Reserve Bank, the Bank of England and the Swiss National bank have

slashed their central bank rates to 0.25%. Given the recent debt turmoil

in Europe, Libor has increased by 10 basis points since the end of 2009.

Accordingly, three-month Libor traded at 0.4% in the US and at 0.72% in

the UK on 7 June. In Switzerland Libor slipped to 0.1%. Even though Libor

increased slightly, they remain at a historically depressed level, with limited

potential to decrease further. Thus inverse floaters make little sense in the

current low interest rate environment.

Even though yields across the whole interest rate curve are currently at

historically low levels, the difference between long- and short-dated bonds

is still considerable. This means that the interest rate curve is historically

steep in the US, the UK, and the EU and also very steep in Switzerland.

In anticipation of future deflation or substantially lower inflation, investors

should expect the current very steep curve to change shape, primary

driven by movements at the long end of the curve. Usually, when market

participants expect inflation to fall, investors observe an initially flattening

of the yield curve. This is equivalent to a narrowing of the interest rate

spread of long- and short-term yields. This flattening could, over time, even

result in an inverse interest rate curve, where short-dated bonds would payhigher coupons than longer-dated bonds.

In the current interest rate environment, with its very steep yield curve, we

think investors expecting a deflationary environment over the next years

should favor investments in long-term rather than short-term bonds in

order to lock in the higher yields (see Fig. 5). In a portfolio context, they

may consider extending the average duration of their bond allocation.

Daniela Steinbrink-Mattei, Economist, UBS AG

Currencies Deflation promises chaos

Analyzing deflation's economic impact is complicated, not least because

its mechanisms often defy our intuition, which for most of us has been

formed during periods of normal and or even high inflation. For currency

markets the most important effect of deflation economics is that investors

and companies have high incentives to save and low incentives to spend

or invest.

A typical cycle suggests that a country entering deflation will first face

an appreciation of its currency. Deflation typically triggers repatriation,

because the banking system of a country in deflation needs money.

Typically, deflation also means that the real interest rate is much more

attractive than what is available abroad. Also, in deflation, consumer

demand falls, which improves the country's net trade position. In a second

stage of the deflation cycle, the government tries to jump-start domestic

demand and expands government spending. This typically leads to a

depreciation of the currency.





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The economic inefficiency of reducing the growth prospects of a country

and here is just one example of a counterintuitive aspect of deflation

economics is that the interest rate on simple cash holdings cannot become

negative. In times when prices fall and money stays stable, the investorreceives a positive real interest rate, even when the nominal interest on cash

holdings is zero. Our experience with deflation in Japan in the mid-1990s,

as well as during the latest financial crisis, suggests that the effect of rising

real interest rates is most strongly felt at the outset of the crisis and is later

replaced by other influences, which can be traced back to the reduced

growth outlook for the given country.

The currency cycle of deflation

The effects of deflation on currencies are dynamic, not static. We note three

discreet stages that form the deflation cycle of currencies:

s The onset of deflation leads to a rapid reduction of credit positions

(deleveraging) and the unwinding of carry trades. This supports low-

yielding currencies (at present, the Japanese yen or US dollar) and

pressures high-yielders (currently those of emerging markets and

commodity producers).

s Persistent deflation keeps real interest rates high and the currencies

of countries with the strongest deflation experience the sharpest

appreciation.

s Eventually the countries where deflation is strongest will see their

economic strength reduced, leading to a depreciation of the currency

that is often accelerated by reflation policies as governments spend

unusually high amounts of money to revive their stricken economies.

In short, deflation promises chaos on currency markets. In the first phase,low-yielders and the currencies of countries with strong deflation tend to

appreciate due to repatriation of capital and deleveraging. In the second

phase, the currencies of the deflation countries tend to depreciate sharply

as growth prospects decline and the need for government intervention

increases. A vicious cycle, indeed.

We identify two disruptive processes at work in this cycle. One kicks in at

the outbreak of deflation and the other is at work in the transition from

the second to the third stage. Both processes are highly disruptive and the

shift in currency valuation at these stages can be very large. We also note

that while deflation is never supportive for a currency in the long term, the

possibility of short-term spikes should not be ignored, because they can betremendous.

The most likely candidate for a deflationary cycle is Japan, which is

almost half the way through it. Its currency appreciated as inflation rates

entered negative territory. We are now awaiting the second stage, an

even more expansive monetary/fiscal policy, hurting the Yen further. The

next candidate for a deflation cycle is Europe, due to the fiscal austerity

measures. These measures are likely to weaken import demand but improve

competitiveness and therefore strengthen the euro again. Finally, the US is

also not fully protected against a deflationary cycle. The strong appreciation

of the USD this year signals that future appreciation potential is limited,

however.

Thomas Flury, Economist, UBS AG





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Equities Diversification is key

The historical examples of equity returns during prolonged periods of

deflation are very rare. The most prominent example is probably Japan

during the last decade, with a few exceptions. The consequences of

deflation for equity market returns are intimidating. However, if real

purchasing power of money increases, weak nominal returns are somewhat

counterbalanced. A closer look at the key drivers of stock returns can

help to identify some less vulnerable companies, which still might generate

sufficient returns. From a theoretical point of view, risk premiums tend

to rise in a deflationary environment, bond yields tend to fall, making

the net effect of deflation on discount rates for earnings less clear. Past

deflationary periods have seen earnings fall as a result of lower sales or

because purchases are delayed by consumers. Intuitively, equities generated

weak returns and havent been a good hedge against deflation.

However, a few segments of the corporate sector are able to operate

even under these circumstances and to show slightly positive earnings

growth. The Health Care sector offers the advantage that their product

demand can't be delayed and that the price sensitivity of their clients is

very low in general. Both factors are almost unique to this industry and

are clear advantages, if the overall economy suffers from deflation. Both

arguments would also apply for the tobacco industry and regulated utility

companies, albeit to a weaker extent. In addition, companies that have

strong balance sheets and good credit ratings suffer less from the rising

risk premiums effect. They also enjoy better access to capital markets than

weaker companies. Integrated oil companies generally meet these criteria,

for example.

On the other hand, companies with relatively high debt levels and fixed

maturities, and that are also exposed to discretionary consumption would

suffer in a deflationary environment. The auto sector meets both of

these criteria. An additional drag for the car industry is its important

leasing and financing activities. While lower interest rates reduce borrowing

costs, higher customer credit defaults in a deflation scenario would add

pressure to auto makers' balance sheets. Given the significant profit

contribution of their financial services arms, auto makers would likely suffer

in a deflationary environment, in our view. Other consumer discretionary

companies would be heavily impacted as well. Both low-end and luxury

goods would be hurt, as purchases are truly discretionary and can be easily

delayed by a couple of years. Therefore, listed companies of such industrygroups are unlikely to deliver superior earnings growth and should be

avoided by investors who expect deflation. The historical performance of

the better performing sectors during the deflationary decade in Japan is

shown in figure 6, and the annualized nominal return of all equity sectors

in figure 7. Another sector that also depends on the overall business cycle

are capital goods companies like machinery producers and aerospace. With

long lead times for production in both segments, it is very difficult to

operate profitably when new orders are delayed and order books shrink.

However, repair-and-maintenance businesses should suffer less, as installed

products are used longer, mitigating the impact of the order shrinkage on

profitability.

So far, we discussed the case of equity in closed economy and capital

market, with no possibility for investors to diversity internationally.

However, especially under the discussed scenario of deflation it would be a

crucial alternative for investors to diversify their equity portfolio into regions

Fig. 6: Pricing power sectors fare better indeflation10-year performance of MSCI Japan sector indices

during

0

50

100

150

200

250

300

350

00 0 02 03 04 05 06 07 08 09 1

Health Care Utilities MSCI Japan Energy

Source: Datastream, as of 07 June 2010

Fig. 7: Only Energy and Utility companiesdelivered positive returnsAnnualized JP sector performance over the last 10

years

-20%

-15%

-10%

-5%

0%

5%

10%

ENERGY

UTILITIES

MATERIALS

RETAILING

INDUSTRIAL

CONS

STAPLES

HEALTH

CARE

CONSDISCR

MSCIJAPAN

FINANCIALS I

T

TELECOM

annualized sector performance

Source: Datastream, as of 07 June 2010





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and countries, which have higher inflation and growth rates. We stress

the long term positive outlook for emerging markets, in particular in Asia

and the related investment opportunities for private investors. The region is

likely to experience higher growth rates than developed markets, which willbe accompanied by positive inflation rates as well. Hence, investors should

take advantage of this investment opportunity, especially if their domestic

market suffers from deflation.

To sum up, a deflationary environment would probably be challenging for

most companies. Corporate profits would be under pressure and equity

market returns would be weak as well. Companies with a relative stable

product demand are better positioned to maintain their margins and should

be preferred by investors in a deflationary economic environment. Health

Care, Energy companies, the insurance sector, and tobacco firms exhibit

these characteristics. In addition, international diversification plays a far

more important roll under this scenario.

Philippe G. Mller, Analyst, UBS AG

Oliver Dettmann, Strategist, UBS AG

Hedge Funds and Private Equity

Hedge Funds: If the economy turns deflationary and uncertainty stays

high, hedging strategies in general should continue to produce good

returns when compared to traditional buy and hold strategies. In particular,

investors may want to consider exposure to global macro and equity long/

short strategies. This is particularly true under a scenario where underlying

growth drivers and the pace of growth vary significantly among countries,with a deflationary environment confined only to certain economies. Global

Macro managers should be therefore able to extract value from fixed

income and FX, based on timing, geographical biases, and large growth

divergences. As we all know, such a divergence was seen between the US

and Japan over the last two decades. Although a deflationary environment

is not good for equities, Long/short equity strategies should benefit from

fundamental analysis as well as trading skills in an environment that allows

positive attribution on both the long and the short side (trading). Moreover,

talented long-short managers can increase their long exposure to dividend

paying stocks providing good adjusted-for-deflation rates of return. In a

prolonged deflationary environment, liquidity in some markets could suffer

(i.e. some bonds segments). Hence we see no reasons from deviating too

strongly from the above mentioned strategies (e.g. global macro). In this

context we also suggest investors to choose products that offer a certain

minimum level of liquidity.

Private Equity: If the deflationary phase is prolonged, we advocate staying

clear from this group. However, if such phase proves short lived, we see it as

good entry point. Investors are also likely to pay down for their investments

as we expect the valuation discount vs. equities is likely to be the greatest

due to liquidity concerns. As economies recover over time, so should

primary offering, acquisition, and private equity valuations, generally. It is

Interesting to note that private companies are preponderantly in the US and

are obviously more dependent on their domestic economy, which should

lead the recovery, and are therefore somewhat less affected by turmoilelsewhere, in Europe, for instance. Consequently, in most cases the higher

discount (25%-30% premium over equity), is unwarranted in our view.

Cesare Valeggia, Analyst, UBS AG





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Real estate

By assessing whether return oriented real estate investment is a good hedgeagainst deflation one should formulate expectations about the appropriate

future cash flows and the required discount rates (see appendix for details

on how they are defined) to come to the estimated real estate capital

value. The answer also depends on whether a severe, multi-year deflation

is expected or instead a slight and brief one.

In the case of an expected slight and brief deflationary period, discount

rates tend to decrease quite quickly, driven by decreasing or negative

inflation expectations. Should the short deflationary period not be expected

to drive the economy into a recession, then one would expect the discount

rate to decrease faster and deeper than the expected future net operating

income (NOI). The reason is that the future NOI would consequently beexpected to stay stable as the perennial lease contracts are believed to be

enforceable. This in turn would result in growing capital values, while the

overall market related risk premium wouldn't increase at all. We conclude

that an expected slight and brief deflationary period could be positive for

capital values as far as investors do not price a recession in. This case is quite

unrealistic in our view as negative inflation expectations normally reflect

recession fears.

The fact that negative inflation expectations and recession fears are related

is best illustrated by the recent developments in UK real estate values.

First, as a proxy we derive the overall inflation expectations by subtracting

the 5 year real yield of the US inflation linked bond from the yield

of the closest nominal US treasury maturity. Second, we consider thedevelopment of the capital values based on monthly capital growth, income

return and total return figures derived from 75 UK based real estate

portfolios including 4'300 commercial and investment properties, which

are externally appraised on a monthly basis. The growth rates indicate the

change in the month under review compared to the same month a year

earlier.

Deflation expectations materialized quickly in the fourth quarter of 2008

and were highly correlated with fast decreasing capital values (see

chart). Thus real estate was unable to protect against expected deflation.

Furthermore, the recent real estate crisis, which revealed huge debt

deleveraging needs, is believed to have triggered deflation and recession

fears. The income return which is the quotient of NOI and capital value

grew rapidly (see chart), driven by growing risk premiums and a sharp

decrease in expected capital values. The premium first reflects the fears that

the lease contracts won't be enforceable and tenants will default or force

the investors to revise lease terms downward. Second, real estate investors

may be forced to sell their properties, which in turn could additionally

burden the future capital values. The total return on property (see chart)

- putting together capital growth and income return - was left quite

negatively affected, thus unable to protect against deflation or even causing

it.

Equity-financed as well as highly leveraged real estate investors are both

affected by deflation expectations by experiencing a deterioration in theirasset holdings: future cash flows are estimated to decrease, while the

discount rate doesn't fall enough due to increased uncertainty. The highly

leveraged real estate investors may be forced by their lenders to increase

the equity stake in their investment or to sell the properties, because the

Fig. 8: Capital growth and deflationDeflation expectations in the US and capital growth

in the UK strong correlated(%, monthly)

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

02 03 04 05 06 07 08 09 10

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

4

Inflation Expectations Capital Growth (rhs)

Source: IPD, Bloomberg, UBS WMR, as of 07 June 2010

Fig. 9: Income return and deflationInflation expectations (US) and incorme return (UK)

inversely linked (%, monthly)

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

02 03 04 05 06 07 08 09 10

0

0.1

0.2

0.30.4

0.5

0.6

0.7

0.8

Inflation Expectations Income Return (rhs)


Fig. 10: Total Return and deflationTotal returns (UK) negatively affected by US deflationexpectations (%, monthly)

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

02 03 04 05 06 07 08 09 10

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

Inflation Expectations Total Return (rhs)






11/13

credit quality will be put into question. Furthermore in a severe deflationary

environment, borrowers may be unable to repay their debts since the real

cost of debt repayment may rise sharply. Therefore, properties may be

marketed below their actual value, thus reinforcing a deflation spiral dueto forced sales.

We conclude that it is unwise to consider real estate investments as a hedge

against deflation. However, it is expected that equity financed real estate

investors with long term and well enforceable lease contracts will perform

better under a deflationary environment than highly leveraged investors

with uncertain tenant creditworthiness. Good investments for deflation are

accordingly based primarily on safety, which definitively left cash to be the

sole asset not to decline during deflationary periods. In addition, no single

segment of real estate investment the residential, office, retail or the

industrial segment seems to clearly offer any advantage over another,

while our preference would be the residential real estate market.

Thomas Veraguth, Analyst, UBS AG

Commodities - ambiguous impact

There is no simple answer to how deflation might impact commodities.

Deflation risks are a topic for the developed world but not for emerging

markets. It is the developed world that needs to deleverage. Emerging

markets still have room to increase leverage and reap the benefits of

their catch-up potential. Hence, the overall impact on commodities is

ambiguous. Commodities are real assets and, in an environment of no

genuine inflationary pressure, there is less need for prices to appreciatein nominal terms. Moreover, deflationary environments are generally

accompanied by subdued economic activity. Economic textbooks suggest

that the impact of deflation on commodities would be negative, on

average. Economically sensitive commodities like base metals and energy

would suffer the most.

In reality the impact depends on the degree of deflation. On average,

more than 55% of commodity demand relates to emerging markets,

which we forecast to grow at a robust pace. Were the deflation in the

develop world mild, emerging market growth would be sufficient to see

commodity prices still trending higher in USD, EUR or JPY terms. With

the present market situation, we think commodity prices are more than

halfway through the process of discounting a very negative economic

outlook. Base metal prices, with the exception of copper, have been trading

below marginal production costs. In the case of crude oil, prices are at the

lower end, where investment will satisfy long-term demand. Thus, there

is limited downside potential from present levels in the case of increased

deflationary tendencies. Given the oligopolistic supply structure of crude

oil and the strong emerging market demand, crude oil prices should still

head towards USD 90 to USD 100 per barrel, but perhaps with a delay of a

year or two. Agricultural commodities would only be affected in a limited

way. Incremental here demand also relates to emerging markets. Gold

would hold up well initially, given the uncertainty that would likely prevail.

However, a strong appreciation in nominal terms would be difficult. That

said, in a later stage gold would come under pressure and drop below USD1000/oz as the market would price gold again as an industrial commodity

and not as a currency to protect against inflation.

Dominic Schnider, Analyst, UBS AG





12/13

Appendix

Fig. 11: Fiscal debt monetization and inflationConsumer Price Index in percentage points

(10)

(5)

0

5

10

15

1750 1775 1800 1825 1850 1875 1900 1925 1950 1975 2000

US UK

Consumer price inflation (%yoy, 11 year ma)

Napoleonic wars: deficit

monetised

1st industrial revolution:

productivity- led deflation

2nd industrial revolution:

productivity rebound; gold finds

Fiscal monetisation during

WWI

Fiscal monetisation during

WWII

Fiscal monetisation duringVietnam War; oil shocks

Volcker

clamps

down on

inflation

Depression

US civil warUS war of

independence

Source: Reuters EcoWin, UBS WMR, as of 25 Sept 09

Real Estate Appendix

The present capital value for return oriented residential and commercial real estate depend both on expected future cash flows - the

future net operative income (NOI) - in the numerator and on the required capitalization rate on the denominator. The appropriate

net operating income (NOI) is generally driven by expected economic or income growth (1), the expected tenant default's rates

(2), the expected duration of the lease contracts (3) and possible vacancies (4). Capital values are therefore positively driven by

improving expectations towards future NOI but also by falling capitalization rates. Capitalization rates on the other hand are made

up of at least three elements: the real interest rate (1), the expectations over future inflation (2) and a risk premium (2), which

rewards investors for risk taking. Therefore real estate capital values are fundamentally determined by inflation expectations not

actual inflation.





13/13

Appendix

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