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Quarterly Investment Strategy

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Global Asset Management Third quarter 2015

Quarterly Focus Is it time for the QE genie to go back in its bottle?

Investment capabilities and servicesTo meet the needs of our clients, UBS Global Asset Management offers diverse investment capabilities and styles across all major traditional and alternative asset classes. Specialist equity, fixed income, currency, hedge fund, real estate, private equity and infrastruc-ture investment capabilities can also be combined in multi-asset strategies.

Active investment styles encompass both value and growth and these are complemented by quantitative and indexed approaches.

We also combine traditional and alterna-tive investments and services into integrated packages through our Global Investment Solutions (GIS) initiatives. These include asset/liability matching, asset allocation, currency overlay, risk

management and specifically tailored product development for large clients.

We seek to maximize the benefits to clients who have individually managed mandates by understanding and acting upon their return expectations, risk tolerance and time horizon. We state and explain the risk/return profile of each of our investment vehicles.

Integrated strategies

Global Investment Solutions

• Core global, regional, country, emerging markets

• Opportunity, high alpha• Small cap, sector, thematic,

sustainable• Growth style—global, US,

emerging markets• Long/short, unconstrained,

market neutral• Quantitative• High dividend• Multi-strategy

• Global • Country and regional • Money market • Short duration • Core and core plus • Sector specific • Emerging markets • High yield • Unconstrained • Customized solutions

• Indexed equity, fixed income, commodities, real estate and alternatives

• Alternative Beta• Rules-based• ETFs, pooled funds,

mandates• Structured funds

• Single-manager hedge funds • Global multi-strategy • Regional and sector

equity long/short • Credit long/short • Convertible arbitrage • Merger arbitrage

• Global• Country & regional• Income, core, value-added

and opportunistic strategies• Listed securities• Multi-manager funds• Farmland

• Multi-manager hedge funds

• Advisory services• Active commodities,

multi-manager

• Direct infrastructure investment

• Infrastructure fund of funds• Private equity fund of funds

and private banking products

Single strategies

GlobalCountry

& regionalAsset

allocationCurrency

managementReturn & risk

targetedStructured portfolios

Advisory & risk management

servicesMulti-manager

Equities Fixed Income Hedge Fund Solutions

Infrastructure and Private Equity

Structured Beta & Indexing

O’Connor

Global Real Estate

1

2 Global perspectives

3 Market indicators

4 Top-down viewpoints

6 Asset Allocation and Currency

12 Investment Spotlight

13 US Pension Fund Fitness Tracker

Equities

20 Global Equity

21 Global Sustainable Equity

22 US Large Cap Equity

24 US Large Cap Growth Equity

26 US Small Cap Growth Equity

27 Global (ex-US) Small Cap Growth Equity

28 Emerging Markets Growth Equity Fixed Income

30 Global Fixed Income

32 US Fixed Income

33 US Municipal Fixed Income

34 US High Yield

35 Emerging Markets Debt

Is it time for the QE genie to go back in its bottle?

Q UA R T E R LY F O CU S / 14

Quarterly Investment Strategy

Third Quarter 2015

By Curt Custard, CFA Head of Global Investment Solutions

Quarterly Investment Strategy / Third Quarter 20152

Global perspectives: 3Q 2015 update

Normalized asset class valuation models as of June 30, 2015

Reflects UBS Global Asset Management’s expectations using current market assumptions. There is no assurance that these projections ultimately will be realized.

Valuation estimates based on normalized earnings and growth rates.

Note: Price/value for US Credit and US High Yield is computed based on the spread, not the bond price.

For further information and definitions on footnotes 1–6, please refer to page 5.

For a more detailed description of the indices referenced and further definitions of terms in Quarterly Investment Strategy, please visit: http://www.ubs.com/1/e/globalam/Americas/globalamus/globalamusii/mutual_fund.html.

Asset classesNormalized price/value1

Equilibrium return %2

Three-year expected return %3

Secular risk estimate %4

Price/value overvalued (+)/

undervalued % (–)5

Equities

Global Equities: MSCI World Equity Index -0.5 7.4 7.9 15.2 -6.9

US Large Cap Equities: Standard & Poor’s 500 Index 0.1 7.5 4.0 15.7 2.0

Global (Ex-US) Equities: MSCI World (ex-US) Index -1.4 7.2 13.8 15.2 -20.7

Australia Equities -1.2 6.6 13.1 19.2 -22.6

Canada Equities -0.2 7.1 5.8 18.7 -4.5

EMU Equities -1.3 8.0 16.8 20.6 -27.0

Japan Equities 0.2 7.2 3.4 17.8 2.7

Switzerland Equities -1.3 6.5 13.1 17.4 -23.0

UK Equities -2.5 6.7 25.1 17.3 -42.8

Emerging Market Equities: MSCI Index6 -0.9 8.7 14.2 23.0 -20.1

Fixed Income

Global Bonds: Citigroup WGBI Index 1.2 4.2 -0.4 4.5 5.3

US Government Bonds: Citigroup US BIG Treasury Index 0.3 4.2 0.8 5.0 1.5

US Treasury inflation-protected securities (TIPS): Barclays US Gov. Infl. Linked

-0.1 4.0 1.4 3.1 -0.3

US Credit Bonds: Citigroup US BIG Credit Index -0.2 4.9 2.2 6.2 -1.3

US High Yield: Merrill Lynch Master Index 0.0 6.2 2.8 10.4 -0.3

Global (ex-US) Bonds: Citigroup WGBI Index 1.5 4.2 -1.0 4.7 7.3

Australia Bonds 0.7 4.1 0.2 5.2 3.4

Canada Bonds 1.2 4.3 -1.1 6.7 7.8

EMU Bonds 1.2 4.2 -0.9 5.7 7.0

Japan Bonds 1.4 4.0 -1.1 5.4 7.5

Switzerland Bonds 1.3 5.6 -1.1 5.6 7.2

UK Bonds 1.3 4.3 -1.3 7.0 8.7

Emerging Markets Debt: JP Morgan EMBI Global 1.1 7.3 0.6 12.2 13.5

Private Equity

Private Markets: Private Equity Indicator (as of March 2013) -0.7 11.5 15.3 27.5 -18.6

Direct Real Estate*

UK (as of February 2015) 0.9 5.9 6.2 10.0 8.7

US (as of February 2015) 0.3 6.0 5.5 10.1 2.6

Australia (as of February 2015) -1.6 5.7 6.2 10.0 -16.1

*Provided by UBS Global Asset Management’s Global Real Estate team. Note: The three-year expected returns for direct real estate are for new investors.

At UBS Global Asset Management, we use proprietary models that have evolved over the last two decades to value the global investable market, across all asset classes. Investment expectations for all asset classes are derived from passive, index-level information. Our estimates of asset class and market returns and risks are reviewed on a regular basis.

3

Indicator March 31, 2015 June 30, 2015 Definition

Valuation ValMod Equity discounted cash-flow model based on in-house equilibrium assumptions

Fed model Alternative long-term valuation approach; reflects relationship of equity earnings yield and government bonds

Market behavior Monetary policy Means by which a central bank controls the money supply via interest rates, reserve requirements and open market operations

Economic surprise Gauge of economic data—meeting, exceeding or falling short of expectations

Earnings revision Reflects bottom-up earnings outlook

Stress index Market stress gauges price dislocations and investor risk appetite

Economic cycle Assessing where we are in the business cycle and our expectations for growth

Current quarter

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

0.6

98.5 99 99.5 100 100.5 101Strength: relative to trend-growth

Represents a momentum crossover zone

Mom

entu

m: p

ace

of c

hang

e

R E C E S S I O N S L O W D O W N

R E C O V E R Y E X P A N S I O N

Dec ’09

March ’10

March ’11March ’12

March ’13

March ’15

March ’14

US economic roadmap

US equities scorecard

Market indicators

Source: UBS Global Asset Management proprietary model, which assesses a variety of leading, coincident and lagging indicators to determine position within the economic cycle.

Data as of May 31, 2015.

Source: UBS Global Asset Management. Recovery or ExpansionRecessionSlowdown

Equity Positive Equity NegativeEquity Neutral


Global (ex-US) Equities• Uncertainty in Greece has led to a fall in international

equities. We feel there is less contagion risk than even a few years ago and that once a resolution is found, markets will focus on rebounding fundamentals and therefore see upside in global ex-US equities.

• Japan’s equity rally has been based both on structural changes (corporate tax cut, improved shareholder focus, increased buybacks and payouts) and cyclical forces (the yen’s weakness and oil price decline benefit Japanese exporters).

US Equities• While we remain constructive on global equities, we are

seeing more opportunity outside of North America where we see attractive valuations and central banks committed to easing.

• US margins have remained resilient but may face future pressure amid an improving labor market (rising wages), a rising US dollar and Fed rate normalization. Earnings growth is losing momentum and is at risk of heading lower in upcoming quarters.

• Small and medium stocks are an interesting alternative based on expectations of increased M&A activity. This is largely motivated by the large companies’ challenge to deliver earnings growth, and hence looking at smaller targets, which tend to include more companies with higher profit growth.

Emerging Markets Equities• While from a valuation perspective emerging markets appear

broadly attractive, lack of real productivity gains and structural reforms put them at risk. This is particularly the case during periods of falling oil prices and a rising US dollar.

• Opportunity is arising from this global backdrop and we prefer North Asian emerging markets over the broader emerging market index. These countries are less exposed to geopolitical risk and structural issues and are net importers of oil.

Currencies• For now, the USD remains in a strengthening environment,

but most of the adjustment may lie behind us after a significant rally in the dollar over the past year. A major risk is that the US dollar is over-owned in the market.

• Real exchange rate levels signal that the Japanese yen is the most undervalued major currency. Given that it is also the beneficiary of increased uncertainty, the yen is looking more attractive particularly from a diversification standpoint.

• The euro has depreciated significantly since the announce-ment of the Europena Central Bank’s (ECB) QE. Further decline is possible, but this would likely require the Fed to tighten policy more aggressively than the market is pricing in.

US Investment Grade Corporate and High Yield Bonds• Given negative bond yields across a large portion of European

debt, we expect significant flows into investment grade corporates as investors see the asset class as a close substi-tute to government bonds.

• The spread on high yield has improved significantly from only a year ago, and we feel that investors are now appropri-ately compensated for the risk taken. We remain diligent in monitoring potential liquidity issues from here.

Global (ex-US) Bonds• ECB QE could be accelerated if needed to fight any contagion

effects from Greece hurting growth and inflation. The ECB is expected to utilize the tools at its disposal to limit the damage to bond markets.

• Japan continues to look attractive as a funding leg due to extremely depressed yields and a flat curve structure. The Bank of Japan remains a risk to a short position as a large buyer of government bonds, and we continue to monitor their action.

• UK gilts offer relatively attractive yield and have some potential for spread compression in the long term, particularly given investor perception of gilts acting as a safe-haven bond market.

US Government Bonds• It seems opportune for the Federal Reserve to start its

normalization cycle given that the baton of liquidity has been passed to other central banks around the world.

• In our assessment, there is scope for the markets to be surprised by some extra tightening as rates move closer to Fed guidance.

Emerging Markets Debt• Emerging markets debt is now offering attractive yield, in our

view. However, a granular view by country is necessary as commodity-exporting countries face the adverse impact on the current accounts and their ability to service debt due to falling commodity prices.

• Our preference is for emerging markets debt in hard currency due to potential emerging market currency weakness in the short term.

Top-down viewpoints for multi-asset portfolios June 30, 2015

Definitions of normalized asset class valuations

Reflects UBS Global Asset Management’s expectations, estimates and valuations using current market assumptions. There is no assurance that these projections ultimately will be realized.

Valuation estimates based on normalized earnings and growth rates.

Source: UBS Global Asset Management.

1 Normalized price/value The normalized price/value represents the standard deviation, or dispersion, of the asset class from our estimate of intrinsic value. Normalizing the price/value discrepancy provides a standardized relative comparison across asset classes. For example, the normalized price/value for the S&P 500 Index is 0.1.

2 Equilibrium return The equilibrium return represents the return of an asset class in a typical market environment, or one where supply and demand for capital market returns is in ‘equilibrium.’ This is often considered to be the ‘long-term expected asset return’ absent any price/value discrepancy. Equilibrium returns are calculated as the geometric addition of the UBS Global Asset Management estimates of three crucial components:

A Real risk-free rate: An estimate of the underlying real rate common to all assets in the global economy, representing the underlying real interest rate reflects the fundamental ability and willingness of society to expand wealth through savings and investment. The real risk-free rate is currently estimated to be 1.7%.

B Inflation premium: The additional return an asset must provide investors to protect them against losses in purchasing power from inflation. The level of long-term inflation is the result of fiscal and monetary policy objectives and actions, as well as the path of overall global inflation. This premium is currently 2.0%.

C Asset risk premium: Additional return to compensate investors for the additional systematic risk experienced in an asset class. US Equities, carrying more systematic risk to the global investable capital market, thus have higher risk premiums (3.68% for the S&P 500) than US fixed income investments (0.67%).

The equilibrium return for US equities, therefore, is (1.017) × (1.020) × (1.0368) – 1 = 7.5%.

3 Expected (three-year) return Reflects UBS Global Asset Management’s expectations using current market assumptions. There is no assurance that these projections ultimately will be realized. This return is the annualized return expected in an asset class for each of the following three years if the market price fully realizes our estimate of intrinsic value. Simply, an asset class should yield its required return in an efficient market, but any mispricing that may occur has the potential to increase (if the asset is currently underpriced) or decrease (if the asset is currently overpriced) the asset class return.

The calculation is more sophisticated than this estimate, but it helps to conceive of the three-year expected return as follows, for the S&P 500 Index as an example: The required return for the S&P 500 Index is 4.7% as of the end of June 2015. Since this represents a 2.0% overvaluation, if the market price depreciates 0.67% per year relative to the required return for each of the next three years as it matches intrinsic value, then the S&P 500 Index can be expected to depreciate overall by (1.047) × (1 − 0.0067) − 1 = 4.0% for each of the next thee years. This imperfect back-of-the-envelope estimate approximates the true expected three-year return of 4.0%. Any difference results from the process of “averaging” the future 10-year path of required cash returns into a single number for communication purposes. Remember that the required cash return is not a single number per se, but a 10-year process of adjustment.

4 Secular risk estimate The secular risk estimate is defined as the forward-looking standard deviation assigned to each asset class. These are

determined in an integrated fashion along with the risk premiums, taking into account an asset class’s unique risks as well as the relationship of the riskiness of its returns to the global investable market and those of other asset classes.

5 Price/value The price/value discrepancies are in local currency terms. The hedged returns, however, are measures of the market returns that are available to investors, independent of direct currency effects. Market price for each index as of the end of the quarter is scaled against the intrinsic value for each asset class as of the same date. Intrinsic value is a proprietary estimate of UBS Global Asset Management and is defined as the discounted future cash flows provided by that asset class, independent of currency or security selection effects.

6 EME returns These expectations are presented as unhedged returns, or those including the effects from translation into US dollars (USD). Emerging markets equity (EME) returns are presented in this way because the manner in which most clients of— and global balanced strategies at—UBS Global Asset Management invest in EME is through the Emerging Markets Equity Completion Strategy, denominated in USD.

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Investor focus in the second quarter of the year has been on three developments, each unfolding with a different degree of predictability. The US Federal Reserve (Fed) is getting closer to raising interest rates, in what is undoubtedly the most well-flagged rate hike in history. In less smooth fashion, Chinese equities have seen magnificent rallies and declines while the economy adjusts to a slower rate of growth and the central bank attempts to exert some influence over events. At the least predictable end of the spectrum is the ongoing Greek debt saga—a viable solution to which the country and its interna-tional creditors are still working on five years after the onset of the crisis.

These three developments have shaped the macroeconomic and financial market landscape over the past quarter, and we have

therefore sought to position our portfolios to benefit from the attractive investment opportunities that they have provided.

No clearer guide than the FedHaving pored over the statements of Fed Chair Janet Yellen, investors are confident that when the Fed begins to raise interest rates from their record lows—whether in September or December, or the early stages of next year—the increases will be gradual and data-dependent. Developments in the second quarter have suggested that rates will trend upward at an even slower pace than previously anticipated. In our view, this increases the prospect of an inflation surprise that would put upward pressure on long-dated US government bond yields. This led us to exit our US Treasury ‘flattener’ trade (short five-year versus 30-year Treasuries).

Each quarter, our Global Investment Solutions (GIS) group provides a summary of its viewpoints on global asset classes, including equities, fixed income and currencies. The interaction of world economies and financial markets on occasion generates substantial mispricings of assets, providing opportunities to add value by dynamically adjusting the asset mix. We apply two key principles. First, investment across global markets is based on forward-looking investment fundamentals. Second, equilibrium characteristics and value levels for assets and asset classes are defined within a globally integrated capital market framework. Portfolio structure is the result of relative price/value comparisons, focusing on both risk and return.

Asset Allocation and Currency

by Eeva Ellenberg

Asset class attractiveness

Currencies

Equities

Fixed income

UK USA Emerging MarketsSwitzerland

JapanEurozone

Australia

Switzerland UK EMUUSAEMD Local

EMD USDHigh Yield

Corporates AustraliaJapan

NZDCHF

AUD CADGBP

JPYEURUSD

PositiveNegativeOverall view

U N A T T R A C T I V E N E U T R A L A T T R A C T I V E


Data as of June 30, 2015, based on UBS Global Asset Management views with a 12–18 month time horizon. The chart shows relative attractiveness within each asset class. Views are not necessarily reflective of actual GIS portfolio positioning.

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We believe that it is an opportune time for the Fed to start tightening monetary policy, considering that other central banks have recently switched further into easing gear—namely, the European Central Bank (ECB) and the Bank of Japan (BoJ). This goes some way to taking the burden of managing global liquidity off the Fed’s shoulders. As of June, signals are pointing to a September hike, followed by a very gradual path toward normalization. There remains meaningful scope for policy error, however.

We view the broader US equity market as less attractively valued than other developed equities (as represented by the MSCI EAFE Index). While US corporate profit margins have remained resilient, they are likely to come under pressure in the future as the labor market improves and wage growth gathers momentum. The strength of the US dollar has posed a head-wind for exporters, weighing on earnings growth prospects.

With many large US companies struggling to boost profits, we have been looking at small- and medium-sized companies as a more attractive alternative. This is based on our expecta-tions of increased merger and acquisitions activity. Large companies that struggle to deliver organic earnings growth often start looking for takeover targets to boost profits. These tend to include small- and medium-sized companies included in the Russell 2000 Index that may be more profit generating.

China in the spotlightGlobal equity investors have been closely watching the growing importance of China in their investible universe. Late in the second quarter, global benchmark provider MSCI announced that it would not yet be including Chinese mainland-listed (A-share) stocks in its Emerging Market Index (EM Index). According to MSCI, China still lacks sufficient infrastructure to efficiently bring money in and out of the country, with continued concerns about accessibility by many international investors. This concern exists despite the progress that

China has made in opening up the local market to foreign investors, including an exchange link with Hong Kong.

The decision by MSCI not to include China in its EM Index has dampened investor sentiment, and has contributed to Chinese A-shares giving back some of their significant gains. The mainland stock market has enjoyed a momentous year-to-date rally, with investors starting to lock in some of their profits in June. This marked a turning point, with the Chinese mainland market falling by over 30% after the end of the second quarter. Our preference has been for Hong-Kong-listed H-shares over the A-shares, a relative trade to which we have recently been adding. Considering the broader emerging markets universe, we are most positive on North Asia equities, which benefit from commodity price weakness.

The People’s Bank of China is adopting an increasingly accommodative stance in its efforts to stabilize growth condi-tions, having cut its benchmark interest rate and relaxed reserve requirements for some lenders in June. It has resorted to a wide range of tools in seeking to prevent further equity market declines.

Taking stock of Greek developmentsThe quarter has been dominated by headlines about Greece, reflecting the latest twists and turns in the ongoing debt crisis. At the end of June, negotiations between Greece and its international creditors aimed at finding a viable solution to the country’s debt crisis were ongoing. While investors’ preoccupation with each new development was high, the impact on financial markets was relatively muted. This comes as no great surprise, given the extent to which European and other foreign banks have limited their exposure to Greece, and the relative strength of the other peripheral Eurozone economies that have made progress in implementing structural reforms.

8 Quarterly Investment Strategy / Third Quarter 2015

Against this backdrop, we became increasingly positive on Eurozone equities over the quarter. Our view is that the develop-ments in Greece are unlikely to derail the strengthening Eurozone economic recovery. Eurozone corporates are expected to grow their earnings this year, while the ECB’s ongoing quantitative easing program is providing a favorable environ-ment for risk assets. The central bank’s toolkit has been strengthened by the European Court of Justice’s ratification of its Outright Monetary Transactions (OMT) program. We believe that the ECB has the necessary tools at its disposal to limit the contagion of any meaningful escalation in the Greek sovereign debt crisis.

Cyclical Market ForumIn June, participants of our Cyclical Market Forum (CMF), representing investment teams across UBS Global Asset Management, considered the likelihood of three scenarios for the global economy over the next 12–18 months: Scenario 1: Consensus view; Scenario 2: Upside surprise; Scenario 3: Downside surprise. The scenarios differ in their views on growth and inflation for both developed and emerging economies. CMF participants voted Scenario 1 as most likely, followed in order by the other two.

Scenario 1: Consensus viewScenario 1, which is aligned with industry consensus, was voted as being the most probable. The consensus view is that the Eurozone economy returns to an annual growth rate of 1.5%–2.0%, while the US economy rebounds from the slowdown of the first quarter of 2015 to grow by 2.5%–3.0% per annum. The growth outlook for developed economies has improved this quarter, mainly driven by upward revisions in the Eurozone and Japan. The outlook for emerging market economies is more negative for this year, but consensus expects growth conditions to improve next year. The consensus view is that the oil price rebounds to the USD 60–70 range, and this is likely to stabilize the economies of both net exporters and importers of energy at a reasonable compromise level.

US: The US economy shrugs off the first quarter’s growth hiccup, recovering at a robust pace, mostly driven by domestic demand—consumer spending in particular. Investment spending continues to suffer in the short term from the effects of oil price weakness on the energy sector. As the effects of energy price declines wane, inflation progressively moves back up to just above 2% at the beginning of 2016.

Eurozone: The Eurozone economy is expected to retain good growth momentum, supported by lower energy costs, a weak euro that is supportive of exporters, and accommodative monetary policy conditions. Inflation remains well below the ECB’s target of just under 2% until the second half of 2017.

Exhibit 1: Probability of each scenarioVoting results from UBS Global Asset Management investment staff


The above results are the views of the participants of the UBS Global Asset Management Cyclical Market Forum and are not intended to be used as a forecast. Forecasts and probability votes are as of June 26, 2015.

0

20

40

60

Scenario 3Scenario 2Scenario 1

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Japan: Net trade continues to support growth, with Japanese exporters benefiting from a competitive exchange rate and a strengthening recovery in other developed markets. Overall, the underlying pace of GDP growth amounts to just below 2%. While the value added tax (VAT) hike has exerted down-ward pressure on prices, the inflation rate is expected to rise to about 1% in the middle of next year.

UK: While concerns about the pace of the government’s spending cuts may weigh on the economy, UK GDP is likely to grow just over 2% in 2015 and 2.5% the year after.

India: Of the emerging economies, India is among the few that appears to be on a clearly positive trajectory, with both growth and inflation benefiting from a stable oil price. GDP is expected to expand at a rate of about 7.5% this year, and to accelerate further in 2016.

Brazil: Limited commodity exports and persistent government and trade deficits are likely to keep Brazil in stagflation this year, while Latin America more broadly appears stuck in a negative cycle. GDP growth is expected to be positive in 2016, but remains low by historical standards.

Russia: The lower oil price and Western sanctions will continue to dampen growth in Russia, with the economy expected to shrink at a robust rate most of this year.

China: Economic growth in China continues to weaken, and is set to stabilize at around 7.5%. Investment is dampened by excess capacity in many sectors, particularly construction. Improving living standards and stronger income growth support consumer spending.

Scenario 2: Upside surpriseScenario 2, Upside surprise, has a broadly more optimistic view of growth and inflation prospects, and factors in positive surprises.

Global: Latest rounds of monetary policy easing support accelerating investment spending, leading to resurgent global economic growth.

Country-level highlights• In the US, strong employment and wage growth stimulates increased consumption. • Investor sentiment on the Eurozone is boosted by reduced uncertainty from a viable solution to the Greek debt crisis.• UK productivity growth gathers pace, while growing Eurozone demand supports the country’s exporters.• Far-reaching political reforms lead to increased investor confidence in Brazil.

Scenario 3: Downside surpriseScenario 3, Downside surprise, has a broadly more pessimistic view of growth and inflation prospects, and factors in negative surprises.

Global: Financial market volatility implodes as the US Federal Reserve starts increasing interest rates and inflation trends upward.

Country-level highlights• Contagion effects spread through Eurozone financial markets as Greece exits the single currency union.• In Japan, the Bank of Japan meaningfully scales back its monetary policy support, leading to a deflationary spiral.• Actions on the part of Russia exacerbate geopolitical tensions, disrupting the flow of goods and services through Central and Eastern Europe.

Our strategies: CurrencyInvestor anticipation of the first Fed rate hike was a key influence in shaping currency market developments over the quarter. The broad consensus view that the Fed would raise interest rates at least once if not twice this year provided support for further US dollar gains over the three months. Signs that the first


quarter’s economic weakness was an anomaly in the context of a broadly positive US growth trend also boosted the dollar.

Our view is that the strong rally that the dollar has enjoyed over the past year is in its final stages. This is reflected in the fact that long-dollar positioning is now a heavily consensus trade among investors. We have scaled back our US dollar overweight, although we remain bullish. Our preference is to pair a long dollar position with short exposure to a currency that we view as overvalued, such as the New Zealand dollar.

We view the Japanese yen as the most undervalued G10 currency, and believe that it has room to appreciate under most scenarios. With the ECB pursuing a monetary policy trajectory increasingly similar to that of the BoJ, we would expect there to be potential for yen appreciation against the euro, and we are positioned accordingly (long yen versus euro).

Our view is that investors are overestimating the prospect of even more monetary policy accommodation—which would exert downward pressure on the yen—from the BoJ.

We also note that Japanese labor market conditions are tightening and inflation expectations are on the rise. The improvement in Japan’s terms of trade and the moderate growth in export volumes are other factors that are likely to lend support to the yen.

Toward the end of the quarter, developments in the Greek debt crisis became increasingly unpredictable and investors piled into the safe haven provided by the Swiss franc. As the euro plummeted against the franc, the Swiss National Bank inter-vened in the currency markets to stabilize the franc. Our thesis is that weaker Swiss economic data and the country’s deteriorating balance of payments will weigh on the franc over time.

USD appreciation against NZD, JPY, EUR and CHF

June 2014 August 2014 October 2014 December 2014 February 2015 April 2015 June 2015

100

110

120

130

140%

New Zealand dollar Japanese yen Euro Swiss franc

Source: Bloomberg Finance L.P. Data as of June 30, 2015.

Rebased to 100 on June 30, 2015.

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For now, however, the franc is holding up reasonably well against the euro, propped up by investor concerns about the ongoing Greek situation.

Our strategies: AlternativesThe environment remained a challenging one for commodities in the second quarter. Periods of US dollar strength tend to pose a headwind for commodities, while relatively tight liquidity conditions and weakness in the Chinese economy also weighed on returns. Against this backdrop, we see potential for upside in gold and agriculture.

Global oil remains in oversupply, although we believe that supply and demand conditions could correct to become more balanced in the coming quarters. In 12 months’ time, we would expect the price of a barrel of crude oil to fall within the USD 50–70 range.

We have a broadly positive view on private equity, both illiquid and listed.

Source: UBS Global Asset Management. Data as of June 30, 2015.

Actual and intrinsic value rates are shown in terms of how much one reference currency buys of the US dollar. Price/value discrepancies depict our view of how the US dollar is over- or undervalued versus the other currency; negative values indicate overvaluation of the US dollar, positive values indicate undervaluation of the US dollar with respect to the other currency. Intrinsic value is derived by adjusting for relative purchasing power parity (PPP) and real interest rate differential.

Currency price/value discrepancies

Reference currency Actual Intrinsic Price/valuevs. US dollar rate value rate discrepancy %

Euro (EUR) 1.11 1.27 -13.05

Japanese yen (JPY) 0.01 0.01 -19.24

Australian dollar (AUD) 0.75 0.78 -3.35

Canadian dollar (CAD) 0.80 0.83 -4.71

New Zealand dollar (NZD) 0.67 0.73 -7.97

Singapore dollar (SGD) 0.74 0.81 -8.23

Hong Kong dollar (HKD) 0.13 0.13 0.83

British pound (GBP) 0.64 0.62 -3.32

Swiss franc (CHF) 0.94 0.98 4.05

Swedish krona (SEK) 0.12 0.13 -7.46

Norwegian krone (NOK) 0.13 0.14 -11.13

Danish krone (DKK) 0.15 0.17 -8.29

Mexico peso (MXN) 0.06 0.07 -8.24

Korean won (KRW) 0.00 0.00 -7.78

Taiwan dollar (TWD) 0.03 0.03 -6.16

Thai baht (THB) 0.03 0.03 -9.15

Malaysian ringgit (MYR) 0.26 0.30 -12.73

South African rand (ZAR) 0.08 0.11 -29.11

Current strategy: Currency positions in Global Allocation Strategy

-8 -4 0 4 8

Indian rupee (INR)

Japanese yen (JPY)

Mexican peso (MXN)

Phillippine peso (PHP)

Swedish krona (SEK)

Swiss franc (CHF)

Euro (EUR)

Korean won (KRW)

Malaysian ringgit (MYR)

New Zealand dollar (NZD)

Over/underweight %

4.0

4.0

4.0

2.0

2.0

-2.0

-2.0

-4.0

-4.0

-4.0

Source: UBS Global Asset Management. Information is representative of a specific portfolio within the Global Allocation Strategy and may vary slightly within the different investment options. Data as of June 30, 2015.


Long Japanese equities versus US equities Across applicable multi-asset portfolios, we have introduced a trade of long Japanese equities versus US equities. While we see a small valuation case, this trade is largely based on the economic and earnings outlook for the two markets.

Based on traditional valuation metrics, price-to-book and price-to-earnings ratios, there is a neutral to slightly positive signal for this trade. One primary case for this trade is the recent economic developments in Japan. The latest Citigroup Economic Surprise Index for the two economies shows a +88.6 reading for Japan and a -25.1 reading for the US. This indicates that economic data have been coming in significantly stronger than expected in Japan and lower than expected in the US. Additionally, real GDP forecasts (Bloomberg consensus) show a sharp increase in expected GDP in Japan.

Perhaps more important is the earnings outlook for the respec-tive markets. US corporates have been able to maintain very high margin levels, but we expect this to dissipate as the labor market in the US continues to improve and as wages start to impact the bottom line. Earnings revisions have also been on a stronger uptrend in Japan than in the US. Factoring into all of this, including potential future earnings surprises, is currency; the US dollar continues to strengthen, which could put pressure on export-heavy corporates, while the Japanese yen has weakened in the past year, which will likely help improve profit margins going forward.

US

80

90

100

110

120

130

-50

0

50

100

Jan-10

Oct-06 Oct-07 Oct-08 Oct-09 Oct-10 Oct-11 Oct-12 Oct-13 Oct-14

Jan-11 Jan-12 Jan-13 Jan-14 Jan-15

USDJPY

JapanUS

80

90

100

110

120

130

-50

0

50

100

Jan-10

Oct-06 Oct-07 Oct-08 Oct-09 Oct-10 Oct-11 Oct-12 Oct-13 Oct-14

Jan-11 Jan-12 Jan-13 Jan-14 Jan-15

USDJPY

Japan

Each quarter, our Global Investment Solutions (GIS) group provides a summary of its viewpoints on global asset classes, including equities, fixed income and currencies. The Investment Spotlight offers a more in-depth analysis into one of these viewpoints, including both quantitative and qualitative factors.

Investment Spotlight

Citigroup Economic Surprise Index

Japanese yen per US dollar

Source: Bloomberg Finance L.P. Data as of June 30, 2015.

Milestone/signpost

Valuation: Price-to-book and price-to-earnings ratios are neutral to slightly positive in this trade.

Macro: Devaluation of the Japanese yen stands to benefit Japanese corporates’ earnings margins. Real GDP forecasts predict a strong rebound in Japanese GDP.

Economic surprise: Japan has a very strong economic surprise reading, while the US is in negative territory.

Earnings revisions: In Japan, earnings revisions have had an upward bias, much more so than in the US.

Major investment indicators

Signal

PositiveNegative

Overall signal

by Jocelyn Saxon

13

The UBS Global Asset Management US Pension Fund Fitness Tracker saw the funding ratio of the typical corporate US pension plan rise to about 87% in the second quarter of 2015. We recalibrated our model plan further to the adoption of new mortality tables at the last fiscal year-end.

The strong rise in Treasury yields, coupled with the widening of credit spreads, caused liability values to decrease about 7.3% in the second quarter of 2015. Investment returns over the quarter were -0.6%. These estimates are based on the average corporate plan’s reported asset allocation weightings from the UBS Global Asset Management Pension 500 Database and publicly available benchmark information.

The introduction of the new mortality tables had the net effect of reducing the funding ratio by approximately six percentage points. Factoring in the strong decrease in liabilities, the average funding ratio rebounded in the second quarter, increasing on average by about one percentage point. It is worth noting that in the absence of the mortality adjustment, the average funding ratio would stand close to 92%, the same level it was in

the last quarter of 2013. We continue to advise our clients to adhere to their de-risking program as the timing/direction of movements in long-term interest rates is uncertain. The S&P 500 Index ended the quarter slightly up with a total return of 0.28%. In US dollar (USD) terms, the Euro Stoxx Total Return Index was down at -0.63% over the quarter. The MSCI Emerging Markets Total Return Index ended the quarter 0.82% higher in USD terms. The yield on 10-year US Treasury Notes ended the quarter up 43 basis points (bps) at 2.35%. The yield on 30-year US Treasury bonds increased 58 bps, ending at 3.12%. High-quality corporate bond credit spreads, as measured by the Barclays Long Credit A+ option-adjusted spread, ended the quarter 11 bps wider. As a result, pension discount rates (which are based on the yield of high-quality investment grade corporate bonds) increased over the quarter. The passage of time caused liabilities for a typical pension plan to increase by about one percentage point over the quarter. Together, these effects caused liabilities to decrease 7.3% for the quarter.

The UBS Global Asset Management US Pension Fund Fitness Tracker is a quarterly estimate of the overall health of the typical US defined benefit pension plan.

US Pension Fund Fitness Tracker

Exhibit 1: Strong decrease in liabilities improves funding ratios in Q2 2015US Pension Fund Fitness Tracker of the typical US corporate plan’s funding ratio

-10

-8-6

-4-2

02

46

810

12

Dec 14Dec 13Dec 12Dec 11Dec 10Dec 09Dec 08Dec 07Dec 06Dec 05

75

80

85

90

95

100

105

110

115

120

Funding ratio %Fu

ndin

g ra

tio re

turn

%

Sources: UBS Global Asset Management, Barclays, Markit. Data as of June 30, 2015.

by Neil Olympio, CFA, FIA, CMT

15

Is it time for the QE genie to go back in its bottle?

The origins of this article lie in a series of conversations I had with my senior portfolio management colleagues over the course of several weeks early in 2015. The catalyst was the belated decision by the European Central Bank (ECB) to join the money printing party and implement a process of quantitative easing.

As a group, all of us had investment careers that stretched back long before the onset of QE. We had also all studied economics at a university. This combination sparked some lively discussion about the state of play in global bond, equity and currency markets.

In particular, we discussed whether the current generation of central bankers would follow the economic principles that had been taught to all of us. Doing so would mean a return to orthodox central bank policy as soon as possible. We maintained that this would at least provide the opportunity to cut rates from a more substantial starting point when the next recession hits—even if it meant some possibly significant disruption to markets in the interim.

But it was the counter thesis that troubled us more. Policy makers have taken the quantitative easing genie out of the bottle. My colleagues and I started to explore the potential scenarios if the QE genie didn’t go back in.

Origins of QE: the global financial crisis The global financial crisis prompted a massive loss of economic activity and of investor confidence in all risk assets. I remember trading in early 2009 and seeing dealing spreads, in many ways the purest expression of liquidity, widen out to 30% of face value on some securities when just a few weeks previously they had been quoted in less than one tenth of one percent. In some instances, market makers would not even answer their phones.

The sense of panic was almost tangible as we worried who the next Lehman or AIG might be. Pretty much everyone in financial services was worried about their job. But I know that I was not alone in wondering whether the basic principles of capitalism that support markets would survive the chaos.

Quarterly focus

Quantitative easing (QE) has provided a dramatically unorthodox stimulus to the global economy. So should QE now be considered a permanent part of central bankers’ toolkits? Curt Custard, Head of Global Investment Solutions (GIS) at UBS Global Asset Management, considers the impact of prolonging the QE party.


Massive fiscal expansion, the classic solution popularized by British economist John Maynard Keynes, soon followed. This stabilized the situation. But it soon led to another problem: overindebtedness. In Europe, the next stage was heightened concerns about creditworthiness in a number of countries.

In the end, fiscal policy proved to be enough only to stabilize the demand backdrop. But the level of growth it promoted was anaemic at best. And with so much spare capacity, inflation all but disappeared in the developed world. Deflation, not inflation became the dominant concern.

Enter the central banks.

Central banks step into the breach Learning from the lost decade that afflicted the Japanese economy in the 1990s, central banks aggressively lowered official monetary policy rates in order to stave off a debt deflation spiral. However, even that failed to provide sufficient growth or to raise inflation to a more comfortable target. With economic confidence destroyed, there was also almost a complete absence of credit demand.

On the credit supply side, banks were (and continue to be) involved in an exercise of dramatic balance sheet shrinkage. In effect, the major transmission mechanism of capital to the wider economy was broken. Against this backdrop, there was clearly a major risk that without further stimulus, the indebted global economy would slip quickly into very negative territory for a sustained period.

So central banks engaged in what were quickly dubbed “unorthodox measures”: QE. To date these measures seem to have worked. The global economy has improved. The US and the UK, early adopters of QE, have been poster children for its effectiveness, with a return to positive GDP and employment growth. In Europe, the ECB is the latest to engage in QE, and early signs are hopeful: Credit growth and other measures of economic activity are picking up.

So if it works, shouldn’t QE lose its ‘unorthodox’ moniker and be considered a regular part of the monetary policy tool box?

Using Wall Street to boost Main Street To answer that question properly, we need to look at both the mechanisms used and the unintended consequences of those mechanisms.

The mechanism for the delivery of QE has primarily been the purchase of longer-dated fixed income securities from the government and private sector by central bank balance sheets. Central banks have, in effect, therefore acted as a large uneconomic buyer of securities in enough size to further reduce the real interest rate and stimulate the flow of capital to the wider economy.

So what does it mean when there is a substantial actor in the market that is not motivated by the same profit imperative that drives other market participants? We can actually observe the direct effects quite easily: In the first instance, we can see the impact of QE in lower and flatter yield curves. In simple terms, these mean lower borrowing costs for corporations to issue debt.

The secondary impact has been to significantly increase the wealth of financial asset owners. This has occurred directly in terms of those higher bond prices, but by reducing the return on deposits and shorter-dated bonds, QE has pushed investors into riskier assets such as longer-dated credit and equities. This has created a virtuous cycle of broad based financial asset inflation.

Both the lowered borrowing costs and financial asset inflation have a directly positive impact on the real economy— corporations can fund (and invest) at lower costs and financial asset owners spend their new found paper wealth in real ways on goods and services. So what’s the problem?

Central bank sheet as % of GDP, cumulative change since Q3 2007

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

70%

60

50

40

30

20

10

0

USA Eurozone Japan

Source: National central banks, IMF, UBS Global Asset Management.

Data as of May 6, 2015.

Quarterly focus

17

The dangers of ongoing QE Any analysis of the impact of QE needs to be done by looking at all consequences, including those that may be unintended. If QE is to become a regular tool to be used by policy makers in times of recession, we see at least three channels where markets will be structurally disrupted. These disruptions have potentially long-term negative effects on both the real economy and society at large. We believe that:

1) QE leads to uneconomic decisions By lowering borrowing costs for corporations below the ‘natural’ rate, investments are encouraged with a hurdle rate (or minimal required rate of return) that is too low given the risks.

There is therefore the potential to create an investment bubble as investors continue to part with their money even when expected future returns are low. They continue to invest because they have an artificially low marginal cost of investment. Over time, valuations become more and more stretched until, eventually, the bubble bursts.

There is evidence of this impact right across asset classes since QE started, but probably most spectacularly in the property speculation in China post crisis.

2) QE may harm longer-term job creation By artificially lowering the cost of capital versus the cost of labor, QE may actually depress employment as corporations switch from hiring to capital expenditure. By reducing demand for labor this trend also depresses wage growth. The slow labor market recovery in the US could be at least partially explained by corporates focusing on capex rather than hiring due to QE.

3) QE heightens currency volatility Not every central bank has introduced QE and those that have did not do so simultaneously. However, the timing of individual countries’ QE program has had a huge impact on global currency rates, and therefore on those countries’ relative competitiveness within the global economy.

Many countries not introducing QE have become less competi-tive for reasons beyond their control as their currencies strengthen on a relative basis. Ultimately, QE is a ‘beggar thy neighbor’ approach to foreign exchange that protects inefficient industries from global competition. If QE becomes a core part of the central bank toolkit, it is very hard to argue that either sustained currency volatility or the protection of inefficient industries are positive long-term developments for the global economy.

4) QE distorts financial markets Because central banks are buying only certain classes of assets, they are creating structurally different conditions, or at least different price determination mechanisms, in some assets compared to others.

For example, if a central bank purchases the credit of a company in times of distress, this creates a distortion in the price of the credit security relative to its own underlying creditworthi-ness. Complicating matters further is if central banks end up with different buying rules. Such a development will impact where and how companies issue debt.

As investors, we would prefer significantly to own the debt of a company issued in a market where we know the central bank

Each quarter the GIS asset allocation and currency team participates in the UBS Cyclical Market Forum (CMF). The CMF involves the most senior portfolio managers within UBS Global Asset Management coming together to debate major investment issues. All views—quite rightly—are subject to analysis and challenge from colleagues. It is a very important part of how we formulate views and demonstrates how the breadth and depth of expertise within our asset management business can potentially benefit all investment clients.

Within the CMF we ask the managers of every kind of asset class—including credit, equities, structured credit, infrastructure, commodities, hedge funds and currency—what they believe are the likely drivers of asset prices looking forward over the next 12–18 months. In the main we ask questions about things such as economic growth, geopolitics, changes to input costs and valuations. But for more than three years we have included a question in the survey about the impact of quantitative easing.

According to our survey respondents the impact of QE dwarfs that of economic growth, geopolitical risk, asset class valuations and the oil price. Astoundingly, since the QE question was added in 2011 it has ranked as the number one driver of asset price movements across every single asset class across every single region.

QE and Constructive challenge


will intervene, relative to owning the debt issued by the same company with identical features but issued in a country where the central bank leaves market forces alone.

Due to its inconsistent application over differing time periods, the whole QE process renders the accurate long-term valuation of securities extraordinarily difficult. Investors will have to guess what the creditworthiness of a company is in normal times and also under ‘distressed times’ when the central bank may be acting as an uneconomic buyer of that credit.

Paradoxically, it is entirely conceivable that the yield of a cyclical investment grade company could fall during times of extreme economic weakness and rise during periods of mild economic weakness when the central bank is not in the market to buy those securities. QE therefore distorts the orderly workings of the markets in which it operates.

5) QE will likely create ongoing asset bubbles One of the most clearly visible consequences of QE has been the suppression of overall risk asset volatility. By making it punitive to hold cash, global equities and credit, in particular, have enjoyed spectacular returns with only occasional bouts of minimal downward pressure.

This creates risk-adjusted returns metrics that are exceptionally high from a long-term historical perspective, and that are almost certainly very unrealistic on a forward-looking basis.

Unfortunately, the situation has persisted for so long that the abnormal metrics QE has created are being accepted as the norm. We now have an entire generation of young portfolio managers and risk managers who know nothing other than high levels of liquidity and low discount rates.

Risk models are also now in danger of exacerbating the very situation against which they are supposed to protect. For example, many asset managers use trailing five-year daily data as a basis for their risk models. That does not now cover any period in which QE has not been in place. In terms of how asset managers look at the potential for risk-adjusted returns, QE has created forecasts that are as unrealistic as they are dangerous.

Most risk models use a similar method to approximate future risk. This includes many of the Value at Risk models used throughout our industry. When QE ceases and risk-adjusted returns to more ‘normal’ long-term levels, these models will have failed dramatically to model correctly the potential behavior of these assets.

Even more troubling is the impact this dampened risk may have on the ‘subjective’ risk estimates of retail investors everywhere who have bought risk assets (often by borrowing on margin— as in China) in the strong belief that they will deliver an outcome that is wholly incompatible with either historical precedent or likely future.

Equity markets indices relative to pre-crisis peak

2010 2011 2012 2013 2014 201520082007 2009

FTSE 100 Euro STOXX 50 TOPIX S&P/ASX 300 MSCI EM (USD)S&P 500

140

120

100

80

60

40

20

Source: Thomson Reuters DataStream.

Quarterly focus

19

6) QE exacerbates wealth distortions at all levels within society The last and most dangerous distortion that we see ongoing QE having is the growing disparity it perpetuates between those who own financial assets and those who do not.

The idea of authorities stepping in to support markets is not a new one. In the 1990s, the term “Greenspan Put” was coined to describe how Federal Reserve Chairman Alan Greenspan had lowered interest rates to restore market stability and to raise asset prices in response to times of crisis during his tenure.

The ‘put’ refers to a put option. By constantly cutting interest rates during periods of low investor confidence, Greenspan supported the market and allowed equity owners to sell at a higher price than would have otherwise have been the case—mirroring the characteristics of a put option.

QE has taken the concept one step forward by making this put option explicit rather than implicit. Greenspan simply supported the wider market with rate cuts; QE literally buys securities at higher levels than if market forces alone were left to determine prices.

While ultimately the nonrisk asset-owning segments of society benefit from QE too as the economy improves, the owners and issuers of corporate bonds, equities and other risk assets benefit earlier and disproportionally more. Meanwhile, savers (through lower deposit rates) and pensioners (through lower annuity rates) will continue to be penalized.

Encouraging risk-taking while protecting and enhancing the wealth of some at the direct expense of others means QE risks creating further rifts in society at a time when there is already much discourse about income inequality. Central banks are not (and should not be) in the business of wealth redistribution.

Is it time to put the QE genie back? Central banks have done what they needed to do by using the policy tools at hand and inventing new ones as they have become necessary. These have reinvigorated parts of the global economy and have significantly diminished the spectre of deflation.

But as investors, we worry. We worry about the distortions that the more regular use of QE would cause both in markets and in society. If these unorthodox measures become orthodox, it will force us to reframe how we think about markets. We will have to look at financial assets in a new light and change assumptions about the relationships between supply and demand and fair value.

But our concern is not just that the way investors look at risk and return will become even further skewed than it is already. Our concern is that we will be factoring into analysis inputs that have little to do with the true profit potential or creditworthiness that ultimately should determine any individual security’s long-term fair value. Indeed, by incorporating long-term QE into valuations, investors are effectively being asked to repeat the mistakes of the dot.com bubble—a period when analysts created new valuation metrics to justify the share prices of companies that had no earnings. And we all know how that ended.

Perhaps most importantly of all, ongoing QE will likely distort the real economy and society, changing the relationship between capital and labor, and between the haves and have nots. None of these developments strike us as being positive.

Quantitative easing was a vital weapon in fighting a profound, once-in-a-century risk. But now it needs to be put away and locked up very tightly. In short, the QE genie needs to go back in the bottle.


Equity markets were more subdued during the second quarter of 2015, with the MSCI World Index delivering -0.5% in local currency terms. The improved sentiment toward Europe, seen at the beginning of the year, following the measures taken by the ECB to stimulate the economy, reversed sharply as a real possibility of a Greek default and a subsequent “Grexit” dominated the news.

Markets were also watchful over the future possible date for the interest rate hike, as the emergence of strong US housing and labor data increased the likelihood that the Fed will raise interest rates as soon as September. Japan was one of the strongest-performing developed markets this quarter. The Japanese labor market has benefited from the government’s efforts to reflate the economy, with further recovery seen in corporate profits.

Global sectors that were particularly strong this quarter included telecoms, financials and healthcare, while utilities, energy, materials and consumer staples where the worst-performing.

We remain positive on the outlook for US GDP, but believe the relative strength of the economy is already reflected in US company valuations. The Global Equity portfolio, therefore, remains underweight the US, but we continue our search for US domestic exposure at the right price. This underweight stance was damaging to relative performance in the last year or so, but we expect this to reverse. US corporate earnings are unlikely to show the same robust growth of recent years (held back by nascent wage growth and the negative impact of the strong dollar on international earnings). In our view, Europe remains on its recovery path, despite the current concerns over Greece, which although likely to cause a setback in the short term, will not derail long-term recovery. Overall, Japan and Europe have been outperforming the US, and we expect this to continue, supported by bottom-up company valuations and fundamentals.

However, we are mindful of future capital-raising by Japanese corporations, as this could be a warning flag of a shift away from current corporate governance and reform.

StrategyThis strategy follows a core/value style, is driven by bottom-up stock selection and has consistently adopted a price/intrinsic value philosophy since its inception nearly 30 years ago. We aim to select the most attractively valued global stocks and to combine them in a risk-aware manner to deliver outperformance commensurate with client objectives.

As a fundamental, long-term investor, we model an estimate of intrinsic value for every stock. We then compare that value estimate with the current stock price. The resulting price/value discrepancies are the backbone of our security selection process. In a globally integrated investment process, we combine the bottom-up approach with risk analysis to focus the portfolio on what we believe to be the best investment opportunities across the global universe.

Global Equity

Current strategy: Global Equity

-4 -2 0 2 4

Sector

Consumer Discretionary

Financials

Materials

Consumer Staples

Energy

Information Technology

Utilities

Healthcare

Country

Japan

United Kingdom

Netherlands

Finland

Germany

Switzerland

Australia

United States

Largest over/underweights %

3.0

1.7

0.8

0.3

-0.8

-1.3

-1.7

-2.4

4.8

1.7

1.7

1.1

-1.2

-1.7

-2.7

-3.9

Benchmark: MSCI World Index (Unhedged).


by Bruno Bertocci

21

The second quarter brought unsettled equity markets as the Greek crisis seemed to spiral out of control. The referendum called by the Greek government over the July 4th weekend, resulting in a possible “Grexit,” is an outcome that had been thought to be relatively improbable. The MSCI World Index increased by 0.3%, bringing the year-to-date return to 2.6%. The global decline was comprised of several opposing move-ments in regional markets: Europe, after rising strongly early in the year, fell sharply during the quarter; the US, buoyed by good employment and industrial production numbers, and upward revision to first quarter GDP, ended the quarter nearly flat; Japan rose during the quarter and became one of the best-performing world markets, driven by quantitative easing and signs of corporate reform.

The healthcare sector led the quarter, followed by consumer discretionary and financials (slightly positive). All other sectors were negative, with energy falling the most, nearly by 10%; materials and utilities were also poor performers. Energy bounced earlier in the quarter as investors hoped for a slackening of production and an end to inventory growth. However, as production did not slacken much and US producers adjusted their costs to lower prices, energy stocks took a hit. Materials also declined due to weak Chinese growth, high production levels and an inventories glut.

The Global Sustainable Equity (GSE) strategy focuses on companies where management execution is the key to success and on avoiding sectors where macroeconomic effects or commodity prices are the primary earnings drivers. Healthcare remains an overweight, although we have trimmed some winners. We remain underweight energy and materials. We believe it will take longer to balance supply and demand given a decade of high investment levels in both sectors. In addition, while China is attempting to increase economic growth, a collapsing equity market could easily dampen growth.

We see rising interest in sustainable investment strategies as pension funds see material sustainability factors as helpful to the analytical process. We also see heightened awareness of the external social impact of securities portfolios. Up to now, endowments, foundations and individual clients have focused on issues such as mission alignment, but pension funds are now discussing their role as activist investors.

We believe that the GSE strategy is well-positioned for market developments and for the evolution of positive-screening sustainable investment trends.

We invest in companies that meet two important investment criteria. First, we estimate the intrinsic value for every stock and compare that value estimate with the current stock price. We then select securities that are attractive from a bottom-up perspective, combined with market, sector, currency and risk analysis to form a best-ideas portfolio. Second, companies are screened for a sustainable corporate strategy, environmental impact, social guidelines and governance. The intended result is a portfolio of attractively valued companies with a strong environmental, social and governance (ESG) profile.

Global Sustainable Equity

Current strategy: Global Sustainable Equity

-4 -2 0 2 4

Sector


Materials


Healthcare

Industrials

Energy

Utilities

Consumer Staples

Country

Japan

Norway

Netherlands

Spain

France

Australia

Canada

United States

Largest over/underweights %

4.4

3.4

3.2

0.9

-1.6

-2.0

-3.0

-5.9

3.6

3.2

2.6

2.0

-1.3

-2.1

-3.3

-9.4

Benchmark: MSCI World Index (net).


by Bruno Bertocci


Macroeconomic events continued to take center stage during the second quarter, with speculation over US monetary policy broadly pervading the market. Longer-term rates have begun to move higher, supported by improving strength in the employment and housing markets, while confidence that the Federal Reserve will begin raising short-term interest rates in the next quarter or two has increased. Across several key sectors, 2015 continues to be an acquisitive year, with companies looking to bolster their competitive positions in the wake of subindustry consolidation. We believe specialist knowledge and active management have become increasingly important in capitalizing on the evolving US opportunity set.

In healthcare, consolidation has accelerated and spread to the services side of the business, with managed care and distributors joining in on the action. We remain bullish on the biotechnology sector, as we see major advances in science driving substantial, idiosyncratic value creation, particularly within genetics and protein engineering. The current environment continues to support our favorable view of healthcare broadly, although opportunities for further multiple expansion may be limited following several years of sector-wide outperformance.

Within consumer discretionary, fast fashion and high-end outlets continue to take share, while department stores have generally suffered due to lackluster product offerings and decreasing mall traffic. Restaurants are dealing with increased consumer awareness and demand for “pure” ingredient products. Media remains challenged from changes in consump-tion and the lack of ability to measure new distribution devices. While evidence suggests the traditional cable bundle is breaking for younger consumers, quality content remains important and difficult to produce.

For consumer staples, emerging markets have slowed and appear to be headed toward a period of lower expected growth. As a result, many companies have implemented zero-based budgeting to cut costs more aggressively than normal and to drive earnings growth. Food staples are seeing increased activist investor activity, with many food staples stocks failing to trade on fundamentals.

We continue to see value within financials, particularly in companies that have exposure to an improving US economy and strong capital markets activities. Loan growth has improved further, and credit quality remains very strong. Life insurance companies generally screen as being more attractively valued than property/casualty insurance companies, even after a robust quarter that saw the subsector outperform the broader market as Treasury yields rose. Within the life insurance space, near-term pressures resulting from the low-rate environment have been largely offset by improving operating margins in other corners of the business, such as retirement savings products in overseas markets and certain asset management businesses.

Within information technology, semiconductors and semicon-ductor capital equipment markets will likely continue to grow at an above-GDP level as the electronic content of virtually everything expands, with electronic devices being consumed at higher penetration rates. Semiconductor companies will likely continue to consolidate in this slower-than-historic growth environment. Traditional IT hardware manufacturers should continue to see top-line and margin pressure as cloud computing and industry standardization expand their address-able market. Within IT software, the focus is on security software, with an emphasis on network security, particularly firewalls, and continued adoption of Software as a Service (SaaS) applications.

As a fundamental, long-term investor, we model an estimate of intrinsic value for each stock in which we invest. We then compare that value estimate with the current stock price and rank each security in our universe based on these price/value discrepan-cies. Portfolios are constructed by selecting top-quintile stocks, with consideration given to market sensitivity, common factor exposures, industry weightings and rank.

US Large Cap Equity

by Tom Digenan, CFA, CPA

23

In the energy sector, oil prices continue to impact drilling programs in the US onshore tight oil space. We believe 2015 cutbacks from US onshore drilling will go a long way toward balancing the market; however, as short-term commodity prices are unpredictable, we continue to pursue company-specific opportunities within the space.

The industrials and materials sectors appear fairly valued on average; however, the dispersion in price-to-intrinsic value has widened as macroeconomic uncertainty has increased. Within the space, there are several big “macro” debates: i.e. the magnitude of direct and indirect impacts of lower oil prices on industrial company growth; pricing and margins; the medium-term competitive impact of the stronger dollar on US versus global manufacturer competitiveness; and finally, how those factors interact to influence the rate of industrial production and/or GDP growth and cyclicality.

Within yield-oriented sectors, such as utilities and REITs, valuations continue to appear high despite underperformance relative to the broader market year-to-date. Fundamental operating data have generally been positive for commercial real estate landlords, which has combined with favorable borrowing conditions to push valuations close to record highs. We continue to pursue company-specific opportunities within the real estate sector, focusing on REITs that are most likely to generate high single-digit cash flow growth regardless of the macroeconomic environment. Utilities have similarly benefited from the low interest-rate environment, with reduced borrowing costs and a generally permissive regulatory attitude toward earnings-accretive capital expenditure projects driving mid-single-digit earnings growth on a year-over-year basis.

Benchmark: Russell 1000 Index.


-4 -2 0 2 4

Energy

Materials

Capital Goods

Commercial Services

Transportation

Auto

Durables

Consumer Services

Media

Retailing

Food Retail

Food & Beverage

Household

Healthcare

Pharma & Biotech

Banks

Financials

Insurance

Real Estate

Software

Hardware

Semiconductors

Telecommunication

Utilities

Cash & Others

Over/underweight %

0.0

-0.2

-3.9

-0.9

1.5

1.1

0.5

0.6

0.3

-2.0

0.0

3.5

-1.8

-0.7

4.0

1.2

-0.2

1.5

-0.5

-3.0

0.0

3.7

-2.1

-2.9

0.2

Current industry weightings: US Large Cap Equity


Throughout the second quarter of 2015, the US equity market continued to tread water, with neither the bulls nor the bears gaining much ground. In fact, the Russell 1000 Growth Index ended the quarter in essentially the same place it began, having gained only 0.1% during the prior three months. After a six-year bull market, with limited interruption, investors are beginning to increasingly question whether the run is finally getting long in the tooth.

During the quarter, the market focused primarily on macro concerns, including future Federal Reserve (Fed) policy, ongoing debt negotiations with Greece and a precarious equity market in China. With the Fed passing on a June rate hike, as expected, but signaling the possibility for the first move to be in September, investors sold bond proxies such as utilities, telecommunication services and consumer staples, which were among the worst-performing sectors in the index. While the Fed has gone to great lengths to explain to market participants that the path of rate hikes will likely be shallow, which in its view is more important than the timing of the first hike, the market nonetheless continues to be fixated on when the first move will occur. In the end, it‘s not a question of when, but by how much and at what pace that is more important in our view. Until the first move, however, it seems likely that market participants will remain in somewhat of a holding pattern, unwilling to make significant changes until more clarity is provided.

Meanwhile, at the micro level, US corporations have continued to beat lowered expectations. Earnings grew in the first quarter by approximately 0.8%, after analysts anticipated a decline. Excluding the energy sector, which has been impacted by steep declines in commodity markets, earnings for US companies grew 8.6% during the first quarter. More of the same is expected for the second-quarter earnings season, with consensus earnings expected to decline 4.5% year-over-year,

but grow 2.2% when energy is excluded. With profit margins appearing to have limited room left to expand and in a world of subpar growth, companies have begun to get creative in an effort to further grow earnings per share. For the last few years, cost-cutting, productivity gains and share buybacks were enough to keep shareholders happy. Now, companies, particularly in the healthcare industry, are looking at other measures such as acquisitions to fuel future growth. While these maneuvers may provide fuel for the market to grind higher in the short term, more sustainable support of equity markets must be driven by organic earnings growth.

In the current environment, we believe our disciplined approach is well-suited to rewarding investors. Our process of identifying high-quality companies whose growth is misunderstood, while balancing risk among three sources of growth (elite, classic and cyclical), inherently directs us toward sustainable business models with large addressable markets and organic growth opportunities. Additionally, a focus on valuation and diversifica-tion is more important than ever.

As we view the investment landscape, we continue to find opportunities within the information technology sector where many superior business models are found. Specifically, within Internet software and services, we are exposed to companies that are leading the charge into digital and mobile advertising, which continues to take share from traditional mediums. Within software, we are exposed to best-of-breed software-as-a-service companies, which continue to achieve exceptional growth at the expense of more established players.

Within consumer discretionary, we continue to believe that certain companies within Internet retail, which remains our largest overweight, will reap the benefits of scale. Elsewhere, we have reduced our weight within apparel and luxury goods, yet remain overweight due to our position

The strategy aims to buy securities of companies where we believe either the duration or the magnitude of future growth prospects is not fully reflected in the current market price. The strategy invests primarily in companies that we believe possess a dominant market position and franchise, a major technological edge or a unique competitive advantage. The team seeks to identify and invest in three sources of alpha, and diversifies the portfolio holdings into Classic Growth, Elite Growth and Cyclical Growth companies.

US Large Cap Growth Equity

by Grant Bughman

25

in a world-class athletic apparel maker. We also continue to have exposure to distinct opportunities in hotels, restaurants and leisure, as well as specialty retail, which we believe will benefit from the continued improvement of US consumer spending power.

Healthcare has been a fruitful sector for investors over the past 24 months, and we remain overweight large-cap biotech, where we believe that drugs in current production, as well as future options for growth, are underestimated. We have also recently added to companies in the life sciences and healthcare equipment industries that we believe offer attractive risk/reward profiles and complement our elite growth exposure elsewhere.

The strategy’s largest underweight remains consumer staples, where the lack of earnings growth and high valuations due to the low interest rate environment have kept us on the sideline, with the exception of two select opportunities within the personal and food products industries. We are also underweight industrials, seeing limited opportunities in aerospace and air, freight and logistics. Telecommunication services also remains an underweight, with the exception of a lone tower operator that we believe will benefit from increasing wireless capital expenditures. As always, we remain disciplined in our approach and seek to balance risk across three types of growth companies. At the end of the quarter, the allocation among Classic, Elite and Cyclical Growth was 56%, 41% and 3%, respectively.

Current strategy: US Large Cap Select Growth

-4 -2 0 2 4



Healthcare

Materials

Energy

Utilities

Financials

Telecommunication Services

Industrials

Consumer Staples

Over/underweight %

3.6

2.7

2.5

0.2

0.1

0.0

-0.5

-0.6

-0.9

-7.0

Benchmark: Russell 1000 Growth Index.

Source: Factset, UBS Global Asset Management. Data as of June 30, 2015.


US Small Cap Growth companies outperformed their large cap brethren in the second quarter by approximately 200 basis points (bps). This continued a trend that began last September that has seen small caps fly ahead of large caps by over 10%. Much of the performance has been due to a re-rating of valuation multiples after a period of consolidation among small caps. In addition to an upward move in valuations, small caps have benefited from faster earnings growth, as well as a more domestic focus, which has helped given the US dollar’s recent strength. In the first quarter, small caps saw earnings grow 6.6% year-over-year, which was roughly six percentage points more than large caps. Looking ahead over the second quarter, the consensus is for small caps to see earnings decrease by 1.9% versus a 4.5% decrease for large caps.

In a low global growth environment, it’s not surprising to see unique organic growth stories capturing the interest of investors. In the past quarter, this was evidenced by the performance of the healthcare and information technology sectors, which saw the biggest move due to strong earnings growth, as well as an active M&A environment. On the opposite end, the worst-performing sectors were more cyclical in nature, with materials, energy and industrials all falling during the quarter.

In this environment, the US Small Cap Growth strategy continues to find unique opportunities within the information technology sector, particularly in the software and Internet services industries. Within energy, we believe the shakeout in the sector has created opportunities within the energy and production industry, and we’ve tilted our portfolio toward those companies with low-cost acreage, low debt and the ability to fund future growth from cash flows. Industrials continue to be the strategy’s largest underweight, as we find only limited opportunities for organic growth prospects. Where we have found opportunity in the sector is within the construction and

engineering industry. While we remain overweight airlines, the recent positive run within the industry has led us to take some profits. Finally, we remain underweight consumer staples, which has limited opportunities at the moment for sustainable organic growth.

As always, we continue to be committed to executing on our process in a disciplined manner, and believe we are well-positioned to take advantage of sustainable growth stories in the current environment.

Our strategy aims to pursue long-term returns by investing in companies with strong business franchises that generate rapidly rising earnings. The investment team conducts fundamental research that analyzes companies’ earnings growth potential, as well as provides a thorough assessment of companies’ business models. Portfolios seek to manage risk through diversification and attention to reasonable valuations, and are constructed and monitored with close adherence to risk management and client guidelines.

US Small Cap Growth Equity

Current strategy: US Small Cap Growth

Benchmark: Russell 2000 Growth Index.

Source: FactSet, UBS Global Asset Management. Data as of June 30, 2015.

-6 -3 0 3 6


Energy


Healthcare

Utilities


Financials

Materials

Consumer Staples

Industrials

Over/underweight %

5.2

2.8

1.4

0.3

-0.1

-0.2

-0.9

-1.3

-2.3

-5.0

by Grant Bughman

27

The international small cap equities market, as measured by the MSCI World (ex-US) Small Cap Index, ended the second quarter up 3.35%.

Asia-PacificThe Asia-Pacific region (MSCI Pacific Small Cap Index) rose 2.2% in USD terms. Performance was driven by consumer staples, energy and industrials, while telecommunication services and information technology underperformed. From a country perspective, Hong Kong and Japan outperformed, while New Zealand and Australia underperformed.

EuropeEurope (MSCI Europe Small Cap Index) was up 4.5% in USD terms. The United Kingdom, Belgium and Denmark were the strongest performers, while Finland and the Netherlands underperformed. Telecommunication services, consumer discretionary and energy outperformed, while materials and financials lagged.

Emerging marketsEmerging markets (MSCI Emerging Markets Small Cap Index) gained 3.8%. China, Qatar and Korea were leading markets, while Indonesia, Egypt and the Philippines underperformed. From a sector perspective, energy, financials and materials outperformed, while consumer discretionary, information technology and healthcare trailed the broader benchmark.

SectorsTelecommunication services, consumer discretionary and consumer staples were the strongest performers within the MSCI World (ex-US) Small Cap Index, while financials, utilities and information technology lagged during the period.

Summary and outlookWe continue to monitor events globally, particularly the various central banks, macroeconomic data and company earnings. The market will have a close eye on the European Central Bank,

the Bank of Japan and the US Federal Reserve moving furtherinto 2015. Equity investors will also be watching signals from the currency and bond markets. The outlook for growth in China will be an important focus as well.

While Greece continues to grab headlines, we believe the market will focus closely on company earnings growth, and we continue to look for solid stock-specific growth stories.

We focus on investing in companies that display the earnings growth characteristics that are consistent with companies that are undergoing positive, sustainable fundamental change. We identify investments through a combination of quantitative analysis and rigorous fundamental research. Our bottom-up research, the cornerstone of our invest-ment process, seeks to confirm that the changes we search for in companies are sustainable. Risk management is integral to the portfolio construction process and is evaluated at the stock and the portfolio levels.

Global (ex-US) Small Cap Growth

Current strategy: Global (ex-US) Small Cap Growth Equity

-10 -5 0 5 10

Sector

Industrials


Utilities



Energy

Materials

Consumer Staples

Healthcare

Financials

Country

Hong Kong

Mexico

India

Panama

Thailand

Turkey

Indonesia

Brazil

South Africa

China

Over/underweight %

5.5

2.9

1.0

1.0

-0.6

-1.6

-2.3

-2.8

-3.4

-4.1

5.2

4.6

2.2

1.6

1.3

-1.4

-2.0

-2.2

-3.3

-6.0

Benchmark: S&P Developed ex-US Small Cap Growth Index.


by Stephan Maikkula, CFA, CMT


During the second quarter, the MSCI emerging equity markets were up 0.8%, which was in line with the MSCI developed markets, which were up 0.5%. Year-to-date, performance in both asset classes is the same, up 3.0%. MSCI emerging markets small cap equities outperformed during the quarter, rising 3.8%, and returning 8.9% year-to-date. The second quarter was another volatile one in emerging market equities, with about a 10% swing in the asset class. The volatility was driven by big swings in the Chinese A-share market, which traded in an over-30% range. Emerging market currencies generally were down, with the exception of Russia and Brazil, which recovered after significant declines in recent quarters. The sentiment in the asset class continues to be negative, with political uncertainty in Russia and Brazil and economic uncertainty in China. The strength of the US dollar has also weighed on sentiment as it is generally viewed that the emerging markets could see significant capital outflows if the US raises interest rates in the coming quarters.

At the country level, the best-performing markets were Hungary and United Arab Emirates, both up 11% in USD terms. Among the larger emerging markets (EM) countries, China was up 8%. Local investors in China drove Shanghai-listed stocks higher, looking through weak macro data toward further stimulus. Russia was also up 8%, continuing its rebound that began with a 7% increase in the first quarter, after severe declines in the third and fourth quarters of 2014. Russia rallied on the back of stronger oil prices. Brazil also rebounded somewhat, up 7%, after falling 15% in each of the previous two quarters, due largely to weakness in the real and the worst recession in many years.

The worst-performing market was Indonesia, down 14%. Unsettling fiscal balances may pose a further threat to infrastruc-ture spending, which has been slow to materialize, inflation is still high at 6%–7%, and the rupiah remains under pressure. Malaysia fell 8% on the back of a diminishing current account surplus, a property demand slowdown on cooling measures,

and moderating consumption growth following subsidy cuts and a three-year peak in foreign ownership.

At the sector level, energy was the best performer, up 9% due to higher oil prices. Financials and consumer staples were up 3% and 2%, respectively, as investors see benefits for consumers in lower commodity prices and lower interest rates, as well as a potential pickup in economic activity.

The UBS Emerging Markets Growth team believes that companies undergoing positive, sustainable fundamental change that leads to a period of above-average earnings growth will outperform the market over time. Our investment success is determined by our ability to identify and invest in these mispriced earnings growth stories. Attention to sector, region and capitalization biases is merited and monitored in order to size our strategy’s positions to be consistent with our convictions.

Emerging Markets Growth Equity

Current strategy: Emerging Markets Growth Equity

-10 -5 0 5 10

Sector



Industrials

Consumer Staples

Healthcare

Utilities

Materials

Financials


Energy

Country

China

South Korea

Philippines

Peru

Taiwan

Malaysia

Mexico

South Africa

Brazil

Russia

Over/underweight %

5.8

4.1

3.8

3.6

1.3

-2.4

-3.7

-4.2

-6.1

-7.4

8.4

6.0

3.5

0.4

0.3

-2.5

-2.8

-2.8

-3.0

-3.2

Benchmark: MSCI Emerging Markets Index.


by Joseph Devine

29

Information technology, consumer discretionary and healthcare were the worst-performing sectors, down 4%, 3%, and 2%, respectively. Consumer discretionary was weak, largely due to steep falls in Chinese and Korean auto stocks. Healthcare underperformed due to profit-taking after strongly outper-forming in the prior quarter.

Our outlook is cautiously optimistic. It is hard to forecast what could turn around sentiment and investor fund flows back into the asset class in the near term. The looming uncertainty and fear over US interest rates are probably the biggest near-term impediments. In China, the economic data have been generally tepid to disappointing; however; we are seeing signs of stabilization in the real estate market, and the big rally in the stock market may ignite consumer demand if the gains hold. An economic recovery in China would certainly be a huge driver for improving returns in emerging market equities. Weak oil prices, while hurting some export economies, will continue to help the overall asset class as they will contain inflation and improve consumer spending. Despite unexciting returns in the asset class the last few years, we are seeing some very strong pockets of growth in the consumer, tech-nology and healthcare industries. We continue to view these areas as long-term secular growth opportunities, and selective investors should be able to generate attractive returns even if the overall asset class continues to trade in a tight range.

Current strategy: Emerging Markets Small Cap Equity

-10 -5 0 5 10

Sector

Industrials


Utilities



Energy

Materials

Consumer Staples

Healthcare

Financials

Country

Hong Kong

Mexico

India

Panama

Thailand

Turkey

Indonesia

Brazil

South Africa

China

Over/underweight %

5.5

2.9

1.0

1.0

-0.6

-1.6

-2.3

-2.8

-3.4

-4.1

5.2

4.6

2.2

1.6

1.3

-1.4

-2.0

-2.2

-3.3

-6.0

Benchmark: MSCI Emerging Markets Small Cap Index.



The second quarter of 2015 saw broad-based underperformance across a range of global developed government and corporate bond markets. A combination of higher yields on core government bond markets and wider credit spreads led to negative returns across most markets. Eurozone government bond markets led the market selloff as higher-than-expected core inflation in Europe and a surprising dismissal of bond market volatility by Mario Draghi at the European Central Bank’s (ECB) June press conference sent German government bonds sharply higher. Resilience in credit markets gave way in June as a mixture of concerns over the impact of a future Fed funds rate increase, volatility in German bunds and the breakdown in talks between Greece and its creditors weighed on investor risk appetite. The second quarter brought a pause in US dollar strength after the rapid appreciation of the first quarter. Within G10 markets, New Zealand stood out from the crowd following a surprise interest rate cut in June that led bond yields sharply lower and as the New Zealand dollar was the weakest of the G10 currencies. The quarter finished with investor concerns centered on the risks of a Greek Eurozone exit, but also with an eye on recent Chinese financial market volatility and the possible impact of future Fed policy normalization.

In the US, signs of a solid bounce back in growth from a weather-depressed first quarter helped underpin the move higher in Treasury yields, despite comments from Fed Chair Janet Yellen stating that she would like to see more ‘decisive evidence’ of growth before raising rates at the June FOMC meeting. The labor market has continued to steadily improve, and there are signs that wages are beginning to rise. Consumer spending has rebounded, and the housing sector remains robust. The yield curve bear steepened, with the longest-dated bonds moving back above 3%.

In Europe, the major focus was on the escalation of the Greek crisis. The quarter ended in uncertainty, with Greece missing its USD 1.7 bn International Monetary Fund (IMF) payment deadline, imposing capital controls and closing banks ahead of a referendum on July 5. Although peripheral Eurozone bond markets underperformed, against this backdrop, markets were far less volatile than many had feared. Investors continue to expect a forceful response from the ECB, including outright asset purchases, should meaningful contagion spread to peripheral bond markets. Investors appear to have greater confidence in the European institutional response to a potential crisis. This has been led by the creation of the European Stability Mechanism (ESM), the ECB’s OMT (outright monetary transactions) and QE programs, as well as the progress made in banking reform toward a European Banking Union. Economic data on the quarter surprised to the upside, albeit from a low base.

In the UK, growth has remained robust, driven by strength in household spending and business investment. Falling unemployment and growth in average earnings suggest that a strengthening labor market will continue to support a buoyant consumer sector. A surprisingly decisive election victory for the Conservative Party, led by incumbent Prime Minister David Cameron, and a positive tone to the Monetary Policy Committee saw the British pound outperform other G10 currencies. The UK remains one of the few countries positioned alongside the US as likely to see a move higher in interest rates in the near future.

In contrast, Australia and New Zealand continue to feel the external headwinds from falling commodity prices and the slowdown in China. In Australia, the process of rebalancing growth as mining investment falls is requiring additional

Our dynamic investment process combines top-down and bottom-up factors to exploit diversified sources of alpha, which we believe is key to delivering consistent performance over time. Our global fixed income capability is defined by a rigorous investment process supported by a global research organization, local presence and strong risk management capabilities. Emphasis is placed on sector analysis and security selection and, to a lesser extent, duration and yield curve strategy.

Global Fixed Income

by Simon Foster

31

monetary stimulus, leading the Reserve Bank of Australia to cut interest rates by 25 bps to 2% in May. In New Zealand, the post-earthquake reconstruction boom has helped drive strong jobs growth and has supported a 3% GDP growth rate. Despite this, the Reserve Bank of New Zealand (RBNZ) has been driven to an about-turn in policy and delivered a surprise 25 bps interest rate cut, taking the cash rate to 3.3%. Falling oil prices and the high level of the New Zealand dollar have resulted in a sharp fall in imported goods prices, at the same time as high rates of inward migration have meant that labor supply has been strong, which has suppressed wage growth and held down domestically produced inflation. As a result, year-over-year CPI inflation has fallen to just 0.1%, and with it the RBNZ has shifted to an easing cycle.

We expect to see continued near-term monetary policy accom-modation in developed markets in order to support growth and prevent the risk of deflation, the latter exacerbated by the sharp fall in energy prices. The moderate growth and low inflation environment remains supportive of fixed income, and we continue to favor markets in which central banks are in the process of easing monetary policy or have potential to do so later this year—for instance, Europe, New Zealand and Australia. The European Central Bank’s quantitative easing program signifies that peripheral European countries such as Spain and Italy should ultimately be much more resilient to contagion stemming from any further escalation of the Greek crisis. Given ongoing supportive monetary policy, we see the risk/reward for selective carry-oriented investment remaining favorable. In addition to holdings in agencies, supranationals and invest-ment grade corporates, we see opportunities in high yield, and in select emerging market sovereign and corporate bonds.

Note: Exhibits show the active weighted-duration deviation of (1) Global Sovereign Composite relative to JP Morgan Government Bond Index, and (2) the Global Aggregate Composite relative to Barclays Global Aggregate Bond Index.

Source: JP Morgan, Barclays, UBS Global Asset Management. Data as of June 30, 2015.

Current strategy: Global Bond

-0.8 -0.4 0 0.4 0.8

Country (1)

Australia

Canada

Switzerland

Denmark

Eurozone

UK

Japan

Norway

New Zealand

Sweden

US

Total

Sector (2)

Financial Institutions

Industrials

Utility

Government-related

High Yield

Securitized

Treasuries

Total

Weighted-duration deviation in years

0.19

-0.01

0.00

-0.01

0.14

-0.12

-0.50

0.00

0.18

-0.01

-0.09

-0.22

0.18

0.30

0.19

-0.53

0.20

-0.04

-0.27

0.03


For the first time in nearly two years, traditional US investment grade fixed income, as measured by the Barclays US Aggregate Bond Index, generated negative quarterly total returns (-1.7%). US Treasury rates rose and the yield curve steepened during the second quarter, with two-year, 10-year and 30-year Treasury yields rising 8 bps, 40 bps, and 56 bps to 0.6%, 2.3% and 3.1%, respectively. Several factors led to the increase in yields across the curve, most notably, a growing expectation by the market that the Fed is drawing closer to its first rate hike, fueled both by improving data in the second quarter and more hawkish forecasts by the Fed at its June meeting. Corporates underperformed all other investment grade sectors in the second quarter, returning -2.9%, with lower-quality corporates (BBB: -3.5%) underper-forming higher-quality corporates (A: -3.0%). Investment grade corporates suffered primarily from rising rates, wider spreads and a wave of new issuance over the quarter.

On the back of rising rates and wider spreads, we moderately reduced both interest rate risk and credit risk throughout the second quarter. Specifically, we gradually shifted our duration from underweight to near-neutral by quarter-end, while maintaining a curve-flattening bias (i.e., underweight the shorter-maturity portion of the yield curve versus overweight the intermediate-maturity portion). While our belief remains that the Fed may begin rate hikes in the second half of 2015, we felt it prudent to tactically reduce our short-duration position given the sharp spike in yields throughout the quarter. We remain significantly underweight Treasuries, but have added to our tactical overweight to TIPS on the belief that energy prices may rebound in the second half of 2015 on the back of a stronger US economy, while the base effects of low inflation over the last 12 months may begin to roll off. We ended the quarter overweight secured credit (e.g., MBS, CMBS) and underweight unsecured credit (e.g., investment grade corporates). Within corporates, we ended the quarter overweight industries that we believe may benefit from a resumption in the US economic recovery, such as energy,

transportation, and consumer cyclicals. Finally, we maintained our general bias to be long the US dollar, given the continued capital flow to the US, along with our expectation for Fed hikes this year, versus short the European euro and Japanese yen, which may continue to depreciate in the face of aggressive quantitative easing programs in both regions.

After cold weather and various port closures adversely impacted GDP growth in the US in the first quarter, we believe stronger domestic demand growth is poised to follow in the quarters ahead. We believe that households may start spending rather than saving their “oil dividend,” while business investment and residential investment should resume following what has become the annual first quarter “soft patch.” Underlying inflation pressures should increase in the second half of the year, given our expectation for a rebound in energy prices, an uptick in wages and resumption in home price and rent appreciation. We believe the Fed is likely to make its first rate hike during the second half of the year, but the frequency and magnitude of its hikes are expected to be gradual and moderate—“early and slow” rather than “later and fast.”

Our dynamic investment process combines top-down and bottom-up factors to exploit diversified sources of alpha, which we believe is key to delivering consistent performance over time. Top-down factors, including duration, yield curve and sector positioning, allow us to define our strategy and establish a quantitative framework. In order to construct the optimal strategy, portfolio managers work in close collaboration with research analysts to develop investment themes and select securities.

US Fixed Income

Current strategy: US Bond

1 Relative to the Barclays US Aggregate Index. 2 Weighted Duration Deviation (WDD) = Strategy CTD – Benchmark CTD.

Source: Barclays, UBS Global Asset Management. Data as of June 30, 2015.

-4 -2 0 2 4

ABS

TIPS

MBS

Cash

CMBS

Agency

Government-related

Treasury

Corporate

Market value % deviation1 WDD in years2

-0.4 0 0.4

0.1

0.2

0.3

0.0

0.1

-0.1

-0.1

-0.4

-0.1

3.9

3.1

2.4

1.1

1.0

-2.5

-2.6

-3.1

-3.3

by Danielle Cassidy

33

The US municipal bond market, as measured by the Barclays Municipal Bond Index, ended the second quarter of 2015 down 89 basis points (bps). With the drop following a positive first quarter, the market is now slightly up year-to-date (11 bps). For the quarter, yields were higher across the municipal curve and most pronounced on the longer end, where they were up by almost 50 bps. The four-year area was least affected with only seven bps of movement. After flattening by more than 125 bps in 2014, the yield curve has become steeper. Year-to-date, the difference between one- and 30-year matur-ities is almost 300 bps versus 270 bps at the end of 2014.

Refundings (which fueled an uptick in supply earlier this year, due to the lower yield environment) have slowed, resulting in less supply entering the market; however, demand for municipal fixed income has been slowing based on mutual fund flows. On a seasonal basis, municipals tend to become cheaper during tax time as withdrawals to pay taxes occur. Demand tends to increase in June and July, as there are more maturities, calls and coupon payments during that time.

The municipal market continues to show resiliency in credit. Upgrades have increased over downgrades for all three major credit agencies, as we would expect at this stage in the economic cycle. At the state level, California, Florida and Texas are examples of good fiscal decision-making to improve budgets. In fact, Standard and Poor’s has upgraded California to AA– from A+, citing the recently passed budget that funds the rainy-day fund and pays down past deficit loans. Connecticut, Illinois, New Jersey and Pennsylvania are examples of states that have failed to take advantage of budgetary measures. We maintain an underweight to these states, as well as to the city of Chicago.

The strategy seeks to capitalize on the municipal bond market’s inefficiencies by analyzing relative valuations, credit quality and bond structures through a disciplined, top-down investment process. Relative valuations are combined with fundamental in-depth quantita-tive, credit market and economic research. Specifically, duration/yield curve positioning, sector allocation and security selection are distinct steps in the investment process, with the goal to reduce risk through diversification.

US Municipal Fixed Income

Changes in municipal yield curve by maturity over one quarter ended June 30, 2015

Benchmark: Barclays US Municipal Bond Index.

Source: Thomson Reuters. Data as of June 30, 2015.

Funding ratio return (%)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5% 3-31-15

6-30-15

302520151051Maturity (years)

6-30-2015 3-31-2015

by Dawn Zerillo


US economic data for the quarter were generally stronger, notably for the labor market and housing, offsetting more mixed manufacturing data. Labor market reports showed stronger average earnings growth, and employment growth was strong, but offset by a rise in the participation rate. Housing starts increased substantially, rising to the upward-trend level that prevailed before the bad weather in the first quarter. Benefiting from strong personal consumption, US first quarter GDP was revised up in the final release, although economic growth still struggled in negative territory at -0.2% (quarterly, annualized).

Spreads tightened by approximately 35 basis points (bps) during April and May despite volatility in underlying US Treasury yields during this period. Spreads then widened by approxi-mately 50 bps in June as spillover from the increasingly acrimonious Greek debt negotiations impacted investor risk appetite. Much of this spread widening occurred in the last few days of June. During the second quarter, the US high yield market, as measured by the Bank of America Merrill Lynch US Cash Pay High Yield Constrained Index, posted a return of -0.03%. The yield on the index moved higher over this period, largely due to increased underlying US Treasury yields, ending at 6.5%, with the option-adjusted spread on the index at 483 bps, 15 bps higher for the quarter.

Single B-rated bonds outperformed CCC- and BB-rated bonds, with all but the BB-rated category providing positive returns. More than half of the industry categories posted positive returns, with energy, insurance and healthcare among the top performers, while telecom, basic industries and media were among the relative underperformers.

Through the second quarter, we sought to maintain a broadly neutral stance in our portfolios from a beta, or market risk, perspective versus the benchmark, with active risk primarily driven by the bottom-up views of our credit analyst team. Our view remains that economic growth is sufficient to support the high yield market. High yield issuers are benefiting from low borrowing costs and have used much of the proceeds from new issues to extend out their debt maturity profiles. Both these factors support our outlook for defaults being well below long-run average levels. From an industry perspective, our strategies’ overweights include building materials, banks and steels, while portfolio sector underweights include retail, and metals and mining.

We are focused on capturing the high yield market’s return potential, while minimizing losses due to credit deterioration or default. Asset coverage, preservation of principal and diversification are at the forefront of our philosophy. Our disciplined process seeks to avoid taking large risks solely for the sake of a high indicated yield. In constructing the portfolio, we combine industry views with the relative value of companies, diversifying securities by issuer and industry in a risk-managed framework.

US High Yield

Current strategy: US High Yield

-2 -1 0 1 2

Building Materials

Cable TV

Div Financial Services

Healthcare

Leisure

Food/Beverage/Tobacco

Metals/Mining

Telecommunications

Homebuilders/Real Estate

Super Retail Index

Over/underweight %

2.1

1.3

1.0

0.7

0.5

-1.1

-1.1

-1.2

-1.3

-2.1

Top and bottom industry exposures.

Benchmark: BofA Merrill Lynch High Yield Cash Pay Constrained Index.


by Bernard Hunter, ACA

35

During the second quarter of 2015, US dollar-denominated emerging markets debt posted a return of -0.3%, as measured by the JP Morgan EMBI Global Index. Sovereign debt spreads slightly declined by around 20 bps reaching 391 bps at quarter-end. However, this overall move masked the period’s higher volatility. While the positive mood in April, which saw a strong return and significant spread widening, was still driven by an increasing oil price and declining risk aversion, a further deteriorating political situation in Russia/Ukraine, renewed concern about Greece and a more volatile oil price led to wider spreads toward the quarter’s end. Over the same period, 10-year US Treasury yields increased by nearly 40 bps, ending the quarter at 2.4%. This, finally, led to a negative overall performance, despite the positive return from spread tightening.

The best-performing country was Ukraine, ignoring that a debt restructuring is underway. Expectations of a more investor- friendly debt swap drove bond prices up. However, the deteriorating political situation is not supportive for the already collapsing economy. In addition, oil-exporting countries like Venezuela, Russia, Kazakhstan and Ecuador profited from a stabilizing oil price.

Local market investments (measured in USD) provided a negative return for the quarter. Although local yields followed US Treasuries upward, they posted only a minor negative return. Currencies depreciated versus USD and detracted around 70 bps. Russia’s local debt added significantly at around 7% in RUB terms. In addition, the RUB halted its long-term decline and added another nearly 4.6% versus USD. For the quarter, Russia local debt far outperformed the overall market and added around 11.6%, followed by Brazil and Nigeria, which profited from stabilizing oil revenues and declining yields. At the negative end, oil-importing countries in general detracted.

In our strategy in emerging markets sovereign debt, we have maintained a minor underweight to interest rate duration

and have kept the spread exposure stable at slightly above- benchmark levels during most of the period. Local debt exposure is marginally above-benchmark duration levels due to the still slightly higher duration in Brazil. We kept the overall currency exposure neutral in risk terms. At quarter-end, the strategy’s overall risk exposure was around 116%, and nearly 50% of the strategy was invested in local currencies.

While global growth is recovering slowly, and emerging economies are still lagging, we feel that growth could be bolstered by increasing exports. A stable oil price and higher demand for commodities could be a first indication for improving growth in emerging economies. In addition, the recent depreciation in emerging market currencies should make products from developing countries more attractive on a relative basis. This could also be supportive for emerging market countries as long as their central banks keep interest rates on hold. In our view, as inflation is benign, we do not expect policy tightening in the near term.

However, we recognize that some emerging markets countries still exhibit a low level of economic activity, and further downward revisions to growth cannot be ruled out. In addition, we believe that political uncertainty and high dependency on commodity prices will keep volatility high for the time being and will impact investors’ confidence. That being said, current spread levels, together with an improving fundamental outlook, are positive for the emerging markets debt asset class.

Discrepancies sometimes occur between securities’ market prices and their fundamental values. In the case of emerging markets debt, price volatility exceeds that of the underlying macroeconomic fundamentals. We seek to take advantage of these discrepancies by using a disciplined approach to estimate fundamental value from the perspective of a long-term investor. Our strategy reflects our view of the relative attractiveness of the overall asset class, individual countries and specific debt securities.

Emerging Makets Debt

Current strategy: Emerging markets debt

Strategy Index Relative

US interest rate duration 5.89 5.97 0.99

Spread duration 5.71 5.93 0.96

Yield to maturity 7.21% 6.38% 1.13

USD exposure 50.70% 50.00% 1.00

Index: 50% JP Morgan EMBI Global; 50% JP Morgan GBI-EM Global Diversified (in USD).


by Uta Fehm, DVFA, CEFA


For further information, please contact us at one of our worldwide offices.

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UBS Global Asset Management Pension Fund Fitness TrackerFunding ratio Funding ratios measure a pension fund’s ability to meet future payout obligations to plan participants. The main factors impacting the funding ratio of a typical US defined benefit plan are equity market returns, which grow (or shrink) the asset pool from which plan participants’ benefits are paid, and liability returns, which move inversely to interest rates.

Liability indices: MethodologyPension Protection Act (PPA) liability returns are approximated by the Barclays US Long Credit A–AAA Index. This index broadly reflects the duration and credit characteristics of the PPA discount curve that is used to discount expected pension benefit payments for US defined benefit pension plans.

Asset index: MethodologyUBS Global Asset Management approximates the return for the ”typical” US defined benefit plan using the reported asset allocation of the UBS Global Asset Management Pension 500 Database. The series is constructed using the aggregate asset allocation weight-ings and publicly available benchmark information, with geometrically linked monthly total returns. The aggregate asset allocation includes equities, fixed income, hedge funds, private equity, real estate and cash.

Pension Fund Fitness Tracker: MethodologyThe US Pension Funds Fitness Tracker is the ratio of the asset index over the liability index. Assuming all other factors remain constant, it combines asset and liability returns and measures the impact of a “typical” investment strategy on the funding ratio of a model defined benefit plan in the US due to interest rollup, change in interest rates and typical asset performance, but excludes unique plan factors, such as contributions and benefit payments.

The UBS Global Asset Management Pension 500 DatabaseThe UBS Global Asset Management Pension 500 Database (“the Database”) is a proprietary database that is based on the analysis of 500 public companies sponsoring large defined benefit plans, and for which we have 13 years of data, as of fiscal year-end 2012. The information was extracted from the companies’ 10-K statements, and therefore represents generally accepted accounting principles (GAAP) information. The study may include figures for companies’ nonqualified and foreign plans, both of which are not subject to ERISA. The aggregate asset allocation is based on an equally weighted average of the 500 companies included in the database. The aggregate asset allocation includes equities, fixed income, hedge funds, private equity, real estate and cash.

Additional disclosuresThe views expressed are as of June 30, 2015, and are a general guide to the views of UBS Global Asset Management. This document does not replace portfolio and fund-specific materials. Commentary is at a macro or strategy level and is not with reference to any registered or other mutual fund.

This document is intended for limited distribution to the clients and associates of UBS Global Asset Management. Use or distribution by any other person is prohibited. Copying any part of this publication without the written permission of UBS Global Asset Management is prohibited. Care has been taken to ensure the accuracy of its content, but no responsibility is accepted for any errors or omissions herein.

Please note that past performance is not a guide to the future. Potential for profit is accompanied by the possibility of loss. The value of investments and the income from them may go down as well as up and investors may not get back the original amount invested.

This document is a marketing communication. Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdiction designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

The information contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund. The information and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and in good faith. All such information and opinions are subject to change without notice.

A number of the comments in this document are based on current expectations and are considered “forward-looking statements.” Actual future results, however, may prove to be different from expectations. The opinions expressed are a reflection of UBS Global Asset Management’s best judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class or market generally, nor are they intended to predict the future performance of any UBS Global Asset Management account, portfolio or fund.

Currency risk: Securities denominated in foreign currencies may be affected by changes in rates of exchange between those currencies and the US dollar. Currency exchange rates may be volatile and may be affected by, among other factors, the general economic conditions of a country, the actions of the US and foreign governments or central banks, the imposition of currency controls and speculation. A decline in the value of a foreign currency against the US dollar reduces the value in US dollars of investments denomi-nated in that foreign currency. Currency risk may also entail some degree of liquidity risk, particularly in emerging market currencies.

Real estate securities risk: Real estate values may be affected by a variety of factors, including: local, national or global economic conditions; changes in zoning or other property-related laws; environmental regulations; interest rates; tax and insurance considerations; overbuilding; property taxes and operating expenses; or declining values in a neighborhood.

Commodities risk: Returns on commodities can be very volatile, and are subject to sudden price collapses. In addition, experience has shown that commodities may post negative performance for several years at a time. Investing directly in a commodity future is very risky and requires solid financial market expertise.

Services to US clients for any strategy herein are provided by UBS Global Asset Management (Americas) Inc. (“Americas”). Americas is registered as an investment adviser with the US Securities and Exchange Commission (“SEC”) under the Investment Advisers Act of 1940.

Hedge funds risksHedge fund investing entails substantial risks which may place your capital at risk. An investment in a hedge fund includes the risks inherent in an investment in securities, as well as specific risks associated with limited liquidity, the use of leverage, short sales, options, futures, derivative instruments, investments in non-US securities and illiquid investments. Hedge funds may invest largely in other unregulated hedge funds. Such a portfolio of hedge funds may increase an investor’s volatility for potential losses or gains. In general, hedge funds may have minimum required investments in excess of USD 250,000, may not offer investors the ability to liquidate shares on a daily basis, and may have management fees ranging from 1%–2% of total assets, plus a positive performance fee of 20%, and are not subject to SEC registration and reporting requirements.

QIS/3Q15

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UBS Global Asset Management (Americas) Inc.UBS TowerOne North Wacker DriveChicago, Illinois 60606 312-525 7100 [email protected]

©UBS 2015. All rights reserved.C15-0356 8/15www.ubs.com/globalam-us

UBS Global Asset Management (Americas) Inc. is a subsidiary of UBS AG.

What sets UBS Global Asset Management apartWe have a global perspectiveBecause capital markets are global and interrelated, even investing in securities from a single country requires a broad and comprehensive understanding of companies, industries, economies and markets around the world. At UBS Global Asset Management, we take a global view of everything we do.

We stand ready for the challenges aheadWe are currently in one of the most challenging periods on record for both investors and investment managers alike. Now more than ever, you need to set your investment strategy and select your invest-ment managers with extreme care. We offer you the opportunity to work with an experienced firm that is robust in a sometimes uncertain world and is responsive to your evolving requirements.

We are a leading institutional asset managerUBS Global Asset Management, a business division of UBS, is a large-scale asset manager, with USD 695 billion under management worldwide.1 Our financial strength, the stability of our organization and the talent of our people provide us with the depth of resources to craft intelligent investment solutions that can help our clients preserve and build their wealth.

1As of June 30, 2015. UBS Global Asset Management (Americas) Inc. is a memberof UBS Global Asset Management, and has USD 150 billion in assets undermanagement as of June 30, 2015.

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